B I G L E A R N I N G S M A D E E ASY

An initiative of Group

INDIAN
ECONOMY

Civil Services Examination

MADE EASY Publications
Corporate Office: 44-A/4, Kalu Sarai (Near Hauz Khas Metro Station), New Delhi-110016
E-mail: infomep@madeeasy.in
Contact: 011-45124660, 8860378007
Visit us at: www.madeeasypublications.org

Indian Economy
© Copyright, by MADE EASY Publications.
All rights are reserved. No part of this publication may be reproduced, stored in or introduced into a retrieval
system, or transmitted in any form or by any means (electronic, mechanical, photo-copying, recording or oth-
erwise), without the prior written permission of the above mentioned publisher of this book.

First Edition: 2017

Second Edition: 2018
Third Edition: 2019

© All rights reserved by MADE EASY PUBLICATIONS. No part of this book may be reproduced or utilized in any form without the written
permission from the publisher.
Contents
Indian Economy

Unit – I Total Fixed Cost and Total Variable Cost............................ 16

Total Cost............................................................................ 16
Chapter - 1 Average Fixed Cost............................................................ 16
Average Variable Cost........................................................ 16
Introduction to Economics...............................................2 Average Total Cost............................................................. 16
1.1 Basics................................................................................... 2 Marginal Cost...................................................................... 16
1.2 Factors of Production............................................................ 2 Average Total Cost and Marginal Cost............................... 16
Land...................................................................................... 2 Opportunity Cost................................................................. 16
Labour.................................................................................. 2
Capital.................................................................................. 2 Chapter - 3
Entrepreneurship.................................................................. 2
1.3 Types of Goods.................................................................... 3 National Income Accounting..........................................18
Final Goods........................................................................... 3 3.1 Introduction......................................................................... 18
Intermediate Goods.............................................................. 4 3.2 Uses of NI Accounting........................................................ 18
1.4 Study of Economics.............................................................. 4 3.3 Circular Flow of Income...................................................... 18
1.5 Schools of Economic Thought.............................................. 4 Importance of Circular Flow................................................ 18
1.6 Types of Economy................................................................ 4 Flow with Saving and Investment........................................ 19
In Terms of Role of State....................................................... 4 Flows in the Four Sector Open Economy: Adding
In Terms of Per Capita Income............................................. 6 Foreign Sector.................................................................... 19
1.7 Structural Composition.......................................................... 6 3.4 Basic Concepts.................................................................. 19
Primary Sector...................................................................... 6 Gross Domestic Product (GDP).......................................... 19
Secondary Sector................................................................. 6 Gross National Product (GNP)............................................ 20
Tertiary Sector....................................................................... 6 Net Factor Income from Abroad......................................... 20
Quaternary Sector................................................................. 6 GDP Deflator....................................................................... 20
Quinary Sector...................................................................... 6 GNP Deflator....................................................................... 20
1.8 Structural Transformation of Indian Economy....................... 6 Difference between GDP and GNP..................................... 20
Peculiar Structural Changes................................................. 7 Gross Value Added (GVA).................................................. 21
Reasons for Rapid Increase in Tertiary Sector...................... 7 3.5 Methods of Estimating GDP/GNP....................................... 21
Expenditure Approach........................................................ 21

Chapter - 2 Income Approach............................................................... 22

Output Approach................................................................ 22
Microeconomics................................................................8 New GDP Series................................................................. 22
2.1 Basic Concepts.................................................................... 8 New GDP Series: A Critical Analysis................................... 23
Theory of Choice................................................................... 8 3.6 Difficulties in Estimating NI................................................. 23
Demand Curve...................................................................... 8 Conceptual Difficulties........................................................ 23
Law of Demand..................................................................... 8 Statistical Difficulties........................................................... 23
Income Effect and Substitution Effect................................... 9 3.7 GDP: A Measure of Welfare................................................ 23
Giffen Goods......................................................................... 9 Genuine Progress Indicator (GPI)....................................... 24
Veblen Goods....................................................................... 9 3.8 Development....................................................................... 24
2.2. Demand Elasticity (DE)......................................................... 9 Growth and Development: A Comparison.......................... 24
Types of Demand Elasticity................................................ 10 Amartya Sen on Development............................................ 25
2.3 Supply Curve and Law of Supply........................................ 12 3.9 Models of Development...................................................... 25
Law of Supply..................................................................... 12 Harrod-Domar Growth Model.............................................. 25
Factors Affecting Law of Supply......................................... 12 Lewis Structural Change (Dual-Sector) Model.................... 25
2.4 Supply Elasticity.................................................................. 13 Rostow’s Model................................................................... 26
2.5 Market Equilibrium.............................................................. 13 3.10 Development in India.......................................................... 26
2.6 Market Structure................................................................. 13 3.11 Development Index............................................................. 26
Perfect Competition............................................................ 13 Human Development Index (HDI)....................................... 26
Monopoly............................................................................ 14 Social Progress Index (SPI)................................................ 27
Monopolistic Competition................................................... 14 Gross National Happiness (GNH)....................................... 27
Oligopoly............................................................................ 15 Gross Sustainable Development Product (GSDP).............. 27
Monopsony......................................................................... 15 3.12 Green GDP......................................................................... 27
2.7 Cost of Production.............................................................. 15 3.13 Human Capital Index ......................................................... 28
Fixed and Variable Cost...................................................... 16 Stand for India’s ranking..................................................... 29

