2

INDEX
FUNDAMENTALS OF ECONOMY _______________________________________________________________________________ 3
DEMAND & PRICE ELASTICITY, SUPPLY & PRODUCER EQUILIBRIUM, MARKET DYNAMICS ______19
NATIONAL INCOME, NEW METHOD OF GDP ESTIMATION ______________________________________________28
INFLATION _______________________________________________________________________________________________________49
MONETARY POLICY_____________________________________________________________________________________________ 67
BANKING _________________________________________________________________________________________________________86
REFORMS IN BANKING AND FINANCIAL SECTOR _______________________________________________________ 109
BUDGET-EVOLUTION, TYPES, WEAKNESS, REFORMS, GOVERNMENT BUDGETING ______________ 134
TAX, TYPES OF TAX, GST AND OTHER IMPORTANT TAX, TAX REFORM ____________________________ 165
FISCAL POLICY, DEFICIT, FISCAL REFORMS ______________________________________________________________ 191

Self Notes
 3

FUNDAMENTALS OF ECONOMY
1. Fundamentals of Economics 4
1.1 Defining Economics 4
1.2 Economics: Its Subject- Matter 4
1.3 Branches of economics 4
2. Micro and Macro Economics 6
2.1 Difference between Micro Economics and Macro Economics 6
2.2 Basic Concepts in Microeconomics 6
2.3 Basic Concepts in Macroeconomics 14
3. What is an Economy? 14
3.1 Sectors & Types of Economies 14
4. Economic Systems 16
4.1 Capitalist Economy 16
4.2 Socialistic Economy 17
4.3 Mixed Economy 18

Self Notes
 4

1. Fundamentals of Economics
1.1 Defining Economics
● The term or word ‘Economics’ comes from the Ancient Greek oikonomikos (oikos means “households”; and, Nemein
means “management”, “custom” or “law”). Thus, the term ‘Economics’ means ‘management of households’.
○ The subject was earlier known as ‘Political Economy’, renamed as ‘Economics’, in the late 19th century
by Alfred Marshall.
● Economics is a science which studies human behavior as a relationship between ends and scarce means which have
alternative uses.
● Firstly, economics as a subject deals with human behaviour.
○ A critic can say that a study of human behaviour is not a prerogative of economics only. There are other social
sciences, like sociology, psychology, political science etc., which also deal with human behaviour.
○ Like economics these subjects also deal with the behaviour of people in their individual as well as.
● Economics, however, deals with the behaviour of people in the pursuit of economic activities.
● Economics is the study of how societies generate valuable goods and distribute them among a variety of individuals.
○ Economics is the study of how decisions are made by people, businesses, governments, and other social
institutions, and how they affect how a society uses its resources.
○ The most common definition, which is both snappy and brief, is that "economics is the study of how society
uses its scarce resources."

What are Economic Activities?

● To put it simply, economic activities include any activity that involves money. And whenever money is involved, there
is an economic motive/gain—there are various examples: getting a job, giving a job, purchasing and selling something,
starting a business, and so forth.

1.2 Economics: Its Subject- Matter

● Economics focuses on the behaviour and interactions among economic agents, individuals and groups belonging to an
economic system.
○ It deals with the activities such as the consumption and production of goods and services and the distribution
of income among the factors of production.
● The activities of the rational human beings in the ordinary business of life under the existing social, legal and institutional
arrangement are included in the Science of Economics; the abnormal persons and the socially unacceptable and
unethical activities are excluded.
● Economics studies the ways in which people use the available resources to satisfy their multiplicity of wants.
● Scarcity is a problem indicating the gap between what people want and what they are able to get.
○ This scarcity can be eliminated either by limiting the human wants or by increasing the supply of the goods that
satisfy the human wants. The method of getting more is resorted to, rather than the method of wanting less.
● Economics is concerned with the activities of human beings only. Human beings are related to one another and the
actions of one member affect those of the other members in the society. Hence, Economics is called a Human Science
or Social Science.
● The activities of rational or normal human beings are the subject-matter of Economics.
○ All human activities related to wealth constitute the subject-matter of Economics. Thus, human activities
not related to wealth (non-economic activities) are not treated in Economics. For example, playing cricket for
pleasure, mother’s child care.

1.3 Branches of economics

1.3.1 Classical economics
● Classical economics is often considered the foundation of modern economics. It was developed by Adam Smith, David
Ricardo, Jean-Baptiste Say.
● Classical economics is based on Operation of free markets. How the invisible hand and market mechanism can enable
an efficient allocation of resources.
○ It suggests that generally, economies work most efficiently when government intervention is minimal and
concerned with the protection of private property, promotion of free trade and limited government spending.
○ It recognises that a government is needed for providing public goods, such as defence, law and order and
education.

Self Notes
 5

1.3.2 Neo-classical economics

● Neo-classical economics built on the foundations of free-market based classical economics.
○ It is often considered to be orthodox economics. It is the economics taught in most text-books as the starting
point for economics teaching. The tools of neo-classical economics (supply and demand, rational choice, utility
maximisation) can be used in new fields and also for critiques.

1.3.3 Keynesian economics

● Key people: John Maynard Keynes, Paul Samuelson.
● Keynesian economics was developed in the 1930s against a backdrop of the Great Depression.
○ The existing economic orthodoxy was at a loss to explain the persistent economic depression and mass
unemployment. Keynes suggested that markets failed to clear for many reasons (e.g. paradox of thrift, negative
multiplier, low confidence).
○ Therefore, Keynes advocated government intervention to kick-start the economy.
○ Keynesian economics is credited with creating macroeconomics as a distinct study. Keynes argued that the
aggregate economy may operate in very different ways to individual markets and different rules and policies
were needed.
○ Keynes didn’t reject all elements of neo-classical economics but felt new ideas were needed for the macro-
economy – especially with the economy in recession.

1.3.4. Monetarist economics

● Key people: Milton Friedman, Anna Schwartz.
● Monetarism was partly a reaction to the dominance of Keynesian economics in the post-war period.
○ Monetarists, led by Milton Friedman, argued that Keynesian fiscal policy was much less effective than
Keynesians suggested.
○ Monetarists promoted previous classical ideals, such as belief in the efficiency of markets.
○ They also placed emphasis on the control of the money supply as a way to control inflation.
○ Monetarist economics became influential in the 1970s and 1980s, in a period of high inflation – which appeared
to illustrate the breakdown of the post-war consensus

1.3.5. Austrian economics

● Key people: Ludwig Von Mises, Carl Menger
● This is another school of economics that was critical of state intervention, price controls. It is broadly free-market.
○ However, it criticised elements of classical school – placing greater emphasis on the individual value and
actions of an individual.
○ For example, Austrian economists argue the value of a good reflects the marginal utility of the good – rather
than the labour inputs.

1.3.6 Marxist economics

● Key people: Karl Marx
● Emphasises unequal and unstable nature of capitalism. Seeks a radically different approach to basic economic
questions. Rather than relying on free-market advocate state intervention in ownership, planning and distribution of
resources.

1.3.7 Neo-liberalism/Neo-classical
● A modern interpretation of classical economics. Considerable overlap with monetarism. Essentially concerned with the
promotion of free-markets, competition, free trade, privatisation, lower government involvement, but some minimal state
intervention in public services like health and education. Few identify as ‘neo-liberal’ – sometimes used as a term of
abuse.

2. Micro and Macro Economics

● The words Micro and Macro have Greek origins Mikros and Makros.
○ Mikros implies small and Makros large.

Self Notes
 6

● Microeconomics is concerned with the most ‘Elemental’ economic units, like consumer, firm, input, market and
industry.
○ In other words, micro- economic theory analyses the behaviour of a consumer or a group of consumers; a firm,
an industry, a market; a supplier of an input etc. The unit of analysis is small.
○ Micro-economic theory focuses attention on individual markets (like the grain market), consumers (say of
wheat), firms, industries.
■ It is an in-depth study of how these individual economic units or agents operate or function or make
decisions, as well as how they interact with each other.
● In contrast to this, with macro-economic theory the unit of analysis is large.
○ Macro-economic theory deals with broad aggregates like national income, national expenditure, aggregate
consumption expenditure, aggregate investment expenditure, the level of employment, the general price level
and so on.
■ It analyzes how the economy functions through the interactions of these broad aggregates; how these
aggregative variables behave and how they are determined.
● Both micro and macroeconomics are two ways of looking at the same thing, the functioning or the working of an economy.
○ They are two starting points in analysing how an economy functions or operates.
● The distinction between micro and macro is made in terms of the level of aggregation and disaggregation used in
analyzing the functioning of an economy.
○ Microeconomics uses more disaggregative variables than macroeconomics. Together they form the two sides
of the same coin.
● However, it must be noted that economic decisions are ultimately taken at the micro level, and the conjunction of
all micro decisions have important ramifications at the macro level.
○ For instance, when we add consumers’ expenditures on all goods and services, we get the aggregate
consumption expenditure for the economy as a whole, which is a macro concept.
● Similarly, the functioning of the economy at the macro level will have bearings for decision-making at the micro level.
○ When income tax is raised, disposable income of households falls, firms will experience a decline in sales and
as a result will cut back output. Hence, a macro level event will generate a micro manifestation.

2.1 Difference between Micro Economics and Macro Economics

Micro Economics Macro Economics

● It is that branch of economics which deals with the ● It is that branch of economics which deals with
economic decision- making of individual economic aggregates and averages of the entire economy.
agents such as the producer, the consumer etc. E.g., aggregate output, national income, aggregate
savings and investment, etc.

● It takes into account small components of the whole ● It takes into consideration the economy of the country
economy. as a whole.

● It deals with the process of price determination in ● It deals with general price-levels in any economy.
case of individual products and factors of production.

● It is known as price theory. ● It is also known as the income theory.

● It is concerned with the optimization goals of ● It is concerned with the optimization of the growth
individual consumers and producers process of the entire economy.

2.2 Basic Concepts in Microeconomics

2.2.1 Factors of Production
● Factors of production are the inputs that are employed in the manufacturing process to generate the outputs
(finished goods and services).
○ The resources utilised by individuals to generate products and services are referred to as factors of
production.
● There are four major manufacturing elements.
○ They are as follows:

Self Notes
 7

i. Land— It is a physical/tangible factor of production and is a

stock concept. It consists of the total physical resources that
are available. Land not just includes ground, but also includes
the forests, water resources, soil, minerals, mines, etc.
ii. Labour—Labour is human effort that can be applied to
production. People who work to repair tires, pilot aeroplanes,
teach children, or enforce laws are all part of the economy’s
labour. People who would like to work but have not found
employment—who are unemployed—are also considered part
of the labour available to the economy.
iii. Capital — It is a tangible factor of production and refers to all
forms of machinery, buildings, transport services, etc. that are
used in the production process.
iv. Entrepreneurship—This refers to the intangible abilities of an
entrepreneur to conduct and organise the production process
for producing goods and services.
○ Every production is organized by integrating components of production
such as land, labour, physical capital, and human capital.
2.2.2 Goods and Services
● Both goods and services satisfy human wants. In Economics, the term ‘goods’ implies the term ‘services’ also,
unless specified otherwise.
● Goods (also called ‘products’, ‘commodities’, ‘things’ etc)
○ as material things, they are tangible;
○ have physical dimensions, i.e., their physical attributes can be preserved over time;
○ exist independently of their owner;
○ are owned by some persons;
○ are transferable;
○ have value-in exchange;
2.2.2.1 Kinds of Goods
● Economic and free goods
○ Economic goods are those goods which use
scarce resources in their production.
■ For example, to produce simple goods
such as a paper clip, scarce resources
are used including the material itself —
usually steel wire, the machinery that
shapes the clip, the machine
operatives, the boxes to pack the clips
in, and so on.
■ The use of scarce resources to produce
one paper clip creates a cost to the
producer, called the marginal cost.
While this would be extremely small, the
fact that the marginal cost is greater
than zero means that scarce resources
are being used, and the good is an
economic good.
○ In contrast, a free good is one that does not require scarce resources for its production, and hence has a
marginal cost of zero.
■ The classic example of free good air. Air exists as a 'gift of nature' and is a free good.
■ However, the lines between economic and free goods get blurred when we consider water, which on
the surface appears to be a free good. However, other than rainwater, water is generally processed,
purified, piped or distributed in bottles, all of which use scarce resources. In which case water is an
economic good and not a free good.
● Consumer goods and Capital goods:
○ Consumer goods directly satisfy human wants, TV, Furniture, Automobiles etc.
○ Capital-goods (also called producer’s goods) don’t directly satisfy the consumer's wants. They help to
produce consumer goods.
■ For example, machines do not directly satisfy the consumers, but in factories, the manufacturers need
them.

Self Notes
 8

● Perishable goods and Durable goods:

○ Perishable goods are short-lived. Their life-span is limited. For example, fish, fruits, flowers etc., do not have
a long life.
○ Durable goods and semi-durable goods have a little longer life-time than the Perishable goods. For example,
a table, a chair etc.
● Public vs Private Goods
○ Public Goods
■ A good available to everyone to consume, Regardless of who pays and who doesn’t.
■ Public goods are made available free of direct charge to the user.
■ cannot be priced in the market.
■ Public goods are those for the use of which no discrimination is made.
■ Non-rival in consumption and non-excludable; E.g:National defense, Law enforcement.
■ marginal cost is either zero or close to zero.
○ Private Goods
■ A good consumed by a single person or Household;
■ Private goods are financed and supplied by the market on price payment.
■ Rival in consumption and excludable; E.g:food and drink
■ In the case of private goods, the marginal cost to its user is always positive.
● Merit goods and Public Goods
○ Merit goods are the goods which are considered to be socially desirable, and which are likely to be under-
produced and under- consumed through the market mechanism.
■ Only available for certain sections of society
■ Excludable
■ Rivalrous as consumption of the good by one reduces their availability to others
■ Provided by the state sector
■ Healthcare, housing and education are some examples
○ Public goods refer to commodities or services that are made available to all members of the society, provided
free of charge through public taxation.
■ Available to all members and sections of the society
■ Non-excludable
■ Non-rivalrous since consumption of the good by one does not reduce its availability to others
■ Provided by the state sector
■ National defence, street lighting, and lighthouses are some examples

UPSC CSE Prelims 2018: If a commodity is provided free to the public by the Government, then
(a) the opportunity cost is zero.
(b) the opportunity cost is ignored.
(c) the opportunity costs are transferred from the consumers of the product to the tax-paying public.
(d) the opportunity cost is transferred from the consumers of the product to the Government.

Opportunity cost
● It is the potential benefits that are lost when an individual, business or investor chooses a substitute over another.
● As the opportunity cost definition defines it to be hidden, the costs could go unnoticed very easily.
● To make a better decision it is important for a business to understand the possible missed opportunities whenever a
business chooses one investment over another.

2.2.2.2 Kinds of Services

Along with goods, services are produced and consumed. They are generally, possess the following:
a. Intangible:
○ Intangible things are not physical objects but exist in connection to other things, for example, brand
image, goodwill etc. But today, the intangible things are converted and stored into tangible items such as
recording a music piece into a pen-drive. They are marketed as good.
b. Heterogeneous:
○ Services vary across regions or cultural backgrounds. They can be grouped on the basis of quality
standards.
○ A single type of service yields multiple experiences. For example, music, consulting physicians etc.
c. Inseparable from their makers:
○ Services are inextricably connected to their makers. For example, labor and laborer are inseparable;
and,
Self Notes
 9

d. Perishable:
○ Services cannot be stored as inventories like assets. For example, it is useless to possess a ticket for a
cricket-match once the match is over. It cannot be stored and it has no value- in-exchange.
2.2.3 Utility
● Utility’ means usefulness. In economics, utility is the want- satisfying power of a commodity or a service. It is in the
goods and services for an individual consumer at a particular time and at a particular place.
● Utility is psychological. It depends on the consumer’s mental attitude. For example, a vegetarian derives no utility
from mutton;
○ Utility is not equivalent to usefulness. For example, a smoker derives utility from a cigarette; but, his health
gets affected;
○ Utility is not the same as pleasure. A sick person derives utility from taking a medicine, but definitely, it is not
providing pleasure;
○ Utility is personal and relative. An individual obtains varied utility from one and the same good in different
situations and places;
○ Utility is the function of the intensity of human want. An individual consumer faces a tendency of diminishing
utility;
○ Utility is a subjective concept it cannot be measured objectively and it cannot be measured numerically;
○ Utility has no ethical or moral significance. For example, a cook derives utility from a knife using which he
cuts some vegetables; and, a killer wants to stab his enemy with that knife. In Economics, a commodity has
utility, if it satisfies a human want;
2.2.4 Price
● Price is the value of the goods expressed in terms of money. Price of a good is fixed by the forces of demand for
and supply of the good. Price determines what goods are to be produced and in what quantities. It also decides how the
goods are to be produced.
2.2.5 Market
● Generally, a market means a place where commodities are bought and sold.
● But, in Economics, it represents where buyers and sellers enter into an exchange of goods and services over a price.
2.2.6 Cost
● Cost refers to the expenses incurred to produce or acquire a given quantum of a good. Together with revenue, it
determines the profit gained or the loss incurred by a firm.
2.2.7 Revenue
● Revenue is income obtained from the sale of goods and services. Total Revenue (TR) represents the money
obtained from the sale of all the units of a good.
● Thus,
○ TR = P × Q
○ where TR is Total Revenue; P is the price per unit of the good; and, Q is the Total Quantity of the goods sold.
2.2.8 Income
● Income represents the amount of monetary or other returns, either earned or unearned small or big, accruing
over a period of time to an economic unit. Nominal income refers to income, expressed in terms of money. It is termed
as the money income.
○ Real income is the amount of goods that can be purchased with money as income. It is the purchasing
power of income which is based on the rate of inflation.
2.2.9 Law of Supply and Demand
● The law of supply and demand is a theory that explains the interaction between the sellers of a resource and
the buyers for that resource.The theory defines the relationship between the price of a given good or product and the
willingness of people to either buy or sell it. Generally, as price increases, people are willing to supply more.
● According to the law of demand, as prices rise, buyers demand less of an economic good.
● According to the law of supply, at higher prices, sellers will supply more of an economic good.
● These two laws interact to determine the actual market prices and volume of goods traded on a market.
● Several independent factors can influence the shape of market supply and demand, influencing both the prices and
quantities observed in markets.

Self Notes
 10

2.2.9.1 Law of Demand

● According to the law of demand, if all other factors remain constant,
the higher the price of a good, the fewer people will demand that
good. In other words, as the price rises, lower the quantity demanded.
● Buyers purchase less of a good at a higher price because as the
price of good rises, so does the opportunity cost of purchasing that
good.
● As a result, people will naturally avoid purchasing a product that
requires them to forego the consumption of something else that they
value more.
● When there is a lot of change in the quantity demanded with the
change in the price then it is called the elastic demand whereas when
there is no much change in the quantity demanded with the change in
the prices then it is called the inelastic demand.
● There are certain exceptions to the law of demand which include war,
depression, demonstration effect, Giffen paradox, speculation,
ignorance effect, and necessities of life.

Elasticity of Demand
● Elasticity of demand refers to the degree of the change in demand when there is a change in another economic
factor, such as price or income.
○ Examples of elastic goods include luxury items and certain food and beverages.
● If demand for a good or service remains unchanged even when the price changes, demand is said to be inelastic.
○ Inelastic goods, meanwhile, consist of items such as tobacco and prescription drugs.

Exceptions to Law of Demand

● There are some exceptions to the rules that govern the relationship between goods prices and demand.
● A Giffen good is one of these exceptions.
○ This is a staple food, similar to bread or rice, for which there is no viable substitute.
○ In short, when the price of a Giffen good rises, demand rises, and demand falls when the price falls.
○ The demand for these goods is increasing, which contradicts demand laws.
○ As a result, the typical response (rising prices causing a substitution effect) will not apply to Giffen goods, and
the price increase will continue to push demand.
● Veblen goods
○ These are high-quality premium goods, the demand for which increases along with its price.
○ This is caused by the exclusive nature of these products.
○ Examples include sports cars, expensive accessories (diamond rings, watches, necklaces), luxury couture
clothing, etc.
○ The exclusiveness of these goods shows people’s success and demonstrates their wealth.
○ The producers of Veblen goods focus on rich customers who can afford to buy from brands associated with
luxury, exclusiveness, and wealth.
● In other words, Giffen and Veblen goods both contradict the conventional rule of demand and generate a unique
demand curve. The curve for these goods slopes upward. Demand grows together with an increase in product price.
Giffen goods focus on low-cost products, whereas Veblen goods focus on luxury, exclusive, and premium products. This
is the major distinction between the two.

Inferior goods and Normal goods

● Normal goods experience an increase in demand when incomes increase. Normal goods are also called
necessary goods.
○ An example is organic bananas. If a consumer's income is low, they may buy regular bananas.
○ But if their incomes rise and they have a few extra dollars to spend each month, they may choose to buy
organic bananas.
○ Other examples include clothing, water, beer, and alcohol.
● In economics, the demand for inferior goods decreases as income increases or the economy improves. When
this happens, consumers will be more willing to spend on more costly substitutes. Some of the reasons behind
this shift may include quality or a change to a consumer's socio-economic status.
○ Inferior goods, which are the opposite of normal goods, are anything a consumer would demand less of if
they had a higher level of real income. They may also be associated with those who typically fall into a lower

Self Notes
 11

socio-economic class.
○ Public transportation as an example of an inferior good. When people's incomes are low, they may opt
to ride public transport. But when their incomes rise, they may stop riding the bus and, instead, take taxis or
even buy cars.

Shift in Demand Curve: Increase and Decrease

● The demand curve was drawn under the assumption that the consumer’s income, the prices of other goods and the
preferences of the consumer are given.
● Given the prices of other goods and the preferences of a consumer, if the income increases, the demand for the
good at each price changes, and hence, there is a shift in the demand curve.
○ For normal goods, the demand curve shifts
rightward and for inferior goods, the
demand curve shifts leftward.
● Given the consumer’s income and her preferences,
if the price of related good changes, the demand
for a good at each level of its price changes, and
hence, there is a shift in the demand curve.
○ If there is an increase in the price of a
substitute good, the demand curve
shifts rightward. On the other hand, if
there is an increase in the price of a
complementary good, the demand
curve shifts leftward.
● The demand curve can also shift due to a change
in the tastes and preferences of the consumer.
○ If the consumer’s preferences change in favour of a good, the demand curve for such a good shift
rightward.
○ On the other hand, the demand curve shifts leftward due to an unfavourable change in the preferences of
the consumer.
○ The demand curve for ice-creams, for example, is likely to shift rightward in the summer because the
preference for ice-creams goes up in summer.
○ Revelation of the fact that cold drinks might be injurious to health can adversely affect preferences for
cold drinks. This is likely to result in a leftward shift in the demand curve for cold drinks.

Factors that affect demand in economics

(1) The Price of the Goods or Services:
○ The most important influence on the quality demanded of any commodity is its price.
○ All commodities are competing for the limited incomes of households. The price to be paid for any commodity
enables the consumer to compare the satisfaction he gets from buying one commodity with that obtained from
buying another.
(2) Prices of Other Goods and/or Services:
○ Since all commodities are competing to be the best in every household, some commodities competing more
directly or obviously with one another than others, changes in the prices of other goods will affect the quantities
of the particular commodity purchased.
○ The direction and magnitude of the effect depend on whether these other goods are substitutes or are
complementary.
○ If the goods are substitutes, then a rise in the price of the commodity may lead to a fall in the quality of that
commodity bought while the demand for its substitutes will increase. For instance, an increase in the price of
coffee may lead to a fall in the demand for it , but the demand for tea, which is a good substitute for it,may
increase.
○ For complementary goods, a rise in the price of one may lead to a fall in the quantities demanded of both the
good and its compliment ,even though the price of the compliment is relatively cheaper. For example,if the price
of milk goes beyond the reach of customers, the demand for the tea will fall even if tea costs relatively much
cheaper.
(3) Change in Real Income:
○ The household’s incomes play a large part in determining the quality and the type of goods and services that
are purchased.
○ Normally a rise in income may lead to an increase in the quality of goods purchased, and it may lead to the
purchase of goods which were previously considered out of reach to the consumer. Consumption of luxury
goods comes into consideration when real income increases.
(4) The Tastes, Fashion and Preferences of Consumers:
Self Notes
 12

○ Tastes and fashion change from time to time. These days, advertisement has a compelling pressure and
influence on the buying habits of the population. Religious, moral and psychological factors influence the
demand pattern for certain goods.
○ When tastes change in favour of a particular commodity, quality demanded of that commodity increases; when
taste changes in favour of some other commodity the quality demanded of the first commodity falls.
(5) The Size of the Population:
○ Normally a family of eight requires more food, clothes, and so on, than a household of three persons.
Therefore, when population increases, there will be greater demand for goods and services such as food,
clothing, housing and entertainment.
(6) The Distribution of Income Among the Population:
○ The quality of goods demanded depends upon the distribution of income in the society. It is said that the lower
income group displays a high propensity to consume while the high income group saves more of it’s income.
■ Those who earn 150 a month are more likely to spend it all on the basic necessities of life than those
who earn 800 a month.
(7) Expectation of a Change in Price:
○ A rumour of possible shortages in certain goods tends to induce many customers to buy and hoard goods which
they do not normally need.
○ Such a stampede in purchasing leads to high prices. It also increases the quality of goods purchased.
(8) Weather and Climate:
○ Variations in weather and climate, or season, may affect demand for goods such as raincoats, rain boots, ice
cream and soft drinks.
(9) Government Policy:
○ The government policy over the consumption of some goods may discourage or encourage the demand for
them.

2.2.9.2 Law of Supply

● The law of supply is a microeconomic law that states that all else
being equal, as the price of a good or service rises, so will the
number of goods or services offered by suppliers, and vice
versa.
● According to the law of supply, as the price of an item rises,
suppliers will try to maximise their profits by increasing the
quantity offered for sale.
● In contrast to the law of demand, the supply relationship has an
upward slope. This means that as the price rises, so will the quantity
supplied.
● The supply curve slopes upward because suppliers can choose
how much of their goods to produce and later sell.
● However, at any given time, the supply that sellers bring to market is
fixed, and sellers simply face the decision of selling or
withholding their stock from a sale; consumer demand sets the
price, and sellers can only charge what the market will bear.
● The chart below depicts the law of supply using an upward sloping supply curve.

Shift in Supply Curve

● A supply curve is drawn to show the relationship between price and
quantity supplied of a commodity assuming all other factors are
constant. Although in reality, these factors do not always remain constant
and are bound to change at some point. This change in other factors, i.e.
factors other than the price of the commodity, causes a shift in the supply
curve.
● For example, an increase in excise duty on a commodity will raise its
cost of production which will lead to a fall in profit thus causing a
decrease in the supply of the commodity even though its market price
has not undergone any change. Such a decrease in supply cannot be
represented by the original supply curve. It will lead to a shift in the supply
curve.
● When the supply of a commodity changes due to a change in any factor
other than the own price of the commodity, it is known as a ‘change in
supply’. It is graphically represented by a shift in the supply curve.

Self Notes
 13

● Increase in Supply:
○ Increase in supply refers to a rise in the supply of a commodity
caused due to any other factor than the own price of the
commodity. In such a scenario, the supply may rise at the same
price or it may even stay the same at a lower price.
● Decrease in Supply :
○ Decrease in supply refers to a fall in the supply of a commodity
caused due to any other factor than the own price of the
commodity. In this case supply may fall at the same price or may
even remain the same at a higher price.

Factors that affect supply of goods in economics

(1) The Price of the Commodity:
○ As a general rule, more of a commodity will be supplied at a higher
price than at a lower price. A favourable price induces a greater
supply of the commodity.
(2) Prices of Other Commodities:
○ The supply of a commodity will be affected if the prices of other commodities rise. This is because the increase
in the prices of other commodities will attract and encourage more production of those commodities and less
production of the commodity whose price has fallen or has remained the same. This happens mostly to goods
which are substitutes.
(3) Changes in the Cost of Production:
○ If the producer has to pay more for his factors of Production,he will change a higher price for his final product
in order to cover his cost of production.All things being equal, a higher cost of production tends to reduce supply
while a lower cost of production tends to increase supply.
(4) A Natural Disaster or Some Other Catastrophe:
○ A plague of insects,flood, drought,fire, war or epidemic will affect the supply of commodities. In the poultry
industry, for example,an epidemic is a common occurrence. When it takes place, the supply of eggs falls despite
favourable prices.
(5) Government Policies:
○ Government policy, particularly on taxation, can affect the condition of supply. For example, a tax on poultry
farming equipment or poultry products will cause a decrease_while a subsidy given to poultry farmers, in terms
of free importation of equipment and poultry feed, will effect an increase in the supply of eggs.
(6) Entry of New Firms:
○ If there is free entry into the industry or market, it will generally result in an increase of supply. When, for
example, new poultry farmers join the industry, more eggs will be available for sale.
2.2.10 Equilibrium
● Usually, an economic variable (such as the price of a commodity) is subject to various forces trying to pull it in
different directions. When these forces are in balance, the value of the variable stops changing and it is said to be in
equilibrium.
● Equilibrium is a position from which there is no net tendency to move. Its absence is referred to as
disequilibrium.
● Consumers equilibrium occurs when they get maximum satisfaction.
● The equilibrium of producers occurs when he gets maximum profit.
● A resource is in equilibrium when it gets fully employed and gets its maximum payment.
A. Stable Equilibrium
○ Whereas static equilibrium is based on given and constant prices, quantities, income, technology,
population et cetera.
B. Particular Equilibrium and General Equilibrium
○ An equilibrium, when it pertains to a single variable, may be called particular equilibrium.
○ An equilibrium, on the other hand, when it relates to numerous variables or even the economy as a
whole, may be called general equilibrium.

2.2.11 Disequilibrium
● The condition other than equilibrium is known as disequilibrium.
○ It means when the opposite economic forces are not in the situation of equality or balance then it is known as
disequilibrium.
○ The continued functioning of the economic behaviour of individuals creates disequilibrium in the economy.
Regarding microeconomics, the situation of quantity demanded is not equal to the quantity supplied, which is
called disequilibrium.

Self Notes
 14

● In terms of macroeconomics, when the economy faces different fluctuations and policy impacts then there may be
the case of imbalance between aggregate demand and aggregate supply, investment and saving as so on. Such a state
is known as disequilibrium in macroeconomics.
● Macroeconomic, as well as macroeconomic disequilibrium, may occur because of different internal as well as external
shocks mainly caused by the ever-changing behaviour of the individuals.
2.3 Basic Concepts in Macroeconomics
2.3.1 Stock and Flow Variables
● Variables used in economic analysis are classified as stock and flow. Both stock and flow variables may increase
or decrease with time.
● Stock refers to a quantity of a commodity measured at a point of time. In macroeconomics, money supply,
unemployment level, foreign exchange reserves, capital etc are examples of stock variables.
● Flow variables are measured over a period of time. National Income, imports, exports, consumption, production,
investment etc are examples of flow variables.

3. What is an Economy?
● Economy is the application of economics. It is a still-frame representation of economic activity.
○ Each country, organisation, and family has its own economy.
● It is commonly used in the context of countries, such as the Indian economy, the US economy, the Japanese economy,
and so on.
● While economic concepts and theories stay constant, economies (of nations) exhibit diversity due to socioeconomic
diversity.
3.1 Sectors & Types of Economies
● Economic activities in a country/economy are broadly
divided into three main sectors and by their dominance
economies get their names also:

3.1.1 Primary Sector

● The economic activities which take place while
exploiting the natural resources fall under it, such as
mining, agricultural activities, oil exploration, etc.
● When the agriculture sector (one of the sub-sectors of
the primary sector) contributes a minimum half of the
national income and livelihood in a country it is called
an agrarian economy.
3.1.2 Secondary Sector
● It contains all of the economic activities under which the
raw materials extracted out of the primary sector are
processed (also called the industrial sector).
● One of its sub-sectors, manufacturing, has proved to be the largest employer across the western developed Economies.
● When the secondary sector brings in a minimum of half of the national income and employment in a country it is called
an industrial economy.
3.1.3 Tertiary Sector
● All of the economic activities where services are produced falls in this sector, such as education, healthcare, banking,
communication, etc.
● When this sector contributes a minimum of half of the national income and livelihood in a country it is called a service
economy. Later on, experts created two more sectors of the economy—quaternary and quinary. Though, they are sub-
sectors of the tertiary sector.
3.1.4 Quaternary Sector
● Known also as the ‘knowledge’ sector, the activities related to education, research and development, etc. come under
it.
● The sector plays the most important role in defining the quality of the human resources an economy has.
3.1.5 Quinary Sector
● All activities where top decisions are made fall under it. The highest level of decision-makers in governments
(inclusive of their bureaucracy) and the private corporate sector fall under it.

Self Notes
 15

● The number of people involved in this sector is very low; rather they are considered the ‘brain’ behind the socio-economic
performance of an economy.

Organised and Unorganised Sector

● Organised sector
○ Comprises enterprises where the term of employment
is regular and the job is assured.
○ Companies are registered by the government and have
to follow rules and regulations.
○ Employees in the organised sector have fixed working
hours and they are paid if they work overtime.
○ Employees in the organised sector get social security
benefits such as pension, provident fund, paid leave,
sick leave etc.
○ Workers in the organised sector are paid a fixed salary.
● Unorganised Sector
○ Comprises small units where jobs are not regular and
hence the job is not assured.
○ Companies are outside the control of the government.
They have rules and regulations, but these are not
followed.
○ Workers in the unorganised sector are paid low wages which are not regular. There is no provision of
payment if they work overtime.
○ Workers in the unorganised sector do not get benefits such as pension and provident fund. There are no
paid leaves and no leaves due to sickness.
○ Workers in the unorganised sector are not paid a fixed salary.

4. Economic Systems
● Human existence is dependent on the usage (consumption) of some items (goods and services), some of which are also
necessary for survival (such as food, water, shelter, garment, and so on).
● The first challenge for mankind was figuring out how to let people have these goods.
● This task has two components: first, these items must be made (produced), and second, they must reach
(distributed/supplied to) those in need.
● Production requires the establishment of productive assets, for which money must be invested (known as investment).
But who and why will invest?
● As a result of taking on this problem, several economic systems emerged (i.e., different ways of organizing an economy).
● We could make a large list of economic systems, but three of them are regarded as major—a quick review of which is
provided here.
4.1 Capitalist Economy
● In a Capitalist economy, most economic decision-making is done through voluntary transactions according to the
laws of supply and demand.
● A Capitalist economy gives entrepreneurs the freedom to pursue profit by creating outputs that are more valuable than
the inputs they use up, and free to fail and go out of business if they do not.
● Adam Smith is the ‘Father of Capitalism’. The capitalist economy is also termed a free economy (Laissez-faire, in Latin)
or market economy where the role of the government is minimal and the market determines the economic activities.
● The private individual has the freedom to undertake any occupation and develop any skill. The USA, West Germany,
Australia and Japan are the best examples of capitalistic economies.
○ However, they do undertake large social welfare measures to safeguard the downtrodden people from the
market forces.
4.1.1 Features of Capitalist Economy
1. Private Ownership of Property and Law of Inheritance:

Self Notes
 16

○ The basic feature of capitalism is that all resources namely, land, capital, machines, mines etc. are owned by
private individuals. The owner has the right to own, keep, sell or use these resources according to his will. The
property can be transferred to heirs after death.
2. Freedom of Choice and Enterprise:
○ Each individual is free to carry out any occupation or trade at any place and produce any commodity. Similarly,
consumers are free to buy any commodity as per their choice.
3. Profit Motive:
○ Profit is the driving force behind all economic activities in a capitalistic economy. Each individual and
organization produces only those goods which ensure high profit. Advance technology, division of labour, and
specialisation are followed. The golden rule for a producer under capitalism is ‘to maximize profit.’
4. Free Competition:
○ There is free competition in both the product and factor markets. The government or any authority cannot
prevent firms from buying or selling in the market. There is competition between buyers and sellers.
5. Price Mechanism:
○ Price mechanism is the heart of any capitalistic economy. All economic activities are regulated through price
mechanisms i.e, market forces of demand and supply.
6. Role of Government:
○ As the price mechanism regulates economic activity, the government has a limited role in a capitalistic
economy. The government provides basic services such as defence, public health, education, etc.
7. Inequalities of Income:
○ A capitalist society is divided into two classes – ‘haves’ that are those who own property and ‘have-nots’ who
do not own property and work for their living. The outcome of this situation is that the rich become richer and
poor become poorer. Here, economic inequality is increasing.

4.1.2 Merits of Capitalistic System:

1. Economic Freedom: The foremost advantage of this system is that everybody enjoys’ economic freedom as one can
spend one’s income according to one’s wishes. Producers have complete freedom to invest in any business or trade.
2. Automatic Working: Another advantage according to classical economists is an automatic system. Equilibrium points
automatically come with the forces of demand and supply.
3. Variety of Goods and Services: All the basic decisions of what to produce, how to produce and for whom to produce
are taken by producers. Every producer gives attention to consumers’ taste and preferences. Hence, there are large
variety of goods and services produced in the economy.
4. Optimum Use of Resources: All natural resources are used to their optimum level as production is undertaken with a
sole purpose: of earning profit and no scope for wastages at all.
5. Efficient Producer: There is very tough competition among entrepreneurs. They are always encouraged to produce the
best quality of products. Thus, technical development will lead to an increase in higher productivity as well as efficiency.
6. Higher Standard of Living: Varieties of goods at cheap rates make it easy to be within the; reach of poor and weaker
sections of society. This results in a rise in their standard of living.
7. Incentive to efficiency: In this system, incentives are given to the efficient workers in cash or kind. This means every
worker should get a reward according to his ability. Hence, workers will try to work more and more, therefore, total output
will also increase.
8. New Inventions: In this type of economy, there is ample scope of new invention. To get more profit every producer
takes initiative to develop new techniques in production.

4.1.3 Demerits of Capitalistic System:

1. Labour Exploitation: The main defect of capitalism is the exploitation of labour. Labourers get less wages in comparison
to their working hours. The wages less than their marginal productivity are not sufficient for their livelihood.
2. Class Struggle: A lion’s share of income and resources is controlled by the upper sections of the society, while others
remain deprived of the basic amenities of life. Thus, the entire society is divided between ‘haves and ‘have nots. Hence,
the continuous class struggle spoils the health environment of the economy.
3. Wasteful Competition: Capitalism is a wasteful competition. A lot of money is spent on advertisement and publicity for
pushing the sale of the commodity. Its burden ultimately is borne by the poor consumers in the form of increased price.
4. Threat of Overproduction: The production is made on a large scale which cannot be changed in a short period.
Therefore, under capitalism, fear of overproduction always exists. The Great Depression of the 1930s in the USA is an
example of it.
5. Economic Fluctuations: Being automatic in nature, capitalist economy always faces the problem of economic
fluctuations and unemployment. This means the state of instability and uncertainty.
6. Unbalanced Growth: All the resources are put only to those channels where there is maximum profit. Other sectors of
the economy are neglected. As there is no check on the economic system, the growth is unbalanced in nature.

Self Notes
 17

7. No Welfare Activities: In capitalism, the sole motive is maximum profit, but not the public welfare. Variety of goods are
produced according to market demand, not for any welfare activity.
8. Monopoly Practices: This economic system has been criticised on the fact that it develops monopoly activities within
the country.

4.2 Socialistic Economy

● The Father of Socialism is Karl Marx.
○ Socialism refers to a system of total planning, public ownership and state control of economic activities.
● Socialism is defined as a way of organizing a society in which major industries are owned and controlled by the
government. A Socialistic economy is also known as a ‘Planned Economy’ or ‘Command Economy’.
● In a socialistic economy, all the resources are owned and operated by the government. Public welfare is the main motive
behind all economic activities.
○ It aims at equality in the distribution of income and wealth and equal opportunity for all.
● Russia, China, Vietnam, Poland and Cuba are examples of socialist economies. But, now there are no absolutely
socialist economies.
4.2.1 Features of Socialism
1. Public Ownership of Production:
○ All resources are owned by the government. It means that all the factors of production are nationalized and
managed by the public authority.
2. Central Planning:
○ Planning is an integral part of a socialistic economy. In this system, all decisions are undertaken by the central
planning authority.
3. Maximum Social Benefit:
○ Social welfare is the guiding principle behind all economic activities. Investments are planned in such a way
that the benefits are distributed to society at large.
4. Non-existence of Competition:
○ Under the socialist economic system there is the absence of competition in the market. The state has full control
over the production and distribution of goods and services. The consumers will have a limited choice.
5. Absence of Price Mechanism:
○ The pricing system works under the control and regulation of the central planning authority.
6. Equality of Income:
○ Another essential feature of socialism is the removal and reduction of economic inequalities. Under socialism,
private property and the law of inheritance do not exist.
7. Equality of Opportunity:
○ Socialism provides equal opportunity for all through free health, education and professional training.
8. Classless Society:
○ Under socialism, there is a classless society and so no class conflicts. In a truly socialist society, everyone is
equal as far as economic status is concerned.

4.3 Mixed Economy

● In a mixed economy system both private and public sectors co-exist and work together towards economic
development.
● It is a combination of both capitalism and socialism. It tends to eliminate the evils of both capitalism and socialism.
● In these economies, resources are owned by individuals and the government. India and Brazil are examples of mixed
economies.
4.3.1 Features of Mixed Economy
1. Ownership of Property and Means of Production:
○ The means of production and properties are owned by both private and public. Public and Private have the right
to purchase, use or transfer their resources.
2. Coexistence of Public and Private Sectors:

Self Notes
 18

○ In mixed economies, both private and

public sectors coexist. Private industries
undertake activities primarily for profit.
Public sector firms are owned by the
government with a view to maximizing
social welfare.
3. Economic Planning:
○ The central planning authority prepares
the economic plans. National plans are
drawn up by the Government and both
private and public sectors abide by
them.
○ In general, all sectors of the economy function according to the objectives, priorities and targets laid down in
the plan.
4. Solution to Economic Problems:
○ The basic problems of what to produce, how to produce, for whom to produce and how to distribute are solved
through the price mechanism as well as state intervention.
5. Freedom and Control:
○ Though private firms have the freedom to own resources, produce goods and services and distribute the same,
the overall control of the economic activities rests with the government.

Self Notes
 19

DEMAND & PRICE ELASTICITY, SUPPLY & PRODUCER

EQUILIBRIUM, MARKET DYNAMICS

1. Demand 20
1.1 Determinants of Demand 20
1.2 Market Demand 21
2. Supply 22
2.1 Law of Supply 22
2.2 Determinants of Supply 22
2.3 Market Supply 22
3. Market Equilibrium 22
4. Market Mechanism 23
5. Elasticity of Demand 23
5.1 Elasticity of demand 23
5.2 Elasticity of Supply 24
6. Application of Demand and Supply 24
6.1 Law of Demand and Supply - Drawbacks 25
6.2 Law of Demand and Supply – Significance 25
7. Utility 25
7.1 Utility is of two types 25
8. Resources Allocation 26
8.1 Resource allocation by market mechanism 26
9. Types of Markets 26

Self Notes
 20

1. Demand
● Demand is the quantity of commodity which an individual is willing and able to
buy at a particular price.
Law of Demand states that quantity demanded of a commodity increases
with fall in its price and vice-versa, other things held constant. In other words,
generally, price and quantity demanded a good move in the opposite direction.
● The diagram shows the law of demand- price and quantity of bananas move in
opposite direction. As the price of bananas increases from 40 to 50, quantity
demanded of bananas decreases from 15 to 12 units
OR As the price of bananas decreases from 50 to 40, quantity demanded of bananas
increases from 12 to 15 units.
Exception to the law of Demand
● Giffen goods- A Giffen good is a good for which demand increases as the price
increases, and falls when the price decreases. A Giffen good has an upward-sloping
demand curve, which is contrary to the fundamental law of demand. A Giffen good is
typically an inferior product that does not have easily available substitutes.
● Veblen goods - Veblen goods are types of luxury goods for which the quantity demanded increases as the price
increases, an apparent contradiction of the law of demand, resulting in an upward-sloping demand curve. A higher price
may make a product desirable as a status symbol in the practices of conspicuous consumption and conspicuous leisure.
A product may be a Veblen good because it is a positional good, something few others can own.
1.1 Determinants of Demand
1.1.1. Price
The price of a product or service is the most significant determinant of demand.
As the price of a product increases, the quantity demanded decreases, and
vice versa.
1.1.2. Income of the consumer
For a normal good, there is a positive relationship between income of the
consumer and quantity demanded of the good. This is depicted in the adjacent
diagram.
For an inferior good, there is a negative relationship between income of
the consumer and quantity demanded of the good.
Impact on the demand curve of changes in income: When income
increases, demand for a normal good increases and so there is a parallel
rightward shift in the demand curve.
Similarly when income decreases, demand for normal goods decreases and so
there is a parallel leftward shift in the demand curve.

Inferior good
● An inferior good is an economic term that describes a good whose demand drops when people's incomes
rise. These goods fall out of favor as incomes and the economy improve as consumers begin buying more
costly substitutes instead.
● For example, there are two commodities in the economy -- wheat flour and jowar flour -- and consumers are
consuming both. Presently both commodities face a downward sloping graph, i.e. the higher the price the
lesser will be the demand and vice versa. If the income of consumer rises, then he would be more inclined
towards wheat flour, which is a little costly than jowar flour.

1.1.3. Prices of Related Goods

A substitute or substitute good is a product or service that a consumer sees as the same or similar to another
product. In the formal language of economics, X and Y are substitutes if the demand for X increases when the price of
Y increases.

A complement or complementary good is a good or service that is used in conjunction with another good or
service. Usually, the complementary good has little to no value when consumed alone, but when combined with
another good or service, it adds to the overall value of the offering. In the formal language of economics, X and Y are
complements if the demand for X increases when the price of Y decreases.

Self Notes
 21

Related Goods

Complementary goods- As the price of sugar decreases

demand for tea increases at all price levels. This is Complementary Substitute
indicated by the rightward shift in the demand curve from
goods Goods
D to D1 in the figure.

1.1.4. Taste and Preferences of the consumer

Demand is dependent on the tastes and preferences of the consumers as well.
With favourable change in demand, demand increases leading to a rightward shift in the demand curve from D to D1.
Unfavorable change in demand leads to a leftward shift in the demand curve.
For example, earlier, people thought chocolates were mainly for kids. But the advertising industry has changed this
concept by showing that chocolates are for everyone from kids to very older adults.

1.1.5. Change in expectations about future prices

If people expects price of a good to rise in future, they will buy and hoard the commodity, leading to a rightward shift in
the demand curve.
1.2 Market Demand
● The market demand is the sum total of all the individuals of the market. It is derived by adding together the quantity
demanded by the 2 individuals comprising the market, at
each price level. Market demand curve also depends on
an additional factor i.e. number of buyers in the market.
● From individual demand curve to market demand curve.
● Assumption: 2 individuals in the market- A, B
● Horizontal summation of individual demand curves gives
us the market demand curve of the good.
D= Da + Db
Where, D – Market demand
Da – demand of individual A
Db – demand of individual B

Self Notes
 22

2. Supply
● It is the quantity of a commodity which is offered for sale by a firm at a particular price.
2.1 Law of Supply

The diagram shows the law of supply: Price and quantity supplied move in the same direction. As the
price of the goods increases, the quantity supplied increases as well.

● States that quantity supplied of a commodity increases with increase in its price and vice-
versa, ceteris paribus.
Profit = Total Revenue – Total cost.
● Revenue is money received by a firm through sale of output. Revenue= Price x quantity. So
as prices increase, Profits go up, providing producers an incentive to increase the supply of
the good.
2.2 Determinants of Supply
2.2.1. Price
Price and quantity supplied move in the same direction. As the price of the
goods increases, the quantity supplied increases as well.
2.2.2. Cost of Production/ input prices
● Suppose the price of inputs increases (eg- coal becomes cheaper for a steel producing
unit). In this case, the supply curve shifts to the left from S to S1 as production becomes
expensive at each price level.
2.2.3. Technology
● Technological advancement leading to fall in production cost will lead to a rightward shift
in the supply curve.
2.2.4. Expectations
The expectations of producers can also affect supply. If producers expect prices to increase in the future, they may
reduce the quantity of products supplied now to take advantage of higher prices later.
2.2.5. Changes in tax
● Decline in tax rates leading to fall in production cost will lead to a rightward shift in the supply curve.

[Note: Changes in price translates into movement along the demand and supply curve.]
Changes in other parameters like income, price of related goods, tastes and preferences, expectations will lead to
shifting of the demand curve to either left or right.
Changes in other parameters like input prices, technology, expectations, and taxes will lead to shifting of the supply
curve to either left or right.]
2.3 Market Supply
Horizontal summation of individual supply curves gives us the market supply curve of the good. It is derived by adding together
the quantity supplied by the 2 individuals comprising the market, at each price
level.

3. Market Equilibrium
● Market equilibrium is a situation in which quantity demanded of a
commodity is equal to its quantity supplied.
● At equilibrium, what consumers wish to buy is just equal to what
producers plan to supply.
● At equilibrium, demand= supply

Self Notes
 23

4. Market Mechanism
● It is an automatic process through which equilibrium is determined and
maintained in a market on the basis of demand and supply.
● It is also called Price Mechanism or Invisible Hand.
● It was given name of ‘Invisible Hand’ by Adam Smith, the Father of
Economics/Modern Economics.
● In 1776, he wrote a book, “An enquiry into the nature and the causes of Wealth of
Nations”.
Explaining equilibrium with the help of a diagram
● S denotes the supply curve, D denotes the demand curve. Intersection of S and D
curve gives the market equilibrium, e. Corresponding equilibrium price is denoted
by Pe and equilibrium quantity by Qe.

5. Elasticity of Demand
● Elasticity is the proportional change in one variable corresponding to a given
proportional change in another variable.
5.1 Elasticity of demand
1. price elasticity of demand
2. Income elasticity of demand
3. Cross price elasticity of demand
5.1.1 Own price elasticity of demand
● It is the degree of responsiveness of quantity demanded of a commodity to the change in its price.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑒𝑝 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
Value of e elasticity
e = 0 Perfectly inelastic
e < 1 Relatively inelastic
e = 1 Unit elastic
e > 1 Relatively elastic
e = infinity Perfectly elastic

5.1.1.1 Determinants of elasticity (e):

a. Nature of commodity
b. Availability of substitutes
c. Habitual of something
d. Income
5.1.2 Income Elasticity of Demand
● It is the responsiveness of quantity demanded to change in income.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑎 𝑔𝑜𝑜𝑑
𝑒𝐼 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
For normal goods, eI > 0
For inferior goods, eI < 0
Engel Curve: Gives a relationship between quantity demanded and income, ceteris paribus.
Value of eI Elasticity Type of good
>0 Relatively elastic Normal good
Self Notes
 24

0 < eI < 1 Relatively inelastic Basic necessities

1 < eI < infinity Highly elastic luxuries
eI = 0 Perfectly inelastic Non inferior good
eI < 0 Relatively inelastic Inferior good

5.1.3 Cross Elasticity of Demand

● It is the responsiveness of change in demand of one commodity to change in price of related commodity.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑎 𝑔𝑜𝑜𝑑 𝑋
𝑒𝑥𝑦 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒 𝑌

Value of exy
Type of good
<0 X and Y are complements
>0 X and Y are substitutes
=0 X and Y are unrelated

5.2 Elasticity of Supply

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑋
𝑒𝑠 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑋

6. Application of Demand and Supply

Why are prices of agricultural commodities volatile?
Reason- Demand and supply of agricultural commodities are relatively inelastic but
supply is highly variable.

As can be seen from the adjoining diagram, the demand curve for the agricultural
commodities is relatively inelastic, denoted by D. Initial equilibrium is at point E with
price P and quantity Q. In the case of agricultural commodities, as supply curve shifts
from S to S1, agricultural prices decrease from P to P2 ( a larger shift than to P1 in case
of other commodities). Thus, we see that even a small increase in supply of agricultural
goods is sufficient to bring about a large decrease in prices.

Paradox of Poverty among farmers

● Adjoining diagram explains the paradox of poverty of farmers. It's rather a
paradox of plenty. Whenever there is a bumper crop leading to substantial
increase in supply of agricultural crops, shown by the rightward shift of the
supply curve from S to S1, prices fall sharply due to the inelastic nature of the
demand curve. Prices in the adjoining diagram fall from 10 to 2 and quantity
increases from 10,000 to 13,000. Lets see the effect of these changes on
revenue:
Initial revenue = 10 x 10,000 = 1 lakh
New revenue = 2 x 13,000 = 26,000
Thus, we see that the revenue to the farmer falls and so he is worse off now.
Self Notes
 25

Thus, if there is a bumper crop, the farmer suffers. And if there is crop failure, then the farmer suffers.

6.1 Law of Demand and Supply - Drawbacks

● Unemployment is caused by a lack of demand for goods.
○ During the Great Depression, factories sat idle and workers were laid off
because there was insufficient demand for those products.
● In the case of Giffen goods, when the price of a Giffen good rises, demand rises,
and demand falls when the price falls. For example, staple food, similar to bread
or rice, for which there is no viable substitute.
● The demand for these goods is increasing, which contradicts demand laws.
○ Prestigious Goods: Demand for goods of prestige like gold, demand
may not decrease even if there is rise in price. They are purchased and
consumed because of their high prices.
○ Hobbies: The law of demand is not applicable in the case of goods of
hobbies like ticket collection, and collection of historical and
archaeological materials. The things are collected even by paying more
and more price.
○ Addiction: In case of goods and addiction like alcohol, tobacco, drugs etc the demand does not decrease even
if there is an increase in price. Instead of the operation of law of demand consumers purchase more units even
if there is a rise in price.
○ Future Prices: When the price of rice rises and the seller expects the price to rise further in the future, supply
will decrease because the seller will be induced to withhold supplies in order to sell later and earn larger profits.
● Agricultural Output: The law of supply may not apply in the case of agricultural commodities because production cannot
be increased all at once in the event of a price increase.
● Subsistence Farmers: The law of supply may not apply in underdeveloped countries where agriculture is dominated
by subsistence farmers.
● Factors Other Than Price Are Not Constant: The law of supply is stated with the assumption that factors other than
the commodity's price remain constant.

6.2 Law of Demand and Supply – Significance

● The Law of Demand and Supply is critical because it assists investors, entrepreneurs, and economists in
understanding and forecasting market conditions.
○ For example, a company launching a new product may purposefully attempt to raise the price of the product
by increasing consumer demand through advertising.
○ At the same time, they may try to raise their prices even further by deliberately limiting the number of units they
sell in order to reduce supply.
○ In this scenario, supply would be reduced while demand would be increased, resulting in a higher price.
● Together with the Law of Supply, the Law of Demand helps us understand why things are priced the way they are and
to identify opportunities to buy perceived under-priced (or sell perceived overpriced) products, assets, or securities.
○ For example, a company may increase output in response to rising prices caused by a surge in demand.

7. Utility
● Utility is an economic term introduced by Daniel Bernoulli referring to the psychological satisfaction received from
consuming a good or service.

7.1 Utility is of two types

7.1.1 Marginal Utility (MU):
● It is the satisfaction derived from consumption of an additional unit of a commodity.
7.1.2 Total Utility (TU):
● It is the total satisfaction derived from consumption of given units of a commodity.

Classical economists operate under the assumption that all utilities can be measured as a hard number. To help with this
quantitative measurement of satisfaction, the designation of autil was created to represent the amount of psychological
satisfaction a specific good or service generates, for a subset of people in various situations.

Self Notes
 26

7.1.3 Law of Diminishing Marginal Utility

● It states that as a consumer consumes more and more units of a commodity, the satisfaction derived from the
consumption of every additional unit tends to diminish (as seen above from the MU column).
No. of Units (Pepsi) Total Utility (TU) in utils Marginal Utility (MU) in utils
1 10 10
2 17 7
3 21 4
4 21 0
5 11 -10

8. Resources Allocation
● Resource allocation is the distribution of finite resources to specified purposes selected from among several feasible
possibilities. However, no society has endless resources; resources are limited. Because they're limited, it is vital to
choose which commodities and services to create in order to assure efficiency.
● Decisions on how to distribute resources in a market economy are often made by millions of families and thousands of
enterprises — the exact figure will, obviously, vary according to the size of the economy.
8.1 Resource allocation by market mechanism
8.1.1 Advantages
a) Optimal Resource Allocation i.e. resources are allocated on the basis of collective wishes of society.
b) It assures efficiency in productive activities because
i) Markets operate under competitive conditions under which inefficient firms cannot survive and firms cannot
earn profits beyond reasonable limits.
ii) Economic activities are undertaken by the private sector which is motivated by self interest i.e. production is
profit induced.
8.1.2 Disadvantages/Limitations of Market Mechanism
1. Markets cannot ensure social justice i.e. reduction in poverty, unemployment and inequalities. Markets can fill the gap
between demand and supply but not the gap between need and supply.
2. Markets cannot resolve macro economic problems of the economy like long term growth, conservation of environment
(sustainable development), price stability, poverty alleviation etc. Markets cater only to short term needs of well-off
sections in relatively developed areas.
3. Markets fail to allocate resources optimally in the presence of externalities.
4. Markets operate optimally only under competitive conditions, which seldom exist without government intervention.
Markets can lead to unsustainable patterns of resource consumption and negative externalities like pollution, wastage
etc.

9. Types of Markets
● Broadly, markets are of four types:
1. Perfect Competition
2. Monopoly
3. Monopolistic or Imperfect Competition
4. Oligopoly
S. No. Type of market Number of firms Nature of product Ease of entry Control over prices
& exit

1. Perfect competition Very large Homogenous Very high No control,

E.g.: market for firms earn Therefore, firms are the
wheat normal profit price taker

2. Monopolistic/ Large Differentiated with High Firm have some control

Imperfect close substitutes.
competition E.g. Toothpaste,
soaps

3. Oligopoly Few (minimum 2) Homogenous or with Low Firms have high control
differentiated
interdependence

Self Notes
 27

E.g.: Telecom, car

manufacturers,
power, iron

4. Monopoly One firm. Unique with no close Strong Very high, firm is the price
substitutes barriers maker; Firm earns high
E.g.: Railways profit

Certain terminologies related with market:

● Cartel: It refers to an agreement among a few firms to jointly determine their output and prices of products to maximize
collective profit. Cartels are illegal in India.
● Monopsony: It is a type of market in which there are large numbers of sellers but a single buyer of a product.
● Bilateral Monopoly: It is a type of market in which there is a single buyer and a single seller of a product.
● Natural Monopoly: It is a type of market in which only a single firm can maximize economic efficiency. Here competition
is undesirable. E.g.: railways
● Consumer’s Equilibrium: It is situation in which a consumer spends his/her given income on various commodities in
such a way that provides him/her the maximum possible satisfaction.
● Producer’s Equilibrium: It is a situation in which a firm produces that level of output which maximizes its profit.

Self Notes
 28

NATIONAL INCOME, NEW METHOD OF GDP ESTIMATION

1. Important Macroeconomics concepts 29

1.1 Economic Models 29
1.2 Intermediate Goods and Final Goods 29
1.3 Domestic Territory 30
1.4 Normal Resident 30
1.5 Market Price and Factor Cost 30
2. National Income 31
2.1 Significance of National Income 31
2.2 Basic concepts of national income 31
2.3 Basic National Income Aggregates 34
3. Methods of Measuring National Income 35
3.1 Production Method or Value-added method. 35
3.2 Income Method (Factor Earning Method) 36
3.3 The Expenditure Method (Output method) 36
3.4 Difficulties in Measuring National Income 37
3.5 National Income and Welfare 38
4. Gross Domestic Product (GDP) 39
4.1 GDP calculation in India 39
4.2 Green GDP 40
4.3 Potential GDP 41
5. Economic growth 42
5.1 Economic Factors Affecting Economic Growth 42
5.2 Difference between Economic Growth and Economic Development 43
5.3 Economic inequality 44
6. Incremental Capital Output Ratio (ICOR) 45
6.1 ICOR as Economic Factor in Economic Growth 45
6.2 Limitations - Incremental Capital Output Ratio (ICOR) 45
7. Human Development 45
7.1 Human Development Index (HDI) 46
8. Sustainable development 47
8.1 The Sustainable Development Goals (SDGs), 47

Self Notes
 29

1. Important Macroeconomics concepts

1.1 Economic Models
● A model simplified representation of the real situation. Economists use models to describe economic activities, their
relationships and their behaviour.
● A model is an explanation of how the economy, or part of the economy, works. Most economic models are built with
mathematics, graphs and equations, and attempt to explain relationships between economic variables.
● The commonly used economic models are the supply-demand models and circular flow models and Smith models.

1.1.1 Circular Flow of Income

● The circular flow of income is a model of an economy showing
connections between different sectors of an economy.
● It shows flows of income, goods and services and factors of
production between economic agents such as firms, households,
governments and nations.
● The circular flow analysis is the basis of national accounts and
macroeconomics.
● There are three models of the circular flow of income, representing
the major economic systems.
1. Two Sector Model:
○ It is for a simple economy with households and
firms.

2. Three Sector Model:

○ It is for a mixed and closed economy with households, firms and government.

3. Four Sector Model:

○ It is for an open economy with households, firms, government and the rest of the world (External
sector).

1.1.2 Smith Model

● Adam Smith’s economic theory is the idea that markets tend to work best when the government leaves them alone.
● Smith argued that rational people (aka acting in their own interest) would naturally find the best way to use the nation’s
resources — He viewed government regulation as potentially detrimental to economic growth

1.2 Intermediate Goods and Final Goods

● Intermediate Goods:
○ Intermediate goods are those goods which are meant either for reprocessing or for resale. Goods used
in the production process during an accounting year are known as intermediate goods.
○ These are non-durable goods and services used by the producers such as raw materials, oil, electricity, coal,
fuel etc. and services of hired engineers and technicians etc.
Self Notes
 30

○ Goods which are purchased for resale are also treated as intermediate goods. For example, Rice, Wheat, sugar
etc. are purchased by a retailer/wholesaler.
● Final Goods:
○ Goods which are used either for final consumption by the consumers or for investment by the producers are
known as final goods.
○ These goods do not pass through the production process and are not used for resale. For example, bread,
butter, biscuits etc. are used by the consumer.

Capital vs. Consumer Goods

● Capital goods are goods used by one business to help another business produce consumer goods.
○ Capital goods include items like buildings, machinery, and tools.
● Consumer goods are used by consumers and have no future productive use.
○ Examples of consumer goods include food, appliances, clothing, and automobiles.
● The same physical good could be either a consumer or capital good, depending on if it's used by a business in the
production process, or purchased for consumption and not intended for production or profit.

1.3 Domestic Territory

● The concept of domestic territory (Economic territory) is different from the geographical or political territory of a country.
● Domestic territory of a country includes the following
1. Political frontiers of the country including its territorial waters.
2. Ships and aircraft are operated by the normal residents of the country between two or more countries, for
example, Air India’s services between different countries.
3. Fishing vessels, oil and natural gas rigs and floating platforms operated by the residents of the country in
international waters or engaged in extraction in areas where the country has exclusive rights of operation.
4. Embassies, consulates and military establishments of the country located in other countries, for example, Indian
embassies in the U.S.A., Japan etc. It excludes all embassies, consulates and military establishments of other
countries and offices of international organisations located in India.
● Thus, the domestic territory may be defined as the political frontiers of the country including its territorial
waters, ships, aircraft, fishing vessels operated by the normal residents of the country, embassies and
consulates located abroad etc.

1.4 Normal Resident

● The term normal resident is different from the term nationals (citizens).
● A normal resident is a person who ordinarily resides in a country and whose centre of economic interest also lies in that
particular country.
● Normal residents include both nationals (such as Indians living in India) and foreigners (non-nationals living in India).
○ For example, Nepalese living in India for more than one year and performing economic activities of production,
consumption and investment in India, will be treated as normal residents of India.
○ On the contrary, Indian citizens, living abroad (say in the USA) for more than one year and performing their
basic economic activities there, will be treated as normal residents of the country where they normally reside.
They will be considered non-residents of India (NRIs).

1.5 Market Price and Factor Cost

● The buyers purchase goods from the market and the price paid by them is known as the ‘market price’: The sellers pay
a part of this price as ‘indirect taxes’ to the Government.
1. Indirect taxes
○ are those taxes which are levied by the government on sales and production and also on imports of
the commodities in the form of sales tax, excise duties, customs duties etc. These taxes increase the
market price of the commodities.
2. Subsides
○ Sometimes, the Government gives financial help to the production units for selling their product at
lower prices fixed by the government.
○ Such help is given in the case of those selected commodities whose production the Government wants
to encourage.
○ If we deduct these subsidies from indirect taxes, we get net indirect taxes.
3. Net Indirect Taxes
○ It is the difference between indirect tax and subsidy.

Self Notes
 31

Net Indirect Tax = Indirect Tax - Subsidy

Value Added at Market Price - Net Indirect Tax (NIT) = Value Added at Factor Cost (FC)
Or
Value Added at MP - Indirect Tax + Subsidy = Value Added at FC

Factor cost (FC)

● There are a number of inputs that are included into a production process when producing goods and services.
● These inputs are commonly known as factors of production and include things such as land, labour, capital and
entrepreneurship.
● Producers of goods and services incur a cost for using these factors of production. These costs are ultimately added
to the price of the product.
● The factor cost refers to the cost of production that is incurred by a firm when producing goods and services.
● Examples of such production costs include the cost of renting machines, purchasing machinery and land, paying
salaries and wages, the cost of obtaining capital, and the profit margins that are added by the entrepreneur.
● The factor cost does not include the taxes that are paid to the government since taxes are not directly involved in the
production process and, therefore, are not part of the direct production cost.
● However, subsidies received are included in the factor cost as subsidies are direct inputs into the production.

Market price (MP)

● Once goods and services are produced they are sold in a marketplace at a set market price.
● The market price is the price that consumers will pay for the product when they purchase it from the sellers.
● Taxes charged by the government will be added to the factor price while subsidies provided will be reduced from the
factor price to arrive at the market price.
● Taxes are added on because taxes are costs that increase the price, and subsidies are reduced because subsidies
are already included in the factor cost, and cannot be double-counted when the market price is calculated.

2. National Income
● National income is a money measure of the incomes accruing to residents of a country as owners of the factors of
production, during a specified period of time.
● The National Sample Survey defines national income as “money measures of the net aggregates of all commodities
and services accruing to the inhabitants of a community during a specific period.”
2.1 Significance of National Income
Gross Domestic Product (GDP) and National Income are core statistics in National Accounts. They are both important economic
indicators and useful for analysing the overall economic situation of an economy.
● National Income reflects the size of an economy.
● Change in national income shows a country's economic performance i.e. it shows the trend or the speed of the economic
growth in relation to the previous year(s) also in other countries.
● To know the composition and structure of the national income in terms of various sectors and the periodical variations
in them.
● To make projections about the future development trend of the economy.
● To help the government formulate suitable development plans and policies to increase growth rates.
● To fix various development targets for different sectors of the economy on the basis of the earlier performance.
● To help businesses forecast future demand for their products.
● To make an international comparison of people’s living standards.

2.2 Basic concepts of national income

2.2.1 Gross Domestic Product (GDP)
● GDP is the total market value of final goods and services produced within the country during a year.
○ This is calculated at market prices and is known as GDP at market prices.
GDP by expenditure method at market prices = C+I+G+(X–M)
Where C – consumption goods;
I – Investment goods;
G – Government purchases;

Self Notes
 32

X – Exports; M – Imports
(X – M) is net export which can be positive or negative.

