Multidimensional Poverty Index (MPI) – Identification &
Computation Process
I. Identification Process
1. Determine the Set of Indicators
Select the indicators (e.g., health, education, living standards) to measure
poverty.
2. Set the Deprivation Cut-off for Each Indicator
Decide a threshold below which a person is considered deprived in that
particular indicator.
3. Check if the Individual is Deprived in Each Indicator
For each indicator, assign a score of 1 (deprived) or 0 (not deprived).
4. Select Weights for Each Indicator and Dimension
Assign relative importance (weight) to each indicator.
5. Calculate the Weighted Sum of Deprivation
Sum up the weighted values for each individual. This gives the deprivation
score.
6. Apply the Second Cut-off to Identify MPI Poor
If the deprivation score exceeds a threshold (commonly 33%), the
individual is considered MPI poor.
II. Aggregation (Measuring MPI at Population Level)
1. Head Count Ratio (H)
Percentage of the population identified as MPI poor.
2. Intensity of Poverty (A)
Average deprivation score among the poor.
3. MPI Formula:
MPI=H×A
Example: MPI Score for India (Middle Age Group)
● Cut-off: 0.33
● Sample Deprivation Score:
○ Nutrition: 0.74
○ Health: 0.52
○ Others: 0.21
○ Calculation:
Indicators and Weights Used in MPI
(Health)
1. Nutrition (1/6)
2. Child Mortality (1/6)
3. Maternal Health (1/6)
(Education)
4. Years of Schooling (1/6)
5. School Attendance (1/6)
(Living Standards)
6. Drinking Water (1/21)
7. Housing (1/21)
8. Assets (1/21)
9. Bank Account (1/21)
10. Cooking Fuel (1/21)
11. Electricity (1/21)
12. Sanitation (1/21)
Note: India follows the MPI methodology set by the UNDP but adjusts
indicators slightly to reflect local conditions.
III. Important Notes:
● The MPI does not consider the quality of indicators.
● It raises questions like:
○ How are the weights decided?
○ Who decides the cut-offs?
IV. Characteristics of the Poor
1. Poor health outcomes due to malnutrition.
➜ Leads to disease spread, inability to work, and high medical
expenditure.
2. Poor access to education
➜ Leads to child labor and employment in low-income jobs.
3. Larger family sizes
4. High dependency ratio
➜ Reduces income per person.
5. Work in unorganized sectors with no job security or social protection.
6. Around 90% of the poor work in the informal sector.
7. Lack of assets — only possess bare minimum.
8. Female-headed households are more likely to be poor due to lack of
support.
9. BIMARU states (Bihar, MP, Rajasthan, UP)
➜ Account for 62% of India’s poor.
V. Fundamental Causes of Poverty
● Lack of Education
● Debt
● Lack of Wealth
● Conservative Social Approach
● Corruption
● Societal Division
● Lack of Opportunities
● Luck (Birth Circumstance)
● Choice (Addiction, poor decision-making)
VI. Poverty Alleviation Policies in India
1. Direct Cash Transfers
➜ Money given directly to the poor.
2. BPL Card (Below Poverty Line)
➜ Gives access to subsidized goods and services.
3. Health Schemes
➜ Ayushman Bharat, Jan Arogya Yojana.
4. Food Security Schemes
➜ Midday Meal Scheme, PDS (Public Distribution System)
5. MGNREGA (Mahatma Gandhi National Rural Employment Guarantee Act)
➜ Provides guaranteed 100 days of wage employment.
VII. Types of Policies
● Targeted Policies:
➜ Meant specifically for the poor (e.g., BPL, ration cards).
● Universal Policies:
➜ Available to all citizens (e.g., public health, school education).
Lecture 19
Why Study Economic Inequality?
Economic inequality shows the gap between rich and poor in terms of income or wealth.
Understanding it is essential for framing effective policies.
Economic Inequality - An Illustration
● Suppose we compare two countries:
○ Country 1: Person A earns ₹1,000 and Person B earns ₹3,000.
○ Country 2: Person A earns ₹2,000 and Person B earns ₹6,000.
➤ Inequality is higher in Country 2.
