This article deals with ‘Income Inequalities.’ This is part of our series on ‘Economics’ which is an important pillar of the GS-2 syllabus. For more articles, you can click here.
Introduction
Income inequality is the degree to which income or wealth holding is unevenly distributed throughout the population.
It is measured statistically using Gini Coefficient.
Apart from that, Oxfam also releases a report every year showing the income inequality in the world and India.
Gini Coefficient
Gini Coefficient is a statistical measure to gauge income inequality or wealth divide.
Its value varies between 0 to 1, 0 indicating perfect inequality and 1 indicating perfect equality.
An increase in value of the Gini Coefficient means that inequality in an economy is increasing, and government policies are not inclusive and benefitting richer.
Calculation of Gini Coefficient
Gini Coefficient = A / (A+B)
In the graph shown above
The horizontal axis on this chart represents cumulative shares of the population.
The vertical axis is cumulative shares of income.
A+ B is constant, and if
A is higher; inequality is higher.
A is smaller; inequality is lower.
If A = 0, then no income inequality.
Hence, Gini Coefficient is measured from 0 to 1, and the lower value means low inequality and higher means more inequality.
Famous US Economist Simon Kuznet showed that market forces would first increase inequality and then decrease inequality among people as an economy develops.
It happens because the initial phase of economic growth boosts the income of workers and investors who participate in the first wave of innovation. But this inequality is temporary as other workers and investors soon catch up, resulting in improvement of their incomes as well.
Palma Ratio
It is the ratio of the percentage of income earned by the richest 10% with the percentage of income earned by the poorest 40%.
For India, this ratio is approximately 1.5.
Quintile Ratio
It is the ratio of income of the richest 10% and poorest 10% in an economy.
In the case of India, the income of the richest 20% is 45% of total income, and the poorest 20% is 8% of total income. Hence, the Quintile Ratio of India is 5.6.
India and Income Inequality
Piketty, the world-famous economist, has cautioned India for rising levels of Income inequalities and their consequences. In countries like India, where other forms of inequalities are present, like the caste system, income inequalities exacerbate the situation.
India grew at an average rate of 7.5% since 2011, but growth is not equally distributed (the rich are growing more). Gini Coefficient shows that income inequality is continuously increasing in India. The following data about India’s Gini Coefficient corroborates this.
According to Oxfam Report
(2020), India’s top 1% wealthy people hold 42% of the
National Wealth while the bottom 60% own less than 5%.
According to Oxfam head, it is morally outrageous that a few wealthy individuals are collecting a growing share of India’s wealth while the poor struggle to find their next meal. If this obscene inequality continues, it will lead to a complete collapse of the country’s social and democratic structure.
According to the World Inequality Report (2022) released by the World Inequality Lab of the Paris School of Economics
It termed India as a ‘poor and very unequal country, with an affluent elite’.
The top 10% of the Indian population holds 57% of national income, including 22% held by the top 1%
The bottom 50% of the Indian population holds just 13% of national income.
The report has suggested levying a modest progressive wealth tax on multimillionaires.
According to the Global Social Mobility report released by the World Economic Forum, the poor in India are more likely to remain poor. It would take 7 generations in India while 2 generations in Denmark for the poor to reach average income.
Further, the Covid pandemic has deepened inequalities of wealth, education, and gender as shown by Oxfam’s report.
Causes of Income Inequality
1. Historical Causes
Caste System: Due to the exclusion of lower caste from ownership of land and education, people belonging to lower caste are poor.
2. Social Causes
Due to the patriarchal and patrilineal nature of Indian society, women don’t own factors of production in India.
3. Frequent Global Economic Crisis
Economic crises like that of 2008 accentuate income inequality by making richer rich and poorer poor. (How= Central Bank cant allow big houses to fall. Due to this, business houses get significant cuts. Currency devaluates, and the loans that companies have to pay decrease in reality. On the other hand, households who deposit their money lose the value of their money).
4. Faulty Taxation System
In India, there is more reliance on Indirect Tax, which is regressive in nature.
Inheritance tax, which is levied when wealth is inherited from one generation to another, is almost negligible in India.
5. Cantillon Effect
The Cantillon Effect is a concept that describes ways in which changes in the money supply can affect different groups of people and economic sectors unequally.
Imagine a situation where the
government decides to print additional money and put it into circulation.
The first people or institutions to receive this new money, such as banks or wealthy individuals, have an advantage because they can spend it before prices rise.
Later, when the money flow increases in the whole economy, it leads to inflation. People who receive the new money later, such as workers or those on fixed incomes, may find that their purchasing power has decreased.
So, the Cantillon Effect
suggests that those who are closer to the source of new money creation benefit
the most, while those further away experience the negative consequences of
inflation. This can result in wealth redistribution and income inequality.
6. India relied on Trickle-Down Approach
India relied on the ‘Trickle Down Approach’, which benefitted the industrial houses and rich businessmen. Instead, in order to reduce inequality, India should have followed the redistributive justice principles of John Rawls, Gandhian trusteeship principles or Amartya Sen’s capability approach.
7. Technological Change
Rapid technological changes are leading to the automation of industries. As a result, few people with high skills are getting high packages while many workers are losing their jobs.
8. Capture of power by elites
Due to Crony Capitalism, political leaders and government work as agents of elites. Policies of government are made to benefit elite sections of society.
Consequences of Inequalities
1. Conflicts and Insurgency
Arab Spring of 2011 in the Middle East was the result of high inequalities in that region.
Earlier in India, Naxalbari Movement was the result of inequality (in landholding).
2. Divides Society
It divides society between haves and have-nots. For India, with an already fractured society over religion, region, gender, or caste, inequality adds another fracture point.
The work of Piketty reveals that when inequalities increase intolerably, governments divide to rule, and persecution of minorities increases with the politics of national identities.
3. Increase in Crimes
It has been observed that unequal societies have higher crime rates. Poverty force people to earn via illegal means.
4. Political Impacts
In case of higher inequalities, political democracy and government lose their legitimacy.
5. Effects on Growth
Income distribution matters for growth. If income is more equally distributed, more potential buyers of goods create bigger markets.
Steps Taken by India
1. Land Reforms
The government introduced the land reforms and abolished the Zamindari System for equitable distribution of the land in the country.
2. Tax Reforms
Piketty has suggested India should improve its Tax: GDP, which is abysmally low. The Indian government is taking steps to bring more people into the tax net.
Apart from that, India has a progressive system of taxation. Progressive Taxation system helps in ‘redistribution of money’ from richer to less well off.
3. Skill Development
Improving education quality, eliminating financial barriers to higher education, and supporting apprenticeship programmes.
4. Social Security
The high cost of healthcare and medicines drives a hundred million people into poverty every year. There must be a universal and permanent safety net for the poorest and most vulnerable. The government has taken various measures like starting the Ayushman Bharat Scheme.
5. Various steps against Black money
The government has taken steps like demonetisation to control black money.
Way Ahead
Universal Basic Income: Introduce universal basic income (as recommended by Economic Survey 2016-17) and raise the minimum income of the common public. These measures can reduce the income gap and result in equal distribution of earnings in the labour market.
Urban Employment Guarantee Schemes: Urban counterpart of MGNREGS, which is demand-based and offers guaranteed employment, should be introduced to rehabilitate surplus labour.
Equitable access to education: Enhance the budgetary allocation for education to 6% of GDP, as committed in the National Education Policy, and the creation of more jobs with long-term growth are vital for triggering upward mobility among people experiencing poverty.
Rationalization of Subsidies: Better targeting of beneficiaries through alternatives like direct benefit transfers over existing inefficient mechanisms
Case Study: Wealth Redistribution Council
In 2021, Japanese PM Kishinev announced the creation of the ‘Wealth Redistribution Council‘ to tackle rising wealth inequalities and redistribute the wealth among households.
