Macro Economics Notes

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GROWTH AND DEVELOPMENT India is a developing country. At the time of independence India was an underdeveloped country (UDC) (i.e. backward). With the process of growth and development it has now transformed into a developing country. Usually the terms growth and development are used interchangeably. However in economics, the two terms are not same: GROWTH: This definition implies following important features: a. There should be in increase in the output of goods and : GROWTH: services in the economy. This implies real increase in the Economic growth is a national income. b. This increase is over a long period of time. Thus growth process whereby real is a long-term process. c. Growth is quantitative in nature and it is measured in national income of terms of Gross National Product (GNP) or Per Capita Income the country increases (PCI). over a long period. d. For economically advanced countries, growth means continuation of existing growth process. Following are the factors that determine economic growth: 1. Economic Factors: 1. Natural Resources: It includes anything that is naturally available. However, the supply of natural resources is not uniform in all the countries. Similarly the supply of natural resources is inelastic (i.e. constant), because man cannot reproduce them. Thus effective use of available natural resources is an essential condition of growth. 2. Human Resources: Population of the country is also an important factor deciding growth. This is because it has its impact on both the sides of the market; i. Demand side: Demand for all goods and services are decided by the size of population. ii. Supply side: The efficiency of labour force decides supply of all goods and services in the economy. 3. Capital Formation: Capital formation implies addition made to the stock of a country during the given period say a year. Capital stock includes tools, machinery, factory buildings raw materials, means of transport and communication etc. The higher the stock of capital, higher will be production capacity of the country and thus faster will be the rate of economic growth. 4. Technique of production: Technique used in production helps efficient utilisation of limited resources. Countries like Japan, Singapore, Korea, Hong Kong etc focussed on human resources and technology to reach a higher level of income. 5. Government policy: in the modern world, government in all the countries are playing the role of welfare state. It means government directly or indirectly, tries to accelerate (speed up) economic growth rate. For this it may adopt various policies like, tax policy, foreign trade policy, monetary policy, fiscal policy etc. 6. Foreign Trade: Through export and import the country not only can earn foreign exchange, but also can get the benefit of foreign technology. This surely helps in improving the domestic production of the country. 2. Non Economic Factors: i. Social Factors: ii. Political Factors: iii. Administrative Factors: The term economic development implies progressive changes in the socio-economic structure of a country. According to Following are important features of the concept of economic development: Prof. MEIER, • It is a multi dimensional concept. It aims at “Economic Development o quantitative changes i.e. rise in GDP; & is a process whereby the o Qualitative changes .i. e. economic welfare. real per capita income of • It results in improvement of the social conditions of life. a country increases over

ECONOMIC DEVELOPMENT

“A determination to succeed is the only way to succeed.”

a long period time.” Page of 1 of 31

Email : [email protected] & [email protected] • It aims at structural changes through shift in sectoral contribution of GDP. • It aims at improvement in life through food security, health services, education and housing facilities etc. • It is concerned with the problem of how to use the unexploited resources INDICATORS OF ECONOMIC DEVELOPMENT:  REAL NATIOANL INCOME: Real national income refers to the value of all final goods and services produced in the country during a year at constant prices. NI is measured at constant prices. The higher the NI higher is the development standards and vice versa. • Limitations: 1.Population aspect not considered. If population is rising at the rate faster than the growth rate of NI, then although NI rises, it will not lead to increase in the welfare of the people 2.Importance is given only to output and not to the method of production. 3.It considers how much is produced; actually what is produced that will have impact on what type of goods are produced. 4.There is possibility of double counting. 5.NI does not consider the benefits arising out of different goods. 6.NI is measured in terms of monetary value. But there are certain goods and services which cannot be measured in terms of money e.g. painting as a hobby, bringing up baby by a mother. 7.NI excludes quality of life which influences economic welfare of the people.  PER CAPITA INCOME (PCI) : If NI is rising at the rate slower than the rate of population, then although NI rises, it will not lead to increase in the welfare of the people. Therefore, PCI is considered as the better indicator of development. PCI refers to income per head. It can be calculated by dividing the total national income by total population. A rise in NI shows growth but the welfare can be mesured by the rise in PCI. Rise in NI > Rise in Population – rise in PCI PCI = Total National Income Rise in NI < Rise in Population – fall in PCI Total Population 1. 2. 3. 4. 

1. 2. 3. 4.

•

Limitations: PCI is just a simple average and does not talk about the distribution of income, which influences the level of economic welfare. PCI is not concerned with the composition of output i.e. what type of goods and services are produced. PCI does not reflect the real standard of living of the people. PCI excludes many good indicators like health, nutrition, sanitation, housing water and education. PER CAPITA PERSONAL CONSUMPTION EXPENDITURE (PCPCE): PCPCE refers to the consumption expenditure per head. Thus it is the ratio of total national consumption expenditure and total population. Basic characteristic feature of poor Total Private Consumption Expenditure PCPCE = countries is low PCPCE. PCPCE Total Population helps us to know the average spending capacity i.e. average standard of living of the society. • Limitations: It does not consider the method of spending adopted by the people. It neglects wasteful expenditure, which results in adverse effects. It is based on the assumption of expenditure on it commodity derives same level of satisfaction. PCPCE may also rise due to inflation.

:SOCIO-ECONOMIC INDICATORS:



 PHYSICAL QALITY OF LIFE INDEX (PQLI) : PQLI is considered as a reliable measure to find out the achievement of a society. MORRIS DAVID MORRIS developed this indicator in the year 1979. Higher the PQLI higher is the development. It is simple average of the three indicators of human development such as: Life Expectancy Indicator. (LEI) Indicator Maximum Minimum Range “A determination to succeed is the only way to succeed.” Page BLI 100 0 2 of 31 100 IMR 229 9 220 LEI 77 38 39

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 

STEPS in construction of PQLI : 1. Fixing the minimum and maximum values for each indicator.: 2. Computing Individual Indices: For all indicators v use following formula:

Actual Index = value – Minimum value Maximum value - Minimum value 3. Calculating PQLI:

1. 2. 3. 4. 1. 2.

PQLI =

BLI + IMI + LEI . 3

Main features of PQLI: This approach measures what the individuals need and desire initially and at the most basic level in order to have a better quality of life. PQLI is called a physical index because it represents the outcome of developments and does not cover psychological factors. Generally low per capita income countries had low PQLI and high per capita income countries had high PQLI but there are exceptions. A higher index shows a higher human development level. Limitations of PQLI as an index: It is an inadequate measure. The PQLI has a technical flaw.  HUMAN DEVELOPMENT INDEX (HDI) : The UNITED NATIONS DEVELOPMENT PROGRAMME (UNDP) defines human development as “the process of widening people’s choices and the level of well being achieved.” UN measures Human Development by considering following indices:  Human Development Index (HDI)  Gender-related Development Index (GDI)  Human Poverty Index (HPI) The UNDP prepares and publishes human development report every year. Steps in construction of HDI: 1. Fixing minimum and maximum values for HDI:Indicator 1. Life expectancy at birth 2. Educational attainment: a) Adult Literacy Rate b) Combined gross enrolment ratio 3. Real GDP per capita 2. Computing individual indices: Real GDP Per Capita Index:

1. 2. 3. 4. 5.

.

Min value 25 yrs

Max value 85 yrs

0% 0% $100

100% 100% $40,000

Actual – Minimum value . Index value = Maximum value - Minimum value Per capita GDP =

GDP at constant prices Population

Calculating HDI HDI = Life Expectancy Index + Educational Attainment Index + Per Capita GDP 3 Superiority of the HDI: Shifts the emphasis from quantity of growth to quality of growth. HDI stresses the importance of quality of life. The HDI shows the wide disparity that exists in the levels of human development. The index also highlights the progress yet to be made. It is a dynamic index. Human Development Report of UNDP 2006 shows that India is on 126th position out of 177 countries surveyed. “A determination to succeed is the only way to succeed.” Page 3 of 31


NATIONAL INCOME MEANING : It is the money value of all goods and services produced by a country during a certain period of time normally one year. When goods are produced, it gives an income to the factors of production. National income is equal to the total income earned by all the people during a year in the form of rent, wages, interest and profit. The income earned by the factor owners is spent partly on consumer goods and partly on capital goods. Hence, total income expenditure during a year is equal to the total national income. DEFINITION: According to the National Income Commission

“A national income estimate measures the volume of commodities and services turned out during a given period counted without duplication.”

1. 2. 3. 4. 5.

This definition implies the following features: 1. It refers to the income of a country. 2. It is expressed for a period of one year. 3. All goods and services having exchange value are included in national income. 4. Double counting is avoided. NATIONAL INCOME CONCEPTS: 1. GROSS NATIONAL PRODUCT(GNP): It refers to the market value of all final goods and services produced by a country during one year. GNP can be calculated at both current and constant price. When GNP is calculated at both prices then it becomes very easy to understand real change in the national income. GNP = C + I + G + (X- M) + (R-P) In GNP, the value of only the final goods and services is taken in order to avoid double counting because the price of raw material and intermediate will be included in the price of the final goods. GNP consists of :Market value of Consumer goods (C) Market value of capital or Investment goods (I) Goods produced by the Government. (G) Net foreign Exports i.e. (X - M) Net amount earned from abroad i.e. (Receipts from foreign countries – Payments to foreign countries) (R-P) 2. NET NATIONAL PRODUCT (NNP): It is also called as national income at market price. It refers to net output of the country during one year. It is derived by deducting the depreciation of replacement cost, losses due to fire, floods, etc,. and other maintenance expenditure. NNP = GNP – DEPRECIATION ALLOWANCE. Depreciation refers to the wear and tear of the capital goods due to the continuous use in the process of production. From GNP, a part of it will be used for the repairs of machines in order to maintain the production work smoothly and efficiently. 3. GROSS DOMESTIC PRODUCT AT MARKET PRICE – (GDPmp) : Gross Domestic Product refers to the total money value of goods and services produced within the geographical boundaries of a country during a year. It excludes income earned from abroad. It is the money value of the output of the nation. Where, GDP = C + I + G + (X-M) where, C = Value of consumption goods. I = Value of investment goods. G = Government expenditure on C & I goods. (X-M) = Net Exports GDPmp = GNPmp – Net Foreign Income GDP includes rent, wages and salaries, interest and profit earned by the factors of production within a country. GDPmp = Total final goods and services at market price. Where, GDPmp = Gross Domestic Product at market price. GNPmp = Gross National Product at market price. GDPmp = NDPmp + Depreciation 4. NET DOMESTIC PRODUCT (NDP): While calculating GDP no provision is made for the depreciation allowance. In such a situation, gross domestic product will not reveal complete flow of goods and services through various sectors. It is for this reason that the term ‘net product’ and ‘net income’ are considered more suitable for the estimation of true national income of a “A determination to succeed is the only way to succeed.” Page 4 of 31