(iii)
 Chapter - 4 Unit – II
Poverty, Inequality and Inclusive Growth..................... 31
4.1 Introduction......................................................................... 31
Chapter - 6
Multidimensional Poverty.................................................... 31 Fiscal Policy.....................................................................62
Multidimensional Poverty Index.......................................... 31 6.1 Introduction......................................................................... 62
4.2 Types of Poverty................................................................. 31 6.2 Objectives of Fiscal Policy.................................................. 62
Absolute Poverty................................................................. 31 6.3 Types of Fiscal Policies...................................................... 62
Relative Poverty.................................................................. 32
6.4 Tools of Fiscal Policy.......................................................... 62
4.3 Poverty Estimation in India.................................................. 33
6.5 Budgeting in India.............................................................. 62
Pre-Independence.............................................................. 33
Budget Formulation............................................................ 63
Post-Independence............................................................ 33
Budget Enactment.............................................................. 63
4.4 Causes of Poverty in India.................................................. 35
Components of Government Budget.................................. 64
4.5 Poverty Alleviations in India Since Independence.............. 35 Deficit.................................................................................. 66
Background........................................................................ 36 Fiscal Consolidation............................................................ 67
Poverty Alleviation Programmes......................................... 36 Types of Government Budgeting........................................ 69
4.6 Strategy for Combating Poverty...................................................... 38 Shortcomings in Budgetary System.................................... 71
Employment-intensive Sustained Rapid Growth................. 39 Budgetary Reforms............................................................. 72
Increasing Effectiveness Anti-Poverty Programs................ 39
6.6 Additional Concepts........................................................... 72
4.7 Inclusive Growth................................................................. 39 Types of Debts.................................................................... 72
Objective............................................................................ 39 Ways and Means Advances (WMA).................................... 73
Steps Taken by Government............................................... 39 Fiscal Drag......................................................................... 73
4.8 Financial Inclusion.............................................................. 40 Fiscal Neutrality.................................................................. 73
Meaning.............................................................................. 40 Crowding Effect.................................................................. 74
Past Efforts.......................................................................... 41 Pump Priming..................................................................... 74
Importance.......................................................................... 41 Economic Stimulus............................................................. 74
Challenges.......................................................................... 41 Tax Expenditure.................................................................. 74
Initiatives on Financial Inclusion......................................... 41 Tax Administration Reforms Commission (TARC)............... 74
4.9 Microfinance....................................................................... 43 15th Finance Commisison – Terms of Refernce................... 74
Importance.......................................................................... 43 Equalisation Levy (EL)........................................................ 75
Challenges.......................................................................... 43 Financial Stability and Development Council (FSDC)......... 75
Way Forward....................................................................... 44
4.10 Universal Basic Income...................................................... 44
Chapter - 7
Meaning.............................................................................. 44
Way Ahead......................................................................... 45 Taxation............................................................................77
4.11 Low Skill Manufacturing...................................................... 45 7.1 Introduction......................................................................... 77
Challenges.......................................................................... 45 7.2 Types of Taxes.................................................................... 77
Steps Taken by Government............................................... 45 7.3 Basic Concepts.................................................................. 82
Proportional Tax.................................................................. 82
Chapter - 5 Progressive Tax.................................................................. 83
Regressive Tax................................................................... 83
Socio-Economic Planning..............................................47 Digressive Tax.................................................................... 83
5.1 Introduction......................................................................... 47
Tax Incidence..................................................................... 84
5.2 Need for Planning............................................................... 47 Tax Burden......................................................................... 84
5.3 Constitutional Provisions..................................................... 48 Tax Base............................................................................. 84
5.4 Objectives of Planning........................................................ 48 Tax Shelter.......................................................................... 84
5.5 Types of Planning............................................................... 48 Tax Avoidance and Tax Evasion......................................... 84
5.6 History of FYPs.................................................................... 49 Tax Haven........................................................................... 84
Four Phases of Indian Plans............................................... 49 Hidden Taxes...................................................................... 84
5.7 Nature of Planning in India.................................................. 52 Pigovian Taxes.................................................................... 84
Imperative Planning............................................................ 52 Tax Buoyancy and Tax Elasticity........................................ 84
Indicative Planning............................................................. 52 Tax Stability........................................................................ 85
Perspective Planning.......................................................... 52 Tobin Tax............................................................................ 85
5.8 Relevance of Planning in Era of Liberalization.................... 52 Robot Tax........................................................................... 85
5.9 Achievements and Failures................................................. 53 GAAR and DTC................................................................... 85
Achievements..................................................................... 53 Minimum Alternative Tax..................................................... 85
Failures............................................................................... 53 Presumptive Tax................................................................. 86
5.10 NITI Aayog.......................................................................... 53 Inverted Duty Structure....................................................... 86
Reasons for Establishment................................................. 54 Laffer Curve........................................................................ 86
Actions Taken by NITI Aayog............................................. 55 Base Erosion and Profit Shifting (BEPS).............................. 86
Evaluation of NITI Aayog’s Performance............................. 58 7.4 Double Taxation Avoidance Agreement (DTAA)................. 87