➤ However, due to growth and mobility, Country 2 may improve in the future.
Sources of Household Income (Personal Distribution of Income):
1. Labour → Wages → Household 1
2. Capital → Rent → Household 2
3. Profit → Household 3
4. Mixed sources → Household 4
Types of Returns:
1. Return for resources that we own.
2. Return in kind for resources we own.
How to Compare Distributions of Income?
Example: Compare 20-30-50 distribution with 22-22-56.
This refers to a 3-person income system.
➤ The second distribution (22,22,56) may be preferred depending on equality.
Properties of a Good Inequality Index
1. Anonymity Principle:
The name of the person should not matter. If we change the identity but not the income,
the index remains unchanged.
2. Population Principle:
Duplicating the population (doubling everyone’s income) should not change inequality.
Criteria for Measuring Inequality
Lecture 20
1. Anonymity Principle
2. Population Principle
3. Relative Income Principle:
Only relative income matters, not the absolute amount.
4. Dalton Principle (Progressive/Regressive Transfer):
Progressive transfer (rich → poor) reduces inequality.
Regressive transfer (poor → rich) increases inequality.
Example:
● Progressive transfer:
(2000, 4000) → (2500, 3500) = Rich to Poor transfer.
● Regressive transfer:
(2000, 4000) → (1500, 4500) = Poor to Rich transfer.
Existing Measures of Inequality
1. Lorenz Curve
A graphical representation of income distribution:
● X-axis = Cumulative % of population
● Y-axis = Cumulative % of income
● 45° line = Perfect equality line
● Further away from this line = Higher inequality
2. Range
Where:
● ymax= Highest income
● ymin= Lowest income
● μ = Mean income
Note: Range doesn't show distribution, only extremes.
3. Mean Absolute Deviation
● Measures average income deviation but fails to show inequality types (whether rich are
richer or poor are poorer).
4. Coefficient of Variation
Gives a normalized measure of inequality.
5. Gini Coefficient
● Based on absolute income differences between all pairs.
6. Another Visual Measure
● If two Lorenz curves are plotted:
○ One closer to the equality line indicates lower inequality.
Comparison of Different Measures
Each measure has strengths and weaknesses:
● Gini Coefficient: Popular and widely used.
● Lorenz Curve: Visually intuitive.
● Range & Mean Absolute Deviation: Easy to compute but limited.
Lecture 21: Relationship Between Income Inequality and
Development Indicators
1. Relationship Between Income Inequality and Per Capita Income
● Kuznets' Hypothesis (Inverted U-Curve):
○ In the early stages of development, inequality rises.
○ After a certain income level, inequality begins to fall.
● Graphical Representation: Inverted U-shaped curve (Kuznets Curve) with income on
X-axis and inequality (measured by Gini or Kuznets Ratio) on Y-axis.
2. Data Used for Analysis
● Cross-Section Data: Comparison across countries at a single point in time.
● Time Series Data: Observing one country over a period of time.
● Panel Data: Combination of cross-section and time series.
3. Tunnel Effect (Hirschman)
● People tolerate rising inequality if they expect upward mobility.
● If mobility doesn’t happen, resentment grows.
4. Income Inequality Function (Empirical Model)
5. Regression Methods
● Variables like GDP per capita (pci), population, etc. are used.
6. Policy Insight
● Important to ensure mobility among the population, especially the poor.
Inequality and Aspects of Development
1. Kuznets' Hypothesis Explained
● Graph: Inverted U-shape curve with income on X-axis and inequality on Y-axis.
● Two Changes with Growth:
○ Uneven Change: Inequality increases.
○ Compensatory Change: Inequality decreases.
2. Technological Change and Inequality
● Technology favors skilled labor → leads to income inequality.
● Industrial Revolution Example:
○ Cotton mills: Capitalists gained from machines.
○ Labourers lost jobs → became poorer.
3. Indian Example:
● Sardar Sarovar Dam (Narmada River project):
○ Development displaced poor communities → inequality.
