1 Module 1 Introduction Unit Structure : 1.0 Objectives 1.1 Distinction between Microeconomics and Macroeconomics 1.2 Circular flow of Economic activities 1.3 Gross National Product (GNP) 1.4 Net National Product (NNP) 1.5 Personal Income 1.6 Disposable Income 1.7 Summary 1.8 Questions 1.0 OBJECTIVES 1. To study the distinction between Microeconomics and Macroeconomics 2. To study the Circular Flow of Economic Activities 3. To understand the concept of Gross National Product (GNP) 4. To understand the concept of Net National Product (NNP) 5. To understand the concept of Personal Income 6. To understand the concept of Disposable income 1.1 DISTINCTION BETWEEN MICROECONOMICS AND MACROECONOMICS 1.1.1 Meaning :- Microeconomics studies economic behaviour of individual economic entities and individual economic variables. The economic entities may be individuals or small group of individuals. It is the study of individual economic units such as individual firms and households, individual prices, wages, income, individual industries and individual commodities. Macroeconomics is concerned with the nature, relationships and behaviour of such aggregate quantities and averages as national income, total consumption, savings and investment, total employment, general price level, aggregate expenditure and aggregate supply of goods and services. As macroeconomics deals with aggregate quantities of the economy as a whole, it is also called as aggregative economics. 1.1.2 Subject matter :- Microeconomics seeks to explain how an individual consumer
Transcript
1 Module 1
Introduction Unit Structure : 1.0 Objectives 1.1 Distinction between Microeconomics and Macroeconomics 1.2 Circular flow of Economic activities 1.3 Gross National Product (GNP) 1.4 Net National Product (NNP) 1.5 Personal Income 1.6 Disposable Income 1.7 Summary 1.8 Questions
1.0 OBJECTIVES
1. To study the distinction between Microeconomics and Macroeconomics
2. To study the Circular Flow of Economic Activities 3. To understand the concept of Gross National Product (GNP) 4. To understand the concept of Net National Product (NNP) 5. To understand the concept of Personal Income 6. To understand the concept of Disposable income
1.1 DISTINCTION BETWEEN MICROECONOMICS AND MACROECONOMICS
1.1.1 Meaning :- Microeconomics studies economic behaviour of individual economic entities and individual economic variables. The economic entities may be individuals or small group of individuals. It is the study of individual economic units such as individual firms and households, individual prices, wages, income, individual industries and individual commodities. Macroeconomics is concerned with the nature, relationships and behaviour of such aggregate quantities and averages as national income, total consumption, savings and investment, total employment, general price level, aggregate expenditure and aggregate supply of goods and services. As macroeconomics deals with aggregate quantities of the economy as a whole, it is also called as aggregative economics. 1.1.2 Subject matter :- Microeconomics seeks to explain how an individual consumer
2
distributes his disposable income among various goods and services. How he attains the level of maximum satisfaction and how he reaches the point of equilibrium. Microeconomics is also concerned with how individual firms decide `what to produce‘, `how to produce‘, and `at what cost to produce‘ to minimise the cost of production. To be specific, theory of consumer‘s behaviour, theory of firms or theory of production, theory of product pricing, theory of factor pricing ( or distribution theory )and the theory of economic welfare constitute the body of microeconomics. Theories of National Income, consumption, saving and investment, theory of employment, theories of economic growth, business cycles and stabilization policies, theories of money supply and demand and theory of foreign trade broadly constitute the subject matter of macroeconomics. Macroeconomic theories seek to answer questions such as how is the level of National Income of a country determined? What determines the levels of overall economic activities in a country? What determines the level of total employment? How is the general level of price determined? etc. 1.1.3 Uses :- Microeconomic theory explain the behaviour of various individual elements and bring out the nature of interrelationship and interdependence between them. Microeconomic theories contribute a great deal in formulating the economic policies and can also be applied to examine the appropriateness of economic policies. One of the most important uses of microeconomic theories is to provide basis for formulating propositions that maximise social welfare. It also suggests ways and means to correct mal-allocation of resources and to eliminate efficiency. The main justification for macroeconomics lies in the need for generalising the behaviour of and relationships between economic aggregates. To study the system as a whole and to explain the behaviour of aggregate quantities and the relationship between them is extremely difficult. Macroeconomic approach has made it possible. It ignores the details pertaining to the individual economic agents and quantities and compresses the unmanageable economic facts to a manageable size and makes them capable of interpretation. Macroeconomic theories are used in formulating public policies. They provide clarity to the macroeconomic concepts and quantities and bring out the relationship between macro variables of the economy in the form of models or equations. 1.1.4 Limitations :- Microeconomic theories assume a given level of National Income, employment, saving and investment. In reality, these factors are subject to change with the change in their determinants. Secondly, microeconomic theories assume the existence of a free enterprise economy i.e. absence of any government intervention. However
3
government controls and regulations of economic activities are the rules of the day. Thirdly, another limitation of microeconomics that it is concerned with the behaviour of individual elements of the economic organism and not with the organism as a whole. Microeconomic theories, therefore, cannot be applied to study the complex economic system treated as one unit. Study of macroeconomics is limited to only aggregates. It cannot be applied to explain the behaviour of individual components of the economic system and the individual quantities. Secondly, it ignores the structural changes in constituent elements of the aggregate. Hence conclusions drawn from the analysis of aggregates may involve error of judgement and may be misleading.
1.2 CIRCULAR FLOW OF ECONOMIC ACTIVITIES An economy can be defined as an integrated system of production, exchange and consumption. In carrying out these economic activities, people are involved in making transactions- they buy and sell goods and services. Economic transactions generate two kinds of flows :
i) Real flow i.e. the flow of goods and services, and ii) Money flow.
