IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

HANDOUTS AND NOTESPLUS REFERENCE MATERIAL .......................1

FALL WINTER

2007-2009

IIPM BANGALORE

NAME
NEP II STUDY MATERIAL AND EXERCISES ...........2

SECTION

ADDITIONAL AND AUXILLARY READINGS AND REFERENCES........2

National Economic

WORKBOOK

planning

This workbook forms the basis of our interaction during the National Economic Planning (NEP) course throughout this trimester. The book has excersises that will have weightage for internal marks along with the final examination. Every student is required to bring the workbook to class every week.

How to use this workbook

THE DOS Bring it to the class each day Get the excercises checked on time Meet the deadlines for the exercises THE DONTS Dont leave it languishing at home Dont treat this as just a bunch of handouts you can revise before an exam Dont forget to check for regular updates on auxiliary readings from your faculty

ACTIVITIES / EXERCISES
Prof Tareque Laskar
There are exercises at the end of each unit as well as in between. All of them carry certain number of learning points (LP). The total number of LPs add up to 50 points. These will be converted into marks out of 40 to count as your internals for the NEP II Exam (10 percent will be attendance and class participation and 50 percent would be the end term exam. Make sure -1you dilligently attend all classes and finish all excersises on time. ALL THE BEST!

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GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

PROLOGUE Every short statement about economics is misleading (with the possible exception of my present one). ALFRED MARSHALL Keeping Mr. Marshalls comment in mind, we shall venture to try and make sense of the planning process in India, its relevance in an MBA course and the impact it has on our lives. However, it would be confusing for you and unfair on my part if I dont keep the whole thing short, crisp and easily understandable. Before anything else lets settle on a formal definition of what exactly is economic planning: It is a deliberate government effort to co ordinate economic decision making over the long run and to influence plus control the level and growth of a nations principal economic variables like income, consumption, investment etc. with a view to achieve predetermined set of economic objectives. That said the question that logically pops up next is: Why plan? Of course, it is nothing but another approach to develop an economy. By development we simply mean the phenomenon where every constituent of an economy has an improvement in living standards. There are three basic models of development Economic planning (Using the visible hand of the government to allocate resources and distribute income) Market Mechanism (Letting the invisible hand of the market allocate the resources and distribute income) Market Intervention (The market is allowed to take most of the decisions but is dictated by the government to some extent) India, after independence decided to borrow the first ideology from the erstwhile USSR and went in for National Economic Planning (NEP) with a scheme of Five Year Plans to be prepared by a Planning Commission whose de facto chairman would be the Prime Minister. Although there was a subtle difference in the sense that the USSR model was totalitarian whereas the Indian model was directive (i.e. public sector was dominant and most active while residual economic activity was taken care of by the private sector that too under strict directives from the government e.g. Industrial Licensing [more on that later]) Generically, in an economy the government plays four major roles: 1. Planning The government plans the utilization of the resources in the country. 2. Initiator Initiates the process of starting and running business if entrepreneurship is not forthcoming. 3. Facilitator Facilitates a conducive environment for conducting business 4. Regulator Regulates the running of business to protect consumer interests. The Government might also act as a consumer, but since it is not exactly a decision-making role that directly affects the economic variables, we will not discuss it. Planning in India derives its objectives and promises from the directive principles of state policy enshrined in the Constitution. The Planning Commission was set up in 1950 to prepare the blueprint of development, taking an overall view of the needs and resources of the country. Early on the government focused on the first two roles mentioned above. But with changing global dynamics the focus has shifted to the last two roles in the past decade and a half. Whatever the government does in terms of affecting our lives as consumers or producers constitutes Economic Policy. And for businesses this along with the market size, rate of growth etc constitutes the economic environment they have to operate in. Naturally an understanding the environment can have profound impact on a business performance. Something that is highlighted in a model called the SCP (Structure-Conduct-Performance) paradigm. * There are two facets of Economic Policy that we intend to studyFiscal Policy and Monetary policy. Fiscal policy deals with the facet of decision-making that involves government revenue and expenditure (revenues from taxes etc. and spending for development purposes or just running the bureaucratic machinery). The monetary policy deals with moneyits availability, cost and allocation. This is taken care of in conjunction with the central bank (The Reserve Bank in our case) of the country which has various tools like interest rates, liquidity requirements etc as the tools that are used. As a business, it makes particularly good sense to look at expenditure by the government. It can be complimentary (i.e. it compliments private expenditure) which is favorable for a business or substituting (i.e. it substitutes for private expenditure)
Prof Tareque Laskar -2-

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GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

which, obviously is not favorable. Also the government might sometimes crowd out private players because there are limited resources and they want the first choice in using it. This might mean certain controls in specific sectors and areas. Availability and cost of money also tremendously affects a business. It is not just the business but also the consumers of the products that it sells whom this affects. Availability is affected by controlling the liquidity requirements in the money system (Basically the banks). So if liquidity requirements are high less money is flowing in the economy. This kind of scenario is called a tight monetary policy. The opposite is obviously an easy monetary policy. The cost of money is regulated by the interest rates and the allocation is taken care of by either quantitative credit control or selective (or qualitative) credit controls.

