An economy is not only about money or government policy. It is the practical working of everyday economic life – how people earn, spend, save, produce, exchange and consume goods and services.
When a farmer grows wheat, a factory produces clothes, a family buys groceries, a bank accepts deposits, or the government builds roads, all these activities become part of the economy.
This article introduces the basic building blocks of economics: money, types of goods, demand, supply, households, sectors of economy, and early ideas related to national income.
Table of Contents
What Is Economy?
An economy is the practical application of economics.
It explains how limited resources are used to produce goods and services and how these goods and services are distributed among people.
In simple words, an economy studies:
- How goods are produced.
- How services are provided.
- How people earn income.
- How people spend and save money.
- How goods and services are exchanged.
- How government, firms, banks and households interact.
What Is Macroeconomics?
Macroeconomics studies the economy as a whole.
It focuses on large economic indicators such as:
- GDP
- National income
- Inflation
- Inflation rate
- Unemployment rate
- Economic crisis
- Monetary policy
For example, if the government studies why prices are rising across the country, that is a macroeconomic issue. If RBI changes interest rates to control inflation, that is also part of macroeconomics.
Money: Meaning And Importance
Money is the major medium of exchange in an economy.
Before money, people used the barter system. In barter, goods were exchanged directly for other goods. For example, a farmer could exchange wheat for cloth.
But barter had serious problems. Money solved those problems by giving everyone a common medium of exchange.
If a student buys a notebook for Rs 50, the shopkeeper accepts the money because money has general acceptability.
Functions Of Money
Money performs both primary and secondary functions.
Primary Functions Of Money
1. Medium Of Exchange
Money is used to buy and sell goods and services.
Example: You use rupees to buy food, books, clothes or transport services.
Without money, both buyer and seller would need to want each other’s goods at the same time. Money removes this difficulty.
2. Measure Of Value
Money helps measure the value of goods and services.
Example:
- A pen costs Rs 10.
- A shirt costs Rs 800.
- A mobile phone costs Rs 15,000.
Because all prices are expressed in money, comparison becomes easy.
Secondary Functions Of Money
1. Store Of Value
Money can be saved for future use.
Example: If someone saves Rs 5,000 in a bank account, they can use it later.
However, during inflation, the value of money may fall because the same amount of money buys fewer goods.
2. Standard Of Deferred Payment
Money is used for future payments.
Example: If a person takes a loan today and repays it after 1 year, the repayment is made in money.
This function is important for credit, loans, banking and business contracts.
Types Of Money
Money has taken different forms at different stages of economic development.
Commodity Money
Commodity money is money that has value in itself and can also be used to buy goods.
Examples:
- Gold
- Silver
- Coins made of valuable metals
If a silver coin contains silver worth Rs 200, it has value as a commodity and also works as money.
Metallic Money
Metallic money is made from metals, especially superior metals such as gold and silver.
Its value may come from the metal used in it.
Example: A gold coin or silver coin.
In metallic money, the face value and intrinsic value may be close, especially when the coin is made of valuable metal.
Bank Money
Bank money includes payment instruments issued through the banking system.
Examples:
- Cheques
- Credit cards
- Bank drafts
Bank money is accepted because people trust the banking system.
Fiat Money
Fiat money is currency that has value because the government has legally approved it.
It does not have intrinsic value like gold or silver.
Examples:
- Indian rupee
- US dollar
A Rs 100 note is not made of paper worth Rs 100. It is accepted because the government has declared it legal tender.
Virtual Money
Virtual money is digital money available only in electronic form.
Example: Bitcoin.
The chapter describes virtual money as an unregulated digital currency that is not controlled by any central banking authority.
Fiduciary Money
Fiduciary money is accepted because of trust between the payer and the payee.
Example: cheque.
A cheque does not have value in itself like gold, but it is accepted because the receiver trusts that the bank will honour it.
