The National And Global Economies

Question 0

Explain the types of countries as categorised by WB

Answer 0

The nations of the world may be divided into two categories: industrial countries and developing countries.

1. Industrial countries:

Most commonly, the criteria for evaluating the degree of economic development are gross domestic product (GDP), the per capita income, level of industrialization, amount of widespread infrastructure and general standard of living.

Which criteria are to be used and which countries can be classified as being developed are subjects of debate.

The economies of the industrial nations are highly interdependent.

As conditions change in one nation, business firms and individuals looking for the best return or interest rate on their funds may shift large sums of money from one country to others. As they do, economic conditions in one country spread to other countries.

As a result, the industrial countries, particularly major economic powers such as the United States, Germany, and Japan, are forced to pay close attention to each other’s economic policies.

• Developing countries greatly outnumber industrial countries.
  2. Developing countries:

A developing country, also called a less-developed country, is a nation with a lower living standard, underdeveloped industrial base, and low Human Development Index (HDI) relative to other countries.

There is no universal, agreed-upon criterion for what makes a country developing versus developed and which countries fit these two categories, although there are general reference points such as a nation’s GDP per capita compared to other nations.

• The World Bank (an international organization that makes loans to developing countries) groups countries according to per capita income (income per person).
• Low-income economies are those with per capita incomes of $1,005 or less. (< ~ ₹ 58,000*)
• Lower-middle-income economies have per capita incomes of $1,006 to $3,975. (~ ₹ 58,000* +)
• Upper-middle-income economies have per capita incomes of $3,976 to $12,275. (~ ₹ 2,32,000* +)
• High-income economies—oil exporters and industrial market economies—have per capita incomes of greater than $12,275. (~ ₹ 7,17,000* +)
• Some countries are not members of the World Bank and so are not categorized, and information about a few small countries is so limited that the World Bank is unable to classify them.

Question 1

Define a household, consumption and investment

Answer 1

1. Household:
   - A household consists of one or more persons who occupy a unit of housing.

• The unit of housing may be a house, an apartment, or even a single room, as long as it constitutes separate living quarters. A household may consist of related family members, such as a father, mother, and children, or it may comprise unrelated individuals, such as three college students sharing an apartment.
• The person in whose name the house or apartment is owned or rented is called the householder.
  2. Consumption:
• Household spending is called consumption. Householders consume housing, transportation, food, entertainment, and other goods and services.
• Household spending (also called consumer spending) is the largest component of total spending in the economy.
  3. Investment:
• Investment is the expenditure by business firms for capital goods—such as machines, tools, and buildings—that will be used to produce goods and services.
• The economic meaning of investment is different from the everyday meaning, “a financial transaction such as buying bonds or stocks.” In economics, the term investment refers to business spending for capital goods.

Question 2

Explain forms of business organisations

Answer 2

Forms of Business Organizations:

Firms are organized as,

• sole proprietorships,
• partnerships, or
• corporations.

1. A sole proprietorship:

is a business owned by one person. This type of firm may be a one-person operation or a large enterprise with many employees. In either case,

the owner receives all the profits and is responsible for all the debts incurred by the business.

There is no separation between the owner and the firm in that the owner has unlimited liability for the firm’s debts, and profits are taxed at the owner’s individual income tax rate.

However, the owner also has sole control over business decisions.

2. A partnership:

is a business owned by two or more partners who share both the profits of the business and responsibility for the firm’s losses.

The partner could be individuals, estates, or other businesses.

Partners owning a firm have unlimited liability for firm debts and are taxed at individual tax rates.

3. Corporations:

State law allows the formation of corporations. A corporation is a business whose identity in the eyes of the law is distinct from the identity of its owners.

A corporation is an economic entity that, like a person, can own property and borrow money in its own name.

The owners of a corporation are shareholders. If a corporation cannot pay its debts, creditors cannot seek payment from the shareholders’ personal wealth.

The corporation itself is responsible for all its actions. The shareholders’ liability is limited to the value of the stock they own.

Corporations are taxed at corporate income tax rates.

In many corporations there are many shareholders who exercise no control over the firm.

A separation of ownership and control may occur when the professional managers of the firm are different individuals from those who own large amounts of stock.

4. Multinational firms:

A multinational business is a firm that owns and operates producing units in foreign countries.

The best-known U.S. corporations are multinational firms. Ford, IBM, PepsiCo, and McDonald’s all own operating units in many different countries.

Ford Motor Company, for instance, is the parent firm of sales organi- zations and assembly plants located around the world.

As transportation and communication technologies progress, multinational business activity will grow.

Question 3

Define Trade surplus, Trade deficit and Net exports

Answer 3

trade surplus:
the situation that exists when imports are less than exports

trade deficit:
the situation that exists when imports exceed exports

net exports:
the difference between the value of exports and the value of imports

Question 4

Explain fiscal year : India

Answer 4

While Indian government, for all its civil and administrative purposes, follows the Gregorian calendar that begins on January 1, it mandates a different 12 month period on called the “fiscal year” for taxation, budget, and financial reporting by the private sector.

The fiscal year begins on April1 and ends on March 31.

Question 5

Explain ‘budget’ what does it constitute, process of its approval and presentation in context of India

Answer 5

The scope of the government is quite broad– from establishing and running the judiciary and law and order, through undertaking activities where market fail and interfere in activities that involve externalities and policy measures.

The government needs finance to support all these economic activities. For which it requires to maintain and present a statement of the expenditures and revenues for the year gone by, and to draw up an estimate for the new year.

The preparation and presentation of such a economic statement is called “budget”. In India, it is finance minister who presents the Union budget in Parliament on the last working day of February. Although the railway budget is presented separately, the consolidated two amounts do form part of the part of the general budget presented by the finance minister.

The speech of the finance minister consists of two parts; Part A the minister presents the Economic Survey of the fiscal year gone by.
It is the ministries view on the annual economic development of the country and it forms the backdrop for the presentation of the budget for new fiscal year in Part B.

Question 6

What is Annual Financial Statement and what does it consist of?

Answer 6

Along with other items presented in the budget document, the finance minister submits the Annual Financial Statement which consists of estimated receipts and spending, which are operated through three separate accounts:

1. The Consolidated Fund
2. The Contingency Fund
3. The Public Account

Question 7

Explain,

1. The Consolidated Fund
2. The Contingency Fund
3. The Public Account

Answer 7

1. The Consolidated Fund:
   - All revenues and loans raised and recovered form part of the consolidated fund.
   - No amount can be spent without the approval of Parliament.
2. The Contingency Fund:
   - It is an imprest that is available to the President of India to meet unforeseen expenditures, such as, expenditure to tackle natural disasters or accidents.
   - Post-facto approval of such expenditure is sought from the Parliament, and an equivalent amount is drawn from the Consolidated Fund.
   - The current corpus of this Contingency Fund is ₹ 500 Cr.
3. The Public Account:
   - holds amounts which are held by the government in trust.
   - these include items such as the Employees’ Provident Fund and Small Savings Collections.
   - the funds in these items do not belong to the government, and have to be eventually returned to the people who have deposited them.
   - No Parliamentary approval is needed for such payments, except when the amounts are withdrawn from the Consolidated Fund and kept in the Public Account for specific expenditures (e.g. road construction)

Question 8

Where does the government get its revenue from?