EXERCISE (Ungraded)
Pick out a news clipping from any leading economic daily that describes any of the above roles in a specific case. Explain why it fits that role and how? The exercise needs to carry a photocopy of the article and a 50-100 word explanation from you as to why you think the role fits. Submission deadline: Next Class

Prof Tareque Laskar

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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

ONE: The Planning Commission and its role

The Planning Commission was set up by a Resolution of the Government of India in March 1950 in pursuance of declared objectives of the Government to promote a rapid rise in the standard of living of the people by efficient exploitation of the resources of the country, increasing production and offering opportunities to all for employment in the service of the community. The Planning Commission was charged with the responsibility of making assessment of all resources of the country, augmenting deficient resources, formulating plans for the most effective and balanced utilization of resources and determining priorities. Jawaharlal Nehru was the first Chairman of the Planning Commission. The first Five-year Plan was launched in 1951 and two subsequent five-year plans were formulated till 1965, when there was a break because of the Indo-Pakistan Conflict. Two successive years of drought, devaluation of the currency, a general rise in prices and erosion of resources disrupted the planning process and after three Annual Plans between 1966 and 1969, the fourth Five-year plan was started in 1969. The Eighth Plan could not take off in 1990 due to the fast changing political situation at the Centre and the years 1990-91 and 1991-92 were treated as Annual Plans. The Eighth Plan was finally launched in 1992 after the initiation of structural adjustment policies. For the first eight Plans the emphasis was on a growing public sector with massive investments in basic and heavy industries, but since the launch of the Ninth Plan in 1997, the emphasis on the public sector has become less pronounced and the current thinking on planning in the country, in general, is that it should increasingly be of an indicative nature. The 1950 resolution setting up the Planning Commission outlined its functions as to: a. b. c. d. e. f. Make an assessment of the material, capital and human resources of the country, including technical personnel, and investigate the possibilities of augmenting such of these resources as are found to be deficient in relation to the nations requirement; Formulate a Plan for the most effective and balanced utilisation of country's resources; On a determination of priorities, define the stages in which the Plan should be carried out and propose the allocation of resources for the due completion of each stage; Indicate the factors which are tending to retard economic development, and determine the conditions which, in view of the current social and political situation, should be established for the successful execution of the Plan; Determine the nature of the machinery which will be necessary for securing the successful implementation of each stage of the Plan in all its aspects; Appraise from time to time the progress achieved in the execution of each stage of the Plan and recommend the adjustments of policy and measures that such appraisal may show to be necessary; and
duties assigned to it, or on a consideration of prevailing economic conditions, current policies, measures and development programmes or on an examination of such specific problems as may be referred to it for advice by Central or State Governments.

g. Make such interim or ancillary recommendations as appear to it to be appropriate either for facilitating the discharge of the

Evolving Functions From a highly centralized planning system, the Indian economy is gradually moving towards indicative planning where Planning Commission concerns itself with the building of a long term strategic vision of the future and decide on priorities of nation. It works out sectoral targets and provides promotional stimulus to the economy to grow in the desired direction. Planning Commission plays an integrative role in the development of a holistic approach to the policy formulation in critical areas of human and economic development. In the social sector, schemes which require coordination and synthesis like rural health, drinking water, rural energy needs, literacy and environment protection have yet to be subjected to coordinated policy formulation. It has led to multiplicity of agencies. An integrated approach can lead to better results at much lower costs.
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GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

The emphasis of the Commission is on maximizing the output by using our limited resources optimally. Instead of looking for mere increase in the plan outlays, the effort is to look for increases in the efficiency of utilization of the allocations being made. With the emergence of severe constraints on available budgetary resources, the resource allocation system between the States and Ministries of the Central Government is under strain. This requires the Planning Commission to play a mediatory and facilitating role, keeping in view the best interest of all concerned. It has to ensure smooth management of the change and help in creating a culture of high productivity and efficiency in the Government. The key to efficient utilization of resources lies in the creation of appropriate self-managed organizations at all levels. In this area, Planning Commission attempts to play a systems change role and provide consultancy within the Government for developing better systems. In order to spread the gains of experience more widely, Planning Commission also plays an information dissemination role.

MORE TO KNOW: (Not for grading)

Visit the website of the Planning Commission http://planningcommission.nic.in/ to find out more about the organization and answer the following questions: Q. Who is the deputy chairman of the planning commission currently?

Q. Who is the chairman of the planning commission currently? Who was the preceding chairman?

Q. What Five Year Plan are we in right now? Till which year will it run?

Q. What is the rate of growth for the economy set as a target in the current 5 year plan?

Prof Tareque Laskar

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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

TWO:THE ECONOMIC DASHBOARD

THE FUEL GAUGE, SPEEDOMETER, AND THE ODOMETER OF THE ECONOMY

GROSS DOMESTIC PRODUCT (GDP) and its growth rate RATE OF INFLATION: Wholesale and consumer price inflation / general level of price rise INTEREST RATES and Bank rates + Stock market indices

What is GDP?

GDP is the short form for Gross Domestic Product. This is the most often used term to measure what are known as National Income accounts, which, as the name suggests, are a measure of how much product (or income in terms of goods and services) a country generates. What are the components of GDP?

GDP is 'gross' because it includes the cost of deprecation of plant and machinery, or any other capital good that is used in the process of production. If we subtract the cost of depreciation, we get Net Domestic Product. It is called domestic product because it measures the value of goods and services produced within the geographical boundaries of a country. So this includes the value of exports, but not imports, which are not made at home. Now, the price of any good in the market is also inclusive of the tax levied on it. If GDP also includes the tax component, then it is called GDP at Market Prices, and if it excludes taxes, it is called GDP at Factor Cost. Note that only indirect taxes are being taken into account at this point. How is GDP measured?

Typically, GDP is measured by segregating the economy into 3 broad categories: agriculture, industry, and services. In India, agriculture GDP is measured both inclusive and exclusive of GDP in forestry, fishing and logging, apart from GDP from cultivation. At present, the share of agriculture and allied activities in India's GDP is roughly 20 per cent. Industry makes up roughly 19 per cent of the GDP and the rest is made up of what are loosely called services. Industry contribution to GDP is measured at a disaggregated level by dividing the industries into groups on the basis of the kind of product being manufactured.