Real and Money flows go in opposite direction in a circular fashion. The goods flow consists of (a) factor flow, i.e., flow of factor services, and (b) product flow, i.e., flow of goods and services. In a monetized economy, the flow of factor services generates money flows in the form of factor payments which take the form of income flows. The factor payments and expenditure on consumer goods and services take the form of expenditure flows. Both income and expenditure flow in a circular fashion in opposite direction. The magnitude of these flows determines the size of national income. To present the flows of income and expenditure, the economy is divided into four sectors i.e. household sector, business sector, the firms, government sector and foreign sector. These are combined to make the following three models for the purpose of showing the circular flows. i) Two sector model including the household and business
sectors; ii) Three sector model including the household, business and
government sectors iii) Four sector model including the household, business,
government and the foreign sectors. 1.2.1 Circular flows of income and expenditure in a two sector
model :- The two sector model consists of only household and firm sectors
4
representing a private closed economy in which there is no government and no foreign trade. It is therefore unrealistic but provides a starting point to analyze the circular flows. The households are assumed to possess certain specific features : - the households are the owners of all factors of production - their total income consists of wages, rent, interest and profits -they are the consumer of all the consumer goods and services -they save a part of their income and supply finance to the firms. The business firms are assumed to have the following features and functions : -they own no resources of their own -they hire and use the factors of production from the households -they produce and sell goods and services to the households -they do not save, i.e. there is no corporate saving. The working of a Two sector economy and the circular flows of incomes and expenditure are illustrated in the following figure.
The Circular flows in a Two sector model
Figure 1.1
There are two sectors i.e. households and firms. They divide the diagram in two parts. The upper half represents the factor market and the lower half represents the commodity market. Both the markets generate two kinds of flows- real and money flows. In the factor market, factors of production flows from households to firms. This makes the real flow shown by a continuous arrow. There is another real flow of factor incomes (wages, interest, rent and profits) which flows from firms to households. In the commodity market (lower half) the goods and services produced by the firms flow from the firms to the households. The
5
payment made by the households for the goods and services creates money flow. By combining the goods and money flows we get a circular flow. In reality, there are leakages from and additions to the circular flows of income and expenditure. They are also called as withdrawals and injections. A withdrawal is the amount that is set aside by the households and firms and is not spent on the domestically produced goods and services over a period of time. On the other hand, an injection is the amount that is spent by households and firms in addition to their incomes generated within the regular economy. The Two sector model with savings :- Household do save a part of their income for investment. The financial sector is constituted of a large variety of institutions involved in collecting household savings and passing it on to the business sector. The financial sector includes only banks and financial intermediaries like insurance companies, industrial finance corporations, which accept deposits from the households and invest it in the business sector in the form of loans and advances. It is explained in the following figure.
The Circular flows in a Two sector model with the Financial sector
Figure 1.2
With the inclusion of the financial sector, the households incomes (Y) is divided into two parts : consumption expenditure and savings (S). As shown in the following figure, C and S take different routes to reach the business sector. The consumption expenditure (C) flows directly to the firms, whereas savings (S) are routed through the financial sector as the banks and FIs use the deposits to buy shares and debentures of the firms which is investment (I). In the final analysis the entire money income generated by the firms flows back to the firms which flows back again to the households as factor payments.
6
1.2.2 Circular flows of income and expenditure with government : A Three sector model :-
It depicts a more realistic economy. It includes the government which plays an important role in the economy. The economic role of the government has increased tremendously during the post War II period. Here we will include only three fiscal variables to the circular flows, viz. direct taxes, government spending on goods and services and transfer payments. These variables have different kinds of effects on the income and expenditure flows. As seen in the figure below, a part of the household income is claimed by the government in the form of direct taxes. Similarly, a part of the firm‘s income is taxed away in the form of corporate income tax. The firms pass on to the government the indirect taxes also which is collected from the households. The government spends a part of its tax revenue on wages, salaries and transfer payments to the households and a part of it on purchases from the firms and payments of subsidies. Thus, the money that flows from the households and the firms to the government in the form of taxes, flows back to these sectors in the form of government expenditure.
The Circular flows of income in a Three sector model
Figure 1.3
1.2.3 Circular flows in a Four sector model : Model with the foreign sector :-
The Four sector model is formed by adding foreign sector to the three sector model. It consists of two kinds of international transactions : foreign trade i.e. exports and imports of goods and services and inflow and outflow of capital. For simplicity we make following assumptions : -the external sector consists only of exports and imports of goods and services -the export and import of goods and non-labour services are made
7
only by the firms -the households export only labour The circular flow is explained in the following figure
The Circular flows of income in a Three sector model
Figure 1.4
The lower part is the circular flows of money in respect of foreign trade. Exports (X) make goods and services flow out of the country and make money (foreign exchange) flow into the country in the form of receipts from export. This is in fact, flow of foreign incomes into the economy. Exports (X) represent injections into the economy. Similarly, imports (M) make inflow of goods and services and flow of money (foreign exchange) out of the country. This is flow of expenditure out of the economy. Imports (M) represent withdrawals from the circular flows. So far as the effect of foreign trade on the magnitude of the overall circular flows is concerned, it depends on the trade balance i.e. X-M. If X > M, it means inflow of foreign income is greater than the outflow of income, or there is a net gain from foreign trade. The net gain increases the magnitude of circular flows of income and expenditure. If X < M it decreases the magnitude of circular flows. Check Your Progress :
1. State whether the following statements are True or false : a) Microeconomics deals with aggregates. b) Macroeconomics is a study of whole economic system. c) In reality Two sector model is use to explain the circular
flow of economic activities. d) Foreign trade is included to represent a Four sector
Introduction of the concepts of National Income Aggregates :
1.3 GROSS NATIONAL PRODUCT (GNP): GNP is the total market value of all final goods and services produced in a year plus net income from abroad. This is the basic social accounting measure of the total output or aggregate supply of goods and services. GNP includes four type of final goods and services. First, consumers goods and services to satisfy, the immediate needs and wants of the people Second, gross private domestic investment. Third, goods and services produced by government and four, net income from abroad i.e. net export of goods and services GNP is the total amount of current production of final goods and services There are two things which have to be noted in regard to gross national product Firstly, it measures the market value of annual output or it is a monetary measure This enables the process of adding up the different types of goods and services produced in a year. However, for accuracy, the figure for GNP is adjusted for price changes Secondly, for calculating gross national product accurately, all goods and services produced in any given year must be counted only once. GNP includes only the market value of final goods and ignores transactions involving intermediate goods. Final goods are those goods, which are being purchased for final use and not for further processing. The inclusion of intermediate goods will involve double counting. This will give us an inflated figure of the national product. In national income accounting, GNP is calculated both at market prices and factor cost. In order to calculate GNP at market prices, the outputs of all final goods and services are valued at market price and the values thus obtained are added. The market price of a good includes indirect taxes such as the sales tax and excise tax. Thus it is greater than the price received by the seller. Sometimes, the government may grant subsidy on a product. In this case, the market price would be less than the price received by the seller GNP at factor cost eliminates the influences of indirect taxes and subsidies. It provides an estimate of the total value of the final goods and services produced during a year at cost of production.
