MODULE 4

MACROECONOMIC CONCEPTS

Circular flow of Income

Circular flow of income shows the flows of income and expenditure in an economy.
An economy is divided into four sectors- Household sector, Business sector or
firms, Government sector and Foreign sector.
Circular flow of income shows the flow of goods and services and the flow of
money among these sectors of the economy.
Economic transactions generate two types of flows : product flow or real flow and
money flow.
In an economy products and money flow in opposite directions in a circular
manner ; this is called circular flow of income. Product flow includes flow of goods
and services and flow of factor services. Money flows represent the flow of
payment to factors of production and the prices to the business sector.
When factors of production supply their factor services, they get factor incomes this
is the income flow .this income is spent on various goods and services and creates
expenditure flow.
Circular flow of income can be explained with the help of the two sector, three
sector and four sector models.
Circular flow in a two sector model
In a simple two sector model, the two sectors are households and firms.
Households possess all factors of production; they supply these factor services to
firms and get factor payments in the form of rent, interest, wages and profit. This
income is spent for buying goods and services produced by firms .firms hire the
factor services of households and produce various goods and services. They sell
these goods and services to the households. these flows are presented in the
following chart .
This model is built on the basis of the assumption that the entire income received by
the households are spent on goods and services.
In the diagram, upper part represents the factor market and the lower part represents
commodity market. In the factor market, there is a flow of factor services from the
household sector to the firms. In return, there is a flow of factor payments from
firms to households. In the commodity market, there is a flow of goods and services
from the firms to household sector. In return, there is a flow of payment for goods
and services from household sector to the firms. Thus the money flows and real
flows are completed.
Three sector model

In a 3 sector model, the government sector is included. The household sector and
the firms pay tax to the government. Like other two sectors, government also
spends money. Governments make payment to the firms for the purchase of goods
and services . Government also pays subsidies to the firms. Similarly Government
makes use of the manpower services of the households and pay wages and salaries
as well as transfer payments in the form of welfare expenditure like pension to the
household sector. The figure shows the circular flow in a three sector model. For
convenience only money flows from and to the government are shown.
Circular flow in a four sector model
In a four sector model, there are four sectors - the firms, households, government
and the foreign sector. Households export their manpower to the foreign sector and
in return they get foreign remittances. Firms export their goods and services to the
foreign sector and they get receipts from exports. At the same time firms import raw
materials and other inputs from the foreign sector and they make payment for their
inputs. Export adds income to the economy but import is a leakage of income. The
figure explains the circular flow in a four sector model.

Factor income and transfer income

Factor income is the income received for supplying factor services. it can be in the
form of rent, interest, wages or profit.
Transfer payments – Transfer payments are unilateral or one sided payments ; they
do not add anything to the current flow of goods and services. Donations to charity,
unemployment allowance , old age pension , gifts etc. are examples of transfer
payments. Tax is a compulsory transfer payment.
National income
National income can be defined as the sum total of the incomes of all the nationals
of a country. It is the sum total of the factor incomes received by the residents of a
country in the form of rent, interest, wages and profit over a period of one year .
When net income from abroad is added to this, we get national income of the
country
Domestic product at market price (GDPmp)
It is the total money value of all final goods and services produced by the people of
a country during a financial year.
Gross domestic product (GDP )
GDP is defined as the market value of all final goods and services produced in the
domestic economy during a period of one year plus income earned locally by the
foreigners minus incomes earned abroad by the nationals.
GDP = GNP - Net income from abroad.
Moreover the value of goods and services produced in the domestic territory alone
will be taken into account. That is, goods produced outside the country by the
nationals will not be considered.
Net Domestic product at market price ( NDPmp )
When depreciation is deducted from GDP we get NDP. Depreciation is the loss in
the value of capital assets due to wear and tear during production.
That is,
NNPmp = GDPmp -depreciation.
Net National Product at market price ( NNPmp )
GDP includes the money value of goods or income generated within the domestic
territory only; but a nation also gets income from abroad . When net factor income
from abroad NFIA is added to NDP we get NNP; That’s the difference between
domestic product and national product is NFIA.
NNPmp = NDP mp + NFIA
Net National Product at factor cost (NNPfc ): Market price includes indirect
taxes and subsidies . When the effects of these two are deducted from the value of
output, we get the value of output at factor cost . To estimate the value at factor cost
net indirect tax is to be deducted.
NNP fc =NNPmp – Net Indirect Tax (NIT)
NIT = Indirect tax – Subsidy
Gross National Product (GNP)
GNP is the money value of all final goods and services produced in a country
including net factor income from abroad.