4. Other Examples:
● Reliance Mall vs Kirana Store
● Green Revolution: Benefited large farmers → widened regional inequality
How Income Inequality Affects Growth and Development
1. Country A Case:
● Low average income + High inequality
● Skilled labor force declines → lower productivity
2. Cycle of Inequality and Low Growth:
● Inequality → Low purchasing power among majority
● Low demand → Less investment in production → Economic stagnation
3. Scenarios on Income and Savings:
● Case 1: ₹55,000 vs ₹5,000
● Case 2: ₹30,000 vs ₹30,000
● Higher inequality → less effective aggregate savings → lower Marginal Saving Rate
(MSR)
Interconnections Between Inequality, Growth, and Wealth
1. Bidirectional Relationship
● Growth can increase inequality (e.g. via tech changes).
● Inequality can hinder growth.
2. How Growth Affects Inequality
● Theoretically: Growth may lead to unbalanced development.
● Empirically: Seen in Kuznets' curve.
3. How Inequality Affects Growth
● Theoretical Effects:
○ Restricts formation of human capital
○ Reduces savings among the poor
○ Limits productive investment
4. Channels Through Which Inequality Affects Growth:
1. Human Capital – Poor can’t access education/health.
2. Savings – Lower among the poor.
3. Transfer Policies – May be inadequate.
4. Consumption Pattern – Low demand for mass goods.
5. Credit Market – Poor face borrowing constraints.
6. Investment Incentives – Rich may not invest in inclusive growth sectors.
Redistribution Policies
Redistribution policies are strategies used by governments to reduce economic inequality and
support low-income groups. These policies aim to redistribute wealth, income, and resources
across the population.
Main Types of Redistribution Policies
1. Progressive Taxation
○ Higher income individuals are taxed at a higher rate.
○ Objective: Redistribute income by collecting more from the rich and using it for
public welfare.
2. Providing Subsidies
○ The government offers financial support for essential goods (e.g., food, fuel,
fertilizers, education).
○ Makes necessities affordable for the poor.
3. Direct Money Transfers
○ Cash is directly transferred to the accounts of beneficiaries (e.g., Jan Dhan,
PM-KISAN, DBT).
○ Promotes targeted welfare without leakages.
4. Land Redistribution
○ Redistribution of land from large landowners to landless farmers or smallholders.
○ Aims to ensure fair access to land, which is a productive asset.
Consumption Pattern – A Theoretical Model
Assumptions:
1. There are only two inputs of production:
○ Capital
○ Labor
2. There are two types of goods produced:
○ Consumption goods (basic needs)
○ Luxury goods (non-essential, consumed mainly by the rich)
3. Every individual owns the same amount of labor but a different amount of capital.
Central Question:
Will historically given inequality (in capital ownership) reduce, stay constant, or
worsen over time?
This depends on savings, consumption, credit access, and occupational mobility, all of which
are influenced by inequality.
Inequality on Growth
1. Role of Savings
● Inequality affects how much different income groups can save.
● Higher inequality may reduce the overall saving rate in the economy, especially if the
poor (who have a higher marginal propensity to consume) dominate.
2. Human Capital Aspects
● Human capital and physical capital are two critical inputs for economic growth.
● Inequality in access to education and health can reduce the development of human
capital.
3. Consumption Spending
● Inequality affects the pattern of consumption:
○ Poor households spend more on basic consumption goods.
○ Rich households spend more on luxury goods, which are less demand-inducing.
● This can reduce the overall demand in the economy.
4. Credit Market Access
● Poor people often face difficulty accessing credit due to lack of collateral (assets to
secure a loan).
● Collateral: An asset pledged by the borrower to secure a loan (e.g., house, land).
Rural and Urban Sectors
1. Migration
● Migration from rural to urban areas happens due to differences in wages and
employment opportunities.
● This reflects the process of structural transformation.
2. Structural Transformation
● Economic growth typically shifts the focus from:
○ Agriculture → Industry → Services
● Most developed countries have undergone this process.
3. Sectors of the Economy
● Agricultural and Allied Sector
● Industrial Sector
● Service Sector
4. Transition Requirement
● For industrialization to happen, adequate food supply must be ensured by the
agricultural sector to support urban labor.
Urban Sector Structure
1. Informal Sector
● Non-organized, self-employed, agriculture-based.
● Lacks job security and worker protections.