9
GNP at factor cost is obtained by subtracting net indirect taxes from GNP at market prices. GNP at Factor cost = GNP at market price - Net indirect taxes = GNP at market prices - (Total indirect taxes - Subsidies)
National income is usually calculated by 3 methods (a) The product method. (b) The income method (c) The expenditure method . In the product method, GNP is the value added by the various industries and activities of the economy in a particular year. In the income method, we add up the income earned by the owners of factors of products in a particular year. This gives the gross national income (GNI). In the expenditure method; we add up the final expenditure of all residents in a country. All the three different ways of looking at one and the same thing.
1.4 GROSS DOMESTIC PRODUCT (GDP): GDP refers to the value of final goods and services produced within the country in a, particular year. GDP is different from GNP. A part of GNP may be produced outside the country For example the money earned by the lndians working in USA is a part of India's GNP But it is not a part of GDP since they are earned abroad. Therefore the boundaries of GNP are determined by the citizens of a country whereas the boundaries of GDP are determined by the geographical limits of a country. It is also clear that the difference between GDP and GNP is due to the "net revenue from abroad." If the citizens of a country are earning more from abroad than foreigners are earning in that country, GNP exceeds GDP If the foreigners in the country are earning more than its citizens are earning abroad, GNP is less than GDP 1.4.1 Net National Product :- This is a very important concept of national income. In the production of gross national product, during a year, some capital is used up or consumed i.e. equipment, machinery etc. the capital goods wear out or undergo depreciation. Capital goods fall in value due to its use in production process. By deducting the charges for depreciation from the gross national product, we get the net national product. It means the market value of all the final goods and services after providing for depreciation. It is called national income at market prices. In other words, net national product is the total value of final goods and services produced in the country during a year after deducting the depreciation, plus net income from abroad.
1.4.2 Net Domestic Products:- NDP is obtained by subtracting the depreciation from the GDP. NDP differs from MNP due to the net income from abroad. If the net
10
income from abroad is positive, NDP will be less than NNP If the net income from abroad is negative, NDP will be greater than NNP NDP is also calculated either at market price or at factor cost. National Income at Factor Cost:- means sum total of all income earned by resource suppliers for their contribution of land, labour, capital and entrepreneurial ability which go into the years net production. National income at factor cost shows how much it costs society In terms of economic resources to produce the net output. We use the term national income for the national income at factor prices. National Income at factor cost = Net national product ( National Income at market prices) - (indirect taxes +Subsidies)
1.5 PERSONAL INCOME Personal income is the sum of the income actually received by individuals or households during a given year. Personal incomes earned are different from national income. Some incomes which are earned such as social security contributions corporate income taxes and undistributed corporate profits are not actually received by households In the same manner, some incomes which are received like transfer payments are not currently earned ex Old age pension, unemployment compensation, relief payments interest payments etc. To get personal income from national we must subtract from National income the three types of incomes which are earned but not received and add incomes that are not currently earned , Personal income = N.I - Social Security - contributions - corporate income taxes -undistributed corporate profit + Transfer Payments
1.6 DISPOSABLE INCOME The personal income which remains after payment of taxes to the government in the form of income tax, personal property tax etc., is called disposable income. Disposable income = Personal Income - Personal Taxes. An individual can decide to consume or save the disposable income as he wishes. Check Your Progress :
1. Generally three methods are use to calculate national Income-Explain.
1.7 SUMMARY 1. Microeconomics studies economic behaviour of individual
economic entities and individual economic variables. Macroeconomics deals with aggregate quantities of the
economy as a whole, it is also called as aggregative economics.
2. There are three models which explain the circular flows. a) Two sector model including the household and business
sectors; b) Three sector model including the household, business and
government sectors c) Four sector model including the household, business,
government and the foreign sectors. 3. GNP is the total market value of all final goods and services
produced in a year plus the net income from abroad. GNP at factor cost = GNP at market Prices - Net indirect taxes - subsidy.
4. Net National Product:- is the total value of final goods and services produced in the country "during a year after deducting the depreciation, plus net income from abroad.
5. National Income at Factor Cost:- means the sum total of all incomes earned by the resource suppliers for their contribution of land, labour, capital and entrepreneurial ability which go into the years net production.
National income at factor prices = [Net National Product (National Income at market prices) - Indirect taxes + subsidies] 6. Personal Income .- is the sum of all income actually received by
individuals or households during a given year. Personal Income = National Income - Social Securities Contributions - corporate income taxes - undistributed
corporate profit + Transfer Payment
1.7 QUESTIONS
1. Discuss in detail the difference between Microeconomics and Macroeconomics.
2. Explain the Circular Flow of various economic activities. 3. Explain the concepts of a) GNP b) NNP c) GDP d) Disposable income.
12
2
NATIONAL INCOME and PRICE INDICES Unit Structure : 2.0 Objectives 2.1 Methods of measurement of National Income 2.2 Net output or Value Added Method 2.3 Factor-income method 2.4 Expenditure method 2.5 Measurement of national income in India 2.6 Price Indices 2.7 Stages in the construction of Index numbers 2.8 Laspeyre‘s price Index or Base Weighted Price Index 2.9 Paashe‘s current weighted price index 2.10 Difficulties in construction of Index number 2.11 Use of index numbers 2.12 Summary 2.13 Questions
2.0 OBJECTIVES 1. To study various measures of measurement of national
income 2. To study Net output method 3. To study Factor income method 4. To study Expenditure method 5. To understand the measurement of national income in India 6. To study the concept of price indices 7. To study the various stages in the construction of index
numbers 8. To study Laspeyer‘s price index 9. To study Paashe‘s current weighted price index 10. To understand the difficulties in construction of index numbers 11. To understand the uses of index numbers
2.1 METHODS OF MEASUREMENT OF NATIONAL INCOME
For measuring national income, the economy through which people participate in economic activities, earn their livelihood, produce goods and services and share the national products is viewed from three different angles :
1. The national economy is considered as an aggregate of producing units combining different sectors such as agriculture, mining, manufacturing, trade and commerce, etc.