GNP = GDP + NFIA
NUMERICAL EXAMPLE
From the data given below, estimate GNPmp, GNPfc, NNP MP and National
Income.
GDPmp = 5000 (in 100 billion )
NFIA= - 50
Indirect tax = 70
Subsidy = 20
Depreciation = 30
Answer
GNPmp= GDPmp + NFIA =5000 + - 50 = 4950
GNPfc = GNPmp – NIT
=4950 – (70 - 20 )=4900
NNPmp= GNPmp – Depreciation ( or GDPmp -Depreciation+ NFIA)
= 4950- 30 = 4920
National Income (NNPfc) = NNPmp – NIT
=4920 - (70 – 20) = 4870
Personal income
It is the sum of all incomes actually received by an individual or household during a
year. it is the income of the household sector from all sources before paying direct
taxes in a financial year.
Disposable personal income
It is defined as the part of personal income left for consumption and saving after
payment of taxes
Personal disposable income = Personal income- Direct taxes
Per capita income
It is the income per head.
Per capita income is obtained by dividing national income by the population of the
country.
Per capita income = National income / Population
Three sectors of the economy
Economic activities are classified under 3 sectors – primary, secondary and tertiary
sectors.
Primary sector consists of activities related to the exploitation of natural resources;
the main activities under primary sector are agriculture, mining and quarrying,
forestry, fishing, animal husbandry, poultry farming etc.
Secondary sector is the manufacturing sector. Secondary sector includes registered
and unregistered manufacturing units.
Tertiary sector provides various services like health, education ,banking,
insurance ,transport and communication ,trade and commerce ,hotels and
restaurants etc.
In developed countries, the tertiary usector contributes the largest share towards
national income.
Stock and flow
Stock is the quantity of a variable measured at a point of time ; it is a static concept.
On August 1st 2020 , there is Rs. 50,000 in your bank account. On August 1st 2021
there is ₹15,000 in your bank account. All such values are stock values as these are
measured at a specific point of time.
A flow is the quantity of a variable measured over a period of time ; it has a time
dimension, may be a week, month, year etc. It is a dynamic concept. You may be
getting ₹150 per month as travel allowances ; you may be spending 5 rupees every
day in the canteen, you may be getting 5% annual interest on your bank deposits.
All these values or quantities are flows as these are measured per unit of time ( an
hour, week, a month, an year etc. )
Measurement of national income
Measuring national income is important to predict the future course of the
economy. It also broadly indicates the standard of living of the people.
There are three important methods of measuring national income. They are:
1. Product method or output method
2. Income method
3. Expenditure method
Any of these methods can be used in calculating national income but the choice of a
particular method depends on the availability of data.
Production method or output method
According to this method the economy is divided into 3 sectors such as primary
sector consisting of agriculture ,mining ,fishing etc. , secondary sector consisting of
industries and tertiary sector consisting of service sectors . The gross product is
found out by adding up net values of all the production that has been taken place in
these sectors during a given year. When the net income from abroad is added to this
GDP we get GNP.
The following are the important steps involved in the estimation of national income
through production method.
[Link] the production units and classifying them under respective industries
corresponding to different sectors
[Link] the value of final output produced by each production unit in each
industry under each sector.
The sum of the value of output produced by all the three sectors gives GDPmp.
While using this method the value of goods produced for self consumption is also
added.
The great advantage of this method is that it reveals the relative importance of
different sectors of the economy by showing their respective contribution to the
national income .
The major problem of this method is the problem of double counting. Double
counting means counting the value of a product more than once . This difficulty
arise because final product of one firm becomes the intermediate product of another
firm ; hence it is difficult to classify the goods as final goods and intermediate
goods. Double counting leads to overestimation of national income . This problem
can be solved by using the value added method .
Value added method involves adding only the final value of output produced and
not adding the value of intermediate goods.
Gross value added at market price ( GVAmp) = GVOmp (gross value of output at
market price) - Intermediate Consumption.
Suppose a Baker produces bread for Rs .1000 by using the inputs like milk ,wheat
flour ,sugar [Link] ₹600. Value added by Baker is 1000 – 600 = 400. If we add the
value of bread as well as milk ,sugar and wheat flour in national income estimation,
double counting arises.
Income method
In the income method , GDP is calculated by adding all the incomes earned by
various factors of production which are engaged in the production of output . The
various incomes included to compute the gross national income are rent, interest,
wages and salaries, profits and dividends of business corporations. When net flow
of income from abroad is added to this we get GNP.