2.2.2 Net Domestic Product (NDP)

● NDP is the value of the net output of the economy during the year. Some of the country’s capital equipment wears out
or becomes outdated each year during the production process.
● Thus —
○ Net Domestic Product = GDP - Depreciation.

2.2.3 Gross National Product (GNP)

● The total value of all goods and services generated by citizens and enterprises of the country, regardless of where they
are produced, is referred to as the gross national product (GNP).
● GNP includes five types of final goods and services:
a. value of final consumer goods and services produced in a year to satisfy the immediate wants of the people
which is referred to as consumption (C);
b. gross private domestic investment in capital goods consisting of fixed capital formation, residential construction
and inventories of finished and unfinished goods which are called a gross investment (I); during the year.
c. goods and services purchased by the government which is denoted by (G); and
d. net exports of goods and services, i.e., the difference between the value of exports and imports of goods
and services, known as (X-M);
■ Net factor incomes from abroad which refer to the difference between factor incomes (wage, interest,
profits ) received from abroad by normal residents of India and factor incomes paid to the foreign
residents for factor services rendered by them in the domestic territory in India (R-P);
e. GNP at market prices means the gross value of final goods and services produced annually in a country plus
net factor income from abroad (C + I + G + (X-M) + (R-P)).
GNP at Market Prices = GDP at Market Prices + Net Factor Income from Abroad.

Q. Increase in absolute and per capita real GNP do not connote a higher level of economic development, if [2018]
(a) industrial output fails to keep pace with agricultural output.
(b) agricultural output fails to keep pace with industrial output.
(c) poverty and unemployment increase.
(d) imports grow faster than exports.
Answer: c

2.2.4 Net National Product (NNP) (at Market price)

● Net National Product refers to the value of the net output of the economy during the year. NNP is obtained by deducting
the value of depreciation, or replacement allowance of the capital assets from the GNP.
NNP = GNP – depreciation allowance.

2.2.5 NNP at Factor cost

● NNP refers to the market value of output. Whereas NNP at factor cost is the total of income payment made to factors of
production.
● Thus from the money value of NNP at market price, we deduct the amount of indirect taxes and add subsidies to arrive
at the net national income at factor cost.
NNP at factor cost = NNP at Market prices – Indirect taxes + Subsidies.

2.2.6 Personal Income

● Personal income is the total income received by the individuals of a country from all sources before payment of direct
taxes in a year.
● Personal income is never equal to the national income because the former includes the transfer payments whereas they
are not included in national income.
● Personal income is derived from national income by deducting undistributed corporate profit, and employees’
contributions to social security schemes and adding transfer payments.

Self Notes
 33

Personal Income = National Income – (Social Security Contribution and undistributed corporate profits) + Transfer
payments

2.2.7 Disposable Income

● Disposable Income is also known as Disposable personal income. It is the individual's income after the payment of
income tax. This is the amount available for households for consumption.
○ Disposable Income = Personal income – Direct Tax.
○ As the entire disposable income is not spent on consumption,
■ Disposable income = consumption + saving.

National Disposable Income

● National disposable income = Net National Product at market prices + other current transfers from the rest of the
world.
○ National disposable income gives an idea of the maximum amount of goods and services in the domestic
economy at its share at its disposal. Current transfers from the rest of the world include items such as gifts,
eight, etc.
● Private Income = Factor income from net domestic product accruing to the private sector + National Debt Interest +
Net Factor Income from abroad + Current transfers from government + other net transfers from the rest of the world

2.2.8 Per Capita Income

● The average income of a person of a country in a particular year is called Per Capita Income. Per capita income is
obtained by dividing national income by population.

2.2.9 Real Income

● Nominal income is national income expressed in terms of a general price level of a particular year; in other words, real
income is the buying power of nominal income.
● National income is the final value of goods and services produced and expressed in terms of money at current prices.
But it does not indicate the real state of the economy. The real income is derived as follows:
Real Income at = National Income at constant price current price ÷ P1 / P0
P1 – Price index during the current year; P0 – Price index during base year

2.2.10 GDP deflator

● GDP deflator is an index of price changes of goods and services included in GDP. It is a price index which is calculated
by dividing the nominal GDP in a given year by the real GDP for the same year and multiplying it by 100.

Gross Value Added (GVA)

● The contribution of a corporate subsidiary, company, or municipality to an economy, producer, sector, or region is
measured by gross value added (GVA), an economic productivity statistic.
● GVA is significant because it is used to adjust GDP, which is a major indicator of a country's overall economic health.
● It can also be used to calculate how much a product or service has helped a firm meet its fixed costs.
● It is the principal entry on the revenue side of the nation's accounting balance sheet, and it reflects the supply side
from an economic standpoint.
● GVA is the sum of a country's GDP and net of subsidies and taxes in the economy at the macro level, according to
national accounting standards.
Gross Value Added = GDP + subsidies on products - taxes on products
● Previously, India measured GVA at 'factor cost' until a new approach was implemented, with GVA at 'base prices'
becoming the key indicator of economic output.
● Production taxes will be included in GVA at basic prices, while production subsidies will be excluded.
● GVA at factor cost did not include any taxes or subsidies.
● In addition, the base year has been changed from 2004-05 to 2011-12.
● The National statistical office (NSO) publishes estimates of GVA output on a quarterly and annual basis. It contains
data on eight main types of commodities produced and services offered in the economy, as well as sectoral
classification data.

Self Notes
 34

2.3 Basic National Income Aggregates

1. Gross Domestic Product ● GDP is the market value of all final goods and services produced
at Market Prices within a domestic territory of a country measured in a year.
(GDPMP) ● All production done by the national residents or the non-residents
in a country gets included, regardless of whether that product is
owned by a local company or a foreign entity.
● Everything is valued at market prices.
● GDP = C+I+G+X−M

2. GDP at Factor Cost ● GDP at factor cost is gross domestic product at market prices,
(GDPFC) less net product taxes.
● Market prices are the prices as paid by the consumers Market
prices also include product taxes and subsidies.
● The term factor cost refers to the prices of products as received
by the producers. Thus, factor cost is equal to market prices,
minus net indirect taxes.
● GDP at factor cost measures the money value of output produced
by the firms within the domestic boundaries of a country in a year.
● GDP = GDP − NIT

3. Net Domestic Product at ● This measure allows policy-makers to estimate how much the
Market Prices (NDPMP) country has to spend just to maintain its current GDP.
● If the country is not able to replace the capital stock lost through
depreciation, then GDP will fall.
● NDP = GDP − Dep.

4. NDP at Factor Cost ● NDP at factor cost is the income earned by the factors in the form
(NDPFC) of wages, profits, rent, interest, etc., within the domestic territory
of a country.
● NDP = NDP — Net Product Taxes — Net Production Taxes

5. Gross National Product ● GNPMP is the value of all the final goods and services that are
at Market Prices produced by the normal residents of India and is measured at the
(GNPMP) market prices, in a year.
● GNP refers to all the economic output produced by a nation’s

Self Notes
 35

normal residents, whether they are located within the national

boundary or abroad.
● Everything is valued at market prices.
● GNPMP = GDPMP + NFIA

6. GNP at Factor Cost ● GNP at factor cost measures the value of output received by the
(GNPFC) factors of production belonging to a country in a year.
● GNP =GNP - Net Product Taxes - Net ProductionTaxes

7. Net National Product at ● This is a measure of how much a country can consume in a given
Market Prices (NNPMP) period of time. NNP measures output regardless of where that
production has taken place (in the domestic territory or abroad).
● NNPMP = GNPMP − Depreciation
● NNPMP = NDPMP + NFIA

8. NNP at Factor Cost ● NNP at factor cost is the sum of income earned by all factors in
(NNPFC) the production in the form of wages, profits, rent and interest, etc.,
Or belonging to a country during a year.
National Income (NI) ● • It is the National Product and is not bound by production in the
national boundaries. It is the net domestic factor income added
with the net factor income from abroad.
● NI= NNPMP — Net Product Taxes — Net Production Taxes =
NDPFC + NFIA= NNPFC

9. GVA at Market Prices ● GDP at market prices

10. GVA at basic prices ● GVAMP - Net Product Taxes

11. GVA at factor cost ● GVA at basic prices - Net Production Taxes

Q. The national income of a country for a given period is equal to the (2013)
(a) total value of goods and services produced by the nationals
(b) sum of total consumption and investment expenditure
(c) sum of personal income of all individuals
(d) money value of final goods and services produced
Answer : A

3. Methods of Measuring National Income

● During a year, all goods and services produced in the country must be recorded and converted to monetary value. As a
result, whatever is produced is either consumed or saved. Thus, the national output may be calculated at three different
levels: production, income, and expenditure. As a result, there are three ways of calculating national income.
1. Production or value-added method
2. Income method or factor earning method
3. Expenditure method

3.1 Production Method or Value-added method.

● Product method measures the output of the country. It is also called an inventory method.
● Under this method, the gross value of output from different sectors like agriculture, industry, trade and commerce, etc.,
is obtained for the entire economy during a year.
○ The value obtained is actually the GNP at market prices. Care must be taken to avoid double counting.
● The value of the final product is derived by the summation of all the values added in the productive process. To avoid
double-counting, either the value of the final output should be taken into the estimate of GNP or the sum of values added
should be taken.

Self Notes
 36

3.1.1 Challenges of using this method

● The product method is followed in underdeveloped countries, but it is less reliable because the margin of error in this
method is large.
● In India, this method is applied to agriculture, mining and manufacturing, including handicrafts.
● Double counting is to be avoided under the value-added method. Any commodity which is either raw material or
intermediate good for the final product should not be included.
○ For example, the value of cotton enters the value of yarn as cost, and the value of yarn in cloth and that of
cloth in garments. At every stage value-added only should be calculated.
● The value of output used for self-consumption should be counted while measuring national income.
● In the case of durable goods, the sale and purchase of second-hand goods (for example pre-owned cars) should not
be included.

3.2 Income Method (Factor Earning Method)

● This method approaches national income from the distribution side. Under this method, national income is calculated
by adding up all the incomes generated in the course of producing national products.
● Income received by basic factors like labour, capital, land and entrepreneurship are summed up.
● NI is estimated by adding up incomes of all the factors of production as follows:
○ wages and salaries + Rents & Royalties + Interest + Profit + Mixed income of self-employed.

3.2.1 Items not to be included

1. Transfer payments are not to be included in the estimation of national income as these payments are not received for
any services provided in the current year such as a pension, social insurance etc.
2. The receipts from the sale of second-hand goods should not be treated as part of national income as they do not
create a new flow of goods or services in the current year.
3. Windfall gains such as lotteries are also not to be included as they do not represent receipts from any current
productive activity.
4. Corporate profit tax should not be separately included as it has been already included as a part of company profit.

3.2.2 Items to be included

1. The imputed value of rent for self-occupied houses or offices is to be included.
2. Imputed value of services provided by owners of production units (family labour) is to be included.
3.3 The Expenditure Method (Output method)
● Under this method, the total expenditure incurred by the society in a particular year is added together.
● To calculate the expenditure of a society, it includes personal consumption expenditure, net domestic investment,
government expenditure on consumption as well as capital goods and net exports.
GNP = C + I + G + (X-M)
C - Private consumption expenditure
I - Private Investment Expenditure
G - Government expenditure
X-M = Net exports

3.3.1 Excluded items

● Second-hand goods: The expenditure made on second-hand goods should not be included.
● Purchase of shares and bonds: Expenditures on the purchase of old shares and bonds in the secondary market should
not be included.
● Transfer payments: Expenditures towards payments incurred by the government like old age pension should not be
included.
● Expenditure on intermediate goods: Expenditure on seeds and fertilizers by farmers, cotton and yarn by textile
industries are not to be included to avoid double counting. That is only expenditure on final products are to be included.

GDP (Expenditure) GDP (Factor Incomes) GDP (Value of Output)

● Consumption ● Income from people in jobs and ● Value added from each of the
● Government spending in self-employment (e.g. wages main economic sectors

Self Notes
 37

● Investment spending and salaries) ● These sectors are Primary,

● Change in value of stocks ● Profits of private sector Secondary, Manufacturing,
● Exports business Quaternary
● −Imports ● Rent income from the
ownership of land
● = GDP (known as aggregate
demand)

Methods used in India

Methods Sectors

1. Value Added Method Primary Sector (Agriculture & Allied Activities) Manufacturing
Activities (Under Secondary Sector)

2. Income Method Tertiary (Services) Sector

3. Expenditure Method Construction Activity

3.4 Difficulties in Measuring National Income

1. Transfer payments
○ Government makes payments in the form of pensions, unemployment allowance, subsidies, etc.
○ These are government expenditures. But they are not included in the national income. Because they are paid
without adding anything to the production processes.
2. Difficulties in assessing depreciation allowance
○ The deduction of depreciation allowances, accidental damages, repair and replacement charges from the
national income is not an easy task. It requires a high degree of judgment to assess the depreciation allowance
and other charges.
3. Unpaid services
○ A housewife renders a number of useful services like preparation of meals, serving, tailoring, mending,
washing, cleaning, bringing up children, etc.
○ She is not paid for them and her services are not directly included in national income. Such services performed
by paid servants are included in the national income.
○ The reason for the exclusion of her services from national income is that the love and affection of a
housewife in performing her domestic work cannot be measured in monetary terms.
○ Similarly, there are a number of goods and services which are difficult to be assessed in money terms for the
reason stated above, such as rendering services to their friends, painting, singing, dancing, etc.
4. Income from illegal activities
○ Income earned through illegal activities like gambling, smuggling, illicit extraction of liquor, etc., is not
included in national income.
○ Such activities have value and satisfy the wants of the people but they are not considered as productive
from the point of view of society.
5. Production for self-consumption and changing price
○ Farmers keep a large portion of food and other goods produced on the farm for self-consumption. The
problem is whether that part of the product which is not sold in the market can be included in the national income
or not.
6. Capital Gains
○ The problem also arises with regard to capital gains. Capital gains arise when a capital asset such as a
house, other property, stocks or shares, etc. is sold at a higher price than was paid for it at the time of purchase.
○ Capital gains are excluded from national income.
7. Statistical problems
○ There are statistical problems, too. Great care is required to avoid double counting.
○ Statistical data may not be perfectly reliable when they are compiled from numerous sources.
○ Skill and efficiency of the statistical staff and cooperation of people at large are also equally important in
estimating national income.

Self Notes
 38

3.5 National Income and Welfare

● National Income is considered an indicator of the economic wellbeing of a country.
○ The economic progress of countries is measured in terms of their GDP per capita and their annual growth rate.
● A country with a higher per capita income is supposed to enjoy greater economic welfare with a higher standard
of living.
● But there are at least three reasons why this may not be correct.

3.5.1 Distribution of GDP: How uniform is it

● If the GDP of the country is rising, welfare may not rise as a consequence.
● This is because the rise in GDP may be concentrated in the hands of very few individuals or firms. For the rest,
the income may in fact have fallen. In such a case the welfare of the entire country cannot be said to have increased.
Example: Suppose in the year 2000, an imaginary country had 100 individuals each earning Rs 10. Therefore the GDP of
the country was Rs. 1,000 (by income method).
In 2001, let us suppose the same country had 90 individuals earning Rs 9 each, and the rest 10 individuals earning Rs. 20
each. Suppose there had been no change in the prices of goods and services between these two periods.
The GDP of the country in the year 2001 was 90 × (Rs 9) + 10 × (Rs 20) = Rs. 810 + Rs. 200 = Rs. 1,010. Observe that
compared to 2000, the GDP of the country in 2001 was higher by Rs. 10.
But this has happened when 90 percent of people of the country have seen a drop in their real income by 10 per cent (from
Rs. 10 to Rs. 9), whereas only 10 per cent have benefited by a rise in their income by 100 per cent (from Rs. 10 to Rs. 20).
90 per cent of the people are worse off though the GDP of the country has gone up. If we relate welfare improvement in the
country to the percentage of people who are better off, then surely GDP is not a good index.

3.5.2 Non-monetary exchanges

● Many activities in an economy are not evaluated in monetary terms.
● For example, the domestic services women perform at home are not paid for. The exchanges which take place in the
informal sector without the help of money are called barter exchanges.
● In barter exchanges goods (or services) are directly exchanged against each other. But since money is not being used
here, these exchanges are not registered as part of economic activity.
● In developing countries, where many remote regions are underdeveloped, these kinds of exchanges do take place,
but they are generally not counted in the GDPs of these countries.
● This is a case of underestimation of GDP. Hence GDP calculated in the standard manner may not give us a clear
indication of the productive activity and well-being of a country.

3.5.3 Externalities
● Externalities refer to the benefits (or harms) a firm or an individual causes to another for which they are not paid (or
penalised). Externalities do not have any market in which they can be bought and sold.
● For example, let us suppose there is an oil refinery which refines crude petroleum and sells it in the market. The output
of the refinery is the amount of oil it refines.
○ We can estimate the value-added of the refinery by deducting the value of intermediate goods used by the
refinery (crude oil in this case) from the value of its output. The value-added of the refinery will be counted as
part of the GDP of the economy. But in carrying out the production the refinery may also be polluting the nearby
river.
○ This may cause harm to the people who use the water of the river. Hence their utility will fall. Pollution may also
kill fish or other organisms of the river on which fish survive. As a result, the fishermen of the river may be losing
their income and utility.
○ Such harmful effects that the refinery is inflicting on others, for which it does not have to bear any cost, are
called externalities. In this case, the GDP is not taking into account such negative externalities.
○ Therefore, if we take GDP as a measure of the welfare of the economy we shall be overestimating the actual
welfare. This was an example of a negative externality. There can be cases of positive externalities as well. In
such cases, GDP will underestimate the actual welfare of the economy.

4. Gross Domestic Product (GDP)

4.1 GDP calculation in India
● India's Central Statistic Office calculates the nation's gross domestic product (GDP).

Self Notes
 39

● India's GDP is calculated with two different methods, one based on economic activity (at factor cost), and the second on
expenditure (at market prices).
● The factor cost method assesses the performance of eight different industries.
● The expenditure-based method indicates how different areas of the economy are performing, such as trade, investments,
and personal consumption.

Gross National Happiness (GNH)

● The term Gross National Happiness was coined in 1972 during an interview by a British journalist for the Financial
Times at Bombay airport when the then king of Bhutan, Jigme Singye Wangchuck, said "Gross National Happiness
is more important than Gross National Product.
● In 2011, The UN General Assembly passed Resolution "Happiness: towards a holistic approach to development"
urging member nations to follow the example of Bhutan and measure happiness and well-being and calling happiness
a "fundamental human goal."
● The four pillars of GNH are
1. sustainable and equitable socio-economic development
2. environmental conservation
3. preservation and promotion of culture
4. good governance.
● The nine domains of GNH are psychological well-being, health, time use, education, cultural diversity and resilience,
good governance, community vitality, ecological diversity and resilience, and living standards.

Human Development Index

● In 1990 Mahbub ul Haq, a Pakistani Economist at the United Nations, introduced the Human Development Index
(HDI).
● The HDI is a composite index of life expectancy at birth, adult literacy rate and standard of living measured as a
logarithmic function of GDP, adjusted to purchasing power parity.
● India's HDI value for 2019 is 0.645 which puts it in the medium human development category. India has been
positioned at 131 out of 189 countries and territories, according to the report. India had ranked 130 in 2018 in the
index.

4.1.1 Revision in the National Income Accounting Methodology

● The government switched to a new base year of 2011-12 for national accounts in January 2015, replacing the previous
base year of 2004-05.
● The government adopted the recommendations of the United Nations System of National Accounts (USNA), which
included measuring the GVA, Net Value Added (NVA), and the use of new data sources wherever available.
● The following are the major changes incorporated in the concluded base year revision:
○ Headline growth rate is now measured by GDP at constant market prices, which is referred to as ‘GDP’, as
is the practice internationally.
■ Earlier, growth was measured in terms of growth rate in GDP at factor cost at constant prices.
○ Sector Wise estimates of gross value added (GVA) are now given at basic prices instead of factor cost.
○ The relationship between GVA at factor cost, GVA, at basic prices, and GDP (at market prices) is given
below:
GVA at factor cost = GVA at basic prices - production taxes less production subsidies
GDP = GVA at basic prices + product taxes - product subsidies
where, CE: compensation of employees; OS: operating surplus;
MI: mixed-income; and, CFC: consumption of fixed capital.

4.1.2 Old Method Vs New Method

● IIP was used to measure manufacturing and trading activity in the previous system. This accounted for changes in
volume but not in value. We use the concept of GVA – Gross Value Added – in the newer methodology to measure the
value addition done to the economy.
● In the previous system, GDP was estimated using IIP data and then updated using ASI data (Annual Survey of
Industries). ASI accounted only for those firms which were registered under the Factories Act.
○ Data from MCA 21 is used in the newer system (MCA 21 is an e-governance initiative of the Ministry of
Corporate Affairs that was launched in 2006 and allows firms/companies to electronically file their financial
results).
● Previously, farm produce was used as a proxy for calculating agricultural income. The new methodology has
broadened the scope for calculating value addition in agriculture.
Self Notes
 40

● In the previous system, very few mutual funds and NBFCs were considered when evaluating financial activity.
○ The new methodology broadens the coverage by including stockbrokers, asset management funds, pension
funds, stock exchanges, and so on.
● The previous system used trading income data from the NSSO’s 1999 establishment survey, whereas the new series
uses data from the 2011-12 survey.
● The new method is statistically more robust because it estimates more indicators such as consumption,
employment, and enterprise performance, as well as factors that are more responsive to current changes.

4.1.3 Real GDP and Nominal GDP

● The value of all goods and services used in calculating GDP at the current price is called the nominal GDP.
○ Current prices mean prices in the year of GDP calculation. If we are calculating the GDP of 2019-2020, then
calculating GDP at 2019-20 prices gives nominal GDP.
■ For instance, consider a country producing only 10 units of cloth of 10 crores each in 2019-2020.
Therefore the nominal GDP for 2019-2020 is 100 crores.
● The Value of all goods and services used in calculating GDP at the base year price is called the Real GDP. It can also
be understood as Nominal GDP adjusted for the inflation compared to the base year gives Real GDP.
○ Let us consider an example if we have to find the Real GDP of the economy in 2020-2021 with the base year
of 2019-2020.
○ Using the previous example, the price of cloth has increased to 11 crores in 2020-2021 and the country still
produces 10 units of cloth.
○ Therefore, nominal GDP in 2020-2021 is 10 units multiplied by 11 crores which gives us a nominal GDP of 110
crores.
○ The real GDP of 2020-2021 considers the 2019-2020 price of the cloth which is 10 crores, therefore for 10 units
of cloth produced the Real GDP is 100 crores.

Difference between Nominal GDP and Real GDP

Parameter Nominal GDP Real GDP

Meaning Nominal GDP is the money value of all goods and Real GDP is the money value of all
services used in calculating GDP at the current goods and services used in calculating
price GDP at the base year price

Calculation Nominal GDP includes inflation value Real GDP doesn’t include inflation value

Represented in Current Year Prices Base Year Prices

Indicates Absolute increase in value of goods in a year or Real increase in productivity or growth of
size of the economy the economy

Used to compare Inflation across different quarters in the same GDP growth for different financial years
year

Growth Analysis Its is not explicitly visible without knowing the Gives a clear indication of growth or
inflation status slowdown in the economy

4.2 Green GDP

● Green GDP is a term used generally for expressing GDP after adjusting for environmental damage.
● In other words, Green GDP is a monetization of the loss of biodiversity caused by climate change. It is calculated
by subtracting resource depletion, and environmental degradation from the traditional GDP figure. It is very helpful for
managing economies as well as resources.
● It is expected to account for the use of natural resources as well as the costs involved. It also includes medical costs
generated from factors such as air and water pollution, loss of livelihood due to environmental crises such as floods
or droughts, and other factors.

Self Notes
 41

4.3 Potential GDP

● Like GDP, potential GDP represents the market value of goods and services, but rather than capturing the current
objective state of a nation’s economic activity, potential GDP attempts to estimate the highest level of output an economy
can sustain over a period of time.
1. It assumes that an economy has achieved full employment and that aggregate demand does not exceed
aggregate supply.
2. Sustainability is the key concept here. Every economy has certain natural limits, determined by its available
labour force, technology, natural resources, and other limitations.
3. When GDP falls short of that natural limit, it means the country is failing to live up to its economic potential.
When GDP exceeds that natural limit, inflation is likely to follow. This is why potential GDP is sometimes referred
to as potential output or natural GDP.

Base Year
● When calculating a business operation or economic index, a base year is used for comparison. Thus, the base year
acts as a benchmark in the growth of a firm or an economy.
● The base year of National Accounts is set to allow for inter-year comparisons. It enables the computation of inflation-
adjusted growth estimates and offers a sense of changes in buying power.
● The base year for the most recent National Accounts series was altered from 2004-05 to 2011-12.
● The base year serves as a baseline against which national account metrics such as GDP, gross domestic savings,
and gross capital creation are measured.

Base Year - Importance

● The base year prices are also known as constant prices since they reduce all of the data to a similar baseline, the
base year price.
● The base year is a representative year that is free of unusual events such as droughts, floods, earthquakes, and so
on.
● It is a year that's very close to the one for which the national accounts statistics are being compiled.
● The base year must be updated regularly to reflect structural changes in an economy, such as a rising percentage of
services in GDP.
● The data will be more accurate if the base year can be updated more regularly.

Q.With reference to the Indian economy, consider the following statements: (2015)
(1) The rate of growth of Real Gross Domestic Product has steadily increased in the last decade.
(2) The Gross Domestic Product at market prices (in rupees) has steadily increased in the last decade.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer : A

Q. A decrease in the tax to GDP ratio of a country indicates which of the following? ( 2015)
(1) Slowing economic growth rate
(2) Less equitable distribution of national income
Select the correct answer using the code given below.
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer : A

Q. Consider the following statements : [2017]

(1) Tax revenue as a percent of GDP of India has steadily increased in the last decade.
(2) Fiscal deficit as a percent of GDP of India has steadily increased in the last decade.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Self Notes
 42

Answer: d

5. Economic growth
● Economic growth is an increase in the production of goods and services in an economy.
● Increases in capital goods, labour force, technology, and human capital can all contribute to economic growth.
● Economic growth is commonly measured in terms of the increase in the aggregate market value of additional
goods and services produced, using estimates such as GDP.

5.1 Economic Factors Affecting Economic Growth

5.1.1 Natural Resources
● Natural resources include land area and soil quality, forest wealth, a good river system, minerals and oil
resources, a favourable climate, and so on.
● The abundance of natural resources is critical for economic growth. A country lacking in natural resources may be unable
to develop rapidly.
● However, the availability of abundant natural resources is a necessary but not sufficient condition for economic growth.
● Natural resources are unutilised, underutilised, or misutilized in developing countries. One of the reasons for
their backwardness is this only.
● Countries such as Japan, Singapore, and others, on the other hand, are not endowed with abundant natural
resources, but they are among the world's developed nations.
● These countries have demonstrated a commitment to preserving available resources, putting forth their best efforts to
manage resources, and minimising wastage of resources.

5.1.2 Capital Formation

● Capital formation is the process by which a community's savings are channelled into investments in capital goods
such as plants, equipment, and machinery, which increases a country's productive capacity and worker
efficiency, ensuring a greater flow of goods and services in a country.
● The process of capital formation implies that a community does not spend its entire income on goods for current
consumption, but rather saves a portion of it and uses it to produce or acquire capital goods that significantly increase
the nation's productive capacity.

5.1.3 Technological Progress

● Technological progress primarily entails research into the use of new and improved methods of production or
the improvement of existing methods.
● Natural resources are sometimes made available as a result of technological progress. However, in general,
technological progress leads to increased productivity.
● In other words, technological advancement increases the ability to make more effective and fruitful use of natural and
other resources for increasing output.
● It is possible to obtain a greater output from a given set of resources by using improved technology, or a given output
can be obtained by using a smaller set of resources.
● Technological progress improves the ability to make better use of natural resources, for example, with the aid of power-
driven farm equipment, agricultural production has increased significantly.
● The United States, United Kingdom, France, Japan, and other advanced industrial nations have all gained industrial
strength through the application of advanced technology.
● Adoption of new production techniques, in fact, facilitates economic development.

5.1.4 Entrepreneurship
● Entrepreneurship entails the ability to identify new investment opportunities, as well as the willingness to take
risks and invest in new and growing business units.
● The majority of the world's underdeveloped countries are poor not because of a lack of capital, lack of infrastructure,
unskilled labour, or a lack of natural resources, but because of a severe lack of entrepreneurship.
● As a result, it is critical in developing countries to foster entrepreneurship by emphasising education, new research, and
scientific and technological advancements.

Self Notes
 43

5.1.5 Human Resource Development

● A good quality of population is critical in determining the level of economic growth.
● As a result, investment in human capital in the form of educational, medical, and other social schemes is highly desirable.
● Human resource development improves people's knowledge, skills, and capabilities, which increases their productivity.

5.1.6 Population Growth

● The increase in labour supply is a result of population growth, which creates a larger market for goods and
services. As a result, more labour produces more output, which a larger market absorbs.
● Output, income, and employment continue to rise as a result of this process, and economic growth improves.
● However, population growth should be expected to be normal. A galloping rise will stifle economic progress.
● Only in a sparsely populated country is population growth desirable. It is, however, unjustified in a densely populated
country like India.

5.1.7 Social Overheads

● The provision of social overheads such as schools, colleges, technical institutions, medical colleges, hospitals,
and public health facilities is another important determinant of economic growth.
● Such facilities help the working population to be healthier, more efficient, and responsible.
● Such people have the potential to propel their country's economy forward.

5.2 Difference between Economic Growth and Economic Development

● Economic growth is defined as an increase in the production of economic goods and services from one period of time to
another.
● Economic growth denotes an increase in both national income and per capita income.
○ The increase in per capita income is a better measure of Economic Growth because it reflects an improvement
in the living standards of the masses.
● Economic development is defined as a sustained improvement in society's material well-being.
○ Few indicators of economic development are qualitative indicators such as the HDI (Human Development
Index), gender-related indexes, Human Poverty Index (HPI), infant mortality, literacy rate and so on.

Economic Growth Economic Development

● Economic Growth is the positive change in the ● Economic development is the quantitative and
indicators of the economy. qualitative change in an economy

● Economic Growth refers to the increment in the ● Economic development refers to the reduction
number of goods and services produced by an and elimination of poverty, unemployment and
economy. inequality with the context of a growing
economy.

● Economic growth means an increase in real ● Economic development means an improvement

national income / national output. in the quality of life and living standards, e.g.
measures of literacy, life expectancy and health
care.

● It refers to an increase over time in a country’s ● Economic development includes the process
real output of goods and services (GNP) or real and policies by which a country improves the
output per capita income. social, economic and political well-being of its
people.

● Economic growth focuses on the production of ● Economic development focuses on the

goods and services. distribution of resources.

● Economic growth relates to a gradual ● Economic development relates to growth of

increasing in one of the components of GDP; human capital indexes and decrease in
consumption, government spending, inequality.
investment or net exports. ● It is concerned with how people are affected.

Self Notes
 44

● Economic growth is single-dimensional in ● Economic development is multidimensional in

nature as it only focuses on the income of the nature as it focuses on both income and
people. improvement of the living standards of the
people.

● Economic Growth is the precursor and ● Economic development comes after economic
prerequisite for economic development. It is the growth. It is a positive impact on economic
subset of economic development. growth.

● Indicators of economic growth are: ● Indicators of economic development are:

○ GDP ○ Human Development Index (HDI)
○ GNI ○ Human Poverty Index (HPI)
○ Per capita income ○ Gini Coefficient
○ Gender Development Index (GDI)
○ Balance of trade
○ Physical Quality of Life Index (PQLI)

● It is for a short term/short period. It is measured ● It is a continuous and long-term process.

in a certain time frame/period. Economic development does not have a
specific time period to measure.

● Economic growth only looks at the quantitative ● Economic development brings a quantitative
aspect. It brings quantitative changes to the and qualitative change in the economy.
economy.

● Economic growth is an automatic process that ● Economic development requires intervention

may or may not require intervention from the from the government as all the developmental
government policies are formed by the government

5.3 Economic inequality

● Inequality can be viewed from different perspectives, all of which are related.
● Most common metric is Income Inequality, which refers to the extent to which income is evenly distributed within a
population.
○ Other inequalities are lifetime Inequality (inequality in incomes for an individual over his or her lifetime),
Inequality of Wealth (distribution of wealth across households or individuals at a moment in time), and Inequality
of Opportunity (impact on the income of circumstances over which individuals have no control, such as family
socioeconomic status, gender, or ethnic background).

5.3.1 How is Income Inequality measured

5.3.1.1 Lorenz Curve
● A Lorenz curve is a graphical representation of the distribution of
income or wealth within a population.
● Lorenz curves graph percentiles of the population against
cumulative income or wealth of people at or below that percentile.
● Lorenz curves, along with their derivative statistics, are widely used
to measure inequality across a population.
● Because Lorenz curves are mathematical estimates based on fitting
a continuous curve to incomplete and discontinuous data, they may
be imperfect measures of true inequality.
5.3.1.2 Gini coefficient
● Gini coefficient is a typical measure of income inequality.
● The coefficient varies between 0 and 1, with 0 representing perfect
equality and 1 perfect inequality.
● Most of the analysis is centred on the concept of income inequality as captured by the Gini coefficient, which is available
for a large number of countries and relatively long periods.
● Unless specified otherwise, Gini income inequality refers to disposable income or consumption and thus already reflects
any redistribution through taxes and transfers.

Self Notes
 45

Q. Economic growth in country X will necessarily have to occur if (2013)

(a) there is technical progress in the world economy
(b) there is population growth in X
(c) there is capital formation in X
(d) the volume of trade grows in the world economy
Answer: C

6. Incremental Capital Output Ratio (ICOR)

● Incremental Capital Output Ratio (ICOR) is the additional capital required to increase one unit of output.
● The incremental capital-output ratio (ICOR) is a commonly used tool for explaining the relationship between the level of
investment made in the economy and the subsequent increase in the Gross Domestic Product (GDP).
● The additional unit of capital or investment required to produce an additional unit of output is denoted by ICOR.

6.1 ICOR as Economic Factor in Economic Growth

● The incremental capital-output ratio (ICOR) describes the relationship between the amount of investment made in
the economy and the resulting increase in GDP.
● The marginal amount of investment capital required for a country or other entity to generate the next unit of production
is measured by ICOR.
● Lower ICORs are preferred because they indicate that a country's production is more efficient.
● Some critics of ICOR have suggested that its use is limited because it favours developing countries that can increase
infrastructure and technology use over developed countries that are operating at the highest level possible.
● Any further advancements in a developed country would have to come from more expensive research and
development (R&D), whereas a developing country can improve its situation by implementing existing
technology.
● ICOR can be calculated as follows:
○ ICOR = Annual Investment / Annual Increase in GDP
● Example: Assume that Country X has an incremental capital-output ratio (ICOR) of 10. This means that a ₹ 10 capital
investment is required to generate a ₹ 1 increase in output. Furthermore, if Country X's ICOR was 12 last year, it means
that Country X has become more efficient in its capital use.

6.2 Limitations - Incremental Capital Output Ratio (ICOR)

● One of its main criticisms is its inability to adapt to the new economy, which is increasingly driven by intangible assets
such as design, branding, research and development (R&D), software, which are difficult to measure or record.
● Tangible assets, such as machinery, buildings, and computers, are more difficult to account for in investment levels
and GDP.
● On-demand options, such as software-as-a-service (SaaS), have significantly reduced the need for fixed-asset
investments.
● All of this adds up to businesses increasing their output with items that are now expensed rather than capitalised and
thus considered an investment.

7. Human Development
● During the second part of the twentieth century, global debates about the linkages between economic growth and
development arose.
○ By the early 1960s, there were growing demands to "dethrone" GDP: economic growth had evolved as the
main aim and indication of national success in many nations despite the fact that GDP was never intended to
be used as a measure of happiness.
○ In the 1970s and 1980s, development discussion proposed adopting various focuses to go beyond GDP, such
as emphasising employment, followed by redistribution with growth, and finally whether people's fundamental
needs were addressed.

Self Notes
 46

● These views paved the way for the human development approach, which focuses on increasing the richness of human
existence rather than just the richness of the economy in which people live.

● It is a strategy aimed at providing equal opportunities and choices for all individuals.
● People:
○ The human development approach focuses on enhancing people's lives rather than expecting that economic
progress would inevitably result in more possibilities for everybody. Income growth is a necessary means to an
objective rather than an end in itself.
● Opportunities:
○ Human development is about giving people more freedom and opportunities to live lives they value. In effect,
this means developing people’s abilities and giving them a chance to use them.
■ For example, educating a girl would build her skills, but it is of little use if she is denied access to jobs,
or does not have the skills for the local labour market.
○ Three foundations for human development are to live a healthy and creative life, to be knowledgeable, and
to have access to resources needed for a decent standard of living.
○ Many other aspects are important too, especially in helping to create the right conditions for human
development, such as environmental sustainability or equality between men and women.
● Choices:
○ Human development is, fundamentally, about more choice.
○ It is about providing people with opportunities, not insisting that they make use of them.
○ No one can guarantee human happiness, and the choices people make are their own concerns.
○ The process of human development should at least create an environment for people, individually and
collectively, to develop to their full potential and to have a reasonable chance of leading productive and creative
lives that they value.

7.1 Human Development Index (HDI)

● The Human Development Index (HDI) is a summary measure of average achievement in key dimensions of human
development:
○ a long and healthy life,
○ being knowledgeable and
○ having a decent standard of living.
● The HDI is the geometric mean of normalized indices for each of the three dimensions.

Self Notes
 47

○ The health dimension is assessed by life expectancy at birth,

○ The education dimension is measured by means of years of schooling for adults aged 25 years and more and
expected years of schooling for children of school entering age.
○ The standard of living dimension is measured by gross national income per capita.

● India's HDI value for 2019 is 0.645 which put it in the medium human development category. India has been positioned
at 131 out of 189 countries and territories, according to the report. India ranked 130 in 2018 in the index.

8. Sustainable development
● Sustainable development is the overarching paradigm of the United Nations. The concept of sustainable development
was described by the 1987 Brundtland Commission Report as “development that meets the needs of the present without
compromising the ability of future generations to meet their own needs.”
● There are four dimensions to sustainable development –
○ society,
○ environment,
○ culture and
○ economy
● Sustainability is a paradigm for thinking about the future in which environmental, societal and economic considerations
are balanced in the pursuit of improved quality of life.
○ For example, a prosperous society relies on a healthy environment to provide food and resources, safe drinking
water and clean air for its citizens.

8.1 The Sustainable Development Goals (SDGs),

● The Sustainable Development Goals (SDGs), also known as the Global Goals, were adopted by the United Nations in
2015 as a universal call to action to end poverty, protect the planet, and ensure that by 2030 all people enjoy peace and
prosperity.
● The 17 SDGs are integrated—they recognize that action in one area will affect outcomes in others and that development
must balance social, economic and environmental sustainability.

Self Notes
 48

● Countries have committed to prioritizing progress for those who're furthest behind. The SDGs are designed to end
poverty, hunger, AIDS, and discrimination against women and girls.

Self Notes
 49

INFLATION

1. Inflation 50
2. Types of Inflation 50
2.1 Demand-Pull Inflation 50
2.2 Cost-push inflation 51
3. Measures to Control Inflation 53
3.1 Basics of Inflation control 53
3.2 Monetary Measures 53
3.3 Fiscal Measures 55
3.4 Supply Management Measures 55
3.5 Administrative Measures 55
3.6 Other measures 55
4. Impacts of inflation 56
4.1 Positive impacts of Inflation 56
4.2 Negative impacts of inflation 56
4.3 Effects of Inflation on Different Groups of Society 57
5. Growth-Inflation Trade-Off 59
5.1 Why Economic Growth can lead to Inflation? 59
5.2 Economic growth and Low Inflation 59
5.3 Low Inflation causing long-term economic growth 59
5.4 High Inflation and Low Growth 59
6. Measurement of Inflation in India 59
6.1 Index Numbers 59
6.2 Difference between GDP and Inflation 62
6.3 Proposed Indices 63
7. Some Important Terminologies related to Inflation 63

Self Notes
 50

1. Inflation
● Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the
general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a
reduction in the purchasing power per unit of money.
● Inflation is defined as a consistent increase in the general level of prices for goods and services. It is measured
as an annual percentage increase. Another way of looking at inflation is when “too much money chasing too few
goods”.
○ This definition attributes the cause of inflation to monetary growth rate to the output/availability of goods and
services in the economy, where cash in the hand of consumers increases but the supply of commodities
remains stagnant, thereby raising the price of the commodity without any significant value addition in it.
● Let us consider we can buy 1 litre of milk for Rs. 50 at the current time. Exactly 1 year before 1 litre of milk cost us Rs.
40.
○ Here there is an increase of Rs. 10 per liter of milk or the purchasing power of Rs.40 has reduced from buying
1 litre of milk to 800 ml of milk in 1 year. =>((50-40)/40)*100=25
○ Therefore we can say that there is an inflation of 25% in milk prices compared to last year.

2. Types of Inflation
2.1 Demand-Pull Inflation
● The major cause of demand-pull inflation is a rise in aggregate
demand.
○ The increase in aggregate demand is primarily due to an
increase in government spending (Expansionary Fiscal
Policy) or an increase in household and business spending.
■ For instance, if the government is spending money
in a system with limited resources, it can result in
demand-pull inflation.
● Inflation that occurs due to expansionary monetary policy and fiscal
stimulus are examples of demand-pull inflation.
2.1.1 Causes of demand-pull inflation
● Various variables might cause an increase in aggregate demand.
Some of them are
1. Increase in Government Spending (Fiscal Stimulus):
○ This will increase the money supply in the economy and will increase the aggregate demand and in
turn cause inflation. The ways in which the government can increase its spending are:
i. Schemes like Universal Basic Income (UBI), etc
ii. Increased financial assistance under PM-KISAN
iii. Wages under the MGNREGA are increasing
2. Population Pressure:
○ Increase in population will increase the demand for goods and services. This would in turn create
inflation.
3. Increase in Net exports:
○ If the essential items are exported from the country at an accelerated rate then the demand for these
goods will increase in the economy given their poor availability. This will in turn result in inflation.
i. For instance, If Indian farmers export large quantities of foodgrains, onions, and other
items, demand will not be met, resulting in demand-pull food inflation.
ii. Depreciation of the domestic currency will make exports more competitive and increase
the money supply.
4. Monetary Stimulus:
○ When the central bank takes up monetary stimulus, the money supply in the economy is increased
causing inflation.
○ The other implications of the monetary stimulus also cause inflation by:
i. The availability of surplus money increases Household consumption.
ii. If the RBI has adopted a low-cost money policy, lower-cost credit will be available. As a
result, people's willingness to spend rises resulting in inflation.
5. Policy Decisions:
○ Policy decisions that enable accessibility of funds to the public and increased money supply will result
in increased aggregate demand.
i. Increasing Salaries: The seventh pay commission put additional money in the hands of the
public sector employees.
Self Notes
 51

ii. Private investment is on the rise which is due to liberalised FDI regulations that will, in turn,
increase the money flow in the economy.
iii. Increasing forex reserves increase the money supply in the economy due to the RBI buying
dollars.
iv. Reduction of direct tax rates: This will result in the availability of more money to the
households for spending driving the demand.
v. Deficit Financing: This acts as a fiscal stimulus where the government prints more money
to finance the budget resulting in more supply in the economy increasing the effective
demand.
Q. With reference to the Indian economy, demand-pull inflation can be caused/increased by which of the following? (UPSC
2021)
1. Expansionary policies
2. Fiscal stimulus
3. Inflation-indexing wages
4. Higher purchasing power
5. Rising interest rates
Select the correct answer using the code given below.
a) 1, 2 and 4 only
b) 3, 4 and 5 only
c) 1, 2, 3 and 5 only
d) 1, 2, 3, 4 and 5

Answer: (a)

2.2 Cost-push inflation

● There is a condition in an economy where inflation is fueled by
increases in the cost of producing goods and services, rather
than by increases in aggregate demand.
○ Demand remains generally consistent even as supply
falls due to global policies, conflict, or natural disasters,
and gasoline prices rise. This results in cost-push
inflation.
● Inflation that occurs due to rising oil prices and increased raw
materials prices due to the breakdown of the supply chain during
the COVID Pandemic is an example of cost-push inflation.
2.2.1 Causes of Cost-push inflation
● The fundamental cause of cost-push inflation is rising production
costs. The following reasons can cause production costs to rise.
1. Employees' salaries being raised:
○ The increase in salaries of the employees will
have a bearing on the final cost of the product. Therefore increased cost of production will result in
cost-push inflation.
i. Wages have grown as a result of the 7th pay commission.
ii. The management of a manufacturing firm is compelled by a labour union to raise worker
wages.
2. Raw material prices increasing:
○ Raw material cost is a very important parameter in determining the cost of production of a product.
Therefore any increase in raw material prices causes inflation.
i. A spike in crude oil prices (for a variety of causes) might increase input costs.
ii. Floods, hunger, and other natural disasters reduce agricultural output.
3. Firm's profit margins:
○ A firm's profit margin is added as a part of the cost of production. Any increase in the profit margin of
the firm will increase the cost of the product and cause inflation.
i. When businesses opt to enhance their profit margin, the cost of goods and services rises. It
usually occurs when a single company is the primary source of goods (monopoly)
4. Import prices:
○ If the raw and the production is dependent on imports then any import price rise results in cost-push
inflation.
i. Increases in the price of imported inputs might lead to an increase in the overall price of
goods.
Self Notes
 52

ii. Devaluation/Depreciation of currency increases the import costs.

5. Increase in Indirect taxes:
○ An increase in indirect taxes will cause inflation.
i. After the introduction of GST, many products and services earlier charged 12% of tax were
brought into the 18% tax bracket increasing their prices.
ii. Reduction in subsidies results in increased prices of goods and services causing cost-push
inflation.
6. Reduction of Supply of goods and services:
○ When the supply of goods is reduced with the demand remaining unchanged it results in inflation.
i. Hoarding and Speculation can disrupt the demand-supply equilibrium causing a reduced
supply of goods.
ii. Defective Supply Chain: This will disrupt the timely supply of goods resulting in sudden
inflation. Example: Poor supply chain in the Onion and Tomato results in short-term supply
constraints and skyrocketing prices within a couple of days.

Core Inflation vs Headline Inflation

Core Inflation Headline Inflation

Core inflation is inflation-related to all the commodities, Headline inflation is inflation-related to all the economy’s
goods, and services in the economy minus the volatile food commodities, goods, and services.
prices and fuel prices.

It is more stable than headline inflation due to the absence The volatile food and petroleum prices are more volatile
of volatile commodities like food and petroleum. than the other inflation.

The developing nation uses it to calculate its inflation. The developed nation is ideal for the application of headline
inflation.

It denotes the ongoing trends in the inflation of a country It means the total inflation within an economy of a country.
used by the state to design economic strategies for the
future.

Q. A rise in general level of prices may be caused by: (2013)

1. an increase in the money supply
2. a decrease in the aggregate level of output
3. an increase in the effective demand
Select the correct answer using the codes given below:
a) 1 only
b) 1 and 2 only
c) 2 and 3 only
d) 1, 2 and 3

Answer : d

Q. Which one of the following is likely to be the most inflationary in its effect? (2021)
a) Repayment of public debt
b) Borrowing from the public to finance a budget deficit
c) Borrowing from banks to finance a budget deficit
d) Creating new money to finance a budget deficit

Answer : d

Q. Which among the following steps is most likely to be taken at the time of an economic recession? (2021)
a) Cut in tax rates accompanied by increase in interest rate
b) Increase in expenditure on public projects

Self Notes
 53

c) Increase in tax rates accompanied by reduction of interest rate

d) Reduction of expenditure on public projects

Answer : b

3. Measures to Control Inflation

3.1 Basics of Inflation control
● Inflation can be majorly caused due to two reasons. One is the Demand-Pull inflation and the other is the cost-push
inflation on the supply side.
● In the case of demand-pull inflation all the control measures revolve around reducing the demand, this can be done by
either reducing the money supply or increasing prices by taxation.
● In the case of cost-push inflation, the control measures revolve around increasing the supply to meet the demand in the
market and reduce the prices by providing subsidies and technological expertise.
● In all cases, the inflation control measures can be divided into Monetary Measures, Fiscal Measures, and Price Control.
3.2 Monetary Measures
● Monetary policy refers to the central bank's approach to managing the money supply and interest rates through the use
of monetary policy instruments under its control.
● The Reserve Bank of India (RBI) Act, 1934 was amended in May 2016 to provide a legal foundation for the
implementation of the flexible inflation-targeting framework.
● The primary goal of monetary policy is to keep prices stable (keeping inflation within the target band of 2% to 6%).
3.2.1 Different monetary policy instruments to control inflation
Monetary Policy Tools Impact on Inflation

1. Statutory ● To combat inflation, the RBI must raise the SLR. When the SLR is
Liquidity raised, banks are required to keep a larger amount in safe and liquid
ratio (SLR) assets.
○ As a result, the bank's ability to lend to the market
declines, lending rates rise. Market liquidity will shrink, as
a result, inflation is controlled.
● The RBI must decrease SLR to fight deflation, which works the
opposite way.

2. Cash ● To combat inflation, the RBI must raise the CRR. When the CRR is
Reserve raised, banks are required to keep a larger amount of cash with the
Ratio RBI. As a result, the bank's ability to lend to the market declines,
(CRR) lending rates rise. Market liquidity will shrink, as a result, inflation is
controlled.

3. Repo Rate ● During periods of high inflation, the RBI raises the repo rate to
reduce the flow of money in the economy.
● A rise in the repo rate disincentivizes banks from borrowing from
the RBI. As a result, market liquidity decreases.
● Lending rates rise, making borrowing more expensive for
businesses and industries, slowing investment and money supply
in the market. It aids in the control of inflation.

4. Reverse ● To combat high levels of inflation, the RBI raises the reverse repo
Repo rate rate. It encourages banks to park funds with the RBI (more certainty
of return + higher interest rate) rather than lend to the private sector.
○ As a result, market liquidity is reduced and borrowing
Quantitative Tools interest rates rise. Borrowing will be more expensive for
private players, reducing investment. It aids in the control
of inflation.

Self Notes
 54

5. Bank Rate ● During periods of high inflation, the RBI raises the bank rate to
reduce the flow of money in the economy.
● A rise in the bank rate disincentivizes banks from borrowing from
the RBI. As a result, market liquidity decreases.
● Lending rates rise, making borrowing more expensive for
businesses and industries, slowing investment and money supply
in the market. It aids in the control of inflation.

6. Marginal ● The MSF which is aligned with the bank rate will be increased by
Standing the RBI to reduce the flow of money supply and disincentivize
Facility people and firms to borrow. This will help control inflation.
(MSF)

7. Open ● To combat higher levels of inflation, the RBI drains the market of
Market excess liquidity by selling government securities. Banks lend money
Operation to the RBI by borrowing government securities.
(OMO) ● This reduces the economy's excess liquidity. Lending rates rise,
making borrowing more expensive, stifling private investment. As a
result, it prevents inflation.

1. Fixed ● A higher margin requirement implies that more collateral is required

Margin for the same amount of loan.
Requireme ● For example, if the margin requirement is 20%, a buyer will receive
nt only Rs 80,000 as a loan for gold worth Rs. 1 lakh (if it is increased
to 30 per cent, then a maximum loan of Rs. 70,000 can be given)
○ As a result, in order to combat inflation, the RBI may
impose higher margin requirements, raising the cost of
Qualitative Tools credit availability.
○ As a result of less loan disbursement and less private
investment, there is less demand and thus less inflation.

2. Moral ● In the event of high inflation, the RBI may nudge banks to raise
Suasion lending rates and implement a tight money policy.

3. Credit ● Rbi can direct banks to increase lending in one sector while
Control decreasing lending in another.
● For example, if food inflation is rising, the RBI can direct banks to
increase loans in agricultural sectors in order to bring prices down.

Q. With reference to the Indian economy, consider the following statements:

1. If the inflation is too high, the Reserve Bank of India (RBI) is likely to buy government securities.
2. If the Rupee is Rapidly Depreciating, RBI is likely to sell dollars in the market.
3. If interest rates in the USA or European Union were to fall, that is likely to induce RBI to buy dollars.
Which of the statements given above are correct? (2022)
a) 1 and 2 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3

Answer : b

Q. In India, which one of the following is responsible for maintaining price stability by controlling inflation? (2022)
a) Department of Consumer Affairs
b) Expenditure Management Commission
c) Financial Stability and Development Council
d) Reserve Bank of India

Answer : d

Self Notes
 55

3.3 Fiscal Measures

● Fiscal measures are highly effective for controlling government expenditure, personal consumption expenditure, and
private and public investment. The principal fiscal measures are the following:
(a) Reduction in Unnecessary Expenditure: The government should reduce expenditure on non-development
activities in order to curb inflation.
(b) Increase in Taxes: To cut personal consumption expenditure, the rates of personal and corporate should be
raised. To increase the supply of goods within the country, the government should reduce indirect taxes like
import duties, excise duties, etc.
(c) Surplus Budgets: The government should give up deficit financing and instead have surplus budgets. It means
collecting more in revenues and spending less.
(d) Public Debt: It should stop repayment of public debt and postpone it to some future date till inflationary
pressures are controlled within the economy. Instead, the government should borrow more to reduce the money
supply to the public.
3.4 Supply Management Measures
1. One of the foremost measures to control inflation is to increase the production of essential consumer goods like food,
clothing, kerosene oil, sugar, vegetable oils, etc.
2. If there is a need, raw materials for such products may be imported on preferential basis to increase the production of
essential commodities,
3. Efforts should also be made to increase productivity. For this purpose, industrial peace should be maintained through
agreements with trade unions, binding them not to resort to strikes for some time,
4. The policy of rationalisation of industries should be adopted as a long-term measure. Rationalisation increases
productivity and production of industries through the use of brain, brawn and bullion,
5. All possible help in the form of the latest technology, raw materials, financial help, subsidies, etc. should be provided to
different consumer goods sectors to increase production.
6. Reforms in the supply chain.
7. Distribution of the commodities, which are in short supply through PDS.
3.5 Administrative Measures
● In addition to monetary and fiscal instruments, the government can use other measures to maintain price stability and
control inflationary price rises in the economy.
● Other measures include direct price controls, restrictions on speculation and hoarding, the use of buffer stocks, a ban
on exports, and imports to supplement domestic supply, and a prohibition on commodity futures trading.
● Price Control Through Direct Action
○ Under the Essential Commodity Act of 1955, the government can declare a commodity to be an essential
commodity in order to ensure that it is available to the public at reasonable prices.
○ The Drug Price Control Order (DPCO) aims to keep pharmaceutical prices under control.
● Examine Speculation and Hoarding
○ The Act to Prevent Black Marketing and Maintain Supplies of Essential Commodities, 1980 – This act authorizes
the central government or a state government to detain individuals who engage in activities such as hoarding,
creating artificial scarcity of essential commodities in the market, and price rigging.
● Policy on Buffer Stocks
○ The Government of India has maintained buffer stocks of food grains to cover any unanticipated situation. Food
Corporation of India is in charge of purchasing, storing, moving, transporting, distributing, and selling food grains
and other food items.
● Ban on Exports
○ The Government of India imposes a Minimum Export Price (MIP) to discourage commodity exports and ensure
their availability in domestic markets.
● Ban on Commodity futures trading
○ To reduce speculation-driven price increases, governments frequently prohibit future trading in commodities
(e.g., the government prohibited future trading in chana, etc.).
3.6 Other measures
(a) Rational Wage Policy: To control this, the government should freeze wages, incomes, profits, dividends, bonuses, etc.
(b) Price Control: Price control and rationing are other measures of direct control to check inflation. Price control means
fixing an upper limit for the prices of essential consumer goods.
○ They are the maximum prices fixed by law and anybody charging more than these prices is punished by law.
But it is difficult to administer price control.
(c) Rationing: Rationing aims at distributing consumption of scarce goods so as to make them available to a large number
of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil, etc.

Self Notes
 56

Q. With reference to inflation in India, which of the following statements is correct?(UPSC 2015)
a) Controlling the inflation in India is the responsibility of the Government of India only
b) The Reserve Bank of India has no role in controlling the inflation
c) Decreased money circulation helps in controlling the inflation
d) Increased money circulation helps in controlling the inflation

Answer: (c)

4. Impacts of inflation
4.1 Positive impacts of Inflation
● Increased Profits for Producers
○ In most cases, inflation benefits the producers of goods. They make more money because they can sell their
products at higher prices.
● Increased Investment Returns
○ During periods of inflation, investors and entrepreneurs are given additional incentives to invest in productive
activities. As a result, they benefit from higher returns.
● Increase in production output
○ When producers receive the appropriate investment, they produce more goods and services. As a result,
inflation causes an increase in product/service production.
● Increased Employment and Earnings
○ As output rises, so does the demand for the various production factors, including labour. As a result,
employment and income rise in response to inflation.
● Shareholder's income increases
○ If a company's profits increase as a result of inflation, it can pay out dividends to its shareholders. As a result,
during inflationary periods, shareholders' dividend income may increase.
● Borrowers' Advantages
○ Inflation reduces the purchasing power of money. As a result, if the borrower pays an interest rate that is lower
than the inflation rate, he benefits from the process. This is due to the fact that the real value of the money
returned by the borrower is less than the value of the money borrowed.
● Governments' tax revenue improves
○ As the cost of goods and services rises, people must pay more indirect taxes, known as ad valorem (on value)
○ Direct taxes rise as people move into higher tax brackets (but not in real terms), a phenomenon known as
bracket creep.
○ Tax revenue increases for the government, but the real value does not keep pace with the current rate of
inflation due to a lag in tax collection.
● A moderate inflation stimulates economic growth as it increases the profit margin of firms, which encourages them to
increase production. It indicates that there is no deficiency of demand in the economy and firms feel confident to invest.
Phillips Curve
● The curve is given by A W Phillips, based on actual data from USA and UK shows
that there is an inverse relationship between rate of inflation and rate of
unemployment in an economy.
● The theory states that with economic growth comes inflation, which in turn
should lead to more jobs and less unemployment as initial price rise will encourage
producers to increase production to take the benefit of price rise and increase
his/her profit and this would require more manpower, thereby increasing jobs.
● But, such a situation will be favourable only for short term and not long term,
because beyond a certain limit excess price increase will reduce demand, thereby
forcing the firm to curtail production and lay off his workers.
However, the original concept has been somewhat disproven empirically due to the
occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.

4.2 Negative impacts of inflation

● Real-Income falls for groups with fixed income
○ An individual's true income is the purchasing power of his income money. To put it another way, Real
Income=Money Income/Price Level.
○ This means that people on fixed incomes, such as salaried workers, pensioners, and the like, will see a drop in
real income. To put it another way, their purchasing power will reduce.

Self Notes
 57

● Income Distribution Inequality Rises

○ Profits for business owners and entrepreneurs rise as a result of inflation.
○ People in fixed-income groups, on the other hand, see a decrease in their real income.
○ As a result, income inequality becomes more pronounced during this time period.
● Disturbs the Planning Process
○ Inflation raises the prices of goods, raw materials, and factor services. As a result, the government must spend
more money to complete any investment project initiated during the planning period.
○ If the government fails to raise more financial resources through savings or taxation, the entire planning process
is thrown off.
● Increased Speculative Investment
○ Assume that prices are increasing at an alarming rate. People are unsure how much prices will rise in the
coming weeks or months. Many people begin speculative investments in such cases.
○ For example, they may begin purchasing shares, gems, land, and so on solely for speculative purposes.
○ This is done with the intention of making quick money. Such investments do not contribute to the creation of
productive capital in the economy.
● Negative Impacts on Capital Accumulation
○ Assume that rising prices become a recurring feature of an economy. People begin to prefer goods over money
during such times because the real value of money will fall in the future. In addition, people begin to prefer
immediate consumption to future consumption.
○ As a result, the general desire to save begins to wane. As people's willingness and ability to save decreases,
so does the amount of money available for further investment.
○ As a result, the overall impact on the economy's capital accumulation is negative, because capital accumulation
in an economy is dependent on investment growth.
● Lenders Will Sustain Losses
○ As mentioned before, borrowers benefit from inflation when it has a positive impact.
○ As a result, lenders risk losing money during such times. This is due to the fact that they receive a sum with
less purchasing power than the amount loaned.
● Rupee may depreciate
○ Due to less purchasing power parity, the demand for the dollar increases, depreciating the Indian rupee.
○ This benefits the exporters and will burden the importers.
● Export Earnings Suffer as a Result
○ Because the prices of raw materials and factors of production rise during inflation, the prices of export items
rise as well.
○ As a result, their demand in foreign markets may fall, resulting in a decrease in the country's export income.
○ Though the rupee depreciates, lack of demand due to high prices nullifies the exchange rate benefit.
4.3 Effects of Inflation on Different Groups of Society
● The effects of inflation on different groups of society are as follows:
1. Debtors and Creditors:
○ During inflation, the debtors are the gainers and the creditors are the losers. The debtors stand to gain
because they had borrowed when the chasing power of money was high and now return the loans
when the purchasing power of money is low due to inflation. The creditors, on the other hand, stand
to lose because they get back less in terms of goods and services than what they had lent.
2. Wage and Salary Earners:
○ Wage and salary earners usually suffer during inflation because:
i. wages and salaries do not rise in the same proportion in which the prices or the cost of living
rise and
ii. there is a lag between a rise in the price level and a rise in wage and salary.
○ Among workers, those who have formed trade unions, stand to lose less than those who are
unorganised.
3. Fixed Income Groups:
○ The fixed-income groups are the worst sufferers of inflation. Persons who live on past saving,
pensioners, interest and rent earners suffer during periods of rising prices because their incomes
remain fixed.
4. Business Community:
○ The business community, i.e., the producers, traders, entrepreneurs, speculators, etc., stand to gain
during inflation:
i. They earn windfall profits because prices rise at a faster rate than the cost of production
ii. They gain because the prices of their inventories go up, thus increasing their profits,
iii. They also gain because they are normally borrowers of money for business purposes.
5. Investors:

Self Notes
 58

○ The effect of inflation on investors depends on in which asset the money is invested. If the investors
invest their money in equities, they are gainers because of the rise in profit.
○ If the investors invest their money in debentures and fixed income bearing securities bonds, etc, they
are the loser because income remains fixed,
6. Farmers:
○ Farmers generally gain during inflation because the prices of the farm products increase faster than
the cost of production, thus leading to higher profits during inflation.
○ Thus inflation redistributes income and wealth in such a way as to harm the interests of the consumers,
creditors, small investors, labourers, middle class and fixed income groups and to favour the
businessmen, traders, debtors, farmers etc. Inflation is socially unjust because it makes the rich richer
and the poor poorer; it transfers wealth from those who have less of it to those who have already too
much of it.

Q. Consider the following statements:

1. Inflation benefits the debtors.
2. Inflation benefits the bondholders.
Which of the statements given above is/are correct? (UPSC 2013)
a) 1 only
b) 2 only
c) Both 1 and 2
d) Neither 1 nor 2

Answer: (a)

5. Growth-Inflation Trade-Off
5.1 Why Economic Growth can lead to Inflation?
● If demand rises faster than firms can increase supply, firms will respond to the excess demand and supply constraints
by putting up prices.
● Businesses will hire more people at a time of fast expansion, and
the unemployment rate will decline. As the unemployment rate
declines, businesses might have a tougher time filling open
positions; this labour scarcity will drive up wages.
● When salaries grow, businesses' expenses rise, and they pass
those cost increases along to customers.
● Additionally, as salaries rise, workers have more money to spend,
which boosts aggregate demand (AD).
● People may begin to anticipate inflation with increased economic
growth, and this anticipation of rising prices might become self-
fulfilling.
● As a result, rapid economic growth frequently results in upward
pressure on wages and prices, which increases the inflation rate.
5.2 Economic growth and Low Inflation
● It is conceivable to experience economic expansion without
experiencing inflation.
● If productivity and investment improve as a result of growth, then
the economy's productive capacity can develop at the same pace
as total demand (AD).
● As a result, inflation-free economic growth is possible.
5.3 Low Inflation causing long-term economic growth
● Low inflation is also said to have the potential to boost long-term
economic growth at a faster rate. This is because low inflation
fosters investment by fostering stability, confidence, and security.
● This investment supports sustained economic expansion. Economic growth rates are typically lower when there are
periods of high and unstable inflation.

Self Notes
 59

5.4 High Inflation and Low Growth

● Recession resulted from cost-push inflation in 1973 brought on by rising oil prices because higher costs reduced
disposable income.
● It is feasible for an economy to have both high inflation and slow growth (e.g. in 2009, 2011, 2017).
● If there is cost-push inflation, this may happen. The cost of oil could be increasing, pushing up prices. It raises business
expenses and lowers disposable income. As a result, there is high inflation and weaker growth. Stagflation is another
name for this phenomenon.

6. Measurement of Inflation in India

● There are several ways to measure inflation. On the basis of population coverage, the inflation indices are developed to
understand the levels of inflation for certain sets of populations such as consumers, producers, retailers, wholesalers
etc. Such indices are called Consumer Price Index (CPI), Producer Price Index (PPI), Wholesale Price Index (WPI)
etc.
● On the basis of items, the inflation indices are developed to understand the levels of inflation for certain sets/baskets of
items.
○ Since the prices of some items are more volatile than others like food and fuel, it might give conflicting signals
to policymakers as the overall inflation could change because of a selected few goods.
○ Hence, separate indices can be developed separating the volatile items from the main index. This gives rise
to concepts of Headline inflation and core inflation whereby, the Headline inflation includes all the items and
core inflation usually excludes food and fuel items.
● There is another variant of core inflation called mean inflation. In this, the components that show the most extreme
monthly price changes are excluded.
● In India, headline inflation is measured through the CPI.
6.1 Index Numbers
● An Index number is a single figure that shows how the whole set of related variables has changed over time or from one
place to another.
● In particular, a price index reflects the overall change in a set of prices paid by a consumer or a producer, and is
conventionally known as a Cost-of-Living index or Producer's Price Index as the case may be.
● The purpose of a price index is to quantify the overall increase or decrease in prices of several commodities through a
single number.
6.1.1 Wholesale Price Index (WPI)
● The wholesale Price Index (WPI) is an index that measures and tracks the changes in the price of goods in the
stages before the retail level. This index measures the change in the prices of commodities traded in the wholesale
market.
○ It gauges the prices of a basket of commodities whose list and weightage along with the base year are
changed periodically so that the WPI reflects the current impact of changing prices on the lives of the people.
● It is measured on a year-on-year basis i.e., the rate of change in the price level in a given month vis a vis the
corresponding month of last year. This is also known as Point to Point inflation.
● In India WPI is calculated on a monthly and yearly basis compiled by the Office of Economic Advisor to the Ministry
of Commerce and Industry of Govt. of India.

Revised IIP, WPI Series

● The government has released a new-look index of industrial production (IIP) and the wholesale price index (WPI),
in May 2017 which have been built on the new series of data.
● The new IIP and WPI series has been released by Chief Statistician of India and Secretary, Ministry of Statistics &
Programme Implementation, and Secretary, Department of Industrial Policy and Promotion to usher in greater
accuracy and improved synchronisation leading to better policies.