Japan aims to pass on wealth from corporations to the households to double the household incomes and rebuild a broader middle class. It will also help in recovering the Japanese economy post-Covid pandemic.
This article deals with ‘National Incomes.’ This is part of our series on ‘Economics’ which is important pillar of GS-2 syllabus . For more articles , you can click here .
Introduction
Income level is the most commonly used tool to determine the wellbeing and happiness of nations and their citizens.
GDP, NDP, GNP, and NNP are the four ideas/ways to calculate a nation’s income.
Gross Domestic Product (GDP)
Gross Domestic Product or GDP is the market value of all the final goods and services produced within the boundary of a country during one year period.
In GDP, the
boundary of the country matters and not the citizenship of the person. If the good or service is
produced within the nation’s boundary, then it will be counted in the GDP.
Interpretation
Nominal GDP and Real GDP
GDP at Current Price (Nominal GDP) vs GDP at Constant Price (Real GDP)
After looking at Nominal GDP/ GDP @ Current Price, we can’t say whether the economy has improved or not. E.g., in the example shown in the infographic below, quantity-wise production has decreased, but figures show that GDP has remained constant.
To rectify this problem, economists set a Base Year (2011 for India) & then use the production data of the current year but the price of goods that of the base year. Using this process, GDP at a Constant Price or Real GDP can be calculated.
In FY22-23, the nominal GDP growth is 15.4%. But the real GDP growth is expected to be close to 7%.The difference (8.4%) is the effect of price inflation.
GDP Deflator
The GDP deflator measures the price changes of goods and services. It is calculated in the following way
GDP deflator can also be used to measure inflation in the economy.
GDP at Factor Cost & GDP at Market Price
GDP at Factor Cost
There are four factors of production & each factor will be paid in money in the following way
Land: Rent
Labour: Wage
Capital: Interest
Entrepreneurship: Profit
GDP at factor cost is obtained by adding the value of these factors of production.
GDP at Market Price
But GDP at factor cost will
attract some tax & subsidies, which need to be added and subtracted
respectively to get GDP at market price.
The official GDP of India is GDP AT CONSTANT MARKET PRICE.
Methods to calculate GDP
There are three methods to calculate GDP
In India, we use Income method to calculate GDP.
Method #1: Income Method
In India, we use the Income method to calculate GDP.
In any economy, a person will get wage (w) for his labour, interest (I) on his capital, profit (P) on his entrepreneurship and rent (R) on his land or building. Under this method, GDP (at factor cost) is calculated by adding up all the incomes generated in the course of producing final goods and services.
Subsequently, if we add taxes and subtract subsidies and adjust that for inflation, we will get GDP at constant and market prices.
Method #2: Expenditure Method
An alternative way to calculate the GDP is by looking at the demand side of the products.
All the final goods & services produced in the economy will ultimately be purchased. Hence, if we add the expenditure of all the persons in an economy, we can calculate GDP (at the current market price).
Under this method, the total expenditure incurred by the society in a particular year is added together. .
Precautions
Second-hand goods: The expenditure made on second-hand goods should not be included.
Purchase of shares and bonds: Expenditures on purchasing old shares and bonds in the secondary market should not be included.
Transfer payments: Expenditures towards payments incurred by the government like old age pension should not be included.
Expenditure on intermediate goods: Expenditure on seeds and fertilizers by farmers and cotton and yarn by textile industries are not to be included to avoid double counting.
Method #3: Gross Value Addition or Production Method
The final goods and services are produced by passing through value addition in various stages. GDP can be calculated by adding value-added during each step of the finished product. This method is known as GVA or Production Method.
By doing that, we get GDP at factor cost, which can be easily converted to GDP at constant market price by adding taxes, subtracting subsidies and adjusting it with inflation.
Gross National Product (GNP)
GNP is the monetary value of all the goods and services produced by NORMAL RESIDENTS of a country.
Here, boundary of territory is not important but normal residency is important.
Interpretation
Indian earning in India => His income will be counted in Indian GNP.
Indian earning in Saudi Arabia => His income will be added in Indian GNP.
Earnings of Korean-owned Hyundai car factory in India => It’s earning will not be counted in Indian GNP.
Net National Product (NNP)
NNP is obtained by deducting the value of depreciation from the GNP.
Capital assets get consumed due to wear and tear whenever something is produced. This wear and tear is called depreciation. Naturally, depreciation does not become part of anybody’s income.
Net National Product at Factor Cost
Through the expression given above, we get the value of NNP evaluated at market prices. But market price includes indirect taxes and subsidies as well.
If we add taxes and subtract subsidies from NNP evaluated at market prices, we obtain Net National Product at factor cost.
India’s National Income is NNP at Factor Cost.
Per Capita Income
Per Capita Income is the average income of a person in a country in a particular year.
It is calculated by dividing national income (Net National Product at Factor Cost) by population.
India’s Per Capita Income is ₹ 1,35,000 (2019-20).
Personal Income
Personal income is the total annual income received by all the individuals of a country from all the sources before the payment of direct taxes.
Personal income is calculated by deducting the undistributed corporate profit and employees’ contributions to social security schemes and adding transfer payments to the national income.
Disposable Income
Disposable Income is the individual’s income after the payment of income tax.
Limitations in measuring National Incomes
Illegal Activities not accounted: Income earned through illegal activities such as smuggling, gambling, illicit extraction of liquor, etc., is not included in National Incomes.
Nature of Statistics: Statistics lag behind the actual happening in the economy, thus increasing the time to capture and understand the significant structural change. E.g., In India, the most accurate GDP data, i.e., revised estimates, comes after a lag of almost 3 years.
Many activities in an economy can not be evaluated in monetary terms. For example, the domestic services women perform at home are not paid for. These Non-marketed activities are not accounted in National Incomes.
Barter exchanges which are still prevalent in rural and tribal areas are not accounted in National Incomes.
Externalities refer to the benefits (or harms) a firm or an individual causes to another for which they are not paid (or penalized). Negative externality is also not accounted .
National Incomes doesn’t give any picture of distribution of income and income inequality within the economy. The trickle down of benefits failed in most nation’s with rise in inequalities in almost all major economies. These inequalities are further pushed by the recent pandemic
The deduction of depreciation allowances, accidental damages, repair and replacement charges from the national income is not an easy task. It requires high degree of judgment.
Rise in national incomes and welfare
National Income is considered an indicator of the economic wellbeing of a country. The country’s economic progress is measured in terms of its GDP per Capita and annual growth rate.
But the rise in GDP or per capita income need not always promote economic welfare as
Economic welfare depends upon the composition of goods and services provided. The greater the proportion of capital goods over consumer goods, the lesser will be the improvement in economic welfare.
Higher GDP with greater environmental hazards such as air, water and soil pollution will be little economic welfare.
Production of war goods will show an increase in national output but not welfare.
An increase in national output can also result from the exploitation of labour. This exploitation doesn’t lead to the welfare of people.
Indian GDP Trends and Analysis
The base year for India is 2011. (there is news of changing it to 2018, but as of now, it is 2011)
In the recent years, GDP growth rate (at constant price) trends was as follows:-
Note regarding above graph: When we say that the Indian economy grew by 10 per cent in a particular year, what it essentially means is that the total GDP of the country in that year was 10 per cent more than the total GDP produced a year ago. Similarly, when we say the economy contracted by 8 per cent this year, we mean that the total output of the economy (as calculated by GDP) is 8 per cent less than the total output of the preceding year. This is called the year-on-year (YoY) method of arriving at the growth rate.
India is the fifth largest economy of the world considering GDP at current prices in US dollars. The top 5 economies are as
follows .
Global Shocks and impact on India’s GDP
Global Financial Crisis of the
past had a limited impact on India. This
was due to following reasons
Prior to 1991, Indian economy had limited integration with the world economy. Hence, it was insulated from the crisis the economic crisis happening in other countries.
There was significant gaps in the global economic crisis and they didn’t happen one after another. For example, Oil Price Shock of 1973, East Asian Crisis of 1997 and Financial Crisis of 2007-08.