Email : [email protected] & [email protected] country. ‘Net domestic product’ is obtained by subtracting depreciation cost from the gross domestic product. It is a matter of common knowledge that capital goods like machines, equipments, tools, factors buildings, tractors, etc., get depreciated during the process of production. After some time these capital goods needs replacement. A part of capital is therefore, set-aside in the form of ‘depreciation allowance’. Deduction of the depreciation allowance from the gross domestic product provides us with net domestic product In brief: NDP = GDP – DEPRECIATION ( CONSUMPTION OF FIXED CAPITAL) 5. DISPOSABLE PERSONAL INCOME: It refers to that part of national income an individual can spent or disposes off. A person who receives an income may not be in a position to dispose of the whole amount but only a part of it. This is obtained by deducting direct taxes like income tax, wealth tax, property tax, etc., from the personal income. D.P.I. = Personal Income – Direct Taxes. D.P.I. = Consumption + Saving of an Individual. 6. GDP AT CONSTANT AND CURRENT PRICES: GDP can be estimated at current prices and at constant prices. If the domestic product is estimated on the basis of the prevailing prices, it is called gross domestic product at current prices. On the other hand, if it is estimated on the basis of some fixed prices, i.e. prices prevailing at a point of time or in some base year it is known as gross domestic product at constant prices or real domestic product. The relationship between GDP at current prices and at constant prices can be explained as follows: Suppose, an economy produces three goods, viz. A, B & C. Following table shows the output and prices in 1980- 81 and 1999-2000 GDP at current prices and at constant prices:

Commodity

Output in 1980-81 (units)

Prices in 1980-81 (Rs. Per units)

GDP At current 1980-81 (Rs. per unit)

Output in 19992000 (units)

Prices in 19992000 (Rs. Per units)

GDP At current 1999-2000 (Rs. per unit)

GDP At constant Prices (1980-81)

1

2

3

4

5

6

5*6

5*3

A B C

2,000 3,000 1,000

10/5/15/-

20,000/15,000/15,000/-

2,000 3,000 1,000

15/10/20/-

30,000/30,000/20,000/-

20,000/15,000/15,000/-

80,000/-

50,000/-

50,000/-

From the table, it can be seen that the total output of three commodities is the same in year 1980-81 and 1999-2000. However, the GDP for 1999-2000 estimated at current prices is Rs. 80,000, which whereas, at constant prices it is Rs. 50,000. In order to estimate the real increase in the domestic product, it should always be estimated at constant prices. 7. GDP AT FACTOR COST: (GDPfc) GDP at factor cost is estimated as the sum of domestic factors incomes rent, wages, interest and profit and the consumption of fixed capital. Conceptually, PRICE = COST = rent + wages + interest + profit. But actually, 1) PRICE > COST because it includes indirect taxes or 2) PRICE < COST because it excludes subsidies. Therefore, in order to arrive at more realistic results, indirect taxes must be subtracted from and subsidies added to gross domestic product at market prices. GDP f.c. = GDP m.p. – i.t. + s. Where, i.t. = Indirect taxes & s. = Subsidies. The logic behind this is: In case of indirect tax, income received by factor owners is less than actual market price because market price includes indirect taxes (tax is a transfer payment to government) While in case of subsidies, market price is less than actual cost as part of market price is government’s contribution i.e. called as subsidy. In this case income received by factor owners is more than actual market price. CIRCULAR FLOW OF NATIONAL INCOME IN A CLOSED ECONOMY There is a circular flow of economic activity between the households and the firms. Firms are the Production units. Households are the Consumption units. “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] Firms undertake productive activity by organizing land, labour and capital to satisfy the wants of the households. They pay rent, wage, interest and profits to the owners of the factors of production. Households who are the owners of factors of production provide services to the firms and earn incomes in the form of rent, wages, interest and profits. They spend this income in buying goods and services produced by the firms. The expenditure of household is the income of the firms and vice-versa. Thus, there is a circular flow of income and expenditure between the firms and households. The diagram shows the circular flow of income. There are two simultaneous flows in the economy. Real Flow:- The factor services flow from the households to firms and goods and services flow from the firms to the households. This is the real flow between the households and firms. The outer circuit in the diagram shows the real flow i.e. physical flow.(In the diagram inner flow is real flow) Money Flow:- The firms pay for the factor services and households pay for the goods and services purchased. Thus, money flows from the firms to the households in the form of rent, wages, interest and profits. This constitutes the income of the households. (In the diagram outer flow is money flow) Rent, Wages, Interest & Profit Factors of Production (N,L,K & O)

HOUSEHOLD

FIRM

Consumption

Production

Inner Flow Goods & Services Thus there are two simultaneous flows in the economy. 1) The real flow in terms of goods and Prices services. (Inner Flow) of Goods & Services Outer flow 2) The money flow in terms of income and expenditure. (Outer Flow) This continuous flow of money and services between firms and households is called the circular flow. The circular flow of economic activity is continuous i.e. it continues indefinitely day by day, week by week and year by year. It shows the relationship between production, income and expenditure and the inter-dependence between firms and households. It shows how the economy function and it is common to all modern economics The circular flow of national income shows a triple identity. Total expenditure of firms = total income of households. Total expenditure of households = total income of firms. Total output = total income = total expenditure. National product = national income = national expenditure. The circular flow consists of three phases. 1) Production; 2) Distribution; 3) Expenditure. National output = National Income = National Expenditure NQ = NI = NE The circular flow of national income is also known as the wheel of wealth. When real flow and money flow are in balance, price would be stable. A smooth circular flow of money is necessary for the smooth functioning and stability of the economic system and for promoting growth. If the flow of money increases without corresponding increases in the flow of goods, there will be inflationary pressure in the economy. If the flow of goods and services surpasses the flow of money payments; there will be depression in the economy. The flow of money will not always continue at a steady greater a GNPlevel. During = a period C of+prosperity I it will + expand G and become + (X - M)in volume. + During (R - P) period of depression, it will contract and become lesser in volume. This is because the flow of NNP = GNP – DEPRECIATION ALLOWANCE. money is measure of NI and will change with the changes in national income.

GDP = C + I + G + (X - M) GDPmp = GNPmp – Net Foreign Income GDPmp = NDPmp + Depreciation NDP = GDP – DEPRECIATION “A determination to succeed is the only succeed.” Page 6 of 31 DPI = Personal Income – way to Direct Taxes. DPI = Consumption + Saving of an Individual. Y = C + S GDP f.c. = GDPmp. + Subsidies Indirect Taxes


MONEY DEFINITION: Money may be any commodity chosen with common consent as a medium of exchange. It is widely accepted in payments for goods, services and in settlement of debts. Different economists have defined money differently. According to Prof. F. A. WALKER: “Money is what money does”. According to Prof. SELIGMAN: “Anything that possesses general acceptability is money”. These definitions of money were rejected on the ground that these definitions do not cover various functions of money. From this point of view Prof. Crowther’s definition is widely accepted: -

“Money is anything that is generally accepted as a means of exchange and at the same time acts as a measure and store of value”. FUNCTIONS OF MONEY: Money in modern times performs two functions, which are classified by Prof. Kineley as follows. Primary Function: i) Medium of Exchange ii) Measure of Value. Secondary Function: i) Store of Value ii) Standard of Deferred Payment. PRIMARY FUNCTIONS 1. Medium of Exchange: The most important economic function of money is to facilitate buying and selling of goods i.e. to serve as a common medium of exchange. Everything can be bought and sold for money, thereby eliminates the need for double co-incidence of wants. This function of money is the basic function and all other functions are derived from this function of money. 2. Measure of Value: Money serves as a common denomination and is a measure of value. Every transaction is represented in terms of money. Values of various commodities are expressed in terms of money. Because of this, it becomes possible to compare value of two commodities. SECONDARY FUNCETIONS 1. Store of Value: Classical economist didn’t recognise the store of value function of money. It was Prof. J. M. KEYNES who laid stress on this function of money. Money represents goods and services and the person who accumulates money, in reality is accumulating goods and services. Therefore, money serves as a store of value. It preserves value through time and space. A store of value implies the shifting of purchasing power from present to future. According to J. M. KEYNES “The importance of money essentially flows from its being link between the present and the future”. 2. Standard of Deferred Payment: Money also facilities credit truncations i.e. exchange of present goods against future goods. This function of money is important in modern times because of this function of money; it has been possible to express future payments in terms of money. Similarly, purchase on credit can be made. This function of money enables current transactions to be discharged in future. OTHER / CONTINGENT FUNCTIONS OF MONEY 1. Distribution of National Income: National income can be distributed among various factors of production, because of existence of money. All factors of production act together in the production process. It is because of money, we can pay proper amount of rewards in the form of rent, wages, interest, and profits. 2. Equating Marginal Utility: Utility is measured in terms of money consumer as well as the producer measures utility of different goods with the help of money and try to get maximum returns by equating marginal utility. “A determination to succeed is the only way to succeed.”

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3. Basis of Credit: Further, credit is the basis of modern economic progress and money provides the base for credit. Banks create credit not out of thin air but with the help of cash money.