Income method of estimating national income has the great advantage of indicating
the distribution of national income among different income groups such as
landlords ,capitalists, workers etc.
Though this method is very popular in application, it is not free from the problem of
double counting; to avoid double counting we can use two methods:
(a)Final product method
(b)Value added method.
Expenditure method
Expenditure method measures national income as the sum total of all final
expenditure made by different agents of the economy during a year. It includes
household consumption expenditure, investment expenditure on capital goods,
government expenditure and net exports.
There are four major components of final expenditure: private final consumption
expenditure ( C) , investment expenditure ( I) , government consumption
expenditure ( G ) and net exports ( X – M ) .When these four items are added, we
get GDPmp. that is
C +I + G + X – M =GDPmp

Uses or significance of national income estimation

• To evaluate the performance of the economy over the years
• For economic planning and for the formulation of economic policies
• to understand the contribution of each sector towards national income
• to make comparison between the economic performance of two countries
to measure the inequalities in the distribution of income.
Difficulties in the measurement of national income
There are two types of difficulties in the measurement of national income :
conceptual difficulties and statistical or practical difficulties.
Conceptual difficulties are common to developed as well as developing
[Link] practical difficulties are mainly applicable to underdeveloped
countries.
Conceptual difficulties
• Service without remuneration: certain services such as service rendered by a
housewife is not included in national income because payments are not made.
 But when the same services are supplied by a house made, remuneration is
paid and it is included in national income estimation
• Classification of goods as intermediate goods and final goods : it is very
difficult to classify certain goods as final goods and intermediate goods
because the same product is used as an intermediate good and final good.
• Difficulty in estimating the value of output produced in the government
sector: Since the government provide public goods either at free of cost or at
nominal prices it is very difficult to estimate their value.
Practical difficulties
• Inadequate statistical data – in developing countries accurate and adequate
statistical data is not maintained.
• Illiteracy of farmers: majority of the farmers are illiterate¿ hence they do not
keep proper accounts of their production.
• Lack of occupational specialization – in developing countries people are
mostly unskilled and they earn their income from more than one occupation.
hence it is difficult to compute their incomes.
• Production for self consumption in developing countries: a major part of the
agricultural output is consumed by the farmers themselves . Hence its value
cannot be estimated.
• Existence of a non monetized sector-In developing countries ,in villages
people still make certain barter transactions.
Besides, black money price changes etc. also pause problems to national income
estimation.

INFLATION:
Inflation is a rise in the general level of prices of goods and services in an economy
over a period of time or inflation is a process of rising prices.
Inflation is a situation in which there is a persistent or continuous rise in the general
price level ; in other words, it is a situation in which there is an upward movement
of average level of prices .According to Caulborn, inflation is a situation in which
“too much money chasing too few goods”. That is the availability of goods is less
when compared to the supply of money . When there is inflation, value of money
decreases. Value of money is the purchasing power of money or the quantity of
goods and services that a unit of money can purchase.
Types of inflation
There are several types of inflation which are classified on different basis. Based on
the rate, inflation can be classified as creeping, walking, running and galloping
inflation :
Creeping inflation :when the rise in prices is very slow that is less than 3% per
annum, it is called creeping inflation. It is mild inflation and it is considered as good
for economic growth.
Walking inflation: when prices rise moderately and the annual inflation rate is 3%
to 10%, it is called walking inflation; at this rate inflation is a warning signal to the
government.
Running inflation: when prices rise rapidly and the rate of increase is 10% to 20%
per annum, it is called running inflation. It’s control requires strong monetary and
fiscal measures and it is a dangerous situation.
Galloping or hyperinflation : when price rises between 20% to 100% per annum or
even more, it is called galloping or hyperinflation. Such a situation brings a total
collapse of the monetary system because of the continuous fall in the purchasing
power of money.
Demand pull inflation and cost push inflation
Demand pull inflation – demand pull inflation is also called wage inflation. It
occurs when the total demand for goods and services in an economy exceeds the
available supply and the prices for them rise in a market economy. Demand pull
inflation is caused by excess demand which can originate from war, high exports,
strong investment, rise in money supply or government financing. However this
type of inflation can be controlled by suitable tax policies.