13
2. The whole national economy is viewed as a combination of individuals and households owing different kinds of factors of production which they use themselves or sell factor services to make their livelihood.
3. The national economy may also be viewed as a collection of consuming, saving and investing units (individuals, households and government).
National income may be measured by three different corresponding methods :
A) Net product method B) Factor-income method C) Expenditure method
2.2 NET OUTPUT OR VALUE ADDED METHOD : It is also called the Value Added Method. It consists of three stages : i) estimating the gross value of domestic output in the various branches of production; ii) determining the cost of material and services used and also the depreciation of physical assets; iii) deducting these costs and depreciation from gross value to obtain the net value of domestic output. Measuring gross value : For measuring the gross value of domestic product, output is classified under various categories and it is computed in two alternative ways : i) by multiplying the output of each category of sector by their respective market price and adding them together, or ii) by collective data about the gross sales and changes in inventories from the account of the manufacturing enterprises and computing the value of GDP on the basis thereof. If there are gaps in data, some estimates are made thereof and gaps are filled. Estimating cost of production : is, however a relatively more complicated and difficult task because of non-availability of adequate and requisite data. Countries adopting net-product method find some ways and means to calculate the deductible cost. The costs are estimated either in absolute terms or as an overall ratio of input to the total output. The general practice in estimating depreciation is to follow the usual business practice of depreciation accounting. Following a suitable method, deductible costs including depreciation are estimated for each sector. The cost estimates are then deducted from the sectoral gross output to obtain the net sectoral products. The net sectoral products are then added together. The total thus obtained is taken to be the measure of net national products or national income by net product method.
14
2.3 FACTOR - INCOME METHOD :
This method is also known as income method and factor-income method. Under this method, the national income is calculated by adding up all the ―incomes accruing to the basic factors of production used in producing the national product‖. The total factor-incomes are grouped under three categories : i) Labour incomes : included in the national income have three components : a) wages and salaries paid to the residents of the country including bonus and commission and social security payments; b) supplementary labour incomes including employer‘s contribution to social security and employer‘s welfare funds and direct pension payments to retired employees; c) supplementary labour incomes in kind, e.g. free health and education, food and clothing, and accommodation, etc. Compensations in kind in the form of domestic servants and other free-of-cost services provided to the employees are included in labour income. War bonuses, pensions, service grants, are not included in labour income as they are regarded as transfer payments. Certain other categories of income, e.g., incomes from incidental jobs, gratuities, tips etc., are ignored for lack of data. ii) Capital incomes : According to Studenski, capital incomes
include the following capital earnings a) Dividends excluding inter-corporate dividends; b) Undistributed before-tax profits of corporations; c) Interest on bonds, mortgages, and savings deposits
(excluding interests on war bonds, and on consumer-credit) d) Interest earned by insurance companies and credited to the
insurance policy reserves; e) Net interest paid out by commercial banks; f) Net rents from land, building, etc., including imputed net rents
on owner-occupied dwellings; g) Royalties; h) Profits of government enterprises.
iii) Mixed income : include earnings from a) Farming enterprises; b) Sole proprietorship (not included under profit or capital
income) c) Other professions, e.g., legal and medical practices,
consultancy services, trading and transporting etc. This category also includes the incomes of those who earn their living through various sources as wages, rent on own property, interest on own capital, etc.
All these three kinds of incomes added together give the measure of national income by factor income method.
15
2.4 EXPENDITURE METHOD Also known as final product method, measures national income at the final expenditure stages. In estimating the total national expenditure, any of the two following methods are followed ; First, all the money expenditures at market price are computed and added up together, and Second, the value of all the products finally disposed of are computed and added up, to arrive at the total national expenditure. The items of expenditure which are taken into account under the first method are
a) Private consumption expenditure; b) Direct tax payments; c) Payments to the non-profit making institutions and
charitable organizations like schools, hospitals, orphanages, etc.
d) Private savings.
Under the second method, the following items are considered a) Private consumer goods and services; b) Private investment goods; c) Public goods and services; d) Net investment abroad.
The second method is more extensively used because the data required in this method can be collected with greater ease and accuracy. Treatment of Net Income from Abroad : Nowadays, most economies are open in the sense that they carry out foreign trade in goods and services and financial transactions with the rest of the world. In the process, some nations get net income through foreign trade while some lose their income to foreigners. The net earnings or loss in foreign trade affects the national income. In measuring the national income, therefore, the net result of external transactions are adjusted to the total. Net incomes from abroad are added to, and net losses to the foreigners are deducted from the total national income arrived at through any of the above three methods. Briefly speaking, all exports of merchandise and of services like shipping, insurance, banking, tourism and gifts are added to the national income. And all the imports of the corresponding items are deducted from the value of national output to arrive at the approximate measure of national income. To this is added the net income from foreign investment. These adjustments for international transactions are based on the international balance of payments of the nations.