Answer 8

1. Government receipts are classified into,
   a) Revenue Receipts: (tax + non-tax receipts)
   - tax receipts: the tax that the government collects in the form of corporation tax, personal income tax, customs, excise etc.
   - non-tax receipts: stamp duties, fees, dividends (from PSUs)
   - recurring nature
   b) Capital Receipts:
   - Loans raised by the Center from the market, government borrowings from the RBI & other parties, sale of Treasury Bills and loans received from foreign governments all form a part of Capital Receipt.
   - Non-debt Capital Receipts: Recovery of Loans (RoL) and Disinvestment Receipts (DR) occasional disinvestment proceeds earned by selling PSUs. These are called
   - Non-recurring nature

Question 9

Explain types of government expenditure

Answer 9

There are two types of government expenditure

1. Revenue Expenditure:
   - It includes all expenditure incurred on the functioning of the judiciary, maintaining law and order, routine administration, salaries, subsidies, pensions for the administrative staff, and payments on past debts are classified as revenue expenditure.
   - these are expenditures that do not lead to the creation of assets and are used up for the normal functioning of the government.
2. Capital Expenditure:
   - it include asset-creating expenditures for providing public goods, such as, dams, bridges and roads, and plants and machineries built for use in the government sector.

Question 10

Why governments need to borrow? and generally how many choices does it exercise?

Answer 10

Generally, the non-debt capital receipts are low (earnings are low), as a result governments has to borrow to cover the deficit amount.

Therefore borrowing is a capital receipt, albeit a debt-creating capital receipt.

The government has three choices for generating debt capital receipt:

1. borrowing domestically from the public
2. borrowing from external financial institutions or (under extreme conditions)
3. borrowing from Central bank of the country (RBI)

These three types of borrowings are undertaken by spelling new government securities or bonds.

Question 11

Explain GDP with its different uses

Answer 11

GDP:
Gross Domestic Product (GDP) is the value of the all final goods and services produced within the boundary of a nation during one year. For
India this calendar year is from April 1 - March 31.

‘NOMINAL’: since GDP is calculated with the current market price it is also called as ‘Nominal GDP’

‘GROSS’: means same thing to Economics and Commerce as ‘total’ means to Mathematics;

‘DOMESTIC’: means all the economic activities done inside the boundary of the Nation/Country with its own capital.

‘PRODUCT’: is a word used to define ‘goods and services’ together.

‘FINAL’ is a stage of a product after which there is no known chance of any value addition in it.

Different uses:

1. Per annum percentage change in the GDP is the growth rate of the economy.
2. It is the ‘quantitative’ concept and represent the internal strength of the economy but says nothing about the ‘qualitative’ aspect of the goods and services in the economy.
3. It is used by IMF/WB for comparative analysis of its member nations.

Question 12

Explain NDP [ Net Domestic Product ] and its uses

Answer 12

NDP = GDP - Depreciation

Net Domestic Product (NDP) is the GDP calculated after adjusting the weight of the value of ‘depreciation’(i.e. ‘wear and tear’ that happens when the goods and services are produced).

Everything (except human beings) goes through the process of depreciation.

Governments of the economies decide the rate at which different assets depreciate (in India it is done by Ministry of Commerce and Industry) e.g. residential home in India depreciate 1% per annum while electric fan 10% per annum calculated in terms of the assets price.

This in one way to concept of ‘depreciation’ is used in economics, other is when the value of the domestic currency falls in comparison to the foreign currency it is the situation of ‘depreciation’ for domestic currency, calculated in terms of loss in value of the domestic currency.

In this way, NDP of the economy is always lower than the GDP of the economy for that year because even by innovations/technological development the value of ‘depreciation’ cannot be reduced to absolute zero.

Different uses of NDP:

1. For domestic use only, to study and analyse the loss to economy by depreciation taking into consideration different sectors independently and in comparative period.
2. To show achievements in the area of research and development which had reduced the overall depreciation in historic time period.
3. For economic policy making

However, NDP is not used in the comparative economics because of the relativea/subjective depreciation value interpretations around the world, due to which the depreciation rate varies significantly.

The concept of depreciation does not have absolute universal constant. It is only used by the modern economies to increase the veracity of the national income calculations by reducing the variables and manipulate the nation policy to achieve desired outcomes.

Question 13

Explain GNP [Gross National Product]

Answer 13

GNP is the GDP of a nation with added ‘income from abroad’ (i.e. Factored in trans-boundary economic activities of the nation)

Trans boundary economic activities include:

1. Trade balance:
   The net outcome of the total imports and exports of the country which might be negative (more imports than exports) or positive (more exports than imports). In case of India this has always been negative except three consecutive years i.e. 2000-03. (due to boom in service sector/BPO)
2. Interest of external loans:
   The net outcome on the front of external interests (incoming and outgoing). In case of India it’s always negative as Indian economy has been a ‘net-borrower’ from the world economy.
3. Private remittances:
   The net outcome of the inflow and outflow of private remittances. On this front India has always been a gainer. In 1990s from gulf and afterwards from USA and European countries. In 2012 India was the top gainer ahead of China.

Ultimately, balance of all the three components may turnout to be positive or negative. In CASE OF INDIA it has always turnout to be NEGATIVE which means IT MUST BE SUBTRACTED FROM INDIAS GDP TO CALCULATE THE GNP.

GNP= GDP + INCOME FROM ABROAD* (In case of India it has been NEGATIVE hence will have to subtracted)

This also implies that in case of India the value of GNP has always been lower that the GDP.

Different applications of GNP:

• This is the national income according to which IMF ranks nations of the world (on the basis of PPP volumes).
• GNP is more comprehensive concept of national income as it reflects ‘quantitative’ as well as ‘qualitative’ aspects of the ‘internal’ as well as ‘external’ strengths of the economy.
• GNP is a more comprehensive concept to study and analyse,

> standard of its human capital on international level (net outflow and inflow of remittances)
its dependence or independence on international economic community (net interest outcome on external borrowing/lending)
quality of many social development parameters
(e.g. quality of education, health etc which directly adds to the quality of human capital)

Question 14

Explain NNP [Net National Product]

Answer 14

The NNP of a nation is a GNP after deducting the ‘depreciation’, ergo,

NNP = GNP - Depreciation
or
NNP = GNP + Income from abroad - depreciation

Different uses of NNP:

1. It is the NATIONAL INCOME (NI) of the nation. Though, GDP, NDP, GNP are all national incomes, they are not written with capital ‘N’ and capital ‘I’.
2. It is a PUREST form of National Income
3. When we divide NNP with the population of the country we get “PER CAPITA INCOME (PCI)” of that nation i.e. ‘Income per head per year’.

The important point to be noted is about the subjectivity of the ‘depreciation rate’ which directly affects the comparative outcome of the ‘per capita income’ – higher the rate of depreciation, lower the comparative per capita income. It also affects the outlook of international organisations like WB, IMF, ADB etc

Question 15

Explain Nominal, Real and Disposable Income

Answer 15

Nominal Income:
Is the wage someone gets in hand per day or per month. Without deducting taxes.

Real Income:
This is the nominal income minus present day rate of inflation – adjusted in percentage form.

Disposable Income:
the net part of wage one is free to use which is derived after deducting the direct taxes from the real/nominal income – depending upon the need of the data.

Question 16

Explain the concepts of ‘cost’ and ‘price’ of national income

Answer 16

There are two sets of costs and prices and economy needs to decide which to use for the calculation of its national income.

1. COST:

> Factor/Input/Production cost:
This is a cost that producer has to incur in the process of producing a good or service (such as capital cost). This is also termed as factory cost. This is nothing but the price of the commodity from the producers side.

> Market cost:
Market cost is obtained by adding the indirect taxes to the factor cost. This is the price at which the goods reach the market. (these taxes include cenvat/central excise, CST which is paid by the producers to the central government in India) at this stage it is also known as ‘ex-factory price’ after which state levy their taxes to finally obtain the ‘Market Cost’.

In general parlance the two costs are also referred to as ‘factor price’ and ‘market price’.