4. Liquidity to Wealth: Money provides liquidity to various forms wealth. It is the most liquid asset and therefore wealth is stored in the form of money. TYPES OF MONEY Money has been classified on two major grounds. I.e. a) Acceptability b) Monetary System. A. Acceptability: On the basis of acceptability money is classified under two heads depending upon the degree of acceptability. I) Legal tender money and II) Non-legal tender money or optional money or near money. I. Legal Tender Money: It refers to that money which is backed by law. It is legally enforceable. If anyone refuses to accept legal tender money, it becomes offence punishable by law. It can further be classified as: a) Limited legal tender money: Which is used to make payments upped certain amount and is called as limited legal tender money. For e.g. in India smaller denomination coins like 5, 10, 20 and 25 paise coins can be used to make the payments only upto RS. 10/-. If the payment exceeds Rs. 10/- person can refused to accept the payment in the form of these coins. Thus the legal backing of these coins is limited. b) Unlimited legal tender money: It is that money, which has to be, accepted as a means of payment upto any amount. The currency notes and standard coins are unlimited legal tender money. In India 50 paise and above denomination coins and one rupee coins and note onwards are unlimited legal tender money. II. Non-Legal Tender Money or Optional Money or Near Money: It is the money, which is customarily accepted as money but it doesn’t have any legal backing such money may or may not be accepted by the person. Hank cheques, demand drafts, postal ordered are the examples of non legal tender tender money. Since payment in the form of optional money may not be universally accepted, they are called as near money or subsitutional money. M0NETRY SYSTEM: - On the basis of monetary system money can further be classified as follows: Cash Bank money. money. 1. Cash Money / Common Money: Common money is used by the state and it statuary money or legal tender money. Thus, it has legal backing and accepted within the territory of the country. Cash money is legally enforceable. All currency notes and metal coins of all denominations constitute cash money. Common money is further classified as Metallic money and paper money. a. Metallic Money: Metallic money refers to coins of gold, sliver, bronze, nickel or any other metal. A coin is a piece of metal, the size, weight, fitness and value of which is sanctioned and certified by the state government issues such coins. Every metal coin possesses two values: Face value i.e. the value minted on the coin and Intrinsic Value i.e. value of the metal used for the coin. On the basis of their intrinsic value, coins are further classified as: i) Full bodied coins ii) Token coins / Standard coins i. Full-bodied coins: They are those, the face value of which is equal to its intrinsic value. Intrinsic value refers to the market value of the metal used for that coin and face value refers to the exchange value written on the coin. These are also called as standard coins or commodity money. This type of money doesn’t exist anywhere in the world. ii. Token Coins: A token coin is the coins in case of which face value is greater than intrinsic value. Thus, face value of token coin is always greater than its intrinsic value. Token coins are generally limited legal tender money and are made of bronze, nickel, and copper. All the smaller denominations are the examples of token coins. “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] b. Paper Money: Paper money refers to all currency notes. In modern economies, paper money constitutes a major part of money supply. Paper money is further classified under three hands. i. Representative Paper money: While issuing paper money when equal amount of metallic reserves are maintained with the central bank i.e. entire amount of paper notes in circulation are represented by precious metal in central bank, it is called as representative paper money. ii. Convertible paper money: paper money is said to be convertible when it can be converted into gold or sliver. However, like representative paper money isn’t backed by 100 p.c. metallic reserves it is partially by metallic reserves and partially by government securities. It is also called as fiduciary paper money. iii. Inconvertible paper money: It is the one, which cannot be converted into gold or sliver. It is also called as money, i.e. money by order or command all the currency; notes issued by the government of India are the examples of inconvertible paper money. 2. BANK MONEY: Bank money refers to bank deposits, which are withdrawal by means of cheques; bank deposits can be converted into money with the help of cheques. Therefore, although cheques are not considered as money, they perform the functions of money. Bank money is also called as credit money or cheque money or deposits money. Bank is an institution dealing with money and credit. Bank provided link between investors and savers. It accepts cash deposits from the people and uses them for advancing loans. Through this process banks earns profit. When we deduct administrative change form the differences between interest paid and interest paid and interest received by the bank COMMERCIAL BANK

FUNCTIONS OF COMMERCIAL BANK Commercial banks perform various important functions which are categorised under two heads i.e. I) primary function II) secondary functions.

PRIMARY FUNCTIONS Accepting deposits and advancing loans are the tow important functions of bank. a. Accepting deposits: - one of the important functions of bank is to attract and mobilize the savings of the people. Commercial banks accept the surplus income or cash balances with public and tries to mobilize ideal saving. Deposits are broadly classified as- Demand deposits and Time deposits. b. Advancing loans: - Another important function of commercial bank is to advance loans and earn profits by changing more rate of interest. Such loans can be secured or unsecured. Loans generated by commercial banks are generally short term and medium term loans. They don’t generate long-term loans. c. Credit creation: - while accepting deposits and advancing loans commercial banks not only transfer money form saver to investor but also create credit which has become the most important function of commercial bank in modern days. Commercial banks credit creation process is based on the basis of principle i.e. “deposit create loans and loans create deposits”.

SECONDARY FUNCTIONS /SUBSIDIARY FUNCTION I) AGENCY SERVICES II) GENERAL UTILITY SERVICES I. Agency services: - under these services banks act as a representative of the customers and discharge many duties in order to: a. Attract more customers. b. Widen banking services c. Earn higher profits Following are the agency services: a. To make insurance payments, rent payments, membership fees, electricity bills etc. b. Collection and payment of dividends salaries, pensions etc. c. Selling and purchasing of shares, debentures, government securities, etc. “A determination to succeed is the only way to succeed.”

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Acting as anent for government and local bodies.

II) GENERAL UTILITY SERVICES Various facilities are provided by the commercial banks to general public. Provision of safe custody and safe deposits vaults; Issuing traveller’s cheque; Issuing letters of credit Dealing in foreign exchange and financing foreign trade.

TYPES OF DEPOSITS DEMAND DEPOSITS: -those deposits which are withdrawals on demand, are called as demand deposits they are of two types. CURRENT DEPOSITS:-businessman usually hold these accounts and any number of withdrawals are allowed on these account. Very negligible or no interest is paid on current A/c. SAVING DEPOSITS: - savings account offer saving facilities to public. There are restrictions on the withdrawals from this account as compared to current A/c saving A/c are paid more interest. TIME DEPOSITS: -those deposits, which can be withdrawn only after certain period are called as time deposits. This can be sub-divided as a) FIXED DEPOSITS In case of fixed deposits the entire sum to be deposited in regular the account is deposited at once while in case recurring the sum is deposited in regular intervals. FDs get more rate of interest n relation to recurring deposits.

CREDIT CREATION PROCESS Credit creation is one of the important functions of commercial bank. Accounting to Prof. SAYERS , “commercial banks are the manufacturers of money.” Credit creation refers to the powers of banks to expand or to contract trading. Credit is not created by a single bank but by a banking system as a whole by creating derivative deposits for several times. Bank’s demand deposit arise mainly form  Cash deposits from customers called as primary deposits.  Bank loan and investment called as derivative deposits. Primary deposits arise out of actual savings or cash deposits in a bank. This relates to the acceptance function of bank. Primary deposit is the base of credit creation process. Bank advances loan out of such primary deposits. Thus. DEPOSITS CREATE LOANS. When bank advances loan instead of paying cash it opens a deposits in the name of the person asking of loan and the loan and the loan is credited on his account. Thus every loan creates deposits. Advancing loans create derivative deposits. Thus LOANS CREATE LOANS. Credit creation process is based on following principle’ deposit becomes a base for a loan; when loan is sanctioned it again comes to the banking system as fresh deposit which becomes a basis for a new loan. This can be explained with the help of following example in our example we assume that 1)initial amount received by first bank is Rs. 1,000/2)all banks maintain CRR of 10 p.c. C.C.R. implies the minimum amount of cash reserves, which every bank must maintain in order to honour the cheques drawn on demand deposits. When firs bank receives Rs. 1000/- in the form of primary deposit it will keep Rs. 100/- as cash reserves and will lend remaining amount of Rs. 900/- to Mr. ‘B’ who has his account in the second bank. This bank will deep cash reserves of Rs. 90/- and will lend remaining amount of 810/- to Mr. ‘c’. he may pay this amount to Mr. ‘D’ who has his account in the third bank. This bank will maintain cash reserves of Rs. 81/- and will lend remaining amount of Rs. 729 to some other person. This process will continue till all the original excess reserves of Rs. 900/- will be created plus original sum of RS. 1000/- total being “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] 10,000/- thus the original amount of rs.1000/- has multiplied itself to 10 times in the process of credit creation. Credit creation formula: *K represent deposits multiplier and *R represent cash reserve ration in our example cash reserve ration is 10% -therefore, K= 1/10% = 1/10/100 = 1x 100/10 =10 thus the value of K i.e. deposit multiplier is 10; therefore the original sum will multiply itself by 10 formula represents that there is relationship between the deposit multiplier (K) and the CRR(R).therefore the greater the CRR the less will be (amount generated) credit created and lesser the CRR more will be credit created. Form the above explanation, it is clear that a single bank cannot create credit but is the entire banking system that creates credit. LIMITATIONS OF CREDIT CREATION :Amount of cash:- first important faco5tr affecting credit creation capacity of the commercial bank is the ‘amount of cash’ which bank can get through primary deposits. The larger the amount of cash the greater will be excess funds and therefore larger will be credit creation capacity. Thus there is direct relationship between the amount of cash and credit creation. Cash reserve ration:-there exists inverse relationship between the CRR and the credit creation. If the demand for loans is less, then less credit will be created. Creation capacity. Willingness to borrow:-credit creation also depends upon the willingness of the people to borrow form the banks. If the demand for loans is less, then less credit will be created. Demand for loans depends upon the market condition in the economy . Availability of securities:- it is said that ‘the bank does not credit money out of thin air. It transform the other forms of wealth into money.’ Thus some valuable form of wealth secures every loans advanced by a ban. If proper approved securities are not available then the power of bank to create credit is limited. ************************************************************

CENTRAL BANK In all the countries CENTRAL BANK is an apex institute. CENTRAL BANK can be distinguished form other banks because of its following important features 1. as is the case of other banks CENTRAL BANK. does not function in order to earns profits. 2. CENTRAL BANK. is owned by the public i.e. govt. and also managed by the Govt. 3. it enjoys privileged i.e. special position in the economy 4. various functions like monopoly of note issue, bankers of govt. custodian of the countries reserve are of wider economy significance as they affect the economy growth/development if monetary and banking system of the country etc. 5. it has special relationship with of the other banking institutes as it is the friends, philosopher and guide to those banking institution.

FUNCTION OF CENTRAL BANK BANK OF ISSUE: central bank is responsible for maintaining the stability in the monetary system. But this cannot be done unless it has control over the currency and credit in the economy. Therefore only central bank empowered to issue currency notes. No other institute can issue notes. Thus central bank enjoys thus central bank enjoys monopoly as in these of bank of England or partial monopoly because RESERVE BANK OF INDIA issue all the currency notes except one Rs. Note which is issued by the ministry of finance. This helps to bring uniformity in note circulation and (enable state to exercise control over under credit expansion) control credit creation. Uniformity, elasticity, severity are the three consideration which CENTRAL BANK deeps in view while issuing notes. “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] BANKER TO GOVT:- under this function of central bank it functions in three ways if function as govt. bankers, agent and adviser to the govt. 1. maintains a/c of govt. Depot’s, boards and enterprises. 2. makes temporary advances the govt. also makes extraordinary advance during war and emergency period 3. carries out govt. transactions regarding foreign currencies. As govt. agents central bank advises govt. on the matters like deficit financing. Devaluations, pubic dept. price stability trade and foreign exchange policy etc. BANKER TO COMMERCIAL BANKS:-broadly speaking the central bank functions as a banker to commercial banks in there ways.  As a custodian of cash reserve.  Lender of last resort  As a clearing agent. 1. custodian of cash reserve :-all commercial banks in a country deep a part of their cash balances with the central bank by customs by or by law. This system of centralized cash reserve, enables CENTRAL BANK. to influence the credit creation by commercial banks. 2. lender of last resort:- this function of CENTRAL BANK. implies that when commercial face any difficulty or crisis, they approach CENTRAL BANK. for assistance. Under such condition CENTRAL BANK. helps them either by advancing loans on approved securities or rediscounting bills of exchange. 3. as a banker’s bank:- CENTRAL BANK. deeps reserves of all commercial banks. It becomes easier for member-bank to adjust their claims against each other in the books of the accounts. Thus CENTRAL BANK. functions as a clearing agent. 4. custodians of nation reserves :-CENTRAL BANK. function as a custodian of foreign exchange reserves of the country. It maintains the rate of exchanged fixed by the govt. and looks after the balance of payments conditions of the country. 5. controller of credit:-it is the main important function of CENTRAL BANK. i.e. regulating volume cost and direction of bank loans. It tries to control and regulate credit creation process through various quantitative and qualitative measures. 6. promoter of economic development :-in modern times CENTRAL BANK> play very important role in the economic development. It is an institution maintaining economic stability and assisting growth of the economy. It tries to develop efficient monetary system. It helps to mobilize resources in productive channels. In develop in g courtiers like India it plays important role in developing veracious in developing various area and industrial sector through various banking institute LIKE NABARD, IDBI CICIC etc. METHODS OF CREDIT CONTROL One of the important functions of CENTRAL BANK’s to control credit is categorized under two heads quantitative and qualitative. Qualitative credit control measure relates to the cost and volume of bank credit without considering in which; activity it is used. They are traditional and indirect in nature e.g. bank rate O.M.O. an variable reserve ration.