Features
1. Instead of the earlier 2004-05, the base year for the IIP and the WPI will be 2011-12. Already, the Consumer Price
Index (CPI), the Gross Domestic Product (GDP) and gross value addition etc. have 2011-12 as the base year.
2. IIP: The new series of IIP will include 809 manufacturing products and 55 mining products that are re-grouped into
521 item groups.
○ The new series of IIP will include technology items like smart phones, tablets, LED television etc.
○ A technical review committee has also been established to identify new items by ensuring that the series
remains relevant. The committee is slated to meet at least once a year.
3. WPI: Under the new series of WPI, the weight of manufactured items has decreased to 64.2 percent from 64.9 percent
in the old series.

Self Notes
 60

○ Similarly, the weight of fuel and power has decreased to 13.1 percent from 14.9 percent.
○ On the other hand, the weight of primary items has increased to 22.6 percent from 20.1 percent.

New Features
● In the new series of WPI, prices used for compilation do not include indirect taxes in order to remove impact of
fiscal policy. This is in consonance with international practices and will make the new WPI conceptually closer to
‘Producer Price Index’.
○ A new “WPI Food Index” will be compiled to capture the rate of inflation in food items.
● Item level aggregates for new WPI are compiled using Geometric Mean (GM) following international best practice
and as is currently used for compilation of All India CPI.

6.1.2 Consumer Price Index (CPI)

● Consumer Price Indices (CPI) measure changes over time in the prices of goods and services that households acquire
for the purpose of consumption. It depicts the cost of living of a common man.
● CPI numbers are widely used as a macroeconomic indicator of inflation, as a tool by governments and central banks for
inflation targeting and for monitoring price stability, and as deflators in the national accounts.
● CPI is also used for indexing dearness allowance (DA) to employees for an increase in prices. CPI is therefore
considered one of the most important economic indicators.
● CPI is constructed on a monthly basis and measures changes in retail prices. It is constructed for four groups of
consumers as follows:
a. CPI for Industrial workers (CPI-IW)
b. CPI for Urban Non-Manual Employee (CPI-UNME)
c. CPI for Agricultural Labourer (CPI-AL)
d. CPI for Rural Labourer (CPI-RL)

(a) Consumer Price Index for Industrial Workers

○ From 1958-59, the Labour Bureau, an attached
office under the Ministry of Labour & Employment,
started the compilation of CPI (IW). Consumer
Price Index Numbers for Industrial workers
measure a change over time in prices of a fixed
basket of goods and services consumed by
Industrial Workers.
○ The labour bureau under the Ministry has finalised
the new CPI-IW with the base year 2016, and it is
proposed that the base be revised every six years
to capture the changes in living expenses more
quickly.
○ The new index will include the addition of new
industrial centres to make price gauze more
representative, taking the total number of industrial
centres under consideration to 88 against 78 now.

(b) Consumer Price Index for Urban Non-Manual

Employees (CPI-UNME)
○ It was used for determining the dearness allowances of employees of some foreign companies working in India
in service sectors. It had the base year 1984-85. It was discontinued in January 2011.

(c) Consumer Price Index for Agricultural Labourers (CPI-AL)

○ The Labour Bureau has been compiling CPI Numbers for Agricultural Labourers since 1964.The base of
CPI(AL) is 1986-87. CPI-AL is used for revising minimum wages for agricultural labour in different States.

(d) CPI for Rural Labourer (CPI-RL)

○ It is compiled by the Labour Bureau While the retail prices utilized in the compilation of CPI-AL and CPI-RL are
the same, the weights are different due to the difference in coverage of the two series. The present base year
of CPI-RL is 1986-87.

6.1.2.1 Base Year Revision of Consumer Price Index (CPI)

● The government has revised the base year of the All India CPI series from 2010=100 to 2012=100 starting with January
2015.

Self Notes
 61

● The weights of the sub-components within the new CPI basket will be based on the Consumer Expenditure Survey
(CES) of 2011-12, against the old/current basket individual weights based on CES of 2004-05.
● These changes reflect the falling share of household expenditure on food and the rising share of the non-food items.
● In addition, the number of items will also increase from 437 to 448 in the rural basket and from 450 to 460 in the urban
basket. Compared with the old basket, the weights of the food and fuel groups have been reduced in the new basket.
● Meanwhile, the weights of the miscellaneous and clothing, bedding and footwear groups have been increased. With
these changes, the weight of the Core group ( CPI ex-food and fuel) will rise to 47.3% from 42.9% earlier.

CPI rural and CPI Urban

● This new series of CPI has two components, one a representative of the entire urban population, viz. CPI (Urban),
and another for the entire rural population, viz. CPI (Rural).
○ These indices reflect the changes in the price levels of various goods and services consumed by the urban
and rural population respectively.
● The indices are compiled at State/UT and all-India levels and are based on 2012 as base year.
○ CPI (urban) covers 1114 urban markets while the span of CPI (rural) is 1181 villages.
● Each of these indices considered a basket of products across multiple categories like food, fuel, transport and so on.
However, what forms these baskets and the weights they have in the final index numbers, differ for the two regions.
○ For example, food has a weight of 54.18% in the CPI rural index and only 36.29% in the urban index. Also,
the urban index takes into consideration housing prices that are not a part of the rural index. These variations
affect the final numbers drastically.

6.1.2.2 The rationale for the introduction of new CPI

● CPI numbers presently compiled and released at the national level reflect the fluctuations in retail prices pertaining to
specific segments of the population in the country viz. industrial workers, agricultural labourers and rural labourers.
● These indices do not encompass all the segments of the population in the country and as such do not reflect the true
picture of the price behaviour in the country.
● To overcome the above, the Central Statistics Office (CSO) of the Ministry of Statistics and Programme Implementation
has started compiling a new series of CPI for the entire urban population, viz. CPI (Urban), and CPI for the entire rural
population, viz.
● CPI (Rural), which would reflect the changes in the price levels of various goods and services consumed by the urban
and rural populations. These new indices are compiled at State/UT and all-India levels.
6.1.3 Issues with CPI and WPI
6.1.3.1 Issues in WPIs
● Incongruent with global standards as most of the nations either use CPI or PPI.
● Consider only goods and not services which are a huge part of our economy and can't be neglected.
● The rates are mostly captured from mandis or places of wholesale business. Hence they don't include prices at the
household consumer level.

6.1.3.2 Issues in CPIs

● Measures the change in the important commodities at the retail level but not at the producer level.
● The prices determined at the consumer level are affected by subsidies, sales and excise taxes and distribution costs.

CPI is still considered a better option over WPI as it gauges changes in the general price level of goods and services at the
household level.
WPI vs CPI

WPI CPI

It is used to measure the average change in price in the sale CPI is a consumer price index that measures the change in
of goods in bulk quantity by the wholesaler. the price in the sale of goods or services in retail or directly to
the consumer.

WPI is published by the office of economic advisor of the CPI is published by the National Statistical Office (NSO) of
Ministry of Commerce and Industry. the Ministry of Statistic and Programme Implementation.

It is restricted to goods only. It is both for goods and services.

Self Notes
 62

Prices are borne by the manufacturer and wholesaler. Prices are borne by the consumer.

It releases on a weekly basis for primary articles, fuel, and It releases on a monthly basis.
power for rest items in publishing monthly.

6.1.4 The divergence between WPI and CPI

● Differences can be explained by the variation in base years, a basket of
items and weights allocated to the individual items in the two indices.
○ While the WPI and CPI inflation have both been declining, the
dip in WPI is more because the basket of items is different in CPI
and WPI.
■ Hence, the WPI is more directly affected by international
commodity prices than the CPI.
○ The composition of the two indices is such that while food has a
higher weightage in CPI, manufacturing has a higher weightage in
WPI. The fall in global food prices has definitely helped in bringing
down both the retail and wholesale prices, but certainly WPI more
than CPI.
6.1.5 Introduction of Consumer Food Price Indices (CFPI)
● The Central Statistics Office (CSO), Ministry of Statistics and Programme Implementation (MOSPI) started releasing
Consumer Food Price Indices (CFPI) for three categories -rural, urban and combined - separately on an all India basis
with effect from May, 2014.
● Like Consumer Price Index (CPI), the CFPI is also calculated on a monthly basis and methodology remains the same
as CPI. The base year presently used is 2012.
● The CSO revised the Base Year of the CPI and CFPI from 2010=100 to 2012=100 with effect from the release of
indices for the month of January 2015.

Did You Know?

● In India, the wholesale price index (WPI) is the main measure of inflation. The WPI measures the price of a
representative basket of wholesale goods.
● In India, the wholesale price index is divided into three groups: Fuel and Power (13.2 percent), Primary Articles
(22.6 percent of total weight) and Manufactured Products (64.2 percent).
○ Food Articles from the Primary Articles Group account for 15.2 percent of the total weight.
○ The most important components of the Manufactured Products Group are Basic Metals (9.7 percent of total
weight); Food products (9.1 percent); Chemicals and Chemical products (6.5 percent) and Textiles (4.9
percent).

6.2 Difference between GDP and Inflation

Parameter GDP Deflator Inflation

Meaning The changes in prices for all of the goods and The changes in prices for certain goods and
services produced in an economy. services are used for the calculation of Inflation.

Index Represented as GDP Deflator Represented as Consumer Price Index (CPI) and
Wholesale Price Index(WPI)

Number of Items All goods and services in the economy. Approximately 700 for WPI and 450 for CPI
used to
calculate

Published by Ministry of Statistics and Programme CPI: Central Statistic Office (MoSPI) WPI: Office
Implementation (MoSPI) of Economic Advisor (Ministry of Commerce)

Self Notes
 63

6.3 Proposed Indices

6.3.1 Producer Price Index (PPI)
● PPI measures price change from producer's perspective as against the Consumer Price Index (CPI), which measures
price change from consumers' perspective.
● Most of the countries have switched over to PPI from WPI, only basic prices are used for compilation, while taxes, trade
margins and transport costs are excluded. PPIs, apart from measuring inflation, are used as deflators in the compilation
of GDP.
● PPI is considered to be a better measure of inflation as price changes at crude and intermediate stages can be tracked
before it creeps into the finished goods stage.
● Advantages of having PPIs:
○ Will be globally comparable.
○ Will not include hidden costs like shipping, taxes and other levies thus providing a much clear picture of inflation.
○ Will give a view of the economy's efficiency in transferring goods and services from the first level of the
transaction to another level.

A Working Group on Revision of Wholesale Price Index (WPI) (1993-94=100), under the chairmanship of Prof. Abhijit Sen,
Member, Planning Commission, is inter alia, looked into the feasibility of switching over from WPI to a Producer Price Index (PPI)
in India.
Government of India set up a 13-member committee headed by Professor BN Goldar and has representation from various central
ministries and departments to devise a Producer Price Index (PPI)
6.3.2 Service Price Index
● There is no index so far to measure the price changes in the service sector which contributes about 60% to India’s GDP.
● The present WPI only shows the price movement of commodities of primary and secondary sectors and not tertiary
sectors.
● Abhijit Sen committee also recommended the need for such an index and it is under consideration.
6.3.3 Housing Price Index (RESIDEX )
● National Housing Bank, at the behest of the Ministry of Finance, undertook a pilot study to examine the feasibility of
preparing an index at the National level.
○ The pilot study covered 5 cities viz. Bangalore, Bhopal, Delhi, Kolkata and Mumbai. Besides, a Technical
Advisory Group (TAG), with Adviser, Ministry of Finance, as its Chairman and comprising of experts members
form RBI, NSSO, CSO, Labour Bureau, NHB and other market players, was constituted to deal with all the
issues relating to methodology, collection of data and also to guide the process of construction of an appropriate
index .
● Based on the results of the study and recommendations of the TAG, NHB launched RESIDEX for tracking prices of
residential properties in India.

7. Some Important Terminologies related to Inflation

● Inflation: Consistent increase in the general price level.
● Disinflation: Reduction in the rate of inflation i.e. inflation is there and prices are rising but at a decreasing rate. Price
level declines without any decline in production. It is regarded as desirable.
● Deflation: Sustained decrease in the general price level i.e. negative inflation. It is a situation in which, price level
decreases along with a decline in production. It is not desirable.
● Reflation: It refers to an increase in the price level along with an increase in production and employment during the
phase of economic recovery.
● Shrinkflation: Shrinkflation is the practice of lowering a product's size while keeping its suggested retail price. A tactic
used by businesses, primarily in the food and beverage industries, to covertly increase profit margins or preserve them
in the face of growing input prices is raising the price per unit of product.
○ Package downsizing is another name for shrinkflation in commercial and academic studies. This phrase may
also be used to describe a less common macroeconomic circumstance in which prices are increasing while the
economy is contracting.
● Suppressed inflation: It refers to a situation in which inflationary pressures (i.e., excess of demand over supply) may
be building up in the economy but prices are held stable by the government through direct price control measures like
price controls, ceiling prices etc.
● Open Inflation: It is an inflationary process in which prices are permitted to rise without being suppressed by government
price control or similar measures. Or in other words, it refers to a consistent increase in the general price level.
● Stagflation: It refers to the coexistence of inflation and unemployment (or recession). It is caused due to cost-push
inflation.

Self Notes
 64

What is Stagflation?
● Stagflation is defined as an economic situation when it is suffering both an increase in inflation and a stagnation in
economic output at the same time.
● Stagflation was initially identified in the 1970s, when an oil shock caused fast inflation and significant unemployment
in many industrialised economies.
● The misery index was created as a result of stagflation. When the economy was hit by stagflation, this index, which is
the simple sum of the inflation and unemployment rates, served as a tool to show just how bad people were feeling.

Causes of Stagflation
● Decline in Consumption: A decline in consumption contributes to stagflation. Consumption decreases as a result of
lower-income and fewer jobs giving way to slower growth and even more inflation.
● Oil Price Volatility: The volatility in oil prices results in a further reduction in spending. An increase in oil prices results
in a rise in transportation costs, which leads to an increase in overall pricing, particularly for food items.
● Decrease in credit availability: Less money in the economy leads to reduced investment. This results in reduced
industrial activity impacting economic growth.
● Unemployment: Unemployment impacts the buying ability of individuals. The increased automated production and
inability of the manufacturing sector to boost up the growth also impacts job growth of the country.
● Inflation: With rising input costs and reduction in supply, prices of various products and services increase. As the
supply is reduced, there is a fall in output and
employment and the price level rises.

Consequences of Stagflation
● The trifecta of slow growth, high unemployment,
and fast inflation puts significant pressure on the
economy.
● Stagflation is unambiguously harmful to the
economy, as high inflation and inflation
uncertainty distort investment decisions.
● It is also damaging to fixed income markets, as
rising interest rates push bond prices lower and
depress equity valuations.
Steps needed to control stagflation in the Indian
economy:
● Tax Measures: Reduced income and
corporation taxes are the best policy measures
since they tend to lower labour costs and
increase demand for labour.
○ In the same way, taxes like GST
should be cut in order to keep prices from growing.
● Pay control: To limit wage increases, a wage control strategy should be implemented with government intervention.
Firms are forced to reduce production and employment when wages rise.
○ As a result, real income and consumer spending have decreased. Limiting salary rises can assist to break
the wage inflation cycle and strengthen the economy.
● Supply-side solutions: Increasing aggregate supply through supply-side policies such as privatisation and
deregulation to boost efficiency and lowering production costs is one way to combat stagflation. Tax incentives must
be used to encourage the private sector to spend more and expand supply.
● Monetary policy: Inflation reduction should be the major macroeconomic goal. In the short term, lowering inflation
may result in increased unemployment and slower economic growth. However, once the price level is under control,
this unemployment may be targeted.
● Reforms in the labour market: Frictions in the labour market should be addressed by reducing the time and cost of
acquiring information about job openings. Barriers to entry into a profession should be reduced, as should those that
keep pay artificially high.

● Real Interest Rate: It is the difference between the nominal {actual} interest rate and the rate of inflation, i.e. nominal
interest rate minus the inflation rate.
○ Misery index = Rate of inflation + Rate of unemployment.
● Structural Inflation: Exists in under-developed countries on account of structural, rigidities and bottlenecks in the
economy like deficiency of capital, resource constraints of government and market imperfections. It is also known as
bottleneck inflation.
● Inflationary Gap: It is the situation in which aggregate demand in the economy is more than the productive capacity of
the economy i.e. aggregate supply at full employment level. It leads to an increase in the price level.
Self Notes
 65

● Deflationary Gap: It is a situation in which aggregate demand in the economy is less than productive capacity i.e.
aggregate supply at full employment level. It leads to deflation in the economy.
● Core inflation: It is based on the prices of only those commodities whose prices are non-volatile i.e. it does not take
into account prices of fuel and food. It is used to show the trend of inflation.
● Headline Inflation: It is calculated for all commodities including fuel and food prices.
● Chronic inflation: It is a situation in which a country experiences high inflation for a prolonged period of time (several
years or decades).
● Engel’s law: It states that the percentage of income spent on food reduces with an increase in income.
● Creeping Inflation: When prices are gently rising, it is referred to as Creeping Inflation. It is the mildest form of inflation
and is also known as Mild Inflation or Low Inflation. When prices rise by not more than 3% per annum, it is called
Creeping Inflation.
● Walking/Trotting Inflation: When the rate of rising prices is more than the Creeping Inflation, it is known as Walking
Inflation. When prices rise by more than 3% but less than 10% per annum (i.e between 3% and 10% per annum), it is
called Walking Inflation.
● Running Inflation: A rapid acceleration in the rate of rising prices is referred to as running Inflation. When prices rise
by more than 10% per annum, running inflation occurs. Though economists have not suggested a fixed range for
measuring running inflation, we may consider price rise between 10% to 20% per annum (double-digit inflation rate) as
running inflation.
● Galloping Inflation: If prices rise by double or triple digit inflation rates like 30% or 400% or 999% per annum, then the
situation can be termed as Galloping Inflation. When prices rise by more than 20% but less than 1000% per annum (i.e.
between 20% to 1000% per annum), galloping inflation occurs. It Is also referred to as jumping inflation. India has been
witnessing galloping inflation since the second five year plan period.
● Hyperinflation: Hyperinflation refers to a situation where the prices rise at an alarming high rate.
○ The prices rise so fast that it becomes very difficult to measure its magnitude. However, in quantitative terms,
when prices rise above 1000% per annum (quadruple or four digit inflation rate), it is termed as Hyperinflation.
○ During a worst-case scenario of hyperinflation, the value of national currency (money) of an affected country
reduces almost to zero.
○ Paper money becomes worthless and people start trading either in gold and silver or sometimes-even use the
old barter system of commerce.
○ Two worst examples of hyperinflation recorded in world history are of those experienced by Hungary in 1946
and Zimbabwe during 2004 to 2009.
● Inflation Tax:
○ It is a punishment for having too much cash during a period of excessive inflation. Despite the fact that it is
not directly charged by the government.
○ The value of money declines during inflation and cash-carrying individuals will eventually lose some of it.
● Inflation Premium :
○ It is a method by which an investor calculates the normal rate of return on assets or investment during an
inflation period.
○ In simple words, it is a part of the prevailing interest rate which results from investors pushing the nominal
interest rates to a higher level to compensate for the expected inflation.
○ The actual rate of interest is calculated by deducting the premium from nominal interest rates.
● Inflationary Spiral
○ A situation in which prices increase, then people are paid more in their jobs, which then causes the price of
goods and services to increase again, and so on.
● Base effect
○ The base effect refers to the effect that the choice of a basis of comparison or reference can have on the
result of the comparison between data points.
○ Using a different reference or base for comparison can lead to a large variation in ratio or percentage
comparisons between data points.
○ The base effect can lead to distortion in comparisons and deceptive results, or, if well understood and
accounted for, can be used to improve our understanding of data and the underlying processes that generate
them.
○ For example, the base effect can lead to an apparent under- or overstatement of figures such as inflation
rates or economic growth rates if the point chosen for comparison has an unusually high or low value relative
to the current period or the overall data.

Q. Economic growth is usually coupled with? (UPSC 2011)

a) Deflation
b) Inflation
c) Stagflation
d) Hyperinflation

Self Notes
 66

Answer: (b)

LECTURE: 5

Self Notes
 67

MONETARY POLICY

1. Monetary System 68
1.1 Money 68
1.2 Demand for Money 68
1.3 Evolution of Money 69
1.4 Money Supply 71
1.5 Money Multiplier (m) 73
1.6 Indian Monetary System 74
1.7 Monetary Policy 74
1.8 Instruments of Monetary Policy 76
1.9 Monetary Policy Reforms 82

Self Notes
 68

1. Monetary System
1.1 Money
Money is defined as anything that is generally accepted as a form of payment. According to Hartley Withers money is “the
stuff with which we buy and sell things”. Money is primarily a medium of exchange or means of exchange. It is a way for a
person to trade what he has for what he wants. Ideal money has three crucial characteristics:
· it acts as a medium of exchange
· it is an economic good
. it is a means of economic calculation
1.1.1 Functions of Money
● Primary functions of money
1. Money as a Medium of Exchange- Money acts as an intermediary for the goods and services in an exchange
transaction.
2. A measure of Value- The value of all goods and services is expressed in terms of money.
● Secondary Functions of Money
1. Store of Value- Wealth can be stored in the form of money, as it possesses generalised purchasing power.
2. Standard of Deferred Payments- Money serves as the unit in terms of which deferred or future payments are
stated.
3. Transfer of Value- It can be used to sell or purchase goods not only in domestic but also in international
markets.
1.1.2 Types of Money
Token Money Full-bodied Money Fiat Money Legal Tender Money

It is also called Paper Money It is the money whose It serves as money on the It refers to such money
or credit money. Its intrinsic intrinsic value is equal fiat (i.e. order) of the which can't be denied for
value (i.e. value as a to its face value. government. It is the money the fulfilment of a
commodity) is less than the which is authorised by the general monetary
face value government obligation.
● Legal Tender Money is of two types- Limited Legal Tender Money and Unlimited Legal Tender Money. The former
includes coins of smaller denominations and are legal tender for only limited amounts, while the latter includes money
that can't be legally denied in the discharge of monetary obligations irrespective of the amount involved.
● Optional money or Non-Legal Tender Money: It is a form of money, which is generally accepted, but there is no legal
boundation for their acceptance. Example- cheques, bank drafts, bills of exchange, postal orders. They are accepted
only at the option of the creditor, lender, or seller.

FACE VALUE INTRINSIC VALUE

The face value of a coin/currency is its legal value in The market value of the constituent metal within a
relation to other forms of currency. coin is referred to as intrinsic value.

Fiat money has face value. Fiat money does not have intrinsic value. Only
metal currency has intrinsic value.

The selling of the constituent metal/currency cannot be Intrinsic value can be derived from the selling of
used to calculate face value. constituent metal itself.

1.2 Demand for Money

● The demand for money tells us what makes people desire a certain amount of money.
○ Since money is required to conduct transactions, the value of transactions will determine the money people
will want to keep: the larger is the quantum of transactions to be made, the larger is the quantity of money
demanded.
○ Since the quantum of transactions to be made depends on income, it should be clear that a rise in income will
lead to rise in demand for money.
○ Also, when people keep their savings in the form of money rather than putting it in a bank which gives them
interest, how much money people keep also depends on the rate of interest.
■ Specifically, when interest rates go up, people become less interested in holding money since
holding money amounts to holding less of interest-earning deposits, and thus less interest received.
Therefore, at higher interest rates, money demanded comes down.

Self Notes
 69

1.2.1 Transaction Motive

● It refers to the demand for money to meet the current needs of individuals and businesses.
● Individuals require money to meet their immediate needs, which is referred to as the income motive.
● Businesses, on the other hand, require money to carry out their operations, which is known as the business motive.
1..2 Speculative Motive
● The speculative motive for demanding money arises when holding money is perceived to be less risky than lending
the money or investing it in another asset.
● It refers to the motivation of individuals to hold cash in order to profit from market movements regarding changes in future
interest rates.
○ For example, if a stock market crash appeared to be imminent, the speculative motive for demanding money
would come into play; those anticipating a crash would sell their stocks and keep the proceeds as money.

1.3 Evolution of Money

1.3.1 Barter System

● Money as a medium of exchange was not used in early human history since households were self-sufficient and
there was little exchange of goods.
● Whatever exchange occurred between the households was done through barter or the exchange of goods for other
goods.
● As there was no common unit of account and medium of exchange, the barter system did not allow for direct purchases
of goods.
● The problem with a barter system is that in order to obtain a specific good or service from a supplier, one must
also have a good or service of equal value that the supplier desires.
● In other words, in a barter system, the exchange can occur only if two transacting parties have a double coincidence
of wants.
● The likelihood of a double coincidence of wants is quite low and making the exchange of goods and services rather
difficult.

1.3.2 Commodity Money

● In the beginning, there were only a few commodities that were required by everyone.
● Commodities such as arrows, bows, and seashells, which are mostly used for hunting, became the first form of medium
of exchange and thus acted as money.
● When early humans transitioned from hunting to agriculture in the second stage of evolution, animals such as cattle,
goats, and sheep became a medium of exchange and acted as money.
● Since commodities have limitations such as a lack of a standard unit of account, limited supply, and natural factors, etc.
their use was limited and was eventually replaced by other forms of money.

1.3.3 Metallic Money

● Commodity money evolved into metallic money as human civilisation progressed.

● Metals such as gold, silver, copper, and others were used because they could be easily handled and quantified. It was
the primary form of money for the majority of recorded history.
● With the passage of time and technological advancements, the hard form of gold and silver was replaced by a coinage
system (gold and silver coins) that was widely used as money.

1.3.4 Paper Money(FIAT MONEY)

● It was discovered that transporting gold and silver coins was both inconvenient and dangerous. As a result, the invention
of paper money marked a watershed moment in the evolution of money.
● The country's central bank regulates and controls paper money (RBI in India).
● At the moment, a large portion of the money is made up of currency notes or paper money issued by the central bank.

1.3.5 Credit Money

● The emergence of credit money occurred almost concurrently with the emergence of paper money.
● People keep a portion of their cash in bank deposits, which they can withdraw at their leisure via cheques.
Self Notes
 70

● The cheque (also known as credit money or bank money) is not money in and of itself, but it serves the same functions
as money.

1.3.6 Plastic Money

Plastic money, such as credit and debit cards, is the most recent type of money. They intend to do away with the need to carry
cash when conducting transactions.

1.3.7 Mobile Payments

● Mobile payments are payments made for goods or services using a portable electronic device such as a cell phone,
smartphone, or tablet.
● Money can also be sent to friends and family members using mobile payment technology.
● Paytm, PhonePe, Google Pay, and so on are increasingly competing for retailers to accept their platforms for point-of-
sale payments.

What is Cryptocurrency?
● A cryptocurrency is a type of digital asset that is based on a network that is distributed across many computers.
However, cryptocurrencies do not have any underlying use, like for instance car hiring softwares or smartphones.
● Because of their decentralised structure, they can exist independently of governments and central authorities.
● Transactions are authenticated by participants themselves by consensus.
● Bitcoin, the first decentralised cryptocurrency, was created in 2009 by a presumably anonymous developer named
Satoshi Nakamoto.
● Many other cryptocurrencies, known as "altcoins," have been launched in the aftermath of Bitcoin's success. Some
of the well-known altcoins are: Solana, Litecoin, Ethereum, Cardano, Peercoin, Namecoin

Significance

● Cryptocurrencies represent a new, decentralised money paradigm.

● Centralised intermediaries, such as banks and monetary institutions, are not required in this system to enforce trust
and police transactions between two parties.
● Thus, a cryptocurrency-based system eliminates the possibility of a single point of failure, such as a large bank,
triggering a global crisis, such as the one triggered in 2008 by the failure of institutions in the United States.
● Cryptocurrencies promise to make it easier to transfer funds between two parties without the need for a trusted third
party such as a bank or credit card company.
● Cryptocurrency transfers between two transacting parties are faster than traditional money transfers because they do
not use third-party intermediaries.
● Profits can be made from cryptocurrency investments. The value of cryptocurrency markets has skyrocketed.
● It is a less expensive option when compared to other online transactions.
● The transfer of funds is completed with minimal processing fees.

Limitations

● Cryptocurrencies, while claiming to be an anonymous form of transaction, are actually pseudonymous. They leave a
digital trail that agencies can decipher.
● Cryptocurrencies have grown in popularity among criminals as a tool for nefarious activities such as money
laundering and illegal purchases.
● Cryptocurrencies have also become popular among hackers, who use them to carry out ransomware attacks.
● In theory, cryptocurrencies are supposed to be decentralised, with their wealth distributed among many
parties via a blockchain. In practice, ownership is extremely concentrated.
● One of the conceits of cryptocurrencies is that anyone with a computer and an internet connection can mine them.

○ Mining popular cryptocurrencies, on the other hand, necessitates a significant amount of energy, sometimes
equivalent to that consumed by entire countries.
● While cryptocurrency blockchains are extremely secure, other crypto repositories, such as exchanges and wallets,
are vulnerable to hacking.
● Price volatility affects cryptocurrencies traded on public markets. Bitcoin's value has gone through rapid ups and
downs.

Self Notes
 71

● Some economists believe that cryptocurrencies are a passing fad or speculative bubble

Q. Which one of the following statements correctly describes the meaning of legal tender money? [2018]
(a) The money which is tendered in courts of law to defray the fee of legal cases
(b) The money which a creditor is under compulsion to accept in settlement of his claims
(c) The bank money in the form of cheques, drafts, bills of exchange, etc.
(d) The metallic money in circulation in a country
Answer: b

Q. With reference to ‘Bitcoins’, sometimes seen in the news, which of the following statements is/are correct? [2016]
(1) Bitcoins are tracked by the Central Banks of the countries.
(2) Anyone with a Bitcoin address can send and receive Bitcoins from anyone else with a Bitcoin address.
(3) Online payments can be sent without either side knowing the identity of the other.
Select the correct answer using the code given below.
(a) 1 and 2 only
(b) 2 and 3 only
(c) 3 only
(d) 1, 2 and 3
Answer: b

Q. With reference to Non-Fungible Tokens (NFTs), consider the following statements:

1. They enable the digital representation of physical assets.
2. They are unique cryptographic tokens that exist on a blockchain.
3. They can be traded or exchanged at equivalency and therefore can be used as a medium of commercial transactions.
Which of the statements given above are correct? (2022)
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer: a

1.4 Money Supply

● In a modern economy money consists mainly of currency notes and coins issued by the monetary authority of the
country.
○ In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in
India.
○ However, coins are issued by the Government of India.
● Apart from currency notes and coins— the balance in savings, or current account deposits, held by the public in
commercial banks is also considered money since cheques drawn on these accounts are used to settle transactions.
○ Such deposits are called demand deposits as they are payable by the bank on demand from the account
holder.
○ Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits.
● The value of the currency notes and coins is derived from the guarantee provided by the issuing authority of these
items.
○ Every currency note bears on its face a promise from the Governor of RBI 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. The same is also true of coins.
○ Currency notes and coins are therefore called fiat money.
■ They do not have intrinsic value like a gold or silver coin. They are also called legal tenders as they
cannot be refused by any citizen of the country for settlement of any kind of transaction.
■ Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of
payment. Hence, demand deposits are not legal tenders.

1.4.1 Legal Definitions: Narrow and Broad Money

● Money supply, like money demand, is a stock variable.
○ The total stock of money in circulation among the public at a particular point of time is called money supply.
○ RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4.
● They are defined as follows
Self Notes
 72

○ M1 = CU + DD
○ M2 = M1 + Savings deposits with Post Office savings banks
○ M3 = M1 + Net time deposits of commercial banks
○ M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings
Certificates)
where, CU is currency (notes plus coins) held by the public and DD is net demand deposits held by 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, which a commercial bank holds in other commercial banks, are not to be regarded as part of
money supply.
● M1 and M2 are known as narrow money.
● M3 and M4 are known as broad money.
● These gradations are in decreasing order of liquidity.
○ M1 is most liquid and easiest for transactions whereas M4 is least liquid of all.
○ M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources.
1.4.2 Money Creation by the Banking System
● Money supply will change if the value of any of its components such as CU, DD or Time Deposits changes.
○ Various actions of the monetary authority, RBI, and commercial banks are responsible for changes in the values
of these items.
○ The preference of the public for holding cash balances vis- ́a-vis deposits in banks also affect the money supply.
● These influences on money supply can be summarised by the following key ratios.

1.4.2.1 The Currency Deposit Ratio

● The currency deposit ratio (cdr) is the ratio of money held by the public in currency to that they hold in bank deposits.
cdr = CU/DD
● If a person gets Re 1 she will put Rs 1/(1 + cdr) in her bank account and keep Rs cdr/(1 + cdr) in cash. It reflects people’s
preference for liquidity. It is a purely behavioural parameter which depends, among other things, on the seasonal pattern
of expenditure.
○ For example, cdr increases during the festive season as people convert deposits to cash balance for meeting
extra expenditure during such periods.

1.4.2.2 The Reserve Deposit Ratio

● Banks hold a part of the money people keep in their bank deposits as reserve money and loan out the rest to various
investment projects.
● Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI.
○ Banks use this reserve to meet the demand for cash by account holders.
● Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves.
● Keeping reserves is costly for banks, as, otherwise, they could lend this balance to interest earning investment projects.
However, RBI requires commercial banks to keep reserves in order to ensure that banks have a safe cushion of assets
to draw on when account holders want to be paid.
● RBI uses various policy instruments to bring forth a healthy rdr in commercial banks.
○ The first instrument is the Cash Reserve Ratio which specifies the fraction of their deposits that banks must
keep with RBI.
○ There is another tool called Statutory Liquidity Ratio which requires the banks to maintain a given fraction of
their total demand and time deposits in the form of specified liquid assets.
● Apart from these ratios RBI uses a certain interest rate called the Bank Rate to control the value of rdr.
○ Commercial banks can borrow money from the RBI at the bank rate when they run short of reserves. A
high bank rate makes such borrowing from RBI costly and, in effect, encourages the commercial banks to
maintain a healthy rdr.
1.4.2.3 High Powered Money
● The total liability of the monetary authority of
the country, RBI, is called the monetary base or
high powered money.
○ It consists of currency (notes and coins in
circulation with the public and vault cash of
commercial banks) and deposits held by
the Government of India and commercial
banks with RBI.
■ If a member of the public
produces a currency note to RBI
the latter must pay her value
Self Notes
 73

equal to the figure printed on the note. Similarly, the deposits are also refundable by RBI on demand
from deposit-holders.
■ These items are claims which the general public, government or banks have on RBI and hence are
considered to be the liability of RBI.
1.4.3 Factors affecting Money Supply
● Money Supply is affected mainly by two factors viz. Monetary base and Money Multiplier.
● Monetary Base:
○ As the reserve money changes, money supply also changes in the same direction. This means if there is more
reserve money in the system, money supply would increase and vice versa. Please note that most of the
changes in the money supply are due to changes in the high powered money.
● Money Multiplier:
○ Money Multiplier is the ratio of the Narrow Money (M1) or the Broad Money (M3) to Reserve Money.

Q. Consider the following liquid assets: (2013)

(1) Demand deposits with the banks
(2) Time deposits with the banks
(3) Savings deposits with the banks
(4) Currency
The correct sequence of these decreasing order of Liquidity is
(a) 1-4-3-2
(b) 4-3-2-1
(c) 2-3-1-4
(d) 4-1-3-2
Answer : D

Q. Supply of money remaining the same when there is an increase in demand for money, there will be (2013)
(a) a fall in the level of prices
(b) an increase in the rate of interest
(c) a decrease in the rate of interest
(d) an increase in the level of income and employment
Answer : B

Q. If you withdraw 1,00,000 in cash from your Demand Deposit Account at your bank, the immediate effect on the aggregate
money supply in the economy will be
(a) to reduce it by 1,00,000
(b) to increase it by 1,00,000
(c) to increase it by more than 1,00,000
(d) to leave it unchanged
Answer: d

1.5 Money Multiplier (m)

A money multiplier is a method of demonstrating the maximum amount of broad money that commercial banks could create for
a given fixed amount of base money and reserve ratio.

● Money multiplier (m) is the inverse of the reserve requirement (R)

Money Multiplier = 1/Reserve ratio

m = 1/R

● For example, with a reserve ratio of 20%, this reserve ratio can also be expressed as a fraction: R = 1/5
● As a result, the money multiplier, m, will be calculated as: m = 1/(1/5) = 5
● This figure is multiplied by the amount of reserves to calculate the money supply's maximum potential amount.
● For example, if the Reserve Ratio is 1/10 (10 per cent) or the Money Multiplier is 10, Rs.100 can be multiplied by
10 to generate Rs.1000 in the money supply.

The velocity of money

● It is a measurement of the rate at which money is exchanged in an economy. It is the number of times that money

Self Notes
 74

moves from one entity to another.

○ The velocity of money also refers to how much a unit of currency is used in a given period of time. Simply
put, it's the rate at which consumers and businesses in an economy collectively spend money.
● The velocity of money is usually measured as a ratio of gross domestic product (GDP) to a country's M1 or M2 money
supply. The word velocity is used here to reference the speed at which money changes hands.
Velocity of money = GDP/Money Supply

1.5.1 Effects of Money Supply in the Economy

● The increase or decrease in the money supply affects many macroeconomic parameters. A significant effect can be
witnessed in the interest rates and inflation.
● Effects due to increased money supply:
○ An increase in the money supply often lowers interest rates
○ This stimulates spending by generating more investment and putting more money in the hands of consumers.
○ Businesses respond by expanding production and ordering more raw materials.
○ The need for labour rises as company activity rises generating employment.
○ Increased disposable income increases the demand for commodities and results in inflation.
● Effects due to decreased money supply:
○ A decrease in the money supply often increases interest rates
○ This hinders borrowing and spending, reducing investments and disposable income in the hands of consumers.
○ Businesses respond by reducing production and laying off workers.
○ Poor disposable income decreases the demand for commodities and results in deflation and gradually results
in recession.
● The money supply has long been thought to be an important element in determining macroeconomic performance and
business cycles.

Q. The money multiplier in an economy increases with which one of the following? (2021)
a) Increase in the Cash Reserve Ratio in the banks.
b) Increase in the Statutory Liquidity Ratio in the banks
c) Increase in the banking habit of the people
d) Increase in the population of the country
Answer: c

1.6 Indian Monetary System

● The monetary system prevailing in India at present is managed and controlled by the Reserve Bank of India.
● The present monetary system is based on inconvertible paper currency, supplemented by coins described as Paper
currency standard or managed currency standard.
● On the external front Indian currency 'rupee' is again convertible to various other currencies of the world.
● The system governing note issue in India is the Minimum Reserve System. The Reserve Bank of India (RBI) is required
to hold a minimum reserve of Rs. 200 crores in the form of gold and foreign securities, of which not less than
Rs.115 crore must be in the form of gold.
● Subject to the maintenance of such reserves the RBI is empowered to print unlimited currency against the backing of
the securities of the Government of India.
● RBI has the sole right to issue currency notes, other than one rupee note/coin and lower denomination coins,
which are issued by the government of India, under the Indian Coinage Act. However, the circulation of the entire
currency (including notes and coins) is conducted only by the RBI.
1.7 Monetary Policy
● Monetary policy is an economic policy instrument that influences the cost and availability of money and credit
in the economy to various sectors.
● Monetary Policy is the use of interest rates and other instruments by the central bank to influence the money supply in
order to achieve macroeconomic goals.
● To achieve a balance between economic growth and inflation control, the RBI has pursued a policy of 'controlled
monetary expansion.'
Goals of Monetary Policy
● The primary goal of monetary policy is to maintain price stability while still pursuing the goal of economic growth.
Price stability is a critical prerequisite for long-term growth.

Self Notes
 75

● The Reserve Bank of India (RBI) Act, 1934 was revised in May 2016 to give a legal basis for the flexible inflation
targeting framework's implementation.
● The amended RBI Act also mandates that the government of India, in collaboration with the Reserve Bank, determine
the inflation target once every five years.
● As a result, the Central Government published a notice in the Official Gazette setting a target of 4% Consumer Price
Index (CPI) inflation for the period August 5, 2016 to March 31, 2021, with a 6% upper tolerance limit and a 2%
lower tolerance limit.
● The Central Government retained the inflation target and tolerance band for the following 5-year period – April 1,
2021 to March 31, 2026 – on March 31, 2021.
● The following issues have been identified by the central government as contributing to the inability to meet the inflation
target:
a. For any three consecutive quarters, average inflation exceeds the inflation target's upper tolerance level; or
b. For any three consecutive quarters, average inflation falls below the lower tolerance level.
● Prior to the May 2016 change to the RBI Act, the flexible inflation targeting framework was controlled by a February
20, 2015 Monetary Policy Framework Agreement between the Government and the Reserve Bank of India.
Other Goals of Monetary Policy
● Promotion of saving and investment: A higher rate of interest means more opportunities for investment and
savings, ensuring a healthy cash flow in the economy.
● Managing business cycles: A business cycle has two primary stages: boom and depression. By regulating credit
to manage the availability of money, monetary policy is the most effective weapon for controlling the boom and bust
of business cycles.
● Controlling imports and exports: Monetary policy assists export-oriented units in substituting imports and increasing
exports by assisting them in obtaining a loan at a lower interest rate. As a result, the state of the balance of payments
improves.
● Aggregate demand regulation: When credit is expanded and interest rates are lowered, more people are able to
get loans for the purchase of goods and services.
● Employment Generation: Small and medium companies (SMEs) can readily obtain a loan for business expansion
because to the monetary policy's ability to cut interest rates. This could result in more job chances.
● Helping infrastructure development: The monetary policy allows for concessional funding for infrastructure
development within the country.

Monetary Policy can be broadly categorised into Expansionary and contractionary monetary policy.

1.7.1 Expansionary Monetary Policy

● The goal of an expansionary monetary policy is to increase the money supply in a given economy.
● Lowering key interest rates and enhancing market liquidity are used to implement an expansionary monetary policy.
● This is generally used when the economy is undergoing recession to boost the money supply and increase
consumption and generate demand.
● It is also called as Dovish Monetary Policy.
● For Instance, due to the COVID-19 situation present in the country in March 2020, the RBI took an accommodative
stance and reduced Repo Rate by 75 basis points from 5.15% to 4.40%.

1.7.1.1 Effects of an Expansionary Monetary Policy

● An expansionary monetary policy can bring some fundamental changes to the economy. The following effects are the
most common:
1. Stimulation of economic growth
○ An expansionary monetary policy reduces the cost of borrowing. Therefore, consumers tend to spend
more while businesses are encouraged to make larger capital investments.
2. Increased inflation
○ The injection of additional money into the economy increases inflation levels. It can be both
advantageous and disadvantageous to the economy. The excessive increase in the money supply
may result in unsustainable inflation levels. On the other hand, the inflation increase may prevent
possible deflation, which can be more damaging than reasonable inflation.
3. Currency devaluation
○ The higher money supply reduces the value of the local currency. The devaluation is beneficial to the
economy’s export ability because exports become cheaper and more attractive to foreign countries.
4. Decreased unemployment

Self Notes
 76

○ The stimulation of capital investments creates additional jobs in the economy. Therefore, an
expansionary monetary policy generally reduces unemployment.
1.7.2 Contractionary Monetary Policy

● The goal of contractionary monetary policy is to decrease the money supply in an economy.
● Increases in key interest rates, which reduce market liquidity, are used to achieve a contractionary monetary policy.
● This is generally used when the economy is undergoing inflation to reduce the money supply and decrease
consumption and reduce demand.
● It is also called as Hawkish Monetary Policy.
● For Instance, in August 2018 due to inflationary concerns (inflation was estimated around 4.8%) and falling rupee, the
RBI maintained a neutral stance and increased Repo Rate by 25 basis points from 6.25% to 6.50%.

1.7.2.1 Effects of a Contractionary Monetary Policy

● A contractionary monetary policy may result in some broad effects on an economy. The following effects are the most
common:
1. Reduced inflation
○ The inflation level is the main target of a contractionary monetary policy. By reducing the money supply
in the economy, policymakers are looking to reduce inflation and stabilise the prices in the economy.
2. Slow down economic growth
○ Reducing the money supply usually slows down economic growth. As the money supply in the
economy decreases, individuals and businesses generally halt major investments and capital
expenditures, and companies slow down their production.
3. Increased unemployment
○ An unwanted side effect of a contractionary monetary policy is a rise in unemployment. The economic
slowdown and lower production cause companies to hire fewer employees. Therefore, unemployment
in the economy increases.
Q. If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do?
(1) Cut and optimize the Statutory Liquidity Ratio
(2) Increase the Marginal Standing Facility Rate
(3) Cut the Bank Rate and Repo Rate
Select the correct answer using the code given below: (2020)
(a) 1 and 2 only
(b) 2 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer: b

1.8 Instruments of Monetary Policy

There are two broad instruments of the monetary policy of the RBI- Quantitative Methods or General Methods and
Qualitative or Selective Methods.
1.8.1 Quantitative Methods
● The Quantitative tools are also known as the Reserve Bank of India’s general tools.
● These instruments are linked to the quantity and volume of money, as the name implies.
● These instruments are used to regulate the total amount of money and volume of bank credit in the economy.
● These are indirect instruments that are used to influence the amount of credit available in the economy.
● For instance, reducing the Statutory Liquidity Rate (SLR) will increase the liquidity of money in the market and increasing
the SLR will decrease the liquidity.
Different Quantitative tools
There are many quantitative tools available with the RBI to control the volume of money and liquidity under its monetary policy.
They are as follows,
1.8.1.1 Bank Rate
● Bank Rate is the interest rate at which the Reserve Bank of India (RBI) lends money to domestic/commercial banks,
usually in the form of relatively short-term loans.
● Commercial banks are not required to keep any collateral as security when borrowing at Bank Rate.
● There is no repurchasing agreement and obligation to repay on a particular date.
● Section 49 of the Reserve Bank of India Act, 1934, governs the publication of the Bank Rate.
● This rate is linked to the MSF rate, therefore it adjusts automatically when the MSF rate changes, as well as when the
policy repo rate changes.

Self Notes
 77

● As of June 2022, the Bank rate is 5.15%.

1.8.1.2 Statutory Liquidity Ratio (SLR)
● Statutory Liquidity Ratio (SLR) is the minimum percentage of deposits (ie. Net Demand and Time Liabilities (NDTL))
that a commercial bank must keep with itself.
● This asset can be in the form of the following:
○ Cash
○ Gold valued at a price not exceeding the current price
○ Government securities and Treasury Bills
● Note: In the case of securities, the bank can only hold government securities and can not invest in any private stocks.
● The Reserve Bank of India is authorized to set SLR and change it with changing macroeconomic conditions.
● To keep bank credit under control, the Reserve Bank of India raises the SLR as inflation rises. During a recession, the
RBI lowers the SLR to promote bank credit.
● The CRR (Cash Reserve Ratio) and SLR (Stock Liquidity Ratio) have long been used by central banks to limit credit
growth, liquidity flow, and inflation in the economy.
● A bank is liable to pay a penalty to the Reserve Bank of India if it fails to maintain the prescribed SLR. On the deficient
amount for that particular day, the defaulter bank must pay a penalty of 3% above the bank rate.
● The 2007 amendment to the Banking Regulation Act of 1949 removed the lower ceiling of SLR which implied it can be
sr between 0-40% of NDTL of the banks.
● As of June 2022, the SLR is at 18.00% of the NDTL of the banks.
1.8.1.3 Cash Reserve Ratio
● The Cash Reserve Ratio (CRR) is the minimum percentage of total deposits (ie. NDTL) that a commercial bank is
required to retain as cash reserves with the RBI.
● It has to be in the form of Cash.
● It is applicable to all Scheduled commercial banks.
● For Instance, let us consider that Bank A has received 100 Crores as Deposits. If we have a CRR of 3% then Bank A
has to deposit 3 crores in Cash form with the RBI and are left with 97 crores for its operation.
● When a central bank raises the CRR, the amount of money accessible to banks reduces or falls and vice-versa.
● It has to be placed in a vault in the bank or placed with the RBI.
● The RBI Act 1949, Section 42 gave a provision for the RBI to announce a CRR between 3%-15%. This was amended
in 2007 by removing the lower ceiling making it 0-15%.
● As of June 2022, the CRR is maintained at 4.5%.
1.8.1.4 Open Market Operation (OMO)
● Open Market Operations (OMO) is the selling and purchase of government securities and treasury bills by the RBI.
● Selling of G-Secs by RBI will reduce the liquidity in the market and Buying of G-Secs by RBI will increase the liquidity.
● All Scheduled Commercial Banks and Financial institutions can participate in OMO.
● The RBI has allowed even the retail investors to invest in G-secs by opening gilt accounts with the Central Bank.
● In April 2021, the RBI performed a simultaneous buying and selling of Government securities through Open
Market Operations of nearly Rs. 10000 crores each.
1.8.1.5 Liquidity Adjustment facility
● It is a monetary policy tool used largely by the Reserve Bank of India (RBI) that controls the liquidity or money supply
in the economy.
● It does it by either allowing banks to borrow money via repurchase agreements (repos) or lend loans to the RBI via
reverse repo agreements.
● Liquidity Adjustment Facility was recommended by the Narasimhan Committee on Banking Reforms and was
introduced by the RBI in 1998.
● There are two main components of Liquidity Adjustment Facility (LAF):

Repo Rate:
● It is the rate at which the Reserve Bank of India (RBI) lends to other banks.
● It is a part of the Liquidity Adjustment Facility (LAF) of the RBI.
● The Repo rate borrowing is generally available at the overnight repo, 7 days, 14-day repo.
● The commercial banks make a repurchase agreement with the RBI and sell the G-secs and buy back at a different rate
on the agreed price.
● The increased repo rate will discourage banks to borrow from the RBI and lending to the customers. This in turn will
reduce the liquidity and demand in the market. It is part of the contractionary monetary policy.
● On the other hand, decreased repo rate will encourage banks to borrow and lend to customers increasing the liquidity
and demand in the market. This is a part of the Expansionary Monetary Policy.
● As of June 2022 Monetary Policy Review, the Repo rate is set at 4.90%.

Self Notes
 78

Reverse Repo Rate:

● It is the rate at which the Reserve Bank of India (RBI) borrows from commercial banks.
● It is a part of the Liquidity Adjustment Facility (LAF) of the RBI.
● The Reverse Repo rate borrowing is generally available at 7 days, 14 days reverse repo rate.
● The RBI makes a repurchase agreement with the commercial banks and sells the securities and buy them back at a
different rate on the agreed price.
● The increased reverse repo rate will encourage banks to lend to the RBI. This will reduce liquidity with the bank
resulting in decreased lending activities and reduced demand in the market. It is part of the contractionary monetary
policy.
● On the other hand, decreased reverse repo rate will encourage banks to lend to customers rather than lending to RBI,
therefore increasing the liquidity and demand in the market. This is a part of the Expansionary Monetary Policy.
● As of June 2022 Monetary Policy Review, the Reverse Repo rate is set at 3.35%.
Parameter Bank Rate Repo Rate

Meaning The Bank Rate is applied to loans made by the Repo Rate is applied to the central bank's repurchase
central bank to commercial banks. of securities sold by commercial banks.

Collateral No collateral is required Securities, bonds and agreements are given as

collateral

Impact Directly impact customers as it impacts long The Repo rate is handled by the banks and doesn’t
term lending. impact the customers directly.

Rate Higher than Repo due to no collateral and long Lower than Bank Rate as there is a collateral and
term nature. repurchase obligation.

Duration of loan Bank rate caters to long term requirements of Repo Rate focuses on short term financial lending.
commercial banks.

1.8.1.6 Standing Deposit Facility (MSF)

● Marginal Standing Facility (MSF) refers to the rate at which banks can borrow overnight funds from the RBI.
● This was introduced by the RBI in its credit policy of May 2011.
● The banks have to exchange the securities with the RBI to avail of the overnight credit through MSF.
● The maximum credit a bank can avail of through MSF is 3% of its total deposits (NDTL).
● The banks can use the securities under the SLR quota without paying a penalty as it is an emergency situation.
● This will shield the banks from the volatility of overnight inter-bank interest rates.
● Generally, the MSF is higher than the repo rate and MSF in June 2022 is 5.15%.
1.8.1.7 Long-Term Repo Operation
● The Long-Term Reverse Repo Operation (LTRO) is a tool for facilitating the transmission of monetary policy and the
flow of credit into the economy. This contributes to the injection of liquidity into the financial sector.
● The repo rate is used to provide funds through the LTRO. This means banks can take out one-year and three-year
loans at the same one-day repo interest rate. However, compared to short-term (repo) loans, loans with a longer maturity
time (such as one year and three years) normally have a higher interest rate.
● The LTRO scheme will be in addition to the Liquidity Adjustment Facility (LAF) and Marginal Standing Facility
(MSF) operations, according to the RBI.
● In February 2020, the central bank conducted LTROs for one- and three-year tenors of appropriate amounts for up to
a total sum of ₹ 1,00,000 crore at policy repo rates.
● The Core Banking Solution (E-KUBER) platform is used to perform LTROs. The operations would be carried out at a
predetermined rate.
● The minimum bid amount will be Rs 1 crore, plus multiples of that amount. Individual bidders will not be limited in
their maximum amount of bidding.
1.8.1.8 Market Stabilisation Scheme (MSS)
● The RBI's Market Stabilization Scheme (MSS) is a monetary policy tool for managing the economy's money supply.
● The securities issued are government bonds known as Market Stabilisation Bonds (MSBs). As a result, MSBs are the
bonds issued under MSS.
● The government owns these securities, despite the fact that they were issued by the RBI.
● Government securities (bonds/treasury bills) are often sold or issued by the RBI, which serves as the government's
banker.

Self Notes
 79

● The government lends the RBI its bonds or securities (MSBs) to carry out the MSS. The RBI thus becomes a debtor to
the government in the amount of the MSBs.
● However, the government cannot use the money raised during MSS and must be kept in a separate MSS account to
pay for bonds at maturity.
● Interest is paid for the MSB’s by the government.
● During demonetisation, MSBs worth Rs 6 lakh crores were issued by the RBI to withdraw the excess liquidity.
1.8.1.9 Relationship between liquidity and quantitative tools
Quantitative Tool What happens if increased What happens if its decreased

Bank Rate Money Supply decreases Money Supply increases

Statutory Liquidity Ratio Money Supply decreases Money Supply increases

(SLR)

Cash Reserve Ratio (CRR) Money Supply decreases Money Supply increases

Repo rate Money Supply decreases Money Supply increases

Reverse Repo Rate Money Supply decreases Money Supply increases

Standing Deposit Facility Money Supply decreases Money Supply increases

(MSF)

Long Term Repo Money Supply decreases Money Supply increases

Operation (LTRO)

Open Market Operation Selling securities will decrease money supply Buying securities will increase money supply
(OMO)

Market Stabilisation It is done specifically to remove excess liquidity and money supply in the economy in special
Scheme (MSS) cases

1.8.1.10 Significance of Quantitative tools

● Quantitative tools are linked to the quantity and volume of money, as the name implies.
● It is used to regulate the total amount of money and volume of bank credit in the economy.
● Quantitative tools are indirect instruments that are used to influence the amount of credit available in the economy.
● It affects the level of aggregate demand through the supply of money, cost of money and availability of credit.
1.8.1.11 Limitations of Quantitative tools
● Frequent changes in policy rates can cause speculations among the banks leading to poor transmission of monetary
policy.
● Issues such as Non-Performing Assets have hindered credit creation in spite of Quantitative tools used to increase
liquidity.
● The usage of quantitative tools alone can’t achieve the desired situation in an economy as there are many other
parameters deciding money supply.

Q. In the context of Indian economy, Open Market Operations’ refers to (2013)

(a) borrowing by scheduled banks from the RBI
(b) lending by commercial banks to industry and trade
(c) purchase and sale of government securities by the RBI
(d) None of the above
Answer : C

Q. An increase in the Bank Rate generally indicates that the (2013)

(a) market rate of interest is likely to fall
(b) Central Bank is no longer making loans to commercial banks
(c) Central Bank is following an easy money policy
(d) Central Bank is following a tight money policy

Self Notes
 80

Answer : D

Q. The terms ‘Marginal Standing Facility Rate’ and ‘Net Demand and Time Liabilities’, sometimes appearing in news, are used
in relation to ( 2014 )
(a) banking operations
(b) communication networking
(e) military strategies
(d) supply and demand of agricultural products
Answer : A

Q. In the context of the Indian economy; which of the following is/are the purpose/purposes of ‘Statutory Reserve
Requirements’? ( 2014 )
(1) To enable the Central Bank to control the amount of advances the banks can create
(2) To make the people’s deposits with banks safe and liquid
(3) To prevent the commercial banks from making excessive profits
(4) To force the banks to have sufficient vault cash to meet their day-to-day requirements
Select the correct answer using the code given below.
(a) 1 only
(b) 1 and 2 only
(c) 2 and 3 only
(d) 1, 2, 3 and 4
Answer : A

Q. With reference to the Indian economy, consider the following (2015)

(1) Bank rate
(2) Open market operations
(3) Public debt
(4) Public revenue
Which of the above is/are component/ components of Monetary Policy?
(a) 1 only
(b) 2, 3 and 4
(c) 1 and 2
(d) 1, 3 and 4
Answer : C

Q. When the Reserve Bank of India reduces the Statutory Liquidity Ratio by 50 basis points, which of the following is likely to
happen? (2015)
(a) India’s GDP growth rate increases drastically
(b) Foreign Institutional Investors may bring more capital into our country
(c) Scheduled Commercial Banks may cut their lending rates
(d) It may drastically reduce the liquidity to the banking system
Answer : C

Q. If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do?
(1) Cut and optimize the Statutory Liquidity Ratio
(2) Increase the Marginal Standing Facility Rate
(3) Cut the Bank Rate and Repo Rate
Select the correct answer using the code given below: (2020)
(a) 1 and 2 only
(b) 2 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer: b

1.8.2 Qualitative Methods

● Qualitative instruments are selective instruments of the RBI's monetary policy.
● These instruments are used to distinguish between different types of credit, such as preferring export over import or
essential credit supply over non-essential credit supply.
● Both borrowers and lenders are affected by this strategy.
● These instruments have an impact on how credit is used in various sectors. For example, the RBI can set upper limits
on how much money banks can lend to specific sectors of the economy.
Self Notes
 81

● The amount of money in circulation is unaffected. The available funds are simply directed in a certain direction.

Following are the qualitative tools used by the RBI for credit control.
1.8.2.1 Change in Marginal Requirement
● The term "margin" refers to the percentage of a loan that is not offered or financed by the bank.
● A change in the loan size can be caused by a change in the marginal requirement.
● This device is used to boost credit supply for necessary sectors while discouraging it for non-essential ones.
● This can be accomplished by raising the marginal of unneeded sectors while lowering the marginal of other sectors in
need.
● If the RBI believes that additional credit should be available to the agricultural sector, the margin will be reduced, and
80-90 per cent of the loan will be available.
○ For Instance, if the marginal requirement for the agricultural sector is 10% and if someone pledges collateral
worth 10 crores for a loan of 10 crores, then the sanctioned loan would be a maximum of 9 crores.
○ On the other hand, if the automotive sector has a marginal requirement of 20%, for the same collateral and
loan the sanctioned amount will be 8 crores.
1.8.2.2 Regulation of Consumer Credit
● Consumer credit supply is regulated by the instalment of sale and hire purchase of consumer goods.
● Features such as instalment amount, down payment, loan period, and so on are all pre-determined, which aids in the
control of credit and inflation in the country.
● For Instance, for a home loan, the RBI can set a minimum downpayment limit of 15%. Therefore for a home loan of 1
crore, Rs. 15 lakhs must be paid as a downpayment and avail 85 lakhs as a loan.
1.8.2.3 Rationing of Credit
● The Reserve Bank of India sets a credit limit for commercial banks. The quantity of credit accessible to any commercial
bank is limited.
● The higher credit limit might be set for certain objectives, and banks must adhere to it.
● This reduces the bank's credit exposure to unfavourable industries. This device also regulates bill rediscounting.
● For Instance, the banks might be instructed by the RBI not to lend to traders of Onion and Potato in spite of having
eligibility and collateral pledging capacity. This is to ensure there is no hoarding of essential commodities by using bank
loans.
1.8.2.4 Moral Suasion
● Moral suasion refers to the RBI's recommendations to commercial banks that aid in the restraint of credit during
inflationary periods.
● The Reserve Bank of India (RBI) exerts pressure on the Indian banking system without taking any concrete steps to
ensure compliance with the rules.
● Commercial banks are informed of the RBI's expectations through monetary policy.
● Under moral suasion, the RBI can offer orders, recommendations, and suggestions to commercial banks to reduce loan
supply for speculative purposes.
● For Instance, the Governor of RBI made a press statement that the reduction in repo rates has not been transferred to
the consumers. This will nudge the banks to reduce their interest rates.
1.8.2.5 Direct Action
● The central bank (RBI) can punish and impose sanctions on banks for not following the guidelines provided under the
monetary policy.
● For Instance, the imposition of the Prompt Corrective Action Framework is one such Direct Action measure.

1.8.3 Comparison between Quantitative Tools and Qualitative Tools

Parameter Quantitative Tools Qualitative Tools

Indirect in nature as any change in these tools Direct in nature as any changes are directly
Impact may not transmit to the consumer immediately impacting the consumers as the case of
or directly. requirement of a down payment.

Self Notes
 82

The reach of Quantitative tools is general. They

The reach of Qualitative tools is selective. It can
affect the money supply in the entire economy
Reach affect the money supply in a specific sector of the
and all sectors be it housing, automobile,
economy like automobiles or agriculture.
manufacturing- everything.

1.9 Monetary Policy Reforms

The Committee to Review and Strengthen the Monetary Policy Framework headed by Dr. Urjit R. Patel submitted its report
in January 2014.

Key Recommendations

● The headline Consumer Price Index (CPI) should be the nominal anchor for monetary policy and the Reserve Bank of
India (RBI) should make this the predominant objective.
● The nominal anchor for inflation should be set for a two-year horizon at 4 percent with a band of plus or minus 2 percent.
● When inflation is higher than the nominal anchor, it is expected that ‘real’ policy rate will on an average be positive.
● Monetary policy decisions should be vested in a Monetary Policy Committee (MPC) comprising the Governor, the Deputy
Governor and the Executive Director in charge of monetary policy and two external full-time members.
● The decisions of the MPC will be by voting. Members will be accountable for failure to attain the target—failure being
defined as the inability to attain the target for three successive quarters.

1.9.1 Monetary Policy Framework Agreement

● Monetary Policy Framework Agreement is an agreement reached between Government and the central bank on the
maximum tolerable inflation rate that RBI should target to achieve price stability.
● This amendment to the RBI Act was carried out through the Finance Bill, 2016 presented along with the Union Budget
documents.
● India thereby formally joined the list of nations which tasks its central bank with the responsibility for inflation targeting.
1.9.1.1 Features
● The primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth.
● Under the present Monetary Policy Framework Agreement signed on 20 February 2015, the RBI will be responsible for
containing inflation targets at 4% (with a deviation of +/- 2%) in the medium term.
● Under Section 45ZA(1) of the RBI Act, 1934, the Central Government determines the inflation target in terms of the
Consumer Price Index, once in every five years in consultation with the RBI. This target would be notified in the Official
Gazette.
● Though the central bank already had a monetary framework and was implementing the monetary policy, the newly
designed statutory framework would mean that the RBI would have to give an explanation in the form of a report to the
Central Government if it failed to reach the specified inflation targets.
● In the report it shall give reasons for failure, remedial actions as well an estimated time within which the inflation target
shall be achieved.
● Further, RBI is mandated to publish a Monetary Policy Report every six months, explaining the sources of inflation and
the forecasts of inflation for the coming period of six to eighteen months.
1.9.2 Monetary Policy Committee

● On June 27, 2016, the Government amended the RBI Act to hand over the job of monetary policy-making in India to a
newly constituted Monetary Policy Committee
● Before the establishment of the Monetary Policy Committee, the final decision on interest rates etc. would come
from RBI Governor’s desk.
● Though there was a Technical Advisory Committee (TAC) comprising the governor as its chairman, the deputy governor
as its vice-chairman and other 3 deputy governors to decide on monetary policy yet, the Governor had overriding powers
upon the decision-making process. The TAC was advisory in nature and there was no voting system there
● The new MPC is to be a six-member panel that is expected to bring “value and transparency” to rate-setting decisions.
● It has three members from the RBI — the Governor, a Deputy Governor and another official and three independent
members to be selected by the Government.
● A search committee will recommend three external members, experts in the field of economics, banking or finance, for
the Government appointees.
● The MPC will meet four times a year to decide on monetary policy by a majority vote. And if there’s a tie between the
‘Ayes’ and the ‘Nays’, the RBI governor gets the deciding vote.

Self Notes
 83

Objectives of MPC

● The monetary policy Committee is concerned with setting policy rates and other monetary policy decisions in order to
achieve:
○ Price stability
○ Accelerating the growth of the economy
○ Exchange rate stabilisation
○ Balancing savings and investment
○ Generating employment
○ Financial stability
● The primary goal of the monetary policy committee is to maintain price stability while keeping growth in mind as per
the monetary policy framework agreement. Price stability is a prerequisite for long-term growth.
● In order to maintain price stability, inflation must be kept under control.
○ Every five years, the Indian government sets an inflation target.
○ The Reserve Bank of India (RBI) plays an important role in the consultation process for inflation targeting.
○ The current inflation-targeting framework in India is flexible with a target of 4% with a band of +/-2%.
Why focus on inflation targeting?
● Previously, India's central bank used to take its monetary policy decisions based on the multiple indicator approach.
● Its rate decisions were expected to take into account inflation, growth, employment, banking stability and the need for
a stable exchange rate.
● As this is a tall order, RBI (with the Governor as the focal point) would be subject to hectic lobbying ahead of each
policy review and trenchant criticism after it.
● The Government would clamour for lower rates while consumers bemoaned high inflation. Bank chiefs would want
rate cuts, but pensioners would want high rates.
● RBI ended up juggling all these objectives and focussing on different indicators at different points in time.