Full-Bodied Money
In full-bodied money, the face value is equal to the intrinsic value.
Example: A gold coin whose metal value is equal to its money value.
Face Value And Intrinsic Value
These 2 terms are important for understanding money.
| Term | Meaning | Example |
| Face Value | The value written or officially assigned to money | Rs 100 written on a note |
| Intrinsic Value | The actual material value of money | Value of gold or silver in a coin |
A Rs 100 paper note has a face value of Rs 100, but its paper is not worth Rs 100. A gold coin may have both face value and intrinsic value.
Liquidity: Meaning And Order
Liquidity means the ease with which an asset can be converted into cash.
Cash is the most liquid asset because it can be used immediately.
Liquidity Order
The chapter gives the following order of liquidity:
- Currency
- Demand deposits
- Savings deposits
- Time deposits in banks
Explanation Of Liquidity Order
Currency
Currency includes notes and coins. It is immediately usable.
Demand Deposits
Demand deposits are bank deposits that can be withdrawn whenever needed.
Example: money in a current account or savings account.
Savings Deposits
Savings deposits are fairly liquid because money can be withdrawn, but some conditions may apply.
Time Deposits
Time deposits, such as fixed deposits, are less liquid because money is normally available only after a fixed period.
Currency Deposit Ratio
Currency Deposit Ratio (CDR) is the ratio of money held by the public in currency to the money held in bank deposits.
Formula:
CDR = Currency Held By Public / Demand Deposits
During festive seasons, CDR often rises because people keep more cash for spending.
Example: During Diwali or wedding season, families may withdraw more money from banks for shopping and ceremonies.
Reserve Money Or High-Powered Money
M0 is called Reserve Money or High-Powered Money.
It includes:
- Currency in circulation with banks and public.
- Bankers’ deposits with RBI.
- Other deposits with RBI.
It is called high-powered money because it becomes the base for money creation in the banking system.
Money Supply Measures
Money supply is measured in different forms depending on liquidity.
| Measure | Meaning |
| M1 | Narrow money |
| M2 | M1 plus savings deposits with post offices |
| M3 | Broad money |
| M4 | Wider measure including post office deposits |
M1 is called narrow money because it includes the most liquid forms of money.
M3 is called broad money and is commonly used as an important measure of money supply in India.
Adam Smith And Economics
Adam Smith is known as the Father of Modern Economics.
His famous book is The Wealth of Nations.
Economics studies the collective process of:
- Production
- Consumption
- Distribution
- Exchange of goods and services
Factors Of Production
Factors of production are the basic inputs used to produce goods and services.
| Factor Of Production | Reward |
| Land | Rent |
| Labour | Wages |
| Capital | Interest |
| Entrepreneurship | Profit |
Land
Land includes all natural resources used in production.
Examples:
- Agricultural land
- Forests
- Minerals
- Water resources
Labour
Labour means human effort used in production.
Example: workers in a factory, teachers in a school, drivers in transport services.
Capital
Capital is the amount or asset that supports production.
Examples:
- Machines
- Tools
- Buildings
- Money used in business
Entrepreneurship
Entrepreneurship means organising land, labour and capital to produce goods or services.
The reward for entrepreneurship is profit.
Goods In Economics
Goods can be classified in different ways depending on their use, ownership, price behaviour and income relationship.
Public Goods
Public goods are goods where people generally cannot be excluded from use.
Examples:
- Roads
- Railways
- Public parks
Public goods are used by many people. Their benefit is not limited to one individual only.
Private Goods
Private goods are goods that cannot be used without permission, payment or ownership rights.
Examples:
- Private car
- Private house
- Mobile phone
If a person owns a private car, others cannot use it without permission.
Merit Goods
Merit goods are goods and services that increase the efficiency and welfare of society.
Examples:
- Education
- Health services
A healthy and educated population improves productivity and social development.
Normal Goods
Normal goods are goods whose demand increases when income increases.