Accounting for services is problematic because there are two kinds of services. Public administration and government services contribution to GDP is well accounted for and easier to measure, but a whole range of services are rendered by unregistered small entities which is next to impossible to measure. So there are some rules of thumb that are applied to estimate the contribution of services to GDP.

Prof Tareque Laskar

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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

GDP by PURCHASING POWER PARITY (PPP) [Read the Auxiliary reading piece on PPP]

THE WORLDS LARGEST ECONOMIES RANK 1 2 3 4 5 6 7 8 9 10 11 12 COUNTRY The United States of America Japan Peoples Republic of China Germany United Kingdom France Italy Canada Spain Brazil Russia India WORLD TOTAL GDP (in $ billions) $13.2 $4.3 $3.0 $2.9 $2.3 $2.2 $1.8 $1.2 $1.2 $1.1 $1.1 $1.0 $48.2

QUICK ACTIVITY: Identify the BRIC economies in the list. What does BRIC stand for? FOLLOW ON ACTIVITY: Find out and compare the rates of growth of GDP for the four BRIC economies. Whos growing the fastest?

Prof Tareque Laskar

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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

Inflation You may have heard your parents or grandparents talk about how different things were when they were your age. It only cost 25 Paise to see a movie. Petrol was Rs. 3 a liter. A brand new car might cost about Rs. 35,000. In the intervening years, prices have risen, sometimes drastically. Seeing a movie in the theater now costs about Rs. 150; petrol can cost more than Rs. 50 per liter in some places; and few new cars cost less than Rs. 2,50,000. That's inflation. (Well, the TATA Nano will be out soon costing Rs. 1,00,000 [list price] defying inflation but thats just a very very special exception!) Inflation is when a certain form of currency starts to have less value over time. It is caused mainly by two things: people's perception of value, and the economic principle of supply and demand. People's perceptions of a currency's value can affect its value. This effect causes inflation by directly affecting the value of the money. When currency was still on a gold standard, inflation often happened when people started to worry that the government or bank wouldn't be able to redeem their cash for gold. If you had a dollar that was worth an ounce of gold, but people thought the government only had half of the gold required to redeem it, then dollars would start being traded at a value of half an ounce of gold. Supply problems have had far more dramatic inflationary effects. Throughout history, governments have tried to solve financial problems by simply printing more money. This can drive the value of money drastically downward, especially in modern markets where money is not backed by gold. Twice as many dollars in an economy makes those dollars worth half as much. After World War I, Germany was forced to pay war reparations of about $33 billion. It was virtually impossibly for the nation to produce that much actual output, so the government's only choice was to print more and more money, none of which was backed by gold. This resulted in some of the worst inflation ever recorded. By late 1923, it took 42 billion German marks to buy one U.S. cent! It took 726 billion marks to buy something that had cost just one mark in 1919.

THE INDEX THAT TRACKS INFLATION: The Consumer Price Index (CPI)
Name of collection/source The index covers 260 items, and approximately 160,000 retail price quotes are obtained each month from 16,545 outlets and selected open markets. About 81 percent of the price quotes are collected every week for price sensitive items. Prices for some commodities (about 18 percent of the price quotes) are collected on a monthly basis. Prices of items such as house rent, school or college fees and school/college books (about 1 percent of the price quotes) are collected every six months. The price quotes include all taxes. Direct source Ministry of Statistics, India / International Monetary Fund (data between 1/1957 - 9/1988) Other coverage The reference populations is all Industrial Workers of seven sectors: factories, mines, plantations, railways, public motor transport, electricity generation and distribution, and ports & docks. The index is compiled using a representative sample of 70 industrial centres selected in the country. The population covered is approximately 20 percent of the total population of India. Key statistical concept The index measures monthly changes in the general level of prices of goods and services that households acquire for consumption.

Prof Tareque Laskar

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GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

Group/Sub-group wise percentage change in All-India index from last month and last year
Aug-06 472 455 564 307 540 403 536 547 424 392 494 593 687 544 514 427 419 483 491 503 381 410 692 381 421 576 484 Jul-07 512 475 603 363 608 440 592 637 469 306 525 632 793 580 538 442 433 505 505 524 401 426 687 399 444 595 514 Aug-07 515 479 606 368 605 445 595 648 435 304 526 636 799 582 539 443 433 506 507 528 402 426 689 402 446 599 515 Last month 0.59 0.84 0.50 1.38 -0.49 1.14 0.51 1.73 -7.25 -0.65 0.19 0.63 0.76 0.34 0.19 0.23 0.00 0.20 0.40 0.76 0.25 0.00 0.29 0.75 0.45 0.67 0.19 Last year 9.11 5.27 7.45 19.87 12.04 10.42 11.01 18.46 2.59 -22.45 6.48 7.25 16.30 6.99 4.86 3.75 3.34 4.76 3.26 4.97 5.51 3.90 -0.43 5.51 5.94 3.99 6.40 I Group & Sub-group FOOD, BEVERAGES & TOBACCO a. Cereals b. Pulses c. Oils & Fats d. Meat, Fish etc. e. Milk & Milk Products f. Condiment, Spices etc. g. Vegetables h. Fruits i. Sugar, Honey etc. j. Non-alc Beverages k. Prep. Meals etc. l. Pan, Supari, Tobacco etc. II III IV FUEL & LIGHT HOUSING CLOTHING, BEDDING & FOOT-WEAR etc.

a. Clothing & Bedding b. Foot-wear V MISCELLANEOUS a. Medical care b. Education c. Recreation & Amusement d. Transport & Communication e. Personal Care & Effect f. Household Requisites g. Others General Index

ACTIVITY: What is the current rate of inflation in India? In the US?