But now the situation is
different. Indian economy is very well connected with the world economy.
Moreover, global economy is facing ‘Triple Shocks’ one after another
Covid-19 Pandemic: It slowed down the global economy as world was virtually shut down.
Russia-Ukraine Crisis: It led to supply chain disruptions and massive increase in price of fuel, food and fertilizers.
Rate Hike by Advanced Economies: The Easy Money Policy followed by Advanced Economies during Covid led to massive inflation in advanced economies. To control the situation, Central Banks of Advanced Economies started to increase their Repo Rates which led to FPI outflows from emerging economies (like India), depreciation of currency and increase in the yield of government bonds.
But inspite of that, the impact
of these shocks can be withstood by the Indian Economy
Side Topic: K Shaped Recovery
The Economic Survey (2021) predicted the ‘V-Shaped Recovery’ of the Indian economy post-Covid pandemic. It was hoped that the GDP growth rate would bounce back quickly owing opening up of economic activities. Historically, a similar trend was observed in the Spanish Flu of 1918-20. But other economists tend to differ and present various scenarios like
U-Shaped Recovery: GDP growth will remain low for a longer time before bouncing back.
W-Shaped Recovery: GDP growth will bounce back, then dip and bounce back again.
K-Shaped Recovery: Some sectors of the economy (like e-education, e-commerce etc.) will see massive growth while other sectors (like tourism, restaurants etc.) will continue to shrink or suffer losses.
But, India has witnessed a K-shaped recovery. In simple terms, while some sectors/ sections of the economy have registered a speedy recovery, many are still struggling. The entities that have done well are firms already in the formal sector and had the financial wherewithal to survive the repeated lockdowns and disruptions. Many big firms in the formal economy have increased their market share during the Covid-19 pandemic and this has come at the cost of smaller, weaker firms that were mostly in the informal sector.
This article deals with ‘Monetary Policy .’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.
Demand – Supply Theory
Suppose,
at a particular time, equilibrium is reached for the price of any product, say
wheat.
Now,
the government decides to print a lot of Currency and distribute it to the
public as an election gimmick to win elections. Will this practice end poverty
in India? The answer is negative because although the money supply has
increased, the number of goods in the economy hasn’t increased in the same
proportion. It will lead to inflation as too
much money is chasing a few goods. The wheat that was sold at Rs
100 will now sell at Rs 1000 (hypothetical amounts).
If we
want to cope with this situation, there are two ways
Either increase the supply of wheat (can be done by the government by asking FCI to overflow the market with wheat) or
Reduce the supply of money (can be done by RBI via Monetary Policy)
What can RBI do to control Inflation or Deflation?
The Central Bank of the nation formulates monetary policy to control the money supply in the economy.
Objectives of monetary policy can be (depending on the economy)
Control inflation
Accelerating the growth of the economy
Exchange rate stabilization
Balance savings & investments
Generating employment
Monetary Policy can be
1. Expansionary
Expansionary Monetary Policy increases the total money supply in an economy.
E.g.
In 2008, all countries, including India, used this to beat the recession.
During the Covid crisis, all the countries, including India, used this to spur the demand in the economies.
Traditionally Expansionary Monetary Policyis used to combat unemployment in a recession by lowering the interest rate.
2. Contractionary
Contractionary Monetary Policy decreases the total money supply in the economy.
E.g.
2010 onwards, India & many other countries used it.
Post Covid Crisis, almost all the countries, including India, used it to remove excess liquidity from the economy.
Traditionally Contractionary Monetary Policyis used to combat inflation in the economy.
When is the Monetary Policy announced in India?
1. Till 1988-89
It was
announced twice a year according to
agricultural cycles
Slack Season Policy
April
-September
Busy Season Policy
October
-March
2. After 1989
Since the economy became more dynamic, RBI reserved its right to alter it from time to time, depending upon the state of the economy.
Additionally, the share of credit toward industry has increased, which was earlier dominated by agriculture. So aligning the Monetary Policy with agriculture doesn’t make sense.
The major policy was announced in April & reviews took place every quarter. But within a quarter at any time, RBI could make any major change in policy depending upon the need.
3. Now
Changes can be made at any time when RBI feels but announced necessarily after two months.
Before proceeding
further, we will look into the concept of Net
Demand & Time Liabilities(NDTL)
Case 1
Case 2
Demand Liabilities
Time Liabilities
Demand liabilities are those liabilities on the banks which depositors can demand at any time.
Time Liabilities are those which mature after some time. If withdrawn before that, then some penalty is charged.
Demand Liabilities are more liquid as the depositor can easily convert them into cash without penalty.
Relatively less liquid as a person will have to pay the penalty if withdrawn before the maturity.
Consist of money deposited in Current Account & Saving Account
Consist of money deposited in 1. Fixed deposits 2. Recurring Deposits 3. Cash Certificate 4. Staff security deposit
Banks pay less interest on demand liabilities.
Banks pay more interest on demand liabilities. (= people tend to place money here because of more interest)
The sum of both
Demand & Time Liabilities is known as Net Demand & Time Liabilities.
1. Reserve Ratios
1.1 Cash Reserve Ratio (CRR)
CRR is the percentage of public deposits (Net Demand and Time Liabilities (NDTL)) that banks have to keep with the RBI in cash at any point in time. Usually, RBI doesn’t give any interest in this.
Present Rate (Sept 2024): 4.5% of Net Demand and Time Liabilities
1.2 Statutory Liquidity Ratio (SLR)
SLR is the percentage of NDTL that banks must maintain with themselves in the form of specified liquid assets (like cash, gold & government securities, or RBI-approved securities) at any point in time.
It is mandated under RBI Act.
SLR applies to all Scheduled Banks, Non-Scheduled Banks, Cooperative Banks and NBFC deposit-taking. RBI can prescribe different levels for each.
Although not used as Monetary Policy Tool, but if decreased, a large amount of capital is infused into the economy.
Present Rate (Sept 2024): 18% of Net Demand and Time Liabilities
Trends of CRR and SLR
Note: Previously, CRR & SLR were very high (53% combined). As a result, banks had significantly less money to lend. It impacted the Indian Economy because the rate of loans was high, and businesses were not expanding. It was one of (the many) reasons for the 1990 Balance of Payment Crisis. Narasimhan Committee & other experts recommended reducing this. As a result, it was gradually reduced.
CRR Trends
SLR Trends
Use of CRR and SLR
CRR and
SLR can be used to fight Inflation and Deflation
Inflation Fight
Deflation Fight
Method
Tight |
Dear Policy
Easy |
Cheap Policy
CRR, SLR
Increase
Decrease
They
also act as security in case of bank runs.
Side Topic: What are G-Secs?
Concepts like Repo, Reverse Repo and Open Market Operations involve the concept of G-Secs (or Government Securities). Hence, we will first deal with the concept of G-Secs.
When the Government wants extra money to fund its projects, it asks RBI to arrange it (as RBI is the Government’s Debt Manager). The RBI gives the required cash to the Government and prints equivalent amount of Government Securities (G-Secs).
Government Security (G-Sec) is a tradeable instrument issued by RBI on behalf of the Central Government or the State Governments. It acknowledges the Government’s debt obligation. It promises that Government will pay interest of x% to the holder for y years and pay principal at the end of tenure.
Now RBI can use these G-Secs for various operations. E.g. to absorb the excess liquidity from the market etc.
In India, the Central Government can issue Treasury Bills (or T-Bills) and Dated Securities, while State Governments can only issue Dated Securities to raise funds.
Types of G-Secs
1. T- Bills
T-bills are the short-term debt instruments issued by the Union Government. Presently, they are issued in three tenors, i.e., 91-day, 182-day and 364-days.
They are zero-coupon securities, i.e. Government pays no interest. Instead, they are sold at a discount on face value and redeemed at face value.