IN INDIA, THE INCOME IS CALCULATED BY THE ‘FACTOR COST’ and so is the case of many developing countries (but in developing countries the income is calculated by the market cost). The reason being lack of uniformity in taxes, prices not printed on the products etc

Presently we see great degree of uniformity coming to the tax regime as far as central mechanism through initiation of concepts like GST (Goods and Services Tax) with implementation of GST this aberration will hopefully end at central level. But states remain with their sundry tax regimes as of now.

Although in India income is calculated by the factor cost the CSO (Central Statistical Organisation) publish the income also calculated as per market cost.

2. PRICE:

> Constant price:
For constant price the inflation is considered as stand still at a year of the past (this year of the past is also known as ‘Base year’).

> Current price:
For current price the current rate inflation is added. Current price is the ‘Maximum Retail Price (MRP)’ as we see printed on the products we Se in market.

As per new guidelines the base year has been revised from 1993-94 to 2004-05 (this data based on constant price is known as the ‘new series’ data)

Question 17

Explain ‘base year’

Answer 17

Definition of ‘Base Year’

The first of a series of years in an economic or financial index. A base year is normally set to an arbitrary level of 100. Any year can be chosen as a base year, but typically recent years are chosen. New, more up-to-date base years are periodically introduced to keep data current in particular index.

A base year is the year used for comparison for the level of a particular economic index. The arbitrary level of 100 is selected so that percentage changes (either rising or falling) can be easily depicted.

For example, As per new guidelines the base year for India has been revised from 1993-94 to 2004-05 (this data based on constant price is known as the ‘new series’ data)

Question 18

Explain different types of deficit along with CAD

Answer 18

Based on the types of budget expenditures and revenues, economists consider three kinds of deficits for measuring the prudent handling of government finances,

1.Revenue deficit:

This is the difference between the revenue receipts and revenue expenditure.

This shows the inefficiency of the government in managing its finances as in such a case it has to borrow to finance its administrative activities.

2. Fiscal deficit:

It is difference between the governments total expenditure and total non-debt receipts.

It shows that government has exhausted all of its options to finance its expenditure and only recourse remains is to borrow.

Thus fiscal deficit shows the total debt generated by the government to finance total budget expenditure.

Such a deficit is justified as long as debt incurred is utilised to finance the expenditure to create national assets.

However high fiscal deficit is a matter of great concern for any economy. If accrued year on year it could amount to huge debt and even breakdown of economy e.g. Recently, Greece and Cyprus etc

3. Primary deficit:

This is the difference between fiscal deficit and the interest payments on the debts incurred in earlier years. If the interest payments on earlier debts are removed the primary deficit becomes a smaller amount.

The primary deficit is used by the incumbent government to show that the interest on earlier debts are not of it’s making.

CAD ( CURRENT ACCOUNT DEFICIT ):

• CAD is a measure of a countries trade in which the value of goods and services it imports exceeds the value of goods and services it exports.
• CAD also includes net income, such as interest and dividends, as well as transfers such as foreign aid, though these components tend to make up a smaller percentage of the current account than exports and imports.
• The current account is a calculation of a country’s foreign transactions, and along with the capital account is a component of a country’s balance of payment.

Question 19

What are different principles of taxation?

Answer 19

There is no single principle philosophy for taxation in general. Government uses pragmatic combination of different principles in different contexts according to need and aspirations of the economy.
Broadly we can identify four principles as followes;

1. Benefit principle:
   It holds that tax should be in proportion to the benefit one receives from the government. i.e. If A uses toll five times more than B then A should be taxed five times more than B.
2. Ability to pay principle:
   It holds that taxes people pay should relate to their income and wealth.
   i.e. If A has higher income than B then A should pay higher tax than B, as A’s ability to earn, and therefore pay, is more than B.
3. Vertical equity and Horizontal equity principle:
   It holds that those who are equal should be taxed equally and those who are unequal should be taxed unequally. e.g. If A has same income as B, then they should pay equal taxes. However, if A has higher income than B then A should pay higher taxes than B.
4. Efficiency principle:
   It holds that taxation should not affect the market consumption and production decisions.

One important thing to be noted is that, in any given permutation combination some principles will always be in conflict with the other.
The fairness of any such combinations depends upon the checks and balances in the policy making and implementation.

Question 20

Explain the types of taxes in India

Answer 20

All taxes are classified as either DIRECT TAXES or INDIRECT TAXES,

DIRECT TAXES:

Taxes like personal income tax, wealth tax, corporate tax are charged directly on people or firms.

Taxes like income tax are consistent with the ability to pay principle. e.g. In proportionate income tax all tax payers pay exactly the same proportion of their income as tax. So, the absolute amount paid as tax is higher for the higher income.

Income tax is generally made more distributive by making it PROGRESSIVE, in that, people with higher income not only pay higher amount as tax but also pay higher proportion of their income as tax.

On the other hand REGRESSIVE income tax takes higher proportion of income as tax from poor than it does from the rich.

INDIRECT TAXES:

Indirect taxes are charged on the goods and services and hence indirectly on the people and firms.

These taxes include, Excise Duty charged on the production of goods; Sales Tax imposed on goods at the time of sale; Octroi charged on goods entering a city; Service tax imposed on services; property tax on real estate; and customs duty on the import of goods.

Indirect taxes are easy to collect as they are charged at the point of sale both at wholesale and retail level.

Indirect taxes are generally regressive as poor people end up paying more proportion of their income as tax on goods and services than the rich.

Question 21

Explain the constitutionality of taxation in India

Answer 21

Taxes in India are levied by the Central Government and the state governments. Some minor taxes are also levied by the local authorities such as the Municipality.

The authority to levy a tax is derived from the Constitution of India which allocates the power to levy various taxes between the Centre and the State.

An important restriction on this power is Article 265 of the Constitution which states that “No tax shall be levied or collected except by the authority of law.” Therefore each tax levied or collected has to be backed by an accompanying law, passed either by the Parliament or the State Legislature.

Article 246 of the Indian Constitution, distributes legislative powers including taxation, between the Parliament of India and the State Legislature. Schedule VII enumerates these subject matters with the use of three lists;

List - I:
entailing the areas on which only the parliament is competent to make laws,

List - II:
entailing the areas on which only the state legislature can make laws, and

List - III:
listing the areas on which both the Parliament and the State Legislature can make laws upon concurrently.

Union and the States have no concurrent power of taxation.

Question 22

Enlist the heads(subjects) under Union and State lists for taxation

Answer 22

The list of thirteen Union heads of taxation and the list of nineteen State heads are as follows,

UNION LIST: Parliament of India

1 Taxes on income other than agricultural income (List I, Entry 82)
2 Duties of customs including export duties (List I, Entry 83)
3 Duties of excise on tobacco and other goods manufactured or produced in India except (i) alcoholic liquor for human consumption, and (ii) opium, Indian hemp and other narcotic drugs and narcotics, but including medicinal and toilet preparations containing alcohol or any substance included in (ii). (List I, Entry 84)
4 Corporation Tax (List I, Entry 85)
5 Taxes on capital value of assets, exclusive of agricultural land, of individuals and companies, taxes on capital of companies (List I, Entry 86)
6 Estate duty in respect of property other than agricultural land (List I, Entry 87)
7 Duties in respect of succession to property other than agricultural land (List I, Entry 88)
8 Terminal taxes on goods or passengers, carried by railway, sea or air; taxes on railway fares and freight (List I, Entry 89)
9 Taxes other than stamp duties on transactions in stock exchanges and futures markets (List I, Entry 90)
10 Taxes on the sale or purchase of newspapers and on advertisements published therein (List I, Entry 92)
11 Taxes on sale or purchase of goods other than newspapers, where such sale or purchase takes place in the course of inter-State trade or commerce (List I, Entry 92A)
12 Taxes on the consignment of goods in the course of inter-State trade or commerce (List I, Entry 93A)
13 All residuary types of taxes not listed in any of the three lists (List I, Entry 97)