ACTIVITY: Read the auxiliary reading piece titled Price Pressure. Do you consider inflation as a bad sign for an economy? Why?

ACTIVITY: Find out three countries which are currently struggling with very high levels of inflation. Heres a hint to get you startedChina

Prof Tareque Laskar

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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

FIVE: Fiscal Policy or The Business of Government

What is meant by Fiscal Policy?

Fiscal policy is the name given to the government's policy regarding its revenue and expenditures. The government is an important service provider to the economy, incurring expenses on administration, development services, defence and other heads. In order to finance these operations, the government needs to generate revenue through taxation and other non-tax means like borrowing. Its policies regarding these operations is called fiscal policy. Since the operations of the government have a significant impact on the economy, it is important for the government to enunciate its intentions in a well formulated fiscal policy statement. One such statement made each year is the Budget presented by the Finance Minister of India. What kind of fiscal policies are possible?

Fiscal policy can be expansionary or contractionary. If the government intends to increase its expenditures in order to, say, give a fillip to the economy, then it termed as expansionary. It may lead to an increase in money supply, inflation in the short run, increase in the output of goods and services, and lower unemployment. If expansionary policy is followed at a time when the domestic economy is not performing too well, say there is high unemployment and low growth, then it is termed as counter-cyclical.

A contractionary fiscal policy does the opposite. It seeks to curtail government expenditure, keep deficits to a minimum, and prevent an increase in money supply. This could be followed at a time when the economy is said to be 'overheating': when all indicators in the economy are pointing upwards, interest rates are falling, and investment is booming, then a such a counter-cyclical contractionary policy seeks to add a modicum of caution in a bullish environment. How does fiscal policy affect the Current Account?

Fiscal expansion by the government refers to increased expenditures on various government programmes. Suppose as part of its fiscal package, the government decides to increase the salary of government employees to boost spending in the economy. This could end up creating or widening an existing current account deficit. Even if 10 per cent of income is spent on imported goods, then the additional income earned via the fiscal packaged will mean that 10 per cent of that additional income will go to finance imports. At the same time, domestic residents spend nothing on exports. Therefore, imports increase, and other things equal, government expenditure can cause an expansion of the current account deficit through an increase in imports. However, it depends on the propensity of domestic residents to spend money on imported goods and services. It also depends on the nature of fiscal expansion. Is the Fiscal Deficit a cause for concern?

There is nothing obviously good or bad about a fiscal deficit. Of course, if the deficit is too large a proportion of the GDP, and if the government finds itself increasingly incapable of repaying debt raised to cover excess of expenditure over income, then it is a cause for concern. However, given the sovereign nature of the government, it is possible for it to roll over its obligations to repay for the future without worrying too much today. The government can ask the central bank to print money any time and pay back all its debt and interest obligations. Why do developing nations run large fiscal deficits?
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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

In a developing economy needing the construction of social overheads and public goods that the private sector cannot provide, government expenditure is necessary, and a moderate deficit incurred in order to raise the future productive capacity of the economy is probably worth it. On the other hand, if the government is over spending without raising the quality of social infrastructure, and overwhelmingly spending on covering immediate expenses, then a growing deficit is harmful to the long-run interests of the economy. Most developed countries adopt very strict standards for the size of the fiscal deficit, around 2-3 per cent of GDP, while the revenue deficit is kept as close to zero as possible. What is the experience of the Indian government in deficit management?

The deficit to GDP ratio in India is obviously much higher by international standards and a cause of concern for everyone. Also whatever fiscal discipline that the government might have succeeded in achieving in the recent years, it is not because of revenue increases, it is on account of expenditure cuts, and typically, it's the capital expenditure aimed at building social infrastructure that bears the brunt of these cuts. So while outwardly it may appear that 'fiscal discipline' may have improved, the quality of government expenditure has worsened, as almost 50 per cent of central revenue is spent on just interest expenditure, which is completely wasteful and non-productive. What are the possible harmful effects of a deficit? Fiscal deficits can be a cause for concern if they lead to inflation, and displace private investment (see "crowding out"). By increasing non-productive expenditure, the government puts money in the hands of the public without increasing the output of the economy. As a result, demand goes up as people hold more cash, and there is no increase in supply, which results in inflation. However, this depends on whether the government prints money to pay, or merely borrows existing funds with banks to repay. In the latter case, the cost of government borrowing is higher interest rates, as both the public and the private sector compete for the limited resources of the banking sector. What is the Union Budget? The Union Budget is the single-most important event in the economic and financial world. What is the Budget? Why is it so important? Why does it affect all of us? And above all, how does one interpret the budgetary lingo flying around? Read on for enlightenment What is the Union Budget? The Union Budget is the annual report of India as a country. It contains the government of India's revenue and expenditure for the end of a particular fiscalyear, which runs from April 1 to March 31. The Union Budget is the most extensive account of the government's finances, in which revenues from all sources and expenses of all activities undertaken are aggregated. It comprises the revenue budget and the capital budget. It also contains estimates for the next fiscal year. What is a revenue budget? The revenue budget consists of revenue receipts of the government (revenues from tax and other sources), and its expenditure. Revenue receipts are divided into tax and non-tax revenue. Tax revenues are made up of taxes such as income tax, corporate tax, excise, customs and other duties that the government levies. In non-tax revenue, the government's sources are interest on loans and dividend on investments like PSUs, fees, and other receipts for services that it renders. Revenue expenditure is the payment incurred for the normal day-to-day running of government departments and various services that it offers to its citizens. The government also has other expenditure like servicing interest on its borrowings, subsidies, etc.
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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