2. Dated G-Secs
Dated G-Secs have a fixed interest rate on the face value and a tenor ranging from 5 to 40 years.
In this, Bank borrows immediate funds from the RBI for the short term (up to 14 days) with Government Securities as collateral and simultaneously agrees to repurchase the same Securities after a specified time at a specified price. For example, when a bank borrows, it will give its securities worth, say, ₹ 100 crores, & agree to repurchase it back at a rate of ₹ 104 crores ( if the repo rate is 4).
The amount that can be borrowed under this facility is: From 5 crores to unlimited.
All Banks, Central & State Governments and Non-Banking Financial Institutions are eligible for Repo Operations.
But during the whole operation, the Bank has to maintain its SLR, i.e. collateral securities can’t be from the SLR quota.
Present Repo Rate is 6.50% (Sept 2024)
Recent Trends
RBI was reducing the rates during the COVID-19 pandemic to spur economic activity.
However, the Easy Money policy led to excessive liquidity in the economy. Additionally, the Russia-Ukraine War increased the price of commodities, especially oil and food grains. Hence, RBI changed its stance and increased the Repo Rate in Feb 2023 to remove excess liquidity from the economy. It has not changed the Repo Rate since then.
Suppose the Bank is in dire need of cash but doesn’t have spare securities. Under such conditions, the Bank can borrow overnight under MSF without any collateral. But they will have to pay 0.25% higher than Repo Rate (say as punishment)
MSF= Repo + 0.25%
(Presently (as of Sept 2024) = 6.75%)
Only Scheduled Commercial Banks can avail this facility within a range of a minimum of 1 crore & Maximum of 1% of Net Time and Demand Liabilities.
It helps to solve short-term liquidity crunch.
It is also necessary because Repo operations are limited to a specific period during the day.
2.3 Reverse Repo Rate
In this, RBI takes money from banks & gives them securities (opposite of the Repo Rate) (explained in the Infographic below)
RBI pledges securities in the form of G-Secs.
All clients eligible in the Repo rate are eligible here as well.
The current Reverse Repo is 3.35% (as of Sept 2024)
2.4 Standing Deposit Facility (SDF)
Timeline
2013: Urijit Patel Committee on Monetary policy proposed a Standing Deposit Facility (SDF)
2018: The government included Standing Deposit Facility as a Monetary Policy Tool
Policy Corridor is the difference between Marginal Standing Facility (Repo + 0.25%) and Standing Deposit Facility (Repo-0.25%)
The formula has changed recently,
Before April 2022: Policy Corridor = total width between MSF <—> REPO <—> Reverse
After April 2022: Policy Corridor = Total width between MSF <—> REPO <—> SDF
Hence, SDF has replaced the Reverse Repo Rate as the floor of the Policy corridor.
2.4 Bank Rate
Bank Rate is the interest rate at which the central bank lends for the long term to commercial banks.
No collateral is required under these operations.
Presently: 6.75% (as of Sept 2024) (although Bank Rate = MSF, but both are declared separately)
Although RBI doesn’t use this tool to control the money supply,
if it does, the same theory applies here as well.
Inflation Fight
Increase
Bank Rate
Deflation Fight
Decrease
Bank Rate
It is not the primary tool to control the money supply these days but acts as a penal rate charged to banks for shortfalls in meeting their reserve requirements. How is it done? If a bank is not maintaining its SLR or CRR, it is fined a penalty on whatever amount is less than the amount to be maintained. Rate Charged is determined as:-
First time: Bank rate +3%
Second Time: Bank Rate +5% and so on
3. Open Market Operations (OMO)
In Open Market Operations (OMO), the Central Bank (RBI) buys and sells Government Securities to influence the money supply in the economy.
It is different from Repo and Reverse Repo Rates because there is no promise by either party to repurchase it back. RBI will pay the interest rate to the holder of the security, but there is no repurchasing agreement.
How does the government use this to control the money supply?
Case 1: When there are inflation trends in the market, RBI issues these securities. Banks buy these securities & the money supply decreases.
Case 2: When the government wants to increase the money supply, it starts buying these securities at a high price.
Why do banks go for OMO, although there are no compulsions on this?
A lot of money keeps on lying idle with banks. Banks don’t earn any interest on that. Hence, investing those in govt securities & earning ~8% interest on them is a better option.
Dollar-Rupee Swap
To manage liquidity in the market, RBI has developed a new tool. It was started in 2019.
Under this, RBI purchases dollars from banks in exchange for rupees.
Increasing liquidity = Buy $ from Banks and give them ₹
Decreasing liquidity = Give $ to Banks and take ₹ from them
For example: In March 2022, RBI conducted a swap of $5 billion by infusing dollars and sucking rupees equivalent to $5 billion from the Indian economy.
Incomplete Transmission of Rate Cut by Banks
Monetary policy transmission refers to how changes in the RBI’s policy rates (such as Repo) lead to commensurate changes in the rates of Interest of the Banks.
Issue
Earlier, when RBI decreased Repo Rate, Banks didn’t reduce their interest rates proportionately.
Why don’t banks transmit Repo Rate cuts to borrowers?
1. Banks don’t depend on RBI
In India (& all developing countries), RBI is not the primary source of money for banks. Ordinary people are the main supplier(mainly because people don’t have many options to invest money in alternate investment facilities, e.g. mutual funds etc.)
2. Small Saving Schemes rate not reduced
High small savings rates also limit transmission as banks worry that if they cut their deposit rates, customers will flee to small savings instruments such as PPF, NSC etc.
3. High Statutory Liquidity Ratio
Significant money must be kept idle as SLR, which banks can’t lend. It reduces their ability to pass the benefit to consumers.
4. Banks increasing their Spread
Due to losses incurred by banks due to high NPAs, banks increased their Spread to maintain their profits in absolute terms.
5. Higher NPAs
Indian banks face the issue of huge NPAs, which reduces banks’ profitability.
To deal with the inadequate transfer of Repo Rate cuts by banks to borrowers, RBI Came up with MCLR and External Benchmark Rate System.
External Benchmark System
How Banks decide their Interest Rate: Timeline
1969
The government began nationalising private banks and ‘administered interest rates‘ on them.
1991
M.Narsimhan suggested deregulation: Government should not dictate/administer individual banks’ interest rates & RBI should only give a methodology to banks.
2003
RBI introduced Benchmark Prime Lending Rate (BPLR).
2010
RBI introduced the BASE Rate + Spread System; update frequency was at individual banks’ discretion.
2016-17
RBI introduced the Marginal Cost of Funds based Lending Rate (MCLR) +Spread system. – Banks to calculate the lending rate on a monthly basis. – Lending Rate to be calculated using of CRR Cost, Operating Cost, and Marginal cost of funds (calculated using Repo Rate) (don’t need to go into detail. Just remember, MCLR has Repo Rate as a component in it).
Benefits? – Better transmission of Monetary Policy. – Transparency & accountability to borrowers.
RBI’s Janak Raj internal study group (2017) showed MCLR did not yield all benefits. So banks keep on increasing Spread based on their discretion.
Hence, a new method was introduced.
External Benchmark System
Applicable from April 2019 (on recommendations of Dr Janak Raj Committee).
All New Loans are to be linked with the External Benchmark system.
In this system
Banks have been asked to choose any of the following 4 benchmarks like
Repo rate or
91-day T-bill yield or
182-day T-bill yield or
Any other benchmarks by Financial Benchmarks India Pvt. Ltd.
It has to be updated at least every 3 months.
The Lending Rate of the Bank will be External Benchmark + Spread (e.g. if Bank choose Repo Rate as External Benchmark, then Interest Rate will be Repo Rate + Spread)
Benefits?
Better transmission of Monetary Policy.
Better transparency and accountability.
Qualitative / Selective / General tools
These measures are used to regulate the money supply in specific sectors (i.e. these are sector-specific measures).