(iv)
 Chapter - 8 RBI: Regulator of Banking Sector..................................... 105
Functions of RBI................................................................ 105
Money and Monetary Policy...........................................89 10.3 Public Debt Management Agency (PDMA)....................... 106
8.1 Money................................................................................. 89 10.4 Nationalisation of Banks in India....................................... 107
8.2 Types of Money.................................................................. 89 Nationalisation.................................................................. 107
Commodity Money.............................................................. 89 Need................................................................................. 107
Metallic Money.................................................................... 90 Problems........................................................................... 107
Paper Money....................................................................... 90 Advantages....................................................................... 108
Credit Money (Bank Money)............................................... 90 10.5 Types of Banks in India..................................................... 108
Plastic Money...................................................................... 90 General Banks.................................................................. 108
Fiat Money.......................................................................... 90 Special Banks................................................................... 110
Helicopter Money................................................................ 90 10.6 Reforms in Banking Sector............................................... 110
8.3 Money Supply..................................................................... 90 Narasimhan I Committee.................................................. 110
Components of Money Supply............................................ 90 Narasimhan II Committee................................................. 111
Velocity of Money................................................................ 91 10.7 Reforms Proposed............................................................ 112
8.4 Monetary Policy.................................................................. 91 Basel Accords.................................................................. 113
Monetary Policy in India...................................................... 91 Small Finance Banks and Payment Banks........................ 114
Tools of Monetary Policy..................................................... 92 Re-organisation of Banks.................................................. 115
8.5 Additional Concepts........................................................... 94 Domestic Systemically Important Banks (D-SIBs)............. 115
Monetary Policy Transmission............................................. 94 Gyan Sangam................................................................... 116
Monetary Policy Trilemma................................................... 95 10.8 Problems in Banking Sector.............................................. 116
Quantitative Easing............................................................. 95 Rising NPAs...................................................................... 116
Sterilization by RBI.............................................................. 96 Twin Balance Sheet Problem............................................ 117
Governance Issues........................................................... 117
Chapter - 9 10.9 Way Forward..................................................................... 118
‘Indradhanush’ Plan.......................................................... 118
Inflation.............................................................................98
Insolvency and Bankruptcy Code (IBC)............................ 118
9.1 Introduction......................................................................... 98

9.2
Concept of Price and Price Level ...................................... 98
Types of Inflation................................................................. 98
Unit – III
Based on Rate.................................................................... 98 Chapter - 11
Based on Causes............................................................... 98
Other Types........................................................................ 99 Foreign Investment.......................................................123
9.3 Effects of Inflation............................................................. 100 11.1 Exchange Rate................................................................. 123
Lender and Borrower........................................................ 100 Types of Exchange Rate System...................................... 123
Wages............................................................................... 100 Exchange Rate System in India........................................ 124
Salaried Employees.......................................................... 100 Objectives of Exchange Rate Management in India......... 125
Self-Employed................................................................... 100 Nominal Effective Exchange Rate (NEER)........................ 125
Demand and Investment................................................... 100 Real Effective Exchange Rate (REER).............................. 125
Saving............................................................................... 100 11.2 Forex Reserve of India...................................................... 125
Exchange Rate and Export............................................... 100 11.3 Purchasing Power Parity................................................... 125
Import............................................................................... 100 Introduction....................................................................... 125
Employment...................................................................... 100 Big Mac Index: An Example of PPP.................................. 126
Trade Balance.................................................................. 100 GDP (Nominal) and GDP (PPP)........................................ 126
9.4 Measures of Inflation......................................................... 100 11.4 External Commercial Borrowings (ECB)........................... 127
Wholesale Price Index (WPI)............................................. 100 11.5 Foreign Investments: FDI and FII/FPI................................ 128
Consumer Price Index (CPI)............................................. 101 Foreign Direct Investment (FDI) in India........................... 129
Producer Price Index (PPI)............................................... 102 Prohibited Sectors for FDI................................................. 132
9.5 Business Cycle................................................................. 102 FDI Investment Figures..................................................... 132
Recession......................................................................... 102 Recent Government Initiatives to Further Liberalise
Depression........................................................................ 102 FDI Policy.......................................................................... 132
Recovery........................................................................... 102
Boom................................................................................ 102 Chapter - 12
Chapter - 10 Balance of Payments....................................................136
12.1 Introduction....................................................................... 136
Banking System in India...............................................104 12.2 Components of BoPs........................................................ 136
10.1 Introduction....................................................................... 104 Current Account................................................................ 136
Origin................................................................................ 104 Capital Account................................................................ 137
Purpose of Banks During British Rule............................... 104 12.3 Balance of Payments and Foreign Reserve (Forex) ......... 137
10.2 Reserve Bank of India....................................................... 104 Measures to Overcome Disequilibrium/Imbalances in BoP...137
Objectives......................................................................... 105 12.4 Balance of Payments Crisis.............................................. 138
Nationalization after Independence ................................. 105 Role of Global Institutions in BoP Crisis............................ 138