In the diagram AD is the aggregate demand curve, AS is the aggregate supply
curve. Initially the economy is in equilibrium at point E. Y is the equilibrium level
of output and P is the price level. When aggregate demand increases AD curve
shifts upwards and the new AD curve is AD1 which intersects the AS curve at point
E1. Here price level increases to P1 and there is an increase in output from Y to
YF .Beyond the YF level of output AS curve becomes perfectly inelastic. That is
the output cannot be increased beyond this level of output .Hence YF is the full
employment level of output. Any increase in aggregate demand beyond this level
will push the price up without any change in output. The theory of demand pull
inflation is associated with the name of JM Keynes.

Cost push inflation is the result of increase in cost of production. Cost of

production increases mainly due to increase in wages ,increase in profit margin or
due to a supply shock which means a sudden fall in supply. . Increase in cost of
production decreases the supply and when supply decreases, supply curve shifts
leftwards. Therefore the price level goes up this is shown in the diagram.
 Cost push inflation
In the diagram, initially the economy is in equilibrium at point a where the
aggregate supply curve ASI intersects the aggregate demand curve AD . This is full
employment equilibrium where the output is YF and P is the price level. When
aggregate supply decreases the S curve shifts leftwards and the new supply curve is
AS2 which intersects the AD curve at E1. Therefore the price level goes up to P1
and the output decreases to Y.
Measurement of inflation: inflation is measured by two price indices : Wholesale
price index (WPI) and Consumer price index (CPI)
Causes of inflation
• The basic cause of inflation is that the total demand for output exceeds the
total supply .Hence, causes of inflation are studied under two headings:
• The factors which lead to increase in demand and
• The factors which lead to the shortage of supply
Demand side causes
• Increase in money supply- inflation is caused by an increase in the supply of
money which leads to increase in aggregate demand.
• Increase in disposable income – when the disposable income of the people
increases it raises their demand for products.
 • Increase in consumer expenditure : the demand for goods and services
increases when consumer expenditure increases
• Increase in government expenditure : when the government follows an
expansionary fiscal policy, government expenditure will increase and as a
result demand for goods and services also increases.
• Increase in population : when population increases the number of buyers also
increases and the aggregate demand thus increases.
Black money : people spend unearned money lavishly, thereby creating unnecessary
demand for commodities. This tends to raise the price level further.
Supply side causes or factors affecting supply
There are certain factors which tend to reduce the aggregate supply ; they are the
following:
• Shortage of factors of production – shortage of factors such as labor, raw
materials [Link] to reduction in industrial production and reduction in
supply of goods.
• Increase in wages – when wage rate increases, cost of production also
increases. As a result supply falls and price level goes up.
• Speculative hoarding: when traders hoard goods and create artificial
scarcity to get more profit, price will increase.
• Natural calamities – drought or floods or earthquake etc reduces
production and lead to inflationary pressures.
• Increase in exports: when exports increase, availability of goods in the
domestic market decreases.
• Industrial disputes- industrial disputes will affect industrial production
and aggregate supply.
Effects of inflation
Effects of inflation can be studied under
• Effects on distribution of income
• Effects on investment and production
• Social and political effects
Effects on distribution of income and wealth
• Effect of inflation on fixed income group and flexible income group. When
there is inflation, the poor and the middle class whose income is relatively
fixed will lose but the flexible income group categories like businessmen,
industrialists, traders, real estate holders etc gain.
• Debtors and creditors: During inflation, debtors gain and creditors lose.
Because of inflation, value of money decreases and therefore people who
lend their money will have less value when they get back their money and
they can purchase only less amount of goods and services.
• Salaried classes and wage earners: these people are hit hard by inflation.
• Investors : those who invest in shares will gain because companies will make
more profit when there is inflation. On the other hand, those who invest in
bonds and debentures which carry fixed returns will lose.
• Businessmen : since prices go up business people get more profit and they gain
from inflation
• Farmers : when there is inflation, price of agricultural product increases at a
faster rate. Hence farmers get more income.
Effects on investment and production: When there is inflation, people have a
tendency to spend more and save less, which leads to less investment in the
economy and less production. In the initial stages, producers and traders get more
profit because of price rise; hence they produce their maximum and thus production
goes up. But later, inflation increases wage rate and price of raw materials. Hence
cost of production increases and as a result output may decrease.
During inflation, there will be misallocation of resources because producers will
divert their resources from the production of essential commodities to those goods
which gives them maximum profit . Black marketing is another adverse effect of
inflation. Traders may hoard stock of goods to create artificial scarcity to make
more profit by selling it at a higher price
Social and political impact – inflation makes the rich richer and the poor poorer.