1. Marginal Requirements/LTV (Loan to Value)
If Indigo Airlines wants to borrow money from SBI and pledges ₹100 crore collateral but RBI prescribe a margin (Loan to Value ratio) of, say, 65%, then SBI can give only a 65 crore loan.
It is obligatory for SBI to obey the directives of RBI in this context (unlike the base rate)
Hence, it is a Selective & Direct tool.
2. Consumer Credit Regulation
In this, RBI can make various regulations on credit.
E.g
Increase down payment from 10% to 30% (it will force some people to delay buying vehicles financed through bank loans).
Decrease the least EMI for the automobile sector, say, from ₹ 5,000 to 3,000.
3. Selective Credit Control
In this, RBI can instruct banks not to extend loans to a particular sector (Negative / Restrictive Tools) or give a minimum %age to a particular sector (Positive Tool).
These are Qualitative and Direct Tools.
Negative Restrictions
3.1 Ceiling to Big Loans
It was operational from 1965 to 1989.
Under this, all Commercial Banks had to obtain prior approval from RBI before giving loans greater than ₹ 1 crore to a single borrower.
3.2 Ceiling on Non-Food Loans
It started in 1973.
To boost Green Revolution
So that more loans go towards the agriculture sector
These tools were used before LPG Reforms, but they weren’t effective because these can be easily flouted using loopholes.
Positive Restrictions
3.3 Priority Sector Lending/Rationing
Rationing is the main feature of the communist economy. E.g. in the Soviet Union, they used to make provisions like giving a particular amount of loan to a specific sector. PSL is a form of Rationing.
PSL means giving a specific minimum amount of loans to some Priority Sectors. In India, 40% of loans are given to Priority Sectors.
Government can increase the supply of money to that sector by increasing its limit.
4. Moral Suasion
Moral Suasion is “persuasion” without applying punitive measures. RBI governor tries this tactic via conferences, informal meetings, letters, seminars, convocations, panel discussions, and memorial lectures.
Eg
Please reduce giving automobile loans instead; invest your money in government securities.
I have reduced the repo rate; now, you also decrease your base rate.
It is not obligatory on the part of the Bank to follow orders, but generally, they do follow.
5. Direct Action
RBI can take direct action against any bank for going against the rules. RBI gets this power under the Banking Regulation Act, RBI Act, Foreign Exchange Management Act, Prevention of Money Laundering Act etc.
E.g., if Bank is not maintaining CRR or SLR, RBI can scrap its license.
This article deals with ‘Money Supply .’ This is part of our series on ‘Economics’ which is an important pillar of the GS-2 syllabus. For more articles, you can click here.
Introduction
It is the total stock of all types of money (currency and deposits) held by the public at any time. The term public includes all economic entities other than the government and banking system.
Factors affecting Money Supply
Season
For example, during November & April, crops are harvested, and industries also buy their raw material leading to more money in the hands of a farmer. Hence, the Money supply will increase.
– Money supply decreases with higher taxation and the sale of G-sec and vice-versa.
People’s Choice
– If people deposit more of their income in banks (instead of storing it in their lockers), the bank can expand loans. The money supply rises in such cases.
Monetary Policy
– If RBI follows a Dear Money Policy = the money supply decreases. – If RBI follows a Cheap Money Policy = the money supply increases.
Why should we measure the money supply?
The job of RBI is to control inflation through qualitative & quantitative tools (i.e. Repo Rate, Cash Reserve Ratio etc.)
But for this, RBI must first know how much money supply is in the system. Only then RBI can make a policy to control the money supply.
Side Topic: Money Demand
The Total Demand for Money in an economy consists of transaction demand (for monetary transactions like buying things) and speculative demand (for trading or other investments).
Side Topic: Net Demand & Time Liabilities(NDTL)
Before proceeding further, we will look into the concept of Net Demand & Time Liabilities(NDTL)
Case 1
Case 2
Demand Liabilities
Time Liabilities
Demand liabilities are those liabilities on the banks which depositors can demand at any time.
Time Liabilities are those which mature after some time. If withdrawn before that, then some penalty is charged.
Demand Liabilities are more liquid as the depositor can easily convert them into cash without penalty.
Relatively less liquid as a person will have to pay the penalty if withdrawn before the maturity.
Consist of money deposited in Current Account & Saving Account
Consist of money deposited in 1. Fixed Deposits 2. Recurring Deposits 3. Cash Certificate 4. Staff Security Deposit
Banks pay less interest on demand liabilities.
Banks pay more interest on demand liabilities. (= people tend to place money here because of more interest)
The sum of both Demand & Time Liabilities is known as Net Demand & Time Liabilities.
Types of Money
M0 (Reserve Money or High Powered Money)
It is the total stock of currency held by the public and banks.
Mo is the base for creating a Broad Money Supply (M3)
Mo is the sum of the following things
Currency held by the Public and Banks
Bankers’ deposits with RBI
Basically, it is the Total Currency Printed by RBI. RBI prints money equivalent to bonds or G Secs it gets from Government.
M1 (Narrow Money)
M1 includes
Currency with Public
Demand Deposit in all Banks (i.e. Deposit in the Current Account and Savings Account)
Basically, it denotes a situation when a person has money; he can do two things to maintain liquidity. He can keep that money in its hard form or deposit it in the bank in a Current or Savings Account (not a Fixed Account).
M2 (Narrow Money )
M2= M1 + Demand Deposits in Post Office
M2 includes
Currency with Public
Demand Deposit in all Banks
Demand Deposits in Post Office
M3 (Broad Money or Money Aggregate)
M3 = M1 + Time Deposits with Commercial Banks
M3 includes
Currency with Public
Demand Deposit in all Banks
Time Deposits with Banks
M3 is most commonly used to measure money and is regarded as the primary indicator of money supply in the economy.
M3 is the Net Demand and Time Liabilities (NDTL).
M4 (Broad Money)
M4 = M3 + total Post Office Deposits
M4 includes
Currency with Public
Demand Deposit in Banks
Time Deposits with Banks
Demand Deposit in Post-offices
Time Deposits with Post-offices
Ranking of Liquidity
Liquidity
is the ease with which an asset can be converted into cash.
Name
Liquidity
Liquidity Rank
M1
highest
1
M2
less
than M1
2
M3
less
than M2
3
M4
lowest
liquidity
4
Liquidity Ranking : M1 > M2 > M3 > M4
Money Multiplier
Before looking into the concept of Money Multiplier, we will look at the concept of the Velocity of Money Circulation
Side Topic: Velocity of Money Circulation
The
average number of times money passes from one person to another during a given
period.
Factors affecting Velocity of Money Circulation
Low Financial Inclusion means less velocity because banking penetration is low. People tend to save more on physical assets. Hence, money doesn’t change hands much.
Poor people immediately use their money. Hence, cash in the hands of the poor has a higher velocity.
Booming period = higher velocity.
If more people use EMI loans for purchases, the velocity is high.
Money Multiplier – 1st Approach
The Money Multiplier is the ratio of Broad Money & Reserve money, i.e. M3 / Mo
M3 = Mo X Money Multiplier
Its value depends on the credit creation capacity of banks, which depends on the following
Banking habits of the public
Monetary Policy
In India, Money Multiplier generally revolves around 5. For example, in Dec 2021, India’s Money Multiplier was 5.3.
Money Multiplier – 2nd Approach
Money
Multiplier is 1/R (R= Cash Reserve
Ratio)
Explanation of the above formula?
Consider a situation
in which a Person deposited ₹ 100 hard currency in the bank. Let’s assume that
Cash Reserve Ratio (CRR) fixed by RBI is 10%. First Bank will keep aside ₹10
& give ₹90 as a loan to some person. Then the person who got the loan again
paid another person through the bank by depositing money in the person’s bank
account. This bank will keep ₹9 (10% of 90) aside and give 81 as a loan to some
other person. And the game keeps on going like this. So, ₹ 100 printed by the
RBI generated a value of ₹ 1000 (i.e. 100 X (1/10%)) if the CRR was 10% and
money was used through the banking system up to its full potential.