There is a direct relationship between income and demand.
Example: If a person’s income rises, they may buy better-quality clothes, better food or improved household items.
Inferior Goods
Inferior goods are goods whose demand decreases when income increases.
There is an inverse relationship between income and demand.
Example: When income rises, some people may shift from cheaper food items to better-quality alternatives.
Giffen Goods
Giffen goods are special inferior goods whose demand rises when price rises.
This appears to go against the normal law of demand.
For a good to be called a Giffen good:
- It is usually an inferior good.
- It has no close substitute.
- It takes a large share of the consumer’s income.
- Demand may rise with price under special conditions.
Example: A very basic food item consumed by poor households may behave like a Giffen good in rare cases.
Substitute Goods
Substitute goods are goods that can replace each other and give almost the same satisfaction.
Examples:
- Tea and coffee
- Butter and margarine
- Bus travel and metro travel in some cities
If the price of tea rises, some consumers may shift to coffee.
Complementary Goods
Complementary goods are goods used together.
Examples:
- Car and petrol
- Pen and ink
- Printer and cartridge
If the demand for cars increases, demand for petrol may also increase.
Demand: Meaning And Law
Demand means the quantity of a commodity that consumers are willing and able to buy at a given price.
Demand is related to price.
Normally, there is an inverse relationship between price and demand.
- When price increases, demand decreases.
- When price decreases, demand increases.
This is called the Law of Demand.
Supply: Meaning And Law
Supply means the quantity of a commodity that producers are willing to sell at a given price.
Supply is also related to price.
Normally, there is a direct relationship between price and supply.
- When price increases, supply increases.
- When price decreases, supply decreases.
This is called the Law of Supply.
Macro And Micro Difference Through Example
One useful point from the chapter is that something may be good for the macro economy but bad for an individual.
Example: Excess wheat production may be good for the country because total food production rises. But it may be bad for individual farmers if excess supply reduces wheat prices.
This example shows the difference between macro and micro impact.
Household In Economics
A household means members of a family living together and using the same kitchen.
Temporary absence does not remove a person from the household.
Example: If a family member goes out for work or study for a short period, they may still be counted as part of the household.
Circular Flow Of Economy
The economy works through interaction between households, firms, financial markets and government.
Households
Households provide labour and savings. They receive wages, rent, interest and dividends.
Firms
Firms produce goods and services. They pay income to households in the form of rent, wages, interest and profit.
Financial Market
Financial markets connect savers and borrowers.
Examples:
- Banks
- Insurance companies
- Bonds
- Mutual funds
Households save money in financial markets. Firms borrow money for production and investment.
Government
The government collects taxes and provides subsidies, services and transfers.
This circular flow shows how money, goods and services move in the economy.
Sectors Of Economy
The economy is divided into different sectors based on the nature of activity.
| Sector | Main Activity | Examples |
| Primary Sector | Direct use of natural resources | Agriculture, fishing, animal rearing |
| Secondary Sector | Manufacturing and industry | Factories, construction, processing |
| Tertiary Sector | Services | Banking, transport, education, health services |
| Quaternary Sector | Knowledge-based activities | Education, research, information services |
| Quinary Sector | High-level decision-making and administration | Bureaucracy, policy-making, senior administration |
National Income
National income refers to the total income earned by a country from production of goods and services during a year.
A simple expenditure-based expression given in the chapter is:
National Income = Total Consumption + Total Government Expenditure + Investment + (Exports – Imports)
This connects national income with consumption, government spending, investment and net exports.
Dadabhai Naoroji And National Income
Dadabhai Naoroji is known for early work related to India’s national income.
He is also associated with:
- Drain of Wealth Theory
- Study of poverty under British rule
- The book Poverty and Un-British Rule in India
The chapter mentions that he tried to estimate national income in 1876 and estimated per capita income at Rs 20.