Hence people will be unhappy because of the rising cost of living; workers resort to
strikes which lead to loss in production. To make more profits, people resort to
hoarding, black marketing, adulteration, manufacture of substandard commodities,
speculation etc. Corruption spreads in every walk of life. There will be social unrest
in the economy.
If hyperinflation persists and the value of money continuously fall, it ultimately
leads to the collapse of the monetary system. Further, rising prices also encourage
agitations and protests by political parties opposed to the government. This may
lead to the downfall of the government.
Measures to control inflation
There are three important ways in which inflation can be controlled:
Monetary policy measures
Fiscal policy measures
Other measures
Monetary policy measures
These are the measures adopted by the Central Bank of a country to control credit
and money supply in an economy. The twin objectives of monetary policy are price
stability and economic growth.
Monetary policy measures can be classified as:
a)Quantitative credit control measures
b)Selective or qualitative credit control measures
c)Quantitative credit control measures
Quantitative controls aim at regulating the overall volume of bank credit without
considering the purpose for which credit is used. The important quantitative
measures are:
1. Bank rate policy- the Bank rate is the rate at which the central bank
rediscount’s approved bills of exchange. According to RBI it is the rate at which
bills of exchanges and commercial papers are re discounted or bought. During
inflation, the central bank raises the Bank rate due to which the cost of borrowing
goes up. As a result commercial banks borrow less money from the central bank
with the reduced borrowings from the central bank, the flow of money from the
commercial bank to the public decreases.
As the central bank raises the interest rate, the commercial banks also raise their
lending rate to the public thereby making the borrowings costlier. Hence people
take less loans from the commercial banks and spend less money. This helps to
reduce money supply and aggregate demand in the economy.
Increase in Bank rate is called dear money policy and decrease in Bank rate is
called cheap money policy.
2. Reserve ratio - Depending upon the economic conditions, central bank increases
or decreases the reserves that every commercial bank should keep in the central
[Link] are two types of reserve ratios:
Cash reserve ratio (CRR) – Every commercial bank should keep a certain
percentage of their total deposits in the central bank in the form of cash rereserves.
This is mandatory and this percentage is called CRR. According to RBI, it is the
average daily balance that a commercial bank is required to maintain with the RBI
as a percentage of its total deposits. When there is inflation, the central bank
increases the CRR; this reduces the availability of cash with the commercial banks
and their lending capacity decreases. Hence people get less money in the form of
loans from the commercial banks and it helps to control inflation.
Statutory liquidity ratio (SLR) : A commercial bank should keep a certain
percentage of their total deposits in the form of safe and liquid assets such as cash,
gold and government securities. When there is inflation, SLR is increased and it
helps to decrease bank credit and to ensure the solvency of the banks.
[Link] market operations : open market operations means the sale and purchase
of government securities and bonds by the central bank . When there is inflation,
the government securities are sold through commercial banks to the public so that a
certain amount of bank deposit is transferred to the central bank as the public
purchases government securities; as a result the credit creation capacity of the
commercial banks reduces.
Selective or qualitative credit control measures
Under this method , credit or loans to essential purposes is encouraged and for non
essential purposes it is discouraged ; these methods prevent the flow of credit into
undesirable channels and also direct the flow of credit to useful purposes. The
important selective credit control measures are
[Link] requirements margin means the proportion of the value of security
against which loan is given for productive purposes; for productive purposes ,
margin requirements will be less and if a loan is taken for unproductive purpose,
then the margin requirement will be high.
2. Regulation of consumer credit : Under this method the central bank lay down
terms and conditions for regulating consumer credit given by commercial banks of
a country. The amount of credit that might be given to consumers is restricted by
the commercial banks. The time that might be available for repaying the loan is also
restricted.
3. Moral suasion: these are the informal requests by the central bank to commercial
banks to reduce credit in times of inflation and to expand credit in times of
depression. The central bank issues periodical letters to commercial banks
regarding the inflationary tendencies in the country.
4. Direct action : Central bank take direct action against those banks which do not
follow the directions of the central bank. It may involve refusal by the central bank
to rediscount bills or cancellation of license.
Fiscal policy measures
These are the measures taken by the government to control the aggregate demand in
the economy. The main instruments of fiscal policy are Public revenue, Public
expenditure and Public borrowing.
[Link] revenue : the main source of public revenue is tax . When there is
inflation, the government increases the tax rates to reduce the total spending by the
people. Increase in direct taxes decreases the disposable income of the people and
hence they spend less money.