Note: Presently, Money Multiplier is around 5. But considering the 4.5% Cash Reserve Ratio, it should be 22.22.
Reason for low Money Multiplier than theory
Since Financial Inclusion is low, there might be a case that either banks have money, but people are not available to take loans, or people cannot keep their money in banks.
Along with that, Banks aren’t always willing to give loans.
Significant cash in India is stored as Black Money and is never stored in Banking System.
This article deals with ‘Money.’ This is part of our series on ‘Economics’, which is an important pillar of the GS-2 syllabus. For more articles, you can click here.
Barter System
People
have been trading with each other even before the advent of money, coin, cash,
currency, rupee, dollar, euro or Yuan. They exchanged
goods and services with each other through the barter system. E.g.,
1 kg rice for 200 grams of tomatoes
1 kg tomatoes for 50 gm almonds and so on
Problems with Barter System
It can happen only with a ’Double-Coincidence of Wants.’
Search Cost / Cost of Transaction is high.
Don’t favour Division of Labour / Specialization: Due to the above problems, all persons will try to become Jack of all trades but master of none.
Don’t favour Industrialization: Industrialists will have to find a large supply line with every person having a double coincidence of wants.
Don’t favour Concentration of Wealth: Since all the wealth is perishable. E.g., one can’t store tomatoes for an extended period.
The Problem of Divisibility of Value: In Barter System, you cannot always divide the value to buy whatever you want.
Not always Fungible: In Fungible items, division & mutual substitution is possible, e.g. Gold bars, Currency Notes & Coins. But barter goods are not always fungible. E.g., if a diamond is cut into smaller pieces, the summation of all the smaller parts will not equal one bigger diamond. Hence, diamond isn’t fungible.
Benefits of the Barter System
Barter System promotes Joint Family
Food Inflation is lower in Barter Economy compared to Money Economy.
Money
Money is anything that is generally accepted as a means of payment.
The money System was invented to answer the above limitations of the Barter System.
Money serves the following functions
a. Primary Functions
Measure of Value
Money serves as a measure of value. E.g., – Labour’s value in Money System is Wage – Land’s value in Money System is Rent
Medium of Exchange
– It is the medium of exchange because it has generalized purchasing power. – E.g., a person earns money from his labour, and that money is used to buy food.
b. Secondary Functions
Due to the above Primary Functions, it can be used for various Secondary Functions as well
Store of Value
– The value of labour paid in the form of money can be stored for later use – E.g., A person can store the value of his labour, i.e. wage, for later use.
Transfer of Value
– The value paid in the form of money can also be transferred to another place. – E.g., A person earning in Bangalore can transfer it to his Parents in Punjab.
Deferred Payment
– It serves as a standard for the settlement of future monetary obligations. We can make deferred payments like paying in advance (like Paying Rent of Dish TV at once) or Paying later (e.g. taking the car on loan). – It is possible because we can measure the Time value of Money using an Interest Rate.
Benefits of the Money Economy
Due to money’s primary and derivative functions, it can be used for social empowerment, dalit entrepreneurship etc. Labour and Service of each kind can be paid, which wasn’t possible in Barter Economy.
It also helps in the Redistribution of National Income (via a taxation system).
Evolution of Money
1. Commodity Money
It is the first stage in the evolution of money.
In this, a particular commodity is used to measure the value.
E.g., Cocoa Beans (used by Aztecs), Cowry Shells (in India), Cigarettes (in Jails) etc.
Note: Commodity Money has Intrinsic Value too.
Different Examples of Commodity Money
2. Metallic Money
Traders and Kings used to stamp their marks on the coins to ensure that the metal was of uniform quantity and quality.
Benefits
It has intrinsic value.
It is non-perishable
It is divisible & fungible.
Even foreign trade is possible
Full-Bodied Coin vs Token Coin
1. Full-Bodied Coin
It is the money whose intrinsic value is equal to or greater than face value.
It is also known as good money.
E.g., One Rupee Coin of British India (shown below) had a face value of 1 ₹, but if somebody melted the silver and sold that in the market, it was greater than 1 ₹.
2. Token Coin
It is money whose intrinsic value is lower than its face value.
It is also known as Bad Money.
E.g., Present 1 ₹ Coin.
Issues with Full Bodied coin
Full-Bodied coins result in various problems. People start to melt metal from the coin and use it for other things. (The same thing was seen in the recent past in Indian Coinage too. Indian ₹5 coins were sent to Bangladesh, where the cost of metal was more than the face value of the coin. People used to melt the coin and make blades out of that. Cupro-Nickel coins were introduced to tackle such activities.)
Apart from that, to adjust to inflation, the government keeps on reducing the metal content in the coins to keep the intrinsic value of the coin lesser than its face value.
Note: It should be
noted that melting coins for other purposes is a punishable offence.
3. Paper Currency
The genesis of paper currency can be traced back to Hundis, where traders used to pay using metal at one place and take Hundi to avoid any theft while carrying metal during an extensive voyage. Later, the State started to do the same work and introduced Paper Currency.
It is called Fiduciary Money, i.e. although the paper has no intrinsic value, it is circulated because of trust in issuing authority.
Types of Fiduciary Money
1. Non-Legal Tender
It is not issued by the government
E.g., Bill of Exchange, Cheque, Bank Draft, Postal Orders etc.
It is also called Optional Money because its acceptance is optional.
2. Legal Tender/Fiat Money
It is issued by the government and acts as money on the fiat or order of the national government.
It can be classified as Coin and Currency.
Its acceptance is not optional within the boundary of the country. It can’t be denied for settlement of any monetary obligation.
Types of Legal Tenders
1. Limited Legal Tender (Coin)
It can be used to settle a limited amount of debt.
According to the Coinage Act of 2011
Using 50 paisa coins, a maximum debt of ₹10 can be settled.
Using ₹1 coin or above, a maximum debt of ₹1,000 can be settled.
All coins below 50 paise are not legal tenders (since 2011).
2. Unlimited Legal Tender (Currency)
It can be used to settle the unlimited debt binding by the government’s command.
Every bank note is legal tender in India.
Who Issues what?
Government
The government issues all coins. Government can issue any amount of coin (even 1,000 ₹ coins).
The government issues ₹ 1 Note with the sign of the Finance Secretary on it.
RBI
Under RBI Act, all Notes except ₹1 can be issued by RBI with the sign of the RBI Governor.
How Fiat Money is issued?
a . Earlier Times
Gold Standard System: Earlier, Bank Notes were backed by an equivalent amount of gold. Notes amounting to the equal reserve of gold were issued. E.g.,
1 US Dollar was issued against 22-grain gold
1 British Pound was issued against 113-grain gold
If this note was taken to Central Bank, it paid an equivalent amount of gold in return.
But later, due to various problems like printing of more cash during wars, the cold war and depressions, this system was discarded.
b. Indian System
Earlier, following systems was used
1935 to 56
RBI used to maintain 40% goldto the value of currency issued.
1956 to 95
India abandoned the old system and moved to the ‘Minimum Foreign Reserve System.’
Under this, RBI was required to maintain a total reserve of at least Rs. 200 crores, with at least Rs.115 crore in the form of gold and the rest in the form of Foreign Securities.
1995 to Present
India is following the ‘ Managed Paper Currency Standard‘.
Under this system, the Government of India can print any amount of money under the backing of gold, foreign securities and Government of India-backed Securities.
Hence, if the government wants to print more money (than gold and foreign currency), the government will issue securities (G-Secs) to RBI, and RBI, in return, will print equivalent money with the backing of those securities.
What does it mean?
It means that if any person with any bank note issued by RBI goes to RBI to exchange that note, RBI is bound to give him other Notes and Token Coins of equal face value.
Demonetisation
Demonetisation is the wholesale withdrawal of currency from circulation.