2. Formal Sector
● Features:
1. Assured income
2. Labor unions
3. Minimum wages
4. Pension schemes
5. Compensation policies
6. Leave policies
7. Safety and security measures
Agricultural Sector Structures
1. Family Farming:
○ Family owns the land.
○ Production is mainly for self-consumption.
2. Capitalist Farming:
○ Large-scale land ownership.
○ Hires labor for profit-making production.
3. Co-operative Farming:
○ Farmers pool their resources and farm collectively.
4. Tenant Farming:
○ Farmers work on land owned by someone else and pay rent.
5. Casual Labour:
○ No permanent employment.
○ Low productivity due to lack of skills and equipment.
Lewis Model of Development
1. Dual Economy Structure
The Lewis Model explains how a dual economy functions, where two sectors coexist:
● Traditional Sector: Primarily agricultural; labor-intensive with low productivity and
surplus labor.
● Modern Sector: Non-agricultural or industrial; higher productivity and capital-intensive.
2. Characteristics of the Traditional Sector
● Based in agriculture.
● Operates using informal methods and traditional tools.
● Has surplus labor, meaning more workers than needed for the same level of output.
● This surplus labor leads to zero marginal productivity—removing some laborers does
not affect total output.
Output vs. Labour – a flat portion indicating surplus labor beyond point L₀)
3. Income Sharing in Traditional Sector
● Income is shared equally among all family members.
● Even if a laborer's productivity is zero, they still get a share of the total family income.
4. Surplus Labor and Industrial Shift
● Surplus labor from agriculture can be moved to the modern industrial sector without
reducing agricultural output, up to a certain point (labelled point C in the diagram).
● Wages in the industrial sector are fixed above the agricultural wage rate to attract
workers.
● Migration continues from agriculture to industry until labor reduction reaches point C.
Beyond that, any further reduction affects agricultural output.
Agricultural Output vs. Labour showing marginal productivity curve and surplus labor
zone A to C
5. Rural–Urban Interaction
● Disguised unemployment is common in rural areas.
● Dual economy persists with traditional agricultural methods continuing even as industrial
production increases.
In rural areas:
● Agriculture continues with outdated methods.
● There is surplus labor that can be shifted to cities.
6. Transition Dynamics and Wage Adjustment
● If workers move from agriculture (A → B) to industry, and:
○ Industrial wage remains the same,
○ Agricultural output remains constant,
○ Agricultural wage increases, since fewer workers share the same total output.
Industrial Labour vs. Wage with demand curves D₁ and D₂ showing labor movement and higher
wage equilibrium)
Note: In the case of a food crisis, agricultural output becomes crucial. Then, the
industrial wage rate must remain higher to attract labor.
7. Criticism of the Lewis Model
1. Assumes unlimited absorption of labor into the modern sector
Lewis assumes that industrial sector can keep absorbing rural labor infinitely. In reality, this is
not always true due to limited jobs or industrial slowdown.
2. Neglect of Agricultural Development
Focus is placed only on industrial growth, while the model assumes agricultural productivity
remains stagnant.
3. Ignores Technological Unemployment
The model doesn't account for situations where machines replace workers in the modern
sector, reducing job opportunities.
4. Underestimates Urban Unemployment
This is your missed point:
When surplus labor moves to the industrial sector, it doesn’t always get absorbed immediately.
This can create urban unemployment if industrial jobs aren't sufficient.
Hence, the Lewis Model fails to address the problem of unemployment during the transition
phase from agriculture to industry.
Key Terms
● Disguised Unemployment: More people employed than actually needed.
● Marginal Productivity: Additional output from one more unit of labor.
● Surplus Labor: Labor that can be removed without reducing total output.
● Wage Differential: Wage in the modern sector must be higher to attract labor.
Harris–Todaro Model of Migration
The Harris–Todaro model explains rural-to-urban migration by focusing on the role of expected
income rather than just wage differentials. It accounts for urban unemployment and assumes
that migration decisions are made based on the comparison of expected urban earnings with
rural earnings.
Assumptions of the Model:
1. The economy consists of two sectors:
○ A rural sector which uses traditional methods of production.
○ An urban sector which uses modern methods of production.