2. Public expenditure during inflation: the government cuts down its expenditure
on developmental activities and welfare programs, thereby reduces the income of
the people and hence aggregate demand also reduce decreases
3. Public borrowing: when there is inflation, the government will delay the
repayment of public debt ; at the same time, the government borrows more money
from the public.
4. Other measures:
Other measures include the measures taken by the government to increase the
supply of goods and services, price control, wage control etc.
[Link] the supply of goods and services : when there is price rise,
government takes various measures to increase the supply of goods and services by
importing essential products, banning the export of such items and by encouraging
the production of essential commodities.
[Link] control: Government takes direct measures to control the prices of goods
and services. Essential commodities are distributed through the public distribution
system at reduced price reduced prices.
[Link] control : Wage control helps to prevent the rise in cost of production during
inflation and thus cost push inflation can be controlled.
Repo rate and reverse repo rate
Repo rate is the rate at which RBI provides overnight liquidity to banks against the
collateral of government and other approved securities. In other words, it is simply
the rate at which RBI lends short term funds to commercial banks when they are
facing a financial crunch.
Bank rate and repo rate are not the same. In general, Repo rate focuses on
providing funds to banks for a very short period whereas Bank rate focuses on long
term fund requirements of the commercial banks.
Reverse repo rate is the rate at which the RBI absorbs liquidity on an overnight
basis from commercial banks . In other words, when commercial banks have excess
funds, they can deposit the same in central bank and earn interest in the form of
reverse repo rate.
Repo rate and reverse repo rates are also used to control money supply in the
economy ; when there is excess money supply, these two rates are increased to
control inflation.
BUSINESS FINANCING
Sources of capital
Companies raise funds from two sources:
Domestic sources and Foreign sources.
The important domestic sources are
(a)Internal self finance:
An important source is the saving of the company itself; it may be a household unit
or a business unit or the government. here the household saves and invests its own
finance and lends its surplus to other units through banks, capital market etc.
An advantage of investment through internally generated funds is that it combines
the acts of saving and investment; it helps to reduce the cost of borrowing.
(b)Equity, Debentures and Bonds:
For financing fixed investments like building, machines [Link] types of
equity or shares are utilized .Shares are available in small denominations also to
enable the largest number of people to participate in providing long term finance.
To get long term finance, companies issues debentures and bonds also. They are
debt instruments. The buyers of these debentures and bonds are the creditors of
companies. They get a fixed rate of interest on the money invested in these
securities.
(c)Public deposits
Another source is public deposits. Under this system, people keep their money as
deposit with these companies for a period of six months, a year, two years, three
years or so. Depositors receive a fixed interest. This money is used by companies to
meet their needs of working capital. However, this source of finance is unreliable
because depositors can take back their money at anytime.
(d)Loans from banks: To meet the short term needs of companies,commercial
banks provide loans. Also these banks purchase debentures issued by the companies
First off they can earn fixed interest on such investment.
(e)Indigenous bankers: Indigenous bankers also advanced financial help to
large scale industries, both for fixed capital and working capital. But mainly they
provide finance to small scale industries. These banks charge a very heavy rate of
interest.
(f)Development finance institutions:These institutions cater to the needs of
large and small industries. These institutions include the industrial Development
Bank of India, industrial finance corporation of India, industrial reconstruction
Bank of India, State financial corporations and State industrial development
corporations.
Shares and Bonds
When companies want to raise capital, they can issue shares or bonds.
A share is a stake in the ownership of a company. It is a security that is also
sometimes referred to as an equity. When a company issue shares, they are selling a
certain amount of ownership in their company. An investor who buys the shares has
a claim to the company's earnings and assets. Some companies payout a percentage
of profits to investors in the form of dividends. When more shares are issued, future
earnings must be shared among a larger pool of investors. More shares can cause a
decrease in earnings per share EPS, putting less money in the investors' pockets.
Shares are perpetual investments and they do not have specific [Link] are
a loan agreement that a company enters into with the investor .By buying a bond, an
investor is lending money to a company for a pre agreed period of time. The
company agrees to pay back the money lent by the investor on a fixed date. There
will be regular interest payments during the period of the loan or in bulk at the time
of maturity .When the bond reaches its maturity date, the company repays the
investor. Unlike shares, bonds are temporary investments which have fixed life
cycles. Bond issuance enables corporations to attract a large number of lenders in
an efficient manner. Record keeping is simple because all bond holders get the
same deal. For any given bond, they all have the same interest rate and maturity
rate.
Major differences between shares and bonds
Money market and capital market
A financial market deals with financial assets such as stocks, bonds, treasury bills,
currencies etc.