STATE LIST: State legislature

1	Land revenue, including the assessment and collection of revenue, the maintenance of land records, survey for revenue purposes and records of rights, and alienation of revenues (List II, Entry 45)
2	Taxes on agricultural income (List II, Entry 46)
3	Duties in respect of succession to agricultural income (List II, Entry 47)
4	Estate Duty in respect of agricultural income (List II, Entry 48)
5	Taxes on lands and buildings (List II, Entry 49)
6	Taxes on mineral rights (List II, Entry 50)
7	Duties of excise for following goods manufactured or produced within the State (i) alcoholic liquors for human consumption, and (ii) opium, Indian hemp and other narcotic drugs and narcotics (List II, Entry 51)
8	Taxes on entry of goods into a local area for consumption, use or sale therein (see Value added tax) (List II, Entry 52)
9	Taxes on the consumption or sale of electricity (List II, Entry 53)
10	Taxes on the sale or purchase of goods other than newspapers (List II, Entry 54)
11	Taxes on advertisements other than advertisements published in newspapers and advertisements broadcast by radio or television (List II, Entry 55)
12	Taxes on goods and passengers carried by roads or on inland waterways (List II, Entry 56)
13	Taxes on vehicles suitable for use on roads (List II, Entry 57)
14	Taxes on animals and boats (List II, Entry 58)
15	Tolls (List II, Entry 59)
16	Taxes on profession, trades, callings and employments (List II, Entry 60)
17	Capitation taxes (List II, Entry 61)
18	Taxes on luxuries, including taxes on entertainments, amusements, betting and gambling (List II, Entry 62)
19	Stamp duty (List II, Entry 63)

Question 23

Explain GST

Answer 23

The Goods and Services Tax (GST) is a Value Added Tax (VAT) to be implemented in India, the decision on which is pending.

It will replace all indirect taxes levied on goods and services by the Indian Central and State governments. It is aimed at being comprehensive for most goods and services.

India is a federal republic, and the GST will thus be implemented concurrently by the central and state governments as the Central GST and the State GST respectively.

Exports will be zero-rated and imports will be levied the same taxes as domestic goods and services adhering to the destination principle.

Question 24

What is the significance and implications of deficits, explain with the case of Indian economy in recent years.

Answer 24

DEFICIT = you are spending more than you can earn (though the economic rationale of has many facets).

Although individuals, companies and other organizations can run deficits, the term usually applies to governments.

Ceteris paribus, most governments can run moderate deficits for years, because they are usually highly likely to repay their creditors. With prudent economic policy and management, moderate debt can actually boost the economic growth– as government spending is a component of a nations total output i.e. GDP.

The reason why high and persistent Fiscal Deficit is discouraged lies in its linkage to interest rates, private investment and foreign trade deficit:

IMPLICATIONS ON THE MICRO-ECONOMY:

When governments Fiscal Deficit is large, it implies that the government has to borrow heavily. This means that DEMANDS FOR LOANS WILL RISE IN THE MARKET, CAUSING INTEREST RATES TO RISE. As interest rates rise, the COST OF BORROWING RISES, firms find that fewer and fewer investment projects are viable and many present and future projects are stalled.

This shrinking of economy inadvertently thwarts growth in employment generation and income. In economics, this phenomenon is called ‘Crowding Out’ of private investment by public borrowing.

However, each year the deficit adds to a country’s sovereign debt. As the debt grows, it increases the deficit in two ways.

1. The interest payments = less spending on asset creation = drag on economic growth (as those funds could have been used to stimulate the economy).
2. Higher debt levels can make it more difficult for the government to raise funds. As the debt to GDP ratio is 77% or higher, creditors become concerned about a country’s ability to repay its debt. When this happens, they demand higher interest rates rise to provide a greater return on this higher risk. This increases the deficit each year. (Source: World Bank,Finding the Tipping Point)

Ways of financing Fiscal Deficit and its IMPLICATIONS ON THE MACROECONOMY of the country:

1. Through, Treasury Bonds/printing more money:
   - Actually, It is creating more credit denominated in that country’s currency. However, it has the same effect–it LOWERS THE VALUE OF COUNTRIES CURRENCY. That’s because, as bonds flood the market, the supply outweighs the demand.
   - On the other hand, depreciation in the currency leads to INCREASE IN THE EXPORTS (comparative advantage) while IMPORTS BECOMES EXPENSIVE.
2. Through, Foreign loans:
   - Large Fiscal Deficit might also push the governments to borrow from foreign sources. Sensing profit opportunity due to high interest rates foreign funds increased inflow will increase the demand of the INR.
   - As INR APPRECIATES Indian exports becomes expensive and imports become cheaper.
   - This leads to higher imports for India and lower exports, LEADING TO HIGHER TRADE DEFICIT for the country.
   - Thus, a high Fiscal Deficit may lead to a high trade deficit.

This becomes a self-defeating loop, as countries go deeper into debt to repay their debt and over time leads to large public debt, both domestic and foreign. If it continues, long enough, a country may default.

PIIGS (Portugal, Italy, Ireland, Greece, and Spain) countries in Europe have found themselves in very critical condition on this issue in recent past. e.g. Greece’s debt had crossed more than 142% of its GDP in 2010, leading to disastrous consequences for its economy.

INDIA

India being a net-borrower (except, 2002-04, BPO boom) realising this vulnerability and contingent state of Its economy came up with, THE FISCAL RESPONSIBILITY AND BUDGET MANAGEMENT ACT (FRBM) 2003 (IMF has long been recommending that the FD should not be more than 3% of the GDP). FRBM Act mandated that the Central governments Fiscal Deficit and Revenue Deficit as a percentage of GDP must come down to 3% and 0%, respectively, by 2008-09.

The trend up to 2007-08 clearly showed that the central govt did a reasonable job (asset creation) and considerably reduced the deficits. But in 2008 it had to switch to ‘expansionary fiscal policy’ (in short, increased govt spending and reduced taxes to reduce unemployment) due to global recession, which led to increased percentage of fiscal and revenue deficits in the year 2008-09 and 2009-10.

Under these circumstances the 13th Finance Commission, under chairmanship of Dr V Kelkar, recommended a revised date of 2013-14 to reduce the FD and RD under 3% and 0% respectively. However, the prospect of this happening is low, for Indian economy has not fully recovered from the recession even in 2012.

As a matter of fact the Revenue Deficit as a percentage of the Fiscal Deficit has been extremely high in recent past, averaging about 75%. Such high percentage shows that most of the debts government is incurring is spent on the administrative expenses and will not lead to any asset creation. And these are only central governments deficits. Bigger deficits emerge when the deficits of state governments are included.

Question 25

Explain Currency Swap

Answer 25

Definition:

A currency swap is a foreign-exchange agreement between two institutions to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency.

1. Currency swaps are motivated by comparative advantage.
2. A currency swap should be distinguished from interest rate swap, for in currency swap, both principal and interest of loan is exchanged from one party to another party for mutual benefits.

Structure:

There are three different ways in which currency swaps can exchange loans:

1. The simplest currency swap structure is to EXCHANGE ONLY THE PRINCIPLE with the counterparty at a specified point in the future at a rate agreed now. This type of currency swap is also known as an FX-swap.
2. Another structure is to COMBINE the exchange of loan PRINCIPLE, as above, WITH AN INTEREST RATE SWAP.

In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies.

As each party effectively borrows on the other’s behalf, this type of swap is also known as a back-to-back loan.