1.9.3 Assessment of Monetary Policy Committee

● Reduced conflict between the government and the Central bank

● More democracy with the inclusion of non-RBI members
● Enhanced transparency as the committee has to convey the minutes of the meetings
● lowers the chances of a wrong decision by a single person even in his best faith

However there are few challenges as well

● There is an apprehension that government may influence the independent members and thus can erode the autonomy
of the RBI.
● Governor only enjoys a casting vote and is bound by the decision of the committee, thus his position becomes symbolic.
● Moreover monetary policy is the responsibility of the central banks the world over and thus critics believe that Governor
must have the veto with few checks.
Q. Which of the following statements is/are correct regarding the Monetary Policy Committee (MPC)? [2017]
(1) It decides the RBI’s benchmark interest rates.
(2) It is a 12-member body including the Governor of RBI and is reconstituted every year.
(3) It functions under the chairmanship of the Union Finance Minister.
Select the correct answer using the code given below :
(a) 1 only
(b) 1 and 2 only
(c) 3 only
(d) 2 and 3 only
Answer: a

Q. With reference to ‘Financial Stability and Development Council’, consider the following statements : [2016]
(1) It is an organ of NITI Aayog.
(2)It is headed by the Union Finance Minister.
(3) It monitors macroprudential supervision of the economy.
Which of the statements given above is/are correct?
(a) 1 and 2 only
(b) 3 only
(c) 2 and 3 only

Self Notes
 84

(d) 1, 2 and 3
Answer: c

1.9.4 Monetary Policy Transmission

● Monetary policy transmission is the process by which the central bank's policy action is transmitted in order to achieve
the ultimate goals of inflation and growth.
● For instance, if the RBI reduces the policy rates then the benefits of reduced lending rates must be passed on to the
customers.
● However the reality is different, the monetary policy was not transmitted to the customers in the internal benchmark era.
● The below table summarises the monetary policy transmission before and after the introduction of External Benchmark
Lending Rates.
1.9.4.1 Monetary Policy Transmission Mechanism in India
● In the Indian context, the repo rate has a significant impact on the momentary policy transmission.
● The repo rate serves as the anchor rate in determining the economy's interest rate (of the banking system).
● Now, how far a change in repo rate can cause a corresponding change in interest rate by banks is dependent on the
banking system's financial conditions.
● In this regard, the banking system is central to India's monetary policy transmission.
● In general, there are two steps to the policy transmission mechanism:
○ In the financial markets, there is a transmission from the policy rate to key rates.
○ Transmission through financial markets to final objectives such as inflation, employment, and output.
1.9.4.2 Channels of Transmission
Changes in the central bank's policy rate have a lag effect on the economy through a range of channels, the most important of
which are:
i. Interest Rate
● Empirical studies suggest that call money rates and interest rates in areas, such as the government debt market, credit
market or equities market, and the currency market, are bi-directionally related.
● Furthermore, studies have demonstrated that policy rate transmission through this channel is asymmetric, i.e., the level
of policy rate transmission varies depending on whether there is a liquidity surplus or a liquidity deficit, with transmission
being more successful during the liquidity deficit conditions.
● One reason could be that banks would be more reliant on RBI liquidity during times of constrained liquidity, making them
more susceptible to RBI-influenced short-term interest rates.
ii. Credit
● Even if the role of equities and debt markets has grown in recent years, India remains a banking-dominated economy.
● Because of the high reliance on bank funding, the bank lending and balance sheet channels are particularly crucial for
monetary transmission.
● Credit growth appears to have an inverse relationship with policy rate fluctuations in terms of balance sheet implications.
● The annualised growth in nominal and real bank credit was lowered by 2.78 and 2.17 percent, respectively, by a 100
basis point rise in the policy rate.
iii. Exchange Rate
● Consumption switching between domestic and foreign goods is how the exchange rate channel works.
● In India, this pathway is weak, with some indications of exogeneity. This is due to India's weak integration with global
financial markets and the Reserve Bank of India's interference in Forex markets.
● Despite this, it is discovered that currency rate depreciation is a major source of inflation risk.
iv. Asset Price
● Asset prices, particularly stock prices, react to interest rate changes, according to empirical evidence for India, however
the amount of the influence is minor.
● The asset price transmission channel has improved as the usage of formal finance for real estate acquisition has
increased.
● During periods of high inflation, however, consumers have a tendency to shift away from bank savings and toward other
types of savings such as gold and real estate, which tend to provide a superior inflation hedge.
● Because these acquisitions are financed through informal channels, they may be less responsive to contractionary
monetary policy, weakening India's asset price channel.

1.9.4.3 Monetary Policy Transmission - Significance

● The process of monetary policy transmission affects economic growth, prices and other aspects of the economy.
● Due to central banks raising the official interest rate, bank lending rates and bond yields will rise. Changes in the
official interest rate are one way for central banks to influence the cost of borrowing for businesses and consumers.
● The discount rates used to compute the present value of cash flows, which are used to estimate the value of securities,
are affected by changes in the official interest rate.
Self Notes
 85

● Official interest rate changes have a substantial impact on economic actors' expectations. Economic agents would
expect lending to increase as a consequence of lower borrowing costs, or asset prices to rise as a result of lower
discount rates and expectations of stronger growth if official interest rates were cut.
● Changes in the official interest rate have an impact on exchange rates. When interest rates in a country rise, investment
in that country becomes more appealing, all other factors being equal.

1.9.4.4 Challenges to Monetary Policy Transmission

1. Inflexible Funding Costs
● In India, customer deposits account for the vast majority of funds lent by banks, while market borrowings through the
issuance of debentures/commercial papers are insignificant.
● Because most of these deposits are contracted at fixed rates, the cost of funds is typically fixed.
● Furthermore, interest rates on small savings remained high when compared to bank rates. This has resulted in a
decrease in bank deposits.
● Because of the lack of funds, banks have been unable to lend at lower deposit rates.
● Banks will be unable to transmit monetary policy signals at the desired speed and magnitude until and unless this issue
is addressed.
2. Policy rates are not linked to the market.
● Because the repo rate is administered by the Monetary Policy Committee, it cannot be considered a market-determined
rate.
● Banks are being asked to link their lending rates to the repo rate, with no regard for the cost of lending funds.
3. Nearly three-fourths of the outstanding loans are not linked to external benchmarks.
● The share of outstanding loans linked to external benchmarks has risen from 2.4% in September 2019 to 28.5 per cent
in March 2021.
4. High levels of non-performing assets (NPAs)
● Bank profitability has suffered as a result of the accumulation of large NPAs.
● As a result, banks keep the weighted average lending rate significantly higher than the marginal lending rate.
5. Four Balance Sheet Problems
● According to Arvind Subramanian, former chief economic advisor, India's economic slowdown is facing a "four balance
sheet challenge."
● This has hampered credit growth in India and, as a result, the greater transmission of monetary policy.

Self Notes
 86

BANKING

1. Banking 87
1.1 History of Banking in India 89
1.2 Classification of Banks 89
2. Central Bank/Reserve Bank of India 90
2.1 Historical Background 90
2.2 Functions of RBI 90
2.3 Reserves of RBI 93
2.4 Payment and Settlement Systems Act, 2007 94
2.5 Autonomy for RBI 95
3. Commercial Banks 96
3.1 Functions of Commercial Banks 97
3.2 Role of Commercial Banks in Economic Development of a Country 99
4. Non-banking Financial Institutions (NBFCs) 99
4.1 Criteria for NBFC License 99
4.2 Regulation of NBFCs 99
4.3 Significance of NBFCs 100
4.4 Criticism of NBFCs 100
5. The Regional Rural Banks (RRBs) 100
5.1 Significance 100
5.2 Limitations 101
6. Cooperative Banks (UCBs) 101
6.1 Background 101
6.2 Types of Cooperative Banks in India 101
6.3 Significance 103
6.4 Challenges 103
6.5 Reforms proposed by N.S. Viswanathan Committee 104
7. Small Finance Banks 105
7.1 Eligible promoters 105
7.2 Products and services offered by Small Finance Banks 105
7.3 Difference between NBFC and Small Finance Bank 105
8. Payments Bank 106
8.1 Scope of activities 106
8.2 Promoters who are eligible 106
8.3 Benefits of Payment Banks 106
8.4 Limitations of Payments bank 106
9. Some other banking institutions in India 107
9.1 NABARD 107
Self Notes
 87

9.2 SIDBI 107

9.3 National Housing Bank 107
9.4 MUDRA Bank 107

1. Banking
● The term "banking" as we know it today originated in the Western world.
Self Notes
 88

○ The history of banking in India dates back to the 17th century when it was introduced by British rulers. Since
then, a number of changes have occurred due to the evolution of banking sector, and Indian banks are now
among the best in emerging market economics, with a strong focus on globalisation.a
● Banks are regarded as the pillars of any economy. The Indian economy was experiencing a series of economic crises
in the late 1980s, including the Balance of Payments crisis.
○ From near depletion of foreign reserves in mid-1991 to becoming the world's third largest economy in 2011,
India has come a long way. Banks have made significant contributions to this journey.

What is a Bank?
● A bank is a type of financial intermediary as it mediates between the savers and borrowers. It does so by accepting
deposits from the public and lending money to businesses and consumers. Its primary liabilities are deposits and
primary assets are loans.
● It essentially serves as a conduit between those with excess capital and those in need of those funds. In general, a
country's banking system improves the efficiency of economic transactions.
● Banks are regulated by the country's central bank—in India, the RBI (Reserve Bank of India). The banking sector in
India truly reflects a mixed economy, with public, private, and foreign banks.

1.1 History of Banking in India

1.1.1 Phase I – Pre-Independence Phase
(1786-1947)
● The "Bank of Hindustan," established in 1770
in the then-Indian capital of Calcutta, was the
country's first bank. However, this bank did not
succeed and closed its doors in 1832.
● Over 600 banks were registered in the country
during the pre-independence period, but only a
few survived.
● During British rule in India, the East India
Company established three banks known as
the Presidential Banks:
○ The Bank of Bengal,
○ the Bank of Bombay, and
○ the Bank of Madras.
● These three banks were eventually merged
into a single bank in 1921, which was known
as the “Imperial Bank of India.”
○ The Imperial Bank of India was later nationalised and renamed the State Bank of India, which is now the
largest public sector bank in India.
● In the history of Indian banking, the Oudh Commercial Bank was the country's first commercial bank.
○ Other banks founded in the nineteenth century, such as Allahabad Bank (Est. 1865) and Punjab National Bank
(Est. 1894), have withstood the test of time and continue to exist today.
1.1.2 Phase II – Post-Independence Phase (1947-1991)
● At the time of India's independence, all of the country's major banks were privately led, which was a source of concern
because people in rural areas were still reliant on money lenders for financial assistance.
● To address this issue, the then-Government decided to nationalise the banks.
○ The Banking Regulation Act of 1949 was used to nationalise these banks.
○ The Reserve Bank of India, on the other hand, was nationalised in 1949.
● Following the formation of the State Bank of India in 1955, another 14 banks were nationalised between 1969 and
1991. These were the banks with more than 50 crores in national deposits.
○ Another six banks were nationalised in 1980, bringing the total to twenty.
○ Aside from the aforementioned 20 banks, seven SBI subsidiaries were nationalised in 1959.
○ Except for the State Bank of Saurashtra, which was merged in 2008, and the State Bank of Indore, which was
merged in 2010, all of these banks were merged with the State Bank of India in 2017.
● The primary goal of this move was to reduce the concentration of power and wealth in the hands of a few families who
owned and controlled these financial institutions.
● There were other reasons for nationalisation as well, such as:
○ To assist India's agricultural sector
○ To mobilise individual savings
○ To grow India’s banking network by opening more branches

Self Notes
 89

○ To boost priority sectors by providing banking services

● In addition to nationalising private banks, the Indian government established a few financial institutions between 1982
and 1990 to achieve specific goals.
○ EXIM Bank – a bank that promotes both imports and exports.
○ The National Housing Board – It is responsible for funding housing projects across the country.
○ National Bank for Agriculture and Rural Development (NABARD) – for agricultural development.
○ Small Industries Development Bank of India (SIDBI) – for lending money to small-scale Indian businesses.
1.1.3 Phase III – LPG Era (1991-Till Date)
● Once the banks have been established in the country, regular monitoring and regulations must be followed in order to
maintain the profits generated by the banking sector.
● The final or ongoing phase of the banking sector's development is critical.
● To ensure the stability and profitability of the Nationalised Public Sector Banks, the Government decided to form a
committee led by Shri. M Narasimham to oversee the various banking reforms in India.
● The introduction of private sector banks in India was the most significant development.
● The Reserve Bank of India granted licences to ten private sector banks to establish themselves.
○ Global Trust Bank
○ ICICI Bank
○ HDFC Bank
○ Axis Bank
○ Bank of Punjab
○ IndusInd Bank
○ Centurion Bank
○ IDBI Bank
○ Times Bank
○ Development Credit Bank
● Other notable changes and developments during this time period included:
○ Foreign banks such as Citibank, HSBC, and Bank of America established branches in India.
○ The nationalisation of banks has come to a halt.
○ The Reserve Bank of India and the government treated public and private sector banks equally.
○ Payments banks were established.
○ Small finance banks were allowed to open branches across India.
○ Banks began to digitise transactions and other banking operations.
1.2 Classification of Banks
1.2.1 Scheduled and Non-Scheduled
Banks
● The banking sector is divided into scheduled
and non-scheduled banks.
● Scheduled Banks are listed in the second
schedule of the Reserve Bank of India
(RBI) Act, 1934.
○ The paid-up capital and collected
funds of scheduled banks must be 5
Lakh and above. The RBI grants
loans at the bank rate, and these
banks are eligible to become clearing
house members.
● Non-Scheduled Banks are banks not listed
in the second schedule of the RBI Act, 1934.
○ The paid-up capital and collected
funds are less than INR 5 Lakh.
Such banks need not borrow funds
from the RBI.
1.2.2 Commercial Banks
● Commercial banks can be scheduled or non-scheduled and are regulated under the Banking Regulation Act, 1949.
● These banks accept deposits and grant loans to the general public, businesses, and even the Government. Commercial
types of banking systems are:
○ Public Sector Banks: More than 75% of the total banking business in India comes under the public sector,
also known as nationalised banks. The Indian Government and RBI are the major stakeholders in this sector.

Self Notes
 90

○ Private Sector Banks: Most stakeholders of Private Sector Banks are individual investors, not the RBI or
Indian Government. Nevertheless, these banks must adhere to all the RBI regulations for their operations.
○ Foreign Banks: Foreign Banks have their headquarters in a foreign country but operate as a private entity in
India. They abide by the regulations of their home country and the country in which they operate.
○ Regional Rural Banks: These scheduled commercial banks serve the economically weaker sections, such as
marginal farmers, agricultural labourers, and small businesses. Operating at regional levels, RRBs offer
banking facilities like debit cards, bank lockers, complimentary insurance etc.
1.2.3 Small Finance Banks
● Licensed under section 22 of the Banking Regulation Act, 1949, these types of banking systems cater to sections of
societies not usually served by large banks. They serve micro and cottage industries and small business units.
1.2.4 Payments Banks
● RBI restricts these banks to offer deposit facilities only, with a deposit limit of INR 1 Lakh per customer. You can avail of
debit cards and e-banking facilities.
1.2.5 Cooperative Banks
● These banks are registered under the Cooperative Societies Act, 1912, and function on a no-profit no-loss basis. They
offer banking services to entrepreneurs, small businesses, and industries.

2. Central Bank/Reserve Bank of India

● A central bank, reserve bank, or monetary authority is an institution that manages a state’s currency, money supply, and
interest rates. Central banks also usually oversee the commercial banking system of their respective countries.
2.1 Historical Background
● RBI is the central bank of the country i.e. an apex institution of the Indian monetary system.
● It was established on 1st April 1935 under the RBI Act 1934.
● RBI was set up as the private shareholder's bank with paid-up capital of Rs. 5 crores.
● The Reserve Bank of India (RBI) is a national institution and a pillar of the rapidly growing Indian economy. It is also a
member of the International Monetary Fund (IMF).
● The Reserve Bank of India concept was based on Dr. Ambedkar's strategies outlined in his book "The Problem of the
Rupee – Its Origin and Solution."
● In 1926, the Royal Commission on Indian Currency & Finance recommended the establishment of this central
banking institution.
○ The Hilton Young Commission was another name for this commission.
● The Reserve Bank of India was nationalised in 1949 and became a member of the Asian Clearing Union.
● The Reserve Bank of India (RBI) oversees India's credit and currency systems.
● The RBI's primary goals are to maintain public trust in the system, protect depositors' interests, and provide
people with cost-effective banking services such as cooperative banking and commercial banking.
● The Reserve Bank follows an accounting year from July to June, which enables it to take into account the performance
of banks, which follow an April-March financial year.
● The executive head of the Bank is called the governor, who is assisted by deputy governors and other executive
officers. For general direction, the Bank has a central board of directors, supplemented by four local boards at
Delhi, Calcutta, Madras and Bombay. The head office of the RBI is in Mumbai.

● The process of issuing paper currency was started in the 18th century. Private Banks such as the bank of Bengal,
the bank of Bombay and the Bank of Madras – first printed paper money.
● The first rupee was introduced by Sher Shah Suri based on a ratio of 40 copper pieces (paisa) per rupee. The
name was derived from the Sanskrit word Raupya, meaning silver. Each bank note has its amount written in 17
languages (English and Hindi on the front and 15 others on the back) illustrating the diversity of the country.

2.2 Functions of RBI

The functions of the RBI can be categorised as follows:
1. Monetary policy
○ RBI’s most important functions are the formulation and execution of monetary policy.
○ As provided in the Preamble of the RBI Act 1934, the RBI can regulate the issue of banknotes and the keeping
of reserves to ensure monetary stability in India.
○ It can operate the currency and credit system to its advantage.
○ Under this function, the RBI uses Quantitative and Qualitative tools for the execution of monetary policy.

Self Notes
 91

2. Regulation and supervision of the banking and non-banking financial institutions, including credit information
companies
○ The Reserve Bank's regulatory and supervisory area encompasses not just the Indian banking sector, but
also DFIs, NBFCs, primary dealers, credit information businesses, and select segments of the financial
markets.
○ The Reserve Bank, as the banking system's regulator and supervisor, has a key responsibility to play in
maintaining the system's continuous safety and soundness.
○ This function's goal is to protect depositors' interests by establishing an efficient prudential regulatory
framework for the orderly development and management of banking operations, as well as to maintain general
financial stability through a variety of policy measures.
3. Regulation of money, forex and government securities markets as also certain financial derivatives
○ The Reserve Bank implements its monetary policy through government securities, foreign exchange, and
money market operations.
○ The Monetary operations include Open Market Operations, Liquidity Adjustment Facility and Market
Stabilisation scheme.
4. Management of foreign exchange reserves
○ As the custodian of the country's foreign exchange reserves, the Reserve Bank is responsible for managing
its investment.
○ The Reserve Bank of India Act, 1934, establishes the legislative framework for managing foreign exchange
reserves.
○ The Reserve Bank's reserves management function has expanded in relevance and sophistication in recent
years for two key reasons.
■ First, the Reserve Bank's foreign currency assets have expanded significantly on its balance sheet.
■ Second, with growing worldwide market volatility in currency and interest rates, protecting the value
of reserves and generating an acceptable return on them has become difficult.
○ The Reserve Bank's strategies for managing foreign exchange reserves are based on three main principles:
safety, liquidity, and returns.
5. Foreign exchange management—current and capital account management
○ The Reserve Bank of India is in charge of the country's foreign exchange market.
○ Through the provisions of the Foreign Exchange Management Act of 1999, it oversees and regulates it.
○ The foreign currency market, like all markets, has evolved through time, and the Reserve Bank's approach to
its role as market supervisor has changed as well.
6. Banker to banks
○ Banks are required to keep cash reserves with the Reserve Bank for a portion of their demand and time
liabilities, requiring the need for maintaining accounts with the Reserve Bank.
○ Banks must settle transactions among themselves in order to settle transactions between multiple consumers
who have accounts with different banks. As a result, the settlement of interbank debts becomes crucial.
○ Banks require a common banker in order to ensure a smooth inter-bank movement of funds, as well as to make
payments and receive cash on their behalf.
○ In order to achieve the aforementioned goals, the Reserve Bank of India allows banks to open accounts with it.
○ This is the Reserve Bank's 'Banker to Banks' function, which is provided by the Deposit Accounts Department
(DAD) at regional offices.
○ RBI is the “lender of last resort” as it may lend during a liquidity crisis to meet the bank's operational
requirements.
7. Banker to the Central and State Governments
○ The Reserve Bank has performed the typical central banking job of managing the government's banking
transactions since its creation.
○ The Reserve Bank of India Act of 1934 compels the Central Government to entrust all of its money, remittance,
exchange, and banking activities in India, as well as the management of the country's public debt, to the
Reserve Bank.
○ The Reserve Bank also holds the government's cash balances. By arrangement, the Reserve Bank can also
act as a banker for a state government.
○ Except for Jammu and Kashmir and Sikkim, the Reserve Bank serves as a banker to all Indian state
governments.
○ It has limited arrangements for the management of these two state governments' public debt.
○ The Reserve Bank acts as a banker to the government, receiving and making payments of money on behalf of
various government departments.
○ Debt and cash management for Central and State Governments
8. Oversight of the payment and settlement systems
○ Payment system regulation and supervision are increasingly being recognised as a basic responsibility of
central banks.

Self Notes
 92

○ The proper functioning of the financial system and the successful transmission of monetary policy are
dependent on the safe and efficient operation of these systems.
○ The Reserve Bank, as the financial system's regulator, has been implementing payment and settlement system
changes to ensure a more efficient and speedier movement of cash among the financial sector's numerous
constituents.
○ The growing monetisation of the economy, the country's vast geographic breadth, people's predilection for
paper-based instruments, and quick technological advancements are all aspects that make this a difficult
assignment.
9. Currency Management
○ Section 22 of the RBI Act, 1934 gives the Reserve Bank the required statutory authorities to manage
currency, which is one of the Reserve Bank's basic central banking functions.
○ The Reserve Bank of India, in collaboration with the Government of India, is responsible for the design,
production, and overall management of the country's currency, with the purpose of guaranteeing a sufficient
supply of clean and authentic notes.
○ The Reserve Bank routinely reviews security issues and targets ways to improve security features to limit the
danger of counterfeiting or forging of currency notes in conjunction with the government.
10. Developmental Role
○ The Reserve Bank is one of the few central banks in the world that has taken an active and direct role in aiding
their country's development.
○ The Reserve Bank's developmental function includes providing loans to productive sectors of the economy,
establishing institutions to construct financial infrastructure, and increasing access to cheap financial
services.
○ Its developmental mission has expanded over time to include institution formation in order to facilitate the supply
of a diverse range of financial services across the country.
○ Through its focus on financial inclusion, the Reserve Bank is now actively pushing efficient customer
service throughout the banking industry, as well as the extension of banking services to all.
11. Research and Statistics
○ The Reserve Bank has a long and illustrious history of policy-oriented research, as well as an effective
framework for disseminating data and information.
○ The Reserve Bank, like other major central banks, has built its own research capabilities in the fields of
economics, finance, and statistics, which help to better understand how the economy works and how policy
transmission mechanisms are changing.
12. Sterilisation by RBI
○ RBI often uses its instruments of money creation for stabilising the stock of money in the economy from
external shocks.
■ Suppose due to future growth prospects in India investors from across the world increase their
investments in Indian bonds which under such circumstances, are likely to yield a high rate of return.
■ They will buy these bonds with foreign currency. Since one cannot purchase goods in the domestic
market with foreign currency, a person or a financial institution who sells these bonds to foreign
investors will exchange its foreign currency holding into rupee at a commercial bank.
■ The bank, in turn, will submit this foreign currency to RBI and its deposits with RBI will be credited with
equivalent sum of money.
○ The commercial bank’s total reserves and deposits remain unchanged (it has purchased the foreign currency
from the seller using its vault cash, which, therefore, goes down; but the bank’s deposit with RBI goes up by an
equivalent amount – leaving its total reserves unchanged).
■ There will, however, be increments in the assets and liabilities on the RBI balance sheet.
■ RBI’s foreign exchange holding goes up. On the other hand, the deposits of commercial banks with
RBI also increase by an equal amount. But that means an increase in the stock of high powered money
– which, by definition, is equal to the total liability of RBI. With money multiplier in operation, this, in
turn, will result in increased money supply in the economy.
○ This increased money supply may not altogether be good for the economy’s health.
■ If the volume of goods and services produced in the economy remains unchanged, the extra money
will lead to an increase in prices of all commodities.
■ People have more money in their hands with which they compete with each other in the commodities
market for buying the same old stock of goods. As too much money is now chasing the same old
quantities of output, the process ends up in bidding up prices of every commodity – an increase in the
general price level, which is also known as inflation.
○ RBI often intervenes with its instruments to prevent such an outcome.
■ In the above example, RBI will undertake an open market sale of government securities of an
amount equal to the amount of foreign exchange inflow in the economy, thereby keeping the stock of
high powered money and total money supply unchanged.

Self Notes
 93

■ Thus it sterilises the economy against adverse external shocks. This operation of the RBI is
known as sterilisation.

Q. The Reserve Bank of India regulates the commercial banks in matters of (2013)
(1) liquidity of assets
(2) branch expansion
(3) merger of banks
(4) winding-up of banks
Select the correct answer using the codes given below.
(a) 1 and 4 only
(b) 2, 3 and 4 only
(c) 1, 2 and 3 only
(d) 1, 2, 3 and 4
Answer : D

Q. In India, the Central Bank’s function as the “lender of last resort” usually refers to which of the following?
1. Lending to trade and industry bodies when they fail to borrow from other sources
2. Providing liquidity to the banks having a temporary crisis
3. Lending to governments to finance budgetary deficits
Select the correct answer using the code given below (2021)
a) 1 and 2
b) 2 only
c) 2 and 3
d) 3 only
Answer: b

Q. Consider the following statements:

1. The Governor of the Reserve Bank of India (RBI) is appointed by the Central Government.
2. Certain provisions in the Constitution of India give the Central Government the right to issue directions to the RBI in the
public interest.
3. The Governor of the RBI draws his power from the RBI Act.
Which of the above statements are correct? (2021)
a) 1 and 2 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3
Answer: c

2.3 Reserves of RBI

● RBI’s capital reserve is a buffer for the RBI to meet financial contingencies while facing any potential financial crisis
situation in the economy.
● Components of the Capital Reserve:
2.3.1 Contingency Fund (CF)

● The CF is a fund set apart for meeting unforeseen contingencies, including depreciation in the value of securities, risks
arising out of monetary/exchange rate policy operations, systemic risks and any risk arising on account of the special
responsibilities enjoined upon the Bank.
2.3.2 Asset Development Fund (ADF)

● The Asset Development Fund (ADF) has been set aside for investment in subsidiaries and associates and internal capital
expenditure.
● From 2014 onwards, both CF and ADF are financed through provisioning. Income is estimated after making the
provisioning to the DF and ADF.
2.3.3 Currency and Gold Revaluation Account (CGRA)

● The CGRA shows funds that are available to compensate RBI's loss in the value of gold and foreign exchange reserve
holdings. Changes in the market value of gold and forex assets (like the US Government securities where the RBI
invested its foreign exchange reserves) are reflected in the CGRA.
Self Notes
 94

● CGRA provides a buffer against exchange rate/gold price fluctuations. When CGRA is not enough to fully meet exchange
losses, it is replenished from the contingency fund.
● Increase in the gold price and depreciation of the rupee increases the CGRA fund.
● As of June 2018, the CGRA has an amount of Rs 6,91600 crores billion. It registered an increase in 2018 mainly due to
the depreciation of the rupee against the US dollar and rise in the international price of Gold.
2.3.4 Investment Revaluation Account (IRA)

● The investment Revaluation Account shows the buffer amount available with the RBI to compensate for losses and to
accommodate gains in — foreign securities and domestic securities.
● RBI holds a significant portion of foreign securities and domestic securities (government of India). Under IRA, the market
gains and losses are measured.
2.3.5 Foreign Exchange Forward Contracts Valuation Account (FCVA)

● The FCVA measures market (periodic) gains and losses for the RBI from foreign exchange forward contracts.
● It accumulates due to several sources. First is its income from 3 sources: interest on government bonds held for
conducting open market operations; fees from government & market borrowing programmes; and income from
investment in foreign currency assets. The second source is earnings retained after giving dividends to the government.
The third source is a revaluation of foreign assets and gold.
● There are five main reasons for a central bank to hold capital:
○ Central banks that have foreign assets need capital to absorb potential losses.
○ RBI needs capital to shield the economy from monetary and financial shocks.
○ In the case of unstable governments, monetary authorities carry a bigger burden. A Central bank would need
more capital in such a situation.
○ A central bank needs reserves to perform functions such as price and exchange stability.
○ Reserves give independence to a central bank. Low capital will force the central bank to turn to the government
in times of need. This will give the government influence over the central bank.
● The RBI Act does not specify the amount to be transferred to the government. There is no consensus on the right level
of capital for a central bank. Unlike a private bank, a central bank can work with a negative net worth too. If the RBI
agrees its reserves are in excess or adequate, the government can gain in two ways. If the RBI does not set aside more
in funds, the government going ahead will get more from RBI every year as dividends. In case RBI liquidates reserves
deemed excess, the current government gets a one-time big cash inflow from the RBI as it sells some of its assets.
However, the legality of this liquidation is not clear yet.
2.4 Payment and Settlement Systems Act, 2007
● It provides necessary statutory backing to the Reserve Bank of India for undertaking the oversight function over the
payment and settlement systems in the country.
● These systems include inter-bank transfers such as the National Electronics Funds Transfer (NEFT) system, the Real
Time Gross Settlement (RTGS) System, ATMs, credit cards, etc.
2.4.1 Board for Regulation and Supervision of Payment and Settlement Systems
● It’s a statutory body as per Payment and Settlement Systems Act 2007.
● It is empowered to authorise, prescribe policies and set standards to regulate and supervise all the payment and
settlement systems in the country.
● The Department of Payment and Settlement Systems of the RBI serves as the Secretariat to the Board and executes
its directions.

In September 2018, an inter-ministerial committee, headed by Economic Affairs Secretary Subhash Chandra Garg, on the
regulation of the payments system in India submitted its report to the finance ministry. The panel has also put forward a draft of
the Payment and Settlement System Bill 2018 for consideration by the Cabinet.

Recommendations of the committee:

● The committee recommended setting up an independent Payments Regulatory Board.

● It’s chairperson to be appointed by the government in consultation with the RBI.
● It has been suggested that the head comes from within the central bank itself and has a controlling vote.
● It also recommended that the Securities Appellate Tribunal (SAT) should resolve the cases with respect to the payments.
○ It provides for the PRB to make reference to the RBI in relation to making regulations for designated payment
systems.
○ It also provides the RBI with the powers to make a reference to the PRB to consider any matter, which in the
opinion of the RBI is important in the context of the monetary policy.

Self Notes
 95

Ratan Watal Committee 2016 also recommended the creation of an independent payments regulator within the framework of
the RBI or giving independent status to the RBI’s Board for Regulation and Supervision of Payment and Settlement Systems
(BPSS) to be called the Payment Regulatory Board (PRB).

However RBI opposed the recommendations on the following grounds:

● RBI argues that payments systems are a subset of currency, which is regulated by the RBI. There is a huge impact of
monetary policy on payment and settlement systems and vice-versa. Hence the regulation of payment systems should
remain with the monetary authority, that is, the RBI.
● Besides, the activities of the payments banks come under the purview of the traditional banking system. Thus there is
no reason for having a separate regulator for payment systems outside the RBI.
● Also, the regulation of the banking systems and payment systems by the same regulator provides synergy. The changes
should not end up shaking the existing foundations which are considered to be well-functioning and internationally
acclaimed structures.
● RBI also held that it would prefer the Payments Regulatory Board to function under the purview of the RBI governor.

Subsidiaries of RBI
● Deposit Insurance and Credit Guarantee Corporation of India (DICGC),
● Bharatiya Reserve Bank Note Mudran Private Limited (BRBNMPL),
● Reserve Bank Information Technology Private Limited (ReBIT),
● Indian Financial Technology and Allied Services (IFTAS),
● Reserve Bank Innovation Hub (RBIH).

Acts administered by Reserve Bank of India

● Reserve Bank of India Act, 1934
● Public Debt Act, 1944/Government Securities Act, 2006
● Government Securities Regulations, 2007
● Banking Regulation Act, 1949
● Foreign Exchange Management Act, 1999
● Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002
(Chapter II)
● Credit Information Companies(Regulation) Act, 2005
● Payment and Settlement Systems Act, 2007
● Payment and Settlement Systems Act, 2007 As Amended up to 2019
● Payment and Settlement Systems Regulations, 2008 As Amended up to 2022
● Factoring Regulation Act, 2011

2.5 Autonomy for RBI

● Powers of RBI are statutorily laid down in the RBI Act 1934. RBI being the architect of the monetary policy requires
autonomy to be effective.
● Advocates of central bank independence argue that a central bank being a groupon professionals should be
autonomous"to manage money, credit and exchange rate dynamos in the globalising economy.
○ It helps check populist pressure and schemes that the political leadership may be tempted to indulge in
financial repression (keep rates low to suit government and corporates) even as the inflation is high. It can resist
the pressure if it has autonomy.
● Some others believe that the elected governments should have the final say within which RBI should be autonomous
as the government is democratically elected.
● The arguments in favour of autonomy are:
○ Monetary and economic stability can be best achieved if professional Central bankers with the long term
perspective are given charge.
○ Without such autonomy, government tends prevail with its profligate policies of automatic monetization, lower
rates, indiscriminate lending and soon
● The arguments against are:
○ democratic systems are run with Parliament and Cabinet making all important policies
○ Monetary policy is an integral policy of the overall economic policy and so RBI has to subordinate itself to the
larger objective.

Self Notes
 96

2.5.1 Section 7 of the RBI Act 1934

● Section-7 of the Reserve Bank of India Act, 1934 reads:
1. The Central Government may from time to time give such directions to the Bank as it may, after
consultation with the Governor of the Bank, consider necessary in the public interest
○ Subject to any such directions, the general superintendence and direction of the affairs and business
of the Bank shall be entrusted to a Central Board of Directors which may exercise all powers and do
all acts and things which may be exercised or done by the Bank.
● The prevalence of the government over the opinion of the RBI is to, ifat all, take place on two conditions being
followed:
1. After consultation with the Governor; and
2. In Public interest
● Section 7(1) of RBI Act was not a part of the original 1934 Act but was amended at the time of nationalisation of the
RBI in 1949, to empower the Centre to issue directions to the central bank in public interest.
● RBI is held accountable through consultations; to the Parliamentary committees; to the parliament through the
Finance Minister; and to the judiciary.
● Conventionally, RBI and GOI coordinated in public interest. Autonomy of the RBI as a professional body was
respected as an unwritten law.
○ Section 7 of the RBIAct was never invoked.
● It may be suggested that there should be a collegium to appoint the Governor and the Deputy Governors, so that
the autonomy of the RBI becomes so much more an article of faith.
● The recent measures to make RBI independent are:
○ No automatic monetization since 1997
○ FRBM Act says RBI cannot print money to supply credit to the government.
○ RBI Act amended in 2006 to give it more power for reserve requirement management regarding caps on CRR.

Universal Banking
● Universal banks may offer credit, loans, deposits, asset management, investment advisory, payment processing,
securities transactions, underwriting, and financial analysis.
○ While a universal banking system allows banks to offer a multitude of services, it does not require them to
do so. Banks in a universal system may still choose to specialise in a subset of banking services.
● Universal banking combines the services of a commercial bank and an investment bank, providing all services
from within one entity.
○ The services can include deposit accounts, a variety of investment services, and may even provide insurance
services. Deposit accounts within a universal bank may include savings and checking.

3. Commercial Banks
● Definition
○ As per the commercial bank definition, it is a financial institution whose purpose is to accept deposits from
people and provide loans and other facilities. Commercial banks provide basic services of banking to their
customers and small to medium-sized businesses.
● A commercial bank is a financial institution that provides services like loans, certificates of deposits, savings bank
accounts, bank overdrafts, etc. to its customers.
○ These institutions make money by lending loans to individuals and earning interest on loans.
○ Various types of loans given by a commercial bank are business loans, car loans, house loans, personal loans,
and education loans.
● They give out these loans from the money deposited by their customers in different types of accounts.
○ They use the deposits as capital for providing loans. Commercial banks are essential for the economy of a
country because they help in creating capital, credit as well as liquidity in the market.
○ These banks are generally physically located in cities but these days online banks are growing in numbers.

Self Notes
 97

3.1 Functions of Commercial Banks

● Commercial banks are institutions that conduct
business with profit motive by accepting public
deposits and lending loans for various
investment purposes.

3.1.1 Primary Functions:

1. Accepting Deposits
○ It implies that commercial banks are
mainly dependent on public deposits.
○ There are two types of deposits, which
are discussed as follows
i. Demand Deposits
● It refers to deposits
that can be
withdrawn by individuals without any prior notice to the bank. In other words, the owners of
these deposits are allowed to withdraw money anytime by writing a withdrawal slip or a
cheque at the bank counter or from ATM centres using a debit card.
ii. Time Deposits
● It refers to deposits that are made for a certain committed period of time. Banks pay higher
interest on time deposits. These deposits can be withdrawn only after a specific time period
by providing a written notice to the bank.
2. Advancing Loans
○ It refers to granting loans to individuals and businesses. Commercial banks grant loans in the form of
overdraft, cash credit, and discounting bills of exchange.
3.1.2 Secondary Functions
The secondary functions can be classified under three heads, namely, agency functions, general utility functions, and other
functions.
1. Agency Functions:
○ It implies that commercial banks act as agents of customers by performing various functions.
○ Collecting Cheques
■ Banks collect cheques and bills of exchange on the behalf of their customers through clearing house
facilities provided by the central bank.
○ Collecting Income
■ Commercial banks collect dividends, pension, salaries, rents, and interests on investments on behalf
of their customers. A credit voucher is sent to customers for information when any income is collected
by the bank.
○ Paying Expenses
■ Commercial banks make the payments of various obligations of customers, such as telephone bills,
insurance premium, school fees, and rents. Similar to credit vouchers, a debit voucher is sent to
customers for information when expenses are paid by the bank.
2. General Utility Functions:
○ It implies that commercial banks provide some utility services to customers by performing various functions.
○ Providing Locker Facilities
■ Commercial banks provide locker facilities to its customers for safe custody of jewellery, shares,
debentures, and other valuable items. This minimises the risk of loss due to theft at homes. Banks are
not responsible for the items in the lockers.
○ Issuing Traveler’s Cheques
■ Banks issue traveller’s cheques to individuals for travelling outside the country. Traveler’s cheques
are a safe and easy way to protect money while travelling.
○ Dealing in Foreign Exchange
■ Commercial banks help in providing foreign exchange to businessmen dealing in exports and imports.
However, commercial banks need to take the permission of the Central Bank for dealing in foreign
exchange.
3. Transferring Funds
○ It refers to transferring of funds from one bank to another. Funds are transferred by means of draft, telephonic
transfer, and electronic transfer.
4. Letter of Credit
○ Commercial banks issue letters of credit to their customers to certify their creditworthiness.
○ Underwriting Securities
Self Notes
 98

■ Commercial banks also undertake the task of underwriting securities. As the public has full faith in the
creditworthiness of banks, public do not hesitate in buying the securities underwritten by banks.
○ Electronic Banking
■ It includes services, such as debit cards, credit cards, and Internet banking.
3.1.3 Other Functions
● Money Supply
○ It refers to one of the important functions of commercial banks that help in increasing money supply.
○ For instance, a bank lends Rs. 5 lakh to an individual and opens a demand deposit in the name of that individual.
■ Bank makes a credit entry of Rs. 5 lakh in that account. This leads to creation of demand deposits in
that account. The point to be noted here is that there is no payment in cash. Thus, without printing
additional money, the supply of money is increased.
● Credit Creation
○ Credit Creation means the multiplication of loans and advances. Commercial banks receive deposits from
the public and use these deposits to give loans. However, loans offered are many times more than the deposits
received by banks. This function of banks is known as ‘Credit Creation’.
● Collection of Statistics
○ Banks collect and publish statistics relating to trade, commerce and industry. Hence, they advise customers
and the public authorities on financial matters.
3.2 Role of Commercial Banks in Economic Development of a Country
3.2.1 Capital Formation
● Banks play an important role in capital formation, which is essential for the economic development of a country.
○ They mobilise the small savings of the people scattered over a wide area through their network of branches
all over the country and make it available for productive purposes.
● Now-a-days, banks offer very attractive schemes to induce the people to save their money with them and bring the
savings mobilised to the organised money market. If the banks do not perform this function, savings either remains idle
or used in creating other assets,(eg.gold) which are low in scale of plan priorities.
3.2.2 Creation of Credit
● Banks create credit for the purpose of providing more funds for development projects. Credit creation leads to
increased production, employment, sales and prices and thereby they bring about faster economic development.
3.2.3 Channelizing the Funds towards Productive Investment
● Banks invest the savings mobilised by them for productive purposes.
○ Capital formation is not the only function of commercial banks. Pooled savings should be allocated to various
sectors of the economy with a view to increase productivity.
○ Then only it can be said to have performed an important role in economic development.
3.2.4 Encouraging Right Type of Industries
● Many banks help in the development of the right type of industries by extending loans to the right type of persons.
○ In this way, they help not only for industrialization of the country but also for the economic development of
the country.
● They grant loans and advances to manufacturers whose products are in great demand.
○ The manufacturers in turn increase their products by introducing new methods of production and assist in
raising the national income of the country.
3.2.5 Banks Monetise Debt
● Commercial banks transform the loan to be repaid after a certain period into cash, which can be immediately used for
business activities.
● Manufacturers and wholesale traders cannot increase their sales without selling goods on credit basis.
○ But credit sales may lead to locking up of capital. As a result, production may also be reduced.
○ As banks are lending money by discounting bills of exchange, business concerns are able to carry out the
economic activities without any interruption.
3.2.6 Finance to Government
● Government is acting as the promoter of industries in underdeveloped countries for which finance is needed for it.
● Banks provide long-term credit to the Government by investing their funds in Government securities and short-term
finance by purchasing Treasury Bills.

Self Notes
 99

3.2.7 Promote Entrepreneurship

● In recent days, banks have assumed the role of developing entrepreneurship particularly in developing countries like
India by inducing new entrepreneurs to take up the well-formulated projects and provision of counselling services like
technical and managerial guidance.
● Banks provide 100% credit for worthwhile projects, which is also technically feasible and economically viable. Thus
commercial banks help for the development of entrepreneurship in the country.

The shadow banking

● The shadow banking system is a group of financial intermediaries which facilitate the creation of credit across the
global financial system, but whose members are not subject to regulatory oversight. These companies are often known
as nonbank financial companies (NBFCs). The shadow banking system also refers to unregulated activities by
regulated institutions.
● Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives, and other unlisted
instruments, while examples of unregulated activities by regulated institutions include credit default swaps.

4. Non-banking Financial Institutions (NBFCs)

● A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 that is engaged
in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government
or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit
business, but does not include any institution whose primary business is agriculture, industrial activity, purchase or sale
of real estate.
● A non-banking institution company is a company that receives deposits under any scheme or arrangement in one lump
sum or in instalments by way of contributions or in any other manner is also a non-banking financial company(Residuary
non-banking company).
● A non-banking financial company, also known as a non-banking financial institution, provides financial services and
products but is not recognised as a bank with a full banking licence.
○ NBFCs are not banks, but their activities include lending and other activities such as providing loans and
advances, credit facilities, savings and investment products, trading in the money market, managing stock
portfolios, money transfers, and so on.
● NBFC Registration is required before NBFC activities can begin.
○ Their activities include hiring, leasing, infrastructure finance, venture capital finance, housing finance, and so
on.
○ Deposits can be accepted by NBFC, but only term deposits and deposits repayable on demand are not
accepted.
● Some examples of well-known NBFCs are Kotak Mahindra Finance, SBI Factors, Sundaram Finance, and ICICI
Ventures.
4.1 Criteria for NBFC License
● The company must be registered in accordance with the Companies Act.
● The corporation should be either a Limited Company or a Private Limited Company (PLC).
● The company's Net Owned Fund must be at least Rs. 2 crores.
● Following NBFCs are exempted from the requirement of registration with RBI:
○ Venture Capital Fund / Merchant Banking companies / Stockbroking companies registered with SEBI.
○ Insurance Company holding a valid Certificate of Registration issued by IRDA.
○ Nidhi companies as notified under Section 620A of the Companies Act, 1956.
○ Chit companies as defined in clause (b) of Section 2 of the Chit Funds Act, 1982.
○ Housing Finance Companies regulated by the National Housing Bank.
○ Stock Exchange or a Mutual Benefit company.
4.2 Regulation of NBFCs
● The RBI's Department of Non-Banking Supervision (DNBS) is tasked with regulating and supervising NBFCs in
accordance with the regulatory provisions contained in Chapters III B and C and Chapter V of the Reserve Bank of
India Act, 1934.
○ The Reserve Bank's Regulatory and Supervisory Framework provides for, among other things, registration of
NBFCs, prudential regulation of various categories of NBFCs, the issuance of directions on the acceptance of
deposits by NBFCs, and sector surveillance through off-site and on-site supervision.
● Deposit-taking NBFCs and Systemically Important Non-Deposit Accepting Companies face increased regulation and
supervision.
Self Notes
 100

● The three main goals of regulation and supervision are as follows:

○ depositor protection
○ consumer protection
○ financial stability.
● In extreme cases, the RBI is also empowered under the RBI Act 1934 to take punitive action, such as:
○ cancelling a Certificate of Registration, issuing prohibitory orders against accepting deposits, filing criminal
cases, or filing winding-up petitions under the provisions of the Companies Act.
● The Reserve Bank of India (RBI) recently proposed a tighter regulatory framework for Non-Banking Financial Companies
(NBFCs) by establishing a four-tier structure with a progressive increase in regulatory intensity.
● It has also proposed reducing the classification of non-performing assets (NPAs) of base layer NBFCs from 180 to 90
days overdue.
● The proposed framework is intended to protect financial stability while allowing smaller NBFCs to continue to
operate under light regulations and grow with ease.
4.3 Significance of NBFCs
● NBFCs play an important role in developing countries like India, where access to bank finance remains a challenge for
a large portion of the population and businesses.
● Non Banking financial institutions provide services to market segments that commercial banks do not serve due to
higher risk and lower returns.
● Non Banking financial institutions are an essential part of an economy's financial sector due to their inherent
characteristics.
4.4 Criticism of NBFCs
● The fact that NBFCs are not as heavily regulated as banks adds to the risk. Such a risk was highlighted during the 2008
Global Financial Crisis, when companies' lending practices went unchecked, resulting in a disastrous outcome.
● The IL&FS default and subsequent turbulence in the Indian credit markets in 2018 raised some critical and fundamental
questions about the role of NBFCs, their business model, and the best regulatory regime for them.

5. The Regional Rural Banks (RRBs)

● The Regional Rural Banks (RRBs) were established in 1975 under the provisions of the Ordinance promulgated on
26th September 1975 and Regional Rural Banks Act, 1976.
○ Regional rural banks (RRBs), which have been established in rural India, are intended to play an important role
in rural credit. They have evolved into low-cost, rural-based institutions.
● Regional rural banks, by bringing credit facilities closer to the poorer sections of the rural population, will help to
free them from the grip of the moneylender.
○ In addition, it should be noted that small/marginal farmers, agricultural labourers, artisans, and other
vulnerable groups in rural areas are the primary recipients of loan assistance from regional rural banks.
● The Regional Rural Banks were created with the intention of combining the strengths of cooperative and
commercial banks.
○ It was hoped that these would provide cheap and adequate credit while also being operationally efficient and
easy to access.
● The primary goal of Regional Rural Banks was to end the rural debt culture and close the credit gap that existed
between geographical regions.
○ RRBs are operationally sponsored by scheduled banks, which are typically public sector commercial banks.
○ Instead of burdening commercial banks by extending their operations over large areas and spreading resources
thin, RRBs were thought to be able to function intensively and confine their operations to a single region
consisting of one or two contiguous districts.
○ Thus, RRBs operate similarly to commercial banks, albeit with a smaller geographical reach for each of
them.
● The Central Government, State Governments, the Reserve Bank of India (RBI), and smaller banks all work together
to establish new RRBs and assist them in their operations.
○ Since 1978, the RBI has primarily carried out promotional functions, while state governments carry out statutory
functions.
● RRBs are jointly owned by Gol, the relevant State Government, and Sponsor Banks; the issued capital of an RRB
is divided among the owners in the proportions of 50%, 15%, and 35%, respectively.
5.1 Significance
● Every RRB operates as a commercial bank, and in addition to directly granting short-term and long-term loans, it has
the authority to mobilise savings.
○ They give loans for agriculture, allied activities, retail trade, and small rural industries.

Self Notes
 101

○ They also specifically target the group of small and marginal farmers, landless labourers, rural artisans, and
others through the Integrated Rural Development Programme by extending credit to the poorest of the poor in
rural areas.
● The Regional Rural Banks have a Priority Sector Lending (PSL) target of 75% where loans are lent to agricultural
activities and vulnerable sectors.
● These banks are also providing financial assistance to regional cooperative institutions in low-income areas to
strengthen their financial bases and enable them to play a more positive role as viable financial institutions engaged in
rural development.
5.2 Limitations
● The most troubling aspect of RRB operations is that they are, on average, losing money.
○ The main factor that has contributed to their loss of profitability is that they exclusively lend to the poorer
sections at low-interest rates, despite the fact that their operational costs in handling small loans are quite high.
● Aside from that, loan recovery is unsatisfactory, and debts are piling up.

The RRBs have had a great deal of success in bringing banking services to previously unbanked areas and making institutional
credit available to the weaker sections of the population in these areas.

6. Cooperative Banks (UCBs)

6.1 Background
● The origins of the urban cooperative banking movement in India can be traced back to the late nineteenth century,
when such societies were established in India, inspired by the success of experiments related to the cooperative
movement in Britain and Germany.
● Cooperative societies are founded on the principles of mutual aid, democratic decision-making, and open
membership.
○ The first known mutual aid society in India was most likely the "Anyonya Sahakari Mandali," which was
founded in 1889 in the erstwhile princely state of Baroda under the leadership of Vithal Laxman, also known as
Bhausaheb Kavthekar.
● In their early stages, urban co-operative
credit societies were formed on a
community basis to meet the demand for
consumption-oriented credit.
○ Salary earners' societies that
instilled thrift and self-help habits
played a significant role in
popularising the movement,
particularly among the middle
class and organised labour.
● The passage of the Cooperative Credit
Societies Act in 1904, on the other hand,
provided the real impetus to the
movement.
○ In October 1904, the first urban
cooperative credit society was
established in Canjeevaram
(Kanjivaram), in the then-
Madras province.
○ The Bombay Urban Co-operative
Credit Society, founded on January 23, 1906, by Vithaldas Thackersey and Lallubhai Samaldas, was the most
prominent of the early credit societies.
● The Cooperative Credit Societies Act of 1904 was amended in 1912 to allow for the formation of non-credit societies.
○ The Maclagan Committee, formed in 1915, was tasked with reviewing their performance and recommending
ways to improve it.
Definition
● Cooperative bank is an institution established on the cooperative basis and dealing in ordinary banking business.
Like other banks, the cooperative banks are founded by collecting funds through shares, accept deposits and grant
loans.
6.2 Types of Cooperative Banks in India
● The structure of the co-operative banking sector in India is complex.

Self Notes
 102

○ Credit needs of diverse sections of the population, both in terms of location and tenor, are addressed by
different segments of the cooperative banking sector.
● While the urban areas are served by the urban co-operative banks with a single tier structure.
● The rural areas are largely served by two distinct sets of institutions extending short-term and long-term credit.
○ The short-term co-operative credit institutions have a three-tier structure comprising:
■ State co-operative banks (StCBs) at the apex level,
■ District central co-operative banks (DCCBs) at the intermediate level and
■ Primary agricultural credit societies (PACS) at the base level.
○ The long-term co-operative credit institutions have, generally, a two-tier structure comprising:
■ The State co-operative agriculture and rural development banks (SCARDBs) at the State level
■ The primary co-operative agriculture and rural development banks (PCARDBs) at the district or block
level.
○ Long-term co-operative credit institutions have a unitary structure in some States with State level banks
operating through their own branches, while in other States they have a mixed structure with the existence of
both unitary and two-tier systems. The States which do not have long-term co-operative credit entities are
served by State co-operative banks.

6.2.1 Urban Co-operative Banks

● The term "Urban Co-operative Banks" refers to primary cooperative banks in urban and semi-urban areas.
○ These banks primarily lent to small borrowers and businesses centred on communities, neighbourhoods,
and workplace groups.
○ They primarily finance entrepreneurs, small businesses, industries, and self-employment in urban areas, as
well as home purchases and educational loans.
● Primary credit societies (PCSs) in urban areas that meet certain criteria may apply to the RBI for a banking
licence in order to operate as urban co-operative banks (UCBs).
○ They are registered and governed by the respective states' cooperative societies acts, as well as the
Banking Regulation Act of 1949, and thus are subject to dual regulatory control.
● The RBI only partially regulates UCBs.
○ Their banking operations are governed by the RBI, which establishes capital adequacy, risk management, and
lending standards.
○ However, their management and resolution in the event of a crisis are governed by the Registrar of Co-
operative Societies, who works for either the state or the federal government.
● Primary UCBs with deposits of more than Rs. 50 crore are also permitted to operate in more than one state, subject
to certain conditions.
○ They have certain rights and obligations because they are covered by the RBI Act, 1934 (2nd Schedule) –
rights to obtain refinance and loans from the RBI and obligations such as maintaining cash reserves, submitting
returns to the RBI, and so on.
● The Shivalik Mercantile Co-operative Bank Limited is the first Urban Co-operative Bank (UCB) to be granted 'in-
principle' permission by the Reserve Bank of India to convert into a Small Finance Bank (SFB).
● The move comes after the RBI announced in September 2018 a scheme for voluntary conversion of UCBs to SFBs.
6.2.2 Rural Cooperative Banks
6.2.2.1 Short-Term Rural Cooperative Banks
1. In rural India, there exists a 3-tier short-term rural cooperative structure.
○ Tier-I — includes state cooperative banks (SCBs) at the state level;
○ Tier-II — includes central cooperative banks (CCBs) at the district level; and
○ Tier- III — includes primary agricultural credit societies (PACSs).
1. State Cooperative Banks (SCBs):
○ State cooperative banks are the apex institutions in the three-tier cooperative credit structure, operating at the
state level. Every state has a state cooperative bank.
○ State cooperative banks occupy a unique position in the cooperative credit structure because of their three
important functions:
■ They provide a link through which the Reserve Bank of India provides credit to the cooperatives
and thus participates in rural finance.
■ They function as balancing centres for the central cooperative banks by making available the surplus
funds of some central cooperative banks. The central cooperative banks are not permitted to borrow
or lend among themselves.
■ They finance, control and supervise the central cooperative banks, and, through them, the primary
credit societies.
○ Capital:

Self Notes
 103

■ State cooperative banks obtain their working capital from own funds, deposits, borrowings and other
sources:
I. Own funds include share capital and various types of reserves. Major portion of the share
capital is raised from member cooperative societies and the central cooperative banks, and
the rest is contributed by the state government. Individual contribution to the share capital is
very small;
II. The main source of deposits is also the cooperative societies and central cooperative banks.
The remaining deposits come from individuals, local bodies and others.
III. Borrowings of the state cooperative banks are mainly from the Reserve Bank and the
remaining from state governments and others.
○ Loans and Advances:
■ State cooperative banks are mainly interested in providing loans and advances to the cooperative
societies.
■ More than 98 per cent loans are granted to these societies of which about 75 per cent are for the
short-period. Mostly the loans are given for agricultural purposes.
2. Central Cooperative Banks (CCBs):
○ Central cooperative banks are in the middle of the three-tier cooperative credit structure.
○ Capital:
■ The central cooperative banks raise their working capital from their own funds, deposits, borrowings
and other sources. In the own funds, the major portion consists of share capital contributed by
cooperative societies and the state government, and the rest is made up of reserves.
■ Deposits largely come from individuals and cooperative societies. Some deposits are received from
local bodies and others. Deposit mobilisation by the central cooperative banks varies from state to
state.
■ For example, it is much higher in Gujarat, Punjab, Maharashtra, and Himachal Pradesh, but very low
in Assam, Bihar, West Bengal and Orissa.
■ Borrowings are mostly from the Reserve Bank and apex banks.
3. Primary Agricultural Credit Societies (PACSs):
○ Primary agricultural credit society forms the base in the three-tier cooperative credit structure.
○ It is a village-level institution which directly deals with the rural people. It encourages savings among the
agriculturists, accepts deposits from them, gives loans to the needy borrowers and collects repayments.
○ It serves as the last link between the ultimate borrowers, i.e., the rural people, on the one hand, and the higher
agencies, i.e., Central cooperative bank, state cooperative bank, and the Reserve Bank of India, on the other
hand.
○ A primary agricultural credit society may be started with 10 or more persons of a village. The membership
fee is nominal so that even the poorest agriculturist can become a member.
○ The members of the society have unlimited liability which means that each member undertakes full
responsibility for the entire loss of the society in case of its failure.
○ The management of the society is under the control of an elected body.
○ Capital:
■ The working capital of the primary credit societies comes from their own funds, deposits, borrowings
and other sources.
● Own funds comprise of share capital, membership fee and reserve funds. Deposits are
received from both members and non- members. Borrowings are mainly from central
cooperative banks.
■ In fact, the borrowings form the chief source of working capital of the societies. Normally, people
do not deposit their savings with the cooperative societies because of poverty, low saving habits, and
non--availability of better assets to the savers in terms of rate of return and riskiness from these
societies.
6.3 Significance
● Urban cooperative banks play an important role in mobilising deposits and financing the small-borrower sector, which
includes small-scale industries, professionals, retailers, and so on.
● Cooperative banks have been instrumental in providing financial assistance to the rural sector.
● Since UCBs are a tried and tested model for catering to the unorganised sector in all types of urban centres, they are
well suited to be replicated in large numbers across all states.
6.4 Challenges
● For the past few years, cooperative banks in India have struggled to survive.
○ The issue gained prominence following the Punjab and Maharashtra Cooperative (PMC) Bank debacle,
which resulted in frantic depositors visiting the branches in an attempt to withdraw their hard-earned money.

Self Notes
 104

○ The evolving changes in the financial sector, which combine and integrate microfinance, FinTech companies,
payment gateways, social platforms, e-commerce companies, and NBFCs, pose a threat to the continued
presence of UCBs, which are mostly small in size, lack professional management, and have geographically
less diverse operations.
● Loans and deposits are both declining at a faster rate.
○ Rural cooperatives account for a sizable proportion of total cooperative size which is around 65 percent of total
cooperatives.
● Reduced share of agricultural lending.
○ Despite this critical role, the sector's share of total agricultural lending has declined significantly over the years,
from as high as 64 per cent in 1992-93 to just 11.3 per cent in 2019-20.
● Following the liberalisation of licensing policy in 1993, nearly one-third of newly licenced businesses became financially
unsound within a short period of time.
● For years, despite failures and frauds, such banks have escaped scrutiny due to dual regulation by the state registrar of
societies and the RBI.
○ An amendment was introduced in 2020 to bring UCBs under the supervision of the RBI.
○ As a result, the RBI was given direct supervision over 1482 urban cooperatives and 58 multi-state cooperative
banks.
○ This gave the central bank enough power to control the cooperatives.
● Frauds, COVID, and other factors impacted asset quality, resulting in a decline in profitability for urban cooperative
banks.
● Lax corporate governance standards, combined with political influence and interference, were major contributors to
the sector's demise.
6.5 Reforms proposed by N.S. Viswanathan Committee
● The RBI revised the Supervisory Action Framework (SAF) for UCBs in January 2020.
○ The Central Government approved an Ordinance in June 2020 that will bring all urban and multi-state
cooperative banks under the direct supervision of the RBI.
A committee led by former RBI Deputy Governor NS Vishwanathan has recently proposed the following findings for Urban
Cooperative Banks (UCBs).
1. Categorisation of UCBs
○ For regulatory purposes, UCBs can be classified into four tiers based on the cooperativeness of the banks,
the availability of capital, and other factors:
i. Tier 1– includes all unit UCBs and salary earner UCBs (regardless of deposit size) as well as all other
UCBs with deposits up to Rs 100 crore.
ii. Tier 2 – It includes UCB deposits ranging from Rs 100 crore to Rs 1,000 crore.
iii. Tier 3 - It includes UCB deposits ranging from Rs 1,000 crore to Rs 10,000 crore.
iv. Tier 4 - It includes UCBs of more than Rs 10,000 crore in deposits.
○ The minimum Capital to Risk-Weighted Assets Ratio (CRAR) for them could range from 9% to 15%, and the
Basel III prescribed norms for Tier-4 UCBs.
2. Umbrella Organisation (UO)
○ The committee has proposed establishing an umbrella organisation (UO) to oversee cooperative banks and
has suggested that they be allowed to open more branches if all regulatory requirements are met.
○ The UO should be financially strong and well-governed by a professional board and senior management that
are both fit and proper.
3. Reconstruction
○ The RBI may prepare a scheme of compulsory amalgamation or reconstruction of UCBs, similar to banking
companies, under the Banking Regulation (BR) Act of 1949.
4. Supervisory Action Framework (SAF)
○ Instead of using triple indicators, SAF should use a twin-indicator approach, focusing solely on asset quality
and capital as measured by Net Non-Performing Assets and CRAR.
○ The SAF's goal should be to find a time-bound solution to a bank's financial stress.
○ If a UCB is subjected to more stringent stages of SAF for an extended period of time, it may have an adverse
effect on its operations and may further erode its financial position.
5. Raising capital from the market
○ The umbrella organisation, structured as an NBFC, will be able to raise market capital and then lend it to
member UCBs.
○ At a later stage, the umbrella organisation (UO) may consider converting into a universal bank owned by
member banks.
○ Once the UO has stabilised, the licensing of new UCBs may be considered.
6. Globally Accepted System
○ As an alternative to mandatory consolidation, the Committee preferred smaller banks gaining scale through the
UO network, which is one of the world's most successful models of a strong financial cooperative system.
Self Notes
 105

From its inception to the present day, the thrust of UCBs has been to mobilise savings from middle and low-income urban groups
and to provide credit to their members, many of whom belonged to the weaker sections.

7. Small Finance Banks

● Small Finance Banks in India are a specific segment of banking created by RBI, under the guidance of the Government
of India.
● They were introduced with the objective of furthering financial inclusion by primarily extending basic banking services
to unserved and underserved sections including small and marginal farmers, small business units, micro and small
industries and unorganised entities.
○ A majority of our population lives in rural areas. And it is a challenge to extend banking services to the remotest
locations in India.
○ The expansion of Small Finance Banks in India aims to provide access to bank credit and services to
unbanked and under-banked regions of India.
● Small finance institutions offer all basic banking services including lending and taking deposits.
● After the announcement during the Union Budget for the year 2014-15, RBI issued the guidelines for Small Finance
Banks in November 2014.
● Small Finance Banks are operational under the regulation of the RBI in India, under the purview of the apex bank’s
Banking Ombudsman Scheme, 2006, as amended from time to time.
○ SFBs are registered as public limited companies under the Companies Act, 2013 and governed by
Banking Regulations Act, 1949; RBI Act, 1934 and other relevant Statutes and Directives from time to time.
7.1 Eligible promoters
● Resident individuals/professionals with 10 years of experience in banking and finance;
● Companies and societies owned and controlled by residents will be eligible to set up small finance banks.
● Existing Non-Banking Finance Companies (NBFCs), Micro Finance Institutions (MFIs), and Local Area Banks (LABs)
that are owned and controlled by residents can also opt for conversion into small finance banks.
● Promoter/promoter groups should be ‘fit and proper’ with a sound track record of professional experience or of running
their businesses for at least a period of five years in order to be eligible to promote small finance banks.
7.2 Products and services offered by Small Finance Banks
● Small Finance Banks offer basic banking services such as Savings Accounts, Current Accounts, Fixed Deposits,
Recurring Deposits, Loans, etc.
○ The banks can undertake such simple activities with prior approval of the RBI and after complying with the
requirements.
○ The activities do not require any commitment of own funds and they can be engaged in the distribution of mutual
fund units, pension products, insurance products, etc.
● The SFBs can even become Authorised Dealer in foreign exchange business as per the requirements of their clients.
7.3 Difference between NBFC and Small Finance Bank
Parameters NBFCs SFBs

Meaning Engaged in the business of loans and Small Finance Banks are government
advances, acquisition of authorised entities aimed at offering
bonds/debentures/shares, securities basic banking facilities to unserved &
issued by the government of India or underserved areas
local authority.

Regulated by The Department of Non-Banking RBI under Banking Regulations Act,

Supervision (DNBS) under the 1949; RBI Act, 1934 and others
provisions contained under Chapter III B
and C and Chapter V of the Reserve
Bank of India Act, 1934.

Credit Creation NBFCs do not offer Credit SFBs offer Credit facilities

Demand Deposit NBFCs do not accept demand deposits Demand deposits are acceptable by
SFBs

Transaction Services Not offered Offered by SFBs

Self Notes
 106

8. Payments Bank
● A payment bank is a distinct type of bank that performs only the limited banking functions permitted by the Banking
Regulation Act of 1949.
● Acceptance of deposits, payments and remittance services, internet banking, and acting as a business correspondent
for other banks are examples of some of the activities.
● They can help with money transfers as well as sell insurance and mutual funds. Furthermore, they can only issue
ATM/debit cards, not credit cards.
● They are not permitted to establish subsidiaries to provide non-banking financial services. More importantly, they are
not permitted to engage in any lending activities.
● A committee chaired by Dr Nachiket Mor recommended the establishment of a "Payments Bank" to serve low-income
individuals and small businesses.
● Non-bank PPIs, NBFCs, individuals, corporations, mobile phone companies, supermarket chains, real estate
cooperatives, and public sector entities are all eligible promoters for payment banks.

Payment Banks – Objective

● The primary goal of a payments bank is to provide payment and financial services to small businesses, low-income
households, and the migrant labour workforce in a secure, technology-driven environment.
● The RBI's goal with payments banks is to increase financial service penetration in the country's remote regions.
8.1 Scope of activities
● Payment banks accept deposits up to a limit of Rs 2,00,000. Demand deposits were initially limited to a total balance
of Rs 1,00,000 for each customer.
● ATM/debit card issuance
● They can not issue credit cards.
● They are not permitted to give loans.
● Payment and remittance services are provided via numerous methods.
● Marketing of simple non-risk-sharing financial goods and services such as mutual funds and insurances, among
others.
● They can only invest the funds collected from consumer deposits in government securities.
● They can not accept NRI deposits.
● A payments bank account owner can deposit and take funds from any ATM or even other service providers.
● Payment licences would be provided to mobile companies, grocery chains, and others in order to serve individuals and
small enterprises.
8.2 Promoters who are eligible
● Existing non-bank issuers of pre-paid Payment Instruments (PPIs)
● Other businesses such as:
○ Non-Banking Finance Companies (NBFCs)
○ Mobile phone companies, big corporate business correspondents (BCs)
○ Residents owned and governed supermarket chains, businesses, and real estate cooperatives
○ Payment banks may be established by public sector enterprises.
● To establish a payments bank, a promoter/promoter group may enter into a partnership with an established scheduled
commercial bank.
● To the extent permissible by the Banking Regulation Act of 1949, scheduled commercial banks may invest in a payments
bank.
8.3 Benefits of Payment Banks
● Rural banks and access to financial services are being expanded.
● Effective substitute for commercial banks.
● Handles low-value, high-volume payments efficiently.
● Access to a variety of services.
● Among the difficulties encountered include the lack of public understanding about the availability of these services and
Inadequate infrastructure and operating resources. Further, incentives for agents to participate in these activities are
lacking besides obstacles related to technology.
8.4 Limitations of Payments bank
● Payments banks have a no-lending business model – they can't lend money from their deposits, so they can't earn
high interest on a user's borrowed capital.