The two important components of a financial market are money market and capital
market.
Money market
Money market deals with short term financial assets, that is, assets up to a maturity
period of one year. The important instruments used in the money markets are
deposits, collateral loans, bills of exchange, treasury bills, certificate of deposits etc.
Institutions operating in money markets are central banks, commercial banks,
acceptance houses [Link] market plays a major role in the circulation of short
term funds in the economy ; it helps the industries to fulfill their working capital
requirement.
Functions of money market
Financing trade – money market finance internal and international trade.
Financing industry- money market helps the industries in securing short term
loans to meet their working capital requirements.
Profitable investment – money market enables the commercial banks and other
financial institutions to invest their excess reserves in a profitable way.
Financial mobility – money markets helps in financial mobility by facilitating the
transfer of funds from one sector to another .
Economic growth - money market helps in the development of trade,industry and
agriculture; it promotes overall economic growth.
Capital market
A capital market deals with long term financial assets. In other words, a capital
market is a financial market in which long term financial assets are bought and
sold .Capital markets channel the wealth of savers to those who can put it into long
term productive use or they facilitate long term investment. The instruments which
are traded in a capital market includes stocks, bonds debentures etc. whose maturity
is not limited up to one year or sometimes the securities are irredeemable, (no
maturity). The capital market works under full control of Securities and Exchange
Board of India ( SEBI ) to protect the interest of the investor.
A capital market is broadly divided into two major categories : primary market and
secondary market. A market where fresh securities are offered to the public for
subscription is known as primary market whereas a market where already issued
securities are traded among investors is known as secondary market.
Functions of capital market
Allocative function - the capital market functions as a link between savers and
investors. In this way, capital market plays a vital role in transferring the savings to
productive areas thus increasing the productivity and prosperity of the country.
Encourages saving - with the development of capital market, the banking and non
banking institutions provide facilities to people to save more.
Encourages investment – the capital marketlensds to the businessmen and
government and thus encourages investment. Various financial assets like shares,
securities, bonds etc. induce savers to lend or invest in industry.
Promotes economic growth – capital market enables the expansion of Trade and
Industry in both public and private sectors thus promoting balanced economic
growth in the country.
Indicative function- a capital market acts as a barometer showing the share price
movements and also the progress of a company.
Liquidity function - in a developed capital market, securities can be purchased and
sold without any delay and hence it ensures liquidity in the economy.
Stock market
The stock market refers to the collection of markets and exchanges where regular
activities of buying , selling and issuance of shares of publicly held companies take
place. Stock Exchange means an association, organization or body of individuals
constituted for the purpose of assisting, regulating or controlling the business of
buying, selling or dealing in securities.
In short, stock market is an institution which provides a platform for buying and
selling of existing securities. While the terms Stock market and Stock Exchange are
used interchangeably, Stock Exchange is a subset of the Stock market . If one says
that he trades in the stock market, it means that he buys and sells shares or equities
on one of the stock exchanges that are part of the overall stock market. Since the
stock market brings together hundreds of thousands of market participants who
wish to buy and sell shares, it ensures fair pricing practices and transparency in
transactions.
As the primary market, the stock market allows companies to issue and sell their
shares to the common public for the first time through the process of initial public
offerings( IPO ): this activity helps companies raise necessary capital from
investors. A listed company may also offer new, additional shares. Following the
first time share issuance called the listing process, the Stock Exchange also serves
as the trading platform that facilitates regular buying and selling of the listed shares.
This constitutes the secondary market. As almost all major stock markets across the
globe now operate electronically, the exchange maintains trading systems that
efficiently manage the buy and sell orders from various market participants.
The following are some of the important functions of stock market
• Providing liquidity and marketability to existing securities
 • Pricing of securities
• Safety of transaction
• Contributes to economic growth
• Providing scope for speculation
NSE
The National Stock Exchange of India limited NSE is the leading Stock Exchange
of India located in [Link] was established in 1992 as the first dematerialized
electronic exchange in the country. As per data in May 2021, NSE is the world’s
tenth largest Stock Exchange. It was a cognized as a Stock Exchange by SEBI in
April 1993 and commenced operations in 1994. In February 2000, the NSE started
an Internet trading [Link] provides a trading platform for investors for
various types of securities- equity, debentures, central and state government
securities, treasury bills, commercial papers, certificate of deposits, mutual fund
units etc.