3. Last here, but certainly not least important, is to swap ONLY INTEREST payment cash flows on loans of the same size and term.

Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US dollar interest payments for floating-rate interest payments in Euro.

This type of swap is also known as a cross-currency interest rate swap, or cross currency swap.

Question 26

Explain ‘Anti-dumping duty’

Answer 26

• Duty charged by a government on a product that is imported from a foreign firm and that is being sold at a price below the normal value in the exporters domestic market.
• The duty would be equal to the difference between the exporters price in the importing country and the normal value of the product in the exporters domestic market.
  e. g. India has recently imposed anti-dumping duty of $787 per tonne on import of paracetamol, a widely used medicine, from China for five years to protect interest of domestic players from the cheap shipments.

Question 27

What is beggar-thy-neighbour policy?

Answer 27

• Policy followed by many countries to competitively DEVALUE their CURRENCY IN ORDER TO GET ADVANTAGE IN THE EXPORTS.
• Competitive restriction on trade, such as, IMPORT BANS, QUOTAS, and the IMPOSITION OF HIGH CUSTOMS DUTIES, are also sometimes described by this term.

Question 28

Explain Comparative advantage

Answer 28

• A factual description where a person, a firm, or a country has the ability to produce two (or more) goods, though it is relatively more efficient in producing one of them.

Question 29

What is customs duty?

Answer 29

Duty charged by a country on a product before its entry into the domestic market. Sometimes, the term is also referred to as ‘import
tariff’ or just ‘tariff’

Question 30

Explain Free Trade Area (FTA)

Answer 30

• A free-trade area is a theoretical concept where a trade bloc whose member countries have signed a free-trade agreement (FTA), which eliminates tariffs, import quotas, and preferences on most (if not all) goods and services traded between them.
• If people are also free to move between the countries, in addition to FTA, it would also be considered an open border. It can be considered the second stage of economic integration.
• Countries choose this kind of economic integration if their economic structures are complementary. If their economic structures are competitive, it is likely there will be no incentive for a FTA, or only selected areas of goods and services will be covered to fulfill the economic interests between the two signatories of FTA.
  e. g. European Union is one such example of economic and monetary union along with Schengen Agreement for open border policy.

Question 31

Explain the concept of Most Favoured Nation (MFN)

Answer 31

• MFN refers to the principle that forms Article I of GATT.
• This principle mandates that, what ever trade policy treatment a member country metes out to its most favoured nation, the same treatment should be meted out to all other member countries.
• In essence, simply put, it means that all member countries have to be given MFN status. Alternatively, this is also referred to as the NON-DISCRIMINATION PRINCIPLE.

Question 32

Explain New Trade Theories (NTTs)

Answer 32

Trade theories that rely on a preference for variety on the part of consumers and the existence of economies of scale that lead to intra-industry trade.

Question 33

Explain Non-Tariff Barriers (NTBs)

Answer 33

> NTBs are the barriers to import in a country–other than customs duty–and which, among others include quotas, sanitary and phytosanitary regulations, and import licensing.

> Their use has risen sharply after the WTO rules led to a very significant reduction in tariff use.

> Some non-tariff trade barriers are expressly permitted in very limited circumstances, when they are deemed necessary to protect health, safety, sanitation, or depletable natural resources. In other forms, they are criticized as a means to evade free trade rules such as those of the World Trade Organization (WTO), the European Union (EU), or North American Free Trade Agreement (NAFTA) that restrict the use of tariffs.

> Six Types of Non-Tariff Barriers to Trade

1. Specific Limitations on Trade:

Import Licensing requirements
Proportion restrictions of foreign domestic goods (local content requirements)
Minimum import price limits
Free
Embargoes

2. Customs and Administrative Entry Procedures:

Valuation systems
Anti-dumping practices
Tariff classifications
Documentation requirements
Fees

3. Standards:

Standard disparities
Intergovernmental acceptances of testing methods and standards
Packaging, labeling, and marking

4. Government Participation in Trade:

Government procurement policies
Export subsidies
Countervailing duties
Domestic assistance programs

5. Charges on imports:

Prior import deposit subsidies
Administrative fees
Special supplementary duties
Import credit discrimination
Variable levies
Border taxes

6. Others:
   Voluntary export restraints
   Orderly marketing agreements

Question 34

Explain Voluntary Export Restraints (VERs)

Answer 34

• Restraints sought through bilateral negotiations to persuade exporting countries to limit their exports ‘voluntarily’ or to agree to some other means of sharing markets, with a view to protecting domestic industry.
• WTO does not allow continuance of VERs. Instead, some form of special safeguard is allowed for a maximum period of four years if VERs exist, predating the formation of WTO.

Question 35

How is the total output of an economy measured?

Answer 35

1. National income accounting is the system economists use to measure both the output of an economy and the flows between sectors of that economy.
2. Gross domestic product (GDP) is the market value of all final goods and services produced in a year in a country.
3. The GDP also equals the value added at each stage of production.
4. The GDP as output equals the sum of the output of households, business
   firms, and government within the country.
5. The GDP as expenditures equals the sum of consumption plus investment
   plus government spending plus net exports.
6. The GDP as income equals the sum of wages, interest, rent, profits,
   proprietors’ income, capital consumption allowance, and indirect business
   taxes less net factor income from abroad.
7. Other measures of national output include gross national product (GNP),
   net national product (NNP), national income (NI), personal income (PI), and disposable personal income (DPI).

Question 36

What is the difference between nominal and real GDP?

Answer 36

> Nominal GDP measures output in terms of its current dollar values including the effects of price changes; real GDP measures output after eliminating the effects of price changes.

Question 37

What is the purpose of a price index?

Answer 37

> A price index measures the average level of prices across an economy.

> Total expenditures on final goods and services equal total income.

Question 38

How is money traded internationally?

Answer 38

> Foreign exchange is currency and bank deposits that are denominated in foreign currency.

> The foreign exchange market is a global market in which people trade one currency for another.

> Exchange rates, the price of one country’s money in terms of another country’s money, are necessary to compare prices quoted in different currencies.

> The value of a good in a domestic currency equals the foreign currency price times the exchange rate.

> When a domestic currency appreciates, domestic goods become more expensive to foreigners, and foreign goods become cheaper to domestic residents.

> When a domestic currency depreciates, domestic goods become cheaper to foreigners, and foreign goods become more expensive to domestic residents.

Question 39

How do nations record their transactions with the rest of the world?

Answer 39

> The balance of payments is a record of a nation’s transactions with the rest of the world.

> The current account is the sum of the balances in the merchandise, services, investment income, and unilateral transfers accounts.

> The financial account reflects the transactions necessary to finance the movement of merchandise, services, investment income, and unilateral transfers into and out of the country.

> A deficit in the current account must be offset by a surplus in the financial account.

Question 40

Explain ‘Business Cycle’, ‘Boom and Bust’ and ‘Cyclical unemployment’ with reference to Indian economy.

Answer 40

> A phenomenon in a free market economy where periods of high growth in GDP and employment are followed by a low or negative growth in GDP and employment.