QUANTITATIVE CREDIT CONTROL METHODS Bank rate policy: -bank rate is the rate charged by CENTRAL BANK. form commercial bank while rediscounting their securities of advancing loans to them. This is rate charged by CENTRAL BANK., which is related closely to all other rates of interest in the money market. If bank rate is increas3e then the R/s will also increase leading to decrease in the Dd. for credit form business community. Therefore there will be decrease in credit creation since Dd. for it has decreased. Thus there is inverse relationship between the bank rate and credit creation. Open market operation: - when as a measure of credit control CENTRAL BANK. enters the market for buying and selling securities or bills of exchange it is called open market operation. When there is inflationary condition in the market, CENTRAL BANK. sells its first class bill or securities and buyers maker’s payment either through commercial banks or commercial banks themselves buys those bills or securities this results into reduction in cash reserves of commercial banks leading to decrease in their credit creation capacity. “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] In times of depression CENTRAL BANK. will buy bills / securities by making payments to commercial banks and thus their credit cr4eation capacity will increase. VARIABLE RESERVE REQUIREMENTS: -this principle of maintaining cretin % of reserve began in U.S.A. All countries mainly for following reasons adopt this method. *It ensures liquidity and solvency of commercial banks * Provide deposits to CENTRAL BANK. for its local operations. * Provides an additional instruction of credit control There is inverse relationship between the CRR and credit creation capacity. If CRR is more than commercial banks have to keep more cash reserves with CENTRAL BANK. meaning reduction in credit creation capacity. If CRR is low then commercial bank will more credit leading to increase in credit creation capacity. SELECTIVE CREDIT CONTROL MEASURES. Special features: *They distinguish between essential and non-essential uses of bank credit *Only non-essential uses are brought under CENTRAL BANK. control; and * They affect not only the leader but also the borrowers. Margin requirement: - while advancing loans for purchasing securities commercial banks sanctions loans which is less than the value of security. This margin is maintained because of instability in the value of securities. During inflationary conditions CENTRAL BANK raises this margin so that less credit is created. While in deflationary condition CENTRAL BANK. lowers the marginal so that more credit is created. Regulation of consumer credit: - through this method CENTRAL BANK. limits the amount of credit for the purchase of any commodity this provided lower credit form chasing consumer goods. Whatever credit is provided it is to be paid in shorter period this method was user for the firs time in U.S.A. Control through directives: - directives by CENTRAL BANK. are writer statements appeals and warning to the commercial banks e.g. R.B.I. can give directions to commercial banks in respect of their lending policies, purpose for cost advances may or may not be and margins to be maintained in respect of seared loans. MORAL SUASION :- it is request made by central bank to commercial banks in order to follow particular monetary policy. In inflationary conditions central bank appeals them not to create credit while in depression, it request them to supply credit to affected industries. Rationing of credit: - in controls and regulated the purpose for which credit is granted. It may be of tow types. a) Variable portfolio ceiling – under this CENTRAL BANK. fixes ceiling on loans and advances for every commercial bank. b) Variable le capital assets ration- under this central bank fixes the ration, which the capital of commercial banks should have, to total assets of the bank. Direct action: - refers to all the credit controls and directions, which central banks may enforce on all banks or any bank in particular concerning leading and investment Money Supply Measures in India (RBI)

M1

M2

Original concepts Revised concepts = Currency = Currency + Demand Deposits + Demand Deposits + Other Deposits + Other Deposits C + DD + OD C + DD + OD = M1 + = M1 + + Savings Deposits + Time liability portion of with Post Offices savings deposits with banks + CDs issued by banks + Term Deposits maturing within one year


Liquidity Aggregates L1 = revised M3 + All deposits with post offices (excluding NSCs) L2 = L 1 + term deposits with term lending institutions. + Term borrowing Page 13 of 31


M3 = M1 + Time Deposits of bank M4 = M3 + Total Deposits with post offices

= M2 + Term deposits over one year maturity. + Call / term borrowings of banks = Abolished.

of FIs + CDs issued by FIs L3 = L 2 + public deposits of NBFCs LA = L1+L2+L3

PORTFOLIO MANAGEMENT : TRADE OFF BETWEEN LIQUIDITY AND PROFITABILITY LIQUIDITY: refers to the capacity of the bank to give cash on demand in exchange for deposits. The confidence of the depositors in the bank depends upon its ability to produce cash when demanded by customers. So the banks must maintain sufficient liquid assets. Cash is the most liquid asset. But it does not earn any income. That is why it is called as ‘barren asset”. Thus after making provisions for cash reserves, the banker should invest money in the assets which are liquid in nature. These assets must be liquid in short period. SHIFTABILITY: Shiftability of asset means that asset should be easily shiftable to other banks or central bank to acquire cash e.g. Treasury Bills and Bills of Exchange. PROFITABILITY: principal objective of bank is to earn profit. - Therefore banks distribute its funds among various assets in such a manner as to derive sufficient income. SOLVENCY: a bank is solvent when its assets are more than a equal to its liabilities when its assets are more than or equal to its liabilities. On the other hand a bank is liquid when its assets cab be converted into cash without loss. CAPITAL ADEQUUACY RATIO: CARs’ are measure of the amount of a bank’s capital expressed as a percentage of tis risk weighted credit exposures. Application of CARs’ protect depositors and promote the stability and efficiency of the financial system by reducing the likelihood of banks becoming insolvent. Thus CAR is the Ratio of Capital to Risk Asset (CRAR). Tier I Capital : a. paid up capital b. bank’s statutory reserves. c. Other disclosed free reserves. d. Capital reserves. Tier II Capital : a. Undisclosed reserves and paid up capital of Perpetual Preference Shares. b. Revaluation Reserves. c. Hybrid Capital Instruments. d. Subordinated Debt. e. General Provisions and loss Reserves. Tier II capital cannot exceed 50% of tier I capital for the purpose of arriving at the prescribed capital adequacy ratio. \

PUBLIC FINANCE MEANING & DEFINITION OF PUBLIC FINANCE The term public finance refers to monetary resources of the public authorities or the government bodies at all the levels – central, state or local. This monetary resources i.e. public finance includes raising and disbursement of public funds. Thus the incomeexpenditure process of government is studied in “public finance”. “A determination to succeed the onlywhich way to succeed.” “Public Finance is aisscience deals with income &

expenditure of public authorities & government of a nation”.

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Email : [email protected] & [email protected] In every country govt., has to perform various functions which can be grouped as: a) Obligatory Functions: They include defence expenditure & maintaining internal law & order. These are compulsory for every govt. b) Optional Functions: All other functions are included in optional functions. Government undertakes various activities like building, roots, bridges, dams, canals, etc., In order to perform all these functions, funds are needed. Govt. raises this fund from public in the form of taxes, fees, duties, fines, etc. It may also take loans from internal & international bodies. How, and what form the funds must be raised and how to spend them depends on economic and political system of the country. Public finance deals with this area of study. It is defined differently by various economist• By SHIRIAS: “Public finance is the study of principles underlying the spending and raising of funds by public authorities”. • By H.L.LUTZ: “Public finance deals with the provisions, custody and disbursement of resources needed for conducting public or government functions”. Thus, public finance deals with income and expenditure policy of government. It is a science as will as art. It is science because we study it in various principles, problems and policies related to the raising and disbursement of government funds, thus it deals with who to collect taxes in the best way and how to maintain them economically and spend them properly. It is an art because; it helps in solving various financial problems in the best possible way in order to achieve benefit of people. In short, public finance is a systematic analytical study of the economic behaviour of state, as a relationship between multiple social wants and scarce monetary resources having alternative uses.

IMPORTANCE OF PUBLIC FINANCE Till the 19th century, role of government was confined to maintaining internal law and order and safeguarding the country from foreign aggression. Thus, the state was primary POLICE STATE. However, in 20th century government role widened to perform various functions and therefore, it became WELFARE STATE. Therefore, the importance of public finance is increasing day by day.  INFANT INDUSTRIES: - The government of under develop countries (UDC) protected its infant industries against foreign competition. For this purpose government adopts measures like imposition of tariffs, quotas and other fiscal measures. This helps infant industries to develop and face competition of multinational companies.  PLANTED DEVELOPMENT: - Most of the countries relive more and more on economic planning. Under this, priorities are fixed and therefore government needs funds in order to implement plants. Public finance helps in implementing these plants.  REGULATING CONSUMPTION HABITS: - If government wants to decrease the consumption’s of sub-commodity like drinker, drugs it may rise taxes on such commodity. Similarly in order to raise savings, government will charge more taxes on luxury items. Government also gives subsidy on necessary commodity in order to increase its consumption. E.g. fertilisers, good products etc.  INVESTMENT: - By implementing proper tax system govt. can increase rate of investment. in rural or under-developed areas govt. can charge confessional rate of taxes and to developed areas progressive taxes. This will help in achieving regional balance. Thus implementation of proper tax policy will divert investment in the priority sectors.  PRODUCTION: - The implementation of proper rate of taxes will also divert the production of certain necessary commodities. Govt. can increase production of those commodities will are useful and decrease production for those commodities harmful for country.  ECONOMIC STABILITY: - Tax system and deficit finance are important measures for controlling inflation and deflation. Thus, public finance helps in achieving stable economic growth rate.


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Email : [email protected] & [email protected]  SOCIAL JUSTICE: - Progressive tax system is one of the measure to redistribute income and wealth thus it helps in reducing the gap between rich and poor that is achieving maximum possible social justice.