Self Notes
 107

○ Credit as a product does not exist for PBs, putting them at a significant disadvantage when compared to
commercial banks.
● Payments banks are also facing fierce competition from unexpected sources such as Unified Payments Interface
(UPI).
○ UPI quickly became the star of digital transactions due to its seamless interoperability, stringent security, and
massive cash backs from third-party payments apps on the platform.
○ In contrast to payment banks, the UPI app (third party) has a simple interface that is not governed by banking
regulations. It is a one-tap solution that a user can use without the need for KYC.
● There is a general lack of awareness among the general public about how to access these services.
● Incentives for agents to participate in these activities are lacking.
● Inadequate infrastructure and operational resources.
○ Various technology-related obstacles.

9. Some other banking institutions in India

9.1 NABARD
● National Bank for Agriculture and Rural Development (NABARD) was established on July 12, 1982, by transferring the
agricultural credit functions of the RBI and the refinance functions of the then Agricultural Refinance and Development
Corporation (ARDC).
● It was established to meet the credit needs of agriculture and rural development.
● NABARD today is fully owned by the Government of India as a result of a change in the composition of share capital
between the Government of India and the Reserve Bank of India.
● It provides financial assistance to the farm sector through refinancing for a variety of agriculture and allied activities
● Commercial banks, state cooperative banks, regional rural banks, and state land development banks are eligible
for refinancing.

9.2 SIDBI
● Small Industries Development Bank of India (SIDBI), established on April 2, 1990, by an Act of the Indian Parliament,
serves as the primary financial institution for the promotion, financing, and development of the Micro, Small, and Medium
Enterprise (MSME) sector
● Shares of SIDBI are held by the Government of India and other institutions / public sector banks / insurance
companies owned or controlled by the Central Government.

9.3 National Housing Bank

● NHB was established on July 9, 1988, under the National Housing Bank Act of 1987 to operate as a principal
agency to promote housing finance institutions
● The entire paid-up capital was contributed by the Reserve Bank of India.
● The government took over the NHB from the RBI in 2019 after purchasing the entire stake for Rs. 1,450 crores.
9.4 MUDRA Bank
● Micro Units Development Refinance Agency (MUDRA) Bank is a refinancing institution for micro-finance institutions.
It was launched on April 8, 2015
● Its products are divided into three finance buckets: Shishu (loans up to 50,000), Kishor (50,000 to 5 lakh), and Tarun
(5 lakh to 10 lakh).
● Despite the fact that the scheme covers fruit and vegetable traders, it does not, in general, refinance the agriculture
sector.

What is National Payments Corporation of India (NPCI)?

● an umbrella organisation for operating retail payments and settlement systems in India
● an initiative of Reserve Bank of India (RBI) and Indian Banks’ Association (IBA) under the provisions of the
Payment and Settlement Systems Act, 2007
● incorporated as a “Not for Profit” Company under the provisions of Section 25 of Companies Act 1956 (now Section
8 of Companies Act 2013)
● The ten core promoter banks are State Bank of India, Punjab National Bank, Canara Bank, Bank of Baroda, Union
Bank of India, Bank of India, ICICI Bank Limited, HDFC Bank Limited, Citibank N. A. and HSBC. In 2016 the
shareholding was broad-based to 56 member banks

Initiatives by NPCI

Self Notes
 108

RuPay- Indigenously developed Payment System designed to meet the expectation and needs of the Indian consumer,
banks and merchant ecosystem. RuPay supports the issuance of debit, credit and prepaid cards by banks in India and
thereby supporting the growth of retail electronic payments in India.

IMPS- Immediate Payment Service (IMPS) is for real time payments in retail sector.

NACH- National Automated Clearing House (NACH), an offline web based system for bulk push and pull transactions.

ABPS- Aadhaar Payment Bridge (APB) System is helping the Government and Government agencies in making the Direct
Benefit Transfers for various Central as well as State sponsored schemes.

AePS- Aadhaar enabled Payment System (AePS) has been introduced to increase accessibility of basic banking services
in underserved areas.

NFS- National Financial Switch (NFS) is the largest network of shared Automated Teller Machines (ATMs) in India
facilitating interoperable cash withdrawal, card to card funds transfer and interoperable cash deposit transactions among other
value added services in the country.

UPI- Unified Payments Interface (UPI) has been termed as the revolutionary product in the payment system. It is a system that
powers multiple bank accounts into a single mobile application (of any participating bank), merging several banking
features, seamless fund routing & merchant payments into one hood. It also caters to the “Peer to Peer” collect request
which can be scheduled and paid as per requirement and convenience.

Bharat Bill Payment System- Bharat Bill Payment System is offering one-stop bill payment solution for all recurring payments
with 200+ Billers in the categories Viz. Electricity, Gas, Water, Telecom, DTH, Loan Repayments, Insurance, FASTag
Recharge, Cable etc. across India.

NETC- National Payments Corporation of India (NPCI) has developed the National Electronic Toll Collection (NETC) program
to meet the electronic tolling requirements of the Indian market. It provides an electronic payment facility to customer to make
the payments at national, state and city toll plazas by identifying the vehicle uniquely through a FASTag.

Self Notes
 109

REFORMS IN BANKING AND FINANCIAL SECTOR

1. Reforms in Banking and Financial Sector 110
1.1 Need for financial sector reforms 110
1.2 Reforms introduced over the years 110
2. Evolution of Bank Lending Rates 112
2.1 Base Rate 112
2.2 Marginal Cost of Funds based Lending Rate (MCLR) 112
2.3 External Benchmark Lending Rates 113
3. Priority Sector Lending (PSL) 115
3.1 Categories of Priority Sector Lending 115
3.2 PSL Targets for Scheduled Commercial Bank 115
4. Non Performing Assets (NPA) 117
4.1 Trends of Non-Performing Assets 118
4.2 Reasons for rising NPAs in India 118
4.3 Impact of NPAs 119
4.4 Measures to curb NPAs in India 119
5. Basel Norms 127
5.1 BASEL I 127
5.2 BASEL II 127
5.3 BASEL III 128
6. Capital Adequacy Ratio 128
6.1 Capital Adequacy Ratio Formula 129
6.2 Importance of Capital Adequacy Ratio 129
7. Financial Inclusion 130
7.1 Financial Inclusion – Initiatives 130
7.2 Digital financial inclusion 131
8. Consolidation of Public Sector Banks 132
8.1 Benefits of bank consolidation 132
8.2 Challenges to bank consolidation 132
9. Some related terms 132

Self Notes
 110

1. Reforms in Banking and Financial Sector

● When India began financial sector reforms in the early 1990s, there was a need to remove structural impediments
to new adjustments and growth.
● The goal was to allow the price mechanism to function freely in both the real and financial sectors.
● Between 1992 and 1997, the financial system in general, and the banking system in particular underwent a huge change
with a focus on creating a sound and healthy banking structure.
● There was an emphasis on a market-oriented approach in line with international trends and the adoption of best global
practices.
● Between January 1993 and March 1998, 24 new private banks (9 domestic and 15 foreign) entered the market
1.1 Need for financial sector reforms
● One of the goals of bank nationalisation in 1969 was to expand the reach of organised banking services to rural
areas and underserved sections/sectors of society. However, by the 1980s, it was clear that operational efficiency
was inadequate.
● Banks were known for their low profitability and high and growing non-performing assets.
● There was a problem of low capital base and also a belief that with Government ownership, there was little to worry
about a low capital base.
● More important, the lack of proper disclosure norms led to many problems being kept under cover.
● Poor internal controls raised doubts about the integrity of the system itself. The quality of customer service did not
keep pace with increasing expectations.

1.2 Reforms introduced over the years

1.2.1 Narasimham Committee Recommendations
1.2.1.1 Reforms in the Banking Sector
● phased reduction in SLR to 25.0 per cent over a period of five years
● progressive reduction in CRR from its high level
● phasing out directed credit programmes and redefining the priority sector
● deregulating interest rates so as to reflect emerging market conditions
● achieving a minimum 4.0 per cent capital adequacy ratio in relation to risk-weighted assets by March 1993
● adopting uniform accounting practices, particularly with regard to income recognition and provisioning against doubtful
debts
● imparting transparency to bank balance sheets and ensuring full disclosures
● setting-up special tribunals to speed up the process of recovery of loans
● establishing an asset reconstruction fund (ARF) to take over from banks and FIs a portion of their bad and doubtful
debts at a discount
● restructuring of the banking system so as to have 3 or 4 large banks, which could become international in character,
8 to 10 national banks with a network of branches throughout the country engaged in universal banking, local banks
whose operations were generally confined to a specific region, and rural banks (including RRBs) whose operations were
confined to rural areas and whose business was predominantly to engage in financing agriculture and allied activities
● abolishing branch licensing and leaving the matter of opening or closing of branches to the commercial judgement of
the individual banks;
● ending duality of control over the banking system between the Reserve Bank and the Banking Division of the Ministry of
Finance and making the Reserve Bank the primary agency for regulating the banking system
1.2.1.2 Reforms in the Debt Market
● enabling substantial and speedy liberalisation of the capital market and dispensing with the prior approval of any
agency for any issue in the market
● providing supervision over institutions such as merchant banks, mutual funds, leasing companies, venture
capital companies and factoring companies by a new agency to be set up under the aegis of the Reserve Bank
● enacting new legislation along the lines existing in several countries to provide an appropriate legal framework for the
constitution and functioning of mutual funds
● laying prudential norms and guidelines governing the functioning of such institutions as in the case of banks and FIs
● Securities and Exchange Board of India (SEBI) was thus given statutory recognition in 1992
1.2.1.3 Reforms in the Foreign Exchange Market

● Market-based exchange rates and the current account convertibility was adopted in 1993.
● The government permitted the commercial banks to undertake operations in foreign exchange.

Self Notes
 111

● Participation of newer players allowed the rupee foreign currency swap market to undertake currency swap
transactions subject to certain limitations.
● Replacement of foreign exchange regulation act (FERA), 1973 was replaced by the foreign exchange management
act (FEMA), 1999 for providing greater freedom to the exchange markets.
● Trading in exchange-traded derivatives contracts was permitted for foreign institutional investors and non-resident
Indians subject to certain regulations and limitations.

Issues with Public Sector Banks

● They do not have independent and fully empowered boards like their private counterparts.
● All major recruitments are done by the Government, the majority stakeholder.
● Acts governing the PSBs (Bank Nationalisation Act, SBI Act) create a non-level playing field for them as they face
dual regulators - GOI and RBI.
● They also come under vigilance and RTI Act unlike private sector banks.
● Unlike private sector banks, Human Resource and Technology policies are homogenised across PSBs rather
than being custom built

In 1997, another committee, the Committee on Banking Sector Reforms, was formed under the chairmanship of the same
M. Narasimhan (Narasimhan Committee - II). Its major recommendations are as follows:

● For the public sector banks to operate with the same professionalism as their foreign rivals, greater autonomy was
advocated. It recommended GOI equity in nationalised banks be reduced to 33% for increased autonomy.
● Merging large Indian banks to make them resilient enough to support global trade
● Reserve Bank as a regulator of the monetary system should not be the owner of a bank in view of a possible conflict of
interest. Consequently, RBI has transferred its shareholdings of public banks like SBI, NHB and NABARD to the
government of India.

1.2.2 P J NAYAK Committee

● Public Sector Banks (PSBs) have been established through the “State Bank of India Act 1955” and “The banking
companies (acquisition and transfer of undertakings) act, 1970” also referred to as Bank Nationalisation Act.
● These Acts require Govt. of India to have majority shareholding and voting power in the PSBs and this empowers the
Govt. to appoint Board of Directors and involve in the decision making of the PSBs.
○ It leads to governance issues as the people appointed on the board of these PSBs are not that qualified for
their job but are close to Govt.
○ Through this, Govt. starts manipulating the decisions which lead to various kinds of frauds and corruption.
● In January 2014, P J Nayak committee was constituted, for review of governance of boards of banks in India (which
submitted its report in May 2014) to examine the working of banks’ boards, review RBI guidelines on bank ownership
and representation in the board, and investigate possible conflicts of interest in the board representation.

The following were the main recommendations:

● The Government should set up a Bank Investment Company (BIC), under Companies Act, 2013.
○ Govt. should transfer its present ownership in PSBs to BIC and all the PSBs will be incorporated as
subsidiaries of BIC and will be registered under the Companies Act 2013.
■ And the PSBs will become limited companies, for example “State Bank of India” will become “State
Bank of India Limited”. (This limited means now if the State Bank of India Limited will become bankrupt
then Govt. of India/BIC will not be liable and may not have to put funds from their own resources to
protect SBI limited).
■ Government should reduce its stake in PSBs (through BIC) to less than 50%.
● The BIC will become a holding company which will be owned by the Govt. of India. BIC will have the voting powers
to appoint the Board of directors and other policy decisions of the banks.
○ Government will sign a shareholding agreement with BIC, promising its autonomy. This means that even if the
Govt. will be majority shareholders in BIC, but it will not intervene in its working and BIC will select banks
directors and top management. (And if required to preserve the autonomy of BIC, Govt. may reduce its
ownership to less than 50% in BIC).
● But since repealing of the Acts (1955, 1970) and establishment of BIC will take time, so for the time being Govt. can
establish a Banks Board Bureau (BBB) through an executive order and BBB will select and appoint directors/top
management in public sector banks and other public sector financial institutions like NABARD/SIDBI/LIC etc. And once
BIC is set up, BBB will be dissolved.

Self Notes
 112

○ In line with the recommendations of the P J Nayak committee and with a view to improve the Governance of
Public Sector Banks (PSBs), the GoI appointed an autonomous Banks Board Bureau (BBB) which started
functioning from 1st April, 2016. The Board has three ex-officio members and three expert members in addition
to a Chairman.
○ The following are the functions of the BBB:
■ It will be responsible for the selection and appointment of Board of Directors in PSBs and Financial
Institutions (FIs) [FIs means 'Non-bank Public Financial Institutions' like Development Financial
Institutions (NABARD, NHB, SIDBI, EXIM, MUDRA), Insurance Companies of Govt. like LIC etc....]
■ It will advise the Government on matters relating to appointments, confirmation or extension of tenure
and termination of services of the Board of Directors
■ It will help banks to develop a robust leadership succession plan for critical positions
■ It will build a data bank containing data relating to the performance of PSBs/FIs and its officers.
■ It will advise the Government on the formulation and enforcement of a code of conduct and ethics for
managerial personal in PSBs/FIs
■ It will advise the Government on evolving suitable training and development programmes for
management personnel in PSBs/FIs
■ It will help banks in terms of developing business strategies and capital raising plans etc.

2. Evolution of Bank Lending Rates

2.1 Base Rate
● The Reserve Bank of India establishes a minimum rate below which banks are not permitted to lend to their customers.
● The base rate is meant to increase credit market transparency and ensure that banks pass on lower funding costs to
their clients.
● Based on the credit risk premium, the loan will be priced by adding a base rate and a reasonable spread.
● The Base Rate system was introduced in June 2006 and was operational till April 2016.
Illustration
● Let us consider the RBI has set a base rate of 6%. Then no bank can lend below 6% to their customers.
● The actual lending rate of the banks would include a spread beyond the base rate including the bank's profit and the
credit risk of the sector and the customer.
● Let us imagine the bank spread of Bank A is 2% and Bank B is 2.8% lending to a customer.
Parameter Base Rate Bank Spread Credit Risk(Agri) Total lending rate

Bank A 6 2 0.2 8.2%

Bank B 6 2.4 0.2 8.6%

NOTE: The above table illustrates lending by both Bank A and Bank B for Agriculture sector.
2.1.1 How is Base Rate Calculated?
Many factors are taken into account when calculating the base rate. Each bank is permitted to set its own base rate, which is
based on the RBI's guidelines. The bank claims that the base rate must be calculated by taking into account the following factors:
● Average cost of funds: It is the interest rate on deposits.
● Operating costs/Unallocatable Overhead Costs: These are the costs of running the business on a day-to-day basis
and include items such as legal fees, depreciation, administrative costs, stationery costs, and so on.
● Negative Carry in the Cash Reserve Ratio: This is the cost that banks must bear to maintain a certain level of cash
reserves with the RBI.
● Profit Margin/Average Net Worth Return: The profitability and net amount received are part of this.
● As a result of differences in one of these criteria, base rates may range from bank to bank. The majority of the time, it's
the difference in deposit interest rates.
2.2 Marginal Cost of Funds based Lending Rate (MCLR)
● The MCLR (Marginal Cost of Funds based Lending Rate) is the minimum lending rate below which a bank is not
allowed to lend.
● On April 1, 2016, the RBI implemented the MCLR to set lending interest rates.
● It's an internal reference rate that banks use to figure out how much interest they can charge on loans.
● Following the installation of MCLR, interest rates are calculated based on each customer's relative risk factor
(creditworthiness). In other words, MCLR was calculated considering the current cost of funds as well as the
incremental cost of funds.
● When the RBI cut the repo rate in the past, banks took a long time to reflect the change in lending rates for borrowers.
● Banks must modify their interest rates as soon as the repo rate changes under the MCLR regime.
Self Notes
 113

Illustration
The below table illustrates lending by both Bank A and Bank B for the Agriculture sector for customers of different CIBIL scores
or creditworthiness.

Customer 1 - Low credit risk

Parameter MCLR Credit Risk (Agri) Custom Credit Risk Total lending rate

Bank A 6 0.2 0.2 6.4%

Bank B 6.2 0.2 0.25 6.65%

Customer 2 - High credit risk

Parameter MCLR Credit Risk (Agri) Custom Credit Risk Total lending rate

Bank A 6 0.2 0.7 6.9%

Bank B 6.2 0.2 0.85 7.25%

2.2.1 How is MCLR calculated?

The MCLR considers the current cost of funds as well as the incremental cost of funds. Let's look at the things that influence
the MCLR based on this approach.
● Marginal Cost of Funds: The marginal cost of borrowings, as well as the return on net worth, make up the marginal
cost of funds. The marginal cost of borrowings has 92% of the influence, whereas the other factor has only 8%. It is also
affected by the repo rate and bank interest rates.
● Operating Costs: These are the costs of issuing the loan, obtaining capital, and running the business on a day-to-day
basis.
● Cost of carry in Cash Reserve Ratio (CRR): Banks must take into account the cash deposits they must maintain with
the Reserve Bank of India.
● Tenor Premium: This is the premium that will be charged for long-term loans in order to minimise the risk of long-term
lending.
● Banks are allowed to publish the internal benchmark rate (MCLR) for overnight, one-month, three-month, six-month, and
one-year maturities once a month.
2.2.2 Reasons for introducing MCLR
● To promote the lending rates of banks.
● For making the calculation of interest rates on bank advances more transparent.
● To make bank lending available at rates that are fair to both lenders and banks.
● To assist banks in becoming more efficient and profitable in the long run, as well as to contribute to economic
development.
● However, the banks failed to reduce the interest rate in spite of lower repo rates giving way to External Benchmark
Lending Rates.

2.2.3 Difference between Base Rate and MCLR

Base Rate MCLR

Uses the average cost of financing as a guide. Based on the incremental/marginal cost of money.

Calculated by taking into account the minimum Tenor premium is factored into the calculation.
rate of return/profit margin.

Operating expenses and expenses required to The MCLR is calculated by taking into account deposit and
maintain the cash reserve ratio also affect the repo rates, as well as operating costs and the cost of
base. maintaining a cash reserve ratio.

2.3 External Benchmark Lending Rates

● External Benchmark Lending Rates are the lending rates set by the banks based on external benchmarks.

Self Notes
 114

● From October 1, 2019, the RBI ordered that banks establish a uniform external benchmark within a loan category.
● The following are four external benchmarking mechanisms:
○ The repo rate announced by the Reserve Bank of India.
○ The yield on a 91-day T-bill
○ The yield on the 182-day T-bill
○ Any Financial Benchmarks India Pvt. Ltd. developed market interest rate benchmarks.
● The spread above the external benchmark is left to the discretion of the banks. However, the interest rate must be
changed at least once every three months in accordance with the external benchmark.

Illustration
Let us see an illustration of SBI EBLR linked to Repo Rate.

External Benchmark based Lending Rate

Effective date Repo Rate
(EBLR)

01.01.2019 8.05 + CRP 6.50%

01.01.2020 7.80 + CRP 5.15%

01.04.2020 7.05 + CRP 4.40%

01.07.2020 6.65 + CRP 4.00%

01.10.2020 6.65 + CRP 4.00%

01.01.2021 6.65 + CRP 4.00%

01.04.2021 6.65 + CRP 4.00%

01.07.2021 6.65 + CRP 4.00%

NOTE: Here CRP is the Credit Risk Premium.
2.3.1 Significance of the External Benchmark
● The spread above the external benchmark is left to the discretion of the banks.
● However, the interest rate must be changed at least once every three months in accordance with the external
benchmark.
● Because it is an external system, any policy rate cut decision will reach borrowers more quickly.
● Interest rates will become more transparent as a result of the use of external benchmarking.
● The spread or profit margin for each bank above the set interest rate will also be known to the borrower, making loan
comparisons easier and more transparent.
2.3.2 Difference between MCLR and External Benchmark
Marginal Cost of Lending Rate External Benchmark Lending Rate

Linked to bank's cost of funds Linked to RBI's lending rate

Takes 4-6 months to move after RBI rate cut Responds immediately to RBI rate cut

RBI rate cuts not fully passed on to borrowers Rate cuts are automatically passed on

Resets annually for most banks Reset every three months

Low volatility High volatility

Self Notes
 115

3. Priority Sector Lending (PSL)

● Priority Sector means those sectors that the Government of India and Reserve Bank of India consider as important
for the development of the basic needs of the country and are to be given priority over other sectors.
● The banks are mandated to encourage the growth of such sectors with adequate and timely credit.
● It is a compulsory target that banks have to follow while lending loans to customers.

3.1 Categories of Priority Sector Lending

● Agriculture
● Micro, Small and Medium Enterprises
● Export Credit
● Education
● Housing
● Social Infrastructure
● Renewable Energy
● Others

In 2007, the RBI included five minorities—Buddhists, Christians, Muslims, Parsis and Sikhs under the PSL. In its new
guidelines of March 2015, the RBI
added ‘medium enterprise,
sanitation and renewable energy’
under it.

3.2 PSL Targets for

Scheduled Commercial
Bank
● To the extent of shortfall in
the achievement of target,
banks may be required to
invest in the Rural
Infrastructure
Development Fund (RIDF)
established with National
Bank for Agriculture and
Rural Development
(NABARD) and other Funds
with NABARD or National
Housing Bank (NHB) or
Small Industries
Development Bank of India
(SIDBI) or Micro Units
Development Refinance
Agency Bank (MUDRA Ltd), as decided by the Reserve Bank from time to time

3.2.1 Targets for priority sector lending by Primary (Urban) Co-operative Banks (UCBs)

● Total Priority Sector - 40 per cent of ANBC or CEOBE, whichever is higher, which shall stand increased to 75 per cent
of ANBC or CEOBE, whichever is higher, with effect from March 31, 2024
● Micro Enterprises - 7.5 per cent of ANBC or Credit Equivalent Amount of Off-Balance Sheet Exposure, whichever is
higher
● Advances to Weaker Sections -12 per cent# of ANBC or credit equivalent amount of Off-Balance Sheet Exposure,
whichever is higher.

The targets for Lending to Small and Marginal Farmers (not applicable to UCBs) and Weaker Sections (not applicable to RRBs)
are revised upwards to reach 10% and 12% respectively. This target has to be met by 2023-2024.

Self Notes
 116

Education Education loans to individuals for educational reasons, including vocational courses, shall be
considered eligible for priority sector classification if they do not exceed Rs 20 lakh.

Housing Housing loans up to Rs. 25 lakh in non-metropolitan centres and up to Rs. 35 lakh in metropolitan
centers to individuals for the purchase or construction of one dwelling unit per family are available,
provided that the overall cost of the dwelling unit in the metropolitan centre and in other centres
does not exceed Rs. 45 lakh and Rs. 30 lakh, respectively.

Social infrastructure For the construction of health care facilities, such as those under "Ayushman Bharat" in Tier II to
Tier VI centres, bank loans up to a limit of Rs 10 crore per borrower are also permitted. These
limits apply to loans for the establishment of schools, drinking water facilities, and sanitation
facilities, including the construction or renovation of household toilets and water improvements at
the household level, etc.

Renewable Energy Loans from the Renewable Energy Bank to borrowers for things like solar power generators,
biomass power generators, wind turbines, micro-hydel plants, and non-conventional energy-based
public utilities, like street lighting systems and remote village electrification, etc., will be eligible for
Priority Sector classification up to a limit of Rs 30 crore.
The maximum loan amount for one household will be Rs. 10 lakh.

3.2.2 Revised lending policies for priority sectors

The UK Sinha-led expert committee on MSMEs offered recommendations, which RBI took into account when revising the PSL
classifications and lending ceiling in 2020.

● Updated categories: Bank loans for the construction of compressed biogas plants, loans to farmers for the installation
of solar power plants for the solarization of grid-connected agriculture pumps, and bank financing for start-up businesses
up to Rs. 50 crore.
● A higher credit limit: The ceiling for health infrastructure has been raised to 10 crores, while the ceiling for renewable
energy has been raised to 30 crores. For the construction of schools, drinking water systems, and sanitary amenities,
banks may also grant loans of up to 5 crores.

Weaker Sections under Priority Sector Lending

1. Small and Marginal Farmers
2. Artisans, village and cottage industries where individual credit limits do not exceed Rs 1 lakh
3. Beneficiaries under Government Sponsored Schemes such as the National Rural Livelihoods Mission (NRLM),
National Urban Livelihood Mission (NULM) and Self Employment Scheme for Rehabilitation of Manual Scavengers
(SRMS)
4. Scheduled Castes and Scheduled Tribes
5. Beneficiaries of Differential Rate of Interest (DRI) scheme
6. Self Help Groups
7. Distressed farmers indebted to non-institutional lenders
8. Distressed persons other than farmers, with loan amount not exceeding Rs 1 lakh per borrower to prepay their debt
to non-institutional lenders
9. Individual women beneficiaries up to Rs 1 lakh per borrower
10. Persons with disabilities
11. Minority communities as may be notified by the Government of India from time to time
3.3 Priority Sector Lending Certificates

● The scheme has been brought to enable banks to achieve the priority sector lending target and sub-targets by the
purchase of these instruments in the event of shortfall
● It incentivizes the surplus banks thereby enhancing lending to the categories under priority sector.
● The seller sells fulfilment of priority sector obligation and the buyer would be buying the same.
● There is no transfer of risks or loan assets.
● PSLCs are traded through the CBS portal (e-Kuber) of RBI.

E-Kuber (Core Banking Solution)

● Commercial banks and other institutions can access their current accounts with the RBI to a high degree thanks to

Self Notes
 117

the RBI's core banking solution, e-kuber.

● With the use of e-kuber, banks can access their current accounts from anywhere in the country at any time.
● The RBI conducts a number of transactions with banks using the e-kuber.
● E-kuber is useful since it can be used for tasks like government securities auctions.

Q. The term ‘Core Banking Solutions’ is sometimes seen in the news. Which of the following statements best describes/describe
this term? [2016]
(1) It is a network of a bank’s branches that enables customers to operate their accounts from any branch of the bank on its
network regardless of where they open their accounts.
(2) It is an effort to increase RBI’s control over commercial banks through computerization.
(3) It is a detailed procedure by which a bank with huge non-performing assets is taken over by another bank.
Select the correct answer using the code given below.
(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer: a

4. Non Performing Assets (NPA)

● When an asset no longer generates income for the bank, it is
considered a non-performing asset.
● Previously, an asset was classified as a non-performing asset
(NPA) based on the concept of "Past Due."
● A 'non-performing asset' (NPA) was defined as a credit for which
interest and/or principal instalments have been 'past due' for
a specified period of time.
● To move toward international best practices and ensure greater
transparency, '90 days' overdue norms for identifying NPAs
were made applicable beginning with the fiscal year ended
March 31, 2004.
● Commercial loans that are more than 90 days past due and
consumer loans that are more than 180 days past due are
typically classified as nonperforming assets by banks.
● In the case of agricultural loans, NPAs are declared if the
interest and/or instalment or principal remain unpaid for two
harvest seasons.
○ However, this period should not be longer than two years. Any unpaid loan/instalment will be classified as
NPA after two years.

Classification of Non Performing Assets

● Sub-standard: When the NPAs have aged <= 12 months.

● Doubtful: When the NPAs have aged > 12 months.
● Loss assets: When the bank or its auditors have identified the loss, but it has not been written off.

Self Notes
 118

4.1 Trends of Non-Performing Assets

● The NPA was on a declining trend from FY 2018 due to
various initiatives by the Reserve Bank of India and the
central government such as the Insolvency and
Bankruptcy Code, Abolition of previous initiatives like
5:25 rule etc.
● Due to the effects of the coronavirus (COVID-19) epidemic
and lockdown, the country was expected to see an
increase in bad loans.
● The Reserve Bank of India projected three scenarios for
the fiscal year 2022 until September 2021 based on the
value for September 2020.
● Under the baseline scenario, the GNPA-ratio would reach
13.5 percent, setting a new high.
(NPA Trends)

Who is a Wilful Defaulter?

● Any entity is considered a wilful defaulter when:
○ The unit has failed to make its payment/repayment commitments to the lender, despite having the
financial means to do so.
○ The unit has failed to meet its payment/repayment commitments to the lender and has not used the
lender's funds for the specific objectives for which they were obtained, instead diverting the money
to other uses.
○ The unit has failed to meet its payment/repayment commitments to the lender and has syphoned off
the funds, such that the funds have not been used for the precise purpose for which credit was obtained,
nor are the funds available in the form of other assets with the unit.
● The Banks have to submit the names of the Wilful defaulters to the Reserve Bank of India (RBI) with outstanding
loans of more than 25 Lakhs.

4.2 Reasons for rising NPAs in India

● Historical factors:
○ Between the early 2000s and 2008, the Indian economy was booming. During this time, banks, particularly
public sector banks, lent heavily to businesses.
○ However, due to a slowing global economy, a restriction on mining projects, and delays in environmental-related
licences affecting the power, iron, and steel sectors, as well as volatility in raw material prices and a scarcity of,
most corporations' profits have declined.
○ This has harmed their ability to repay loans and is the primary reason for the rise in nonperforming assets (NPA)
at public sector banks.
● Relaxed lending norms:
○ One of the key causes of rising NPA is the loosening of lending standards, particularly for corporate executives
whose financial situation and credit rating are not thoroughly examined.
○ In addition, in order to compete, banks are aggressively selling unsecured loans, which contributes to the high
level of nonperforming assets (NPAs).
● Poor Contingency Plan:
○ Banks did not conduct enough contingency planning, particularly for managing project risk, due to a lack of
contingency planning.
○ They did not account for contingencies such as the failure of gas projects to ensure gas supply or the collapse
of the highway land acquisition procedure.
● Poor Restructuring and loan servicing: Restructuring of credit facilities was extended to enterprises with more serious
over-leverage and under-profitability issues. This issue was more prevalent in public sector banks.
● Unforeseen conditions: Economic shocks such as demonetization and Covid 19 are unforeseeable.
● The problem of Wilful Defaulters:
○ Diversification of finances into unrelated businesses or fraudulent activities.
○ Due to a lack of diligence, there are lapses.
○ Willful defaulters, for example, are the result of corporate malfeasance.
● Poor Governance:
○ Loans become non-performing assets (NPAs) as a result of mismanagement and policy gridlock, which slows
down the timetable and speed of projects. Take, for instance, the Infrastructure Sector.
○ Land acquisition is being held up due to social, political, cultural, and environmental factors.
○ Changes in the business/regulatory environment have resulted in business losses.
Self Notes
 119

○ Morale was low, especially after government loan forgiveness programmes.

● Unsustainable Competition: Intense competition in a specific market segment. Consider India's telecommunications
industry.
4.3 Impact of NPAs
● Twin Balance Sheet Syndrome: In which both banks and corporations have strained balance sheets, leads the
investment-led growth process to come to a halt.
● Judicial burden: Cases involving NPAs add to the pressure on the judiciary's already overburdened docket.
● Reduced Profits: Profit margins for lenders are shrinking.
● Stress in the banking sector means less money is available to fund other projects, resulting in a negative impact on the
overall economy.
● Poor monetary policy transmission: Banks are raising interest rates to retain their profit margins.
● Funds are being diverted from good initiatives to bad ones.
● Unemployment: As a result of the stagnation of investments, it is possible that unemployment will result.
● Reduced revenue for the government: In the case of public sector banks, poor financial health equals poor
shareholder returns, which means the government of India receives less money as a dividend. As a result, it may affect
the ease with which money is used for social and infrastructure development, resulting in social and political costs.
● Investors do not receive their due returns.
4.4 Measures to curb NPAs in India
NPAs are not a new problem in India, and the government has taken many attempts to address them at the legal, financial, and
policy levels. The Narasimhan Committee suggested a number of measures to deal with nonperforming assets (NPAs) in 1991.
Some of them were put into practice.
4.4.1 SARFAESI Act
● SARFAESI Act of 2002 is ".. an act to regulate securitization and reconstruction of financial assets and enforcement of
security interests, and to provide for a central database of security interests created on property rights, and for matters
associated with or incidental thereto,".
● SARFAESI is an acronym for Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interest.
● It permits banks and other financial institutions to recover loans by auctioning off the defaulter's residential or
commercial assets.
● Under this act, India's first Asset Reconstruction Corporation (ARC), ARCIL, was established.
● Secured creditors (banks or financial institutions) have rights to security interest enforcement under section 13 of the
SARFAESI Act, 2002.
● The SARFAESI Act of 2002 will now apply to all state and multi-state co-operative banks, according to the Supreme
Court of India. Banks can now seize and sell defaulters' properties to recoup their debts, thanks to the Supreme Court's
momentous decision.
4.4.1.1 SARFAESI Act - Provisions
● If a borrower of financial assistance defaults on a loan or an instalment, and his account is categorised as a non-
performing asset (NPA) by a secured creditor, the secured creditor may request written notice before the term of
limitation expires.
● Unsecured loans, loans under ₹100,000, and debts that are less than 20% of the initial principle are exempt from
the statute.
● This law permitted the formation of asset reconstruction companies (ARCs) and the sale of non-performing assets by
banks to ARCs (which are regulated by the RBI).
● Without the consent of a court, banks are authorised to take ownership of collateral property and sell it.
● To conclude, the SARFAESI Act gives financial institutions the authority to "seize and desist." They should send a
notification to the delinquent borrower, requesting payment within 60 days.
● If the debtor does not cooperate, the bank may take one of the following three actions:
1) Take control of the loan security.
2) Sell, lease, or assign the security's right.
3) Take care of the asset or appoint someone to do so.
4.4.1.2 SARFAESI Act - Amendments
● The Central Government passed a law in 2013 bringing cooperative banks under the SARFAESI Act of 2002.
● The Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment)
Bill, 2016, altered the statute once again.
● The Supreme Court also held that co-operative banks that engage in banking activities are subject to Sections 5 (c)
and 56 (a) of the Banking Regulation Act of 1949, which are laws related to List I Entry 45. (Union List).

Self Notes
 120

4.4.1.3 Functions under the Act

● The Reserve Bank of India registers and regulates Asset Reconstruction Companies (ARCs).
● Facilitating the securitization of banks' and financial institutions' financial assets, with or without the use of underlying
securities.
● The ARC promotes the seamless transferability of financial assets by issuing debentures, bonds, or any other instrument
as a debenture to buy financial assets from banks and financial organisations.
● By entrusting the Asset Reconstruction Companies with the task of raising cash through the sale of security receipts
to qualified buyers, the Asset Reconstruction Companies will be able to raise funds.
4.4.2 Insolvency and Bankruptcy Code

● The Insolvency and Bankruptcy Code, 2016 (IBC) is India's bankruptcy law, which aims to unify the existing framework
by establishing a single insolvency and bankruptcy law.
● It aims to address challenges faced by enterprises in exiting business
● It aims to expedite and simplify the process of bankruptcy proceedings, ensuring fair negotiations between the
borrower and creditors.
● Insolvency is a condition in which a debtor is unable to pay his/her debts.
● Bankruptcy is a legal process that involves an insolvent person or company that is unable to pay its debts.
● It establishes clearer and faster insolvency procedures to assist creditors, such as banks, in recovering debts and
avoiding bad loans, which are a major drag on the economy.
● It is an all-encompassing insolvency code that applies to all businesses, partnerships, and individuals (other than
financial firms).
● It shifted the balance of power from borrowers to creditors and instilled a significantly increased sense of credit
discipline among debtors.

As per data released by the Insolvency and Bankruptcy Board of India (IBBI), from December 2016 till March 2022, 47 percent
of corporate insolvency processes went into liquidation, compared with 14 percent that ended in a resolution plan.

Out of a total of 5,258 corporate insolvency proceedings initiated under the code till March, only 3,406 have been closed.
Among those closed, as many as 1,609 proceedings have ordered liquidation, while 480 have ended in approval of resolution
plans.

4.4.2.1 Major factors resulting in the delay in the resolution process:

● Multiplicity of cases
● Lesser number of tribunals have increased the backlog of cases
● Strict timelines prescribed under the code
● lack of infrastructure
● Lesser number of members manning the adjudicating authority
● A very high haircut (accepting less than what was due)-- as much as 95% in some cases for banks
Use of “pre-packs” to resolve insolvency proceedings

Self Notes
 121

● A pre-pack is a way of resolving the troubles of creditors and

owners of a distressed business.
● Under a pre-pack resolution, creditors and owners of a business
agree to sell the business to an interested buyer before going
to the court to sanction the agreement.
● The buyer may be a third party or someone related to the
business.
● The pre-pack insolvency resolution process (PIRP) is in contrast to
the corporate insolvency resolution process (CIRP) that has been
used under the IBC to sell or liquidate troubled businesses till now.
● Under CIRP, once a creditor moves to court, a resolution
professional appointed by the court takes charge of the
business and then draws up and implements a plan of resolution.
● The resolution professional is not a business owner or
creditor, and thus may have very little reason to maximise
recoveries. By the time a business is finally sold or liquidated
under CIRP, a process which can take over a year, creditors
typically manage to recover much less than half of their debts.
● Further, the cost of bankruptcy proceedings in court can turn out to
be substantial.
● The pre-pack option was introduced to help micro, small and
medium enterprises (MSMEs) hit hard by the pandemic.
● Pre-packs offer creditors and business owners a way out of these
problems by working out an arrangement out-of-court with an
interested buyer.
● Creditors and business owners can try to keep the business going smoothly and extract the most value out of it.
This is not to say that all distressed businesses must be or will be kept going. The logic is that creditors and business
owners along with interested buyers are better suited to make these crucial business decisions than resolution
professionals in courts.
4.4.3 Bad Bank
● A bad bank is a financial institution that was formed to purchase the bad loans and other illiquid assets of another
financial institution.
● The organisation with a large number of nonperforming assets will sell them to the bad bank at market value.
● The original institution may be able to clear its balance sheet by transferring such assets to the bad bank, albeit it will
still be compelled to take write-downs.
● Instead of a single bank, a bad bank structure may assume the risky assets of a consortium of financial organisations.
● Grant Street National Bank is a well-known example of a bad bank. This entity was founded in 1988 to house Mellon
Bank's bad assets.
● Outside of the United States, the Republic of Ireland established the National Asset Management Agency, a bad bank,
in 2009 in response to the country's own financial crisis.
4.4.3.1 Need for Bad Bank
● The Reserve Bank of India (RBI) launched an Asset Quality Review (AQR) of banks during Governor Raghuram
Rajan’s tenure, which discovered that numerous banks had suppressed or hidden poor loans in order to present a
healthy balance sheet.
● He suggested the setting up of Bad Bank to absorb the rising NPAs of the banks.
● Due to several procedural problems, Asset Reconstruction Companies (ARCs) have had no effect in settling bad
loans.
● While conventional banks continue lending, a "bad bank," or a bank of bad loans, would endeavour to sell these
"assets" on the open market.
● It is a tried and tested method of dealing with NPAs and bad assets during the 2008 financial crisis.
● Existing ARCs have aided in the resolution of stressed assets, particularly for loans with a smaller value.
● The Insolvency and Bankruptcy Code (IBC) and other applicable resolution tools have been shown to be useful.
4.4.3.2 Bad Bank in India
● The government of India has established two new firms to acquire stressed assets from banks and then sell them in the
market in order to resolve large NPAs (Non-Performing Assets) in the Indian banking sector.
● NARCL: National Asset Reconstruction Company Limited (NARCL) was established under the Companies Act
and has applied for an Asset Reconstruction Company licence from the Reserve Bank of India (ARC).

Self Notes
 122

○ In phases, NARCL will buy stressed assets totalling

roughly Rs 2 lakh crore from various commercial banks.
○ NARCL will be owned by public sector banks (PSBs)
to the tune of 51 per cent.
○ The NARCL will buy bad loans from banks first.
○ It will pay 15% of the agreed price in cash and the rest
85% in "Security Receipts."
○ The commercial banks will be paid back the remainder
when the assets are sold with the help of IDRCL.
○ The government guarantee will be activated if the bad
bank is unable to sell the bad loan or must sell it at a
loss.
○ This guarantee is extended for a five-year period.
● IDRCL: The stressed assets will subsequently be sold in the market by another firm, India Debt Resolution Company
Ltd (IDRCL).
○ IDRCL will be owned to a maximum of 49 per cent by PSBs and Public Financial Institutes (FIs).
○ Private-sector lenders will own the remaining 51 per cent of the company.
● The new bad bank structure is this framework of NARCL-IDRCL.

4.4.3.3 Significance of Bad Bank

● It will assist lenders in moving problematic assets to a bad bank and cleaning up their books.
● Banks will be able to re-start lending after the bad bank releases capital. It will be more goal-oriented, and hence better
able to collect debts from borrowers.
● Because it is backed by the government, it will not be hampered by governance flaws, a slow-moving legal system,
or poorly constructed regulations, among other concerns that plague ARCs.
● Overall, it will provide a significant boost to the macroeconomic environment.
● We must not overlook the fact that a bad bank will not be able to prevent future NPAs. The government must identify
strategies to eliminate nonperforming assets (NPAs), which are the primary cause of banks' losses and the
economy's slowdown.
4.4.3.4 Challenges for Bad Banks
● When it comes to the bad bank, the majority of these problematic assets have already been completely funded and
recorded on bank books. The banks have abandoned all expectations of a significant recovery.
● The most crucial aspect of these assets will be how banks arrive at a valuation for their transfer to the bad bank.
For future provision write-backs by banks, the bad bank's capacity to resolve these assets in a timely manner will be
crucial.
● Another challenge that may arise is the sale of stressed assets to potential buyers while also correcting the system's
fundamental dilemma.
● Finding potential purchasers for distressed assets might be difficult in the current situation when economic conditions
are deteriorating and the Insolvency and Bankruptcy Code has been suspended.
● Furthermore, public sector banks will be both shareholders and customers of the bad bank, posing the risk of the bad
bank becoming nothing more than a conduit for transferring bad debt from one book to another.
4.4.3.5 Criticism of Bad Bank
● Moral Hazard: Former Reserve Bank Governor Raghuram Rajan believes that establishing a bad bank could generate
moral hazard issues among banks, allowing them to continue with their irresponsible lending practices and increasing
the NPA problem.
● Not a trusted Antidote: It has been suggested that establishing a bad bank only moves the problem from one location
to another. Without major reforms to address the NPA problem, the bad bank is likely to devolve into a storage facility
for bad loans with no prospect of recovery.
● Poor Fiscal Position: Another major worry is the inability to raise capital for the bad bank. In a pandemic-affected
economy, it's difficult to find purchasers for distressed assets, and the government's finances are tight.
4.4.4 Asset Quality Review (AQR)
● Inspectors from the Reserve Bank of India (RBI) typically review bank records once a year as part of the Annual
Financial Inspection (AFI) process.
● In 2015-16, however, throughout the months of August and November, a special inspection was carried out. Asset
Quality Review (AQR) was the name given to this.
● A small sample of loans is evaluated in a routine AFI to see if asset classification matches loan repayment and if
banks have made necessary reserves.
● The sample size in the AQR, on the other hand, was substantially larger, and most of the large borrower accounts were
investigated to see if categorisation complied with prudential standards.
Self Notes
 123

● According to some reports, a list of over 200 accounts was identified, and banks were instructed to designate them as
non-performing.
● Banks were allocated two quarters to complete the asset classification: October-December 2015 and January-March
2016.
● The main aspect of AQR is that it is a random check rather than a periodic check.
4.4.4.1 Why is Asset Quality Review conducted?
● The RBI had a strong suspicion that some banks were underreporting their nonperforming assets (NPAs).
● Asset classification processes are inadequate, and numerous banks have resorted to accounting evergreening.
● Banks were deferring bad-loan classification while portraying accounts as performing in this case.
4.4.5 Recapitalisation of Banks
● Recapitalisation of Banks is injecting additional capital into state-
owned banks to bring them up to capital adequacy standards.
● It entails injecting more capital into state-owned banks in order for
them to achieve capital adequacy requirements.
● The requirement for Indian public sector banks to maintain a Capital
Adequacy Ratio (CAR) of 12 per cent has been underlined by the
Reserve Bank of India in line with BASEL norms.
● The capital-to-risk-weighted-assets-and-current-liabilities ratio (CAR)
is the ratio of a bank's capital to its risk-weighted assets and
current liabilities.
● The government injects capital into banks that are short on cash
using a variety of instruments.
● Because the government is the largest stakeholder in public sector
banks, it is the government's responsibility to increase capital reserves.
● The government injects capital into banks by issuing bonds or buying new shares.
● In 2017, the government had announced an Rs. 2.11 Lakh crore recapitalisation package for the Public sector Banks
4.4.5.1 Need for Recapitalisation
● The government, which is also the largest shareholder, pours capital into banks by either buying additional shares or
issuing bonds in accordance with RBI requirements.
● As state-run banks struggled to deal with rising nonperforming assets (NPAs), the government announced
recapitalizations from time to time to keep the banks viable.
● In terms of asset size, state-run banks account for 70% of the entire market share in the Indian banking industry.
● Bank recapitalization is "essential" for the country's economic revival.
● To allow banks to fulfil Basel III's higher regulatory capital requirements.
● PSBs' gross nonperforming assets (NPAs) increased to 12.47 per cent in March 2017 from 4.72 per cent in March 2014.
4.4.5.2 Recapitalisation in India
● In India recapitalisation is achieved through 3 major ways:
○ Budgetary Allocation
○ Market borrowings
○ Issue of recapitalisation bonds
Budgetary Allocation
● Budget 2021 allocated Rs.20000 crore and Budget 2020 allocated Rs.7000 crores for bank recapitalisation.
Market borrowings
● In 2017, the government announced that the banks will raise Rs.10312 crores from the market as shares and bonds to
recapitalise banks.
Recapitalisation bonds
● Banks subscribe to bonds issued by the government. As the government raises its part of equity ownership, the money
collected by the government is used to shore up banks' capital reserves in the form of equity capital.
● Banks' money invested in recapitalisation bonds is classified as an investment that pays interest. As a result, the
government is able to stick to its budget deficit target because no money is taken directly from its coffers.
● Between January 2018 and March 2020, banks were issued recapitalization bonds in tranches.
Special Zero-Coupon Recapitalisation Bonds
● These are unique bonds issued by the central government to a specific institution.
● Nobody else, only those banks, who are designated, can invest in them.
● It is neither marketable nor transferable. It is restricted to a single bank and is only valid for a short time.
● There is no coupon, it is a zero-coupon, it is issued at par, and it will be paid at the end of the term.
○ The interest that an investor receives on a bond is known as a coupon.
● According to RBI requirements, it is held under the bank's Held-To-Maturity (HTM) category.
○ HTM securities are purchased with the intention of holding them until they mature.
Self Notes
 124

● These are products that are similar to recapitalisation bonds but serve the same objective, and they are issued in
accordance with RBI regulations.
● The issuing of these special bonds will have no impact on the fiscal deficit while also providing the bank with much-
needed equity capital.
● For instance, Punjab & Sind Bank will be recapitalized by issuing Special Zero-Coupon Recapitalisation Bonds worth
Rs. 5,500 crore.
4.4.5.3 Advantages of Recapitalisation
● It will increase lending and, as a result, growth, as well as increase tax collections and partially reduce the fiscal deficit.
● In 2-3 years, the capital infusion in PSBs will lower loan rates, boost aggregate demand, put idle industries to work, and
stimulate investment.
● When the economy improves, the government can gradually convert these recap bonds into regular G-secs and sell
them on the open market.
● It will make it easier for banks to raise equity capital.
● Viability Ratings (VRs) have been reduced multiple times in the last three to four years, and a capital infusion will help
to alleviate the downward pressure.
● It will assist banks to enhance their financial risk profiles and meeting Basel-III regulatory capital requirements.
● It also acts as a buffer against an increase in provisioning for non-performing assets that is envisaged (NPAs).
4.4.5.4 Drawbacks of Recapitalisation
● Fiscal Deficit: Due to the government's obligation to meet strict budgetary deficit goals, recapitalization will be
challenging.
● Recap is not the solution for Bad Loans: Recapitalization will not result in the repayment of bad debts.
● Moral Hazard: While banks know the government will step in to aid if the loans go bad, they may not take necessary
measures when lending.
● Interest Payments: Centre could end up paying about ₹1.2 lakh crore as interest on recap bonds over the five fiscals
(starting FY21)
4.4.6 Prompt Corrective Action
● The RBI uses the PCA framework to keep track of banks with poor financial performance.
● The PCA framework was introduced by the RBI in 2002 as a structured early-intervention mechanism for banks that
have become undercapitalized or fragile due to a loss of profitability.
● Its goal is to address the issue of non-performing assets (NPAs) in India's banking system.
● Based on the recommendations of the Financial Stability and Development Council's working group on Resolution
Regimes for Financial Institutions in India and the Financial Sector Legislative Reforms Commission, the framework
was reviewed in 2017.
● If a bank is in crisis, PCA is supposed to inform the regulator, as well as investors and depositors.
● The goal is to prevent problems from reaching crisis proportions.
● Essentially, PCA assists RBI in monitoring banks' key performance indicators and taking corrective action to restore a
bank's financial health.
4.4.6.1 Parameters used in PCA Framework
1. CAR (Capital Adequacy Ratio)
● The CAR is a percentage of a bank's risk-weighted credit exposures expressed as a percentage of available capital.
● The Capital Adequacy Ratio, commonly known as the capital-to-risk-weighted-assets ratio (CRAR), is used to protect
depositors and promote financial system stability and efficiency around the world.
2. CET 1 Ratio
● The percentage of common equity capital, net of regulatory adjustments, to total risk-weighted assets as defined in RBI
Basel III guidelines.
3. Non-Performing Asset (NPA)
● It's a loan or advance where the principal or interest payment is past due for more than 90 days.
● NPAs must be classified as Substandard, Doubtful, or Loss assets by banks.
4. Tier 1 Leverage Ratio:
● It refers to the link between a bank's core capital and total assets.
● Tier 1 capital is divided by a bank's average total consolidated assets and certain off-balance sheet exposures to
establish the tier 1 leverage ratio.
● A leverage ratio is one of numerous financial metrics used to evaluate a company's capacity to satisfy its financial
obligations.
● Here are a few examples:
○ Equity Ratio: This figure represents the entire amount of money invested by the company's owners.
○ Debt Ratio: This figure represents the company's entire leverage.
○ Debt to Equity Ratio: This ratio compares the amount of debt a company has to the amount of equity it has.

Self Notes
 125

4.4.6.2 Trigger Points and Risk Thresholds for PCA framework

PCA Matrix – Parameters, Indicators and Risk Thresholds

Parameter Indicator Risk Threshold 1 Risk Threshold 2 Risk Threshold 3

(1) (2) (3) (4) (5)

Capital CRAR - Minimum regulatory Upto 250 bps below More than 250 bps but not In excess of 400 bps
(Breach of prescription for Capital to Risk the Indicator exceeding 400 bps below below the Indicator
either CRAR or Assets Ratio + applicable prescribed at column the Indicator prescribed at prescribed at column (2)
CET 1 Ratio) Capital Conservation Buffer (2) column (2)
(CCB) In excess of 312.50 bps
Upto 162.50 bps below More than 162.50 bps below the Indicator
and/or the Indicator below but not exceeding prescribed at column (2)
prescribed at column 312.50 bps below the
Regulatory Pre-Specified (2) Indicator prescribed at
Trigger of Common Equity column (2)
Tier 1 Ratio (CET 1 PST) +
applicable Capital
Conservation Buffer (CCB)

Breach of either CRAR or CET

1 ratio to trigger PCA

Asset Quality Net Non-Performing >=6.0% but <9.0% >=9.0% but < 12.0% >=12.0%
Advances (NNPA) ratio

Leverage Regulatory minimum Tier 1 Upto 50 bps below the More than 50 bps but not More than 100 bps below
Leverage Ratio regulatory minimum exceeding 100 bps below the regulatory minimum
the regulatory minimum

4.4.6.3 Actions taken by RBI under PCA

Mandatory and Discretionary Actions

Specifications Mandatory actions Discretionary actions

Risk Threshold 1 1. Restriction on dividend Common menu

distribution/remittance of profits. 1. Special Supervisory Actions
2. Promoters/Owners/Parent (in the case of 2. Strategy related
foreign banks) to bring in capital 3. Governance related
4. Capital related
Risk Threshold 2 In addition to mandatory actions of Threshold 1, 5. Credit risk related
1. Restriction on branch expansion; domestic 6. Market risk related
and/or overseas 7. HR-related
8. Profitability related
Risk Threshold 3 In addition to mandatory actions of Threshold 1 & 2, 9. Operations/Business related
1. Appropriate restrictions on capital 10. Any other
expenditure, other than for technological up-
gradation within Board approved limits
● The RBI imposes a few mandatory restrictions to each threshold zone such as restrictions of dividend distribution,
promoters infusing capital, restrictions on branch expansion and capital expenditures as mentioned in the table above.
● Common Discretionary Actions can be taken by the RBI for all three risk threshold zones.
4.4.6.4 Prompt Corrective Action - Issues
● PCA is a unique move that has an impact on the bank's rating as well as consumer confidence. This is harmful in the
long run since it affects the bank's credit history and raises concerns about its management.
● PCA may hasten the loss of market share and cause the public sector banks' position in the financial system to
deteriorate further in favour of private and foreign banks.

Self Notes
 126

● The government views PCA as a barrier to economic growth, hence it is advocating for friendlier lending regulations by
reducing PCA criteria and aligning them with global norms.
● The quarrel between the RBI and the government has the potential to harm India's reputation as an investment
destination.
4.4.7 Other Measures Taken
Many of the below-mentioned measures are either abolished over time or merged with other initiatives.
4.4.7.1 Debt Recovery Tribunals (DRTs)
● The Debt Recovery Tribunals (DRTs) were established in 1993.
● To reduce the amount of time it takes to settle matters. The requirements of the Recovery of Debt Due to Banks and
Financial Institutions Act, 1993, apply to them. However, because their numbers are insufficient, they face a time lag,
with cases in many locations pending for more than two years.
4.4.7.2 Credit Information Bureau (CIB)
● In the year 2000, the Credit Information Bureau (CIB) was established.
● To avoid loans getting into the wrong hands and, as a result, NPAs, a good information system is essential. Individual
defaulters and wilful defaulters are tracked and shared, which aids banks.
4.4.7.3 Lok Adalats - 2001
● They are useful in dealing with and recovering small loans, but the RBI guidelines established in 2001 limit them to loans
of up to 5 lakh rupees. They are beneficial in that they prevent more cases from entering the legal system.
4.4.7.4 Compromise Settlement - 2000
○ For advances under Rs. 10 crores, it provides a straightforward route for NPA recovery. Willful default and fraud
cases are excluded. It covers lawsuits in courts and DRTs (Debt Recovery Tribunals).
4.4.7.5 Asset Reconstruction Companies (ARC)
● Following the modification of the SARFAESI Act of 2002, the RBI has granted licences to 14 additional ARCs. These
businesses were formed in order to extract value from troubled loans. Prior to the passage of this law, lenders could only
enforce their security interests through the courts, which was a lengthy procedure.
4.4.7.6 Restructuring of Corporate Debt – 2005
● Its purpose is to reduce the company's debt burden by lowering the interest rates paid and lengthening the time it takes
to repay the debt.
4.4.7.7 5:25 rule
● The 5:25 rule was enacted in 2014.
● Flexible Structuring of Long-Term Project Loans to Infrastructure and Core Industries is another name for it. It was
suggested that such organisations maintain their cash flow because project timelines are long and they do not receive
money back into their books for a long time, necessitating the need for loans every 5-7 years and therefore refinancing
for long-term projects.
4.4.7.8 Joint Lenders Forum 2014
● It came about as a result of the inclusion of all PSBs with stressed loans. It's there to prevent many banks from lending
to the same person or firm. It was created to prevent situations in which a person accepts a loan from one bank in order
to give a loan from another bank.
4.4.7.9 Indradhanush Framework – 2015
● Since banking nationalisation in 1970, the Indradhanush framework for changing PSBs has been the most
comprehensive reform effort undertaken by ABCDEFG to remodel the PSBs and improve their overall performance.
● Appointments: Based on worldwide best practices and guidelines in the Companies Act, a distinct post of Chairman
and Managing Director will be created, with the CEO receiving the designation of MD & CEO, and a non-executive
Chairman of PSBs would be appointed.
● Bank Board Bureau: will replace the Appointments Board in the selection of Whole-time Directors and non-Executive
Chairman of PSBs.
● Capitalization: According to the finance ministry, the capital requirement for the next four years up to FY 2019 is
estimated to be around Rs.1,80,000 crore, of which the government will pay 70000 crores and PSBs will have to raise
the remainder from the market.
● Destressing: De-stressing entails resolving concerns in the infrastructure sector in order to keep stressed assets out of
banks by bolstering asset reconstruction firms. The creation of a thriving debt market for PSBs.
● Empowerment: PSBs should be given more flexibility and autonomy when it comes to employing staff.
● Framework of Accountability: The banks will be evaluated based on a few key performance indicators. It would include
everything.

Self Notes
 127

○ Non-performing asset management, growth, diversification, return on capital, financial inclusion, and other
quantitative indicators
○ Steps have been taken to improve asset quality, human resource initiatives, and so on are examples of
qualitative parameters.
● Governance Reforms: Banker's Retreats or Gyan Sangam talks between bankers and government officials to resolve
banking sector concerns and determine the future course of action.
4.4.7.10 SDR (Strategic Debt Restructuring)
● Under this programme, banks that have provided a corporate borrower with a loan have the option to convert all or part
of their loan into equity shares in the company that has accepted the loan.
● Its main goal is to give promoters a bigger stake in rescuing stressed accounts and to give banks better tools for initiating
a change of ownership in appropriate instances.
4.4.7.11Sustainable Asset Structuring (S4A) 2016
● It's been designed as an optional framework for resolving accounts that are heavily pressured.
● It entails determining a stressed borrower's sustainable debt level and bifurcating outstanding debt into sustainable debt
and equity/quasi-equity instruments that are projected to deliver upside to lenders if the borrower recovers.
Q. With reference to the ‘Banks Board Bureau (BBB)’, which of the following statements are correct?
1. The Governor of RBI is the Chairman of BBB.
2. BBB recommends for the selection of heads for Public Sector Banks.
3. BBB helps the Public Sector Banks in developing strategies and capital raising plans.
Select the correct answer using the code given below: (2022)
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer: b

5. Basel Norms
● The Basel accord refers to a set of agreements that primarily address risks to banks and the financial system
● The agreement's goal is to ensure that financial institutions have sufficient capital on hand to meet obligations and
absorb unexpected losses.
● The Basel accords for the banking system have been accepted by India. In fact, the RBI has imposed more stringent
standards on a few parameters than the BCBS has.

5.1 BASEL I
● BCBS introduced the capital measurement system called Basel capital accord in 1988. It was also known as Basel
1.
● It was almost entirely concerned with credit risk.
● It established the capital and risk-weighting structure for banks.
● The required minimum capital was set at 8% of risk-weighted assets (RWA).
● RWA refers to assets with varying risk profiles. For example, an asset-backed by collateral would be less risky than a
personal loan with no collateral.
● Capital is divided into two categories: Tier 1 capital and Tier 2 capital.
○ Tier 1 capital is the bank's core capital because it is the primary measure of the bank's financial strength.

■ The majority of core capital is made up of disclosed reserves (also known as retained earnings) and
paid-up capital.
■ It also includes non-cumulative and non-redeemable preferred stock.
○
○ Tier 2 capital – It is used as supplemental funding since it is less reliable than the first tier.
■ It consists of undisclosed reserves, preference shares, and subordinate debt.
■ In 1999, India adopted the Basel 1 guidelines.

5.2 BASEL II
● BCBS published Basel II guidelines in June 2004, which were considered to be refined and reformed versions of the
Basel I accord.
● The guidelines were founded on three pillars, as the committee refers to them:
Self Notes
 128

○ Capital Adequacy Requirements: Banks should keep a minimum capital adequacy requirement of 8% of risk
assets.
○ Supervisory Review: According to this, banks were required to develop and implement better risk
management techniques for monitoring and managing all three types of risks that a bank faces: credit, market,
and operational risks.
○ Market Discipline: This necessitates stricter disclosure requirements. Banks must report their CAR, risk
exposure, and other information to the central bank on a regular basis.

5.3 BASEL III

● The Basel III guidelines were published in 2010.
● These guidelines were put in place in response to the 2008 financial crisis.
● There was a need to further strengthen the system because banks in developed economies were undercapitalized, over-
leveraged, and relied more on short-term funding.
● Furthermore, the quantity and quality of capital required under Basel II were deemed insufficient to contain any additional
risk.
● The Basel III norms aim to make most banking activities, such as trading books, more capital-intensive.
● The guidelines are intended to promote a more resilient banking system by focusing on four critical banking
parameters: capital, leverage, funding, and liquidity.

5.3.1 Capital

● The capital adequacy ratio should be kept at 12.9 percent.

● The minimum Tier 1 and Tier 2 capital ratios must be maintained at 10.5 percent and 2 percent of risk-weighted
assets, respectively.
● Furthermore, banks must maintain a capital conservation buffer of 2.5 percent.
● The counter-cyclical buffer should also be kept at 0-2.5 percent.

5.3.2 Leverage

● The leverage rate must be at least 3%.

● The leverage rate is the ratio of a bank's tier-1 capital to average oftotal consolidated assets.

5.3.3 Funding and Liquidity

● Basel-III established two liquidity ratios: LCR and NSFR.

● Liquidity coverage ratio (LCR) will require banks to maintain a buffer of high-quality liquid assets sufficient to deal with
cash outflows encountered in an acute short-term stress scenario as specified by regulators.
○ This is done to avoid situations like the "Bank Run." The goal is to ensure that banks have enough liquidity to
weather a 30-day stress scenario if it occurs.
● Net Stable Funds Rate (NSFR) mandates that banks maintain a consistent funding profile in relation to their off-balance-
sheet assets and activities.
○ The NSFR requires banks to fund their operations with stable sources of funding (reliable over the one-year
horizon).
○ The NSFR must be at least 100 percent.
● As a result, LCR assesses short-term (30-day) resilience while NSFR assesses medium-term (1-year) resilience.

Q. Basel III Accord’ or simply ‘Basel III’, often seen in the news, seeks to (2015)
(a) develop national strategies for the conservation and sustainable use of biological diversity
(b) improve banking sector’s ability to deal with financial and economic stress and improve risk management
(c) reduce the greenhouse gas emissions but places a heavier burden on developed countries
(d) transfer technology from developed countries to poor countries to enable them to replace the use of chlorofluorocarbons in
refrigeration with harmless chemicals
Answer: b

6. Capital Adequacy Ratio

● In 1988, the Basel Committee decided to introduce a capital measurement system, the Basel Capital Accord, popularly
known as Basel I.
Self Notes
 129

● This system provided for the implementation of a credit risk measurement framework with a minimum capital
standard of 8.0 per cent to be attained by end-1992.
● Since 1988, this framework has been progressively introduced not only in member countries but across all countries with
an international banking presence.
● In April 1992, the Reserve Bank announced detailed guidelines on the phased introduction of norms on capital
adequacy, income recognition, asset classification, and provisioning in pursuance of Basel I norms.
● Banks with an international presence were directed to achieve the capital adequacy norms by March 1995 and other
banks in two stages by March 1996.
● The Capital Adequacy Ratio (CAR) of a bank is the ratio of its capital to its risk-weighted assets and current liabilities.
● The capital adequacy ratio, also known as the capital-to-risk-weighted-assets ratio (CRAR), is used to protect
depositors and promote the stability and efficiency of global financial systems.
● Central banks and bank regulators make the decision to prevent commercial banks from taking on excessive
leverage and becoming insolvent in the process.
● CAR is critical in ensuring that banks have enough cushion to absorb a reasonable amount of losses before going
bankrupt.
● CAR is used by regulators to determine a bank's capital adequacy and to run stress tests.
● CAR is used to measure two types of capital. Tier-1 capital can absorb a reasonable amount of loss without causing
the bank to cease trading, whereas tier-2 capital can sustain a loss if the bank is liquidated.
● The disadvantage of using CAR is that it does not account for the risk of a bank run, or what would happen if one
occurred.

6.1 Capital Adequacy Ratio Formula

● The CAR or CRAR is calculated by dividing the bank's capital by the total risk-weighted assets for credit risk, operational
risk, and market risk.
● This is calculated by adding a bank's tier 1 and tier 2 capitals and dividing the total by the bank's total risk-weighted
assets. That is to say:
● Tier 1 CAR = (Eligible Tier 1 capital funds) =(Market Risk RWA + Credit Risk RWA + Operational Risk RWA).
● Total CAR = (Eligible Total Capital Funds) /Credit Risk RWA + Market Risk RWA + Operational Risk RWA)

6.1.1 Tier 1 capital

● It can absorb losses without requiring a bank to stop trading.

● This includes ordinary share capital, equity capital, audited revenue reserves, and intangible assets.
● It is also referred to as core capital.
● This is permanently available capital that can be used to absorb losses incurred by a bank without forcing it to cease
operations.

6.1.2 Tier 2 capital

● This can absorb losses if the bank goes bankrupt, providing depositors with a lesser level of protection.
● Unaudited reserves, unaudited retained earnings, and general loss reserves make up this category.
● This capital absorbs losses after a bank loses all of its tier 1 capital and is used to cushion losses if the bank is winding
up.

6.1.3 Risk-weighted assets

● These assets are used to determine the minimum amount of capital that banks should hold in order to reduce their
insolvency risk.
● The capital required for all types of bank assets is determined by risk assessment.

6.2 Importance of Capital Adequacy Ratio

● The CAR is set by central banks and bank regulators to prevent commercial banks from taking on too much leverage
and becoming insolvent.
Self Notes
 130

● The CAR is necessary to ensure that banks have enough leeway to absorb a reasonable amount of loss before becoming
insolvent and losing depositors' funds.
● A bank with a high CRAR/CAR is considered safe/healthy and likely to meet its financial obligations.
● When a bank is being wound up, depositors' funds take precedence over the bank's capital, so depositors will lose
their savings only if the bank suffers a loss greater than its capital.
● As a result, the higher the CAR, the greater the protection for depositors' funds held by the bank.
● The CAR contributes to the stability of an economy's financial system by lowering the risk of bank insolvency.