1. Business cycles are recurring changes in real GDP, in which expansion is followed by contraction.
2. The four stages of the business cycle are expansion (boom), peak, contraction (recession), and trough.
3. Leading, coincident, and lagging indicators are variables that change in relation to changes in output.

e. g. The period during three fiscal years, 2005-06 to 2007-08 witnessed a stellar performance by the Indian economy, where the average GDP growth rate was 9.47%. And then all of sudden growth rate dipped to 4.93% in 2008-09. Episodes of such booms and busts with uncertain periodicity get repeated.
- If we try to analyse the GDP growth rate of India from the fiscal year 1966-67 to the fiscal year 2011-12 keeping in mind the coinciding socio-economic and political events, following inferences emerge:
- 1966-67 (growth rate of about -0.04) > WAR WITH PAKISTAN > the very low growth rate of about 1.63% in 1971-72
- Negative growth rate of about -0.55% in 1972-73 can be attributed to the WAR that carved out a new nation > BANGLADESH
- The biggest trough in the GDP growth rate appears in the fiscal year 1979-80, the year of the OIL SHOCK, when world experienced the shortage of crude oil due to the Iranian revolution and successive price hikes by OPEC.
- Another monumental event that affected the Indian economy was the beginning of ECONOMIC REFORM 1991. Prospects were bleak for the economy at that time– business refrained from major decisions in the expectation of a devaluation of the Indian rupee. As expected rupee was devalued by about 20% in July 1991. GDP GROWTH RATE CAME DOWN TO MERE 1% that year.

• A decade later 9/11, the WORLD TRADE CENTRE came down in one of history’s most horrendous terrorist attacks in September 11, 2001.
  It jolted the world economy, bringing India’s GDP in 2002 to 3.77%.
• The last full downturn in India was witnessed in 2008, immediately following the 2007, US subprime crisis.

> Boom and Bust is a term used to describe business cycles.

> Cyclical unemployment is a unemployment associated with the business cycle or the boom and bust in the economy.

Question 41

Why is inflation a problem?

Answer 41

1. Inflation becomes a problem when income rises at a slower rate than prices.
2. Unexpectedly high inflation hurts those who receive fixed-dollar payments (e.g., creditors) and benefits those who make fixed-dollar payments (e.g., debtors).
3. Inflation can stem from demand-pull or cost-push pressures.
4. Hyperinflation—an extremely high rate of inflation—can force a country to introduce a new currency.

Question 42

What is ‘Stagflation’? Explain with reference to recent developments in India.

Answer 42

STAGFLATION:

An economic phenomenon characterised by HIGH INFLATION and HIGH UNEMPLOYMENT.

> Owing to some negative socio-economic and political factors, business pessimism sets in, and a deficient demand leads to recession (fall in GDP and Employment).

> In such a situation (i.e. recession) EXPANSIONARY fiscal and monetary policies are adopted to revive the economy.

> On the other hand, if economy is overheated (i.e. high growth rate in GDP and low unemployment rate and high inflation) the CONTRACTIONARY fiscal and monetary policy will be followed.

> In the aftermath of the subprime crisis, economies world over suffered a recession, which in the US and the UK turned into depression (i.e. very severe form of recession)

> India’s GDP growth rate suddenly fell from 9.82 in the fiscal year 2007-08 to 4.93 in the fiscal year 2008-09, but it pulled out of the recession through expansionary fiscal and monetary policies. As a result, GDP averaged about 9% in 2009-10 and 2010-11.

> But soon double digit inflation surfaced in the economy at the same time, throughout 2011. Along with financial crisis resurgence in European countries around 2010 dampening stock-market activity and international trade.

(* And, to add to this, business confidence was weakened due to successive corruption allegations, scams and policy paralysis in the incumbent government)

> The some total of the above developments was that, on the one hand, cost-push inflation raised its head, and on the other, a deficient demand in the economy slowed down the GDP growth rate.

> THIS MENT THAT INDIA IN 2011 SUFFERING FROM STAGFLATION, i.e. Simultaneous existence of Inflation and unemployment.

> Double digit inflation was such a major concern that RBI throughout the year increased the repo-rate more than a dozen times in the hope that private sector would slow down and the inflation would be curtailed (even at the cost of fall in GDP growth rate).

> Handling Stagflation is always difficult. Ergo, it has to be complemented by some customised policies. (Check ‘reforms’).

Question 43

Explain ‘fiscal policy’

Answer 43

The policy adopted by the government of a country to alter its SPENDING or TAXES to bring changes to GDP, employment and inflation in the economy.

Question 44

What is ‘monetary policy’?

Answer 44

The policy adopted by the central bank of a country to change MONEY SUPPLY to bring changes to GDP, employment and inflation in the economy.

Question 45

What is ‘recession’?

Answer 45

An economic phenomenon where GDP falls for at least two consecutive quarters. Quite often, a sharp fall in the GDP growth rate also gets described as recession.

Question 46

Define following unemployments;

1. Frictional
2. Involuntary
3. Natural
4. Structural
5. Voluntary

Answer 46

1. Frictional Unemployment:
   Unemployment that occurs when people happen to be between jobs or have just graduated from school.
2. Involuntary Unemployment:
   An activity status where individuals actively seek jobs at given wage rates but do not find one.
3. Natural Unemployment:
   Unemployment that consists of the frictional and structural types.
4. Structural Unemployment:
   Unemployment caused by structural changes among various sub-sectors of the economy, leading to a mismatch between the vacancies and the skills in the labour force, until workers can be retrained or relocated.
5. Voluntary Unemployment:
   An activity status where individuals choose not to seek employment at the given wage rates.

Question 47

Explain Fiscal Consolidation:

Answer 47

Fiscal consolidation is a term that is used to describe the creation of strategies that are aimed at minimizing deficits while also curtailing the accumulation of more debt.

The term is most commonly employed when referring to efforts of a local or national government to lower the level of debt carried by the jurisdiction, but can also be applied to the efforts of businesses or even households to reduce debt while simultaneously limiting the generation of new debt obligations.

From this perspective, the goal of fiscal consolidation in any setting is to improve financial stability by creating a more desirable financial position.

Fiscal consolidation is important to any type of government fiscal policy that focuses on the elimination of debt. In order for the policy to function properly, it must consider the total cost of essential expenses and identify ways to generate as much benefit from those purchases as possible.

This often means creating procedures that help to eliminate waste, effectively increasing the efficiency of the consumption of the goods and services purchased. Doing so helps to minimize the amount of new debt that is created as a result of making purchases.

Question 48

What is “primary surplus”? explain with current Eurozone crisis.

Answer 48

Simply put, it means that tax revenues exceed program spending

One crucial concept for understanding the Eurozone crisis or sovereign debt dynamics in general is the idea of a budget that’s in “primary surplus.” What does that mean? Simply put, it means that tax revenues exceed program spending — i.e., spending if you ignore interest on outstanding debt. But what’s the significance of that?

I don’t normally like to explain public finance in terms of analogies to household budgets, but in this case I think it’s illuminating. Imagine a household where current month-to-month expenses are lower than income. You have a salary, in other words. Then you deduct taxes and health insurance premiums and then you pay the rent and the utility bills and the groceries and the care insurance and gasoline and other basic expenses and you’ve got a positive number left over each and every month. You should be in good shape. Your income exceeds your expenses, so you’re prepared to save up for vacations or new purchases of durable goods or the occasional luxury. But you have a problem. Several years ago you wracked up a ton of credit card debt traveling to your friends’ destination weddings even though you really couldn’t afford it. So today in addition to all those basic expenses you have to pay interest on the outstanding debt. You’ve got a primary surplus, meaning that income > expenses but an overall deficit meaning that income < expenses + interest. What are your options? Well you can cut expenses to shift into overall surplus (austerity), you can declare bankrupty (default), or else you can try to refinance your debt (bailout).

Here I think it’s best to exit the analogy since the options look different for a household than for a country. A person declaring bankruptcy is quite different from a country defaulting, but the bottom line is that an entity (be it a household or a firm or a government) with a primary surplus is in pretty good shape. All you need to do to get fully into the black is to stop making payments on your debt. The biggest price you’ll pay for this is that you can’t borrow any more money. But with your primary surplus in place, you don’t need to borrow any more money. It’s your creditors who have a much more fundamental problem. Unless they can find a way to coerce you into austerity, they’re going to wind up eating a loss one way or the other. If the bankruptcy code is sufficiently favorable to the interests of creditors, they may be able to do this. In an international context, it may be possible to send in the navy to blockade ports and demand payment.