SCOPE OF PUBLIC FINANCE Public finance is not just to study the composition of public revenue and public expenditure. It covers the govt. fiscal operations on the level of overall activity, employment, prices and growth process of the economic system as a whole. The scope of public finance embraces the following three functions of the govt.’s budgetary policy confined to the fiscal department:  The Allocation Branch: - The function of allocation branch is to determine what adjustments in allocation are needed, who shall bear the cost, what revenue and expenditure policies are to be formulated in order to realise the desired objectives.  The Distribution Branch: - The function of distribution branch is to determine what steps are needed to bring about the desired state of distribution. Govt. intends to ensure fair distribution of economy’s income and wealth among citizens.  The Stabilisation Branch: - The function of stabilisation branch is to maintain the decisions in order to secure price stability and to maintain full employment level.  The Growth Branch: - The function of growth branch is to make the use of fiscal instruments and policies for promotion of economic growth and development in the economy.

PUBLIC FINANCE vs PRIVATE FINANCE Public finance deals with of govt. policies regarding income and expenditure. On the other hand private finance deals with financial aspect of the private individuals of institutions of corporate bodies. SIMILARITIES BETWEEN PUBLIC FINANCE & PRIVATE FINANCE: 1. MAXIMUM ADVANTAGE: Every individual or institutions aims of achieving maximum utilisation of available resources in order to satisfy personal wants. Whereas public finance utilises the monetary resources to satisfy social wants. 2. SCARCITY: Both public as well as private finance has to face the problem of scarcity of resources. And none of them is able to achieve maximum satisfaction i.e. to satisfy wants from scarce resources. 3. BORROWING: When income exceeds expenditure there is surplus earning called savings. But when expenditure exceeds income there is need for borrowings. Resort is made to borrow in both the finances. 4. RATIONALITY: Both the kinds of the finances make rational behaviour. They must try to achieve maximum benefits from minimum utilisation of expenditure. 5. NEED FOR INCOME: In both the finances income precedes expenditure which means revenue has to be raised before expenditure is effected. DIFFERENCES BETWEEN PUBLIC FINANCE & PRIVATE FINANCE: 1. MOTIVE: The motive of private finance is to profit making, while public finance motive is to achieve social welfare. Thus objective of private finance is the satisfaction of individual wants. Public finance on the other hand has various objectives such as full employment, social justice, etc. 2. INCOME EXPENDITURE ADJUSTMENT: Every individual tries to adjust his expenditure according to income. Although his expenditure exceeds income which is for short period. But for public finance govt. adjust his income to given pattern of expenditure. This means in private finance income determined expenditure while in public finance expenditure determines its income. 3. PRIVATE CURRENCY: Private individual cannot raise funds through printing new currency in spit of urgency. On the other hand govt. can do so under urgency. “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] 4. SOURCES OF RAISING FUNDS: Under private finance sources of funds are limited on the other hand for public finance they are unlimited and diversified. Govt. can raise funds through various sources like taxes, fees & fines, profits of PSU’s, internal & external borrowing, printing currency etc. 5. PRINCIPLES OF FINANCE: Private finance includes activities, which are guided by market forces like Demand & Supply. It operates on the principle of quid pro quo, which means direct benefit against any payments is expected. On the other hand public finance operates on the budgetary principle. All the decisions regarding revenue and expenditure are to be functioned by elected representatives. In its budget. 6. ELASTICITY OF FINANCE: Public finance is more elastic. The state can make drastic changes in income and expenditure policy. But in case of private finance an individual cannot change his budget drastically due to various limitations on sources of income. 7. COERCIVE AUTHORITY: Govt. can use force to collect taxes. No body can refuse to pay taxes. But in private finance money cannot be collected by force. 8. SECRECY OF BUDGET: In case of private finance the budget is usually top secret while govt. budget is presented in the parliament and is given wide publicity. Thus, it is said to that public finance is PUBLIC and private finance is PRIVATE. 9. SOLVENCY: As the state is a long lasting institute, it cannot be declared insolvent. Whereas the individual may be declared insolvent if his liabilities exceed his assets. 10. PRINCIPLE OF EQUI-MARGINAL UTILITY (EMU):Usually both public and private finances try to follow principle of EMU and get maximum satisfaction. In case of individuals the law is strictly followed. But govt. may spend money without accepting this principle under this it considers non-economic factors like justice and welfare of certain communities. 11. PRESENT AND FUTURE INCOME: For an individual present is more valuable than future. But for govt. both are equally important present as well as future. Many times, its current expenditure are incurred keeping in view future operations. 12. AUDIT: Govt. expenditure and income are subject to audit by constitutional authorities while in case of private finance audit is not necessary. If it is performed, there are minimum formalities.

Source of Public Revenue

TAX REVENUE DIRECT TAX INDIRECT TAX

NON-TAX REVENUE

PUBLIC REVENUE

PRICE AND PROFITS OF PSU’s 7. FEES GIFTS AND FRANTS 8. FINES SPECIAL ASSESSMENT 9. ESCHEAT “A determination to succeed is the only way to succeed.” FORFEITURES 10. PUBLIC DEBT TRIBUTED AND INDEMNITIES DEFICIT FINANCE

The income of the govt. from all sources is called Public Revenue.

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TAX REVENUE:

Funds raised through various taxes are referred as tax revenue. Taxes are compulsory imposed by govt. on to its citizens to meet general expenses incurred for interest of nation. Definition by Seligman – “A tax is a compulsory contribution from a person to the government to defray the expenses incurred in the common interest of all, without a reference to special benefits conferred.” FEATURES OF TAX: 1. Tax is compulsory payment by citizens who are liable to pat and refusal to pay a tax is a punishable. 2. There is no direct quid pro quo between the tax payer and the public authority i.e. tax payer cannot claim any reciprocal benefits against the taxes paid. 3. Tax is levied to meet the expenses incurred by the govt. for the interest of the nation. 4. Tax is payable regularly and periodically as determined by the taxing authority. DIRECT TAX: A tax, which is paid by a person on whom it is legally imposed and the burden of which cannot be shifted to any other person, is called a direct tax. For e.g. income tax, wealth tax, property tax, estate duties, capital gains tax etc. INDIRECT TAX: An indirect tax on the other hand, is a tax the burden of which can be shifted to others. An indirect tax is levied on and collected from a person who manages to pass it on to some other person or persons on whom the real burden of the tax falls. Hence, in case of indirect taxes taxpayer is not tax-bearer. For e.g. sales tax, excise duties etc. Thus, tax constitutes a significance part of public revenue in modern public finance. Taxation can affect the size and mode of consumption, pattern of production and distribution of income and wealth. Thus, taxes constitute an important source of development finance.

NON –TAX REVENUE: PRICE & PROFITS OF PUBLIC SECTOR UNITS (PSU): In modern times public sector undertakings occupy very important place. These PSU’s provide various services for which some price is charged. Although these undertakings are not profits motivated, the revenue earned by them through prices is very important of Public Revenue. GIFTS & GRANTS: “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] Grants are given by govt. at higher level to the govt. or bodies’ are lower level. For e.g. Central Govt. to State Govt. or State Govt. to Local Bodies. Similarly state receives grants from other states or private bodies. Grants may be given in special situations like earthquake, flood, draughts cyclone etc. FEES: It is a compulsory payment made by those who obtain a definite service in return. It is intended to cover a part of cost of service. It is never more than cost of service. For e.g. educational fees. SPECIAL ASSESSMENT: According to Prof. SELIGMAN “Special assessment is a compulsory contribution levied in proportion to the special benefit derived to defray the cost of the specific improvement to property undertaken in the public interest. Suppose govt. builds a road, it leads to increase in the value of property in the roadside area. The state has right to recover a part of extra ordinary expenditure incurred by the public authority. It is compulsory like tax. Seligman emphasized following features of Special Assessment: a. b. c. d.

There is element of special purpose. The special benefit is measurable. These assessments are not progressive but proportional to the benefit received. They are for specific local improvements.

FINES: Fines are imposed as a penalty for breaking a law. It is compulsory like tax but it is imposed for discouraging people from breaking law rather than, as source of revenue. FOREFEITURES: If an under-trial jumps a bail or a party to contract fails to carry his part of the contract, the money deposited is forfeited. The money so forfeited goes to the state. However, it is a minor source of public revenue. ESCHEAT: When a person dies heir-less or without a successor or leaves no will behind, his property or assets will to the state. This claim of the state to a deceased’s assets is called escheat. TRIBUTES AND INDEMNITIES: Foreign countries pay these. Tributes are paid by conquered countries and indemnities for any damage done to the country either by war of aggression or otherwise.

DIRECT TAX: A tax, which is paid by a person on whom it is legally imposed and the burden of which cannot be shifted to any other person, is called a direct tax. For e.g. income tax, wealth tax, property tax, estate duties, capital gains tax, etc. MERITS OF DIRECT TAXES: 1. Equitable: Direct taxes are more equitable as they are passed on principle of ability to pay the allocation of tax burden is well secured by these taxes. The rate of tax varied to make the tax confirm to the ability to pay. 2. Economical: The cost of collection is small in direct taxes. There being no intermediary between the tax-payer and the state, no part of the tax evaporates in transit. 3. Certainty: The direct taxes are more exact and are calculated with a fair degree of precision. The taxpayer is also certain about the amount he has to pay and the state an also estimate the yields correctly. 4. Elastic: Direct taxes have a high degree of elasticity. Income tax has remarkable responded to the enormously enhanced needs of the state of defence and development.


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Email : [email protected] & [email protected] 5. Civic Consciousness: Direct tax creates a civic consciousness among the taxpayers. A taxpayer feels that he is contributing towards the state expenditure. He is expected to take keener interest in civic affairs. 6. Anti-inflationary: Direct taxation can serve as a good instrument of antiinflationary fiscal policy designed to maintain the price level at a stable level. DEMERITS OF DIRECT TAXES: 1. Pinching: Direct taxes are to be paid in a lumpsum they pinch the taxpayers. Thus, the announcement effect of a direct tax always tends to cause resentment among the taxpayer. 2. Unpopular: Direct taxes are vary unpopular. Nobody likes to pay them. To part with money in not an easy thing, especially when there is no direct quid pro quo. 3. Evasion: They can be easily evaded and the state defrauded of its due. That is why it is said that a direct tax is a tax on honesty. 4. Inconvenient: Direct taxes are very inconvenient to pay. These have to filed in time and complete records are to be maintained up-to-date by each individual taxpayer. 5. Arbitrary: The nature and base of direct taxes are arbitrarily in the sense that the rates of taxes are fixed by the govt. The rates are not determined in any scientific principle. The Finance Minister uses his own value judgement in determining the taxation potential of the taxpayer, 6. Disincentive-ness: Direct taxes being based on income and wealth, if they are excessive they may discourage savings and kill the incentive to work hard.