7. Financial Inclusion
● According to the World Bank, Financial inclusion means that individuals and businesses have access to useful and
affordable financial products and services that meet their needs.
● Exclusion from the financial system is commonly used to define financial inclusion.
○ If a target group does not have access to mainstream formal financial services such as banking accounts, credit
cards, insurance, payment services, and so on, they are considered financially excluded.
● In 2006, the Government of India formed a committee chaired by Dr. C. Rangarajan to study the pattern of exclusion
from access to financial services across region, gender, and occupational structure, as well as to identify the barriers
faced by vulnerable groups in accessing credit and financial services and to recommend steps needed for financial
inclusion.
● In January 2008, the committee submitted its report. According to the committee, financial inclusion is defined as:
○ The process of ensuring access to financial services and timely and adequate credit where needed by
vulnerable groups such as weaker sections and low-income groups at an affordable cost.
● Financial inclusion is achieved when all individuals and businesses have access to and can use a wide range of financial
services that are responsibly and affordably provided by sustainable institutions in a well-regulated environment

7.1 Financial Inclusion – Initiatives

7.1.1 Jan Dhan-Aadhar-Mobile (JAM) Trinity

● The combination of Aadhaar, PMJDY, and an increase in mobile communication has transformed how citizens access
government services.
● According to estimates in August 2021, the total number of Jan Dhan scheme beneficiaries was more than 430 million.
● Aadhaar has significantly altered the concept of individual identity, resulting not only in a secure and easily verifiable
system but also in an easy-to-obtain system that will aid in the financial inclusion process.
● The government has also launched a number of
flagship schemes to promote financial inclusion and
provide financial security in order to empower the
country's poor and unbanked citizens.
● The Pradhan Mantri Mudra Yojana, the Stand-Up
India Scheme, the Pradhan Mantri Jeevan Jyoti Bima
Yojana, the Pradhan Mantri Suraksha Bima Yojana,
and the Atal Pension Yojana are among them.

7.1.2 Financial services expansion in rural and

semi-urban areas

● The Reserve Bank of India (RBI) and NABARDhave

launched initiatives to promote rural financial
inclusion.
● These include the establishment of bank branches in
remote regions.
● Kisan Credit Cards (KCC) are being issued.
● Self-help groups (SHGs) are linked with banks.
● Increasing the number of ATMs.
● Business correspondent model of banking.

7.1.3 Digital Payments Promotion

● In comparison to the past, digital payments have become more secure thanks to NPCI's strengthening of the Unified
Payment Interface (UPI).

Self Notes
 131

● The Aadhar-enabled payment system (AEPS) allows an Aadhar-enabled bank account (AEBA) to be used at any location
and at any time through the use of micro ATMs.
● The payment system has become more accessible as a result of offline transaction-enabling platforms such as
Unstructured Supplementary Service Data (USSD), which allows users to use mobile banking services without the
need for an internet connection, even on a basic mobile handset.

7.1.4 Improving Financial Literacy

● The Reserve Bank of India has launched a project called "Project Financial Literacy."
○ The project's goal is to disseminate information about the central bank and general banking concepts to a
variety of target groups, including school and college students, women, the rural and urban poor, military
personnel, and senior citizens.
● ‘Pocket Money’ is the flagship programme of the Securities and Exchange Board of India (SEBI) and the National
Institute of Securities Markets (NISM) aimed at increasing financial literacy among school students.
○ The goal is to teach students about the value of money and the importance of saving, investing, and financial
planning.

7.2 Digital financial inclusion

● Digital financial inclusion entails using cost-effective digital means to reach currently financially excluded and
underserved populations
● It includes a variety of formal financial services tailored to their needs that are responsibly delivered at a cost that is
affordable to customers and sustainable for providers.
As per RBI, over 26 crore digital payment transactions are processed daily by our payment systems, of which Unified
Payments Interface (UPI) system itself processes more than two-thirds.

Total digital payments have increased by 216% and 10% in terms of volume and value, respectively, for March 2022
when compared to March 2019.

Data shows an increase of more than 500% in merchants accepting digital modes of payments during the half-
year ended September 2021 as compared to half-year ended March 2019; in case of UPI alone, there is an increase
of more than 1200% over the same period.

There has been increase in unique users of mobile banking and internet banking by 99% and 18%, respectively,
between March 2019 and September 2021.

7.2.1 Benefits
● Access to formal financial services such as payments, transfers, savings, credit, insurance, and securities.
● Additional financial services tailored to the needs and financial circumstances of customers are made available.
● Unlike cash-based transactions, pose fewer risks of loss, theft, and other financial crimes.
● Promote economic empowerment by enabling asset accumulation and, for women in particular, by increasing their
economic participation
7.2.2 Risks
● Customers face novelty risks as a result of their unfamiliarity with the products, services, and providers, making
them vulnerable to exploitation and abuse.
● Risk of privacy or security breach due to digital transmittal and storage of data
● Mistaken transactions due to error in typing phone number or ID.
Q. Consider the following statements:
The Reserve Bank of India’s recent directives relating to ‘Storage of Payment System Data’, popularly known as data diktat,
command the payment system providers that
(1) they shall ensure that entire data relating to payment systems operated by them are stored in a system only in India
(2) they shall ensure that the systems are owned and operated by public sector enterprises
(3) they shall submit the consolidated system audit report to the Comptroller and Auditor General of India by the end of the
calendar year
Which of the statements given above is/are correct? (2019)
(a) 1 only
(b) 1 and 2 only
(c) 3 only

Self Notes
 132

(d) 1, 2 and 3
Answer: a

8. Consolidation of Public Sector Banks

Former RBI governor M. Narasimham proposed to the government in 1991 that banks be merged into a three-tiered
structure, with three large banks with a global presence at the top, eight to ten national banks at tier two, and a large number of
regional and local banks at the bottom.
8.1 Benefits of bank consolidation
● Merged banks have lower labour costs than smaller banks because they can take advantage of economies of scale.
● It will result in improved synergy and resource utilisation, resulting in lower borrowing rates and, as a result, greater
competitiveness.
● By reducing total operating and funding expenses while enhancing risk management procedures, it will gradually
increase operational efficiencies.
● Well-managed public sector banks will increase financial inclusion and spur credit growth.
8.2 Challenges to bank consolidation
● The problem of risk concentration will arise if we create a large number of merged entities.
● Many employees would fear job loss and disparities in the form of regional allegiances, benefits, reduced promotional
avenues, and so on, which could lead to lower morale and problems impeding the merged entity's success.
● Because different banks are currently operating on different technology platforms, technology harmonisation and
integration will be difficult.
Q. With reference to the governance of public sector banking in India, consider the following statements [2018]
(1) Capital infusion into public sector banks by the Government of India has steadily increased in the last decade.
(2) To put the public sector banks in order, the merger of associate banks with the parent State Bank of India has been affected.
Which of the statements given above is/are correct?
(a) 1 only
b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: b

9. Some related terms

Microfinance Institutions: Those financial institutions focus on assisting typically poor households and small enterprises
in gaining access to financial service. Microfinance allows people to take on reasonable small business loans safely, and in a
manner that is consistent with ethical lending practices.

Peer to Peer Lending: It is a form of financial technology that allows people to lend or borrow money from one another without
going through a third party or intermediary

CBS – Core Banking: It is the networking of bank branches, which allows customers to manage their accounts, and use various
banking facilities from any part of the world.

Systemically Important Banks: They are perceived as banks that are ‘Too Big To Fail (TBTF)’. This perception creates an
expectation of government support for these banks at the time of distress. Due to this perception, these banks enjoy certain
advantages in the funding markets. SIBs are thus subjected to additional policy measures to deal with the systemic risks

SWIFT: Society for Worldwide Interbank Financial Telecommunications (SWIFT) is a member-owned cooperative that provides
safe and secure financial transactions for its members. It is the largest and most streamlined method for international payments
and settlements.

Financial Inclusion Index: RBI constructed the FI-Index as a comprehensive measure that includes details of banking,
investments, insurance, postal as well as the pension sector in consultation with the government and regulators.
The index helps to determine and assess the extent of financial inclusion in India. It captures information on various aspects
of financial inclusion on a scale from 0 to 100, where 0 represents complete financial exclusion and 100 indicates full finan cial
inclusion.

Self Notes
 133

Letter of Credit: A document sent from a bank or financial institute that guarantees that a seller will receive a buyer's
payment on time and for the full amount. Letters of credit are often used within the international trade industry. Banks collect a
fee for issuing a letter of credit

Banking Ombudsman: Banking Ombudsman is a senior official appointed by the Reserve Bank of India to redress
customer complaints against deficiency in certain banking services covered under the grounds of complaint specified under
Clause 8 of the Banking Ombudsman Scheme 2006. The scheme is an expeditious and inexpensive forum for bank customers
for resolution of complaints relating to certain services rendered by banks.

Public Credit Registry: It is used to store information about existing as well as new borrowers. This includes both corporate
as well as retail borrowers. The idea is to capture all relevant information in a single large database on both the outstanding
loans and repayment history of an entity/corporate/individual.

Currency Swap: A currency swap involves the exchange of interest—and sometimes of principal—in one currency for the same
in another currency. Companies doing business abroad often use currency swaps to get more favourable loan rates in the local
currency than if they borrowed money from a local bank.

KYC: Know Your Customer (KYC) is a set of standards used within the investment and financial services industry to verify
customers, their risk profiles, and financial profile.

Plastic Money: Debit and credit cards represent plastic money. Plastic money has made it easier for us to carry out transactions
in our daily lives. It has replaced cash payments across the world and established itself as a necessary form of instant money.

Q. What is/are the facility/facilities the beneficiaries can get from the services of Business Correspondent (Bank Saathi) in
branchless areas? (2014)
(1) It enables the beneficiaries to draw their subsidies and social security benefits in their villages.
(2) It enables the beneficiaries in the rural areas to make deposits and withdrawals.
Select the correct answer using the code given below.
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: c

Self Notes
 134

BUDGET-EVOLUTION, TYPES, WEAKNESS, REFORMS,

GOVERNMENT BUDGETING

1. Budget 135
1.1 Background 135
1.2 What is a Budget 135
1.3 Components of Budget 136
1.4 Government Budget 141
1.5 Types of Budget 145
1.6 Budget Deficit 149
1.7 Public Debt 152
1.8 Weaknesses in the Budgetary System and Implementation 155
1.9 Reforms in Budgeting and proposed reforms 156
1.10 Some important budget related terms 160
1.11 Budget 2022-23 163

Self Notes
 135

1. Budget
1.1 Background
● The term budget is derived from the french word ‘Bougette’ which means leather briefcase.
● A budget is an estimate of revenue and expenses for a specific future period of time that is usually prepared and
updated on a regular basis.
● A budget is made up of two parts:
○ Government receipts
○ Government expenditures.
● In terms of the amount of money received and spent a budget can be classified into different types.
● The Budget for India was first presented to the British Crown on April 7, 1860, by Scottish economist and statesman
James Wilson of the East India Company.
● Mr. Liaquat Ali Khan, Member of the Interim Government presented the Budget of 1947-48.
● After Independence, India’s first Finance Minister, Shri Shanmukham Chetty, presented the first budget of
independent India on 26th November, 1947.
● In many aspects, our budget is similar to the UK budget, particularly in terms of schedule (it used to be conducted at
5:30 pm, which is noon in the UK), and level of secrecy.
Do You Know?
INDIA'S FIRST BUDGET: was presented by James Wilson in the year 1860. India's first budget was presented on November
26, 1947 by the then Finance Minister RK Shanmukham Chetty.
LONGEST BUDGET SPEECH: Finance Minister Nirmala Sitharaman delivered the longest budget speech of 2 hours
and 42 minutes while presenting the Union Budget 2020-21 on February 1, 2020. With 2 pages left, she felt unwell and
requested the speaker to consider it as read.
SHORTEST BUDGET SPEECH: Finance minister Hirubhai Mulljibhai Patel delivered the shortest budget of 800 words
in 1977.
MOST NUMBER OF BUDGETS: Morarji Desai presented the highest number of Budget in Independent India’s History. He
presented a total of 10 budgets.
TIME: Following the British system, the government presented the budget at 5 PM (noon in UK). In 1999, then Finance Minister
Yashwant Sinha presented the budget at 11 AM.
Since 2017, the day of the budget is 1st february rather than the last day of February. Arun Jaitley became the first
Finance minister to present the Budget on 1st February.
LANGUAGE: Since 1955, the budget has been printed in both English and Hindi. Prior to this it was printed only in English.
PAPERLESS: The union budget of 2021-22 became the first budget presented paperless due to Covid-19 pandemic.
FIRST WOMAN: Indira Gandhi became the first woman Minister who presented the budget in 1970-71.
In 2019, Nirmala Sitharaman became the second woman Minister to present the budget, she also changed the ‘Budget’ into a
traditional 'bahi-khata' with the National Emblem to carry the speech and other documents.
RAILWAY BUDGET: up to 1924, railway budget was presented along with the union budget. And from 1924, the railway budget
was separated from the general budget.
After 2017, the budget was merged again and presented along with the general budget.
PRINTING: the budget was printed in Rashtrapati Bhawan till 1950. However, it got leaked and the venue after that has been
shifted to a press at Minto Road.
In 1980, a government press was set up in the ministry of finance at North block.

1.2 What is a Budget

● A budget can be defined as an estimation of revenue and expenses over a specified future period of time and is
usually compiled and re-evaluated on a periodic basis.
● The government budget, also known as the Annual Financial Statement of the nation, is the annual fiscal statement
that depicts the revenues and expenditures of the country for a financial year.
● Under Article 112 it shall be the responsibility of the president to lay annual financial statement in the Parliament every
financial year.
● The government budgeting is deliberated by the legislature, sanctioned by the Chief Executive or President, and
prepared by the Finance Minister of the country.
● We might have a budget that is in balance, a budget that is in deficit, or a budget that is in surplus.
● The government has a balanced budget when its expenditures are exactly equal to its income.
● A deficit budget is one in which the government's expenditures exceeded its receipts.
● When the government's revenue exceeds its spending, the government has a budget surplus.

Self Notes
 136

1.3 Components of Budget

● A government budget is a declaration of the
government's expected receipts and expenditures
for a fiscal year.
● The two major components of the budget are
Revenue Budget and Capital Budget.
● In India, the government delivers its budget to the
Lok Sabha at the start of each year, outlining
expected receipts and expenses for the coming
fiscal year.
● The fiscal year begins on April 1st and ends on
March 31st of the following year.
● The government budget and its components can be
divided into two parts –
1. Capital budget
2. Revenue budget
1.3.1 Capital Budget
● The Capital Budget covers non-recurring transactions through capital expenditures and income through the
sale of assets.
● These refer to receipts that reduce assets for a government and increase financial liabilities.
● Government capital expenditure, on the other hand, aids in the creation of assets and the reduction of liabilities.
● As a result, the capital budget is an account of the government's liabilities and assets, which represent a change in total
capital.
● Examples: Market borrowings by the government from the public, Borrowings from the RBI, Borrowings from commercial
banks or financial institutions through the sale of T-BILLS, loans received from foreign governments or international
financial institutions, post office savings, post office saving certificates, and PSUs Disinvestment.

UPSC CSE PRELIMS 2016: Which of the following is/are included in the capital budget of the Government of India?
(1) Expenditure on acquisition of assets like roads, buildings, machinery, etc.
(2) Loans received from foreign governments
(3) Loans and advances granted to the States and Union Territories
Select the correct answer using the code given below.
(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

1.3.1.1 Capital Expenditure

● Capital Expenditure includes payments on assets like land, buildings,
machinery, and equipment, as well as investments in shares, loans,
and advances made by the federal government to state and union
territory governments, government companies, corporations, and
other parties.
● Capital Expenditure: Examples
○ The portion of government payments that goes toward the
construction of assets such as schools, colleges,
hospitals, roads, bridges, dams, railway lines, airports,
and seaports is known as capital expenditure.
○ Procurement of new weapon systems such as missiles
and tanks needs substantial capital requirements.
○ The defence sector receives over a third of the central
government's capital spending, primarily for armament
acquisitions.

Self Notes
 137

○ Despite the fact that defence spending is classified as a capital expenditure, it does not result in the
development of infrastructure to
support economic growth.
○ Also includes investments that will
produce earnings or dividends in the
future.
1.3.1.2 Capital Receipts
● Capital Receipts are loans raised from the public
(also known as market loans), borrowings from the
Reserve Bank and other parties through the sale of
Treasury bills, loans received from foreign bodies
and governments, and recoveries of loans granted
by the Central government to state and Union
Territory governments and other parties.
● Types of Capital Receipts
1. Non-Debt Capital receipts
○ Those that the government does
not have to repay in the future.
○ Recovery of loans and advances, disinvestment, and the issuance of bonus shares are all examples
of non-debt capital receipts.
2. Debt capital receipts
○ The government is obligated to repay debt receipts.
○ Borrowing accounts for around a quarter of all government expenditure.
○ A decrease in debt receiving (or borrowing) can make a significant difference in the economy's
financial stability.
○ Market loans, issuance of special securities to public-sector banks, securities issues, short-term bank
debt, treasury bills, securities against small savings, state pension schemes, relief bonds, saving
bonds, gold bonds, external debt, and other debt capital receipts are all examples of debt capital
receipts.
● Generators of Capital Receipts
○ Additional funds and the relevant assets are presented by the owner or possessor.
○ Debentures and other debt-related instruments.
○ Borrowing of funds from a bank or other financial institution.
○ Insurance claims of many types.
○ Shares are issued.
1.3.2 Revenue Budget
● A revenue budget is a statement of the government's anticipated revenue receipts and expenditures for a fiscal
year. The revenue budget is for revenue items that are recurring
and non-redeemable.
● This budget relates to revenue receipts and expenses incurred as a
result of these receipts.
● The revenue received by a government includes both tax and
non-tax revenue.
1.3.2.1 Revenue Receipts
● Revenue receipts are those that do not produce any liabilities and do
not result in a claim against the government.
● These revenue receipts are non-redeemable and are divided into two
groups: tax revenue and non-tax revenue.
● Tax receipts are the most important components of revenue
receipts, which have been divided into direct taxes, enterprises, and
indirect taxes such as customs duties, excise taxes, and service
taxes for the long period.
● Non-tax receipts, on the other hand, are recurrent income
generated by the government from sources other than taxes.

Classification of revenue receipts

● The revenue receipts are classified into the following:
○ Tax Receipts
○ Non-tax Receipts
Self Notes
 138

1.3.2.2 Revenue Expenditure

● Revenue Expenditure is the part of government
spending that does not result in the production of
assets. Salaries, wages, pensions, subsidies, and
interest payments are all instances of revenue
expenditures.
● The government incurs revenue expenses to meet its
operating demands.
● Revenue expenditures include expenses for the
day-to-day operations of government departments
and various services, interest costs on government
debt, subsidies, and so on.
● Other revenue expenses include:
○ Wages and salaries for employees
○ Any overhead item that falls under selling, general, and administrative expenses, such as salary for the
corporate office
○ Rentals and utilities
○ Travelling for work

Types of Revenue Expenditures

● Earlier, the budget expenditure was divided into two subheads.
● The classification of plan and non-plan expenditures was changed to a simpler division of just capital and
revenue expenditure in the 2018-19 Budget following the demise of the Planning Commission.

UPSC CSE PRELIMS 2014: With reference to the Union Budget, which of the following is/are covered under Non-Plan
Expenditure?
(1) Defence expenditure
(2) Interest payments
(3) Salaries and pensions
(4) Subsidies
Select the correct answer using the code given below.
(a) 1 only
(b) 2 and 3 only
(c) 1, 2, 3 and 4
(d) None

Self Notes
 139

Self Notes
 140

Self Notes
 141

1.4 Government Budget

● A budget is a statement of the estimated receipts and expenditures of the government for that particular year, according
to the constitution.
● It acts as the financial blueprint for the government to function for a financial year.
● The budget is also known as the nation's Annual Financial Statement.
● The legislative debates the government budget, which is then approved by the President and prepared by the country's
Finance Minister.
○ The Budget document consists of the Actual transactions of the past year, revised estimates for the current
year, and the Budget estimates for the next year.
○ For instance, Union Budget 2022-2023 provided the Actual transactions for 2020-2021, revised estimates for
2021-2022, and budget estimates for the FY 2022-2023.
1.4.1 Objectives of Government Budget
1. Reallocation of resources
● Through the budgetary policy, the government aims to redistribute the resources according to the prevailing economic
and social priorities of the economy
● The government can redistribute resources through:
1. Taxes — By imposing higher taxes on the richer section and lower taxes on the low earning groups. Also the
Governments can impose higher taxes on production of harmful goods and services like liquor cigarettes etc.
Taxes can be reduced on welfare goods and services.
2. Subsidies— The low income group should be given subsidies and concession subsidies can also be given on
products to encourage their use. e.g LPG
3. Direct production— When the private sector doesn't take initiative for welfare activities then the government
can undertake production directly.

2. Reducing inequalities in income & wealth

● The government can achieve this objective by imposing higher taxes on the rich and luxury goods. The amount
collected can be spent on providing free services to the poor.
● When the government spends more on providing free services like health and education to the poor, it increases their
standard of living and their efficiency of working. Thereby reducing the income inequality.

3. Economic Stability
● The government budget also aims to control inflationary and deflationary tendency in an economy.
● Income occurs when aggregate demand is more than aggregate supply.
○ Government can correct this situation by reducing its expenditure or by increasing taxes.
○ Deflationary tendencies can be controlled by increase in Government’s expenditure and reduction in taxes.

4. Management of public enterprises

● This is solely the responsibility of the government. Many PSUs which are established with the aim of social welfare have
to be looked after by the government.
○ Provisions have to be made in the budget regarding their expenditures, income etc.

5. Economic Growth
● The growth rate of an economy depends on its rate of saving and investment. Therefore an economy’s budget also
makes provision for mobilisation of resources for investment in the public sector.
● Governments also make policies which encourage the rate of savings in the economy. thereby boosting the level of
investment.

6. Reducing Regional Disparities

● In order to reduce regional disparities, the Government encourages the private sector to set up production units in
backward areas.
● Various types of tax concessions and tax holidays are offered to those firms who volunteer for such initiatives.
● Thus the Government’s responsibility of developing these areas is shared and in return the firms receive a bigger profit
margin.
1.4.2 Budget Formulation
● Every year, the Budget, India's money bill, is presented in the first week of February. The Budget is usually presented
at the beginning of the Budget session of the Parliament.
● Generally, there are three stages in budgetary cycle:
1. Preparation of the budget
2. Budget Presentation and Enactment
Self Notes
 142

3. Budget Execution
● The executive is responsible for budget preparation, while the enactment is a legislative procedure.
● The Constitution of India vests powers with the parliament/legislature to ensure budgetary control, so that no public
resources are spent without parliament/legislature‘s approval.
● Budget execution involves the utilisation of allocated funds to implement government’s policies.
1.4.2.1 Budget Preparation
● In India, every September/October, about six months prior to the fiscal year’s commencement, the administrative
agencies initiate the process of preparation of budget estimates. It is as given below:
1. Dispatch of Circulars
○ The finance ministry sends circulars and forms to the drawing and disbursing officers of various
ministries/departments to initiate the process of formulating the estimates of the projected expenditure for the
ensuing fiscal year.
2. Consolidation and Scrutiny
○ The heads of the departments and ministries and departmental controlling officers scrutinise and consolidate
the received estimates from the drawing and disbursing officers.
○ The administrative ministry corroborates these estimates with the policy laid down by the department to achieve
pre-set goals.
○ Outdated schemes can be scrapped, and funds reallocated to more useful ones.
3. Factual Verification by the Comptroller and the Auditor General of India
○ All estimates are submitted to the Comptroller and the Auditor General of India (CAG) by departments to check
them for their factual accuracy. The CAG being the repository of such facts makes its comments on the
budget estimates.
4. Consolidation by the Finance Ministry
○ The next step of consolidation and scrutiny of budget estimates is done by the Finance Ministry’s budget division
from the financial perspective.
○ It sees to it that no duplication takes place and estimates are made keeping in mind the economy to utilise
judiciously its limited funds.
○ New expenditure is scrutinised strictly to ascertain its worthiness in keeping with the national plans.
■ It consults with the NITI Aayog (earlier Planning Commission) in this regard.
○ New Schemes: The Departments/Ministries submit new schemes to the finance ministry through budget
estimates and consider its decisions as final. In case of a dispute, it is referred to the union cabinet, in which
case its decision would be considered final.
5. Approval by the Cabinet
○ The consolidated budget is submitted to the cabinet by the Finance Ministry before presenting it to the
Parliament.
1.4.2.2 Budget Enactment
● This is the second stage of the budgeting process.
○ It includes the discussion of the budget in the legislature and passing of the finance bill which becomes an
Act.
○ This stage commences with formal legal discussions as per parliamentary rules.
● The budget speech of the finance minister comprises two parts:
1. Part A: The finance minister presents the financial statements of the previous and current year’s and the
ensuing year’s estimates.
2. Part B: In the Part B of the budget speech, the Finance minister presents the detailed accounts of tax
proposals and other measures to increase revenue levels for the projected expenditure estimates in the
ensuing year.
● Steps in Budget Enactment
○ There are six stages or steps through which the budget goes through in the legislature/ parliament, which are
discussed below:
1. Presentation of the Budget
2. General Discussion
3. Scrutiny by Departmental Committees
4. Voting of Demands for Grants
5. Passing of the Appropriation Bill
6. Passing of the Finance Bill

1. Presentation of the Budget

● In India the practice has been that the budget used to be presented in two parts namely, railway budget and general
budget. The railway minister would present the railway budget prior to the general budget presentation, presented by
the finance minister on the last working day of February.

Self Notes
 143

○ However, since 2016, the two parts of the budget have been merged into one and are presented together. And
now it is presented in the first week of February.
● The budget speech in the Lok Sabha precedes the laying of the budget in the Rajya Sabha which discusses it, as it
does not have the power to vote on the demand for grants.
● The other documents presented along with the budget are:
○ An Explanatory Memorandum on the Budget
○ An Appropriation Bill
○ A Finance Bill comprising tax proposals
○ Annual Reports of Ministries
○ Economic Classification of the budget
○ The Economic Survey is presented to the Lok Sabha a few days prior to the presentation of the budget in
respect of the grant proposed for each ministry. The
● The Economic Survey is presented to the Lok Sabha a few days prior to the presentation of the budget in respect of
the grant proposed for each ministry.

2. General Discussion- Statement of Demand for Grants

● Budgets are discussed in two stages—the general discussion followed by detailed discussion and voting on the
demands for grants.
○ The whole process of discussion and voting on the demands for grants and the passage of the appropriation
and finance bills are to be completed within a specified time.
● As a result, often the demands for grants relating to all the ministries/departments cannot be discussed and demands
of some ministries get guillotined i.e., voted without discussion.
● The Minister of Parliamentary Affairs, after the presentation of the Budget, holds a meeting of leaders of parties/
groups in Lok Sabha for the selection of ministries/ departments whose demands for grants might be discussed in the
house.
○ Based on decisions arrived at this meeting, the government forwards the proposals for the consideration of the
Business Advisory Committee.
○ After considering the proposals, it allots time and recommends the order in which the demands might be
discussed. It is generally left to the government to make any change in the order of discussion.
● During the general discussion, the House is at liberty to discuss the budget as a whole or any question of principles
involved therein but no motion can be moved.
○ The scope of discussion is confined to an examination of the general scheme and structure of the budget,
whether the items of expenditure ought to be increased or decreased, the policy of taxation as expressed in
the budget and in the speech of the finance minister.
○ The finance minister has the right of reply at the end of the discussion.

3. Scrutiny by Standing Committees

● With the creation of departmentally related standing committees of Parliament in 1993, the demands for grants of all
the ministries/departments are required to be considered by these committees.
● After the general discussion on the budget is over, the House is adjourned for a fixed period.
○ During this period, the demands for grants of the ministries/ departments are considered by the committees.
○ These committees are required to make their reports to the house within a specified period without asking for
more time and make separate reports on the demands for grants of each ministry.
● Discussion on Demands for Grants:
○ The demands for grants are presented to Lok Sabha along with the annual financial statement.
○ These are not generally moved in the house by the minister concerned.
○ The demands are assumed to have been moved and are proposed from the Chair to save the time of the
House.
○ After the reports of the standing committees are presented to the House, it proceeds to the discussion and
voting on demands for grants, ministry-wise.
■ The scope of discussion at this stage is confined to a matter which is under the administrative control
of the ministry and to each head of the demand as is put to the vote of the house.
■ It is open to members to disapprove a policy pursued by a particular ministry or to suggest measures
for the economy in the administration of that ministry or to focus its attention to specific local
grievances.

4. Voting of Demands of Grants

● The next step is the voting of demand for grants, where the demands are presented ministry-wise.
○ The legislators are made available the annual reports and other relevant documents for every ministry while
voting is done.
○ The Speaker makes the ministry wise timetable for the process after coordinating with the members of the
legislature.
Self Notes
 144

○ After the voting for demands is completed, the demands become grants.
● At this stage, cut motions can be moved to reduce any demand for grant but no amendments to a motion seeking to
reduce any demand is permissible.

● Cut motions:
○ When the general budget is put to discussion, the legislators get a chance to do that in detail through cut
motions to bring out any loopholes in the administration.
■ Generally, in practice the cut motions are not passed due to the simple reason that the government
has the majority on the floor. But cut motions promote transparency.
● Policy cut motion:
○ This cut motion represents the withholding of approval for any policy on which the demand for grant is
based. The amount of the demand can be reduced to Re 1 and a substitute policy can be suggested.
● Economy cut motion:
○ This motion aims at affecting the economy in the proposed estimates. The amount of the demand can be
reduced to a certain amount, or an item can be omitted.
● Token cut motion:
○ This motion’s objective is to register dissatisfaction against a specific demand and can ask the amount of
the demand be reduced by Rs. 100.

Conditions of Admissibility of a Motion

● It should:
○ Relate to one demand only.
○ Be clearly expressed and must not be defamatory.
○ Be restricted to one particular subject; In addition, cut motion is not to:
○ Contain any proposition to amend or repeal any existing law.
○ Address a union government subject.
○ Be connected to any expenditure charged on the Consolidated Fund of India.
○ Concern any issue sub-judice
○ Raise a question of privilege.
○ Be a repetition of a matter already taken up in the same session.
● The Speaker decides whether a cut motion is or is not admissible and may disallow any cut motion when in his/her
opinion it an abuse of the right of moving cut motions is or is calculated to obstruct or prejudicially affect the procedure
of the House or is in contravention of the Rules of Procedure of the House.

● Lastly, all demands for grants are voted, as soon as the time scheduled for its passing lapses, as a guillotine motion.
○ A Guillotine Motion or ‘Guillotine order’ is the common name for an allocation of time motion which is a
British House of Commons procedure that can be used to restrict the time set aside for debate during the
passage of a bill through the House.

5. Consideration and Passing of the Appropriation Bill

● It is mandated that “no money shall be withdrawn from the Consolidated Fund of India except under appropriation made
by law.”
○ Hence, an appropriation bill is placed in the legislature.
○ It is the sum of voted demands and charged expenditure.
● Once the appropriation bill is passed, the money becomes available to the executive agencies to carry out their activities.
○ The procedure followed in passing the appropriation bill is the same as any other bill barring any amendment.
● The appropriation bill on getting the assent from the President of India becomes an Act.
Vote-on-Account
● This budget process generally continues until the end of April, but the problem lies in the fact that the government
departments need money after 31st March, at the end of the financial year to incur expenditure on various activities.
● The Constitution allows a vote-on-account to the Lok Sabha to provide funds in advance for the estimated
expenditure which finally becomes a part of the appropriation bill.
● This is passed after the completion of the general budget discussion for two months for a sum total of not more
than one-sixth of the total appropriation bill amount.

6. Consolidation and Passing of the Finance Bill

● Rule 219 of the Rules of Procedure and Conduct of Business in Lok Sabha, states that a ‘Finance Bill’ means the bill
ordinarily introduced in each year to give effect to the financial proposals of the Government of India for the
next financial year and includes a Bill to give effect to supplementary financial proposals for any period.
○ No amendments to existing laws can be made in this bill except the taxation proposals.
Self Notes
 145

● After the voting has been concluded by the House on all demands for grants, the ways and means of raising funds
(revenue) to meet the proposed expenditure are considered.
● The income side of the budget is dwelled upon by passing the finance bill. This is the second part of the budget.
● The finance bill includes: Imposition; remission; or regulation of taxes.
● It has to be ratified by the parliament prior to any implementation of proposals, which are usually tabled along with the
budget. The proposals can relate to: New taxes; Any increase in taxes; and Revision of any tax.

Discussion
● The finance bill entails a full-length discussion while debating it. The members of the Parliament discuss issues related
to general administration or the financial policy.
● Then:
○ The bill is referred to a select committee of the Parliament.
○ The select committee returns the finance bill with its suggestions and remarks.
○ Discussion of the bill of every clause takes place.
○ The members can move an amendment for a decrease but not for an increase .
○ Voting on the bill takes place which becomes an Act.
● The finance bill, after it has been passed in the Lok Sabha, is sent to the Rajya Sabha.
○ The Rajya Sabha does not have the power to make any changes to it or to reject it but has to send it back with
its suggestions within 14 days.
○ It is mandated under the Provisional Collection of Taxes Act, 1931, that the Parliament has to pass the finance
bill with the approval of the President within 75 days from which the bill was introduced. The President gives
his/her assent.
● The finance bill and the appropriation bill together constitute the Annual Financial Statement (Budget).
1.4.2.3 Budget Execution
● The budget execution is the final phase of the budgetary procedure in India which involves the utilisation of allocated
funds to implement the government’s policies.
● It is only natural to consume the apportioned funds, but it is not necessary that a good budget will lead to its effective
execution.
● The changes that are made during the financial year should be such that they should be coherent with the original policy
aims so that there is no adverse effect on the performance of agencies and project management.
● Micromanagement environment and the capabilities of the agencies to execute the budget affect the successful
implementation of the budget.
● The execution of the budget involves the collection of taxes, and revenues, the services performed by the Treasury
and Finance Departments, auditing and controlling of accounts.
1.4.3 Parliament Control over Finance
● The Finance Bill and the Appropriation Bill are presented, debated, and passed according to a set of rules.
● The executive, which makes requests, receives grants from the Parliament, which is sovereign. These demands can
include requests for grants, supplementary grants, additional grants, and so forth.
○ Other than those for the Consolidated Fund of India, expenditure estimates are provided to the Lok Sabha in
the form of grant demands.
● The Lok Sabha has the authority to accept or reject any demand, or to accept a demand with a reduction in the sum
demanded. Following the completion of the general debate on the budget, the Lok Sabha receives requests for grants
from various ministries.
○ Previously, the finance minister introduced all demands; however, they are now formally introduced by the
ministers of the relevant departments. These demands are not forwarded to the Rajya Sabha, despite the fact
that a general budget debate takes place there as well.
● The Constitution states that the Parliament may issue a grant to cover an unanticipated demand on the nation's
resources where the demand cannot be articulated with the specifics normally provided in the yearly financial statement
due to the scale or indefinite nature of the service.
● Passing such a grant again necessitates the passage of an Appropriation Act. It's designed to serve a specific purpose,
such as addressing wartime requirements.
1.5 Types of Budget
1.5.1 Balanced Budget
● A balanced budget is one in which the government's projected revenue for the year is equal to its anticipated
expenditure.
● Total budget expenditure = Total budget receipts.

Self Notes
 146

● For instance, if the budget expenditure is Rs 2 lakh crores and if budget receipts are Rs 2 lakh crores. Then it is called
a balanced budget.
1.5.2 Deficit Budget
● A deficit budget is one in which expected government spending exceeds expected revenue.
● The expected revenue of the government is less than the proposed expenditure of the government.
● The budget is said to be a deficit if expenditures surpass revenue over time.
● Total Budgeted Receipts < Total Budgeted Expenditure
● For instance, if the budget expenditure is Rs 2.4 lakh crores and if budget receipts are Rs 2 lakh crores. Then it is called
a deficit budget.
● The shortfall is usually compensated by borrowing from the public or pulling funds from the accrued reserve
surplus.
● In certain ways, a deficit budget is a government liability since it adds to the weight of debt or diminishes the government's
reserve stock.
● When large sums of money are required for economic growth and development in developing countries like India, and it
is not possible to generate these funds through taxation, deficit budgeting is the only choice.
● The deficit budget is used to finance planned development in developing countries, and it is used as a stability
tool to limit business and economic swings in rich countries.

UPSC CSE PRELIMS 2016: There has been a persistent deficit budget year after year. Which action/actions of the following
can be taken by the Government to reduce the deficit?
1. Reducing revenue expenditure
2. Introducing new welfare schemes
3. Rationalising subsidies
4. Reducing import duty
Select the correct answer using the code given below:
(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2, 3 and 4

Revenue Deficit: Revenue Deficit is the difference when the government’s total revenue expenditure exceeds the total revenue
receipts and the net income is less than the net expenditure. Transactions that directly affect the government’s existing earnings
and expenses come under the revenue deficit.

Fiscal Deficit: Fiscal Deficit is the difference between total revenue and total expenditure of the government. The fiscal balance
of a country is calculated by its government’s revenue followed by its expenditure in the provided financial year, the situation
where the government expenses increase more than the revenue in a year is a fiscal deficit.

Primary Deficit: The Primary Deficit is the difference between the current year's fiscal deficit (total revenue minus total
government expenditures) and the interest paid on the previous year's borrowings. In simpler words, the primary deficit refers
to the government's borrowing needs, excluding interest. It depicts the amount of borrowing required to cover the government's
spending needs.

Line item budgeting

● Emphasises on items of expenditure without highlighting its purpose and conceives budget in financial terms.
● Amount granted by legislature on an item should be spent on that item only.
● Objective is to prevent wastage, overspending, misuse also called incremental budget as funds are allocated on
incremental basis after identifying existing base.

Performance budget
● Output oriented budget with long range perspective so that resources can be allocated effectively or efficiently.
● It presents a budget in the form of functions, programs, activities, projects.
● Established correlation between physical performance and financial aspects of each program. It leads to a functional
classification of budget.

Self Notes
 147

1.5.3 Surplus Budget

● When the year's predicted revenues exceed planned expenditures, the budget is called a surplus budget.
● Total Budgeted Receipts > Total Budgeted Expenditure
● For instance, if the budget expenditure is Rs 2.4 lakh crores and if budget receipts are Rs 2.8 lakh crores. Then it is
called a surplus budget.
● The government's financial stability is demonstrated by the surplus budget. When there is too much inflation,
the government can pursue a surplus budget strategy, which lowers aggregate demand.
1.5.4 Zero-Based Budget
● “Zero-based budgeting” is an approach to planning and preparing the budget from the beginning.
● As the name suggests, it refers to planning and preparing the budget from scratch or ‘zero bases’.
● Zero-based budgeting (ZBB) is basically a systematic cost management process that prioritises the efficient allocation
of income to fixed expenditure, variable expenses, and savings in order to nullify the difference between income and
expenditure.
● A method of budgeting in which all expenses must be justified for each new period.

Do You Know?
● Zero-based budgeting originated in the 1960s by former Texas Instruments account manager Peter Pyhrr.

1.5.5 Outcome Based Budget

● Outcome-Based Budget is a process of budgeting done at micro levels that sets measurable physical targets
to be allocated on every planned project under various ministries.
● The outcome budget becomes a means to establish a linkage between the fund spent by a government and the outcome
that follows.
● It works as the progress card on what various Ministries and departments have done within a particular year.
● It measures quantitative and qualitative aspects of the budget.
● It makes the budget more accountable and transparent.

Do You Know?
● In India, it was first introduced in 2005-06 by the then finance minister P. Chidambaram. Such a method acts as a
micro-level performance-based finance planning and management tool in economic terminology.
● To bring transparency to the budgeting process, outcome budgeting was introduced in India as a revision of earlier
performance budgeting in 2005-06.
● In 2005-06, the outcome budget was presented to the parliament covering only plan outlays.
● In 2006-07, non-plan schemes with quantifiable and deliverable outputs were also covered.
● The outcome and performance budget have been merged and presented to the parliament as a combined document, i.e.,
the Outcome Budget since 2008.
● There are a few challenges with outcome-based budgeting in India. Like its management requires a strong process
measuring the performance indicators, costing the services and programs.

1.5.6 Gender Budget

● Gender Budgeting is a powerful tool for achieving gender mainstreaming so as to ensure that benefits of
development reach women as much as men.
● Gender Budget is not an accounting practice but rather a continuous process of keeping a gender perspective
in policy formulation, implementation, and review.
● It entails dividing the government budgets to establish its gender-differential impacts and ensuring that gender
commitments are translated into budgetary commitments.
● It is an effective method for achieving gender equity to ensure that development benefits reach women as much
as men.
1.5.6.1 Importance of Gender-Based Budgeting (GBB)
● Gender-based budgeting is critical for eliminating gender inequalities along with significant improvements in the social,
educational, health, and economic indicators of a country.
● Gender inequality hinders the overall growth and development of a nation. The GBB addresses budgetary gender
inequality issues, such as how gender hierarchies influence budgets and gender-based unpaid or low-paid work.

Self Notes
 148

● While some public expenditures are ‘non-excludable’ and ‘nonrival’ such as defence, road building, etc., some expenses
like education, health, sanitation may have intrinsic gender implications and require separate evaluation of gender-
specific needs.
1.5.6.2 Need for Gender Budgeting
● In India, women constitute 48% of the total population. However, they are still marginalised in all walks of life, marked
with inadequate and inequitable human capital investments, lagging in health, education, economic opportunities, etc.
● According to the World’s Economic Forum’s Global Gender Gap Index 2021, India slipped to 140th position from its
112th position in 2020.
○ Therefore India must adopt measures that bridge these gender gaps, and one such way is by implementing
effective Gender-Based Budgeting.
● There is an economic and social rationale behind introducing the GBB.
● Persistent gender inequality hinders the overall growth and development of a nation.
● The economic rationale for promoting a gender-sensitive budget also emanates from an efficiency and equity
perspective.
● It also helps achieve social goals, therefore, justifying social rationale.
● The rationale for gender budgeting arises from the recognition of the fact that national budgets impact men and women
differently through the pattern of resource allocation.
1.5.6.3 Framework for Gender Budgeting
There is a Five-Step Framework for Gender Budgeting which includes:
● Gender Analysis: It is a type of socio-economic analysis that uncovers how gender relations affect a development
problem.
● Assessing gender gaps: Assessment of law, a policy that makes it possible to identify a given decision having negative
consequences for the state of equality between women and men.
● Budgetary allocation: An assessment of the adequacy of budget allocations to implement the gender-sensitive policies
and programs identified.
● Fiscal tracking: Monitoring whether the money was spent as planned, what was delivered, and to whom.
● Outcome assessment: An assessment of the impact of the policy and the extent to which the original issues identified
have improved.
1.5.6.4 Gender Budgeting around the world
● Australia was the first country to implement a women-centric budget in 1984.
● Since then, around 80 countries have adopted gender-based budgeting.
● Even South Africa started Women-centric budget initiatives in 1995 and involved NGOs, parliamentarians, and a wide
range of researchers and advisors.
● Other African states, Tanzania (1997) and Uganda (1999) started gender budget initiatives.
● In 2003 even the UK recognized the efficiency of giving money to women, it was announced that Child Tax Credit would
be paid to the main carer-usually a woman.
1.5.6.5 Gender Budgeting in India
● GBB was introduced in the 2001 Union Budget to address gender inequality as a concept.
○ It was adopted in 2004-05 based on the recommendations of an expert committee constituted by the Ministry
of Finance on “Classification of Budgetary Transaction.”
● As defined by the GOI, a gender-responsive budget acknowledges the gender patterns in society and allocates
money to make policies and programs gender-equitable.
○ It refers to a systematic gender-differentiated impact of fiscal provisions, programs, and policies.
● In India, the Ministry of Women and Child Development (MWCD) is the nodal agency to implement GBB in India.
○ The Ministry of Finance, in coordination with the National Institute of Public Finance and Policy (NIPFP), also
carries out the study of GBB to design the matrices of gender budgeting.
○ The MWCD, in collaboration with the UN Women, has also developed a Manual and Handbook for Gender
Budgeting for Gender Budget Cells for Central Ministries and Departments.
● In recent years, the government of India introduced various schemes like MGNREGA, Beti Bachao Beti Padhao,
Sukanya Samridhi Yojna, and Ujjawala Yojna with their focus on improving women socio-economic conditions.
1.5.6.6 Challenges of Gender Budgeting in India
● Non-utilisation of gender-specific funds: There are only a few “big budgets ' women exclusive schemes of MWCD like
Nirbhaya Fund and Beti Bachao Beti Padhao that face non-utilization of funds.

Self Notes
 149

● There is a lack of dedicated and skilled human resources to implement the allocated gender budgets in specified areas
of concern.
● India’s gender budget has stagnated in recent years due to a lack of monitoring mechanisms at the national level.
● Some schemes that are 100% women-specific are not so, for example, Pradhan Mantri Awas Yojna PMAY.
● The central government’s gender budget has never been more than 1% of India’s GDP, and funds allocated for GBB
are confined to public expenditure.
● Declining Female Labour Force Participation Rate (LFPR) which stood at 18.6% as calculated by the Periodic Labour
Force Survey (PLFS) in 2018.
1.5.6.7 Policy Recommendations
● There is a need to increase the allocations for women focussed programs. Priority sectors should be identified, and
funds must be targeted in the same direction.
● Lahiri committee recommendations that provide a clear roadmap for preparing the analytical matrices for gender
budgeting and institutional mechanisms like Gender Budgeting Cells must be implemented.
● Revising FRMB and incorporating gender goals also need to be analyzed and include SDGs goals number 5 on gender
equality.
1.5.6.8 Gender Budget in financial year 2022-23
● It was India’s 17th Gender Budget presented by finance minister Nirmala Sitharaman.
● A provision of Rs. 1,72,28,000 crore has been made for FY 2022-23 for gender based budget.
● The increase from last year’s budget was 34% which was 27% in FY 2021-22
● On absolute terms, it declined slightly from 4.72% of the GDP (2021-22) to 4.01% of the GDP(4.01%)
● The number of departments also increased from 28 to 33.
● In the year 2022-23, arrangements for gender budgets have been made for about 403 schemes.
● There are 47 schemes benefiting 100 percent women and 356 pro-women schemes.
1.6 Budget Deficit
● A budget is the annual financial statement of a government.
○ It gives us the details of revenue and expenditure of the government.
○ In the case of India, every year the budget of the central government is presented before the Parliament for its
approval.
○ Similarly, budgets of the state governments are presented before the respective state legislature.
1.6.1 Types of Budget Deficit
● Revenue receipts do not have to be repaid by the government while capital receipts have to be repaid.
○ Thus in simple terms revenue receipts are the income while capital receipts are the debt for the
government.
● However some capital receipts don't create debt for the government for example sale of old assets, recovery of
loans and proceeds from the sale of a public enterprise. These are not treated as liabilities of the government.
● In the context of budget, if the total expenditure (both revenue and capital) is equal to revenue receipts of the government,
the budget is said to be balanced.
○ If total expenditure is less than revenue receipts, it is called a surplus budget.
○ If total expenditure, on the other hand, is more than revenue receipts, it is called a deficit budget.
1.6.1.1 Revenue Deficit
● It shows the gap between revenue expenditure and revenue receipts of the government.
● It draws attention to the extent to which the government cannot meet its revenue expenditure from its revenue receipts.

Revenue Deficit = Revenue Receipts – Revenue Expenditure

1.6.1.2 Effective Revenue Deficit

● Effective Revenue Deficit is the difference between revenue deficit and grants for the creation of capital assets.
● Every year the Central Government gives grants to State Government and Union Territories and with the help of these
grants both create capital assets however these capitals are not added to the capital expenditure of the central
government. Therefore to measure such expenditure an effective revenue deficit has been introduced.

Effective Revenue Deficit = Revenue Deficit - Grants in aid for capital assets

1.6.1.3 Fiscal Deficit

● It is the difference between total expenditure (both revenue and capital) and the revenue receipts.
Self Notes
 150

● Fiscal deficit gives an estimate of the borrowing requirements of the government.

Fiscal Deficit = Total Expenditure - total Receipts (excluding borrowings)

1.6.1.4 Primary Deficit

● Interest payments (servicing of debt) constitute a large share of the revenue expenditure (about 25 percent of revenue
receipts).
● Primary deficit is equal to fiscal deficit minus interest payments.
● It shows the real burden of the government and it does not include the interest burden on loans taken in the past.
○ Thus, the primary deficit reflects borrowing requirements of the government exclusive of interest
payments.
● A part of the revenue expenditure is spent on payment of interest.
○ This in fact reduces the debt burden of the country.

Primary Deficit = Fiscal Deficit – Interest Payments = Revenue Receipts – Total Expenditure – Interest Payments

1.6.2 Impact of Budget Deficit

● Fiscal deficit leads to borrowings by the government.
○ Such borrowings over the years accumulate in the form of public debt.
● The government has to pay interests on existing public debt on a regular basis. If the level of public debt is high, interest
payment also is high.
● If the revenue budget is surplus, the government can repay part of its existing debt (so that there is a reduction
in the level of public debt).
○ On the other hand, if the revenue budget is deficit, there is an increase in public debt due to further borrowings.
● Servicing of public debt takes away a substantial part of revenue receipts.
○ Thus, very little is left for productive use of public funds.

Implications of Budget Deficit Depends on

● Nature of deficit
○ more revenue expenditure or capital expenditure
○ on source of financing
● Positive Impacts
○ Economic Growth & recovery
○ Employment
○ Social Welfare

Self Notes
 151

○ Crowding in effect
● Negative Impact
○ Inflation
○ High Debt burden and Debt Trap risk
○ Crowding out – when borrowing from market
○ Increase in taxes & Hamper future growth
○ Loss of investor confidence and downgrade of credit rating of country
○ Could affect overall financial stability of economy

1.6.3 Financing of Budget Deficit

1.6.3.1 Borrowing from the Domestic Market
● The government issues bonds of a certain maturity period to mobilise funds.
○ Borrowing from the market leads to accumulation of
public debt.
○ The government can borrow from the domestic
market or from the rest of the world.
● Borrowing from the domestic market does not lead to an
increase in money supply.
○ However, payment of interest and principal amount from
revenue receipts is often a problem for the country.
● In this context the concept ‘Debt-to-GDP ratio’ is important.
○ If debt-to-GDP ratio is high, a major part of revenue
receipts has to be diverted towards servicing of
public debt.
○ In the case of India in 2019- 20, for example, public debt
(state and centre combined) as a percentage of GDP is
about 76 percent.

Ways and Means Advance (WMA):

● To match short term mismatch in the budget, the government takes loans from RBI for a tenure of 90 days.
● If the government doesn’t pay, it will be added as overdraft. Hence it will not result in an increase in money supply.
● It is decided by the government and RBI mutually.
● It replaced the treasury bill system.
Major instruments covered under Internal Debt are as follows
● Dated Securities: Primarily fixed coupon securities of short, medium and long term maturity which have a specified
redemption date.
● Treasury-Bills: Zero coupon securities that are issued at a discount and redeemed at face value at maturity. These are
issued to address short term receipt-expenditure mismatches under the auction program of the Government. These are
primarily issued in three tenors, 91,182 and 364 day.
● 14 Day Treasury Bills.
● Securities issued to International Financial Institutions: Securities issued to institutions viz. IMF, IBRD, IDA, ADB,
IFAD etc. for India’s contributions to these institutions etc.

Self Notes
 152

● Securities issued against ‘Small Savings’: All deposits under small savings schemes are credited to the National
Small Savings Fund (NSSF). The balance in the NSSF (net of
withdrawals) is invested in special Government securities.
● Market Stabilization Scheme (MSS) Bonds:
1.6.3.2 Borrowing from the Rest of the World
● External borrowing could be in the form of:
○ soft loans from international organisations such as IMF and
World Bank
○ borrowing from commercial markets, or
○ deposits by international emigrants (for example, non-resident
Indians).
● External borrowings lead to accumulation of foreign debt.
○ Debt servicing (i.e., payment of interest as well principal amount)
of such external debt has to be made from current account
receipts.
○ In this context, the concept of 'debt-service ratio’ is very
important.
○ Debt-service ratio is defined as the ratio of debt service to
current account receipts of the country.
○ Debt service ratio of India in 2019-20 was about 6.5 per cent,
which increased to 8.2 percent IN 2020-21, due to COVID-19.
1.6.4 Monetisation of Deficit
● When the government borrows from the market, there is a decrease in money supply in the hands of people.
● Monetisation means printing of new currency notes by the government to repay the debt of the government.
● In the case of monetisation of deficit, there is an increase in money supply in the economy.
● Thus, monetisation of the deficit can be inflationary.
○ In view of the above, the FRBM Act, 2003 prescribes that the Reserve Bank of India should not buy government
bonds, except under exceptional circumstances.
● There are two ways monetisation takes place
○ Direct
■ RBI prints new currency and purchases government bonds directly from the primary market
○ Indirect
■ The government issues bonds in the primary market and the RBI purchases an equivalent amount of
government bonds from the secondary market in the form of Open Market Operations (OMOs).
i) hold the purchased bonds in perpetuity, ii) roll over all the purchased bonds that reach maturity, and
iii) return to government the interests earned on the purchased bonds.
1.7 Public Debt
● Public debt is the total amount of debt borrowed by a government.
● It is when total liabilities of the Union Government needs to be paid from the Consolidated Fund of India (CFI).
● Deficits and surplus, as well as taxes and expenditure, are flow variables. These variables are defined over a period of
time.
○ Public debt is a stock variable and it is defined at a point of time.
● As of March 2021, India’s public debt as a percentage of gross domestic product (GDP) increased to 60.5% mainly
due to the pandemic.
1.7.1 What is Public Debt?
● Public Debt is the total amount that the government borrowed.
● Internal loans comprise the majority portion of this debt.
● Short term borrowings, treasury bills, dated government securities are the different sources of the public debt.
● It is to be paid from the Consolidated Fund of India. It can also refer to the overall liabilities of central and state
governments. This is provided under Article 292 of the Indian Constitution.
● According to the Finance Ministry reports, in FY20, India's total debt burden as a percentage of GDP was 51.6
percent; in FY21, it was 60.5 percent.
● The debt-to-GDP ratio demonstrates the country's ability to repay its debt.
● The debt-to-GDP ratio is frequently used by investors to analyse the government's ability to service its debt. Increased
debt-to-GDP ratios have fueled global economic crises.

Self Notes
 153

1.7.2 Reasons For Borrowing/Public Debt

● The income generated is not sufficient to carry out the required expenditure.
● Presently the tax part of national income is less than 20%, hence there is a small share of taxes in the national income.
● In the financial year 2022-23, the share of income tax is 15% in total income. This is because of a smaller number of
taxpayers. India has only 8.22 crores of taxpayers (both individuals and corporates) out of total population of 136.30
crores (2019-20)
● There is greater reliance on indirect taxation and therefore most of the pressure falls on lower-class strata.
● Asymmetrical institutional setup for taxation for instance complex tax systems with greater tax evasion.
● There is a gross misuse of public funds due to corruption, wasteful projects, red-tapism etc.
● In order to accomplish various government schemes and plans financial resources are needed.
● Lately, the increase in Public Debt has been mainly due to the following reasons.
○ Total central government debt was increased in both absolute terms and as a percentage of GDP that fiscal
due to bank recapitalization.
○ Due to the issuing of Ujwal Discom Assurance Yojana (UDAY) bonds, there has been an increase in liabilities
of states which have increased during 2015-16 and 2016-17.
○ There is a small share of taxes in national income, most of which comes from indirect taxes.
○ Asymmetric taxation systems with high tax evasion because of increased loopholes in the tax system.
○ Misuse of public funds due to corruption, bribe, and red-tapism available and the work done is completed with
great difficulty.
1.7.3 Classification of Public Debt
1. Internal Debt
○ They are the public debt borrowed from
within the country.
○ Major sources of funds for internal debt
include commercial banks and financial
institutions.
○ Here the government obtains finance by
borrowing and not by creating “de novo”
(from the new).
○ It is rarely spent on goods and services.
2. External Debt
○ It is when debt is taken from individuals
and organizations living outside the
country.
○ Here borrowing is from commercial banks,
governments or international financial
organisations.
3. Productive Debt
○ These are those debts that are used to generate income from sources such as railway, plans for
electricity, plans of irrigation, etc.
○ The income generated from such plans can be used for the payment of yearly interest and for the payment of
principal. Such debts put pressure on the taxpayer and the government.
4. Unproductive Debt
○ Such debts are incurred on assets that do not generate income.
○ In such debts at some point, there are losses of interest also.
5. Redeemable/Terminable Debt
○ These are those debts in which the government promises that they would pay back the debt on a fixed
date later.
○ These debts are also called terminable debts.
○ The government must create plans for the repayment of redeemable debts.
○ It can be redeemed on maturity or before as well.
6. Irredeemable Debt/Perpetual Debt
○ These are those debts that are done without any promise to be paid back later.
○ When debts are not paid back on time then the governments decide on specific arrangements to pay back the
debt such as whether such debts need to be paid back from the taxable income, etc.
○ However, the major benefit of them is that they pay a steady stream of interest payments forever.
7. Funded Debt
○ Such debts are long term in nature.

Self Notes
 154

○ Payment of these debts is to be done within one year or it can be possible, not to give any promise.
○ These are mainly raised to fulfil long term requirements of the government.
○ Bonds with maturity more than 1 year, convertible bonds, long term notes payables and debentures are the
examples of funded debt.
8. Unfunded debts
○ Such debts are given for three or six months and their time period is not more than one year such as
treasury bonds, etc.
○ Short term bank loans, bonds with maturity less than 1 year, basically generated to raise funds for meeting
cash requirements.
9. Short Term Debt
○ It is when the government takes debt for a short period. These debts are paid back within a year that is to
be taken to complete the tenure of debts.
10. Long Term Debt
○ It is when the government takes debt for a long period of time.
○ The period of giving it back is not fixed. In this type of debt, the giver got regular interest.
1.7.4 Advantages of Public Debt
● It increases the money supply that facilitates various industries in the country to increase production which in
turn increases the national standard of life.
● It helps to counter various man-made (inflation, etc) and natural calamities (floods, landslides, etc).
● It is especially helpful for developing countries to allocate resources in various sectors of the economy.
● Equitable and suitable distribution of debts takes place which promotes harmony and cooperation in public.
● Public debts are also regarded as secure sources of investment.
● It also helps in various non-economic benefits to nations such as better international relations between friendly nations.
1.7.5 Disadvantages of Public Debt
● There is increased misuse of the resources of the country as a large part of it is given as interests to foreign nations.
● There is a fear of going bankrupt in the near future especially in case of a global economic crisis.
● Extravagant spending can happen when resources are available easily. For instance, Greece had a debt to GDP ratio
of 160% in 2009 due to extravagant spending.
● There can be international pressure and political interference in the domestic policies of the debtor nation.
● Increased burden of repayment on citizens in the form of increased taxation.
● Slower economic and weak economic development
1.7.6 Public Debt Management
● Debt management is a combination of various measures undertaken to secure the government’s funding at lower costs
over the medium or long term while avoiding excessive risk.
● Debt Management is based on three basic elements. These are low cost, risk mitigation, and market development.
● The objective to attain lower cost is accomplished by planned issuances and other appropriate instruments to lower cost
in the medium to long run.
1.7.6.1 What is Debt Management?
● A debt portfolio is generally the largest portfolio in the economy and impacts various other sectors which necessitate a
robust debt management strategy.
● It should be such that it undertakes maturity, currency composition, and interest rate risk exposure of the government.
● Medium-Term Debt Management Strategy (MTDS) is implemented over the medium-term (three to five years)
and includes various benchmarks, portfolio indicators, yearly issuance plans, etc.
● It involves consultations between various domains such as debt management, monetary, fiscal, and financial regulatory
authorities to ensure the smooth functioning of public debt markets.
● It is mentioned in RBI’s Annual Report and the Status Paper on Government Debt by the Ministry of Finance.
1.7.6.2 Objectives of Debt Management Strategy
● It helps to mobilise borrowings at low cost over the medium to long-term which are subject to prudent levels of risk in
the debt portfolio.
● It is necessary that the debt strategy of a nation is stable to ensure financial stability.
● It helps promote liquidity in financial markets.
● It acts as a benchmark for pricing financial assets and helps in maintaining consistency with other
macroeconomic indicators.
● It ensures that various needs of the central governments are met at a low cost and there is a vibrant domestic bond
market.
Self Notes
 155

1.7.6.3 Steps Need to Be Taken For A Robust Debt Management Strategy

● The maturity of the debt portfolio should be extended.
● A balance in maturity profile should be built along the yield curve.
● Various instruments to aid in better management of investors should be encouraged such as inflation-linked bonds.
● There should be continuous investor interaction and consultation to ensure a transparent issuance process.
● Effective liability management.
● Increase in the diversification of the investor base by encouraging participation of retail and mid-segment investors.
1.7.6.4 Status Paper On Debt Management
● Debt management strategy involves borrowing at low cost over the medium to long-term, with a stable debt structure,
while also developing a liquid and well-functioning secondary domestic debt market.
● In April 2022, the Ninth Edition of the Status Paper on the Government Debt was released, which provides a
detailed analysis of the Overall Debt Position of the Government of India and has been published annually since
2010-11.
● Central Government total net liabilities stood at 59.2 per cent of GDP at end-March 2021, up from 49.1 per cent at end-
March 2020.
● General Government Debt (GGD)-GDP ratio was higher at 87.8 per cent at end-March 2021 as compared to 73.7 per
cent at end-March 2020.
● Of the Central Government total net liabilities at end-March 2021, 94.7 per cent were denominated in domestic currency
while sovereign external debt constituted 5.3 per cent, implying low currency risk.
● Further, the sovereign external debt is entirely from official sources, which insulates it from volatility in the international
capital markets.
● The share of marketable securities in internal debt at 79.3 percent at end-March 2021 was lower than 81.8 percent at
end-March 2020.
● The DMS document comprises three chapters:
○ Objectives and Scope of DMS
○ Debt Profile of the Central Government: Current Status and Strategic Objectives
○ Medium-Term Debt Strategy (MTDS) [2021-24].
1.7.6.6 Impact of Increasing Public Debt
● Due to increased borrowing by the government from the market, fewer funds are available for the private investors which
can lead to a crowding-out effect which results in a reduction of private investment as well as a contraction of GDP in
the long run.
● The economic growth could turn negative in the long run if the debt-GDP ratio exceeds 90%.
1.7.6.7 Public Debt Management Cell (PDMC)
● Public Debt Management Cell is an interim arrangement before setting up an independent and statutory debt
management agency namely the Public Debt Management Agency (PDMA).

PDMC has the following advisory functions to the Government:

1. Plan borrowings of the Government, including market borrowings, other domestic borrowings, SGBs
2. Manage Central Government’s liabilities including NSSF, contingent liabilities.
3. Monitor cash balances of the Government, improve cash forecasting and promote efficient cash management practices.
4. Advise other Divisions in DEA on matters related to External Debt involving external borrowings through MI, Bilateral
Cooperation, other possible sources, in terms of cost, tenure, currency, hedging requirements, etc., and monitor
developments in foreign exchange markets.
5. Foster a liquid and efficient market for Government securities
6. Develop interfaces with various stakeholders/agencies in the regulatory/financial architecture etc. to carry out assigned
functions efficiently.
7. Advice on matters related to investment and capital market operations.
8. Undertake research work related to new products development, market development, risk management, debt
sustainability assessment, other debt management functions, etc.
9. Develop a database system for collecting and maintaining a comprehensive database of Government of India liabilities
on a near real time basis and shall be responsible for publication of relevant information.
10. Carry out Preparatory work for independent PDMA.
1.8 Weaknesses in the Budgetary System and Implementation
1. Unrealistic budget estimates.

Self Notes
 156

2. Delay in implementation of projects.

3. Skewed expenditure pattern.
4. a major portion getting spent in the last quarter of the financial year, especially in the last month.
5. Inadequate adherence to the multi-year perspective and missing `line of sight' between plan and budget.
6. No correlation between expenditure and actual implementation.
7. Parking of funds by implementing agencies, outside the government accounts portrays an incorrect picture of the
financial position of the government.
8. Mis-statement of financial position.
9. Ad hoc project announcements.
10. Irrational plan / non-plan distinction leads to inefficiency in resource utilisation.

1.9 Reforms in Budgeting and proposed reforms

1.9.1 Public Debt Management Agency
● There is a long-pending proposal to set up an independent agency to manage Central government borrowings.
○ Setting up of the Public Debt Management Agency (PDMA) will require amendments to the RBI Act.
● The need for an independent debt manager for the Centre is becoming more underlined as its borrowings cross over Rs
6 lakh crore and it is trying to lower its fiscal deficit to less than 4 per cent this fiscal.
● The rationale for PDMA is simple – it would permit the RBI to focus more fully on its responsibility of setting the
monetary policy as well as do away with the conflict of its twin roles as the manager of government debt as well as its
banker.
● The model is followed internationally in most developed economies including the United Kingdom and Sweden.

Why is it needed?
● With the establishment of PDMA, the Government seeks to divest the RBI of its dual and often conflicting roles as the
banker and manager of the Central Government’s borrowing.
● It will also facilitate better planning and management of domestic and foreign market borrowings of the Central
Government.
● It will help in strengthening the bond market and help to promote investment.
● PDMA can be the catalyst for wider institutional reform, including building a government securities market, and bring in
transparency about public debt.
● It is considered as an internationally accepted best practice that debt management should be disaggregated from
monetary policy, and taken out of the realm of the central bank
Even though a separate public debt management agency is to be created, it must be done gradually and systematically. This
agency should be independent. Proposed agency is under the supervision of the central government.
1.9.2 Shift of budget date
● Along with the merger of the railway budget with the general budget, the date of presentation of budget has also been
shifted from the last working day of february to first working day of february.
● This has been done because of its following advantages:
○ In the previous system, there arose the requirement of vote on account to meet the requirements of the first
quarter of the fiscal as the budget was passed by may first week.
○ Now the budget is presented and passed by the end. The government gets complete funds from day one of the
financial year.
■ It will help the private sectors to better access the trends within the government and the economy
and evolve their business strategies accordingly.
● Disadvantages
○ To present the budget by the first day of february, it needs to be prepared by mid january. This will mean the
budget data will not represent the last quarter of the existing financial year (January to March). So, on the basis
of the trends of the first 9 months, assumptions will be made for the last three months.
○ Preparation of the budget will start by October i.e. 6 months prior to the financial year. In that way, representing
an accurate picture of the economy is an impossible task.
○ Passing of the budget by march end means parliamentary committees will have less time to deliberate. This
will effectively reduce the parliamentary control over the executive as the majority of the things will be
deliberated in a time bound manner, which reduces the comprehensiveness.
1.9.3 Merger of railway and union budget
● It was done on the recommendations of a committee headed by Mr. Bibek Debroy (then member of NITI Aayog) in
October 2016.