Question 49

Explain under recovery

Answer 49

What is underrecovery?

It is the gap between the local price of fuel and what would have been the price if the fuel were imported.

Is under-recovery the same as loss?

It is a notional loss in revenue to the extent the international price of the fuel is higher. It may or may not be a loss-making proposition to produce the fuel when there is an under-recovery.

In case of kerosene, oil companies suffer an under-recovery as well as a loss because the local retail price is much lower than the cost of crude oil. But sale of a product like petrol can still be very profitable at times, even if oil companies are reporting under-recovery of a few rupees a litre.

Does a rise in underrecovery make an oil co’s operation less profitable?

It may not. At times, international crude oil prices remain flat but petrol and diesel prices rise. In such a situation, an Indian refinery’s profitability will not change because crude oil costs have not gone up. But under-recovery would have risen because the cost of importing the fuel would have risen.

Question 50

Explain “Deleveraging”

Answer 50

Deleveraging

> At the micro-economic level,

deleveraging refers to the reduction of the leverage ratio, or the percentage of debt in the balance sheet of a single economic entity, such as a household or a firm.

It is the opposite of leveraging, which is the practice of borrowing money to acquire assets and multiply gains and losses.

> At the macro-economic level,

deleveraging of an economy refers to the simultaneous reduction of debt levels in multiple sectors, including private sectors and the government sector.

It is usually measured as a decline of the total debt to GDP ratio in the national account.

The deleveraging of an economy following a financial crisis has significant macro-economic consequences and is often associated with severe recessions.

Question 51

WPI in India

Answer 51

The Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods.

Some countries (like India and The Philippines) use WPI changes as a central measure of inflation.

But now India has adopted new CPI to measure inflation. However, United States now report a producer price index instead.

The Wholesale Price Index or WPI is “the price of a representative basket of wholesale goods”.

Some countries use the changes in this index to measure inflation in their economies, in particular India – The Indian WPI figure was released weekly on every Thursday .

But since 2009 it has been made monthly.

It also influences stock and fixed price markets. The Wholesale Price Index focuses on the price of goods traded between corporations, rather than goods bought by consumers, which is measured by the Consumer Price Index.

The purpose of the WPI is to monitor price movements that reflect supply and demand in industry, manufacturing and construction. This helps in analyzing both macroeconomic and microeconomic conditions.

Question 52

Explain GDP deflator:

Answer 52

GDP deflator:

In economics, the GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestically produced, final goods and services in an economy.

[GDP stands for gross domestic product, the total value of all final goods and services produced within that economy during a specified period]

Like the consumer price index (CPI), the GDP deflator is a measure of price inflation/deflation with respect to a specific base year; the GDP deflator of the base year itself is equal to 100. Unlike the CPI, the GDP deflator is not based on a fixed basket of goods and services; the “basket” for the GDP deflator is allowed to change from year to year with people’s consumption and investment patterns.

Question 53

Explain: India’s Fiscal Deficit issue 2013-15

Answer 53

What is fiscal deficit

While some experts believe that fiscal deficit is a positive that helps the country grow, conservatives think otherwise, favoring a balanced budget policy.

Here’s a start to understanding what fiscal deficit means and why it really matters to India’s economic wellbeing.

What is fiscal deficit?

Fiscal deficit is the difference between the government’s expenditures and its revenues (excluding the money it’s borrowed). A country’s fiscal deficit is usually communicated as a percentage of its gross domestic product (GDP).

Considering that the Indian economy is growing between 5 to 5.5 percent in the financial year ended March 2013, fiscal deficit is definitely a challenge to the economy. According to the World Bank, growth in India is projected to rise to 6.5 percent and 6.7 percent in FY2014 and FY2015, respectively.

All said and done, India’s fiscal deficit has been the centre of debate for many occasions this year. And in April, Finance Minister, P Chidambaram has brought it down from 4.9 percent last year to 4.8 percent of the GDP in 2013-14.

What are the causes of fiscal deficit?

Government spending, inflation and lower revenue are among some of the main factors that point to fiscal deficit. The cynical nature of fiscal deficit does not only jeopardize the growth of the country but also the government’s economic management abilities.

In an ideal financial system, which has a balanced fiscal deficit, the cost of expenditure is low while production and growth is advancing. But when there is an increase in fiscal deficit it means that the government is spending too much while it is earning less. Hence, it is important that the government keeps its expenses under control.

One way the government earns money, is through taxes. For example, if the government lowered taxes or provided tax concessions to a particular group of people, then it would earn less, leading to an increase in fiscal deficit. And that’s one of the reasons why you will find the government giving a face-lift to the tax structures. In the same context, cutting of custom duty and excise duty will lead to declining revenues.

Like India, many developing countries are making an effort to resolve big fiscal deficits. On the bright side, for India, among other sources of revenue, foreign investments and inflow of remittances from Indians living overseas has helped avoid very high deficits.

Fiscal deficit does not come about only in case of creating less revenue and spending more money. Another major reason for a growing fiscal deficit can be slow economic growth or sluggish economic activities.

How fiscal deficit can be bad for India?

A large fiscal deficit is an indication that the economy is in trouble and will have reasons to worry. A high fiscal deficit could pose an inflation risk, minimize the growth of the economy, doubt the government’s abilities; it could affect the country’s sovereign rating, which in turn will limit foreign investors from looking at India as one of the investment hubs.

It is believed that high fiscal deficit can be corrected. For example, if the government could not control its expenditures, it could raise taxes to cover up for the extra amount of money spent. When taxes increase, consumers will involuntarily have to cut down on their expenditure to pay the government.

Also, the government expenditure puts pressure on interest rates creating a negative impact on savings. And yes, the Indian government can choose to import money into the country to balance the soaring fiscal deficit, but this move could appreciate the country’s currency and the government will have to pay interest on its borrowings, eventually increasing the deficit and affect the country’s economic growth. Therefore, delay in adjusting high fiscal deficit shows that the government cannot control its finances properly.

Did you know that several government projects are stalled because of high fiscal deficit? Here’s why. When a country labors under high fiscal deficit, it limits the government’s spending capacity and this has an effect on the continuous funds various projects need. Infrastructure projects, or welfare policies, or education and healthcare projects, for example.

The trouble with high fiscal deficit is that it leads to higher interest rates, disturbing the entire economy.

Since the government is not earning much, it will have to restrict its expenses, unless it chooses to borrow. And since the government abilities are doubted due to its incapacity to control its profligacy, it is very difficult for the government to access loans. And even if it gets loans, they are given at high interest rates. On the one hand, the government borrows because it does not have enough money, and on the other hand, it has to pay more for borrowing money. Hence, fiscal deficit leads to a slow progress of the nation.

Difference between fiscal deficit and budget deficit

Budget deficit is commonly known as the national debt. Budget deficit means that a country has more money going out when compared to the money its earning. Budget deficits can usually be resolved by raising taxes, cutting spending or a combination of both. Unlike fiscal deficit, while calculating budget deficit, the country’s borrowings are taken into consideration. India’s budget deficit last fiscal year was 4.9 percent of gross domestic product.

In case of fiscal deficit, it can be measured without taking into account the interest it pays on its debt. Fiscal deficit is basically the difference between the money it spends and the money it makes.

Difference between fiscal deficit and current account deficit

Fiscal deficit is a percentage of the nation’s GDP and can be considered as an economic event in which the government expenditure exceeds its revenue. Meanwhile, current account deficit occurs when the country’s imports are greater than the country’s exports of goods, services and transfers.