INDIRECT TAXES: An indirect tax on the other hand, is a tax the burden of which can be shifted to others. An indirect tax is levied on and collected from a person who manages to pass it on to some other person or persons on whom the real burden of the tax falls. Hence, in case of indirect taxes taxpayer is not tax-bearer. For e.g. sales tax, excise duties, customs duties, etc. MERITS OF INDIRECT TAXES: 1. Convenient: Indirect taxes are more convenient to pay. The taxpayer does not feel he is paying. The tax is wrapped in the price of the commodity he buys. Hence, taxpayer does not feel the burden directly. 2. No Evasion: It is very difficult to evade an indirect tax, because it is mixed up with the price of the commodity one purchases. 3. Beneficial Social Effects: Indirect taxes have a beneficial social effect. The consumption of harmful commodities as drugs, tobacco, intoxicants etc. can be discouraged by means of such taxes. 4. Forced Saving: Indirect taxes are an effective means of mopping up consumer’s surplus and there savings into hands of the govt. which can be utilised fruitfully in expending the process of capital formation in the country. 5. Elastic: When imposed on necessaries of life or articles for which the demand is inelastic, indirect taxes are also fairly elastic. They can, therefore be varied according to the state needs. 6. Reduce disincentive-ness of direct taxes: Since indirect taxation have proved vary significance revenue for govt., it has obviated the necessity of steeply progressive direct taxation which would have been vary disincentive of saving and investment. DEMERITS OF INDIRECT TAXES: 1. Uncertain: Indirect taxes are uncertain. It is not always possible to anticipate the actual amount of a tax imposed on commodities. A Finance Minister cannot precisely calculate the estimated yield of a tax. “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] 2. Regressive: They are regressive. Every consumer of the taxed commodity, rich or poor, pays the tax at the same rate. Therefore, the real burden of tax on poor is greater than on the rich. 3. No Civic Consciousness: Indirect taxes do not develop any civic consciousness in the taxpayer because nobody feels that he is paying a tax as it is wrapped in price of the commodity. 4. Inflationary: The indirect taxes have SYSTEMS OF TAX TATES: one serious danger especially in d3eveloping countries. Every tax levied on a commodity must inevitable raise its price and if prices are already rising it feels inflation. Systems of tax rates are classified as follows: 1. Proportional Tax Rate of Income System: A proportional tax Tax is one in which, whatever the size of income, same 10,000 rate or same percentage is 20% charged. The percentage of 20,000 tax charged is same from 20% all taxpayer. This is called as Proportional Tax System.

Amount of Tax 2,000 4,000

T A X R A T E LFVEL OF INOCME

2. Progressive Tax System: In progressive tax system the rate if tax rises as the taxable income increases. The principle of a progressive tax is “ higher the income , higher the rate.” In case of proportional tax system the tax-payer with higher income pays more tax. But, under progressive tax system, he will pay much more because as income increases, the rate if tax also increases. This system is more equitable. Because the rate of tax varies with income earned by tax-payer.

Y T A X R A T E O

RATE OF INCOME AMOUNT TAX OF TAX 20 % 10,000 2,000 PROGRESSIVE TAX 30 % 20,000 6,000 3. Regressive Tax System: A tax is said to be regressive when its burden falls REGRESSIVE TAX more heavily on the poor than the rich. It is just opposite to progressive tax. In this case the rate of tax is lowered with increase in income of tax-payer. That is unjust with poor, as the burden of tax rests mainly on poor. RATE OF INCOME AMOUNT TAX OF TAX INCOME X 20 % 10,000 2,000 10 % 20,000 2,000 Y

4. Digressive Tax System : A tax is called digressive when the tax-payer with higher incomes do not make the due sacrifice, or when the burden imposed on them is relatively less with compared to there income. This will happen when rate of tax is only mildly progressive i.e. when the rate of progression is not sufficiently steep. A tax may be progressive up to certain limit beyond that a uniform rate is charged. In this case there will be relative lower sacrifice on the larger incomes that on the smaller incomes. CANONS to OFsucceed TAXATION “A determination is the only way to succeed.”

T A X R A T E

X O

INCOME

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Email : [email protected] & [email protected] Taxation is the most important sources of govt. revenue. Tax refers to the compulsory contribution from public without any quid pro quo. Therefore while deciding the proportion of tax, various aspects should be taken into consideration. It should be charged by considering following principle: ADAM SMITH, Father of Economics has propounded Canons of Taxation. Following are his four celebrated canons: 1. Canon of Equality : This canon embodies the principle of equity of justice. It is the most important canon of taxation. It lays down foundation of tax system. It means with equality of sacrifice of every citizen. The amount of tax paid is to be in proportion to the respective abilities of the taxpayers. Thus the tax will be in proportion to the ability of taxpayer to pay. 2. Canon of Certainty: This principle implies that tax to be paid by every citizens must be certain and not arbitrary. The time of payment, the manner of payment, the quantity to be paid should be clear to every taxpayer. Certainty is needed not only from the point of view of the taxpayer but also from that of the state. The govt. should be able to estimate the procedure and formalities required to be flowed. 3. Canon of Convenience: This canon of certainty implies that the time and the manner of payment should be certain which is convenient to the taxpayer. According to Adam Smith while paying the tax the taxpayer sacrifices his purchasing capacity & therefore govt. should consider the convenience of taxpayer. 4. Canon of Economy: According to this canon the cost of collecting taxes should be minimum. If the tax collection procedure is costly them it will reduce the govt. revenue. A tax is economical if it does not obstruct in any manner the economic progress of the country. And also govt. should see that tax collection is utilized for the social welfare. Since Adam Smith wrote, the science of Public Finance has continued to grow. So some economist have added five canons of there own to the canons of Adam Smith. 5. Canon of Productivity: Prof. put this canon forward BASTABLE. This canon indicate that a few taxes brings a large revenue are better than many taxes each bring a very small revenue. Thus the tax should be of such nature that it should yield sufficient revenue to the govt. in order to work for welfare of citizens. The multiplicity of taxes should be avoided and few productive taxes should be preferred. 6. Canon of Elasticity: The tax system should be elastic so that the burden of taxes may be increased or reduced whenever the need is felt. In a period of stress or emergency the govt. should be in position to yield excess or extra from the tax revenue. Income tax is good example of elastic tax. By raising the rate or by levying surcharge the yield from income tax can be considerably increased. 7. Canon of Simplicity: ARMITAGE SMITH brings this canon forward, he says, “A system of tax should be simple, plain and intelligible to the common understanding.” The taxpayer should be able to assess how much he has to pay without the help of experts. This will reduce the chances of tax evasion and exploitation. 8. Canon of Diversity: A single tax or few taxes will not do. There should be large variety of taxes so that all the citizens, can afford to contribute the revenue. This helps distributing the burden of tax on various sections of society. 9. Canon of Desirability: A tax should be expedient or desirable so that the govt. may defend itself against public criticism. This suggests that tax should be determined on the ground of its economic, social and political advisability. Otherwise govt. ill have to face criticism from public if tax is unjust. Thus govt. should have justification for the tax. Although all this canons cannot be applied in any of the tax systems all over the world every govt. should try to apply maximum possible canons to its tax system.

 MONERARY POLICY “A determination to succeed is the only way to succeed.”

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 

Monetary according to Prof. H. JOHNSON is “employing the central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy”. In the broad sense monetary policy refers to the policy of control and regulation of money supply and credit. Monetary policy deals with money in a broader sense of controlling the total volume of money for maintaining the stability in the purchasing power of money.  OBJECTIVES OF MONETARY POLICY The monetary authorities formulate the monetary policy to achieve certain objectives. The important objectives of monetary policy are growth with stability. Though it is possible to analyse the objectives of monetary policy under the title of ‘growth with stability’, a detailed discussions of all the objectives would help us to understand better, the perspective of the problem. Therefore, the objectives of the monetary policy can be discussed as under. • Economic growth • Price stability • Full employment • Balance of payment equilibrium • Neutrality of money. 1. Economic growth: In all the countries and more so among the developing countries economic growth has become one of the most significant goals of monetary policy. Economic growth means production of more goods and services. Growth manifests it self in an increase in G.N.P. or per capital income or per capital consumption. To promote economic growth more investment is required. It is necessary to built up the capacity to produce more and also simultaneously to promote demand to absorb the increase supply. 2. Price stability: A stable exchange rate is essential for the smooth functioning of international trade. Unstable exchange rate would deteriorate the value of currency in the world market. Many countries have used monetary policy to achieve equilibrium in the balance of payment. A restrictive monetary police will help to reduce the country’s balance of payment deficits in following ways. A reduction in import due to fall in domestic demand. An increase in export due to fall in price.  The interest rates are high under dear money policy. So foreign do no borrow from the deficit country but try to invest there. 3. Full Employment: Full-employment has been considered as the foremost objective of monetary policy may be economists since the publication of KEYNEs’S “General Theory”. Monetary policy can play an effective role in promoting full employment by encouraging saving and investment. Monetary policy can effect employment by influencing the allocation of resources and labour intensity in the technique of production. The use of credit control technique by the central bank must promote optimum allocation of resources and high level of employment. Monetary policy should aim at all full employment of labour and other economic resources so as to ensure maximum efficiency, productivity and social welfare. 4. Exchange Rate Stability: According to economists like KEYNES and CASSEL, maintaining price stability is a very important objective of the monetary policy. The bank should undertake credit regulation measures to promote price stability. Price stability refers to controlling inflation or deflation and checking trade cycles. During inflation, a restrictive monetary policy is adopted. During deflation or depression, an expansionary monetary policy is adopted. Reasonable price stability in necessary to achieve macro-economic goals. 5. Balance of Payment equilibrium: Most of the developing countries have to import capital goods, machinery, equipment, technical know-how, etc. in the initial stages of their development. Consequently, their imports exceed the exports, making the balance of payments unfavourable. Monetary policy should aim at maintaining stability in exchange rates and removing dis-equilibrium in the balance of payment. 6. Neutrality of Money: This objective of monetary policy is associated mainly with Prof. WICKSTEED, HAYEK and ROBERSON. According to this objectives money has no function to perform other than as a medium of exchange. Money should not have any “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] other effect of the economy. For fulfilling this role the quantity of money must be kept constant. Adjustment in money supply is allowed only account of changes in velocity of money or due to basic change in the structure of the economy. It is argued that creation or destruction of money disturbs the equilibrium of supply and demand. The objective of neutral money policy is not considered practice due to the following limitation. • Money, in a monetary economy cannot be neutral. It has a positive role to play. A slow and steady increase in price level provides the required incentive to invest. • The objective has a deflationary tendency. A constant amount of money in dynamic economy where positive changes take place in macro-economic variables is bound to result in decline in price level. • Neutrality of money is based on the quantity theory of money, which establishes a direct and proportional relationship between quantity of money and price level. This objective thus suffers from the same drawbacks as the quantity theory suffers from. • It has more relevance for the long-run full employment situation. If the output has reached it potential capacity and if there is no unemployment, then money can be confined to the role of medium of exchange. • Operation of his objective requires existence of perfect competition. In an imperfect real world money cannot afford be neutral. The drawback of the ‘neutrality of money’ has made the objectives to remain more or less as a theoretical discussion creating only academic interest.