(v)
12.5 Convertibility of Currency.................................................. 139 Need for Reforms in World Bank....................................... 161
Convertibility on Current Account..................................... 139 14.4 IMF and World Bank: A Critical Analysis........................... 162
Convertibility on Capital Account...................................... 139 14.5 Other Institutions............................................................... 163
12.6 India and BoP................................................................... 140 New Development Bank................................................... 163
Historically Important Events............................................ 140 Asian Development Bank (ADB)....................................... 164
Asian Investment Infrastructure Bank (AIIB)..................... 166
Chapter - 13 G20................................................................................... 167
G7..................................................................................... 168
Foreign Trade.................................................................142
13.1 Introduction....................................................................... 142
Chapter - 15
13.2 India’s Place in World Trade............................................. 142
13.3 Foreign Trade Policy in India............................................ 143 World Trade Organization.............................................169
Import Substitution Phase................................................. 143 15.1 Introduction....................................................................... 169
Export Processing Zones (EPZ)........................................ 144 15.2 Rationale for WTO............................................................. 169
Export Oriented Units (1981)............................................ 144 15.3 Objectives of WTO............................................................ 169
EXIM Bank (1982)............................................................. 144 15.4 Evolution of WTO.............................................................. 169
Export Promotion Capital Goods (EPCG) Scheme............ 144 15.5 Organizational Structure................................................... 170
Special Economic Zone (SEZ).......................................... 145 15.6 Principles of WTO............................................................. 171
13.4 Composition of Indian Foreign Trade.....................................147 15.7 WTO Agreements.............................................................. 172
Import Items...................................................................... 147 Agreement on Agriculture (AoA)....................................... 172
Export Basket.................................................................... 148 Trade Related Intellectual Property Rights....................... 173
Trade Balance with Trading Partners............................... 149 Sanitary and Phyto-Sanitary Measures (SPS)................. 174
13.5 Indian Foreign Trade: Agencies........................................ 149 European Union Ban on Imports of Indian Mangoes........ 175
Ministry of Commerce and Industry.................................. 149 General Agreement on Trade in Services (GATS)............ 175
13.6 Foreign Trade Policy (2015-20)......................................... 150 Agreement on Trade Related Investment Measures
13.7 Export Promotion Schemes............................................... 151 (TRIMS)............................................................................. 176
Merchandise Export of India Scheme (MEIS)................... 151 Agreement on Subsidies and Countervailing
Service Export from India Scheme (SEIS)......................... 151 Measures (SCM)............................................................... 176
Duty Exemption and Remission Scheme.......................... 151 15.8 Important Ministerial Meets............................................... 176
13.8 International Collaborations.............................................. 153 Doha Ministerial Meet and Doha Development
India and WTO.................................................................. 153 Agenda (DDA)-2001......................................................... 176
India’s FTAs...................................................................... 153 Bali Ministerial Conference and Bali Package.................. 177
13.9 Regional Agreements....................................................... 155 Nairobi Ministerial Conference.......................................... 178
Regional Comprehensive Economic Partnership (RCEP).155 Buenos Aires Ministerial Conference................................ 178
Trans-Pacific Partnership (TPP) and Comprehensive 15.9 India and WTO.................................................................. 178
and Progressive Agreement for Trans-Pacific India’s Food Security Program and WTO.......................... 178
Partnership (CPTPP)...............................................................155 H-1B Visa Issue and GATS............................................... 179
Trans-Atlantic Trade and Investment Partnership (TTIP).. 156 India-US Poultry Dispute................................................... 180
India and TRIPS (Intellectual Property Rights).................. 180
Chapter - 14
International Economic Organizations........................ 157
Unit – IV
14.1 Bretton Woods Institutions................................................ 157 Chapter - 16
14.2 International Monetary Fund (IMF).................................... 157
Functions.......................................................................... 157 Capital Market and Share Market.................................186
Governance Structure....................................................... 157 16.1 Market............................................................................... 186
IMF Quota System............................................................ 158 16.2 Types of Markets.............................................................. 186
IMF Publications............................................................... 159 Financial Market................................................................ 186
India and IMF.................................................................... 159 Money Market................................................................... 186
Need for Reforms in IMF................................................... 159 16.3 Capital Market................................................................... 187
Reforms Demanded.......................................................... 159 Need for Capital Market.................................................... 187
Recent Reforms Taken by IMF.......................................... 160 Evolution of Capital Market in India................................... 187
14.3 World Bank Group............................................................ 160 Components of Capital Market......................................... 189
Organisation Structure...................................................... 160 Types of the Capital Market.............................................. 189
International Bank for Reconstruction and Secondary Market/Stock Market....................................... 191
Development (IBRD)......................................................... 160 Third and Fourth Markets.................................................. 192
International Development Association (IDA)................... 161 Instruments of Capital Market........................................... 192
International Finance Corporation (IFC)............................ 161 Foreign Investments......................................................... 200
Multilateral Investment Guarantee Agency (MIGA)........... 161 16.4 Regulation of Capital Market in India................................ 205
International Centre for Settlement of Investment 16.5 Securities and Exchange Board of India (SEBI)............... 206
Disputes (ICSID)............................................................... 161 Introduction....................................................................... 206
Important Reports Published by the World Bank.............. 161 Powers.............................................................................. 206

(vi)
 Unit
I
1. Introduction to Economics..............................................................2
2. Microeconomics.............................................................................8
3. National Income Accounting......................................................... 18
4. Poverty, Inequality and Inclusive Growth...................................... 31
5. Socio-Economic Planning..............................................................47
Introduction
1
to Economics
1.1 Basics • This resource includes timber, land, fisheries, farms
and other similar natural resources.
Economics is the science of analyzing the production,
distribution and consumption of goods and services. In • Land is usually a limited resource for many economies.
other words, what choices people make; how and why Example: India has 15% of the global population but
they make them when making purchases. only 2.4% of the global land.

Scarcity is the basic economic problem that exists Labour

because we as humans have unlimited wants that cannot • Labour represents the human capital available to
be met by the limited amount of resources our world transform raw material or national resources into
has. Any good or service that has a non-zero price is
consumer goods.
considered scarce. It will cost you something to consume
• Human capital includes all able-bodied individuals
that good or service. Without scarcity, there would be
capable of working in the nation’s economy and
no reason to study economics. People would consume
providing various services to other individuals or
everything they could possibly consume and not have to
businesses.
make choices or trade-offs between goods and services.
• This factor of production is a flexible resource as
Therefore, Economics is the study of how societies use
workers can be allocated to different areas of the
scarce resources to produce valuable commodities and
economy for producing consumer goods or services.
distribute them among different people.
• Human capital can also be improved through training
1.2 Factors of Production or educating workers.

It is an economic term to describe the inputs that are used Capital

in the production of goods or services in the attempt to • Capital has two economic definitions as a factor of
make an economic profit. The factors of production include production.
land, labour, capital and entrepreneurship. • Capital represents the monetary resources companies
use to purchase natural resources, land and other
capital goods.
• Capital also represents the major physical assets
individuals and companies use when producing
goods or services. These assets include buildings,
production facilities, equipment, vehicles and other
similar items.