Most developing countries run a short term current account deficit to boost domestic productivity, which could lead to increase in exports in the future.

After India’s current account deficit hit a historic high of 6.7 percent of GDP in Q3 of last fiscal year, it was at 5 percent of the GDP in the year ended March, making the rupee weak and also making way for lower interest rates.

India’s fiscal deficit and its current affairs

According to government data, India’s fiscal deficit during 2012-13 financial year was 4.9 percent of the nation’s gross domestic product. While China aims to keep its fiscal deficit below 3 percent this year, let’s take a look at how fiscal deficit is making news in India.

Curbing import on gold is one of the measures taken by the government to correct the country’s fiscal deficit. But with a weakening rupee and increase in global oil prices, the finance minister might put a cap on the country’s expenditure to avoid pressure on fiscal deficit.

In previous years, growing fiscal deficit has given rise to the balance of payment crises. But in the recent years, the government has taken action steps to correct the situation by cutting service taxes, excise duty and carefully stepping up government expenditure.

Also, when the cabinet decided to come out with the Food Security Bill which guaranteed quality food grains at subsidized rates, the concern of fiscal deficit slipping by 0.5 percent was predicted by experts. And then earlier in July, the Government of India reassured the nation that execution of the Food Security Bill will not affect the fiscal deficit target for the year.

Fiscal deficit has been a key concern for credit rating agencies and RBI is likely to be on alert when it pays its debt because paying high interests with cautious investors amid rising deficits might not be considered a smart move.

Why is India’s fiscal deficit continually high?

While the government fights to manage money, here are a few reasons why India has a soaring fiscal deficit. It is high because in the corporate sector, bailouts are becoming common and subsidies are being high. The money that the government earns through non-tax revenue is not big and the money it earns from taxes is not enough.

Question 54

Explain the (REER) Real Effective Exchange Rate or The trade-weighted effective exchange rate.

Answer 54

The trade-weighted effective exchange rate index is an ECONOMIC INDICATOR FOR COMPARING EXCHANGE RATE of a country against those of their major trading partners.

The trade-weighted effective exchange rate index, a common form of the effective exchange rate index, is a MULTILATERAL EXCHANGE RATE INDEX.

It is compiled as a WEIGHTED AVERAGE OF EXCHANGE RATES of home versus foreign currencies, with the WEIGHT FOR EACH FOREIGN COUNTRY EQUAL TO ITS SHARE IN TRADE.

Depending on the purpose for which it is used, it can be export-weighted, import-weighted, or total-external trade weighted.

By design, movements in the currencies of those trading partners with a greater share in an economy’s exports and imports will have a greater effect on the effective exchange rate.

In a multilateral, highly globalized, world, the effective exchange rate index is much more useful than a bilateral exchange rate, such as that between the Australian dollar and the United States dollar, for assessing changes in the competitiveness due to exchange rate movements.

Generally, the weighting method is geometric weighting rather than arithmetic weighting. Refer to weighted geometric mean.

The use of trade weights in a globalized economy is potentially misleading, because the amount of value added content in exports destined for a country may deviate significantly from the gross value of exports shipped to that country. See the entry under effective exchange rate index for an alternative approach to compiling an effective exchange rate index.

Question 55

Gross Value Added (GVA) at basic prices and GVA at Factor Costs

Answer 55

Gross Value Added (GVA) at basic prices and GVA at Factor Costs

Gross Value Added (GVA) Vs. GDP
Gross value added (GVA) is defined as the value of output less the value of intermediate consumption. Value added represents the contribution of labour and capital to the production process. When the value of taxes on products (less subsidies on products) is added, the sum of value added for all resident units gives the value of gross domestic product (GDP). Thus, Gross Domestic Product (GDP) of any nation represents the sum total of gross value added (GVA) (i.e, without discounting for capital consumption or depreciation) in all the sectors of that economy during the said year after adjusting for taxes and subsidies.

Introduction of GVA at basic prices in India
In India, GDP is estimated by Central Statistical Office (CSO). Under the Fiscal Responsibility and Budget Management Act 2003 and Rules thereunder, Ministry of Finance uses the GDP numbers (at current prices) to peg the fiscal targets. For this purpose, Ministry of Finance makes their own projections about GDP for the coming two years while specifying future fiscal targets.

In the revision of National Accounts statistics done by Central Statistical Organization (CSO) in January 2015, it was decided that sector-wise wise estimates of Gross Value Added (GVA) will now be given at basic prices instead of factor cost. In simple terms, for any commodity the basic price is the amount receivable by the producer from the purchaser for a unit of a product minus any tax on the product plus any subsidy on the product. However, GVA at basic prices will include production taxes and exclude production subsidies available on the commodity. On the other hand, GVA at factor cost includes no taxes and excludes no subsidies and GDP at market prices include both production and product taxes and excludes both production and product subsidies.

The relationship between GVA at Factor Cost and GVA at Basic Prices and GDP at market prices and GVA at basic prices is shown below:

GVA at factor cost + (Production taxes less Production subsidies) = GVA at basic prices
GDP at market prices = GVA at basic prices + Product taxes- Product subsidies
Production taxes or production subsidies are paid or received with relation to production and are independent of the volume of actual production. Some examples of production taxes are land revenues, stamps and registration fees and tax on profession. Some production subsidies include subsidies to Railways, input subsidies to farmers, subsidies to village and small industries, administrative subsidies to corporations or cooperatives, etc. Product taxes or subsidies are paid or received on per unit of product. Some examples of product taxes are excise tax, sales tax, service tax and import and export duties. Product subsidies include food, petroleum and fertilizer subsidies, interest subsidies given to farmers, households, etc. through banks.

The concept of GVA at basic prices follows from the United Nation’s System of National Accounts (SNA) introduced in 1993 and carried forward in an identical fashion in SNA 2008 as a part of revision of compilation and classification systems. This has been adopted by CSO in its base revision carried out in January 2015.

Question 56

What is PMI?

Answer 56

What is Purchasing Managers’ Index (PMI)?

Started in 1948 by the US-based Institute of Supply Management, the Purchasing Managers’ Index, or PMI, has now become one of the most closely watched indicators of business activity across the world.

What is a PMI?

PMI or a Purchasing Managers’ Index (PMI) is an indicator of business activity – both in the manufacturing and services sectors. It is a survey-based measures that asks the respondents about changes in their perception of some key business variables from the month before. It is calculated separately for the manufacturing and services sectors and then a composite index is constructed.

How is the PMI derived?

The PMI is derived from a series of qualitative questions. Executives from a reasonably big sample, running into hundreds of firms, are asked whether key indicators such as output, new orders, business expectations and employment were stronger than the month before and are asked to rate them.

How does one read the PMI?

A figure above 50 denotes expansion in business activity. Anything below 50 denotes contraction. Higher the difference from this mid-point greater the expansion or contraction. The rate of expansion can also be judged by comparing the PMI with that of the previous month data. If the figure is higher than the previous month’s then the econ-omy is expanding at a faster rate. If it is lower than the previous month then it is growing at a lower rate.

What are its implications for the economy?

The PMI is usually released at the start of the month, much before most of the official data on industrial output, manufacturing and GDP growth becomes available. It is, therefore, considered a good leading indicator of economic activity. Economists consider the manufacturing growth measured by the PMI as a good indicator of industrial output, for which official statistics are released later. Central banks of many countries also use the index to help make decisions on interest rates.

What does it mean for financial markets?

The PMI also gives an indication of corporate earnings and is closely watched by investors as well as the bond markets. A good reading enhances the attractiveness of an economy vis-a- vis another competing economy. For instance, India’s manufacturing activity as measured by the PMI expanded to 57.6 5 in July, while for China it dipped for the first time in over a year.