 FISCAL POLICY Fiscal policy means the policy dealing with taxation, public expenditure and public tax and also known as budgetary policy. Fiscal policy is used as a BALANCING Device in an economy. In earlier days, the laissez-faire economic policy was prevalent. Fiscal policy was considered to be neutral i.e., it had no role to play in economic activities of the people and economy in general. The great depressions of 1929-1933 in western developed countries and the publication of “The General Theory” by Keynes in 1936 brought about a radical change in the traditional neutralist approach of governments fiscal policy. With the change in laissez-faire policy, state came in the economic field and fiscal policy got a new significance. Germany in the last century was the first country to use the fiscal tools in a very effective way to stop the import of foreign goods and promote home industries. The generally accepted goal of fiscal policy is that of attainment of greater economic stability.  OBJECTIVBES OF FISCAL POLICY The objectives of fiscal policy in underdeveloped countries are quite different to that of developed countries because there exists a basic difference in the nature of their economic problems. The contemporary view in developed countries holds that the primary task of fiscal policy is to ensure cont9nuous growth with high employment at stable prices. In other words, the generally accepted goal of fiscal policy is that of attainment of greater economic stability. The primary task of fiscal policy in a developing economy is to allocate more resources for investment and to restrain consumption. The problem is not only of stabilization but, also of economic development. In order to attain growth with stability, the goal of fiscal policy should be promotion of the highest possible rate of capital formation and should reduce the actual and potential consumption. On the basis of the above discussion the main objectives of fiscal policy in developing countries are as follows: 1. Increase capital formation: The main objective of fiscal in India is to increase the rate of capital formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious circle of poverty mainly on account of capital deficiency. In order to increases the rate of capital formation, the fiscal policy must be so designed that it encourage saving and discourage and reduce spending. The functional finance is to be replaced by activating finance. The finance minister has offered a number of incentives for “A determination to succeed is the only way to succeed.”

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Email : [email protected] & [email protected] increasing savings and encouraging investment in specified are as. The saving income ratio has certainly increased from 16 per cent a few years ago to about 23 per cent. 2. Resource Mobilization: Resource Mobilization is certainly an important objective of any fiscal policy. According to RAJA CHELLIAH, out of the three major instruments of resources mobilization, viz. Taxation, borrowing and credit creation, the most important certainly is taxation. However direct taxes are anti inflationary. They discourage consumption and encourage savings, which can be properly mobilized through efficient system of tax administration. However, we shall see a little later that indirect taxes have proved to be better tax-gatherer in India is that the high marginal rates of taxation has encouraged tax-evasion. The tax structure is now being gradually rationalized so as to prevent evasion of tax payment and thereby induce more people to pay their taxes more honestly. Agricultural incomes have not yet been appropriately taxes and hence the main sector of the economy is almost uncovered by the tax net. 3. Resource Allocation: Resource allocation has to be more rational and efficient so as to encourage investments in production of goods which are more socially desirable. The fiscal policy should aim at diverting the resources from production of socially undesirable goods to production of more socially desirable goods. Taxes are thus, levied at a relatively higher rate on luxuries so as to discourage their consumption and consequently their production. Subsidies too, are resorted to in order to encourage production of socially desirable goods. 4. Promote Social Justice: In the name of social justice one of the major objectives of fiscal policy should be to reduce inequalities in income and wealth. “Tax rich heavily and poor lightly” has been the dictum so as to reduce the glaring area of inequality in income and wealth. In fact, in India the experience is that the share of direct taxes, especially that of income tax to treasury has been very low and is declining. There is large scale tax evasion mainly because of the high rates of taxes. The marginal benefit from public expenditure too is more to the better off section. Poor continue to remain relatively poorer. The objective of reducing inequality still remains unattained. 5. Control Inflation: To reduce inflation is the objective of both, the fiscal as well as monetary policies. Indirect taxes are inflationary. Hence, the government will have to be externally careful and calculate while increasing the rates of indirect taxes or including new items under the tax net. At every stage in the process of production and at every stage in the purchase and sale of goods, right from the stage of sale of raw material to the finished product taxes are imposed. This multiplicity of tax payments get reflected in higher prices. Direct taxes, by nature, are anti-inflationary. But the coverage is very small. In a country where the per capita income is low, very few people are covered by direct taxes; and to collect substantial amount from direct taxes the rates of such taxes have to be relatively high. But the high rates of taxes encourages evasion and result in the emergence of ‘parallel economy’. 6. To generate employment opportunities: Fiscal policy should aim at reducing unemployment and underemployment and increase employment opportunities. The state expenditure should be directed towards providing social and economic overheads. Such expenditures create more employment and increase the productive efficiency of the economy in the long run. The government should also encourage private enterprise through tax holidays, concession, cheap loans, subsidies etc. In rural areas, efforts should be made to encourage industries by providing training, finance and machines connected with them. Expenditure on all these short-term and long-term measure will go a long way in increasing employment opportunities. Rapid economic development is only possible if the rate of increase in employment opportunities and income is much higher than the growth rate of population. Fiscal policy should, therefore, provide more social amenities with a greater emphasis on family planning. Unless population is controlled, the objective of increasing employment opportunities cannot be fulfilled. Although fiscal policy has assumed greater importance in modern times yet, fiscal and monetary policies must be so co-ordinate to achieve the desired economic objectives. The success of fiscal policy will depend upon the timely measures and their effective administration. “A determination to succeed is the only way to succeed.”

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BALANCE OF PAYMENTS In the modern world there is hardly any country, which is self-sufficient in the senses that it produces all the goods, and services it needs. Every country has to import the goods form the other country that cannot be produced. Similarly, countries prefer to buy form aboard rather than produces at home. The balance of payment means to present an account of all goods exported and services rendered and goods imported and services received. DEFINITION:

“The balance of payments is a comprehensive record of economic transactions of the residents of a country with rest of the world during a given period of time.”

BALANCE OF PAYMENT AND BALANCE OF TRADE Export of commodities to foreign countries adds to foreign receipts while imports of commodities add to our payments to foreign countries. If the export exceeds imports the balance of trade is said to be favourable and if imports exceed exports the balance of trade is said to be unfavourable. The commodities exported or imported entering the balance of trade are called visible items because they are recorded in customs barriers. In addition to the imports and exports we also import and export certain services such as transports changes, shipping freight, commercial services, financial services etc. these services are called invisible items. Balance of Trade refers to the difference between the value of exports and imports of commodity. Thus balance of trade refers to only balance on visible items. On the other hand balance of payment refer to the both visible and invisible items. It also includes capital and financial accounts. BoT is partial picture while BoP is a complete picture of countries international economic relations. Similarly, in the accounting sense BoT may be deficit or surplus i.e. it may be imbalanced. Thus, BoP, as a whole must always balance. For this reason there are items like “Errors and Omission”.

HOW DOES BALANCE OF PAYMENTS BALANCES? The BoP account is traditionally divided into tow sections: 1. Current account 2. Capital account Current account mainly consists of two sub-groups: A. Merchandise or trade account, B. Invisible account. Merchandise account includes the transactions relating to goods only. Thus, the value of all goods exported and imported is entered into merchandise account. Invisible account usually consists of the services account and gift or charities account. It reports all the services rendered and received by the citizens of country, e.g. banking & insurance charges, interest on loans, tourist expenditure, transport changes etc. Capital account records all records all receipts and payments by the citizens while transacting their assets or liabilities with the citizens of other counties. It includes direct investment, portfolio investment, as well borrowings and landings. Direct investment – it is undertaken by MNC’s Portfolio investment- it is the acquisition of financial assets in foreign countries. It may be short term or long term. BoP account are maintained by using double- entry book keeping system. Under this system the total debits are always equal debits are always equal to total credits. Due to this BoP always balance CASH (RECEIPTS) DEPOSITS (PAYMENTS) NO. ITEM Rs. (crores) NO. ITEM Rs. (crores) CURRENT ACCOUNT 1. Merchandise trade (export) 2. Services exported

2000 1000

1. Merchandise trade 2. Services imported


3000 2000

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Email : [email protected] & [email protected] 3. Income form foreign investment 4. Unilateral receipts Sub-total 5. Long term borrowings 6. Short term borrowings 7. Sale of gold or assets Sub-total Grand total

2000 1000 6000 2000 1000 1000 4000 10,000

3. Income form investment at home 2000 4. Unilateral receipts 1000 Sub-total 8000 CAPITAL ACCOUNT 5. Long term landings 800 6.shourt term landings 600 7. Purchase of gold or assets 500 Sub total 1900 Errors and omissions 100 Grand total 10,000

Thus, the surplus of the trade or current account must be equal to the deficit in the capital account. And deficit in current account must be equal to the surplus in capital account. This balances the BOP.

EAUILIBRIUM AND DISEQUILIBRIUM TYPES OF DISEQUILIBRIUM IN BALANCE OF PAYMENTS Short run Disequilibrium Long run Disequilibrium Cyclical Disequilibrium Structural Disequilibrium 1. SHORT RUN DISEQUILIBURIM:- This Disequilibrium is for short period i.e. for a year or for few years. Such deficits occur due to a sudden increase in demand for foreign goods and services. Some domestic problems may arise in country due to failure of monsoon, natural calamities or political disturbances etc. which may result in an increase in imports or decline in exports. These can be corrected through short-term borrowings or other adjustments in the capital account. 2. LONG RUN DISEQILIBRIUM:- Disequilibrium that prevails for a long period of time is called as long run Disequilibrium. This Disequilibrium cause due to continuous excess demand for foreign exchange that the supply. The main causes for such Disequilibrium can be found in the excess imports for planned economic development, continuous increase in population compelling a country to import essential goods, domestic investment exceeding domestic savings, increase in the price of imports e.g. increase in crude oil prices, decline in the demand for exports due to technological improvement and change in habits, taste, income etc. in countries where these exports go. The IMF terms such Disequilibrium as “Fundamental Disequilibrium”. 3. CYCLICAL DISEQUILIBRIUM:- As the countries are interdependent they are subject to international transmission of economic ups and down or called as international transmission of cyclical changes. Economic activities are subjects to business cycles which have four phases: a) prosperity or boom b) Recession c) Depression and d) Recovery. During the prosperity period, imports increase. Exports may increase during recession or depression due to decline in price and imports are usually discouraged during this period due to reduced income. If economically strong countries like USA undergo a recession or depression phase of business cycle, this would affect most of the other countries. Countries suffering depression will have more unemployment and less income this will discourage imports form other countries, similarly in prosperity period encourages imports into this country, thus some countries may have a problem of deficit because other countries due to recession or depression do not demand goods and services. Thus Disequilibrium is the result of th3e effects of business cycle at home as well as in other countries. Cyclic period are short in nature. Measures are primarily detected to the control cycled changes, which in turn also help overcome Disequilibrium in the BoP 4. STRUCTURAL DISEQUILIBRIUM:- Structural Disequilibrium arises due to structural changes in economy affecting demand and supply relations in commodity and factor market. Exports of a country may decline if in the rest of the world demand is diverted to other commodities due to a change in taste, fashion habits or income. Demand for raw material may decline either due to technological changes, which reduces the raw material content, or discovery of substitute. Factor market may also undergo structural changes due to changes in the supply factors of production specially labour and capital. A    


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Email : [email protected] & [email protected] shortages or excess supply of these factors may change their prices and accordingly the commodity prices which turns affect the exports.