V. K. R. V. Rao And Scientific Estimate Of National Income
The first scientific estimate of India’s national income was produced by Prof. V. K. R. V. Rao for 1931-32.
However, it was not fully satisfactory because proper data was limited at that time.
National Income Committee
The chapter refers to the National Income Committee formed in 1949.
It was headed by P. C. Mahalanobis.
The committee played an important role in improving national income estimation in India.
Washington Consensus
The Washington Consensus refers to a set of economic reforms associated with the IMF, World Bank and the US Treasury.
It generally supports market-oriented reforms such as liberalisation, privatisation and fiscal discipline.
Beijing Consensus
The Beijing Consensus is linked with China’s economic rise from the mid-1980s.
It refers to the Chinese model of economic development associated with reforms under Deng Xiaoping.
Santiago Consensus
The Santiago Consensus focuses on inclusion.
Its core idea is that development should not only be economic but also social.
FAQs On Introduction To Economy
What is the meaning of economy?
An economy is the practical system through which goods and services are produced, exchanged, distributed and consumed by people, firms and government.
What is money in economics?
Money is a medium of exchange that is generally accepted for buying and selling goods and services.
What are the main functions of money?
The main functions of money are medium of exchange, measure of value, store of value and standard of deferred payment.
What is fiat money?
Fiat money is currency that has value because the government legally approves it. The Indian rupee and US dollar are examples.
What is liquidity?
Liquidity means the ease with which an asset can be converted into cash. Currency is the most liquid asset.
What is Currency Deposit Ratio?
Currency Deposit Ratio is the ratio of money held by the public in currency to the money held in bank deposits.
Who is known as the Father of Modern Economics?
Adam Smith is known as the Father of Modern Economics. His famous book is The Wealth of Nations.
What are the factors of production?
The main factors of production are land, labour, capital and entrepreneurship. Their rewards are rent, wages, interest and profit respectively.
What is the difference between public goods and private goods?
Public goods are generally available for common use, such as roads and parks. Private goods are used by individuals with ownership or permission, such as a private car or house.
What is a normal good?
A normal good is a good whose demand increases when income increases.
What is an inferior good?
An inferior good is a good whose demand decreases when income increases.
What is a Giffen good?
A Giffen good is a special inferior good whose demand may increase when its price increases because it has no close substitute and takes a large part of the consumer’s income.
What is demand?
Demand is the quantity of a good that consumers are willing and able to buy at a given price.
What is supply?
Supply is the quantity of a good that producers are willing to sell at a given price.
What are the sectors of economy?
The main sectors are primary, secondary, tertiary, quaternary and quinary sectors.
Who is associated with the Drain of Wealth Theory?
Dadabhai Naoroji is associated with the Drain of Wealth Theory and early national income studies in India.
What is the Santiago Consensus?
The Santiago Consensus focuses on inclusive development, meaning development should include both economic and social dimensions.
Last Moment Exam Cheat Sheet – Introduction To Economy
- An economy is the practical working of production, consumption, exchange and distribution.
- Macroeconomics studies the economy as a whole, including GDP, inflation, unemployment and monetary policy.
- Money works as a medium of exchange, measure of value, store of value and standard of deferred payment.
- Commodity money, metallic money, fiat money, bank money, virtual money, fiduciary money and full-bodied money are different forms of money.
- Liquidity means ease of conversion into cash.
- Currency is the most liquid form of money.
- Adam Smith is known as the Father of Modern Economics.
- The main factors of production are land, labour, capital and entrepreneurship.
- Public goods, private goods, merit goods, normal goods, inferior goods, Giffen goods, substitute goods and complementary goods are important classifications.
- Demand usually has an inverse relation with price.
- Supply usually has a direct relation with price.
- The economy works through households, firms, financial markets and government.
- The main sectors are primary, secondary, tertiary, quaternary and quinary sectors.
- Dadabhai Naoroji and V. K. R. V. Rao are important names in India’s national income studies.