Entrepreneurship
• Entrepreneurship is considered a factor of production
because economic resources can exist in an economy
and still not be transformed into consumer goods.
• Entrepreneurs usually have an idea for creating
Land a valuable good or service and assume the risk
• Land is an economic resource encompassing natural involved with transforming economic resources into
resources found within a nation’s economy. consumer products for which they earn profit.
B I G L E A R N I N G S M A D E E ASY
Indian Economy 3
An initiative of Group

1.3 Types of Goods Example

The tea leaves purchased by the consumer are not
Final Goods
consumed in that form – they are used to make drinkable
Any good or service purchased by the consumer tea which is consumed. Similarly, most of the items that
(Individual or Enterprise) can be for final use or for use in enter our kitchen are transformed through the process
further production. An item that is meant for final use and of cooking. But cooking at home is not an economic
will not pass through any more stages of production or activity even though the product involved undergoes
transformations is called a final good. transformation. Home cooked food is not sold to the
Features market. However if the same cooking or tea brewing was
• Once it has been sold, it passes out of the active done in a restaurant where the cooked product would
economic flow. be sold to the customers, then the same items such as
tea leaves would cease to be final goods and would be
• It will not undergo any further transformation at the
counted as inputs to which economic addition takes
hands of any producer.
place. Thus, it is not in the nature of the good but in
• It may however, undergo transformation by the action the economic nature of its use that a good becomes a
of the ultimate purchaser. In fact, many such final final good. Final goods can be further distinguished into
goods are transformed during their consumption. consumer goods and capital goods.

Consumer Goods Capital Goods

Goods bought and used by consumers, rather than by Goods which are used in the production process.
manufacturers for producing other goods. Example: Machinery, Building, Furniture etc.
Examples: Food, shirt, shoes, cigarettes, pen, etc. They help in the production of other commodities, but they
They sustain the consumption of people. themselves don’t get transformed in the process.
Further classified into durable and non-durable goods. These goods form a part of capital of an enterprise.
Durable goods can be used repeatedly over a They gradually undergo wear and tear, and thus are repaired
considerable period. e.g., pen, shirt, shoes, TV. or gradually replaced over time.
Non-durable goods are single use goods which are used
up by consumers in a single act of consumption, e.g., milk,
fruits, matches, cigarettes, coal, etc.
4 Introduction to Economics
B I G L E A R N I N G S M A D E E ASY

An initiative of Group

Intermediate Goods • How should the goods and services be produced?

Should producers use more human labour or more
Of the total production-taking place in the economy, a large
capital (machines) for producing things?
number of products do not end up in final consumption
and are not capital goods either. Such goods may be used • How should the goods and services be distributed
by other producers as material inputs. Examples are steel among people?
sheets used for making automobiles and copper used for Based on the answer of these three questions, the
making utensils. These are intermediate goods, mostly
economic systems are classified into 3 categories:
used as raw material or inputs for production of other
commodities. These are not final goods.

1.4 Study of Economics

The study of economics can be subcategorized into
Microeconomics and Macroeconomics.
• Microeconomics is the study of economics at the
individual or business level; how individual people or
businesses behave given scarcity and government
intervention. Microeconomics includes concepts
such as supply and demand, price elasticity, quantity
demanded and quantity supplied.
• Macroeconomics is the study of the performance and
structure of the whole economy rather than individual
markets. Macroeconomics includes concepts such
as inflation, international trade, unemployment, and
national consumption and production. Capitalist
The capitalistic form of economy has its origin in the famous
1.5 Schools of Economic work of Adam Smith – An Enquiry into the Nature and the
Thought Causes of the Wealth of Nations (1776). He stressed on
There are also schools of economic thought. Two of the ‘laissez faire’ state i.e., non-interference by the government.
most common are Classical and Keynesian.
The decisions of what to produce, how much to produce
• The Classical view believes that free markets are the and at what price to sell ,are taken by the market, by the
best way to allocate resources and the government’s private enterprises in this system with the state having no
role should be limited to that of a fair and strict referee. economic role.
• In contrast, the Keynesian approach believes that • In a capitalist economy, the market determines prices
markets do not work well at allocating resources on through the laws of supply and demand.
their own and that governments must step in from time
For example, when demand for coffee increases,
to time and actively reallocates resources efficiently.
a profit-seeking business will boost prices in order
to increase its profit. If, at the same time, society’s
1.6 Types of Economy appetite for tea diminishes, growers will face lower
prices and aggregate production will decline.
In Terms of Role of State
• If labour is cheaper than capital, more labour-intensive
The most contentious issue that has affected civilized methods of production will be used and vice-versa.
history of humankind is how the production process in an • In a capitalist society, the goods produced are
economy should be organized. Whether the production distributed among people not on the basis of what
should be the sole responsibility of State/Government or people need but on the basis of what people can
should it be left altogether to the private sector? afford and are willing to purchase. This means that a
Every society has to answer three questions, which sick person will be able to use the required medicine
determine the type of economic system: only if he/she can afford to buy it; if they cannot afford
the medicine, they will not be able to use it even if they
• What goods and services should be produced in the
need it urgently.
country?
B I G L E A R N I N G S M A D E E ASY
Indian Economy 5
An initiative of Group

• Communist economy advocates withering away of the

state where means of production would be owned by
community.