Usually, expenditure that does not result in the creation of assets, and grants given to state governments and other parties are revenue expenditures. The difference between revenue receipts and revenue expenditure is usually negative. This means that the government spends more than it earns. This difference is called the revenue deficit. What is a capital budget? The capital budget is different from the revenue budget as its components are of a long-term nature. The capital budget consists of capital receipts and payments. Capital receipts are government loans raised from the public, government borrowings from the Reserve Bank and treasury bills, loans received from foreign bodies and governments, divestment of equity holding in public sector enterprises, securities against small savings, state provident funds, and special deposits. Capital payments are capital expenditures on acquisition of assets like land, buildings, machinery, and equipment. Investments in shares, loans and advances granted by the central government to state and union territory governments, government companies, corporations and other parties are also part of it. What are direct taxes? These are the taxes that are levied on the income of individuals or organisations. Income tax, corporate tax, inheritance tax are some instances of direct taxation. Income tax is the tax levied on individual income from various sources like salaries, investments, interest etc. Corporate tax is the tax paid by companies or firms on the incomes they earn. What are indirect taxes? These are the taxes paid by consumers when they buy goods and services. These include excise and customs duties. Customs duty is the charge levied when goods are imported into the country, and is paid by the importer or exporter. Excise duty is a levy paid by the manufacturer on items manufactured within the country. Usually, these charges are passed on to the consumer. What is plan and non-plan expenditure? There are two components of expenditure - plan and nonplan. Of these, plan expenditures are estimated after discussions between each of the ministries concerned and the Planning Commission. Non-plan revenue expenditure is accounted for by interest payments, subsidies (mainly on food and fertilisers), wage and salary payments to government employees, grants to States and Union Territories governments, pensions, police, economic services in various sectors, other general services such as tax collection, social services, and grants to foreign governments. Non-plan capital expenditure mainly includes defence, loans to public enterprises, loans to States, Union Territories and foreign governments.
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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

What is the Central Plan Outlay? It is the division of monetary resources among the different sectors in the economy and the ministries of the government. What is fiscal policy? Fiscal policy is a change in government spending or taxing designed to influence economic activity. These changes are designed to control the level of aggregate demand in the economy. Governments usually bring about changes in taxation, volume of spending, and size of the budget deficit or surplus to affect public expenditure. What is a fiscal deficit? This is the gap between the government's total spending and the sum of its revenue receipts and non-debt capital receipts. It represents the total amount of borrowed funds required by the government to completely meet its expenditure. What is the Finance Bill? The government proposals for the levy of new taxes, alterations in the present tax structure or continuance of the current tax structure beyond the period approved by the Parliament, are laid down before the Parliament in this bill. The Parliament approves the Finance Bill for a period of one year at a time, which becomes the Finance Act. What impact does the Budget have on the market and economy? The Budget impacts the economy, the interest rate and the stock markets. How the finance minister spends and invests money affects the fiscal deficit. The extent of the deficit and the means of financing it influence the money supply and the interest rate in the economy. High interest rates mean higher cost of capital for the industry, lower profits and hence lower stock prices. The fiscal measures undertaken by the government affect public expenditure. For instance, an increase in direct taxes would decrease disposable income, thus reducing demand for goods. This decrease in demand will translate into a decrease in production, therefore affecting economic growth. Similarly, an increase in indirect taxes would also decrease demand. This is because indirect taxes are often partially or completely passed on to consumers in the form of higher prices. Higher prices imply a reduction in demand and this in turn would reduce profit margins of companies, thus slowing down production and growth. Non-plan expenditure like subsidies and defence also affect the economy as limited government resources are used for nonproductive purposes. How is the Budget presented? STAGE 1: Estimates. Part A - Expenditure The Indian Constitution requires the government to present to Parliament a statement that shows separately the expected revenues and expenditures, both current and capital by heads of account. The Budget-making process, in normal times, gets set in motion by the third quarter of the financial year. On the expenditure side, the various ministries provide initial estimates. There are two components of expenditure - plan and non-plan. Of these, plan expenditures are estimated after discussions between each of the ministries concerned and the Planning Commission. Apart from allocations for continuing plan programmes initiated in earlier fiscal year, the Planning Commission decides on the new programmes that can be undertaken on the basis of a tentative estimate or resources available for plan expenditure that is provided to it by the finance ministry.

Prof Tareque Laskar

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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