Advantages of a merger

Self Notes
 157

● A separate Budget statement, including a Demand for Grant, will be made for Railways, which will continue to function
as a business entity under a government agency.
○ The Ministry of Finance will prepare and present a single Appropriation Bill together with the estimates of
Railways in the Parliament and all other legislative work connected therewith will also be handling the Ministry
of Finance.
● The Railways' previous handling of the dividend payment to General Revenues and its Capital-at-charge would be
completely eliminated at this point.
○ To cover a portion of its capital expenses, the Ministry of Railways will get gross budgetary support from the
Ministry of Finance.
○ Railways still have the right and are able to use their traditional method of obtaining extra-budgetary resources
from the market in order to finance their capital expenditures.
● The new consolidated budget presentation will assist the government in determining its actual financial standing.
● Combining the Rail Budget and General Budget would make it easier for the Government to prepare for multimodal
transportation including inland waterways, highways, and railroads.
● It will aid the Ministry of Finance in making more accurate financial decisions, particularly during the mid-year review for
improved resource allocation, etc.

Plan Expenditure
● Any expenditure that is incurred on programmes which are detailed under the current (Five Year) Plan of the centre
or centre’s advances to state for their plans is called plan expenditure. Provision of such expenditure in the budget is
called Plan Expenditure.
● Expressed alternatively, “plan expenditure is that public expenditure which represents current development and
investment outlays (expenditure) that arise due to proposals in the current plan.” Such expenditure is incurred on
financing the Central plan relating to different sectors of the economy.

Non-Plan Expenditure:
● This refers to the estimated expenditure provided in the budget for spending during the year on routine functioning
of the government. Non- Plan expenditure is all expenditure other than plan expenditure of the government. Such
expenditure is a must for every country, planning or no planning.
● For instance, no government can escape from its basic function of protecting the lives and properties of the people
and protecting the country from foreign invasions. For this, the government has to spend on police, Judiciary,
military, etc. Similarly, the government has to incur expenditure on normal running of government departments and
on providing economic and social services.

1.9.4 Abolition of plan and non plan distinction of expenditure

● The fundamental motivation for the government's decision to change the classification of government
expenditures in 2016 was the C.Rangarajan Committee's 2011 recommendation to eliminate the distinction between
Plan and Non-Plan expenditure.
● Previously, the government's decision on Plan expenditure was made after consultations with the Planning Commission.
In the previous system of spending classification, scheduled expenditure was given more weight. The emphasis in the
newly established classification system will be on government expenditures.
● The new capital and revenue spending classifications will establish a clear and effective link between government
earnings, expenditures, and outcomes.
1.9.5 Independent Fiscal Council/Budget expenditure office
1.9.5.1 Mandate of NK Singh Committee
● Over the last 12 years, review the working of the FRBM Act and suggest the way while focusing on the broader
objective of fiscal consolidation and the changes required in times of uncertainty and volatility in the global
economy.
● To focus on different factors, required for determining the FRBM targets.
● To examine the requirement of having a ‘fiscal deficit range’ as the target as compared to the present fixed
numbers (percentage of GDP) as fiscal deficit target.
● To ascertain the need for aligning the fiscal expansion, contraction with credit contraction, expansion in the economy.

Recommendations of NK Singh Committee

● Replacement of the FRBM Act 2003 with Debt Management and Fiscal Responsibility Bill, 2017.
● The debt to GDP ratio by 2022-23 should be 38.7% for the central government and 20% for the state governments.
● The fiscal deficit target should be 2.5% of GDP by FY 2022-23.
Self Notes
 158

● Setting up of an autonomous fiscal council that deals with the preparation of multi-year fiscal forecasts, improves fiscal
data quality, could advise the government on fiscal matters.
● The Fiscal council's responsibilities would include
○ preparing multi-year fiscal forecasts,
○ recommending changes to the fiscal strategy,
○ improving the quality of fiscal data,
○ advising the government if conditions exist for deviating from the fiscal target,
○ advising the government to take corrective action if the Bill is not followed.

1.9.6 Fiscal Responsibility and Budget Management Act 2003

● Fiscal Responsibility and Budget Management (FRBM) Act is the statute to
induce discipline and restrictions on expenditure and debt-related things was
introduced and was passed by the Parliament in 2003.
○ The FRBM Bill was introduced in 2000 by then-finance minister
Yashwant Sinha with the goal of increasing transparency in India's
fiscal management system.

Background
● In the 1990s and 2000s, India stood at the top in borrowing capital.
Indian Economic Status was feeble as it had a high Fiscal Deficit, high
Revenue Deficit, and the degree of high Debt-to-GDP was also lofty.
● In the latter half of 2002-03, the continuous borrowing by the government led
to high debt, which critically affected the Indian Economic Status.
● More than half of the borrowed capital was used for the payments of interest on the previous loans and had nothing
much left for progressive purposes or productivity growth.
● Many economists then warned the government and were made well aware of the strategic conditions that could be the
result of this borrowing culture.
● To prevent the country from falling into a debt ambush, they also suggested going "de-jure."
● Parliamentarians then pointed out the need for a systematic regulation of the government of India on resorting
to a high level of borrowing.
● Henceforth, the Fiscal Responsibility and Budget Management (FRMB) Act was established in 2003.
What is FRBM Act?
● The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 sets a bar for the government to lay a
foundation of monetary limitations in the Indian Economy.
● It contributes to the improvement of the management of public funds and lowers the fiscal deficit rate as well.
● The FRBM Act also allows for the use of an escape clause in times of disaster or national security. In such
cases, the government may deviate from its target annual fiscal deficit.

Objectives of the FRBM Act

● The primary objective of the said act was to strike out of revenue deficit and bring the fiscal deficit down.
● It was the first acquaintance of transparency in the fiscal management system in the country, ascertaining the ethical
dispensation of debt with the passing years, making sure of fiscal solidity in the macroeconomics
● The act is also purposeful in terms of giving necessary modifications to the Central Bank while overseeing the expanding
economy of India.

Key features of the FRBM act

● The FRBM is responsible for maintaining and placing things in a union budget document in parliament every
year which is mandatory.
● Items that the government should maintain along with the budget documents are - Specifications of Medium Term Fiscal
Policy Statement, Specifications of Macroeconomic Framework Statement, and Specifications of Fiscal Policy Strategy
Statement.
● It was recommended that all the four fiscal indices which are - Revenue deficit as GDP percentage, Fiscal deficit
as GDP percentage, Tax revenue as GDP percentage, and total remaining due as GDP percentage, to be shown
in the statement of medium-term fiscal policy.

Self Notes
 159

Targets of FRBM Act 2003

● To reduce and eliminate the revenue shortfall by 2008-09
● After that, build up a sufficient revenue surplus.
● At the end of 2008-09, the budget deficit was reduced to no more than 3% of GDP.
● Reduction of the gross fiscal deficit (GFD) by 31st March 2008.

Recommendations of N.K.Singh Committee

● Replacement of the FRBM Act 2003 with Debt Management and Fiscal Responsibility Bill, 2017.
● The debt to GDP ratio by 2022-23 should be 38.7% for the central government and 20% for the state governments.
● The fiscal deficit target should be 2.5% of GDP by FY 2022-23.
● Setting up an autonomous fiscal council that deals with the preparation of multi-year fiscal forecasts, improves fiscal
data quality, could advise the government on fiscal matters.
● Target commitments could deviate under certain circumstances such as a national calamity, war, agricultural
collapse, etc.
● The debt path to be followed by each state based on their track record of fiscal health and prudence should be
recommended by the 15th Finance Commission.
● Borrowing from RBI should occur when the center is to recover from a temporary shortfall in receipts.
● Monetary and fiscal policies should complement each other and help accomplish economic stability and growth.
Escape Clause in FRBM Act
● The escape clause was recommended by the NK Singh committee to provide flexibility in situations where the
central government can show some flexibility in following fiscal deficit targets under special circumstances.
● FRBM Act was further amended in 2018, where the escape clause enables the government to relax the fiscal deficit
target for up to 50 basis points or 0.5 percent.
● Under the escape clause, RBI participates directly in the primary auction of government bonds, thus formalizing deficit
financing.
● It can be applied after formal discussions and advice from the Fiscal Council.
● It exempts the government from sticking to FRBM guidelines in case of war or a national calamity.
● It was invoked by Finance Minister Nirmala Sitharaman in 2020 to allow the relaxation of the target and revised
it for FY20 to 3.8 percent and pegged the target for FY21 to 3.5 percent.

Latest Changes in FRBM Act with Union Budget 2022-23

● In the Budget speech, the finance minister noted that the government aims to reduce the fiscal deficit to below
4.5% of GDP by 2025-26.
● The estimated fiscal deficit for 2022-23 is 6.4% of GDP and the estimated revenue deficit for 2022-23 is 3.8% of
GDP.
● In 2021-22, the government had set a budget estimate of 6.8% of GDP for fiscal deficit, and 5.1% of GDP for revenue
deficit.
● As per the revised estimates, the fiscal deficit is expected to marginally exceed the budget estimate to 6.9% while the
revenue deficit is estimated to be lower at 4.7% for 2022-23.
● The primary deficit is estimated to be 2.8% of GDP in 2022-23.
● The interest payments as a percentage of revenue receipts have increased from 36% in 2011-12 to 42% in 2020-21.
● As per the budget estimates, this figure is expected to increase further to 43% in 2022-23.
● Outstanding liabilities constituting the accumulation of borrowings over the years is estimated to decrease marginally to
60% of GDP in 2022-23.

UPSC CSE PRELIMS 2018: Consider the following statements:

(1) The Fiscal Responsibility and Budget Management (FRBM) Review Committee Report has recommended a debt to
GDP ratio of 60% for the general (combined) government by 2023, comprising 40% for the Central Government and
20% for the State Governments.
(2) The Central Government has domestic liabilities of 21% of GDP as compared to that of GDP of the State 2
Governments.
(3) As per the Constitution of India, it is mandatory for a State to take the Central Government’s consent for raising any
loan if the former owes any outstanding liabilities to the latter.
Which of the statements given above is/are correct?

Self Notes
 160

(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

UPSC CSE PRELIMS: Consider the following statements:

(1) Most of India’s external debt is owed by governmental entities.
(2) All of India’s external debt is denominated in US dollars.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

UPSC CSE PRELIMS 2022: With reference to the expenditure made by an organisation or a company, which of the following
statements is/are correct?
1. Acquiring new technology is capital expenditure.
2. Debt financing is considered capital expenditure, while equity financing is considered revenue expenditure.
Select the correct answer using the code given below:
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

UPSC CSE PRELIMS 2022: With reference to the Indian economy, consider the following statements:
1. A share of the household financial savings goes towards government borrowings.
2. Dated securities issued at market-related rates in auctions form a large component of internal debt.
Which of the above statements is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

1.10 Some important budget related terms

1.10.1 Fiscal consolidation
● Fiscal consolidation is a set of policies undertaken by the government so as to reduce government deficits and
debt accumulation.
● They are measured as a percent of nominal GDP. Deficits can be curbed by better economic growth leading to more
revenues and less expenditure.

What is Fiscal Consolidation?

● Various policies undertaken by the government at national as well as sub-national levels to reduce the accumulation of
debts and reduce deficits is known as fiscal consolidation.
● Fiscal consolidation can be achieved by increasing revenue and decreasing expenditure.
● The fiscal deficit is the most important indicator of the government's financial health. The fiscal deficit, on the other hand,
represents the amount of government borrowing for that given year.
● The Government's two major deficits are the Revenue Deficit and the Fiscal Deficit.
● The following are some of the negative consequences of a budgetary deficit.
○ Interest rates rise as a result.
○ It raises the rate of inflation.
○ The government's burden of increasing interest payments grows.
● Below is a brief description of the three fiscal policy tools:
○ Government Spending: Government spending can have an impact on economic output. Government
expenditure can be classed as Government Final Consumption Expenditure since it comprises the acquisition
of goods and services for the benefit of the community.
■ Government Gross capital creation is defined as government spending on research and
infrastructure with the goal of generating future benefits.

Self Notes
 161

■ The government should reduce its spending on infrastructure and use its resources efficiently to
follow fiscal consolidation.
○ Transfer Payments: Government payments to individuals through social welfare programs, student subsidies,
and Social Security are referred to as transfer payments.
■ The spending on transfer payments and welfare is reduced while taking up fiscal consolidation.
○ Taxes: Changes in taxes affect the typical consumer's income, and changes in consumption lead to changes
in real GDP. As a result, the government can impact economic output by altering taxation. Taxes can be altered
in a variety of ways.
■ The government has to set tax rates keeping in mind the maximisation of revenue in terms of tax
revenue.

Recommendations of 15th Finance Commission Regarding Fiscal Consolidation

● The Union government should reduce its fiscal deficit to 4% of its Gross Domestic Product by 2025-26 against
6.8% in FY22.
● The fiscal deficit of state governments should be at 4% of Gross State Domestic Product in 2021-22, 3.5% in the following
year, and 3% for the next three years.
● Borrowing limits for state governments should be fixed at 4% of Gross State Domestic Product in 2021-22, 3.5% in 2022-
23, and at 3% of GSDP from 2023-24 to 2025-26.
● The suggested fiscal consolidation path is as follows:
2020-21 2021-22 2022-23 2023-24 2024-25 2025-26

Fiscal Deficit 7.4% 6.0% 5.5% 5.0% 4.5% 4.0%

Revenue Deficit 5.9% 4.9% 4.5% 3.9% 3.3% 2.8%

Outstanding liabilities 61.0% 62.9% 61.0% 60.1% 58.6% 56.6%

● If the states fulfill the parameters for power sector reforms then additional borrowing of 0.5% of GSDP should be allowed.
● It mandates third-party evaluation of all centrally sponsored schemes within a fixed time period.
● Restructuring of FRBM act.
1.10.2 Fiscal stimulus
● Fiscal stimulus refers to a set of fiscal policy measures used by the government to stimulate the economy.
● Fiscal Stimulus involves a conservative approach toward an expansionary fiscal policy that focuses on encouraging
private sector spending so as to make up for losses of aggregate demand.
● Such measures include lowering taxes, increasing the rate of growth of public debt, etc.

What is Fiscal Stimulus?

● A 'Fiscal stimulus' is a set of policies designed by authorities to jump-start a sluggish economy.
● A fiscal stimulus involves the government spending more money from its own coffers or lowering tax rates to put more
money in consumers' hands.
● For instance, during the COVID-19 pandemic, the central government announced a fiscal stimulus package of Rs. 20
Lakh crore.

Features of Fiscal Stimulus

● It emerged as a tool of optimism during the financial crisis and global recession in advanced economies.
● It could also lead to an increase in the deficit and debt levels of countries, which may operate as a permanent drag for
some countries.
● It can lead to deviation from the path of fiscal consolidation and also fiscal deficit.
● When the fiscal stimulus is used to stimulate consumer demand, rather than to create income yielding assets through
appropriate investment it can cause inflation due to a high fiscal deficit.

Need for Fiscal Stimulus

● To stimulate economic demand during the unemployment rise, shrinking income and consumer confidence.
● A fiscal stimulus revives business confidence, restarts stalled projects, helps in job creation and sets off a virtuous cycle
of demand and growth.

Self Notes
 162

● Pandemic induced job losses have resulted in increased rates of unemployment across global economies.
● For better economic growth, wealth creation is essential which can be accomplished by providing a fiscal stimulus.

Impacts of Fiscal Stimulus Framework

● Fiscal stimulus results in a sudden rise in liquidities and can also cause widespread bankruptcies, losses of
organisational capital, a steep path towards economic recovery.
● It can result in a liquidity trap in which the rate of interest decreases, there is a liquidity preference as almost
everyone prefers holding cash.
● It can result in high inflation.
● Fiscal stimulus involves expenditures on health, food and income support for vulnerable households which can put a
strain on the government exchequer.
● It can cause an increase in gross public debt, impact the credit ratings, etc and therefore cause deterioration of public
finances.

Fiscal Stimulus during COVID-19

● During the pandemic there was an increase in job losses that lead to an increase in unemployment.
● Various sectors of the economy especially the manufacturing sector was badly impacted.
● India offered economic relief packages such as the Pradhan Mantri Garib Kalyan Yojana worth Rs 1.75 lakh crore or
roughly 0.8% of the GDP.
● Atmanirbhar Bharat Abhiyan amounting to Rs. 20 lakh crore was launched for farmers, cottage industry, MSMEs,
labourers, middle class etc.
● Many countries such as Bangladesh and Indonesia, etc resorted to expanding their coverage of the cash transfer
programmes from pre-COVID-19 levels.
● Some such as China, Vietnam, etc adopted a dual strategy of providing relief to workers who have been laid off and
feeding poor families, while also trying to keep firms afloat.
1.10.2.1 Fiscal Stimulus Vs Monetary StimulusDifference between Fiscal Stimulus and Monetary Stimulus
Monetary Stimulus Fiscal Stimulus

It is regulated by central banks that focus on low inflation rates

It is a government-regulated measure which involves change
to stabilise economic growth by increasing the amount of
in government spending and taxation to revive the economy.
money available.

It is undertaken by central banks to regulate the supply of The government used fiscal stimulus packages to influence
money in the country. The main tool of a monetary stimulus is overall supply and demand by cutting down on taxes,
interest rates. increasing spending and boosting economic growth

It reduces marketing interest rates, increases the money It is done by the government through direct spending and
supply by injecting more cash into the economy. increasing hiring to promote employment and growth

It puts extra money into the hands of the people during times They are the last resort to achieve price stability, steady
of recession economic growth and promote employment

1.10.3 Extra budgetary resources and off budget expenditure

● Extra budgetary resources (EBRs) are financial obligations raised by public sector enterprises for which the
entire principal and interest payment is made from government funds, according to the budget plan.
● Such borrowings, which are made by state-owned companies to finance government initiatives, are not included in the
budget's official estimates.
● Additional budget borrowing is not included in calculations of the fiscal deficit but is added to the government's overall
debt at the same time.
● Several CPSUs have collected money from the market in recent years by selling Government of India-Fully Serviced
Bonds (GoIFSB), for which the Budget will be used to pay back the principal and interest.
● This indicates that even though the borrowing is not a component of India's consolidated fund, the consolidated
fund is used to pay the interest on such borrowings.
● The borrowing is done through fully-serviced government of India bonds and NSSF loans.)
● According to government data, the total outstanding liabilities for EBRs at the end of March 2019 were 0.5% of
GDP, and it is anticipated that by the end of March 2020, they may increase to 0.7% of GDP.

Self Notes
 163

15th Finance Commission's EBR Report

● In its inaugural report, the Fifteenth Finance Commission encouraged the federal government and the states to stop
making additional budget borrowings.
● The Commission observed that the Union and State Governments have a growing propensity to borrow money
outside of the Consolidated Fund, which has resulted in the accumulation of extra-budgetary obligations.
● The Commission therefore suggested that, in the interest of transparency, complete disclosure of extra-budgetary
borrowings be required from both the Union and the States.
● According to the 2018 FRBM Act's amendment, outstanding extra-budgetary liabilities must be precisely
recognised and erased in a timely manner.
● This indicates that even though the borrowing is not a component of India's consolidated fund, the consolidated fund is
used to pay the interest on such borrowings.
1.10.4 Fiscal Federalism
● The allocation of duties between the various levels of government in terms of public spending and taxation is
referred to as fiscal federalism.
● Fiscal federalism is the economic version of political federalism.
● It allocates duties to various governmental levels and also provides the necessary financial tools to carry out these
duties. For example mandatory sharing of GST and powers to the states to levy its own taxes on certain commodities.
● The choice of these particular fiscal instruments is a difficult undertaking.

Need for fiscal federalism

1. Horizontal imbalances and rising regional inequalities:
○ The finance commission was the sole agency working for fiscal federalism in India. The government replaced
the erstwhile Planning commission with NITI Aayog to incorporate the states in the planning process thereby
reducing regional disparities and imbalances.
2. Vertical imbalances between centre and states:
○ Amongst the three tiers of the government, the central government enjoys the major share of revenues and
little amount of taxation powers to the states. In this aspect there are little funds with the states to work for
welfare.

Steps taken to promote fiscal federalism in India:

● The principles of fiscal federalism and income sharing between the federal government and the states were made official
by the Government of India Acts of 1919 and 1935.
● The 14th Finance Commission, presided over by Dr. Y. V. Reddy advocated giving the states a 42 percent share of
revenue.
● In order to encourage cooperative federalism in India, the Goods and Services Tax was implemented in 2017 to
simplify the indirect tax system, allowing the states a bigger say in developing and administering the revamped
taxing system.
● The new realities of macroeconomic management that the Planning Commission had overlooked were to be addressed
by the NITI Aayog, which was founded in 2015.
1.11 Budget 2022-23
1. Public Capital Investment
○ In comparison to the current year, capital expenditure increased by 35.4 percent to Rs. 7.50 lakh crore in 2022-
23. The outlay in 2022-23 is expected to be 2.9 percent of GDP.
○ The Central Government's 'Effective Capital Expenditure' in 2022-23 is estimated to be 10.68 lakh crore or
around 4.1 percent of GDP.
○ The money spent by the government on the development of machinery, equipment, buildings, health facilities,
education, and so on is referred to as capital expenditure. It also covers the expenditure of acquiring fixed
assets such as land, as well as government investment that will yield profits or dividends in the future.
2. Green Bonds
○ Sovereign Green Bonds will be issued as part of the government's overall market borrowings in 2022-23 to
mobilise resources for green infrastructure.
3. GIFT-IFSC
○ World-class foreign universities and institutions will be allowed to give courses in Financial Management,
FinTech, Science, Technology, Engineering, and Mathematics in the Gujarat International Finance Tec-City
(GIFT City) free of domestic regulations, except those imposed by the International Financial Services Centre
Authority (IFSCA), in order to facilitate the availability of high-end human resources for financial services and
technology.
○ In GIFT City, an International Arbitration Centre will be established to facilitate the timely settlement of disputes
under international jurisprudence.
○ The GIFT City would facilitate services for global capital for sustainable and climate finance in the country.
Self Notes
 164

○ Data Centers and Energy Storage Systems, including dense charging infrastructure and grid-scale battery
systems, will be included in the harmonised list of infrastructure.
4. Investment in Venture Capital and Private Equity
○ The government will form an expert panel to boost venture capital and private equity investments.
○ Last year, Venture Capital and Private Equity spent more than 5.5 lakh crore, enabling one of the world's largest
start-up and growth ecosystems.
5. Blended Finance for Sunrise Sectors
○ To encourage important sunrise sectors like Climate Action, Deep-Tech, Digital Economy, Pharma, and Agri-
Tech, the government will promote thematic funds for blended finance, with the government share limited to
20% and managed by private fund managers.
○ Funds backed by the government Scale funding have been supplied by the National Investment and
Infrastructure Fund (NIIF) and the SIDBI Fund of Funds, creating a multiplier effect.
6. Digital Rupee
○ The government will introduce the Digital Rupee, which will be issued by the Reserve Bank of India and will be
based on blockchain and other technologies, beginning in 2022-23.
7. State Financial Assistance for Capital Investment
○ The budgetary allocation for the 'Scheme for Financial Assistance to States for Capital Investment' has been
increased from Rs. 10,000 crore in Budget Estimates 2021-22 to Rs. 15,000 crore in Revised Estimates 2021-
22.
○ The amount for 2022-23 is one lakh crore to assist states in catalyzing overall economic investment.
■ These fifty-year interest-free loans are in addition to the normal borrowings allowed by the states.
■ This allocation will be used for PM GatiShakti-related and other states' productive capital investment.
It will also comprise the following components:
■ Supplemental funding for PM Gram Sadak Yojana priority areas, including support for the states' share
■ Digitization of the economy, including the digital payments and the completion of the Optic Fibre Cable
(OFC) network, and
■ Reforms related to the building bylaws, urban planning schemes, transit-oriented development, and
transferable development rights.
■ According to the recommendations of the 15th Finance Commission, states will be allowed a budget
deficit of 4% of GSDP (Gross State Domestic Product) in 2022-23, with 0.5 percent related to power
sector reforms.

Self Notes
 165

TAX, TYPES OF TAX, GST AND OTHER IMPORTANT TAX,

TAX REFORM

1. Taxation 167
1.1 Objectives of Taxation 167
1.2 Constitutional Provisions Regarding Taxation in India 167
2. Direct and Indirect Taxes : Concepts 168
2.1 Direct Taxes 168
2.2 Indirect Tax 168
2.3 Progressive, Proportional and Regressive Taxation 169
2.4 Specific Vs Ad Valorem Taxes 170
2.5 Tax-GDP Ratio 170
3. Direct Tax 171
3.1 Income Tax 171
3.2 Corporate Tax 171
3.3 Wealth and Property Tax 172
3.4 Capital gains tax 173
4. Indirect Tax 173
4.1 Customs Duty 1733
4.2 Excise Tax 173
4.3 Value Added Tax (VAT) 174
4.4 Goods and Service Tax (GST) 174
5. Tax Reforms 182
5.1 What is Tax Reform? 182
5.2 Direct Tax Reforms 182
5.3 Indirect Tax Framework 184
6. International Taxation 184
6.1 Tax Haven 184
6.2 Transfer pricing 184
6.3 Base erosion and profit shifting (BEPS) 185
7. International Taxation Measures 185
7.1 Advance Pricing Agreement (APA) 185
7.2 General Anti-Avoidance Rules (GAAR) 185
7.3 The Double Taxation Avoidance Agreement (DTAA) 187
7.4 Equalization Levy (EL) 187
7.5 Global Minimum Corporate Tax (GMCT) 187
8. Some important terms related to taxation 187
8.1 Tax Expenditure 187
8.2 Countervailing Duty [CVD] 187
Self Notes
 166

8.3 Anti-Dumping Duty 188

8.4 Shell Company 188
8.5 Inverted tax structure 188
8.6 Tax Buoyancy 188
8.7 Tax avoidance 188
8.8 Tax evasion 188
8.9 Pigovian tax 189

Self Notes
 167

1. Taxation
● Tax is a compulsory payment by the citizens to the government to meet the public expenditure. It is legally
imposed by the government on the taxpayer and in no case the taxpayer can refuse to pay taxes to the
government.
● It does not guarantee any ‘quid pro quo’. This means, there is no direct mapping between the taxes one paid and public
welfare services received.
● The taxes collected from an individual can be used for any purpose which maximises social welfare, rather than providing
private benefit to the taxpayer.
○ Some view transfers as negative taxes. However, transfers try to achieve distributional goals (i.e. they achieve
specific objectives like reducing malnutrition) for targeted people. Such transfers include social welfare
payments, unemployment stipend, etc. They may also influence consumption, investment and work effort, just
like taxes.
● Taxes are usually categorised as 'direct and indirect taxes' in official tax data systems.

● The primary direct taxes are income, property, and professional taxes, whereas the main indirect taxes are GST (goods
and services tax), customs, stamp duty, and registration fees.
1.1 Objectives of Taxation
● The main objective of taxation is to fund government expenditure. But it is not the only objective, taxation policy has
some non-revenue objectives. These objectives are:
○ Economic development – Resource mobilization for economic development is done through taxation. To step
up both public and private investment, the government taps tax revenues. Through proper tax planning, the
ratio of savings to national income can be raised.
○ Income redistribution — through taxes is meant to reduce inequalities in the distribution of income and wealth.
○ Employment — depends on effective demand. A country desirous of achieving the goal of full employment
must cut down the rate of taxes. Consequently, disposable income will rise and, hence, demand for goods and
services will rise. Increased demand will stimulate investment leading to a rise in income and employment
through the multiplier mechanism.
○ Price stability— through taxes, is an effective means of controlling inflation. By raising the rate of direct taxes,
private spending can be controlled. Thus, the pressure on the commodity market is reduced. But, indirect taxes
imposed on commodities fuel inflationary tendencies. High commodity prices, on the one hand, discourage
consumption and, on the other hand, encourage saving. The opposite effect will occur when taxes are lowered
down during deflation.
1.2 Constitutional Provisions Regarding Taxation in India
● The Constitutional provisions regarding taxation in India can be divided into the following categories:
○ Only by the authority of law can taxes be levied. (Article 265)
○ Levy of duty on tax and its distribution between center and states. (Article 268, Article 269, and Article 270)
Self Notes
 168

○ Restriction on power of the states to levy taxes. (Article 286)

○ Sale/purchase of goods which take place outside the respective state
○ Sale/purchase of goods which take place during the import and export of the goods
○ Taxes imposed by the state or purpose of the state (Article 276, and Article 277)
○ Taxes imposed by the state or purpose of the union (Article 271, Article 279, and Article 284)
○ Grants-in-Aid (Article 273, Article 275, Article 274, an Article 282)

2. Direct and Indirect Taxes : Concepts

2.1 Direct Taxes
● A direct tax is referred to as a tax levied on a person's income and wealth and is paid directly to the government; the
burden of such tax cannot be shifted.
● The tax is progressive in nature. It is levied according to the paying capacity of the person, i.e. the tax is collected more
from the rich and less from the poor people.
The Central Board of Direct Taxes
● The Central Board of Direct Taxes is a statutory authority functioning under the Central Board of Revenue Act, 1963.
● The officials of the Board in their ex-officio capacity also function as a Division of the Ministry dealing with matters
relating to levy and collection of direct taxes.

2.1.1 Merits of Direct Taxes

1. Equity
○ Direct taxes are progressive i.e. rate of tax varies according to tax base. For example, income tax satisfies the
canon of equity.
2. Certainty
○ Canon of certainty can be ensured by direct taxzaxses. For example, an income tax payer knows when and at
what rate he has to pay income tax.
3. Elasticity:
○ Direct taxes also satisfy the canon of elasticity. Income tax is income elastic in nature. As income level
increases, the tax revenue to the Government also increases automatically.
4. Economy
○ The cost of collection of direct taxes is relatively low. The taxpayers pay the tax directly to the state.
2.1.2 Demerits of Direct Taxes
1. Unpopular
○ Direct taxes are generally unpopular. It is inconvenient and less flexible.
2. Productivity affected
○ According to many economists direct tax may adversely affect productivity. Citizens are not willing to earn more
income because in that case they have to pay more taxes.
3. Inconvenient
○ The taxpayers find it inconvenient to maintain accounts, submit returns and pay tax in lump sum.
4. Tax Evasion
○ The burden of direct tax is so heavy that tax-payers always try to evade taxes. This ultimately leads to the
generation of black money, which is harmful to the economy.
2.2 Indirect Tax
● Indirect Tax is referred to as a tax charged on a person who purchases the goods and services and it is paid indirectly
to the government.
○ The burden of tax can be easily shifted to another person. It is levied on all persons equally whether rich or
poor.
● There are several types of Indirect Taxes, such as:
○ Excise Duty: Payable by the manufacturer who shifts the tax burden to retailers and wholesalers.
○ Sales Tax: Paid by a shopkeeper or retailer, who then shifts the tax burden to customers by charging sales tax
on goods and services.
○ Custom Duty: Import duties levied on goods from outside the country, ultimately paid for by consumers and
retailers.
○ Entertainment Tax: Liability is on the cinema theatre owners, who transfer the burden to cinema goers.
○ Service Tax: Charged on services like telephone bill, insurance premium such as food bill in a restaurant etc.
2.2.1 Merits of Indirect Taxes
1. Wider Coverage
○ All the consumers, whether they are rich or poor, have to pay indirect taxes.

Self Notes
 169

○ For this reason, it is said that indirect taxes can cover more people than direct taxes. For example, in India
everybody pays indirect tax as against just 2 percent paying income tax.
2. Checks harmful consumption
○ The Government imposes indirect taxes on those commodities which are harmful to health e.g. tobacco, liquor
etc. They are known as sin taxes.
3. Convenient
○ Indirect taxes are levied on commodities and services. Whenever consumers make purchase, they pay tax
2.2.2 Demerits of Indirect Taxes
1. Higher Cost of Collection
○ The cost of collection of indirect taxes is higher than the direct taxes. The Government has to spend huge
money to collect indirect taxes.
2. Inelastic
○ Indirect taxes are less elastic compared to direct taxes. As indirect taxes are generally proportional.
3. Regressive
○ Indirect taxes are sometimes
unjust and regressive in nature
since both rich and poor persons
have to pay the same amount as
taxes irrespective of their income
level.
4. Uncertainty
○ The rise in indirect taxes increases
the price and reduces the demand
for goods. Therefore, the
Government is uncertain about the
expected revenue collection. So
Dalton says under indirect taxes
2+2 is not 4 but 3 or even less than
3.
5. No civic Consciousness
○ As the tax is hidden in price, the consumers are not aware of paying tax.

2.3 Progressive, Proportional and Regressive Taxation

2.3.1 Progressive Taxation
● A Progressive Tax is a tax that increases with an increase in income.
○ A progressive tax is justified by the fact that a flat percentage tax would disproportionately affect persons with
low earnings.
● The degree to which a tax structure is progressive is determined by how much of the tax burden is passed to those with
higher incomes.
○ It is common knowledge that the more money you earn, the more taxes you should pay, thereby contributing
to society.
● If one tax code has a low rate of 10% and a high rate of 30%, and another tax code has tax rates ranging from 10% to
80%, the latter is more progressive.
○ Income Tax, Luxury Sales Tax, Estate tax and surcharge on net income beyond Rs 50 Lakhs are a few
examples of Progressive tax.
2.3.2 Regressive Taxation
● A regressive tax is a tax that is imposed similarly to all situations, regardless of who is paying it.
○ People with low incomes are disproportionately affected by regressive taxes compared to those with higher
incomes.
○ While taxing everyone at the same rate may be reasonable in some contexts, it is perceived as unjust in others.
● Examples of Regressive Tax
○ Sales Tax
○ Property Tax
○ Excise Tax
○ Tariff
○ Government Fees
○ Flat Taxes
○ "Sin" Taxes

Self Notes
 170

2.3.3 Proportional Taxation

● A proportional tax is one in which the tax rate stays proportional regardless of the taxpayer’s income level.
○ In this case, the individual's tax liability is not proportional to his income.
● Examples of progressive, regressive, and proportional taxes in the table
Taxable income (Rs) Progressive tax (rate) Proportional tax (rate)

10000 10% 20%

30000 20% 20%

50000 30% 20%

Example Income Tax Sales Tax

● People are taxed at the same percentage of their annual income when they pay a proportional tax.
2.4 Specific Vs Ad Valorem Taxes
● A specific tax is levied on the goods and services on a per unit basis.
● It is an ‘ad valorem’ tax when the tax imposed is as a percentage of the value of the product.
● The choice between specific and ad valorem is debatable.
○ Specific taxes do not automatically respond to changes in inflation and therefore reduce the incidence of a tax
on the price of the goods imposed.
○ Most broad based taxes are imposed as ad valorem taxes which can be single stage or multi stage.
○ When it is multistage, it is primarily on value added [e.g. value added tax (VAT) and GST].
■ But there are cases where the combination of both are used to tax a product (e.g. in the new GST
regime in India, tobacco taxes are imposed as a combination of both specific plus ad valorem).
● As the economy moves from traditional to transitional to modern stages of development, the nature of the tax revenue
structure also changes from traditional taxes such as land based taxes to indirect taxes and then to direct taxes.
○ In the traditional economy, mostly taxes on property, land, import and export dominate as the economy is
predominantly agriculture and engages in raw material exports or
imports.
○ In the transitional stage, manufacturing and trade dominates and
the phase of indirect taxes like excise and sales taxes along with
trade tax dominates.
○ In a modern economy with a full-fledged services sector, the
revenue profile is expected to shift in favour of income taxes with
a smaller role to be played by commodity taxes.
2.5 Tax-GDP Ratio
● Tax-to-GDP ratio represents the size of a country's tax basket relative to
its GDP.
○ It is a representation of the size of the government's tax
revenue expressed as a percentage of the GDP.
○ Higher the tax to GDP ratio the better financial position the
country will be in.
○ The ratio represents that the government is able to finance its
expenditure.
■ A higher tax to GDP ratio means that the government
is able to cast its fiscal net wide. It reduces a
government's dependence on borrowings.
Importance
● A higher tax to GDP ratio means that an economy's tax buoyancy is strong as the share of tax revenue rises in sync
with the rise in the country's GDP.
● India, despite seeing higher growth rates, has struggled to widen the tax base.
○ Lower tax-to-GDP ratio constrains the government to spend on infrastructure and puts pressure on the
government to meet its fiscal deficit targets.
2.5.1 India’s Tax/GDP Ratio
● India’s Tax/GDP ratio is low, at around 10-11% of GDP. It has stayed close to that level for the last 20 years. In 2019,
it hit a decade low of 10% of GDP, the same as in 2014.
● In comparison with our peers, India’s tax/GDP ratio is much lower. Therefore, it is argued that it should be increased.
Self Notes
 171

● India consists of one direct taxpayer for every 16 voters present. Income tax is paid by only 1% of India’s population.
● India’s Gross tax to GDP which was 11% in FY19, fell to 9.9% in FY20 and marginally improved to 10.2% in FY21 (partly
due to decline in GDP) and is envisaged to be 10.8% in FY22, this is much lower than the emerging market economy
average of 21 percent and OECD average of 34 percent.

3. Direct Tax
● Taxes on income form a major part of direct taxes.
● Hicks (1939) defines income as: ‘the maximum value which a man can consume during a week and still be as well off
at the end of the week as he was at the beginning’.
● Simons (1938) proposed a definition of income called ‘comprehensive income’.
○ According to this definition, personal income is the sum of: the market value of rights exercised in consumption
and the change in its value between the beginning and end of the period.
● Generally, income from salary, house property, business or profession, capital gains are taken as constituents of income.
○ Some of these incomes are straightforward to compute but some incomes need to be imputed (e.g. rental
income from owner occupied house).
● Sometimes, people may accumulate income from non-market activities (e.g. working in a family farm or helping family
activities/business).
○ Another issue is realised and unrealised incomes.
○ Generally, unrealised incomes are excluded (e.g. capital gains of land or assets).
3.1 Income Tax
● There are no fixed rules on the rate of income tax and there is no optimal rate.
● Income tax rate is always a contested issue in all countries.
● In India, income tax rates were historically high (e.g. the marginal income tax rate i.e. the tax rate on the highest income
slab was as high as 97.5 percent at one time).
○ Over the years, the highest income tax rate has been brought down to around 30 percent.
● In general, governments differentiate between the incomes on certain grounds and allow for tax relief in the form of
standard deduction or itemize deductions or exemptions.
○ Such standard income tax exemptions include: leave, travel concession, death-cum-retirement gratuity, leave
encashment, retrenchment compensation, compensation received at time of voluntary retirement, tax on
perquisites paid by employer, amount received from superannuation fund to legal heirs of employee, house
rent allowance, etc.
● When the government increases tax rates beyond a certain point, it will be counter productive and tax revenues start
declining.
○ High tax rate, disincentivises and demotivates people to work to their fullest of productive levels.
○ Unfortunately, there is no consensus on the maximum upper bound of tax rate beyond which this negativity
kicks in.
○ The Laffer curve effect depends on the existing tax structure and tax rates. When the government increases
tax rates and tax administration is fragile it leads to tax evasion.
○ At low rates, people’s incentive to evade tax remains unprofitable and hence keeps the tax compliance high.
Laffer Curve
● The Laffer Curve describes the relationship
between tax rates and total tax revenue, with an
optimal tax rate that maximizes total government
tax revenue.
● If taxes are too high along the Laffer Curve, then
they will discourage the taxed activities, such as
work and investment, enough to actually reduce
total tax revenue.
○ In this case, cutting tax rates will both
stimulate economic incentives and
increase tax revenue.

3.2 Corporate Tax

● The word corporation originates from the Latin word ‘corporare’ which means ‘to form into a body’.
● Corporation tax is a tax on the incomes of corporations.

Self Notes
 172

○ According to the privilege argument, a corporation should pay the tax for the privilege of being allowed to exist
and function which entitles it to a set of unique legal provisions in terms of savings, debt rising, etc.
○ The social cost view argues that since the corporations consume public services of the state, a tax is justified.
○ The ethical argument put forward the view that corporate tax could be used to reduce inequalities in wealth
distribution.
● Corporation tax is levied on domestic companies that are different from the shareholders.
○ This tax is also payable by foreign corporations whose income arises or is deemed to arise in India. Income
earned as interest, royalties, dividends, technical services fees, or gains through the sale of assets based in
India is taxable.
● Corporate tax also includes the following:
○ Minimum Alternate Tax (MAT)
■ Levied on zero tax companies whose accounts are prepared as per the guidelines of the Companies
Act.
○ Fringe Benefits Tax
■ Such direct tax is paid by companies on fringe benefits (drivers, maids, etc.) provided to employees.
○ Dividend Distribution Tax (DDT)
■ This tax is levied on any amounts that are declared, distributed, or paid by domestic entities as
dividends to the shareholders; foreign companies are exempt from DDT. The Budget of 2020
abolished DDT.
○ Securities Transaction Tax (STT)
■ This liability arises from income earned through taxable securities transactions.
MAT
● MAT stands for Minimum Alternate Tax and AMT stands for Alternate Minimum Tax.
○ Initially the concept of MAT was introduced for companies and progressively it has been made applicable
to all other taxpayers in the form of AMT.
● Objective of levying MAT
○ At times it may happen that a taxpayer, being a company, may have generated income during the year,
but by taking the advantage of various provisions of Income-tax Law (like exemptions, deductions,
depreciation, etc.), it may have reduced its tax liability or may not have paid any tax at all.
○ Due to an increase in the number of zero tax paying companies, MAT was introduced by the Finance Act,
1987 with effect from assessment year 1988-89. Later on, it was withdrawn by the Finance Act, 1990 and
then reintroduced by the Finance Act, 1996.
○ The objective of introduction of MAT is to bring into the tax net "zero tax companies" which in spite of
having earned substantial book profits and having paid handsome dividends, do not pay any tax due to
various tax concessions and incentives provided under the Income-tax Law.
● Basic provisions of MAT
○ As per the concept of MAT, the tax liability of a company will be higher of the following:
■ Tax liability of the company computed as per the normal provisions of the Income-tax Law, i.e.,
tax computed on the taxable income of the company by applying the tax rate applicable to the
company.
■ Tax computed in above manner can be termed as normal tax liability.
■ Tax computed @ 15% (plus surcharge and cess as applicable) on book profit (manner of
computation of book profit is discussed in later part). The tax computed by applying 15% (plus
surcharge and cess as applicable) on book profit is called MAT.
■ MAT is levied at the rate of 9% (plus surcharge and cess as applicable) in case of a company,
being a unit of an International Financial Services Centre and deriving its income solely in
convertible foreign exchange.

3.3 Wealth and Property Tax

● Wealth taxes are one of the oldest forms of taxation.
● It can be imposed as an annual fee based on property valuation or fixed amount.
● It is imposed on estates and inheritance wealth.
● There are four main type of wealth taxes imposed historically: property tax, estate and inheritance tax, net worth tax
and capital levies.
3.3.1 Property Tax
● Property taxation is one of the main sources of revenue for local governments.
○ This is primarily imposed on residential and non-residential land and structures.
○ The main criteria is ownership of the property.
● In India, property owners must pay this tax irrespective of whether the property earns them any income or not.

Self Notes
 173

○ Depending on the residential status of the taxpayers, wealth tax is payable by individuals, Hindu Undivided
Family (HUF), and corporate taxpayers.
○ Working assets like stock holdings, gold deposit bonds, commercial complex properties, house property rented
for more than 300 days in a year, and house property owned for professional or business use are exempt from
paying wealth tax.
3.3.2 Estate and inheritance tax
● It is slightly different from property tax in the sense that the assessment happens only once at the time of death.
○ This is applicable to most of the asset classes of estates and inheritance wealth.
○ Since imposition and collection of estate taxes are complicated, they are not successful in implementation as
well as in generating revenues to the treasury.
3.3.3 Capital levies
● These are mostly one-time tax levies to meet the exigencies of war and calamity. Many countries used this levy during
world wars.
3.4 Capital gains tax
● When an individual earns a profit by selling capital assets such as residential plots, vehicles, stocks, bonds, and even
collectibles such as artwork, capital gains tax is charged.
● It is divided into two types:
○ short-term capital gains tax and
○ long-term capital gains tax.
● Transactions involving any such capital asset are taxable under the Income Tax Act of India, as are any cess and any
other surcharges levied on the sale.
● These taxes apply to both mobile and immovable assets, such as residential properties and unoccupied plots, as well
as assets like shares (both equity and listed), debentures, units of equity-oriented mutual funds, Government securities,
UTI, Zero-coupon bonds, and so on.
● In India, they might be subject to long-term capital gains tax after 12 to 36 months of possession.
○ The long-term capital gain tax rate is usually calculated at 20% plus surcharge and cess as applicable. There
are also special cases when an individual is charged at 10% on the total capital gains.

4. Indirect Tax
4.1 Customs Duty
● Customs duty is a type of indirect tax that is levied on all commodities imported and a few items exported from the
country.
○ Duties placed on imported items are referred to as import duties, whilst duties levied on exported goods are
referred to as export duties.
○ Countries all over the globe pay customs taxes on items imported and exported in order to generate income
and/or protect native institutions from predatory or efficient rivals from other countries.
● Customs duty is levied based on the value of the products or size, weight, and other relevant parameters.
○ Ad valorem taxes are based on the monetary worth of the products, whereas specific duties are based on
quantity/weight.
○ Compound tariffs on items are based on a combination of value and a variety of other variables.
4.2 Excise Tax
● The ‘excise tax’ is the most common of all the indirect taxes. It taxes ‘the act of production or use of specific goods and
services’.
○ Most popular excise taxes include taxes on tobacco, alcohol and petroleum products.
● Excise taxes can be imposed as specific or ad valorem.
● Apart from revenue generating, excise taxes can be used to address the problem of externalities like pollution and can
also be used to deter the people from using harmful goods.
○ Pigovian taxes on externalities are primarily imposed in the form of excise duties.
Pigovian taxes
● A Pigovian tax is intended to tax the producer of goods or services that create adverse side effects for society.
● Economists argue that the costs of these negative externalities, such as environmental pollution, are borne by society
rather than the producer.
● The purpose of the Pigovian tax is to redistribute the cost back to the producer or user of the negative externality.
● A carbon emissions tax or a tax on plastic bags are examples of Pigovian taxes.
● Pigovian taxes are meant to equal the cost of the negative externality but can be difficult to determine and if
overestimated can harm society.

Self Notes
 174

● Generally, the majority of the excise tax incidence falls on ultimate consumers and sometimes to the fullest (e.g. alcohol
and tobacco).
● But, the tax burden is regressive since both the poor and the rich use these products (e.g. petroleum products) and the
poor will be relatively paying a higher percentage of their total incomes as these taxes.
○ The higher excise taxes on essential goods usually leads to illicit trade and smuggling.
○ In India, some of the excise taxes are subsumed with GST but taxes on alcohol and petroleum duties are not
yet combined.
4.3 Value Added Tax (VAT)
● Over the years, tax authorities have identified many
problems with commodity taxes. Most of these taxes are
regressive and iniquitous.
○ Due to the ambiguity and loopholes in tax laws,
and also due to differences of opinion on taxable
events and amounts, there are many inter-
jurisdictional conflicts.
● Historically, commodity taxes are very complex with
multiple rate structures.
○ There are also high compliance costs involved.
○ Additionally, due to lack of coordination between
different tax authorities at central level and
between centre and state tax authorities, there is
a high level of tax cascading.

● As a solution to all these problems, a new variant of indirect

tax called ‘value added tax’ (VAT) was proposed.
● Value-added tax (VAT) is a consumption tax on goods and
services that is levied at each stage of the supply chain where value is added, from initial production to the point of
sale.
○ The amount of VAT the user pays is based on the cost of the product minus any costs of materials in the product
that have already been taxed at a previous stage.
● It ideally rationalises the indirect tax system.
○ It is superior and also self-enforcing due to the invoice based tax credit system.
○ It eliminates cascading and pyramiding. It is a ‘good best’ for tax authorities due to high revenue potential.
● However, despite its merits, VAT is not a simple tax. Administration of VAT is difficult.
4.4 Goods and Service Tax (GST)
● Even though the implementation of VAT solved some of the problems, the integration of goods and services taxes were
still not achieved.
● The problems with the pre-GST tax system were as follows.
○ Cascading and High Tax Rates:
■ In addition to ‘central excise’ and VAT, central sales tax (CST) was collected on inter-state sale of
goods.
○ Input Tax Credit (ITC):
■ The central government allowed selective cross credits across CENVAT (i.e. central VAT) and service
tax providing an assessor to fall either under ‘central excise’ or under ‘service tax’ assessment.
■ VAT was levied on intra-state sale of goods where input tax credit (on inputs and capital goods) was
available only for intra-state purchases of goods.
○ Entry Tax:
■ States where ‘entry tax’ was collected on behalf of local governments and the revenue was passed on
to them, entry tax remained a stranded cost for these states (e.g. Karnataka, Odisha) as no Input Tax
Credit (ITC) against ‘entry tax’ was allowed.
● GST was first introduced in France in 1954. Within 62 years of its introduction about 160 countries across the world have
adopted GST.
○ Generally GST is popular for single models but Canada and Brazil also have dual models of GST.
○ India has adopted a dual GST which will be imposed concurrently by centre and states.
4.4.1 What is GST?
● GST is a comprehensive indirect tax that has replaced a number of indirect taxes, such as VAT, excise duty,
entertainment tax and additional duties of customs.
● It is multi-stage in nature, as it is levied at all stages from manufacturing to final consumption.
Self Notes
 175

○ Moreover, it is applied at every point of sale.

● The Goods and Service Tax Act was passed in the Parliament on 29th March 2017. The Act came into effect on 1st July
2017; Goods & Services Tax in India is a comprehensive, multi- stage, destination-based tax that is levied on every
value addition.
○ In simple words, Goods and Service Tax (GST) is an indirect tax
levied on the supply of goods and services. This law has replaced
many indirect tax laws that previously existed in India.
● GST subsumed the following :
○ Central taxes
■ Central excise duty
■ Additional excise duty
■ Service tax
■ Surcharge and cess
■ Central sales tax
○ State Taxes
■ State VAT
■ Entertainment tax
■ Entry tax
■ Luxury Tax
■ Purchase Tax
4.4.2 Destination Based
● Consider goods manufactured in Delhi and are sold to the consumer in Karnataka. Since Goods & Service Tax is levied
at the point of consumption, in this case, Karnataka, the entire tax revenue will go to Karnataka and not Delhi.
4.4.3 Constitutional Amendment For GST
● Constitution (101st amendment) Act, 2016 was enacted on 8.09.2016 for the following significant amendments.
(a) Concurrent (simultaneously) power on Parliament and State legislatures to make laws for imposing taxes on
goods and services.
(b) GST will be levied on all supplies of goods and services
except alcoholic liquor for human consumption.
(c) Parliament has exclusive power to make laws with respect to
goods and services tax of inter-state (from one state to
another state) supply.
(d) Parliament shall decide principles for determining the place
of supply and when supply takes place in the course of inter-
State trade and commerce.
(e) The explanation to Articles 269A of Constitution of India
provides that the import of goods and services will be deemed
as a supply that takes place in the course of inter-State trade
and commerce.
(f) For the following items Central Excise duty will be imposed
on their production and respective States will impose Sales
tax on their sales.
(i) Petroleum crude
(ii) High speed diesel
(iii) Motor spirit (commonly known as petrol)
(iv) Natural gas
(v) Aviation turbine fuel
(vi) Tobacco and tobacco products
(g) Article 279A of the Constitution of India empowers the
president of India to Constitute Goods and Service tax
Council (GST Council) under the chairmanship of the Union
Finance Minister to recommend about (Article 279A):
(i) the GST rate
(ii) Valuation and other fundamental rules
(iii) Exemption
(iv) Future changes
(v) Return
(vi) Registration

How GST works?

Self Notes
 176

● A product has to go through different stages before it reaches the end consumer, and there are several taxes
applicable throughout this process. However, this situation changes in the GST regime.
● Here’s an illustration to understand how:
● Stage 1: Manufacturing
○ Take apparel manufacturing as an example and 10% as the GST applicable.
○ The manufacturer buys raw material worth INR 500 that is inclusive of the GST of INR 50 (10% of 500).
○ He then adds his own value of INR 50 to the materials during the manufacturing process. This brings the
gross value of the product to INR 550.
○ Now, the total tax amount on the output of the apparel comes to INR 55 (10% of 550).
○ In the old tax system, the manufacturer would be required to pay a tax of INR 55; however, under GST he
can set some of his tax off as he has already paid it while purchasing the raw materials.
○ Therefore, the final GST that the manufacturer will incur will be of INR 5 (total tax amount till now minus the
tax he has already paid) i.e. INR 5 (55-50)
● Stage 2: Wholesale
○ Here, the apparel is passed from the manufacturer to the wholesaler at a gross value of INR 550 that is
inclusive of the GST of INR 55 (10% of 550).
○ The wholesaler then adds his value (his margin) of INR 50 making the total INR 600 (550 + 50).
○ This brings the total tax amount on the final to INR 60 (10% of 600). Like the manufacturer, the wholesaler
too can set off this tax amount with the tax that he has already paid for while purchasing the goods from the
manufacturer.
○ Thus, the final GST for the wholesaler would be INR 5 (60 – 55)
● Stage 3: Retailer
○ In this final step, the retailer buys the apparel from the wholesaler at a gross value of INR 600 that is inclusive
of the GST of INR 60 (10% of 600).
○ He then adds his value or margin of INR 50 making the total cost of the goods INR 650. The GST applicable
here is INR 65 (10% of 650), but since the retailer has already paid a tax while purchasing the goods, he can
set it off.
■ Thus, the final GST incidence for the retailer would be INR 5 (65 – 60).
○ In the end, since the retailer will sell the product at INR 650, the GST paid by the customer would be INR
65(10% of 650) only.
○ This number would have been much higher in old tax structure.

4.4.4 Structure of GST

● GST is levied on supply of goods and services across India.
○ It is a single tax on the supply of goods and services, right from the manufacturer to the consumer.
○ Under GST credit of taxes paid at previous stages is available as set-off from the output tax.
● GST is destination based consumption tax. Benefit of tax (STCG/ UTGST) will accrue to the consuming state.
● Centre and states will impose tax on goods and services simultaneously. The Centre now can impose tax on sale of
goods within the State and States can impose tax on services.
(1) Intra-State supply of goods and services-
■ CGST- Payable to Central Government
■ SGST/ UTGST- Payable to State Government/ Union Territory (as applicable) where they are
consumed
(2) Inter-States Supply of goods and services
■ IGST - Payable to Central Government
● Centre will levy and administer CGST and IGST while respective States/ UTs will levy and administer SGST/UTGST.
● Import will be treated as inter-States supply and IGST will be chargeable along with basic Customs duty.
● However, in GST Export will be treated as Zero rated supplies and no IGST is payable.
● The rates of GST are 5%, 12%, 18% and 28%.
○ In addition , compensation cess will be payable on pan masala, coal, aerated water and motor cars (Sin cess).
4.4.5 GST Slab Rates
● In India, the four major GST slabs cover nearly 500 services and over 1300 products. Rates of 5%, 12%, 18%, and 28%
are among them.
○ The GST Council revises the items under each slab rate on a regular basis to reflect industry demands and
market trends. The revised structure ensures that essential items are taxed at a lower rate, while luxury goods
and services are taxed at a higher rate.
● GST Rate Slab Exempted (No Tax):
○ This category includes 7% of all goods and services.
○ Fresh fruits and vegetables, milk, buttermilk, curd, natural honey, flour, besan, bread, all kinds of salt, jaggery,
hulled cereal grains, fresh meat, fish, chicken, eggs, bindi, sindoor, kajal, bangles, drawing, and coloring books,

Self Notes
 177

stamps, judicial papers, printed books, newspapers, jute and handloom, hotels and lodges with tariffs below
INR 1000, and so on are examples of these
● 5% GST Rate Slab:
○ This category includes 14% of all goods and services.
○ Some examples include clothing under INR 1000 and footwear under INR 500, packaged food items, cream,
skimmed milk powder, branded paneer, frozen vegetables, coffee, tea, spices, pizza bread, rusk, sabudana,
cashew nut, cashew nut in shell, raisin, ice, fish filet, kerosene, coal, medicine, agarbatti (incense sticks),
postage or revenue stamps, fertilizers, etc.
● 12% GST Slab Rate:
○ Edibles such as frozen meat products, butter, cheese, ghee, packaged dry fruits, animal fat, sausages, fruit
juices, namkeen, ketchup & sauces, ayurvedic medicines, all diagnostic kits and reagents, cellphones, spoons,
forks, tooth powder, umbrella, sewing machine, spectacles, indoor games such as playing cards, chess board,
carrom board, ludo, apparels above INR 1000, This category includes 17% of all goods and services.
● 18% GST Slab Rate:
○ This category includes 43% of all goods and services.
○ Pasta, biscuits, cornflakes, pastries and cakes, preserved vegetables, jams, soups, ice cream, mayonnaise,
mixed condiments and seasonings, mineral water, more than INR 500 footwear, camera, speakers, monitors,
printers, electrical transformer, optical fiber, tissues, sanitary napkins, notebooks, steel products, headgear and
its parts, aluminum foil, bamboo furniture, AC restaurants that serve liquor, restaurants in five-star and luxury
hotels, telecom services.
● 28% GST Rate Slab:
○ This category includes 19% of all goods and services.
○ The remaining edibles, such as chewing gum, bidi, molasses, chocolate that does not contain cocoa, waffles
and wafers coated in chocolate, pan masala, aerated water, personal care items such as deodorants, shaving
creams, aftershave, hair shampoo, dye, sunscreen, paint, water heater, dishwasher, weighing machine,
washing machine, vacuum cleaner, automobiles, motorcycles, 5-star hotel stays, race club betting, private
lottery and movie tickets above INR.
4.4.6 GST Council
● As provided for in Article 279A of the Constitution, the Goods and Services Tax council (the Council) was notified with
effect from 2016.
● It shall make recommendations to the Union and the
States on the following issues:
a) the taxes, cesses and surcharges levied by the
Centre, the States and the local bodies which
may be subsumed under GST;
b) the goods and services that may be subjected
to or exempted from the GST;
c) model GST laws, principles of levy,
apportionment of IGST and the principles that
govern the place of supply;
d) the threshold limit of turnover below which the
goods and services may be exempted from
GST;
e) the rates including floor rates with bands of
GST;
f) any special rate or rates for a specified period
to raise additional resources during any natural
calamity or disaster;
g) special provision with respect to the North- East States, J&K, Himachal Pradesh and Uttarakhand; and
h) any other matter relating to the GST, as the Council may decide.
4.4.6.1 Quorum of GST council
● One half of the total number of Members of the Goods and Services Tax Council shall constitute the quorum at its
meetings.
○ The Goods and Services Tax Council shall determine the procedure in the performance of its functions.
○ Every decision of the Goods and Services Tax Council shall be taken at a meeting, by a majority of not less
than three-fourths of the weighted votes of the members present and voting, in accordance with the following
principles, namely: —
a) the vote of the Central Government shall have a weightage of one-third of the total votes cast, and
b) the votes of all the State Governments taken together shall have a weightage of two-thirds of the
total votes cast, in that meeting.

Self Notes
 178

4.4.7 The Goods and Service Tax Network (GSTN)

● The Goods and Service Tax Network (or GSTN) is a non-profit, non-government organization.
● It manages the entire IT system of the GST portal, which is the mother database for everything GST.
● The government uses this portal to track every financial transaction and provide taxpayers with all services – from
registration to filing taxes and maintaining all tax details.
● Private players own a 51% share in the GSTN, and the government owns the rest.
○ The authorized capital of the GSTN is Rs 10 crore (US$1.6 million), of which 49% of the shares are divided
equally between the Central and State governments, and the remaining is with private banks.
● GSTN is the backbone of the common portal, which is the interface between the taxpayers and the government. The
entire process of GST is online, starting from registration to the filing of returns. It has to support about 3 billion invoices
per month and the subsequent return filing for 65 to 70 lakh taxpayers.
● The GSTN handles:
○ Invoices
○ Various returns
○ Registrations
○ Payments & Refunds
eWay Bill

● A waybill is a receipt or a document issued by a carrier giving details and instructions relating to the shipment of a
consignment of goods and the details include name of consignor, consignee, the point of origin of the consignment,
its destination, and route.
○ E-way bill is an electronic document generated on the GST portal evidencing movement of goods.
● A GST registered person cannot transport goods in a vehicle whose value exceeds Rs. 50,000 (Single
Invoice/bill/delivery challan) without an e-way bill.
○ Alternatively, Eway bill can also be generated or cancelled through SMS, Android App and by site-to-site
integration through API.
● E-way bill is to be generated by the consignor or consignee himself if the transportation is being done in own/hired
conveyance or by railways by air or by Vessel.
○ When an eway bill is generated, a unique Eway Bill Number (EBN) is allocated and is available to the supplier,
recipient, and the transporter.
● The validity of e-way bill depends on the distance to be travelled by the goods. For a distance of less than 100 Km
the e-way bill will be valid for a day from the relevant date.
○ For every 100 Km thereafter, the validity will be additional one day from the relevant date.

4.4.8 Composition Scheme

● Composition scheme has been formulated for small businessmen being suppliers of goods and suppliers of restaurant
services.
○ Under the scheme, person with annual turnover up to Rs. 1.5 crore (Rs. 75 lakhs in States of Arunachal
Pradesh, Manipur, Meghalaya, Mizoram, Nagaland, Sikkim, Tripura and Uttarakhand) needs to pay tax equal
to 1% to 5% on his turnover and needs to file his returns annually with quarterly payment from FY 2019-20.
● Composition scheme has been made available for suppliers of services (to those who are not eligible for the presently
available Composition Scheme) with a tax rate of 6% (3% CGST +3% SGST) having an annual turnover in the preceding
FY up to Rs. 50 lakhs.
○ They would be liable to file one Annual Return with quarterly payment of taxes.

Self Notes
 179

The National Anti-profiteering Authority (NAA

● Any reduction in rate of tax on any supply of goods or services or the benefit of input tax credit should be passed on
to the recipient by way of commensurate reduction in prices.
○ However, it has been the experience of many countries that when GST was introduced there has been a
marked increase in inflation and the prices of commodities.
○ This happened in spite of the availability of the tax credit right from the production stage to the final
consumption stage which should have actually reduced the final prices.
○ This was happening because the suppliers were not passing on the commensurate benefits to the consumer
and thereby indulging in illegal profiteering.
● National Anti-profiteering Authority (NAA) is therefore being constituted by the Central Government to examine
whether additional input tax credits availed by any registered person or the reduction in the tax rate have actually
resulted in a commensurate reduction in prices to the recipients.
○ The National Anti-profiteering Authority (NAA) is the statutory mechanism under GST law to check the
unfair profiteering activities by the registered suppliers under GST law.
○ The Authority’s core function is to ensure that the commensurate benefits of the reduction in GST rates on
goods and services done by the GST Council and of the Input tax credit are passed on to the recipients by
way of commensurate reduction in the prices by the suppliers.

4.4.9 GST Compensation

● According to the GST Tax regime, states won't be able to collect the taxes at the point of production (manufacturing).
○ This was disadvantageous for manufacturing states and led to their vehement opposition to the GST adoption.
● The Concept of Compensation to the states for the loss revenue due to the adoption of GST was first brought up as
a means of addressing the concern of opposing states.
○ Many hesitant states were persuaded to join the GST Tax system by the guarantee of Compensation by Centre.
● With the adoption of the GST Regime, it was expected that there would not be any differences in Revenue for States in
the fiscal year after GST implementation and with the revenue generation prior to the GST adoption.
● However, GST is a destination based tax structure, taxes applied at consumption level (states) rather than at
manufacturing level(states).
● Duration: Under the 101st Amendment Act, the Center agreed to compensate the States for a period of five years,
for any decrease in tax revenue brought on by the adoption of the GST.
○ For the first five years, 2017-2022, states are promised compensation for any income shortfall below a growth
rate of 14% (base year 2015–16).
● States receive GST compensation from the Center every two months through the Compensation Cess:
○ The GST (Compensation to States) Act of 2017 set down the compensation cess.
○ The Compensation Cess is a tax that will be levied until July 1st, 2022, on the provision of certain products,
services, or both.
● All taxpayers are responsible for collecting and paying the GST compensation cess to the federal government, with the
exception of those who export certain listed items and those who have chosen the GST composition plan.
Compensation cess fund:
● A compensation cess fund was created from which states would be paid for any shortfall. An additional cess would be
imposed on certain items and this cess would be used to pay compensation.
● The items are pan masala, cigarettes and tobacco products, aerated water, caffeinated beverages, coal and certain
passenger motor vehicles.
● The GST Act states that the cess collected and “such other amounts as may be recommended by the [GST] Council”
would be credited to the fund.
4.4.10 Input Tax Credit
● Input credit means at the time of paying tax on output, you can reduce the tax you have already paid on inputs.
○ Say, you are a manufacturer – tax payable on output (Final Product) is Rs 450 tax paid on input (Purchases) is
Rs 300. You can claim input credit of Rs 300 and you only need to deposit Rs 150 in taxes.

Self Notes
 180

4.4.11 Benefits of GST

● GST will enable seamless credit across the entire supply
chain and across all states using a single tax base.
● The implementation of a Goods and Services Tax would
eliminate the cascading effects of taxes on the production
and distribution costs of goods and services.
● The elimination of cascading effects, i.e. tax on tax, will
significantly improve the competitiveness of original
goods and services in the market, resulting in a positive
impact on the country's GDP growth.
● Revenue will rise under the GST regime as the dealer
base expands by capturing value addition in the
distributive trade and as compliance improves.
● The GST regime is expected to increase transparency in
the indirect tax framework while also lowering the rate of
inflation.
● Exports will be zero-rated in their entirety under the GST regime, as opposed to the current system, where refunds of
some taxes are not permitted due to the fragmented nature of indirect taxes between the Centre and the States.
● All taxes paid on exported goods or services, or on inputs or input services used in the supply of such export goods or
services, will be refunded.
● By eliminating rate arbitrage between neighboring states as well as that between intra and inter-state sales, uniform GST
rates will reduce the incentive for evasion. Harmonization of laws, procedures and tax rates will make compliance easier
and more straightforward.
● Common procedures for taxpayer registration, tax refunds, uniform tax return formats, a common tax base, a common
system of classification of goods or services, and timelines for each activity will provide greater certainty to the taxation
system.
● GST is heavily reliant on technology. The common portal will serve as the taxpayer's interface with the tax authorities
(GSTN). Various processes, such as registration, returns, refunds, tax payments, and so on, will be simplified and
automated.
4.4.12 GST: Challenges
● Input credit for SCGT and CGST cannot be combined.
● Manufacturing states are losing money on a larger scale.
● High tax rate to compensate for revenue collected from multiple taxes now, i.e. High Revenue Neutral Rate
● The states' fiscal autonomy is being eroded.
● Concerns are expressed by banks and insurance companies about the requirement for multiple GST registrations.
● The imposition of an additional cess.
● The ability of state tax authorities, who have traditionally taxed goods rather than services, to deal with the latter is an
unknown quantity.
● GST's success is dependent on the political agreement, technology, and the ability of tax officials to adapt to new
requirements.
4.4.13 Performance of GST in last 5 years
4.4.13.1 Achievements of GST
● Revenue Collection: Five years later, the tax regime is said to have
played a vital part in defining India's economic structure and empowering
enterprises by combining 17 taxes and 13 cesses into a 'one nation, one
tax' framework.
○ The Centre's GST revenue collection is substantially higher today
than it was originally. The gross GST collection in June was Rs
1.44 lakh crore, the second highest after April, when it was almost
Rs 1.68 lakh crore.