16
2.5 MEASUREMENT OF NATIONAL INCOME IN INDIA :
In India, a systematic measurement of national income was first attempted in 1949. Earlier, many attempts were made by some individuals and institutions. The earliest estimate of India‘s national income was made by Dadabhai Naoroji in 1867-68. Since then many attempts were made, mostly by economists and the government authorities, to estimate India‘s national income. These estimates differ in coverage, concepts and methodology and are not comparable. Besides, earlier estimates were mostly for one year, only some estimates covered a period of 3 to 4 years. It was therefore not possible to construct a consistent series of national income and assess the performance of the economy over a period of time. In 1949, a National Income Committee (NIC) was appointed with P.C.Mahalnobis as its Chairman, and Dr. D.R. Gadgil and V.K.R.V. Rao as members. The NIC not only highlighted the limitations of the statistical system of that time but also suggested ways and means to improve data collection systems. On the recommendation of the Committee, the Directorate of National Sample Survey was set up to collect additional data required for estimating national income. Besides, the NIC estimated the country‘s national income for the period from 1948-49 to 1950-52. In its estimates, the NIC also provided the methodology for estimating national income, which was followed till 1967. In 1967, the task of estimating national income was given to the Central statistical Organization (CSO). Till 1967, the CSO had followed the methodology laid down by the NIC. Thereafter, the CSO adopted a relatively improved methodology and procedure which had become possible due to increased availability of data. The improvements pertain mainly to the industrial classification of the activities. The CSO publishes its estimates in its publication, Estimates of National Income. Methodology :- Currently, output and income methods are used by the CSO to estimate the national income of the country. The output method is used for agriculture and manufacturing sectors, i.e., the commodity producing sectors. For these sectors, the value added method is adopted. Income method is used for the service sectors including trade, commerce, transport and government services. In its conventional series of national income statistics from 1950-51to 1966-67, the CSO had categorized the income in 13 sectors. But, in the revised series, it had adopted the following 15 break ups of the national economy for estimating the national income;
i) Agriculture;
17
ii) Forestry and logging; iii) Fishing; iv) Mining and quarrying; v) Large-scale manufacturing; vi) Small-scale manufacturing; vii) Construction; viii) Electricity, gas and water supply; ix) Transport and communication; x) Real estate and dwellings; xi) Public administration and Defense; xii) Other services; xiii) External transactions.
National Income is estimated at both constant and current prices.
Check Your Progress : 1. Write notes on the following : a) Net output method b) Factor income method c) Expenditure method
2.6 PRICE INDICES Macro economic analysis deals with the study and comparison of aggregate economic variables A mathematical or statistical device which helps us to determine the average changes of these economic changes is needed Economists are interested in knowing the changes taking place in the value of money over a period of time. The value of money depends on the level of prices. There is an inverse relationship between the two. In business economics we have to study the comparative changes in the price. The quantity consumed and the expenditure concerning a commodity or group of commodities over a period of time Statistics provide us a tool to Measure these changes known as index numbers Index numbers are a specialized averages designed to measure change in a group of related variables over a period of time. Suppose the index of prices in 2000 is 150, compared to 1998, it means that the prices have risen by 50 over the period under consideration. Here 1998 is the base year and 2000 is the current year. Index numbers help us to measure the changes in the wholesale prices and cost of living.
18
Index numbers are also used to measure the changes in industrial production, agricultural production etc.
2.7 STAGES IN THE CONSTRUCTION OF INDEX NUMBER
1 The first step is to decide the purpose" for which the index
number is to be constructed. Suppose we want to construct the Cost of Living Index Number.
2 We have to choose the commodity for this purpose. Those
commodities, which enter into day-to-day consumption, must be selected.
3. The next step is to consider the prices of these commodities.
The selected price must represent a large volume of transaction and variation.
4 The selection of the base year should be done carefully. It
should be a normal year without fluctuations and should be close to the current year as far as possible.
5 The next step is the tabulation of the commodities and their
respective prices in the base year and current year express them as a percentage and calculate their average.
6. The difference between the average base year price and the
current year price will show the change in prices and hence the value of money.
There are broadly 2 types of index numbers - 1 Simple Index Numbers 2 Weighted Index Numbers Table 2.1 Simple Index Number
It is clear from the above simple index number that the prices between the two years have increased by 3 X 2/10 times. The value of money has decreased to the same extent. To get a reliable picture of the changes in the value of money, simple index number is not sufficient. Weight to different commodities should be assigned on the basis of their importance in the consumption pattern. Let us take two commodities, rice and cigarettes. Let us assume that rice is 10 times more important than cigarettes. By attaching weight one (1) to cigarettes, and 10 to rice, we will multiply the price of rice by 10 and that of cigarettes by 1. Table 2.2 Weighted Index Numbers Commo- dites
Prices in the Base Year
Weight
Index with Weight
Prices in Current year
Weight
Index with Weight
Rice 100 9 900 175 9 1700
Cigarettes 100 1 100 100 1 100
10000 -------- = 100 10
1800 ------- = 180 10
We get a more realistic picture of the change of cost of living and the value of money
2.8 LASPEYRE'S PRICE INDEX OR BASE WEIGHTED PRICE INDEX
This compares the current and base year cost of a basket of goods of fixed composition Suppose the base year quantities of various goods are denoted by qc' and the base year prices by
0qPO the cost of the basket of goods in the base year is 0qPO
The cost of the current basket of the same quantity at current prices
P,' will be 0qPO The ratio of current cost to base years cost gives
the consumer price index.
0qPO
Consumers price Index = ——--—-x100
0qPO
This is known as Laspeyre's price index.
2.9 PAASHE'S CURRENT-'WEIGHTED PRICE INDEX: In this the weights of the current period are used. Formula is given as :-
20
10000
110 x
qP
qPP
2.10 DIFFICULTIES IN THE CONSTRUCTION OF INDEX NUMBERS:-
1 Changes in the general level of prices form the basis for
measuring the changes in the value of money. The concept of the general price level is not very clear.
2. Change in the general price level does not reflect the price of
each and every commodity. All prices do* not change at the same rate. ,
3. It is difficult to select commodities since the pattern of
consumption is not uniform. 4 There are practical difficulties in assessing weights on the
basis of their importance in consumption. 5 Base year is selected arbitrarily.
2.11 USE OF INDEX NUMBERS 1 index numbers help in measuring the changes in the value of
money over a period of time 2 The Cost of living Index Number helps in studying and
comparing the changes in the real wages of the workers. 3 The index number enables us to compare the living conditions
of different people at different times and helps in comparison. 4 Index numbers help to measure the purchasing power of
currency of different countries and helps the government to determine the rate of exchange between the different countries.
5 Index numbers help in formulating suitable monetary policy
The government can devise monetary policy on the basis of changes in the price level of commodities.
Check Your Progress :
1. What do you mean by Index Numbers? 2. Distinguish between Simple index numbers and Weighted
index numbers. 3. What are the difficulties in the construction of Index
2.12 SUMMARY 1. National income may be measured by three different
corresponding methods : Net product method, Factor-income method and Expenditure method.