2. There is an abundant supply of labour in the rural sector.
3. The formal urban sector has a fixed wage rate, which is higher than the rural wage due
to the existence of strong labour unions.
4. The informal urban sector has a flexible wage rate determined by the demand and
supply of labour.
5. Migration from rural to urban areas continues as long as the expected urban wage rate
exceeds the rural wage rate.
Urban Labour Market:
In the urban sector, not all migrants find employment in the formal sector. Some end up working
in the informal sector, while others remain unemployed. Hence, the actual income that a migrant
expects in the urban area depends on the probability of finding a formal sector job.
●
Then, the expected wage rate in the urban sector is given by:
Equilibrium Condition:
Migration from rural to urban areas continues until the expected wage rate in the urban sector
becomes equal to the rural wage rate.
That is,
WE=wR
Where wRis the rural wage rate.
This is the condition of equilibrium migration. Beyond this point, no additional migration will
occur as the expected gains from migration are exhausted.
Diagram: Urban Labour Market
Labelled Diagram:
● X-axis: Total Labour in Urban Sector
● Y-axis: Wage Rate
● A fixed line representing wˉF
● Downward-sloping labour demand curve for formal sector
● Upward-sloping line showing informal wage wT
This shows:
● Excess supply of labour in urban sector
● Only a portion of labour gets formal jobs
● Rest are employed in informal sector or remain unemployed
Conclusion:
The Harris–Todaro model highlights that migration is not solely driven by wage gaps but by
expected income. Even if urban wages are higher, migration will stop when the expected urban
wage equals the rural wage. It explains the existence of urban unemployment as a rational
outcome of migration decisions under imperfect labour markets.
International Trade and Economic Development
1. Trade Patterns
● Developing countries mostly export primary commodities (like raw materials) and
import manufactured goods (like machinery, electronics, etc.).
● Trade often occurs between:
○ Developed ↔ Developing countries
○ Developing ↔ Developing countries
○ Developed ↔ Developed countries
2. Theories of International Trade
a. Comparative Advantage
● This theory explains that countries should specialize in producing goods they can make
more efficiently and import those they produce less efficiently.
● Example:
Suppose Country A and B produce goods X and Y.
If Country B can produce Y more cheaply, it should specialize in Y, and A in X.
By trading, both countries benefit through lower opportunity costs and better resource
use.
● The Production Possibility Frontier (PPF) illustrates how trade expands consumption
possibilities.
b. Factor Endowment Theory (Heckscher-Ohlin Theory)
● Different countries have different quantities of production factors like land (L) and
capital (K).
● A country with more capital should specialize in capital-intensive goods, while one with
more labor should specialize in labor-intensive goods.
● Example: If A has more labor and B more capital, then A should produce labor-intensive
goods and B should produce capital-intensive goods.
● This trade benefits both countries due to resource optimization.
c. Demand Differences
● Even if countries have similar production capabilities (PPFs), differences in demand for
goods can drive trade.
● For example, if Country A prefers good X more than Country B, and B prefers Y more,
trade can occur based on demand variation.
d. Economies of Scale
● When a country increases production, it can reduce per-unit cost due to economies
of scale.
● By trading, countries can expand their markets and produce at larger scales, reducing
costs.
e. Intra-Industry Trade
● This occurs when countries import and export different varieties of the same product
(e.g., cars from Germany and Japan).
● It often happens in industries with monopolistic or oligopolistic competition, where
consumers demand variety.
Trade Policies and Their Implications for Economic
Development
a. Need for Trade Policies
Although basic trade theories support free trade, governments adopt trade policies to address
national priorities. The main reasons include:
● Protection of domestic industries from foreign competition
● Reducing dependency on imports
● Encouraging exports for economic growth
● Safeguarding strategic and national interests
b. Types of Trade Policies
1. Import Substitution
● Involves tariffs, quotas, or bans on imported goods to reduce imports.
● The government supports local industries through SEZs (Special Economic Zones),
subsidies, and tax breaks to promote domestic production.
Diagram Explanation : Import Tariff Impact
The diagram shows the effect of a tariff on imports:
● The international price (P₁) is lower, encouraging imports.