Although every banknote is “legal tender”, but on the RBI Board’s recommendation, the Government of India can notify that Specific Bank Notes (SBN) are no longer legal tender (i.e. Demonetized).
On 8th Nov 2016, ₹500 & ₹1000 notes were demonetised.
Specified Bank Notes (Cessation of Liabilities) Act 2017: The government passed this Act to give legislative backing to Demonetisation. RBI was not required to honour the promise written on old banknotes.
₹2000 Withdrawn from Circulation
In 2023, ₹2000 was withdrawn from circulation. According to RBI, the note has not been demonetised and will continue to remain the legal tender.
The reasons why ₹2000 note was withdrawn are as follows
₹2000 notes were introduced to address the shortage of money during demonetisation, and it served its limited purpose.
₹2000 notes are not used in everyday transactions
Most of these notes were printed in 2016-17 and have passed their lifespan of 5 to 6 years.
Unofficial reasons consisted of fighting black money and corruption.
4. Bank Money
The backend of Bank Money is Fiat Money as well.
Examples of Bank Money
Cheques
Demand Draft: Can’t be dishonoured because the amount is prepaid.
Overdraft: When a person’s bank account has an insufficient balance, he is still allowed to draw more money than is available in his bank (as a loan).
Debit and Credit Cards
Net Banking System
Unified Payment Interface (UPI) System
Advantages of Bank Money
Easy to transfer over a long distance.
The exact amount can be transferred
Hard to counterfeit
Can freeze if stolen
Leave behind a digital trail
Legally recognized for high-value payment
Types of Accounts
1. Saving Account
These are opened by households.
There are some restrictions on transactions.
Banks offer low interest on these accounts.
It has demand and time liability.
2. Current Account
These are opened by business entities (firms or businessmen).
There are no restrictions on transactions.
Banks offer no interest on these accounts.
It has demand liability.
3. Fixed Deposit Account and Recurring Deposit Account
Anyone can open this account (but generally, these are opened by households because they are the savers in the economy).
There are some restrictions as banks are not liable to pay back until the end of the period for which money was deposited in the bank.
Banks offer a relatively high-interest rate on these deposits (6 to 10%).
It has time liability.
Digital Currency
Central Bank Digital Currency (CBDC)
Budget
2022 announced that RBI would issue a digital rupee using blockchain
technology. It will be a digital form of India’s fiat currency.
CBDC is a digital tone that represent legal tender in India. The definition of banknote under the RBI Act 1934 is also amended to broaden the banknote. “Banknote” now means a bank note issued by the bank either in physical or digital form. It has allowed the introduction of CBDC from the RBI.
Other Points about CBDC
CBDC is based on Blockchain Technology.
CBDC held in the digital wallet doesn’t earn any interest (just like cash held in your wallet).
CBDC is programmable (it can be programmed to be used for specific purpose like Stipend obtained in the form of CBDC can be programmed to be used for buying books only).
CBDC is fungible.
Settlement made using CBDC is final and it can’t be reversed or cancelled (just like cash transaction/ in contrast to credit or debit card transaction).
Issuing Digital Currency has many benefits, such as
Cheaper: Significant cost is incurred on printing money in India (more than ₹4900 crores in 2020-21).
Efficient management of currency
It will break the monopoly of crypto-currencies, which are not backed by any sovereign authority.
It will give impetus to the development of the fintech sector.
No challenge of counterfeit currency.
But there are issues as well.
Encroaches privacy as every transaction will be known to the government
It goes against the traditional banking system.
It makes the financial sector vulnerable to cyber attacks.
This article deals with the‘Issue of Poverty.’ This is part of our series on ‘Governance’ and ‘Economics’ series, which is an important pillar of the GS-2 and GS-3 syllabus respectively. For more articles, you canclick here.
Introduction
What is Poverty?
Poverty is a social concept which results due to unequal distribution of benefits of socio-economic progress.
How does it manifest itself?
Poverty manifests itself in the following ways
Hunger & Malnutrition
Lack of access to education and health care
Social Discrimination
Lack of participation in decision making
World Bank definition
World Bank
defines extreme and moderate poverty in the following way
Extreme poverty
Living on less than $ 1.25 per day.
Moderate poverty
Living on less than $ 2 per day.
Note – Poverty is measured in Purchasing Power Parity(PPP) exchange rate & not absolute exchange rate.
A recent World Bank Report has shown that extreme poverty in India more than halved between 2011 and 2019 – from 22.5 per cent to 10.2 percent.
Poverty Gap
It measures the Depth of poverty
It is also called Foster-Greer-Thorbecke (FGT) Index.
Engel’s Law
Engel Law states that when incomes rises, percentage of overall
income spent on food items decreases. This is known as ENGEL’S LAW.
SDG & Poverty
Sustainable Development Goals gives utmost importance to poverty. The First SDG talks about ending poverty in all its forms everywhere by 2030.
India is home to 26% of the global extreme poor. Hence, the Indian role in achieving that goal is most important.
Causes of Poverty
Economic Reason
Growth Model not conducive to poverty alleviation: India chose a capital-intensive model in a labour-intensive country, which was a great fault.
Widespread reliance on agriculture (42% population is dependent on sector contributing 17% to the GDP)
Lack of formal institutional credit pushes a large number of Indians into poverty every year.
MATTHEW EFFECT: The phenomenon, widely spread across advanced welfare states that the middle class tends to be the primary beneficiary of social benefits & services targeted to the poor (India is trying to rectify this using Targeted Delivery of Subsidy with the help of Jan Dhan-Aadhar-Mobile).
Demographic Factors
Rapid Population growth in India is also the primary cause of poverty as enough resources were not available for all.
Social Cause
Caste system: The subordination of low caste people by the high caste people caused poverty of the former.
Joint family system: Joint Family System, followed by many families in India, provides social security to its members. As a result, some people take undue advantage of it and live upon the income of others. They become idlers. Their routine of life consists in eating, sleeping and begetting children.
Social Customs: Ruralites spend a large percentage of annual earnings on social ceremonies like marriage, death feasts etc., which force them to take debt and remain trapped in poverty.
Climatic Factors
Drought, Floods, Cyclones etc. perpetuate poverty.
Historical Factors
Historical reasons such as colonialism & imperialism led to the exploitation of Indian people. India’s wealth was drained to metropole Britain for two centuries.
Institutional Factors
Withdrawal of Government from Social Security, especially after LPG Reforms.
Anti-poverty schemes are not successfully implemented due to institutional inadequacies.
Poverty Line
What is Poverty Line?
The poverty line is the threshold income and households earning below this threshold are considered poor.
Different countries define the poverty line in different ways depending on local socio-economic needs.
Different approaches to define the poverty line
There are two approaches regarding this
Nutritional Approach: It is based on specific minimum criteria of nutrition intake
Relative Deprivation Approach: It doesn’t take into account just nutritional deficits, but in comparison to the progressive section, the person is not that progressed. E.g., a person earning less than 60% of the country’s per capita income
Developing countries generally follow the nutritional Approach. But
now the time has come that India should move from the Nutritional Approach to
the Relative Deprivation Approach to ensure sustainable and equitable
development.
Poverty line in India is decided by
Earlier it was used to be determined by erstwhile Planning Commission
Now NITI Aayog determines the Poverty Line. NITI Aayog made the Commission under Arvind Panagariya recommend Poverty Line in India.
Panagariya has suggested that
Tendulkar Committee’s report should be accepted for poverty line estimation.
But socio-economic indicators, say, as collected by Socio-Economic Caste Census, should be used to determine entitlement for benefits.
Various Committees constituted for Poverty Line Determination
1. Lakdawala Committee
In books, we frequently come across the Poverty Line defined as 2400 calories in Rural & 2100 calories in Urban. This definition of the Poverty Line was based on the recommendations of the Lakdawala Committee (1999).