Mixed Economy
It is an economic system that
features characteristics of both
capitalism and socialism. A
mixed economic system allows a
level of private economic
freedom in the use of capital, but
also allows for governments to
interfere in economic activities in
order to achieve social aims.
Socialist Mixed economic systems are not laissez-faire systems: the
The socialistic form government is involved in planning the use of resources
of economy was and can exert control over businesses in the private sector.
rooted in the ideas of Governments may seek to redistribute wealth by taxing
historical change the private sector, and using funds from taxes to promote
proposed by the social objectives.
German philosopher
Model Adopted by India
Karl Marx (1818-83).
The leaders of Independent India had to decide the type
More specifically,
of economic system most suitable for our nation, which
this kind of economic
would promote the welfare of all rather than a few.
system first came up in the erstwhile USSR after the
Bolshevik Revolution (1917) and got its ideal shape in the Among the different types of economic systems, socialism
People’s Republic of China (1949). appealed to Jawaharlal Nehru the most. However, he was
not in favour of the kind of socialism established in the
Under a true socialist system, it is the government’s role
former Soviet Union where all the means of production, i.e.
to determine output and pricing levels. The challenge is
all the factories and farms in the country, were owned by
synchronising these decisions with the needs of consumers.
the government. There was no private property. It was not
A socialist society answers the above three questions in a
possible in a democracy like India for the government to
totally different manner:
change the ownership pattern of land and other properties
• In a socialist society the government decides what of its citizens in the way that it was done in the former Soviet
goods are to be produced in accordance with the Union.
needs of society.
The leaders found the answer in an economic system,
• The government decides how goods are to be
which, in their view, combined the best features of
produced and how they should be distributed.
socialism without its drawbacks. In this view, India would
• In principle, distribution under socialism is supposed be a socialist society with a strong public sector but also
to be based on what people need and not on what with private property and democracy; the government
they can afford to purchase. Unlike capitalism, for would plan economy with the private sector being
example, a socialist nation provides free healthcare to
encouraged to be part of the plan effort.
the citizens who need it. Strictly, a socialist society has
no private property since everything is owned by the So, after Independence, India opted for the Mixed
state. Economy. In the process of organizing the economy,
some basic and important infrastructural economic
• Socialistic economy emphasized the collective
responsibilities were taken up by the State Governments
ownership of the means of production (property and
(centre and state) and rest of the economic activities was
assets) and it also ascribed a large role to the state in
left to private enterprise i.e. the market.
running the economy,
 2
Microeconomics

2.1 Basic Concepts The important point is

that most demand curves
Microeconomics is the study of economic tendencies, or are negatively inclined/
what is likely to happen when individuals make certain sloping (consumers
choices or when the factors of production change. demand less as the price
Individual actors are often broken down into micro- rises), while most supply
economic subgroups, such as buyers, sellers and curves are positively
business owners. inclined/sloping
(suppliers are likely to
Theory of Choice produce more at higher prices). The participants in a
A production function expresses the fact that a firm’s market will be driven to the price at which the two curves
output depends on the quantity of inputs it employs. intersect; this price is called the “equilibrium” price or
If the firm wants to maximize profits (defined as the “market-clearing” price because it is the only price at
difference between the sales value of its output and the which supply and demand are equal.
cost of its inputs), it will select that combination of inputs
that minimizes its expenses and therefore maximizes its Demand Curve
revenue. The demand curve is a relation between the quantity of the
good chosen by a consumer and the price of the good. The
Each household is endowed with definite “tastes” that
independent variable (price) is measured along the vertical
can be expressed in a series of “utility functions.” A utility
axis and dependent variable (quantity) is measured along
function (an equation similar to the production function)
the horizontal axis. The demand curve gives the quantity
shows that the pleasure or satisfaction households derive
demanded by the consumer at each price.
from consumption will depend on the products they
purchase and on how they consume these products. The demand curve will move downward from the left to the
right, which expresses the law of demand: as the price
It is necessary to assume that households seek to maximize
of a given commodity increases, the quantity demanded
satisfaction and that they will distribute their given incomes
decreases, all other factors being equal.
among available consumer goods in a way that derives the
largest possible “utility” from consumption. Their incomes, Law of Demand
however, remain to be determined.
Law of Demand states that the other factors remaining
In economic theory, the production function contributes to constant, price and quantity demanded of any good and
the calculation of supply curves (graphic representations services are inversely related to each other. When the price
of the relationship between product price and quantity that of a product increases, the demand for the product will
a seller is willing and able to supply) for firms in product fall. In other words, higher price leads to a lower quantity
markets and demand curves (graphic representations of demanded and that a lower price leads to a higher quantity
the relationship between product price and the quantity of demanded, assuming the other factors affecting demand
the product demanded) for firms in factor markets. remain constant. The given below diagram explains the
All of these demand and supply curves express the law of demand clearly:
quantities demanded and supplied as a function of prices As the Price of commodity decreases from ` 5 to ` 2, the
not because price alone determines economic behavior quantity demanded of the commodity increases from 100
but because the purpose is to arrive at a theory of price units to 400 units.
determination.
B I G L E A R N I N G S M A D E E ASY
Indian Economy 9
An initiative of Group

Giffen Goods
A Giffen good is a good for which demand increases as
the price increases, and falls when the price decreases.
A Giffen good has an upward-sloping demand curve, as
shown in the graph, which is contrary to the fundamental
law of demand.