● When a tariff is imposed, the price increases to P.
● This results in reduced imports (from AB to CD).
● Consumers face a higher price, but local producers benefit.
● Domestic demand shifts towards local goods.
2. Export Promotion
● Focuses on boosting exports by providing incentives, tax benefits, and creating
export zones.
● Aims to improve the trade balance and foreign exchange reserves.
3. Infant Industry Argument
● New industries need temporary protection until they become competitive globally.
● Tools used:
○ Learning by doing (gradual improvement in productivity)
○ Government support and subsidies or spillovereffect: sice some linkage
effect exist, other domestic indus will also benefits from it growth of domestic
circule
○ Increasing returns to scale
📈 Diagram Explanation: Learning by Doing
● Shows how a domestic industry’s supply curve shifts from S to S′ as they gain
experience.
● Initially, price is high (P₁), but after learning and government support, the price
decreases.
● The industry becomes more efficient, competitive, and self-reliant over time.
4. Basic Trade Theories – Conclusion
● Free trade helps in the efficient allocation of global resources.
● Countries benefit from specialization and cost advantages.
● However, trade policies are often used to protect national interests, especially in
developing countries.
5. Trade Creation vs Trade Diversion
● Trade Creation: Happens when a country starts importing from a more efficient
partner due to reduced tariffs.
Example: Country A removes tariff on imports from B.
● Trade Diversion: Happens when trade shifts from a low-cost country to a higher-cost
partner due to preferential agreements.
Example: A and B form a trade bloc and stop trading with C.
WTO and International Trade Organizations
● WTO (World Trade Organization): Oversees global trade, settles disputes, and
promotes free trade.
● Most Favoured Nation (MFN): WTO members must give equal trade treatment to all
other members.
● Other Trade Groups:
○ BRICS
○ European Union (EU)
○ South–South / North–North Blocs
Global Institutions and Their Roles
1. IMF (International Monetary Fund)
○ Provides short-term financial assistance to countries facing balance of payments
problems.
○ Helps countries make short-term economic adjustments.
2. World Bank
○ Provides long-term loans and financial assistance for development projects.
○ Focuses on long-term growth and development of countries.
3. GATT (Now WTO - World Trade Organization)
○ Aims to facilitate international trade by reducing tariffs and trade barriers.
○ Supports long-term global economic development.
Phases of Economic Development and Crisis in Developing Countries
1. 1960s–1970s: Import Substitution Phase
○ Developing countries adopted import substitution policies to reduce dependency
on foreign goods.
○ Governments heavily invested in domestic industries.
2. 1970s–Early 1980s: Rising Investment and Oil Shock
○ Huge public investment was required to support import substitution policies.
○ OPEC (Organization of Petroleum Exporting Countries) caused an oil price shock
in the 1970s, increasing the cost of petroleum.
○ Oil-exporting countries deposited money in US banks, which was later loaned to
developing countries.
3. 1980s: Debt Crisis
○ Banks stopped giving loans to developing countries.
○ Countries were already in debt and running fiscal deficits (expenditure >
revenue).
○ This triggered a debt crisis, leading to reduced growth and economic stagnation
in many developing countries.
○ Some countries faced debt crises, hyperinflation, and foreign exchange crises.
Foreign Exchange Concepts
● Sources of Foreign Exchange for a Country:
1. Exports
2. Capital inflows such as Foreign Direct Investment (FDI), especially after 1991.
How Exchange Rate Affects the Economy
1. Exchange rate influences FDI, foreign exchange reserves, and related policy decisions.
2. Demand for US dollars in Country A arises from the need to import goods from Country
B.
3. Supply of US dollars increases when Country B imports from Country A and pays in
dollars.
4. Exchange rate (price of $ in terms of local currency) is determined by the balance of
supply and demand for the dollar.
1960s: Import Substitution in Developing Countries
● Governments focused on building domestic industries.
● Massive public investments were made.
● These projects were largely financed by foreign borrowing, increasing debt.
Common Economic Crises (Examples)
● Debt Crises: Argentina, Chile, Mexico, Brazil (1980s)
● Foreign Exchange Crisis: India (1991)
● Hyperinflation: Mexico (1994)
Stabilization and Structural Adjustment Policies
● Introduced by IMF and World Bank in crisis-hit countries.