2. Measurement of National Income in India : The earliest estimate of India‘s national income was made by Dadabhai Naoroji in 1867-68.
In 1949, A National Income Committee (NIC) was appointed. In 1967, the task of estimating national income was given to the Central statistical Organization (CSO).
3. Price indices:- Index numbers are useful and convenient to get a complete picture of the economic situation in a country. It helps us to compare the price change over a period of time.
4. Weighted index numbers are useful to show the relative importance of commodities in question. The weights reflect the purpose for which the index is constructed.
5. Retail price index is an index of the prices of goods purchased by a typical householder. It is used to measure the changes in the cost of living.
2.13 QUESTIONS 1. Describe the various methods of measuring national income. 2. Distinguish between net-product method and factor-income
method. 3. How is foreign income treated in national income estimates? 4. What is value-added? Explain the value-added method of
estimating national income. 5. What are price indices? Explain the construction of an index
number with the help of examples. 6. What are weighted index numbers? 7. What is a retail price index? Explain its importance.
22
3
Module 2
CLASSICAL THEORY OF INCOME AND EMPLOYMENT
Unit structure : 3.0 Objectives 3.1 Introduction of the Classical Theory of Income and
Employment 3.2 Say‘s Law of market 3.3 Introduction of the Keynesian Theory of Income and
Employment 3.4 Keynes Principle of Effective Demand 3.5 Consumption Function 3.6 Summary 3.7 Questions
3.0 OBJECTIVES 1. To study the Classical theory of Income and Employment 2. To study the Say‘s Law of market 3. To study the Keynesian Theory of Income and employment 4. To study the Keynesian Principle of Effective Demand 5. To study the concept of Consumption function 6. To study the Multiplier Theory
3.1 INTRODUCTION OF THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT :
The study of classical theory of income and employment is essential because some of the aspects of classical theory are more relevant to the conditions prevailing in the developing countries. Classical theory highlights those factors, which govern income and employment in these countries. In fact Keynesian macro economic model is not able to explain the conditions of unemployment and underemployment in less developed countries. Hence it cannot explain the determination of income and employment in such countries. Hence it is necessary to study the classical theory
23
The classical theory of employment is a supply-oriented theory. It is the product of an accumulation and refinement of ideas developed by the 18lh and 19'" century economists. The classical economists were basically concerned with the long run problem of growth of the economy's production capacity and efficient allocation of the given resources at full employment. The classical economists focused their attention more on the supply side and demand side was neglected while discussing the growth process. According to Adam Smith, Ricardo, Say, Mill and followers of classical thought, except Malthus believed that there is no problem on the demand side as the aggregate demand would always take care of itself. Hence the main problem is that of supply rather than demand. According to the classical economists if prices and wage rates were flexible, there would be a built in tendency for the economy to operate at full employment. As a result they ignored the problems of unemployment. The classical economists focused on the following problems:- 1 The different types of goods and services that would be
produced in the economy 2. The allocation of productive resources among the competing
firms and industries. The classical economists tried to find out the conditions leading to the most efficient use and optimum allocation of the given resources.
3 The relative price structure of different goods and factors 4 The distribution of real income among the productive factors.
The main postulates of the classical theory of employment are the following.
1. Long term analysis 2 Full employment 3. Say's law of markets 4 interest Rate and Flexibility 5. Wage rate and Flexibility 3.1.1 The Assumption of Full Employment:- The classical economists believed in the prevalence of a stable equilibrium at full employment as the normal characteristic in the long run. Any deviation from this is abnormal under perfect competition in a free capitalist economy, forces operate in the economic system which tend to maintain full employment without inflation. As a result, the level of output is always at full employment with the optimum use of resources in the long run. Full employment is a condition where there is absence of involuntary unemployment to restore full employment again.
24
The classical theory believed m full employment as a normal condition. This was on certain basic assumptions. – 1. Say‘s law of market- .Supply creates its own demand
according lo Say's law. Hence there can never be any deficiency of demand.
2. Any unemployment that in the process of a competitive system
is automatically eliminated by the free market price system
3.2 SAY'S LAW OF MARKET The belief of classical theory regarding the existence of full employment in the economy is based on Say's Law put forward by a French economist J B. Say. According to J. B. Say's law. "Supply creates its own demand". This implies that any increase in production made possible by the increase in the productive capacity or the stock of fixed capital will be sold in the market. There will be no problem of lack of demand. This appears to be a simple proposition. But it has a number of implications. Say's law contends that the production of output in itself generates purchasing power, equal to the value of that output, supply creates its own demand. Production increases not only the supply of goods but by virtue of the requisite cost payment to the factor of production, also creates the demand to purchase these goods. Any production process has two effects: 1 As factors are employed in production process, income is
generated in the economy on account of the payment of remuneration to the factors of production.
2 It results in the production of a certain level of output, which is
supplied in the market. According to Say's law additional output creates additional incomes which creates an equal amount of extra expenditure.
A new production process, by paying out income to its
employed factors generates demand at the same time, as it adds to supply. Thus any increase in production is followed by a matching increase in demand.
In the original form Say's law was applicable to a barter economy. In a barter economy, people produce goods either to consume or to exchange them for other products. In the process the aggregate demand for goods equals the aggregate supply of goods. Hence there is no possibility of over production. Introduction of money also does not change the basic law. Money is used only as a medium of exchange. The classical theorists believed that money is neutral and does not influence the real process of
25
production and distribution. There is a circular flow of money from the firm to house holds and from households to firms. The firm purchases inputs for production. They pay in the form of wages, rent, interest and profits. This becomes the income of households. The households spend their income on goods and services produced by firms. In this circular flow there is no saving and hoarding. All income received is spent. In case the household saves a part of the income, the circular flow can still be maintained if savings are equal to investment. If there is a divergence between saving and investment, the equality is maintained through the flexibility of money interest. Interest is a reward for saving. Higher the interest, more are the savings and vice-versa. At the same time, lower the interest rate, higher the demand for investment and vice-versa. If I > S rate of interest will rise. Savings will also increase and investment will fall till the two become equal. 3.2.1 Assumptions of the Law The following assumption forms the backbone of Say ‗s law. 1. Optimum Allocation of Resources:- The resources are
optimally allocated in different channels of production on the basis of equality of marginal products and proportionality.