Self Notes
 181

○ This is the fifth time that monthly GST revenues have exceeded Rs 1.40 lakh crore since its introduction, and
the fourth month in a row since March 2022.
● Avoiding Tax Cascading: It absorbed 17 local levies such as excise duty, service
tax, and VAT, as well as 13 cesses. In the pre-GST era, the total of VAT, excise,
CST, and their cascading impact resulted in 31 percent of tax payable by a
customer.
○ With continuous adjustments to the different tax rate levels, the effective
GST rate has fallen to 11.6 percent in 2019 from 14.4 percent when it
was first implemented.
● Ease of Doing Business: The government has been proactive in providing
circulars and explanations to answer misconceptions about GST taxes and
enhance ease of doing business.
○ The GST Council voted to facilitate compliance for small taxpayers who
supply through the e-commerce platform during its 47th meeting in
Chandigarh.
■ Such vendors, who exclusively make intra-state supplies, are
exempt from GST registration.
■ If their yearly sales are less than Rs 40 lakh for products and Rs
20 lakh for supplies.
● The Centre-state relationship
○ In order to work out the mechanisms for efficient operation under this
system, the Center and the States meet in the GST Council.
■ With the exception of one decision, GST council decisions have been
made unanimously. This demonstrates an improvement in India's
cooperative federalism
○ States were guaranteed compensation when the GST was implemented from
the cess fund for five years if their GST income didn't increase at a compounded
rate of 14%. This loss was supposed to be covered by an extra tax
(compensation cess) on sin and luxury goods.
■ However, the economic downturn brought on by the Covid-19 epidemic
resulted in a deficit in cess collection in FY20, which grew even more
so in FY21.
○ According to a recent analysis by SBI Research, the GST compensation for
some states as a proportion of state tax collection is greater than 20%.
■ However, given the poor financial standing of many states, many of
them are providing freebies like farm loan waivers, reinstating old
pension systems, etc.
● Improving Compliance: The GST Network (GSTN) serves as the indirect tax regime's
technical backbone. It has been employing artificial intelligence and machine learning to
provide updated data and address income leaks.
○ The GST-to-GDP ratio increased from 5.8 percent in 2020-21 to 6.4 percent
in 2021-22, demonstrating improved compliance.
4.4.13.2 Challenges associated with GST
● Multiple Tax Rates: India has multiple tax rates, in contrast to many other economies that have adopted this tax system.
○ The implementation of a single indirect tax rate on all commodities and services in the nation is hampered as
a result.
○ The majority of the products come within the 18% high tax category. As it affects
the most underprivileged members of society, this has a regressive effect.
● Revenue Collections and Inflation: According to some economists, the present increase
in GST revenue is the result of high inflation.
○ The growth rate of GST revenues in real terms (adjusted for inflation) is
substantially lower; for example, in March 2022, the nominal growth rate of GST
collections was 14.7%, while the actual growth rate was just 3.7%. (adjusted for
inflation).
● Taxpayers face considerable challenges as a result of the excessive and unjustified
show cause notices that are issued in connection with registration approvals, financial
number reconciliations, and other activities.

Self Notes
 182

● Lack of Coverage: Because petrol, diesel, and Aviation Turbine Fuel (ATF) are exempt from the GST, a sizable portion
of the economy is still unaffected by the indirect tax system.
● Compensation to States: The GST (Compensation to States) Act provided full
compensation to states for the first five years of the GST if their revenues fell below
14 percent annual growth following the introduction of the GST.
○ Many states have become reliant on compensation. Since the provision is
about to expire, many states are requesting an extension. The Union
Government, on the other hand, looks hesitant.
○ Furthermore, as the economy began to weaken in 2019-20, the Union
Government postponed GST payments to the states. It was finally paid in
May 2022, following a lengthy wait.

5. Tax Reforms
● India formed the Tax Reforms Committee in 1991 to lay out a roadmap for the
reform of direct and indirect taxes as a part of the structural reform process.
● This was done to introduce the best approach of broadening the base, lowering
marginal tax rates, reducing rate differentiation, simplifying the tax structure, etc.
5.1 What is Tax Reform?
● Taxation is an important exercise for the economic and social development of the country. It provides the resources to
use goods and services to the people.
● Various tax reform committees were constituted in India in 1971, 1977, but they suggested ad-hoc measures focused
on the impending crisis.
● The Tax Reforms Committee of 1991 suggested a reduction in the rates of all major taxes, i.e., customs, individual, and
corporate income and excise taxes to reasonable levels, maintaining progressivity but not such to induce evasion,
broadening the base of all the taxes by minimizing exemptions and concessions, drastic simplification of laws and
procedures, etc.
5.1.1 Issues With India’s Taxation System
● Retrospective taxation has impacted the inflow of foreign capital to India.
● An unstable policy environment pertaining to tariffs and taxes needs to be resolved to boost business and investment
ties.
● The complex web of taxation laws of the Central and many State Governments cause complexities and litigation.
● Increased threshold provided in case of personal income taxes and exemptions, tax cuts, preferential tax rates, deferral
of tax liabilities etc. lead to a lower tax base.
● Tax evasion and corruption undermine the governance practices by the state.
● Weakness of tax administration such as lack of technical expertise and financial resources, poorly drafted laws and
corruption.
● Structural issues such as low financial literacy, a large share of the informal economy and a large number of cash
based transactions.
5.2 Direct Tax Reforms
● Direct tax is a progressive tax as the proportion of tax liability rises as an individual or entity's income increases.
○ Examples of direct taxes are income tax, corporate tax, dividend distribution tax, securities transaction tax,
fringe benefits tax and wealth tax.
● Various committees such as Arbind Modi Committee on Income Tax Reforms and Akhilesh Ranjan Panel on
formulating a new Direct Tax Code (DTC), aims to revise, consolidate and simplify the structure of direct tax laws (like
Income-tax Act, 1961; Wealth Tax Act, 1957) in India into a single legislation
5.2.1 Need for Direct Tax Reforms
● Rationalization of income tax structure as the tax rate structure – slabs of 10%, 20% & 30% in personal income tax -
has mostly remained the same in the last 20 years
● The urgency to simplify the corporate tax structure, for example in 2014-15, small companies having a profit of up to ₹1
cr paid an average tax rate of 29.37% while companies having a profit of greater than ₹500 cr paid an average tax rate
of only 22.88%.
● Widen the tax base and prevent potential revenue loss due to lower tax rates and simplified tax structure.
● Maintain the balance between direct and indirect taxes, for instance, the contribution of direct taxes has declined from
60% in 2010-11 to 52% in 2017-18.
5.2.2 Measures Taken By The Government
● Various initiatives were launched to increase tax compliance such as the E- Sahyog portal to facilitate online filing of the
returns; extension of Indian Customs Single Window Interface for Facilitating Trade (SWIFT), etc.
Self Notes
 183

● Simplification of tax laws such as specific class of persons exempted from the anti-abuse provisions of Section 50CA
and Section 56 of the Income Tax Act.
● Providing relief for startups with Capital gains exemptions from the sale of residential houses for investment in start-ups
extended till FY21, resolving angel tax issues, etc.
● Providing various anti-tax avoidance measures such as Advanced Pricing Agreements (APAs), GAAR (General Anti-
Avoidance Rules), etc.
5.2.3 Direct Tax Code (DTC)
● It was envisioned to consolidate all direct tax laws of the central government and make the tax system more efficient
and resilient. DTC intends to bring horizontal equity among different classes of taxpayers in line with best international
practices.
● It will help to phase out the multiplicity of tax exemptions and deductions in order to widen and deepen the tax base.
Such tax reforms will increase compliance, therefore simpler taxes lead to a stable and robust taxation system.
5.2.4 Proposal for Direct Tax Code (DTC)
● The government adopted the proposed increased tax slabs in the financial year 2012 – 2013.
● Corporate Income Tax should be 30% with no surcharge on corporate tax.
● The Minimum Alternate Tax (MAT) rate should be 20% from the earlier tax rate of 18.5%.
● Few schemes like PF, Gratuity, pension funds, etc would still come under EEE.
5.2.5 Vivad Se Vishwas Scheme
● This scheme was enacted with the goal to reduce pending income tax litigation, generating timely revenue for the
government and benefiting taxpayers.
● The individuals/companies that opt for the scheme are required to pay a requisite tax following which all litigation against
them are closed by the tax department and penal proceedings are also dropped.
5.2.6 Faceless Tax Assessment Scheme
● A taxpayer or an assessee is not required to visit an I-T department office or meet a department official for income tax-
related businesses.
● It was launched in 2019 to promote an efficient and effective tax administration, minimizing physical interface, increasing
accountability and introducing team-based assessments.
5.2.7 Retrospective Taxation
● A retroactive tax applies to a transaction that occurred before the law was enacted.
● It might be a new or increased charge on previous transactions.
● Countries utilise this type of taxation to correct any flaws in their taxation policy.
● Retrospective taxation affects businesses that have exploited the tax regulations unfairly, either mistakenly or
deliberately.
● Reasons for retrospective taxation amendments
○ Many times, retrospective amendments are made to overturn judicial rulings that were contrary to legislative
purpose or to correct legal problems.
○ Sometimes it is just to aid taxpayers in real circumstances and alleviate unnecessary stress or difficulty.
● India’s retrospective tax law of 2012
○ In 2012, the retrospective tax provision was added to the Income Tax Act of 1961.
○ It enabled the government to tax corporations on mergers and acquisitions (M&As) completed before 2012.
■ In essence, it sought to bring prior indirect transfers of Indian assets into the purview of taxes.
■ As a result, the regulation was utilized to levy significant tax demands on foreign investors such as
Vodafone and Cairn Energy.
○ As a result, it was criticized for undermining India's investment climate.
● Major dispute over Retrospective Taxation
○ Vodafone Case
■ For $11 billion, UK-based telecom giant Vodafone acquired a 67 percent share in Hutchison
Whampoa, a company with operations in Hong Kong.
■ The Indian government demanded a capital gain of Rs 7,990 crore in relation to this deal.
■ It said that before paying Hutchison, the company ought to have taken the tax out at the source.
■ The company appealed the case to the Supreme Court.
■ According to the Court's ruling, Vodafone could not be taxed retrospectively.
■ The legislation governing retrospective taxes was developed to get around the legal obstacle.
■ With this, Vodafone India received a tax notice for Rs 3,100 crore from the I-T department.
● Proposed Amendment Bill
○ The tax laws that were adopted in 2012 are repealed by the Taxation Laws (Amendment) Bill.
■ Any tax demands made on transactions that occurred before to May 2012 will be dismissed in
accordance with the proposed amendments.
Self Notes
 184

■ And any taxes that have already been paid out must be reimbursed, although without interest.
■ The concerned taxpayers would have to withdraw all active legal actions against the government in
order to qualify.
○ Additionally, they should pledge not to assert any claims for expenses or damages.
5.3 Indirect Tax Framework
● Indirect taxes are consumption-based taxes that are applied to goods or services when they are bought and sold.
● The government receives indirect tax payments from the seller of the good/service, the seller, in turn, passes the tax on
to the end-user i.e. buyer of the good/service.
○ Examples of indirect taxes are goods and services tax, customs duty, excise duty, sales tax, etc.
5.3.1 Goods and Services Tax (GST)
● This indirect tax system was introduced to collect and reduce tax evasion, is easy to understand for the customer and
will reduce the tax burden for industry, it ensures that there is no cascading effect of the tax and there is the harmonization
of tax laws, procedures, and rates of tax.
● GST is applicable to the supply of goods or services as compared to the manufacture of goods or on sale of goods or
on the provision of services.
5.3.2 Recent Measures by The Government
● Taxation Laws (Amendment) Ordinance 2019 provided a concessional tax regime of 22% for all existing domestic
companies from FY 2019-20 if they do not avail any specified exemption or incentive.
● Taxation Laws (Amendment) Ordinance 2019 has led to a reduction of the tax rate to 15% for new manufacturing
domestic companies if such company does not avail any specified exemption or incentive
● The rate of MAT has also been reduced from 18.5% to 15%
● The Finance Act, 2020 removed the Dividend Distribution Tax (DDT) under which the companies are not required to pay
DDT.

6. International Taxation
6.1 Tax Haven
● Tax havens, often known as offshore financial hubs, are nations or areas with low or no corporation taxes that allow
foreigners to readily operate businesses.
○ Tax havens often limit public disclosure about businesses and their owners.
○ Tax havens are sometimes known as secrecy jurisdictions since information might be difficult to get.
● Tax havens are small countries with populations of less than one million people that are typically more prosperous than
other countries.
○ Furthermore, tax havens do very well on cross-country governance quality indicators including such voice and
accountability, political stability, government effectiveness, rule of law, and corruption control.
● There are almost no tax havens that are poorly governed.
○ Poorly managed countries, of which there are many in the globe, almost never become tax havens.
○ Better-governed countries are more likely than others to become tax havens because the potential returns
are greater: higher foreign investment flows, and the economic benefits that accompany them, are more likely
to accompany tax cuts in well-governed countries than tax cuts in poorly-governed countries.
● Tax havens may be found all over the world. Some are sovereign states, such as Panama, the Netherlands, and Malta.
Others are either inside nations, such as the United States' state of Delaware, or are territories, such as the Cayman
Islands.
● The Panama Papers, for example, revealed how Mossack Fonseca, one of the world's largest offshore legal firms, sold
thousands of shell corporations in the British Virgin Islands to customers all over the world.
● The Mauritius Leaks investigation looked at how firms exploited Mauritius to avoid paying taxes, whereas the Paradise
Papers exposed the secrets of Bermuda, the island where the legal company Appleby was formed.
● Under international criticism, some tax havens, such as Niue and Vanuatu, have cleaned up their act, while others, such
as Dubai, are emerging as new centres of illegal money.
6.2 Transfer pricing
● Transfer pricing is a method used by multinational organisations to move profits out of the countries in which they operate
and into tax havens by selling goods and services at an artificially high price.
● The multinational corporation "moves" its profits out of the country where it genuinely does business and into a tax
haven by using its subsidiary in a tax haven to charge an inflated cost from its subsidiary in another country.
● Assume a multinational corporation pays 100 Rs to produce a crate of bananas in India.
○ It subsequently sells the crate for 100 Rs to an associate in a tax haven, leaving no earnings in India. The tax
haven affiliate promptly sells the crate to a British affiliate for 300 Rs, leaving a profit of 200 Rs in the tax haven.
○ That British affiliate sells the crate to a grocer for the true market price of 300 Rs, leaving no gains in the UK.
Self Notes
 185

○ As a result, the multinational pays no taxes in India and no taxes in the United Kingdom, and the 200 Rs in
earnings transferred to the tax haven are not taxed.
● In this way, multinational corporations avoid their responsibility to pay tax and fail to contribute to the societies in which
they operate.
6.3 Base erosion and profit shifting (BEPS)
● Base erosion and profit shifting (BEPS) are tax planning strategies used by multinational corporations to exploit loopholes
and differences in tax legislation between nations.
○ This is done to divert earnings to low or no-tax jurisdictions with little or no economic activity.
● BEPS causes tax to be avoided in the jurisdiction where economic activity happens, weakening governments'
revenue bases and compromising the fairness and integrity of their tax systems.
○ Businesses that operate across borders may utilize BEPS techniques to acquire a competitive edge over
domestic competitors.
○ Furthermore, when taxpayers observe multinational corporations legitimately evading income tax, it undermines
voluntary compliance by all taxpayers.
● BEPS practices cost countries 100-240 billion USD in lost revenue annually, which is the equivalent to 4-10% of the
global corporate income tax revenue.
6.3.1 OECD-BEPS
● The Base Erosion and Profit Shifting (BEPS) initiative of the Organization for Economic Cooperation and
Development (OECD) aims to close loopholes in international taxation for businesses that allegedly engage in tax
invasions (moving operations) or intangible asset migration to lower tax jurisdictions in order to avoid paying taxes or
reduce their tax burden in their home country.
● The OECD has released 15 Action Items to address the key issues they believe firms have been using to most
aggressively shift profits, including the digital economy, treaty abuse, transfer pricing paperwork, and more.
○ Transforming transfer pricing documentation is a key goal of BEPS Action Item 13, which will compel
multinational firms to re-evaluate how they submit transfer pricing information to local tax authorities as well as
globally with country-by-country reporting.

7. International Taxation Measures

7.1 Advance Pricing Agreement (APA)
● An APA is an agreement between a taxpayer and a tax authority that establishes the transfer pricing mechanism for
pricing the taxpayer's overseas transactions in future years.
● An APA can be unilateral, bilateral, or multilateral.
○ Unilateral APA: an APA that involves only the taxpayer and the tax authority of the country where the taxpayer
is located.
○ Bilateral APA (BAPA): an APA that involves the taxpayer, associated enterprise (AE) of the taxpayer in the
foreign country, tax authority of the country where the taxpayer is located, and the foreign tax authority.
○ Multilateral APA (MAPA): an APA that involves the taxpayer, two or more AEs of the tax payer in different
foreign countries, tax authority of the country where the taxpayer is located, and the tax authorities of AEs.
● The concept of Advance Pricing Agreement (APA) was been introduced in India in 2012
○ The Central Board of Direct Taxes is managing authority.
○ Given the numerous transfer pricing cases in dispute, introduction of APAs is expected to considerably alleviate
the uncertainty regarding arm’s length pricing of international transactions.
7.2 General Anti-Avoidance Rules (GAAR)
● The implementation of General Anti-Avoidance Rules (GAAR) represents a watershed moment in India's tax policy and
legislation.
○ GAAR went into force in India on April 1, 2017.
● General Anti Avoidance Rules (GAAR) include a set of rules used
by the revenue authorities of a country against aggressive tax
planning for the objective of tax avoidance. In simpler words, it is
the anti-tax avoidance law of India.
7.2.1 Provisions of General Anti Avoidance Rules
● It prevents tax evasion by using the arrangement of international
tax treaties and laws.
● When a sound business is absent for a transaction, the
government can suspend the tax benefits and can reclassify the
profits generated.

Self Notes
 186

● To ensure that only the resident companies take advantage it is required that specific investments and employment
requirements should be undertaken.
● GAAR was introduced in the Budget session of Parliament in 2012, however was proposed in the Direct Tax Code 2009.
● Its implementation was recommended to be postponed for three years till 2016-17 by the Parthasarathi Shome panel.

Tax evasion
● Illegality, wilful suppression of facts, misrepresentation and fraud—all constitute tax evasion, which is prohibited under
law.

Tax avoidance
● Tax avoidance includes actions taken by a taxpayer, none of which are illegal or forbidden by the law.
● However, although these are not prohibited by the law, they are considered undesirable and inequitable, since they
undermine the objective of effective collection of revenue.

Tax mitigation
● Tax mitigation is a ‘positive’ term in the context of a situation where taxpayers take advantage of a fiscal incentive
provided to them by a tax legislation by complying with its conditions and taking cognisance of the economic
consequences of their actions. Tax mitigation is permitted under the Act.

7.2.2 Why GAAR?

● To varying degrees, many countries have particular anti-tax avoidance legislation. Since 1981, Australia has had one.
● After Vodafone's deal with Hutchison-Essar, the GAAR was implemented in India. This transaction occurred in the
Cayman Islands.
● According to the government, nearly USD 2 billion in taxes was lost.
● The Supreme Court found in Vodafone's favor in the ensuing lawsuit.
7.2.3 Importance of GAAR
● Loss of revenue to the government by exploitation of loopholes by business corporations, therefore GAAR would help
incentivize real investments and allow the government to raise more revenue.
● Help in increased generation of revenue from entities earlier not paying taxes.
● An increase in tax revenue would help in the better implementation of welfare schemes and reduce the fiscal deficit.
● It provides competitive benefits to businesses doing genuine business as compared to those exploiting loopholes.
● It would provide ease of doing business and project India as a serious country promoting free and fair trade practices.
7.2.4 Benefits of GAAR
● By highlighting tax avoidance instances would help increase government revenues.
● An increase in tax revenues would help to decrease the fiscal deficit of the country.
● It will help improve the business environment by providing a competitive advantage to those businesses that have been
doing honest transactions and are not resorting to tax evasion.
● This would help encourage increased international investments as it will promote free and fair trade practices.
7.2.5 Limitations of GAAR
● Due to the high subjectivity of rules, GAAR rules could be implemented arbitrarily.
● Several layers of permission are required before GAAR rules can be implemented.
● These rules can result in increased harassment of people by tax officials.
● It provides discretion and authority to the tax administration which can be misused.

Q. Which one of the following situations best reflects “Indirect Transfers” often talked about in the media recently with reference
to India? (2022)

(a) An Indian company investing in a foreign enterprise and paying taxes to the foreign country on the profits arising out
of its investment
(b) A foreign company investing in India and paying taxes to the country of its base on the profits arising out of its
investment
(c) An Indian company purchases tangible assets in a foreign country and sells such assets after their value increases
and transfers the proceeds to India
(d) A foreign company transfers shares and such shares derive their substantial value from assets located in India

Answer: d

Self Notes
 187

7.3 The Double Taxation Avoidance Agreement (DTAA)

● The Double Taxation Avoidance Agreement (DTAA) is a bilateral agreement between two nations. The primary goal is
to encourage and promote economic trade and investment between two countries by eliminating double taxation.
○ This provision allows people to save money by paying taxes in only one nation. Many nations can benefit from
comprehensive DTAAs.
○ The tax structure of a nation is typically determined by the sort of work or business that a citizen has in that
country. Salary, services, capital gains, fixed deposit earnings, property, investment, and so on are examples
of popular categories.
○ This DTAA was developed as a result of global disparities in tax collecting.
■ For example, someone who wants to start a business in another nation must pay double taxes. He or
she must pay taxes in both his or her home country and the nation where he or she earns a living.
○ This can be taxing on a new entrepreneur's finances and savings.
● India has signed DTAAs with 85 other countries to avoid levying taxes twice on the same income.
○ There are regional variations in the DTAA rate chart and associated regulations. This factor often depends on
the agreement that the two nations have signed.
○ The TDS rates that apply in this case to interest profits might range from 10% to 15%. The charge rate might
be as high as 15%.
7.4 Equalization Levy (EL)
● A tax known as the Equalization Levy (EL) is imposed on money received by non-residents in exchange for certain
services.
○ Online advertising, the supply of digital space for online advertising, or any other service for the purpose
of online advertising are all considered Specified Services.
● The Finance Act of 2016 imposes the Equalization Levy, not the Indian Income Tax Act of 1961. In order to tax digital
transactions, the government implemented the Equalization Levy via the Finance Bill of 2016.
○ According to Section 165 of the Finance Act of 2016, anybody who is a resident of India or a non-resident who
has a permanent establishment there must deduct EL at a rate of 6% from the consideration they give a non-
resident for certain services.
7.5 Global Minimum Corporate Tax (GMCT)
● Global Minimum Corporate Tax (GMCT) is a direct tax imposed on the net income or profit that enterprises make from
their businesses. It came into being so as to prevent multinational enterprises from shifting profits and tax revenues to
low-tax jurisdictions.
● Global Minimum Corporate Tax (GMCT) was introduced to reform the international tax scenario to prevent cross
border tension and trade wars. In this system of taxation, countries would be taxed not only where they are
headquartered but also where they operate.
● The Organisation for Economic Cooperation and Development (OECD) announced in October 2021 that 136 countries
(including India) had agreed to a global pact to ensure that large corporations pay a 15% Global Minimum Tax (GMT).
● Even the G7 Finance Ministers have called for a global minimum corporation tax rate of a minimum of 15%.
● Those countries where big enterprises operate would get the right to tax at least 20% of profits exceeding a 10% margin
which would apply to the largest and most profitable multinational enterprises.

8. Some important terms related to taxation

8.1 Tax Expenditure
● Tax Expenditure does not refer to the government's expenditures associated with tax collecting.
● Rather, it refers to the opportunity cost of taxing at reduced rates, or the expense of offering taxpayers exemptions,
deductions, rebates, deferrals credits, and so on.
● Tax expenditures show how much more money the government could have received if such policies had not been
implemented. In other words, it can be understood as revenue foregone.
○ For instance, under the income tax act, every taxpayer can obtain a rebate of Rs. 12500 which is the tax
expenditure for the government.
8.2 Countervailing Duty [CVD]
● Countervailing Duty [CVD], often known as anti-subsidy duties, are trade import levies imposed to offset the negative
impacts of subsidies.
● This tariff is imposed under the World Trade Organization when a government determines that the importing country
is subsidizing the items and damaging domestic providers. To counteract this problem, the government may levy extra
tariffs under WTO regulations.

Self Notes
 188

8.3 Anti-Dumping Duty

● An anti-dumping duty is a protectionist tariff imposed by a domestic government on foreign goods that it considers are
underpriced.
○ Dumping is the procedure by which a business exports a product at a considerably lower price than it ordinarily
charges in its native (or domestic) market.
● Many nations place taxes on items they feel are being dumped in their domestic market in order to defend their separate
economies; this is done on the grounds that these products have the potential to undermine local enterprises and the
local economy.
○ While anti-dumping charges are intended to safeguard domestic employment, they can also result in higher
pricing for local consumers.
○ Anti-dumping duties can restrict the international rivalry of domestic enterprises manufacturing identical items
in the long run.
8.4 Shell Company
● Shell corporations or Shell companies are entities that do not have active business operations but are formed to achieve
specific business goals such as reducing tax liabilities, shielding an entity from legal risks, raising capital, and, in some
cases, illegal purposes such as money laundering, trying to conceal beneficial ownership from law enforcement, or
circumventing sanctions.
8.5 Inverted tax structure
● Inverted tax structure simply means that the tax rate on inputs is greater than the tax rate on outputs for sale. The
condition may not be common in all sectors. The article sheds information on the notion and the associated compliance.
● For example, on leather footwear, on footwear worth less than Rs 1,000, GST is charged at 5% and over that value, the
tax is 18%.
○ However, the GST on inputs for these footwear ranges up to 18%.
8.6 Tax Buoyancy
● Tax buoyancy highlights the relationship between the change in the government’s tax revenue growth and the changes
in GDP.
● When a tax is buoyant, it shows an increase in its revenue rate without increasing the tax rate.
● Tax buoyancy is influenced by the size of the tax base, ease of the tax administration, reasonableness and simplicity of
the tax rates etc.
● Tax buoyancy generally depends on :
○ The size of the tax base
○ The friendliness and ease of the tax administration
○ Reasonable and simplified tax rates
8.7 Tax avoidance
● Tax avoidance refers to avoiding taxes by properly following the rules.
● Tax evasion, however, refers to avoiding paying taxes by deception and
dishonest methods.
● One can take advantage of the provisions' loopholes if they want to avoid
paying taxes, however evading taxes requires engaging in illegal activity
and having ulterior motives.
● Tax Avoidance is a method of tax planning carried out in advance of the
occurrence of tax liabilities, whereas Tax Evasion is blatant deception
carried out after the occurrence of the tax liabilities.
8.8 Tax evasion
● Tax evasion is the use of fraudulent practices such as under-reporting
taxable income or inflating expenses to reduce one's tax liability.
● It's an illegal attempt to lower one's tax bill.
● The goal of tax evasion is to display fewer profits in order to avoid paying
taxes.
8.8.1 Tax Evasion – Causes
● Taxes are High: When the tax rates are high compared to the respective incomes, people tend to evade taxes.
● Tax authorities that are inefficient: When tax authorities are not vigilant, people will evade taxes as they can manage
and give excuses to tax authorities.

Self Notes
 189

● Law enforcement is ineffective: When law enforcement is not strict, people will evade taxes as there are no
consequences of evading taxes.
● Multiple taxes: Multiple taxes and taxes at different levels on the same activity encourage under-reporting of taxable
income or activity.
8.8.2 Impact on Economy
● Less Tax for the Government: The Indian government has failed to collect the estimated amount of tax from the people
of our country on numerous occasions, and credit must be given to the black money-fuelled underground economy for
this.
● Uncontrollable Inflation: When black money circulates in the market, the amount of money in circulation exceeds the
government's expectations, leading commodity prices to rise above normal levels.
● The emergence of the underground economy has had a significant impact on the distribution of wealth and income in
our society.
● Corruption: While corruption contributes to the creation of black money in the economy, it can also be a result of the
emergence of an underground market.
● Inflated Real Estate: People involved in the black money business are usually willing to pay more for a piece of land
since it helps them transform their coloured money into lawful currency.
● Transfer of Indian Funds to Abroad: India's black money is stashed in tax havens around the world. Two of the most
common tactics used by black money holders to transfer money overseas are under-invoicing of exports and over-
invoicing of imports.
8.8.3 Ways to reduce Tax Evasion
● Reducing tax rates.
● Make more simplified laws and simplified system.
● Design a well-organized tax administration structure.
● Strengthen anti-corruption policies.
● Increase awareness among taxpayers by conducting seminars, conferences and through the media.
● Design a permanent tax structure.
● Ensure the political changes do not affect well defined tax structure. Make tax administration more independent and
autonomous without losing final control of the Government.
● Audit, tax collection, depositing and filing provisions to be more strengthened and updated.
● Make penalty provisions stronger and avoid its non-implementation.
● Encourage taxpayers to pay tax by more friendly schemes.
● Give relief provisions to huge tax payers.
8.9 Pigovian tax
● Pigouvian tax is imposed on economic activities that generate negative externalities, which create costs that are borne
by unrelated third parties. The costs generated from negative externalities are not reflected in the final cost of a product
or service. Clean Energy cess on coal is an example of a Pigouvian tax in India.
8.9.1 Examples of Pigouvian Tax
● In India, coal cess or clean environment cess can be regarded as an example of Pigouvian tax.
● It is levied by France as a noise tax on airplanes at its nine busiest airports. It ranges from 2 euros to 35 euros depending
on the airport.
● A carbon tax is imposed by more than 40 countries on corporations that burn coal, oil, or gas and which produce
greenhouse gas emissions.
● The Netherlands imposed a groundwater tax on drinking water companies in order to preserve clean drinking water for
future generations.
● In Europe, a tax on plastic and paper bags was imposed to encourage consumers to bring their own reusable bags from
home to deter the use of plastic and paper.
8.9.2 Benefits of Pigouvian Tax
● By incorporating additional costs associated with negative externalities it increases market efficiency.
● It prevents the promotion of harmful activities that increase the instances of negative externalities such as the introduction
of a carbon tax may place a significant burden on a company that produces substantial emission gases.
● It helps in the generation of additional revenue for the government which can help promote initiatives that will further
challenge negative externalities.
● These benefits are due to the leftward shifting of the supply curve which results in reduced consumption of the goods
along with a higher price due to taxation.

Self Notes
 190

Q. The sales tax you pay while purchasing a toothpaste is a (2014)

(a) tax imposed by the Central Government
(b) tax imposed by the Central Government but collected by the State Government
(c) tax imposed by the State Government but collected by the Central Government
(d) tax imposed and collected by the State Government

Answer: (d)

Q. What is/are the most likely advantages of implementing ‘Goods and Services Tax (GST)’? [2017]
1. It will replace multiple taxes collected by multiple authorities and will thus create a single market in India.
2. It will drastically reduce the ‘Current Account Deficit’ of India and will enable it to increase its foreign exchange
reserves.
3. It will enormously increase the growth and size of the economy of India and will enable it to overtake China in the near
future.
Select the correct answer using the code given below:
(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

Answer: (a)

Q. Which one of the following effects of the creation of black money in India has been the main cause of worry to the
Government of India? (2021)
(a) Diversion of resources to the purchase of real estate and investment in luxury housing
(b) Investment in unproductive activities and purchase of precious stones, jewellery, gold etc.
(c) Large donations to political parties and growth of regionalism
(d) Loss of revenue to the State Exchequer due to tax evasion

Answer: (d)

Self Notes
 191

FISCAL POLICY, DEFICIT, FISCAL REFORMS

1. Public Finance 192

1.1 Scope of Public Finance/Fiscal Economics 192
2. Fiscal Policy 192
2.1 What is Fiscal Policy? 192
2.2 Objectives of Fiscal Policy 193
2.3 Types of Fiscal Policy 193
2.4 Effects of Fiscal Policy 195
2.5 Difference between Fiscal Policy and Monetary Policy 196
3. Fiscal Policy in India 196
3.1 Ministry of Finance 196
3.2 Fiscal Reforms 199

Self Notes
 192

1. Public Finance
● The term ‘Fiscal Economics’ is a new one; the old and popular term of the subject is ‘Public Finance’.
○ The subject of Public Finance is related to the financing of State activities and it discusses the financial
operations of the Government treasury.
○ The term fiscal is derived from the Greek word which means basket and symbolizes the public purse.
○ Hence the subject ‘Public Finance’ has been newly termed ‘Fiscal Economics’.
● Public finance is the study of the financial activities of governments and public authorities.
○ It describes and analyses the expenditures of governments and the techniques used by governments to
finance these expenditures.
○ Its analysis helps to understand why certain services have come to be supplied by the government, and why
governments have come to rely on particular types of taxes.
○ There is both a normative and a positive side to fiscal policy.
● It aims at using its three major instruments – taxes, spending and borrowing – as balancing factors in the development
of the economy.
1.1 Scope of Public Finance/Fiscal Economics
● In Modern times, the subject ‘Public Finance’ includes five major subdivisions —
○ Public Revenue,
○ Public Expenditure,
○ Public Debt,
○ Financial Administration and
○ Fiscal Policy
1.1.1 Public Revenue
● Public revenue deals with the methods of raising public revenue such as tax and non-tax, the principles of taxation, rates
of taxation, impact, incidence and shifting of taxes and their effects.
1.1.2 Public Expenditure
● This part studies the fundamental principles that govern Government expenditure, effects of public expenditure and
control of public expenditure.
1.1.3 Public Debt
● Public debt deals with the methods of raising loans from internal and external sources. The burden, effects and
redemption of public debt fall under this head.
1.1.4 Financial Administration
● This part deals with the study of the different aspects of the public budget.
● The budget is the Annual master financial plan of the Government.
● The various objectives and steps in preparing a public budget, passing or sanctioning, allocation evaluation and auditing
fall within financial administration.
1.1.5 Fiscal Policy
● Taxes, subsidies, public debt and public expenditure are the instruments of fiscal policy.

2. Fiscal Policy
2.1 What is Fiscal Policy?
● Policymakers always have certain goals in mind while framing policies. In the sphere of economics, these goals could
be (i) economic stability, (iii) acceleration in economic growth, (iii) increase in employment, (iv) reduction of poverty, and
(v) better quality of life for people.
● Two prominent tools at the disposal of policymakers to achieve these goals are
○ fiscal policy, and
○ monetary policy.
● Fiscal policy refers to the use of public spending (i.e., government expenditure) and taxation to influence
macroeconomic variables such as aggregate output and employment in an economy.
○ Monetary policy refers primarily to the use of interest rate to influence macroeconomic variables.
○ Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty.
● In the aftermath of the Great Depression (1929-34), Keynes prescribed that the government should play an active role
in the economy.

Self Notes
 193

○ About a decade back, during the global financial crisis

of 2008-09, most countries resorted to fiscal stimulus
packages to accelerate the growth rate of the economy.
○ Further, during the Covid-19 pandemic of 2020-21
fiscal policy played an important role. In India, for
example, when there were phases of lock-down in most
states due to the pandemic, the governments at the
centre and the states came up with several fiscal
measures to protect the life and livelihood of people.
● Governments have always tried to maintain public expenditure at
a high level. In this pursuit, government revenue has fallen short
of government expenditure.
○ Thus there has been a deficit budget of the government in most cases. Such a deficit is funded usually by
borrowing, which leads to public debt.
2.2 Objectives of Fiscal Policy
● Formulation of fiscal policy presumes the identification and clear recognition of the institutional aspects of
government finance, such as tax system, their incidence and shifting, budget formulation and execution and financial
management.
● The focus of budgeting is on the attainment of efficiency in the allocation of resources within the public sector and is
influenced at each stage by the goals of fiscal policy.
● The changes in government income or expenditure have been designed to affect the level of activity in the economy
as a whole.
○ An understanding of fiscal policy is essential for gaining proper perspectives on the different aspects of
budgeting.
● In recent years the importance of fiscal policy has increased due to economic fluctuations. Fiscal policy is an important
instrument in modern time.
● The budgetary fiscal policy can play a key role in the process of economic development by
○ Mobilizing additional resources
○ maintaining economic stability,
○ allocating resources into socially necessary lines of development,
○ reducing extreme inequality in income and wealth, and
○ providing the necessary incentives to the private sector for its healthy growth.
2.3 Types of Fiscal Policy
2.3.1 Expansionary Fiscal Policy
● Expansionary fiscal policy involves the measures taken by the government to put more money back into the economy.
● This generally creates demand for products and services. It creates jobs and increases profits, thus stimulating economic
growth.
2.3.2 Contractionary Fiscal Policy
● The second type of fiscal policy is contractionary, used during economic
booms. Since expansions can also be dangerous for an economy, the
government tries to slow them down lest they become too intense.
● Too much growth can fuel investor exuberance and overconfidence (as
well as greed), creating market bubbles or other unforeseen economic
dangers.
● Contractionary fiscal policies are enacted to try to slow growth to a more
manageable level and control inflation.
○ The government begins collecting more taxes and reduces
spending to keep investment prices down and to raise the
unemployment rate.
○ The economy needs a certain amount of unemployed workers for
businesses to hire—if companies can't find workers, production growth slows down.

Self Notes
 194

2.3.3 Neutral Fiscal Policy

● Neutral fiscal policy is usually referred to as a balanced budget. Here,
the government collects enough tax revenue to cover its expenses. In
other words, taxation and government spending are equal.
● Governments are constrained in how much they can spend based on the
revenue they get under a neutral fiscal policy. Similar to how most
households operate, this is what they do. For instance, unless they use
credit, the typical taxpayer is unable to spend more than they earn.
● A neutral fiscal policy makes it challenging to predict how much
revenue will be generated in taxes from one year to the next.
Therefore, governments frequently predict tax revenues year over year
and make plans accordingly.

Q. There has been a persistent deficit budget year after year. Which of the following actions can be taken by the government
to reduce the deficit? (2015)
(1) Reducing revenue expenditure
(2) Introducing new welfare schemes
(3) Rationalizing subsidies
(4) Expanding industries
Select the correct answer using the code given below.
(a) 1 and 3 only
(b) 2 and 3 only
(c) 1 only
(d) 1,2,3 and 4
Answer: a

Q. In India, deficit financing is used for raising resources for (2013)

(a) economic development
(b) redemption of public debt
(c) adjusting the balance of payments
(d) reducing the foreign debt
Answer: a

2.3.4 Cyclical fiscal policy

Cyclicality of fiscal policy refers to the direction of change in government expenditure and taxes relative to economic/output
conditions. The fiscal policy is considered pro-cyclical, if it is expansionary during economic booms and contractionary during
recessions. On the other hand, if fiscal policy is expansionary during recessions and contractionary during booms, it is considered
to be counter-cyclical.
2.3.4.1 Pro cyclical fiscal policy
● In a pro-cyclical fiscal policy, the government expands during
expansions and contracts during recessions, reinforcing the business
cycle.
● Pro-cyclical fiscal policies are typically viewed as risky. It might worsen
macroeconomic instability, lower real and human capital investment,
impede growth, and hurt the poor.
● In a recession: the government adopts an expansionary fiscal
approach, which involves cutting spending and raising taxes. This
lowers the economy's capacity for spending and makes the recession
worse.
● During economic expansion/boom: the government adopts a
contractionary fiscal policy, meaning that spending is raised while taxes
are reduced.
● This boosts the economy's capacity for consumption and intensifies the current economic boom.
2.3.4.2 Counter cyclical fiscal policy
● Government actions that buck the trend of the economy or business cycle are referred to as counter-cyclical fiscal policy.
● So, to create a demand that can fuel an economic boom, the government lowers taxes and increases spending during
a recession or downturn.
● In recession: the government adopts an expansionary fiscal strategy, which involves raising spending and lowering
taxes. This boosts the economy's capacity for spending and lessens the impact of the recession.

Self Notes
 195

● In an economic boom: the government adopts a contractionary fiscal policy, meaning that spending is cut and taxes
are raised. This lessens the economy's capacity for consumption and serves to contain the boom.
2.4 Effects of Fiscal Policy
2.4.1 Counter-Cyclical Fiscal Measures
● During the recession there is a downturn in economic activities, while the economy may suffer from inflation during the
expansionary phase.
○ Government expenditure can be an important tool for countering business cycles.
● There are two main instruments of fiscal policy, viz., government expenditure and taxation.
1. During the recession, the government should increase its spending so as to compensate for the decline in
aggregate demand.
2. On the other hand, the government should decrease public spending when there is high inflation in the
economy.
3. Similarly, tax rates should be decreased during the recession and increased during boom periods.
● Apart from its effect on these three variables, fiscal policy influences two more variables in the long run:
1. redistribution of wealth,
2. growth of production capacity.
● Redistribution of wealth can be attained through the following three channels:
○ Taxation should be progressive in an economy. It means that tax rate is higher for people with higher income.
○ Poor people are given various subsidies (such as old age pension, subsidized ration, etc.) to supplement their
income.
○ Government provides preferential treatment to certain sectors, which affects the relative income of people
(for example, free electricity or subsidized inputs for priority sectors).
○ Such measures lead to redistribution of income and wealth in the long run.
● Government produces certain goods and services, which are not necessarily ‘public goods’.
○ The government operates hospitals, educational institutions, banks, water supply, etc. It also builds roads,
railway tracks, power plants and several infrastructural projects.
○ Further, the government produces many goods such as steel, coal, heavy machinery, etc.
○ In the long run, all these production activities enhance the production capacity of the economy.
2.4.2 Policy Lags
● The effect of variation in public investment to counter business cycles, however, may not be effective because of certain
policy lags.
● When a certain economic problem comes up in an economy, it takes some time to recognize it.
○ For example, suppose inflation in the economy is about to increase. Policymakers may not be in a position
to recognize the problem immediately.
○ They may think the price rise to be temporary (seasonality, supply shock, etc.) and assume that market forces
will be able to rectify it.
○ Further, policymakers have to take due approval before taking any action.
● Thus, the government may be taking a certain action, which is not needed or which may be negating the objective of the
government.
● There are generally observed four types of policy lags,
○ information lag,
○ decision lag,
○ implementation lag
○ effect lag
2.4.3 Automatic Stabilizers
● Taxes are considered to be automatic stabilizers in an economy.
● The government is not in a position to vary tax rates at times due to several factors – there could be resistance from
people, policymakers have to wait till the parliament approves it, and the government may not want to increase tax rates
keeping forthcoming elections in mind, etc.
○ Even in those cases the tax revenue will have a stabilizing effect.
● Let us assume that the economy is experiencing rapid economic growth. It implies that more workers are employed, the
turnover of firms is growing, and the income of people is growing.
○ This leads to the payment of higher taxes by individuals and firms, even if the government does not increase
tax rates.
○ Consequently, there is an increase in tax revenue of the government.
○ As government expenditure does not depend on the size of GDP, the government can go for a surplus budget,
if needed.

Self Notes
 196

○ In times of recession, on the other hand, there is a dip in the level of employment, income of people and turnover
of firms. During such times there is a decline in taxes paid by people and firms, even if the tax rates are
unchanged.
○ Thus, direct taxes such as income tax work as automatic stabilizers; they soften the impact of business
cycles.
2.4.4 Crowding-Out of Private Investment
● If there is a tax cut. This will result in lower revenue for the government.
○ Public expenditure is likely to remain unchanged.
○ The budget deficit needs to be financed by government borrowing.
● A tax cut would increase the disposable income of consumers.
○ Higher disposable income will increase the demand for goods and services, which in turn will enhance
consumption expenditure.
○ Increased consumption expenditure will lead to an increase in aggregate demand.
○ An increase in aggregate demand will lead to an increase in output and employment.
● Due to the tax cut, there is an increase in the disposable income of households.
○ Part of this income would be spent on consumption, while the remaining part will be saved.
■ Total savings of the households (private savings) will increase as a result of higher disposable
income.
○ Such an increase in private savings will be lower than the decrease in public savings.
■ Therefore, there is a decrease in the desired aggregate saving of the economy. As aggregate saving
falls short of aggregate investment, there is an increase in the real interest rate.
■ This higher interest rate would crowd out domestic private investment.
■ Such crowding out of private investment will result in a smaller stock of productive capital in the long
run.
2.5 Difference between Fiscal Policy and Monetary Policy

3. Fiscal Policy in India

3.1 Ministry of Finance
● The Ministry of finance is the nodal agency to decide the fiscal policy.
● It carries out different functions through its departments and agencies.
3.1.1 department of Economic Affairs
● The DEA is in charge of fiscal policy, the preparation and presentation of the Union budget, including the budgetary item
for railroads.
● Budgets for the states that are governed by the president and the union territory without a legislature.
● The DEA publishes the interest rates for microsavings plans.
Organizations under/related to DEA

1. Finance Commission.
2. Insolvency and bankruptcy board of India

Self Notes
 197

3. Chief Economic Advisor

4. Financial Stability and Development Council (FSDC)
5. Security Printing and Minting Corporation of India Ltd. (SPMCIL).

Financial Stability and Development Council

● Financial Stability and Development Council is an institutional body established based on the recommendations of
the Raghuram Rajan Committee on financial sector reforms in 2010.
● It strengthens mechanisms related to financial stability and aids in promoting financial sector development.

What is the Financial Stability and Development Council?

● Financial Stability and Development Council is an autonomous non-apex body that was established by executive
order.
● It monitors various macro-prudential activities of the Indian economy and is also responsible for the promotion of
financial inclusion and literacy among the masses.
● It is an independent institution with the mission of strengthening and institutionalizing the mechanism for maintaining
financial stability, improving inter-regulatory cooperation, and fostering financial sector development

Financial Stability and Development Council - Historical Background

● In 2010, Pranab Mukherjee the then India's Finance Minister decided to establish an independent organization to deal
with financial regularities across the country's whole banking system.
● In 2010, it became a non-profit organization. Maintaining financial stability and improving inter-regulatory collaboration
are priorities.

Provisions
● The Financial Stability and Development Council (FSDC) is an independent body established in December 2010.
● It replaced the High-Level Coordination Committee on Financial Markets.
● Funding: There are no finances set aside for the Council to carry out its functions.
● Objective: To enhance and institutionalize the mechanism for maintaining financial stability, improving inter-regulatory
cooperation, and fostering financial sector development.
● Need: Governments and institutions all across the world are under pressure to regulate their economic assets as a
result of the recent global economic collapse. This council is considered as India's effort to improve its readiness to
prevent such catastrophes.
● Constitutional Provisions: Under the Ministry of Finance, the Financial Stability and Development Council (FSDC) is
a non-statutory apex council. The Union Government established it through an Executive Order.

Composition of Financial Stability and Development Council

● The Finance Minister chairs the Council, the other members include heads of financial sector regulators (RBI, SEBI,
PFRDA, IRDA, and FMC), as well as the Finance Secretary and/or Secretary, Department of Economic Affairs,
Secretary, Department of Financial Services, and Chief Economic Adviser.
● If necessary, the Council can invite specialists to its meeting.
● Secretaries from the Ministry of Revenue and the Ministry of Information Technology (MeitY).
● Minister of State responsible for the Department of Economic Affairs (DEA)
● Chairman of the Insolvency and Bankruptcy Board of India (IBBI).

FSDC Sub-Committee
● The Governor of the Reserve Bank of India chaired the FSDC Sub-committee.
● It meets more frequently than the Council as a whole.
● The FSDC and the Sub-committee are both made up of members of the FSDC.
● The Sub Committee also includes all four Deputy Governors of the RBI, as well as the Additional Secretary, DEA, in
charge of FSDC.
● The Member Secretary is the RBI's Executive Director (in charge of financial stability), and the Sub-Secretariat
committee is the RBI's Financial Stability Unit.

Functions of Financial Stability and Development Council

● Act as an apex-level forum to improve and institutionalize the financial stability mechanism.
● Improve inter-regulatory coordination and promote the country's financial sector development.
● The emphasis should be on financial literacy and financial inclusion.
● Keep an eye on the economy's macroprudential oversight.
● Examine the operations of huge financial companies.
● To keep an eye on the economy's macroprudential oversight. It evaluates the performance of huge financial
corporations.

Self Notes
 198

● Responsibilities: Financial Stability, Financial Sector Development, Inter-Regulatory Coordination, Financial Literacy,
Financial Inclusion, Macroprudential supervision of the economy including the functioning of large financial
conglomerates.
● A Financial Stability Report is published by the RBI every two years, which helps evaluate the risks to financial stability
and the financial system's resilience.

3.1.2 Department of Expenditure

● The amount of money that will need to be spent from the Consolidated Fund of India is estimated by the Controller
General of Account.
● Reports from the Pay Commission and the Pension Accounting Office are also handled by this department.

3.1.3 Department of Revenue

● This department manages the taxation matters for the following bodies
○ Central Board of Direct Taxes (CBDT) → Department of income tax
○ Central Board of Excise and Customs (CBEC)à Central Board of Indirect Taxes and Customs (CBIC) after
march 2018.
● Various Tribunals and appellate bodies related to taxation.
1. Enforcement Directorate (for PMLA and FEMA Act enforcement)
2. Central Economic Intelligence Bureau
3. Central Bureau of Narcotics Financial Intelligence Unit
4. Goods and Service Tax Network (GSTN)

3.1.4 Department of Financial Services

● To look into Public sector financial intermediaries, including their regulators, financial inclusion programmes, PSB
recapitalization (Except EPFO, ESIC etc.)
● Organizations under/related to DFS:
○ Bank Board Bureau:
○ National Credit Guarantee Trustee Company (NCGTC)

3.1.5 Department of Investment and Public Asset Management (DIPAM)

● Disinvestment of CPSE is managed by the Department of Investment and Public Asset Management (DIPAM).
● The National Investment Fund (NIF) was established to receive funds from disinvestment earnings.
● The usage of this money is for investments in profitable CPSEs, the recapitalization of PSBs, and certain social sector
initiatives.

Disinvestment: if the government reduces its ownership from 100% to 51%.

Privatization: if the government reduces its shareholding in a way that a private party gains managerial control (i.e., a private
party actually owns 51 percent of the company). NITI Aayog, however, calls it "Strategic Disinvestment."

3.1.6 Department of Public Enterprise

● It was first established in 1965 as board of public enterprise (BPE) in ministry of finance
● In September 1985, the BPE was assigned under the ministry of industry. The BPE was later promoted as a full fledged
department under the ministry of industry.
● In July 2021, the department was re-allocated to the ministry of finance.
● The Department of Public Enterprises is the nodal department for all the Central Public Sector Enterprises (CPSEs) and
formulates policy pertaining to CPSEs.
● It lays down, in particular, policy guidelines on performance improvement and evaluation, autonomy and financial
delegation and personnel management in CPSEs.
● It furthermore collects and maintains information in the form of a Public Enterprises Survey on several areas in respect
of CPSEs.

Self Notes
 199

3.2 Fiscal Reforms

3.2.1 Background
● The need for tax reform was considered even during the 1950s. From 1950s to 1990s, a number of Committees and
Commissions were set up to suggest tax reforms aimed at reducing tax evasion and augmenting government revenues.
○ However, the implementation of these recommendations was adhoc.
○ Also, until the beginning of 1980s, the overall fiscal situation was under control with low revenue deficits and
marginal overall fiscal deficits.
● But during the 1980s, the fiscal situation steadily deteriorated.
○ In 1984-85, the overall fiscal deficit touched 7.7% of the GDP.
○ It marginally increased to 7.8% in 1989-90 reaching a further high of 8.3% in 1990-91.
○ The rising fiscal deficits and the monetisation (i.e. borrowing from the RBI which leads to the creation of more
or additional money) of a substantial part of it, led to inflationary pressures and to a growing deficit in the
current account of the balance of payments. In order to understand how this happened, we must first know the
relationship between the current account deficit and the balance of payment deficit.
● The economic condition in the Indian economy resulting from the growing fiscal deficits on the one hand and the
current account deficit in the balance of payments on the other, led to a serious balance of payments crisis towards
the end of 1980s.
○ Further, increasing revenue deficits (which had touched 3.5% of GDP by 1990-91) necessitated a substantial
amount of borrowing for meeting the revenue expenditure.
○ This resulted in an increasing addition to unproductive debt with the interest burden on the general budget
beginning to increase significantly.
○ Though the central government tried to raise resources through taxation to meet the situation, it was not
enough.
○ The borrowing requirements of the government continued to increase with 25% of the overall fiscal deficit being
met through the RBI route.
● A serious implication of fiscal deficits was thus the mounting debt burden, particularly the external debt.
○ Interest payments constituted about 24% of the total expenditure of the central government in the early years
of 1980s.
○ Total outstanding debt of the central government stood at 59.5% of GDP in 1989-90.
○ The problem of debt burden had thus assumed a critical proportion by the end of 1980s. The fiscal situation
prevalent at the beginning of 1990s was thus characterised by sustained high fiscal deficits and mounting
debt accumulation giving rise to inflation, financial repression and overall deterioration of the macroeconomic
fundamentals of the economy.
● Plagued by these situations, and in consequence thereof, the Indian economy in 1990-91 was characterized by the
following features:
i. High inflation – 16.7% in August 1991.
ii. High-interest rates
iii. Large fiscal deficits – 8.3% of GDP.
iv. Higher trade tariffs – import duties ranging from 75% to 350%.
v. Control of capital inflows and outflows.
vi. High subsidies – (amounting to 2% of GDP or 10.2% of government expenditure with growing non-
plan expenditure).
vii. Higher Current Account Deficit – 2.6% of GDP.
viii. Very low foreign exchange reserves, enough only to cover one week’s imports.
ix. Large internal and external debts.
3.2.2 Fiscal Reforms since 1990’s
3.2.2.1 Banking Sector Reform
● Liberalization, like dismantling the complex system of interest rate controls, eliminating prior approval of the Reserve
Bank of India for large loans, and reducing the statutory requirements to invest in government securities; to increase
financial soundness, like introducing capital adequacy requirements and other prudential norms for banks and
strengthening banking supervision
● To increase competition like more liberal licensing of private banks and freer expansion by foreign banks
● Reduced CRR, SLR
● Introduction of prudential norms
● The Board for Financial Supervision was The Board for Financial Financial Supervision Supervision was set up within
the RBI to attend exclusively to supervisory functions
● Removed barriers for entry of private sector banks
● Opening of payments banks and small finance banks.

3.2.2.2 Capital Market Reforms

Self Notes
 200

● Several steps have been taken after 1980’s to attract investments from foreign investors.
○ This resulted in significant expansion of the capital market in the 1980s.
● The market capitalization of companies registered in BSE rose from 5% of GDP in 1980s to 13% in 1990s.
● The financial market was further liberalized after the Narasimham Committee recommendations were accepted by
the government.
○ SEBI, which was originally established as a non-statutory body in 1988, was established as a full-fledged
market regulator.
● Based on Chandrashekhar Committee recommendations, Sebi, in June 2014, merged different classes of investors
such as FIIs, their sub-accounts and qualified foreign investors (QFIs) into a new category called foreign portfolio
investors (FPIs) and simplified the registration rules for FIIs’ entry into the capital market.

3.2.2.3 Insurance Sector Reforms

● Insurance sector experienced drastic changes during the late 1990s and 2000 onwards.
● On the recommendation of the Malhotra committee the amendments consisted of the establishment of IRDA
(Insurance Regulatory Development Authority) in the year 2000 through the enactment of the IRDA Act 1999.
○ The motive of this authority primarily was to look after the development and regulation of the insurance sector.
○ Analogous to RBI, as the prime governing body for the banking sector, this was made solely to deal with
the insurance.
○ Thereafter for every insurance company it was mandatory to get itself registered in IRDA and would abide by
the norms and conditions formulated by it.
● Various other statutes like Insurance Act 1938, General Insurance Business Nationalization Act (GIBA) 1972,
LIC act 1956 were also marked by several amendments.
● Thereafter, the insurance sector thrived immensely under the supervision of IRDA.
● Now, the public sector companies that were previously working under the General Insurance Company of India broke
their alliance and started operating independently thereby increasing the competition in the insurance market.
● As anticipated these developments resulted in the hiatus of monopoly by the public sector in the insurance sector,
thereby carving out a pathway for other private ventures to explore the opportunities that lie un-availed in the insurance
sector.
○ It further gave them an idea of how to harness the hidden potential that lies within the insurance sector.
○ This liberalization gave birth to the competition in the insurance industry and now the spark in insurance
sector was ready to set ablaze the industry

3.2.2.4 Reducing the corporate tax

● Tax rate on both domestic and foreign companies to the current level of 25 percent and 40 per cent, respectively, from
a level of 65 percent and 70 per cent in 1980-81

3.2.2.5 Rationalization of capital gains tax and dividend tax

● Duty on non-agricultural products from a level of more than 300 per cent during the period just prior to reforms to the
level of 25 per cent as announced in the Union Budget 2003-04
● A broad-ranging programme of economic reforms was initiated in June/July 1991 to tide over the crisis.
3.2.3 Tax Reforms
● Tax reforms are an important component of fiscal consolidation.
● The Government set up a high-powered committee in August 1991, under the chairmanship of Dr. Raja J. Chelliah, a
noted Public Finance Expert, to make recommendations for a comprehensive reform of the system of central taxes.
○ It was called the Tax Reforms Committee.
3.2.3.1 Chellaiah’s Tax Reforms Committee, 1991
● The tax reforms Committee (TRC) was tasked to examine the existing tax structure in the country and make appropriate
recommendations to reform in order to make the system fair, broad-based, elastic and more tax compliant.
Recommendations of TRC: Direct Taxes
● In formulating its proposals for reforming direct taxes, the TRC’s approach was to build a fairly simple structure with:
i. Reasonable tax rates;
ii. Progressive Tax rates, yet not leading to tax evasion and not adversely affecting the desire to work,
save and invest; and
iii. Easy to enforce.
● The most important tax recommendations of the Committee are that in order to make the country’s direct tax system
more effective, it is necessary that tax rates are reduced in respect of all taxes.
● With this in view, the recommendations of the TRC relating to direct taxes were as follows:
○ Personal Income Tax
i. The Committee recommended a reduction in the top marginal rate to 40% and the adoption of a 3-tier
slab system with an entry rate of 20% and a top rate of 40% (i.e. 20%, 30% and 40%).

Self Notes
 201

ii. Aggregation of minor’s income, other than wage income, with the income of the parents.
iii. Abolition of tax concessions, rebates and allowances, under various incentives for saving schemes.
○ Wealth Tax
i. The TRC opined that the Wealth tax has failed to achieve any of its objectives i.e. reducing inequalities
and helping the enforcement of income tax through cross checks thereby preventing further
concentration of economic power.
ii. It, therefore, recommended the abolition of the wealth tax on productive assets. Only unproductive
assets and socially undesirable forms of wealth were recommended to be taxed.
○ Capital Gains Tax:
i. The TRC suggested a moderate flat tax rate on long-term capital gains after due indexation for
inflation.
○ Corporate Income Tax:
i. The TRC recommended that the rate of tax be fixed at the same level as the top marginal rate of
personal income tax and a uniform rate be applied to all domestic companies.
ii. It suggested a phased reduction of the corporate tax to 40% and the abolition of surcharge on
corporate tax.
Recommendations of TRC: Indirect Taxes
● In general, TRC’s recommendations relating to indirect taxes are aimed at lowering the level of indirect taxes,
rationalisation and simplification of the indirect tax system and improving administrative efficiency.
● The specific recommendations in respect of the major central indirect taxes are indicated below:
○ Import Duties
i. It recommended a drastic overhauling of the system by suggesting a merger of the regular and
auxiliary duties;
ii. A phased reduction of extra-ordinarily high rates of import duties (many of them above 200% in 1991)
to a range of 15% to 30% for manufacturers and 50% for certain agricultural items by 1997-98;
○ Union Excise Duties
i. The TRC recommended that the ultimate objective of Union Excise Reform should be to make the
excise tax system move towards a full-fledged Value Added Tax (VAT) system i.e. graded conversion
of the Union Excise Tax into a genuine VAT.
ii. VAT is to be levied at only 3 rates – 10%, 15% and 20% for general commodities.
iii. For non-essential commodities, the rates should be 30%, 40% and 50%.
iv. Reduction in the number of commodities enjoying exemptions.
3.2.3.2 Shome Committee, 2001
● The Planning Commission constituted an advisory group headed by Dr Parthasarathi Shome to make appropriate
recommendations on Tax policy and Tax Administration.
● The 5-member group submitted an Interim Report in February 2001 and Final Report in May 2001. The Report is known
as The Report on Tax Policy and Tax Administration (for the 10th Plan).
● The major recommendations of the advisory group are:
○ Maximum marginal rate of personal Income tax should be retained at 30%. Tax incentives should be abolished
and tax concessions should be given in the form of a tax credit rather than as deductions from income;
○ Corporate tax should be reduced to 30% to bring it in line with the existing level of the maximum marginal rate
of income tax;
○ Regarding the union excise, two rate structures of 16% together with a higher rate should be introduced.
Moreover, services should be integrated as early as possible with the central value added tax (CENVAT) to
arrive at a full-fledged VAT at the centre;
○ The median Tariff Rate should be reduced to 15% by 2004-05. Exemptions in respect of customs duties should
be removed. Also, there is no need for so many export promotion schemes by way of exemptions and
entitlements;
○ States should reform their sales taxes and introduce broad-based VAT by April 2002;
○ The ultimate goal should be to have a harmonised VAT for both the centre and the states; and
○ State excise should be rationalized further and its revenue potential fully tapped.
3.2.3.3 Kelker’s Task Force, 2002
● In September 2002, two task forces were set up under the chairmanship of Vijay Kelkar, the then Advisor to the Ministry
of Finance and Company Affairs to recommend measures for simplification and rationalisation of direct and indirect
taxes.
● The Task Forces submitted their Final reports to the Government in December 2002. These two Task Forces have made
several important recommendations on improving tax administration to make it simple and effective.
● Recommendations of the Task Force
○ Main Recommendations on Direct Taxes Relate to
i. Raising the exemption limit of personal income tax;
ii. Rationalization of exemptions;
Self Notes
 202

iii. Abolition of concessional treatment to long-term capital goods;

iv. Reducing rates of corporate tax; and
v. Abolition of wealth tax.
○ Main recommendations on Indirect Taxes relate to
i. widening of the tax base;
ii. removal of the exemptions;
iii. lowering the tax rates, and
iv. expansion in the coverage of service tax.
3.2.4 The Fiscal Responsibility and Budget Management Act (FRBM Act), 2003
● The FRBM Bill was introduced in 2000 by then-finance minister Yashwant Sinha with the goal of increasing transparency
in India's fiscal management system.
● It sets a bar for the government to lay a foundation of monetary limitations in the Indian Economy.
○ It contributes to the improvement of the management of public funds and lowers the fiscal deficit rate as
well.
● The FRBM Act also allows for the use of an escape clause in times of disaster or national security. In such cases,
the government may deviate from its target annual fiscal deficit.
Objectives of the FRBM Act
● The primary objective of the act was to strike out of the revenue deficit and bring the fiscal deficit down.
● It was the first acquaintance of transparency in the fiscal management system in the country, ascertaining the ethical
dispensation of debt with the passing years, making sure of fiscal solidity in the macroeconomics
● The act is also purposeful in terms of giving necessary modifications to the Central Bank while overseeing the expanding
economy of India.
Key features of the FRBM act
● The FRBM Act made it mandatory for the government to place the following along with the Union Budget documents
in Parliament annually:
1. Medium Term Fiscal Policy Statement
2. Macroeconomic Framework Statement
3. Fiscal Policy Strategy Statement
● The FRBM Act proposed that revenue deficit, fiscal deficit, tax revenue and the total outstanding liabilities be projected
as a percentage of gross domestic product (GDP) in the medium-term fiscal policy statement.
○ It was recommended that all the four fiscal indices which are - Revenue deficit as GDP percentage, Fiscal
deficit as GDP percentage, Tax revenue as GDP percentage, and total remaining due as GDP percentage, to
be shown in the statement of medium-term fiscal policy.

Escape Clause in FRBM Act

● The escape clause was recommended by the NK Singh committee to provide flexibility in situations where the central
government can show some flexibility in following fiscal deficit targets under special circumstances.
● FRBM Act was further amended in 2018, where the escape clause enables the government to relax the fiscal deficit
target for up to 50 basis points or 0.5 percent.
● Under the escape clause, RBI participates directly in the primary auction of government bonds, thus formalizing
deficit financing.
○ It can be applied after formal discussions and advice from the Fiscal Council.
○ It exempts the government from sticking to FRBM guidelines in case of war or a national calamity.
● It was invoked by Finance Minister Nirmala Sitharaman in 2020 to allow the relaxation of the target and revised it for
FY20 to 3.8 percent and pegged the target for FY21 to 3.5 percent.

How effective has the FRBM Act been?

● Several years have passed since the FRBM Act was enacted, but the Government of India has not been able to
achieve targets set under it. The Act has been amended several times.
● In 2013, the government introduced a change and introduced the concept of effective revenue deficit.
● This implies that effective revenue deficit would be equal to revenue deficit minus grants to states for the creation of
capital assets.
● In 2016, a committee under N K Singh was set up to suggest changes to the Act. According to the government, the
targets set under FRBM Act previously were too rigid.

Recommendations of N.K.Singh Committee

● Replacement of the FRBM Act 2003 with Debt Management and Fiscal Responsibility Bill, 2017.
● The debt to GDP ratio by 2022-23 should be 38.7% for the central government and 20% for the state governments.
● The fiscal deficit target should be 2.5% of GDP by FY 2022-23.
● Setting up an autonomous fiscal council that deals with the preparation of multi-year fiscal forecasts, improves fiscal
data quality, could advise the government on fiscal matters.

Self Notes
 203

● Target commitments could deviate under certain circumstances such as a national calamity, war, agricultural collapse,
etc.
● The debt path to be followed by each state based on their track record of fiscal health and prudence should be
recommended by the 15th Finance Commission.
● Borrowing from RBI should occur when the center is to recover from a temporary shortfall in receipts.
● Monetary and fiscal policies should complement each other and help accomplish economic stability and growth.

Latest Changes in FRBM Act with Union Budget 2022-23

● In the Budget speech, the finance minister noted that the government aims to reduce the fiscal deficit to below 4.5%
of GDP by 2025-26.
● The estimated fiscal deficit for 2022-23 is 6.4% of GDP and the estimated revenue deficit for 2022-23 is 3.8% of GDP.
● In 2021-22, the government had set a budget estimate of 6.8% of GDP for fiscal deficit, and 5.1% of GDP for revenue
deficit.
● As per the revised estimates, the fiscal deficit is expected to marginally exceed the budget estimate to 6.9% while the
revenue deficit is estimated to be lower at 4.7% for 2022-23.
● The primary deficit is estimated to be 2.8% of GDP in 2022-23.
● The interest payments as a percentage of revenue receipts have increased from 36% in 2011-12 to 42% in 2020-21.
● As per the budget estimates, this figure is expected to increase further to 43% in 2022-23.
● Outstanding liabilities constituting the accumulation of borrowings over the years is estimated to decrease marginally to
60% of GDP in 2022-23.

Over the years, with several amendments and even after the act was enacted, the Government of India has been facing difficulties
to cope with the set targets. In 2016, under N K Singh, a committee was set up to review and suggest necessary changes in the
Act so as to ensure fiscal expansion with credit creation in the economy.

Self Notes