Assumptions to the Law of Demand:

1. Income of the Consumer: If there is a change in the
income of the consumer then the law of demand would
have no effect. If the income of consumer rises then
even during price rise, the demand of consumer would
be unaffected. Vice versa if the income of the consumer
falls then even during price fall, the consumer demand
would be less.
2. Consumer Taste and Preferences: If the taste, A Giffen good is typically an inferior good that does not
preference, custom or habit of the consumer changes have easily available substitutes, as a result of which the
in respect to the product (either in favour or against the income effect dominates the substitution effect. Staple
product) then the Law of Demand would be ineffective. foods are an example of Giffen Goods. They are consumed
by people living in poverty for the sole reason that they
3. Size and Composition of Population: The size and
are unable to afford superior foodstuffs. As the price of
composition of the total population should not change.
a staple food rises, consumers are unable to supplement
As population increases, so does the demand of the
their diet with the more expensive foods, causing demand
commodity. With a change in the demographics of the
to increase as the price of the staple food increases.
population, the needs and demands of the population
changes and so does the demand of the commodity.
Veblen Goods
Income Effect and Substitution Effect A good for which demand increases as the price increases,
because of its exclusive nature and appeal as a status
The substitution effect is the economic understanding that
symbol. A Veblen good, like a Giffen good, has an upward-
as prices rise — or income decreases — consumers will
sloping demand curve, which runs counter to the typical
replace more expensive items with less costly alternatives.
downward-sloping curve.
Conversely, as the wealth of individuals increases, the
opposite tends to be true, as lower-priced or inferior However, a Veblen good is generally a high-quality, coveted
commodities are eschewed for more expensive, higher- product, in contrast to a Giffen good which is an inferior
quality goods and services, known as the income effect. product that does not have easily available substitutes. As
well, the increase in demand for a Veblen good reflects
Although beneficial to some companies like discount
consumer tastes and preferences, unlike a Giffen good,
retailers, the substitution effect is generally very negative
where higher demand is directly attributable to the price
within an economy, as it limits consumer and producer choice.
increase.
The income effect represents the change in an individual’s
or economy’s income and its impact on the quantity 2.2. Demand Elasticity (DE)
demanded of a good or service. The relationship between
Demand elasticity refers to how sensitive the demand for
income and quantity demanded is a positive one; as a good is to changes in other economic variables, such
income increases, so does the quantity of goods and as the prices and consumer income. Demand elasticity is
services demanded. For example, when an individual’s calculated by taking the percent change in quantity of a
income increases, that person demands more goods and good demanded and dividing it by a percent change in
services, thus increasing consumption, all things equal. another economic variable. Higher demand elasticity for
10 Microeconomics
B I G L E A R N I N G S M A D E E ASY

An initiative of Group

a particular economic variable means that consumers are In case the two goods are substitutes for each other like
more responsive to changes in this variable, such as price tea and coffee, the cross price elasticity will be positive,
or income. i.e., if the price of coffee increases, the demand for tea
• Case 1: DE > 1, it is called elastic that is it reacts increases.
proportionately higher to changes in other economic
factors.
• Case 2: DE < 1, it is called inelastic and the demand
reacts proportionately lower to changes in another
variable.

Complementary Goods

The cross elasticity of demand for complementary goods

is negative. As the price for one goods increases, an item
closely associated with that item and necessary for its
consumption decreases because the demand for the main
good has also dropped.

In case the goods are complementary in nature like pen

and ink, then the cross elasticity will be negative, i.e.
demand for ink will decrease if prices of pen increase or
vice-versa.

Price Elasticity of Demand

Price elasticity of demand is a measure of the relationship
between a change in the quantity demanded of a particular
good and a change in its price. The degree to which rising
price translates into falling demand is called demand
elasticity or price elasticity of demand.
% age change in
quantity demanded
Price Elasticity of Demand (PED) =
Types of Demand Elasticity % age change in price

Cross Elasticity If a small change in price is accompanied by a large change

in quantity demanded, the product is said to be elastic
The measure of responsiveness of the demand for a good
(or responsive to price changes). Conversely, a product
towards the change in the price of a related good is called
is inelastic if a large change in price is accompanied by
cross price elasticity of demand. It is always measured in
a small amount of change in quantity demanded. Price
percentage terms.
elasticity of demand measures the responsiveness of
With the consumption behavior being related, the demand to changes in price for a particular good.
change in the price of a related good leads to a change
• Case 1: If PED = 0, demand is perfectly inelastic.
in the demand of another good. Related goods are of
When the consumers do not respond to the increase
two kinds, i.e., substitutes and complementary goods.
or decrease in the price of a good, and the demand
Substitute Goods remains unchanged, it is said to be perfectly inelastic
(i.e., demand does not change when price changes).
The cross elasticity of demand for substitute goods
For Example: Insulin for a Diabetic patient etc. i.e.,
is always positive because the demand for one good
items of necessity.
increases if the price for the other good increases.
 3
National Income
Accounting
3.1 Introduction 3.3 Circular Flow of Income
National Income (NI) accounting is a bookkeeping system The circular flow of income
that a national government uses to measure the level of is a model of the economy
the country’s economic activity in a given time period. in which major exchanges
Accounting records of this nature include data regarding are represented as flows
total revenues earned by domestic corporations, wages of money, goods, services
paid to foreign and domestic workers, and the amount etc., between economic
spent on sales and income taxes by corporations and agents. The flows of
individuals residing in the country. money and goods
exchanged in a closed
According to D.C. Colander, “National Income accounting
circuit correspond in value, but run in the opposite
is a set of rules and definitions for measuring economic
direction. The circular flow analysis is the basis of national
activity in the aggregate economy.” It tries to summarise the
accounts and hence of macroeconomics.
performance of an economy by measuring national income
aggregates in a year. Some of the metrics calculated by Production, consumption and investment are important
using national income accounting include Gross Domestic economic activities of an economy. In carrying out these
Product (GDP), Gross National Product (GNP) and Gross economic activities, people make transactions between
National Income (GNI). different sectors of the economy. Because of these
transactions, income and expenditure move in circular
3.2 Uses of NI Accounting form. This is called circular flow of income. It is based
• It indicates performance of the economy signifying on two principles.
economy’s strength and failures (i) The expenditure of the buyer because of the income of

• It helps to find out structural changes in the economy. the sellers.

For instance, in India, proportional share of primary (ii) Good and services flow in one direction from sellers to
(agricultural) sector in national income is declining the buyers while money payment for these goods, and
whereas those of secondary (industrial) sector and services flow in opposite direction i.e. from buyers to
tertiary (services) sector are rising. sellers.