2. Perfect Equilibrium:- Demand and supply equilibrium leads
to the fixing of commodity price and factor prices. 3. Perfect Competition:- The commodity and the factor markets
have perfect competition as the market conditions. 4. There is a free enterprise or free market economy. 5. Laissez-faire policy of the government:- There is no
government intervention in the economic field. Laissez-fair policy leads to automatic adjustment and smooth working of the market mechanism in the capitalist system.
6. Elastic Market:- The market is very wide and spread out
without limits. Therefore as the output product increases, markets also expand.
7. Market Automatism:- A free market economy stimulates
capital formation. In an expanding economy, new workers and firms will be automatically absorbed into the production channels. There is no displacement of workers or firm.
26
8. Circular Flow:- There is no break in the circular flow of income and expenditure Income is automatically spent through consumption expenditure, and investment expenditure.
9. Saving Investment Equality:- All the savings are
automatically invested. Therefore, savings is always equal to investment. Savings investment equality is the basic condition of equality. Interest flexibility ensures this.
10. Long term :- The economy's equilibrium process is
considered from the long term point of view. Thus according to Say's law, when savings will be offset by an equivalent investment and since hoarding is zero, aggregate demand will always be equal to aggregate supply. Hence there will be no general over production in the long run. Therefore, equilibrium can be maintained automatically at full employment level. Since over-saving is not possible ;Say s Law implied that underemployment equilibrium is not possible. Interest rate flexibility and wage flexibility are the 2 factors which ensures this equilibrium between be discussed. 1. Interest Rate Flexibility :- According to Say's law, all incomes are spent i.e. income = expenditure. However, there may be "leakages" in the circular flow of income & expenditure. Whatever is saved is invested in production activities. Savings and investments tor saving. If savings exceed investment, the rate of interest will fall. Hence investment will rise and level of savings will fall till they are in equilibrium. Therefore, in classical theory of employment, the rate of interest is a strategic variable, which brings about equality between savings and investment Interest rate maintains the equilibrium between savings and investment. 2. Wage Rate Flexibility and Employment :- According to the classical economist, money wage cut policy can solve the problem Involuntary employment is due to a rigid wage structure. If the wages can be lowered, involuntary unemployment will disappear. A self-adjusting system of wage will push the economy towards full employment stage.
27
Figure 3.1 3.2.2 Implications of Say’s Law:- 1. Automatic Adjustment of Full Employment- A free enterprise
economy automatically reaches a stage of full employment level. There are no obstacles to full employment General employment and over production are impossible.
2. Self-adjusting Mechanism:- Increase in supply will ensure an
increase in demand in the process of the functioning of a free capitalist economy There is no need for government intervention.
3. Resource adjustment and utilisation of resources take place
automatically in an expanding capitalist economy. When new workers and firms start operating, they also help to produce additional output and income. The entire economy becomes richer with the increased National Income. The unused and new resources are also productively employed in such a way as to benefit the whole society.
4 Money plays a passive role. It is only a medium of exchange to
facilitate transactions. Behind the flow of money, there is a real flow of goods and services, which is important. As a result, changes in the supply of money has no effect on the economy‘s process of equilibrium at full employment level.
5 A free enterprise economy under Laissez-faire policy has built
in flexibility. Market mechanism helps in optimum adjustments in the economy.
6 Rate of interest is an equilibrating factor in classical theory.
Flexible interest rates lead to equilibrium between savings and investment.
7. Wage flexibility ensures full employment in the economy.
28
3.2.3 Criticism:- J.M. Keynes vehemently criticized the classical theory. The assumptions on which the classical theory is based can be criticized The Great Depression of 1930's has revealed the weaknesses of the classical theory. The classical theory could not suggest a solution to the problem of a depressed economy facing large scale unemployment. 1. Unrealistic Assumptions at Full Employment:- According to
Keynes. The basic assumption of full employment itself is unrealistic. An economy can be in a state of equilibrium. In under employment situation also full employment equilibrium is just one possible equilibrium condition according to Keynes.
2. Too much emphasis on Long Run:- Keynes gave
importance to the short run According to him. In the long run, we are all dead.
3. Keynes refuted Say's Law of Markets:- According to
Keynes, the classical economists failed to examine the level of aggregate demand. Supply may not create demand. Over production is a possibility and reality according to Keynes. Supply can exceed demand. Hence automatic self adjusting mechanism will not work.
4. Interest is not an equilibrating factor:- Keynes attacked the
classical theory in regard to savings and investment. Flexible interest rates will not lead to equilibrium savings and investment. Changes in income bring about the equilibrium between savings and investment according to Keynes.
5. Role of money is neglected:- The classical economists
considered money as a veil. It's role is neutral. Keynes recognized the importance of precautionary measures and speculative demand for money He also recognized the effect of money on output, incomes, employment.
6. Keynes attacked the Laissez faire policy of classical
economists. In the conditions -of the modern world, state intervention is necessary to solve the problem of unemployment. Government spending, taxation and borrowing are important instruments to increase employment and income in an economy.
7. Wage cut policy is not practical. Due to the strong trade
unionism it is not possible to cut wage rates as suggested by the classical economists as a remedy to employ more workers. A wage cut may in fact lead to reduced purchasing power with workers which will lead to reduced effective demand for
29
products. This will adversely affect the levels of employment. Hence a general wage cut will lead to reduced volume of employment. The workers will revolt if the money wages are cut. This is due to money illusion.
8. The classical system will work only if there is perfect
competition. In such a case there should not be trade unionism, wage legislation etc. But in. reality, all these factors exist. Hence classical theory will not become applicable.