BSE
Bombay Stock Exchange was started in 1875 .BSE is Asia's first and the fastest
stock exchange in the world with the speed of 6 microseconds and one of India’s
leading exchange groups. Over the past 145 years BSE has facilitated the growth of
the Indian corporate sector by providing an efficient capital- raising platform.
Stock Exchange indices
Stock market indices are the barometers of the stock market. They mirror the stock
market’s behavior. With some 7000 companies listed on the Bombay Stock
Exchange, it’s not possible to look at the prices of every stock to find out whether
the market movement is upward or downward. The indices give a broad outline of
the market movement and represent the market. Some of the stock market indices
are BSE Sensex, BSE 200, NSE 50, CRISIL 500 etc.
NIFTY
NIFTY is a market index introduced by the National Stock Exchange. It is a
blended word - National Stock Exchange and Fifty coined by NSE on 21st April
1996. NIFTY 50 is a benchmark based index and also the flagship of NSE, which
showcases the top 50 equity stocks traded in the Stock Exchange out of a total of
1600 stocks.
These stocks s cover 12 sectors of the Indian economy which include information
technology, financial services, consumer goods, entertainment and media, financial
services, metals, pharmaceuticals, telecommunications, cement and its products,
automobiles, pesticides and fertilizers, energy and other services.
NIFTY contains a host of indices NIFTY 50, NIFTY IT, NIFTY bank and NIFTY
NEXT 50. NIFTY is owned by India Index Services and Products Ltd. It is
calculated using the free float market capitalization weighted method where the
level of index reflects the total market value of the stocks relative to a particular
base period .The base period selected for calculating nifty 50 index is the close
price on November 3rd 1995 . the base value has been set at 1000.
SENSEX
The BSE Sensex also known as the S&P Bombay Stock Exchange or Sensitive
index or simply the SENSEXi s a free float market weighted stock market index of
30 well established and financially sound companies listed on Bombay Stock
Exchange. These 30 companies are known as blue chip companies. The 30
components companies include some of the largest and most actively traded stocks
representing various industrial sectors of the Indian economy.
Historically Sensex used the weighted market capitalization methodology, but from
September 1, 2003, it’s shifted to free float market capitalization methodology. All
the major indices in the world use the same methodology. The performance of the
30 selected key stocks directly reflects the level of the index.
Demat account
If a person wants to trade in the stock market, he must obtain a demat and trading
account.
Demat account is used to hold the shares purchased in digital or electronic form.
During online trading, shares are bought and held in a demat account, thus
facilitating easy trade for the users. A Demat account holds all the investments an
individual makes in shares government Securities , Exchange traded funds ,bonds
and mutual funds in one place. At any point of time, demat account will show the
shares and securities that a person is currently holding. In other words it is a storage
space to hold the shares and securities purchased.
It is similar to a bank account in which we hold deposits with the bank and the
record of debit/ credit balances are maintained in a bank passbook. In the same way,
when they purchase or sell shares, it will be credited or debited to/ from our Demat
account respectively.
Demat account is an easy and convenient way to hold securities. It is safer than
paper shares and reduces paperwork for transfer of securities. It also reduces
transaction costs and a single account can hold investments in both equity and debt
instruments ; another advantage is that a person can trade from anywhere.
Trading account
A trading account is used to buy and sell shares and securities in the stock market.
A trading account provides an interface to buy and sell shares from the stock
market. Previously the Stock Exchange functioned on the open outcry system. In
this, the traders used hand signals and verbal communication to convey their
buying/selling decisions. Soon after the adoption of the electronic system, trading
account accounts replaced the open outcry system . A trading account refers to a
day trader's primary account. In the online method, the buyers and sellers need not
be physically present at the Stock Exchange to place orders. Instead they open a
trading account with a registered stock market broker who conducts trading on their
behalf. Each trading account has a unique trading ID it is utilized to perform online
transactions nowadays, brokers provide facilities to the investors to perform
transactions by themselves. A trading account acts like a link between demat
account and bank account of an investor. When an investor wants to buy shares, he
places an order through his trading account. This transaction goes for processing in
the Stock Exchange. The required number of shares get credited into the demat
account of the investor and a proportionate sum gets deducted from his bank
account.
A similar kind of process is followed in order to sell equity shares. The investor
places a sale order with the help of his trading account; after processing in the
relevant Stock Exchange, the required number of shares are debited from the
investor’s demat account and a proportionate sum gets credited to his bank account.
At any point of time, a trading account will show the transactions carried out in the
stock market.
If we want to trade in the stock market, we need both the accounts. To open these
accounts, documents like proof of identity, address proof pan card etc. are needed.