Non-plain expenditure for various ministries are prepared by their financial advisors. These are sent to the expenditure secretary who, after exhaustive discussions with financial advisors, makes an assessment of the likely expenditures for the ensuing fiscal year. In one sense, the assessment of likely non-plan expenditure is comparatively simple. Nearly 90 per cent of the non-plan expenditure is accounted for by interest payments, subsidies (mainly on food and fertilisers) and wage payments to employees. STAGE 1: Estimates. Part B - Revenue Parallel to the exercises on the expenditure side, an assessment is made of the revenues, which are likely to flow into the government kitty. Revenue receipts, like expenditure, are of two types - capital and current receipts. Capital receipts include repayment of loans made by the federal government, receipts from divestment of public-sector equity and borrowings both domestic and external. Current receipts, by and large, include tax revenues, receipts by way of dividends from public-sector units and interest payments on loans given out by he federal government. While both dividends from public-sector units and interest receipts are fairly easy to assess, the amounts received by way of tax revenues is estimated on the basis of existing rates of taxation and an assessment of the likely growth and inflation rate over the ensuing fiscal year. On the capital receipts side, targeted amounts to be realised through divestment of public sector equity and amounts to be realised by way of repayments of loans is made. All the estimates flow to the revenue secretary. STAGE 2: First estimates of deficit Once this exercise is completed expenditure estimates are matched with revenue estimate to arrive at a first estimate of the shortfall in revenue to meet projected expenditure. Following this the government, in tandem with its chief economic advisor, determines the optimum level of borrowings that the government can resort to. The level of external borrowings is an easily estimated figure because much of the external borrowing on government account consists of bilateral and multilateral assistance, which is known by the time budget exercises are undertaken. The level of domestic borrowing depends partly on the desired level of fiscal deficit that the government targets for itself. A part of the revenue gap is left unfilled to be met through the issue of ad hoc treasury bills. Over the past few years, this gap, called the overall budget deficit, is government by an understanding between the Reserve Bank of India and the finance ministry on the maximum level of ad hoc treasury bills that can be issued during a fiscal year. This has been done to ensure that the issue of ad hoc treasury bills to fill revenue gaps does not lead to problems of monetary management. STAGE 3: Narrowing of the deficit After the targets for the fiscal deficits and the overall budget deficit have been decided by the government, any remaining shortfall is filled through a revision in tax rates where considered feasible and in keeping with fiscal incentive structure the government wishes to put in place to stimulate the growth in different sectors. Subsequently adjustments are made in expenditures, should it be required, to ensure that the fiscal and overall deficit remain at targeted levels. Such adjustments in expenditure are usually made on the plan side - the only item of expenditure that offers any scope for adjustments. With nearly 90 per cent of non-plan expenditure being accounted for by interest payments, subsidies and administrative expenditure and the political sensitivities involved in reducing subsidies, non-plan expenditure of the Indian government is characterised by an extraordinary degree of rigidity. Inevitably, therefore, plan expenditures are determined as a residual after pre-emptions have already been made for nonplan expenditure. STAGE 4: The Budget
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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

The presentation of the Budget for the ensuing fiscal year (beginning April 1) is usually done on the last working day of February. Parliamentary scrutiny of proposals and the passage of the budget does not normally get completed until the second week of May, well after the commencement of the new fiscal year. Since expenditures cannot be incurred in a new fiscal year without Parliamentary approval, the government usually seeks an interim approval to meet emergent expenditures that have to be incurred pending the approval of the budget. This is called the vote-on-account and the sanctions given by the passage of the vote-on-account get automatically overridden once the Budget is approved by Parliament.

Prof Tareque Laskar

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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

Monetary Policy or Show me what you do with the money

What does Monetary Policy mean?

Just as fiscal policy refers to the government's intentions on revenues and expenditure, monetary policy refers to the monetary authority's intentions about money supply, interest rates, and exchange rates. Usually, the monetary authority is the Central Bank, like the Reserve Bank of India (RBI). Broadly speaking monetary policy regulates money supply and related nominal variables, such as the interest rate, and exchange rates. Of course, the whole portfolio of monetary management is much larger, looking after managing government finances, international borrowing and lending, and the operations of commercial banks, since all three have implications for the supply of money, the interest rates, and inflation. These effects spill over onto the rest of the economy as well. What is the best-known role of monetary policy?

The most widely recognized role of monetary policy is the management of money supply. In India, the RBI fixes targets for the rate of growth of money supply in the economy, by fixing levels for various policy tools like the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratios (SLR) for commercial banks, and by advising the government on the monetization of its deficits. If the Bank feels that the economy can do with more money (either for investment purposes or for making daily transactions), it will follow an easy-money policy, whereby the interest rate on borrowing will come down, making cash via demand deposits more easily available to potential users. If on the other hand the Bank believes that the level of liquidity is too high, and that inflationary pressures from there being excess cash in the system is posing a threat, it will tighten the terms at which cash is available, by raising CRR, raising SLR, asking banks to raise interest rates, or a combination of policy tools. What kinds of monetary policy are possible?

Monetary policy, like fiscal policy, can be pro-cyclical or anti-cyclical. In times when liquidity is already easy, inflation is rising, and interest rates are low, if the bank cuts bank rates even further, this would be a pro-cyclical policy that would exacerbate the existing condition. If on the other hand, it tightens money and chokes off excess liquidity, it would be termed as an anti-cyclical policy. Suppose investments are flagging in the economy, then if the RBI eases the supply of money, it would be a countercyclical policy, as opposed to a tight-money policy, which would be pro-cyclical. What Is A Credit Policy? Very simply, a credit policy announcement is the Reserve Bank of Indias (RBI) way to influence the amount of money and credit in the Indian economy, which has an impact on the rates of interest and inflation and hence on economic growth and prices. RBIs credit policy also the institutions way of giving market signals on which market players will base their production decisions. For example, if the RBI says that inflation may be a concern, then the lenders, like home loan companies, may want to hike up their long term interest rates. Or if the RBI says that we are still in a soft interest regime, then borrowers can hope to borrow cheaply in the future at a lower rate or at least, be sure that rates will not harden. RBI also
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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