● Included policy changes like:
1. Reducing inflation.
2. Controlling fiscal deficits (by cutting spending or increasing revenue).
3. Raising real interest rates to attract investments.
Overvalued Exchange Rate
● When the exchange rate is artificially high (e.g., ₹ value too strong against $), exports
become expensive and imports cheaper.
● Leads to current account deficits and foreign exchange issues.
● Solution: Devalue the currency to match market rates.
Exchange Rate and Trade Policies
Exchange Rate Determination:
In the foreign exchange market, the value of the dollar (or any foreign currency) in terms of
rupees (₹) is determined by the interaction of demand and supply of foreign exchange.
● Diagram Explanation:
○ The vertical axis represents the value of the dollar ($).
○ The horizontal axis represents quantity of dollars.
○ Demand and Supply Curves:
■ Initially, equilibrium is at point A with exchange rate e₁.
■ Due to an export promotion policy, supply of dollars increases (S → S’).
■ Simultaneously, due to an import substitution policy, demand for dollars
reduces (D → D’).
■ New equilibrium is at point B, with exchange rate e₂ > e₁.
This indicates devaluation or correction of an overvalued exchange rate, which previously made
exports less competitive.
Implications and Policy Measures
1. Overvalued Exchange Rate:
○ When e₂ > e₁, the rupee is devalued.
○ Overvaluation of currency makes exports expensive and imports cheaper,
leading to trade imbalance.
○ Correction of exchange rate boosts export competitiveness.
2. Impact on Foreign Exchange Reserves:
○ Overvaluation leads to depletion of foreign exchange reserves.
○ Devaluation helps stabilize reserves by improving export earnings.
3. Export Promotion and Import Substitution Policies:
○ These policies aim to make e₂ > e₁ to correct overvaluation.
○ Export promotion increases foreign exchange inflow.
○ Import substitution reduces foreign exchange outflow.
Fiscal Policy Measures
4. Reduction in Fiscal Deficit:
○ Achieved through:
■ Cuts in public investment.
■ Reduction in social sector spending.
○ Helps improve macroeconomic stability and reduce pressure on the balance of
payments.
Structural Adjustment Policies (SAPs)
5. Long-Term Development Strategy:
○ Aimed at sustainable economic development.
○ Emphasizes liberalization and opening up the economy.
6. Reduction in Import Substitution:
○ Elimination of quotas.
○ Reduction in tariffs.
○ Removal of import-restricting policies.
○ Encourages competitiveness and efficiency.
Additional Points:
7. Export Promotion and Exchange Rate Correction:
○ Both must go together to correct overvaluation of the exchange rate.
○ Helps in long-term improvement in trade balance.
8. Domestic Policy Reforms:
○ Changes in fiscal and monetary policy are essential.
○ These include controlling inflation, managing deficits, and stabilizing interest
rates.
Policy Changes and Domestic Reforms
● Export promotion and correction of overvalued exchange rate.
● Domestic policy changes in fiscal and monetary fronts:
1. Implementation of Five-Year Plans (till early 1980s).
2. Emphasis on the public sector (self-reliance).
3. Closed economy structure.
4. Gradual liberalization and privatization.
Indian Model of Development
1. 1950s–1960s: Policy Planning Phase
● Aim: Complete self-reliance.
● Consumer goods production restricted.
● Priority sectors reserved for the public sector.
2. 1970s–1985
● Several regulatory acts:
○ Foreign Exchange Regulation Act (1973)
○ Monopolies and Restrictive Trade Practices Act (1969)
3. 1985–1990s
● Opening up to advanced technology.
● Beginning of policy liberalization.
1991: Balance of Payments Crisis in India
● Severe economic crisis due to low foreign reserves.
● India adopted stabilization and structural adjustment policies under IMF and
World Bank guidance.
● Major reforms included:
○ Ending industrial licensing (except in select industries).
○ Promoting privatization and deregulation.
○ Liberalizing the banking sector.
○ Enacting the Fiscal Responsibility and Budget Management (FRBM) Act.