CAUSES OF DISEQUILIBRIUM  Import of essential goods and services: - Countries which do not have enough supply of essential of goods like food items or raw material (crude oil) or essential capital equipment are required to import them. Being essential items it is not possible to reduce their imports.  Development programmes:- Developing countries which have embarked upon planed development programmes require to import capital goods, some of the raw materials which are not available at home and highly skilled and specialised man-power. Some development is a continuous process, imports of these items continue for a long time landing these countries in a balance of payment deficit.  Population growth:- Population increases and like in India and china population is not only large but increases at faster rate. To meet their needs imports become essential and quantity of import may increase as population increases,  Demonstration effect: - an increase in income coupled with the awareness of the higher living standard of foreigners; induce people at home to imitate the foreigners. Such behaviour is termed “international demonstration effect.” When people become victims of demonstration effect. Their propensity to import increases.  Discovery of substitutes:- Technological and scientific improvements result in finding out new substitute. For example plastic for rubber, synthetics fibre for cotton etc. technological improvements also reduces the raw material requirement thus reducing the demand for raw material.  Low income elasticity of demand: - Disequilibrium is also caused by slow increase or a6t time a decrease in exports. It a country experiences a low-income elasticity of demand for its exports then the exports may nit increase. Most. Of the poor countries find that their primary exports have very low-income elasticity of demand.  Protectionist trade policy:- Though most developing countries advocate free trade they do not actually follow it in practice. Taking advantage of the existing international trade rules and regulations, they impose many restrictions mainly Non-Tariff Barriers (NIB) on their imports. NIB’s may take the form of place of origin quality requirement, social dumping etc., which restrict the exports of developing countries.  Cyclical transmission:-business cycles affect international trade. Recession or depression in one or more developed countries may affect the rest of the world, as it was the case during the 1930s depression. The negative effects or trade cycle i.e. low income, low demand etc. is transmitted form one country to another. Low demand for imports causes deficit in exporting countries.  Capital flight:- When restriction on the movement of capital are reduced or eliminated, there is a tendency among those who posses many capital many capital to transfer to those countries which give higher returns. If economic and political troubles are sensed then capital are the firs to rum away from that country. Speculation in a foreign exchange market may also result in capital flight as witnessed recently in some South East Asian countries. MEASURES TO CORRECT DISEQUILIBRIUM IN BALANCE OF PAYMENTS A temporary or short-run deficit balance of payments can be corrected through adjustment in capital account. Borrowing form the other countries, international institutions of commercial loans are the main sources, which help restore the balance in external sector. Borrowings are no solutions for Disequilibrium. It is chronic or persistent and continuous. Solutions for such a problems lie in earning more foreign exchange through additional exports or reducing imports. This quantitative changes requires policy changes which are in the corm of monetary and non-monetary measures Monetary measures: 1)deflation 2) devaluation 3) depreciation and 4) exchange controls Non-monetary measures: 1) tariffs 2) import quotas 3) export promotion and 4) import substitution.

MONETARY  Deflation :- deflation

refers to a continuous decline in general price level. A lower price level makes the goods and services cheaper to “A determination to succeed is the only way to succeed.” Page 28 of 31

Email : [email protected] & [email protected] foreigners, thus encouraging exports. At the same time it reduces income with people, which in the turn reduces their demand for imports. Thus under this monetary policy currency will contracts and thus there is fall in price will fall, discouraging exports and promoting imports. This policy is known as expenditure reducing policy. Thus success of deflation as a method to correct Disequilibrium depends on: a.Flexibility of income and prices: - both the variables income and prices should respond to the policy measures. Rigidity in prices will defeat the attempts of the govt. to introduce the deflationary state. b.Elastic demand for exports and imports: - A lower price level at home should encourage export. Similarly low income should discourage imports. If demand for exports and importers is inelastic, deflation will not succeed in correcting the Disequilibrium. c.Co- operation by other countries: - Other countries, which get affected by the deflationary or expenditure reducing policy, may react through appropriate policy measures to safeguard their exports. Retaliation by the affected countries reduces the effectiveness of deflation followed by the deficit country.  Devaluation or expenditure switching method aims at influencing the prices of only traded goods and not the general prices as in the case of deflation. Devaluation refers to official announcement or act of monetary authority through which the exchange rate is changed i.e. the value of domestic currency is reduced vis-à-vis foreign currency. For example- if the existing rate is rs.30=$1, the decision to devaluate currency by 50% will make the new exchange rate Rs.45=$1. Devaluation makes exports cheaper and imports costlier. In the post devolution period, exports are expected to increase as they become cheaper to foreigners and imports to decrease, as they are costlier in terms of domestic currency. Deficit in balance of payments is expected to be corrected due to increased exports and reduced imports.  Depreciation: - depreciation means to depreciate the external value of home currency or increase the foreign currency. Depreciation of a currency takes place in free or competitive foreign exchange market due to market forces. An existing exchange rate, say Rs. 35=$ 1 may depreciate to Rs. 35.50 anything more than Rs. 35 per dollar. Devaluation and depreciation have the same effect on the exchange rate though the former takes place under the fixed exchange rate. Devaluation usually is of larger extent than depreciation. The monetary authorities decide the extent and time of devaluation whereas depreciation is primarily decided by demand for and supply of foreign exchange in the market. Both measures make exports cheaper and imports costlier.

CONDITIONS FOR THE SUCCESSFUL WORKING OF DEVALUATION AND DEPRECIATION

§

§

§

Elasticity of demand for export: - as we know, demand is elastic if change in demand is more than change in price. In this case if the currency is devaluated by 10%, the exports must increase by more than 10%. If the elasticity of demand for exports is equal to one or less, than a change in the exchange rate will not help reduce the deficits in the balance of payments. Elasticity of demand for imports: - One of the requirements for correcting Disequilibrium in the balance of payment is to reduce imports. The above mentioned in the balance of payment is to reduce imports. The above-mentioned measures make our imports costlier and accordingly it is expected that demand must be greater than one. Marshall and Lerner, the two economists who hand made an in-depth study of exports and imports elasticises concluded that for devaluation to be successful the sum total of exports and imports demand elasticises must be greater than one. Elasticity of supply for exports: - It the demand for exports increases the country whose exchange rate has changed must be in a position to increase the supply of exports goods to meet the increased demand. It is possible to do so only if the supply of exports is elastic. Supply elasticity depends upon the availability of inputs or the capability to transfer factors of production forms one industry to another. In may developing countries, insufficient supply of infrastructure facilities checks the capacity of the economy to increase the supply of exportable goods?


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§

Elasticity of supply of import: - When devaluation (depreciation) takes place, the countries; especially the major supplier of imports must be in a position to adjust the supply of their exports. If a country is in a position to adjust its exports (domestic countries) as per the reduced demand, then supply is considered elastic. It its inelastic if the trading partners find the devaluing country as a major market and if they find ways and means in selling the same or earlier quantity to absorb the reduced exports or it is not possible to divert the factors employed in export industries. § Co-operation by other countries: - When exports become cheap due to devaluation or deprecation the competing countries whose currencies have remained stable, find their exports suffer. To be competitive in the world market they too are compelled to devalue their currencies. Competitive devaluation will wipe out all the advantages enjoyed by the country, which devalued its currency initially. It is therefore essential to saucer cooperation by other countries, which is rather difficult. § Control of domestic price level:-a devaluation or depreciation by itself does not affect the domestic price level. However imports in the form of consumer goods or inputs for further production having turned costlier affect the domestic price level. Increased exports also bring in more foreign exchanged which in turn may increase domestic money supply resulting in an increase in domestic price level. Government and monetary authorities are expected to adopt fiscal and monetary measures to control the domestic price line. Failure on this ground will offset all the gains of devaluation. Countries which have failed to check the price line after the devaluation (depreciation) have landed in a series of devaluation. Thus, putting their economies in a serious financial problem.  Exchange Control: -Deficit in the BoP is a result of demand for foreign exchange exceeding its supply. Therefore, one of the methods adopted by the govt. Or monetary foreign exchange earners are expected to surrender the foreign exchange earned to the govt. against the domestic currency. Importers who are permitted by the govt. to import goods and services will receive foreign exchange form the govt. the amount of foreign exchange allotted to various importers is determined by the govt. depending on the importance of goods or services imported.

NON - MONETARY MEASURES A deficit country along with the monetary measurer may adopt the following non-monetary measures too, which will either restrict imports or promote exports.



TARIFFS: - Tariffs are the duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports would increase to the extent of tariffs. The increased price will reduce the demand for imported goods same time induce domestic producers to produce more of import substitutes. Non.-Essential imports can be drastically reduced by imposing a very high rate of tariffs.

A)

LIMIATIONS:-

 Inelastic demand for imports: - Tariffs may not be effective if demand is inelastic. People would prefer imported goods even at a higher price.  RETALIATION:- Other counties affected by the tariffs may retaliate. A tariff imposing country’s export will suffer.  CORRUPTION:- Tariffs to be successful, require an efficient and honest administration which unfortunately is difficult to have in most of the countries. Corruption among the administration staff will render tariffs ineffective.  NOT A PERMANENT SOLUTION :- Presently, under W.T.O. the trend is to reduce tariff to the minimum in order to encourage liberal trade, therefore, countries will not be in position to use tariffs as a long-term or permanent solution. Moreover tariffs do not tackle the root cause of the problem. It provides a temporary reprieve.



QUOTAS: To reduce imports for correcting the deficit in the balance of payments, the govt. may; introduce restrictions on the quantity or volume of goods imported. Quotas may be of different types:“A determination to succeed is the only way to succeed.”

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 The tariffs or custom quota  The unilateral quota

 The bilateral quota, and  Import licensing


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Macro Economics Notes

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