uses the Credit Policy to do some housekeeping functions of giving directions to the banks, for example, yesterdays credit policy allowed banks to raise long term bonds to fund infrastructure projects. The RBIs role as the Central Banker makes it responsible to smoothen out the seasonal wrinkles between demand and supply of money in the economy as well as set the long term agenda for all money matters in the country. This means that RBI, by making money cheaper (lower interest rates) or more expensive (higher interest rates) influences money and credit conditions in the economy, targets good growth, employment and stable prices. Left to its own an economy can get into two opposing cycles - an inflationary one or a recessionary one. Big words but they have simple meanings. An inflationary cycle begins after an event (like a crop harvest in India) that puts a lot of money in peoples pockets, which is spent. This drives up prices as the current goods are less than the demand. As prices increase, production is stepped up, employment increases, more money comes into circulation, driving prices up further. This cycle (given very simplistically here) may spin out of control and cause hyper inflation in extreme cases. On the opposite side is the situation when people have less money to spend (like at tax saving time or crop sowing time), this drives prices down, leading to cuts in production, lay offs and further loss in spending money. Again if unchecked, a downward spiral can spin the economy into recession. Apart from these two signals there are innumerable variables that have the power to shift the economy from the desired growth-inflation equilibrium. RBI has four chief weapons to do its job of maintaining the desired equilibrium, these are: Open Market Operations (OMO). When the RBI buys government securities, it adds to the stock of money in the economy. This is added to the reserve of the selling bank, who can now lend a multiple of this amount. The extra liquidity has the power to push down interest rates and give a boost to business activity, that now be financed more cheaply. The opposite happens when the RBI sells government securities, then it soaks up the extra money with the banks and that has a multiplier effect in reducing money supply and pushing up interest rates. So, the RBI buys securities when the economy is sluggish and demand is not picking up and sells securities when the economy is overheated and needs to cool down. OMO are also used seasonally to heat up or cool off the economy. For example, after the harvest the economy is flush with funds and the RBI will sell securities to soak up some of that liquidity. Reserve Requirements. The RBI does not allow banks to lend all of the money they get as deposits. A fraction has to be kept as a reserve. If the reserve requirement is 10 per cent, then a bank that gets Rs 100 as a deposit may lend forward only Rs 90, Rs 10 it will keep either with itself or will buy government securities from the RBI. Now, whoever borrows this Rs 90 will deposit it somewhere. That bank will be able to lend out only 90 per cent of Rs 90, or Rs 81. This Rs 81 will be deposited by the borrower somewhere, and 90 per cent of that, or Rs 72.9, will get lent by the third bank. This is called the multiplier effect of the banking system. The higher is the reserve ratio, the lower the multiplier effect and the lesser the money supply in the economy, higher the rates of interest. In India, the CRR currently is 4.5 per cent, down from 15 per cent in 1981. The RBI has kept this rate constant signalling no change in its view on the Indian economy - it does not need tinkering now. Bank Rate or Discount rate. This is the rate at which the RBI makes very short term loans to banks. Banks borrow from the RBI to meet any shortfall in their reserves. An increase in the discount rate means the RBI wants to slow the pace of growth to reduce inflation. A cut means that the RBI wants the economy to grow and can handle the accompanying inflation. Between December 1990 and July 1992, the US Fed cut the discount rate seven times from 7 per cent to 3 per cent because the US economy was weak. And from May 1994 to Feb 1995, when the Fed was worried about inflation, it raised the discount rate from 3 per cent to 5.25 per cent. Indian bank rate is at 6 per cent down from 10 per cent in 1981 and 12 per cent in 1991. This credit policy has kept the bank rate unchanged at 6 per cent signalling an economy on course. Repo rate - the rate at which the RBI borrows short term money from the market. This is also an indicative rate that gives price signals on money. Repo rates are now at their lowest, since daily repo auctions began in 2000, at 4.5 per cent. Repo rates are unchanged again giving the on-course signal to the economy. The RBI uses these tools to steer the ship of the Indian economy at a pace that allows for speed without too many lurches. The one message of the RBI this Credit Policy is: no big changes in the pace and direction of the economy, our ship is on course.
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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

What are CRR and SLR?

CRR, or cash reserve ratio, refers to the portion of deposits that banks have to maintain with RBI. This serves two purposes. First, it ensures that a portion of bank deposits is totally risk-free. Second, it enables RBI to control liquidity in the system, and thereby, inflation. Besides CRR, banks are required to invest a portion (25 per cent now) of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements. The government securities (also known as gilt-edged securities or gilts) are bonds issued by the central government to meet its revenue requirements. Although the bonds are long-term in nature, they are liquid as they have a ready secondary market.

What is PLR? What does a cut in PLR mean?

Prime lending rate, or PLR, is the rate at which banks lend working capital to their best customers. However, very few companies can avail of bank loans at this rate: most of them receive funds at a mark-up to the PLR of upto 3.5 per cent. A company which is not considered a good risk will, therefore, get working capital loans at 15.5 per cent even when the PLR is 12 per cent. However, there are some categories of loans to which PLR do not apply. These include loans to some priority sectors, which are at directed rates and lower than PLR. At the same time, banks can charge higher rates on consumer loans such as car loans which are governed by their PLR. Besides working capital loans, banks provide term loans to companies for new projects, for which they announce a separate medium-term prime lending rate (MTPLR). A cut in PLR means money is available at cheaper rates, thereby giving a fillip to new projects, encouraging new investments and stimulating demand.

What do cuts in CRR and PLR mean?