2. Tendulkar Committee
Tendulkar Committee
defined Poverty Line based on per capita monthly expenditure.
While calculating, Tendulkar Committee based its recommendation on food, health, education and clothing.
According to Tendulkar Committee Report, Poverty has declined in
India from 37.2% in 2004 to 22% in 2011.
3. C Rangarajan Committee
C Rangarajan Committee defined Poverty Line based on Monthly Expenditure of family of five.
Rangarajan Committee took more things than Tendulkar Committee into its calculations
Rangarajan Committee
also recommended delinking the
Poverty line from the Government entitlement benefits. Food Security benefits
should be given as per Social and Caste dimensions and not BPL.
4. Saxena Committee on Rural Poverty (2009)
When Tendulkar Committee Report came, the Ministry of Rural development hurriedly set up a committee known as the SAXENA COMMITTEE in 2009 to review the methodology for inclusion of a person in the BPL Category to include them in government schemes.
Recommendation of the Committee
Committee gave the famous Automatic Inclusion and Automatic
Exclusion principle.
The automatic inclusion criterion for the most vulnerable sections of society (E.g. homeless people, persons with disabilities etc.)
Automatic Exclusion: Those having motorbikes etc.
Apart from being Automatically included, find other using scores of various deprivations.
5. Hashim Committee on Urban Poverty (2012)
To suggest a methodology for inclusion of a person in the BPL category in Urban Areas to include them in government schemes.
Recommendations of the Committee
Automatic Exclusion
Automatic Inclusion
Scoring Index: remaining households will be assigned scores from 0 to 12 based on various indicators. They should be considered eligible for inclusion in the BPL List in the increasing order of higher scores.
Multidimensional Poverty Index
In India, we calculate poverty using Tendulkar Method based on household consumption.
But UNDP takes a holistic view of poverty and measure it differently.
The report has been released since 2010.
In Multidimensional Poverty, they look into the following components to measure poverty (HES)
Health with components like child mortality
Education with components like years of schooling
Standard of Living with components like Electricity, water etc.
Andhra Pradesh is already using this approach.
Capability Approach to Poverty by Amartya Sen
Traditional Approach
Poverty is defined by an individual’s income.
E.g., Extreme Poverty is defined as those who live on $1.25 per day or less.
As a result, following this approach, governments centre their Poverty Removal Policies on job creation, GDP growth and other economic policies.
Capability Approach
In richer countries, all are fortunate enough that they can earn a good income. Does that mean they are not poor?
Amartya Sen’s Capability approach defines poverty in a Holistic Way. A better approach to look at poverty is the deprivation of a person’s capabilities to live the life they value.
Well Being Approach
Given by Erik Allard, it
includes three dimensions as:
Having (Material),
Loving (Social), and
Being (Spiritual-emotional)
World Poverty Clock
The World Poverty Clock was developed by World Data Lab to monitor global progress toward ending extreme poverty.
The latest data (released in March 2024) shows that India has managed to reduce extreme poverty to below 3% of its population.
Critique of these Poverty Lines
Experts argue that the Indian way of calculating poverty is incorrect. It is simply what some call a “starvation line”. Critics argue that governments around the world keep the poverty line at low levels to show that millions have been moved out of poverty.
India should be using some relative measure as opposed to the absolute measure to define poverty. In most Europe, a family with a net income of less than 60% of the “median net disposable income” is counted as poor. A poverty line “relative” to the national average also gives an idea about the state of inequality.
A comparison shows that India’s poverty line is abysmally low than even African Poverty Lines. Even the poverty line of Rwanda is higher than that of India. The per capita poverty line of a rural adult Rwandan in Indian terms comes out to be Rs. 900/ month, more than Rs. 816 for a person in rural India.
Another critique that Poverty Line faces is that once decided, the PL remains the same for years & don’t take into account inflation. It needs to be updated every year by applying a cost inflation index to keep it realistic.
Multidimensional Poverty Index: We define poverty in a minimal way by just looking at household consumption. UNDP defines poverty using the Multidimensional Poverty Index, which takes a holistic view and considers indicators like Health, Education, and Standard of Living. India should move toward that.
Reduction of Poverty in India
According to Tendulkar Committee Report,
poverty in India has reduced from 37.2% in 2004 to 22% in 2011.
Reduction in poverty is attributed to
Increase in employment in the non-agriculture sector – The construction sector absorbed the landless labourers & daily wage earners from villages
Schemes like MGNREGA, National rural livelihood mission also reduced the stress during the lean season by creating employment opportunities during the non-agricultural season.
India’s demographic bulge provided more working population compared to dependents (Children and elders).
Social welfare schemes like PDS, AAY, MGNREGA, NRLM, Pension schemes and others provided a safety net to the poor
Inward remittances – Large emigration of the citizen to the US, EU etc. and to west Asian destinations like UAE, Saudi, Qatar etc. generated huge inward remittances for India, which directly benefited dependents in India
Quality jobs in the Service sector like BPO, Hospitality, Retail chain, E-commerce supply chain provided heavy wages.
The rapid growth of the economy provided better opportunities to come out of poverty through better employment opportunities, increased demand for services etc.
Chinese Case Study
According to World Bank, people living below the poverty line reduced from 770 million in 1978 to 5.5 million in 2019.
In 2021, China declared that it had eradicated extreme poverty.
Steps taken by Government in this regard
Targeted Approach: China identified the poorest region to allocate more resources there.
Economic Development: China’s economic development generated a lot of jobs, helping people to come out of poverty
Social Welfare Programs: The government provided healthcare coverage, education, housing assistance etc.
Agriculture and Rural Development: China focused on agricultural reforms, modernization, and supporting farmers.
Impact of LPG Reforms on Poverty
Poverty has decreased: Consider any Poverty Line, all points to the fact that Poverty in India has declined. Take the example of the extreme poverty line as defined by the World Bank.
Inequality: Inequality in India has increased after LPG Reforms.
The
rich section has reaped the benefits of LPG Reforms. This is the leading cause
of the increase in Inequality.
The above Paradox can be explained by the Redistribution of Income by Government. Because of the increase in income of richer sections, the government is getting more taxes. Therefore, redistribution of this source has ensured that Poverty has decreased.
Impact of Poverty
Several issues like hunger, illness and thirst are both causes and effects of poverty. Hence, the term known as poverty trap is usually used for this i.e. bad cycle is created not allowing people to come out of poverty
On Society
Poverty results in inequalities which can culminate into violent upheavals like Arab Spring. Various Revolutions in Arab Spring started because of the lack of jobs and high poverty levels.
On Children
Poverty leads children to build antisocial behaviour and social exclusion.
Terrorism
Most of the time terrorists do come from poor countries with high unemployment.
Diseases
Diseases are very common in people living in poverty because they lack the resources to maintain a healthy living environment.
Education
Those living below the poverty line cannot attend schools and create a vicious cycle in which poverty prevents people from getting a good education, and being uneducated prevents them from escaping poverty.
How can India reduce poverty?
Even though India has grown rapidly, its growth has been less effective at reducing poverty than in some of India’s middle-income peers such as China, Vietnam, Brazil and Turkey. The following can be done in this respect.
In Agricultural sector
With 4
out of every 5 of India’s poor living in rural areas, progress will need to
focus on the rural poor. Hence, the government should focus on following to
increase the income of those involved in the agriculture sector.
Value addition through food processing
Organic farming
Cooperation farming, milk cooperatives, and farmer producer organizations.
In Manufacturing Sector
Create Jobs in India via
Skill development
Make in India
Startup India
In Service Sector
Creation of quality jobs in BPO, IT and ITES for youth
Promotion of tourism
Promotion of higher job creation in e-commerce, supply chain, Hospitality and construction sectors.
In Governance
Implement Jan Dhan- Aadhar- Mobile (JAM) effectively to target subsidy to the poor and eliminate inclusion and exclusion errors.
Look into the feasibility of providing Universal Basic Income.