• It helps in assessing the current standard of living or In this way, the flow of goods and services (real flow) and
the income distribution within a population. flow of money payments (money flow) together make a
• It helps in making comparison among nations in respect circular flow.
of national income and per capita income which lead us
Importance of Circular Flow
to make suitable changes in plans and approaches to
achieve rapid economic development. The concept of the circular flow gives a clear-cut picture
of the economy. We can know whether the economy is
Therefore, national income data, in a way, is manifestation
working efficiently or whether there is any disturbance
of material results of human activity in an economy.
in its smooth functioning. As such, the circular flow is of
National income accounting demands an understanding
immense significance for studying the functioning of the
of the structure of the macro economy which is exposed
economy and for helping the government in formulating
through a Circular Flow of Income and Product.
policy measures.
B I G L E A R N I N G S M A D E E ASY
Indian Economy 19
An initiative of Group

• It is with the help of circular flow that the problems of spending and income if they find their way back into flow
disequilibrium and the restoration of equilibrium can of expenditure. In free market economies there exists a
be studied. set of institutions such as banks, insurance companies,
• The circular flow establishes a link between producers financial houses, stock markets where households deposit
and consumers. It is through income that producers their savings. The government affects the economy in a
buy the services of the factors of production from the number of ways.
consumers with which the latter, in turn, purchase
Flows in the Four Sector Open Economy:
goods from the producers.
Adding Foreign Sector
• The study of circular flow also highlights the importance
Foreigners interact with the domestic firms and households
of monetary policy to bring about the equality of saving
through exports and imports of goods and services as
and investment in the economy.
well as through borrowing and lending operations through
Flow with Saving and Investment financial market. Goods and services produced within
the domestic territory which are sold to the foreigners are
It reflects that how their savings will affect money flows in
called exports. On the other hand, purchases of foreign-
the economy if households save a part of their income.
made goods and services by domestic households are
called imports.

3.4 Basic Concepts

Gross Domestic Product (GDP)

When households save, their expenditure on goods and

services will decline to that extent and as a result money
flow to the business firms will contract. But savings
by households need not lead to reduced aggregate
20 National Income Accounting
B I G L E A R N I N G S M A D E E ASY

An initiative of Group

Gross Domestic Product measures the aggregate GDP at Market Price and Factor Cost
production of final goods and services taking place within
GDP at market price (MP) is the money value of all domestic
the domestic economy during a year.
final gross output or product of a nation. The term domestic
Features of GDP output refers to the output exclusively produced within the
domestic territory of a country.
GDP has certain features. They are:
GDP estimated at market prices, includes indirect taxes
(i) GDP is expressed in monetary terms. It is the money
but excludes subsidies. GDP estimated at factor cost,
value of all the goods and services produced
excludes indirect taxes but includes subsidies.
domestically in a year.
(ii) GDP takes into account all the values of final goods The term factor cost or basic price is used in the national
accounts to refer to the prices of products as received
and services produced annually.
by producers. Market prices are the prices as paid by
(iii) GDP is a measure of value added, it’s not about output.
consumers. Thus, factor cost or basic prices are equal to
(iv) GDP takes into account those goods which are market prices minus taxes on products plus subsidies on
brought to the market for sale. Thus, it includes the products.
goods having market values.
(v) GDP at market price never includes depreciation of
GDP Deflator
capital goods in course of production. The GDP price deflator is an economic measure of inflation
(vi) Transfer payment like pension, maternity benefits, and is the ratio of nominal to real GDP. Thus if GDP stands
unemployment allowance etc. are not included in for nominal GDP and gdp stands for real GDP then,
GDP since, they have no contribution for production of GDP deflator = GDP/gdp.
output. It is important because an economy’s nominal GDP differs
from its real GDP in that nominal GDP includes inflation,
Gross National Product (GNP)
while real GDP does not. Nominal GDP is economic output
Gross national product (GNP) is an estimate of total value without the inflation adjustment. Nominal GDP is usually
of all the final products and services produced in a given higher than real GDP in cases where inflation is typically a
period by the means of production owned by a country’s positive number.
citizens. GNP is related to GDP in the sense that, GNP
starts with GDP, adds citizens’ investment income from GNP Deflator
overseas investments, and subtracts foreign citizens’ It is an economic metric that accounts for the effects of
investment income earned within a country. inflation in the current year’s gross national product by
GNP measures the total monetary value of the total output converting its output to a level relative to a base period.
produced by a country’s citizens. Therefore, any output The GNP deflator is calculated with the following formula:
produced by foreign residents within the country’s borders GNP Deflator = Nominal GNP/Real GNP.
must be excluded in calculations of GNP, while any output
The GNP deflator provides an alternative to the
produced by the country’s citizens outside of its borders
must be counted. GNP does not include intermediary Consumer Price Index (CPI). The CPI is based upon a
goods and services to avoid double-counting since they defined basket of goods and services while the GNP
are already incorporated in the value of final products and deflator incorporates all of the final goods produced by
services. an economy. This allows the GNP to more accurately
capture the effects of inflation since it's not limited to a
Net Factor Income from Abroad smaller subset of goods.
GNP can be calculated using the following formula:
Difference between GDP and GNP
GNP = GDP + Factor income earned by the domestic
Gross Domestic Product (GDP) and Gross National
factors of production employed in the rest of the world –
Product (GNP) both try to measure the market value of all
Factor income earned by the factors of production of the
goods and services produced for final sale in an economy.
rest of the world employed in the domestic economy
The difference is how each term interprets what constitutes
  GNP = GDP + Net factor income from abroad the economy.