Since financial sector reforms began, the Reserve Bank of India (RBI) has moved to market-determined interest rates. This means banks are free to decide on interest rates on term deposits and loans. Yet, as the central bank, RBI has to have a handle on interest rates as it is an important tool to control inflation, one of RBI's prime concern. So RBI continues to play the role of a referee and provides a direction to interest rates. The bank rate is one of the tools used by RBI for this purpose as it re-finances banks at this rate. In other words, the bank rate is the rate at which banks borrow from RBI. What impact does a cut in CRR have on interest rates? From time to time, RBI prescribes a CRR, or the minimum amount of cash that banks have to maintain with it. The CRR is fixed as a percentage of total deposits. Following the half percentage point reduction in CRR last week, banks are now required to maintain 10.5 per cent of their deposits with RBI. The deposits earn around 4 per cent interest, which is less than half of the average cost of funds for banks. At present, the total amount of deposits with banks is Rs 6,90,000 crore. Therefore, every one percentage point cut in CRR means that the banking system will have nearly Rs 7,000 crore more available for lending. As more money chases the same number of borrowers, interest rates come down. Does a change in SLR impact interest rates? SLR reduction is not so relevant in the present context for two reasons: One, as a part of the reforms process, the government has begun borrowing at market-related rates. Therefore, banks get better interest rates compared with the earlier days for their statutory investments in government securities. Second, banks are still the main source of funds for the government. Which means despite a lower SLR requirement, banks' investment in government securities will go up as government borrowing rises. As a result, bank investment in gilts continues to be higher than 30 per cent despite RBI bringing down the minimum SLR to 25 per cent a couple of years ago. Therefore, for the purpose of determining the interest rates, it is not the SLR requirement that is important but the size of
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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

the government borrowing programme. As government borrowing increases, interest rates, too, look up. Besides, gilts also provide another tool for RBI to manage interest rates. RBI conducts open market operations by offering to buy or sell gilts. If it feels interest rates are too high, it may bring them down by offering to buy securities at a lower yield than what is available in the market. How does money supply affect interest rates?

Individual economic agents, or even households, hold their wealth in the form of either cash or in some other form like financial securities. For the sake of simplicity, economic theory assumes that people either hold cash, or bonds which bear a rate of return, or interest rate. Households will adjust this portfolio according to a subjective preference of what is the ideal mix between cash and bonds, and will not like to change that mix if all things remain the same. Now suppose there is an increase in the supply of money, brought about by the central bank by buying bonds from the public. Households will now find themselves holding more cash than initially desired, and will hold the additional cash only if the cost of holding cash comes down. The cost of holding cash in this case is nothing but the interest rate on bonds. Therefore, the rate has to fall in response to an increase in money supply for the stock of cash to be held by the public. The conclusion is that an increase in money supply can be held in equilibrium only with a corresponding fall in the rate of interest. What happens if money supply falls?

Conversely, if the supply of money is decreased, then households will find themselves holding less cash than desired, and will be willing to do so only if the interest rate rises. The mechanism would be an open market operation in which the central bank sells bonds to the public, which will pick them up only if the rate of return is high enough to entice cash holders to switch to bonds. Therefore, money supply and interest rates are inversely related. An increase in money supply will be accompanied by a reduction in the rate of interest, and vice versa. How does money supply affect the exchange rate?

If the exchange rate of a country is freely floating, then an increase in money supply will lead to a depreciation of the domestic currency. The reason for this is that an increase in money supply means that domestic currency holders will find themselves holding more real cash balances than desired, and for money market equilibrium, i.e, the additional stock of money to be held by the public, the interest rate must fall.

This creates an incentive to arbitrage funds out of the country into destinations with higher interest rates. Domestic currency holders want to trade in their rupees for forex and invest abroad, which pushes the price of the rupee down. Therefore, an increase in money supply leads to depreciation. If there is a decrease in money supply, then the opposite effect will take place. The exchange rate will appreciate in response to an increase in interest rates and inflow of funds into the country. Are money supply and prices related? Economic theory tells us that there is a relationship between money supply and prices. An increase in money supply will tend to increase prices if there is no change in the output of goods and services. This occurs because with an increase in money supply, domestic agents find themselves having the cash to purchase more goods and services than the market has, creating an excess demand as a result. As more cash chases fewer goods, prices will be bid up by excess demand, and the result will be inflation. So in this model where output does not respond, an increase in money supply will be completely absorbed by an increase in prices, such that the real money balances in the economy remain unchanged. On the other hand, an increase in money supply has the short run impact of lowering the interest rate, which could encourage investment. If this investment activity does lead to an increase in the production of goods and services, the increase in money supply will not translate into a one-to-one increase in prices, and there will be an increase in output.
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IIPM, Bangalore

GLOBAL ECONOMICS AND INTERNATIONAL PLANNING

What are the sources of money?

Money is created by the banking system as a multiple of cash reserves held by banks and currency held by the public. We don't hold all our cash in banks, but the part we do can be used to generate additional deposits (demand deposits) by the banking system. But the supply of money in the system has to come from some source. Currency does not rain into people's pockets. Once again, the intermediation of banks is crucial. In India, the RBI gives data as to where money stock originates. The most important categories are bank credit to the government and bank credit to the commercial sector. The government borrows money to pay for various expenditure programmes, which may be both demand and time deposits. Credit to the commercial sector would also be a combination of demand and time deposits, though demand deposits would be used more for meeting instant payment obligations such as wages and salaries, against future receivables of the commercial sector. Another source of money stock is the foreign exchange assets of banks. Whenever banks acquire foreign exchange assets from private agents, they would have to pay for it in domestic currency, which increases the stock of money with the public. In addition to these, there are government currency liabilities to the public, gross claims on claims on banks, and net nonmonetary liabilities of the banking sector (excluding time deposits), which make up the various sources of money stock.

HOW TO RUN AN ECONOMY: A ROUGH PRIMER BOOM OR BUST? ACTIVITY: Which of these situations represents the Indian economys current scenario the best? Explain citing information as to why you think so. Prepare a 200-300 word write up on the same and submit by the next class.

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