Check Your Progress :
1. Examine the statement : The classical theory was a supply oriented theory.
2. What are the main postulates of classical theory of employment?
3.3 INTRODUCTION OF THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT :
J.M. Keynes in his book "The General Theory of Employment, Interest and Money, popularly known as the General Theory, published in 1936 rejected the classical theory of full employment equilibrium. He brought out the real determinants of income and employment in a modern economy. His theory is called General theory since he studied all the cases of employment i.e. full employment, less than full employment, and more than full employment. According to Keynes, the economy can be in equilibrium at any level of employment. Full employment is just one possible situation in an economy. Underemployment situations are more common. Another reason why Keynes theory is called the General Theory is that it explains inflation as well as unemployment. Inflation is due to excess demand, whereas unemployment is due to lack of demand. Thus Keyne's theory is demand oriented. It stresses effective demand as a crucial factor in determining the levels of income and employment. Yet another reason for Keynes theory being called a genera Theory is that it integrates theories of money and value. Keynes in contrast to the classical economists gave importance to the short run equilibrium. Keynes assumed that the amount of capital, ' population, technology etc, do not change in titer short run. Therefore, in the
30
short run, the income and the output depend on the volume of employment. The levels of employment in turn depend on the effective demand, which depends on aggregate spending. Hence it is necessary to know what is effective demand.
3.4 THE PRINCIPLE OF EFFECTIVE DEMAND The principle of effective demand occupies a strategic position in Keynes theory of employment. Effective demand manifests itself in the total spending of the commodity on consumption and investment goods. Total employment depends upon effective demand Therefore unemployment results from lack of effective demand. Higher the level of effective demand, the more the level of employment in the economy. Effective demand depends upon 2 factors - Aggregate demand function, and aggregate supply function. 3.4.1 Aggregate Demand Price and Function:- The aggregate demand price for the output of any given amount of employment is the total sum of money or proceeds which is expected from the sale of the output produced .when that amount of labor is employed. In other words, the aggregate demand price is the amount of money, which the entrepreneurs expect to receive from the sale of output produced at a particular level of employment. The aggregate demand curve or function is a schedule of the proceeds expected from the sale of the output at different levels of employment. The aggregate demand curve slopes upwards from left to right. It means that as the level of employment and income increase aggregate demand price also increases With increase in income, people tend to spend a small amount of income on consumption goods, Hence with increase in output and employment, aggregate demand price increases at a diminishing rate The slope of the curve diminishes will increase in employment. The figure below depicts an aggregate demand function.
Figure 3.2 3.4.2 Aggregate Supply Price :
31
The main aim of an entrepreneur in a capitalist society is to earn profits. The producer will employ workers in such a way as to maximise profits. Employment of labour means that some costs have to be incurred. A certain minimum amount of proceeds will be necessary to induce employers to provide any given amount of employment. The supply price for any given quantity of commodity refers to that price at which the seller is willing or is induced to supply that amount in the market. If the seller does not get the minimum receipts, he will reduce output and employment. The aggregate supply curve or function is a schedule of the minimum amount of proceeds required to induce entrepreneurs to provide varying amount of employment. It shows the cost of producing a certain level of output or the minimum receipts which must be obtained if that level of output is to be maintained. The aggregate supply function slopes upwards. The shape of aggregate supply function depends entirely on technical conditions of production. It is decided by the manner in which cost rises in response to expansion of employment. The figure below shows the aggregate supply function.
Figure 3.3 3.4.3 Equilibrium Level of Employment:- The intersection of the aggregate demand function with aggregate supply function determines the level of income and employment. The aggregate supply schedule represents costs involved at each possible level of employment. The aggregate demand schedule represents the expectation of maximum receipts of the entrepreneur at each possible level of employment. As long as receipts exceed costs, the level of employment will go on increasing. The process will continue till receipts become equal to cost. At the point of equilibrium, the amount of sales proceeds which the entrepreneurs expect to receive is equal to what they must receive in order to just appropriate their total costs.
32
Figure 3.4 The point E, where the aggregate demand curve intersects the aggregate supply curve is called the point of effective demand. The equilibrium level of employment is ONF. This is not necessarily full employment. If the level of employment is more or less than ON, the profits will be less than maximum. ONF level of employment is the full employment level in the diagram since at this level of employment the aggregate supply curve AS is vertical in shape. Hence ON level of employment is less than full employment. This happens because investment demand is insufficient to fill the gap between income and consumption.
Figure 3.5 For reaching full employment, employment level has to be increased. For this either the aggregate supply curve should be lowered or aggregate demand should be increased. Increasing the aggregate supply curve will necessitate increase in the productivity. This is a long run problem. Keynesian theory is concerned with short run analysis. Hence raising the aggregate demand is possible. This shifts the equilibrium point to £1. This is the full employment equilibrium. Any expansion of demand beyond E1 will lead to inflation. The-chart below gives us the gist of Keynesian theory of employment.
33
Table 3.1
INCOME
EMPLOYMENT
EFFECTIVE DEMAND
Aggregate Demand Function Aggregate Supply Function Consumption Investment Government Expenditure Expenditure Expenditure Check Your Progress :
1. Examine that Keynesian theory is demand oriented theory. 2. Explain the two factors which determine effective demand.
3.5 CONSUMPTION FUNCTION In Keynes theory of income and employment, we have already seen that the volume of employment in a society depends on the level of effective demand which in turn is determined by the aggregate demand function. The aggregate demand is made up of 2 components i.e. consumption expenditure and investment expenditure. Consumption expenditure is a major component of aggregate demand in a economy. The consumption expenditure depends on the size of income and propensity to consume, which is called consumption function. The marginal efficiency of capital and the rate of interest determine investment. The Investment multiplier expresses the relationship between the increases in investment and increases in consumption. We will be studying the consumption function and the investment rnultiplier in this unit. In macro economic theory, Keynes singled out income as the main determinant-Of consumption. The relationship is expressed in the form of a function. The consumption function is the assumed
34
direct relationship between the national income level and the planned or desired consumption expenditure. Keynes called it the propensity to consume. Algebraically the basic relationship between consumption spending and national income is shown as C = f(Y) 'C' stands for consumption function, 'Y' stands for national income, 'f. stands for functional relationship. The simplest form of relationship between income and consumption can be expressed as follows . C = cY This means that the consumption (C) is a constant proportion (c) of income (Y) According to Keynes, at various income levels, a schedule of the propensity to consume is a statement showing the functional relationship between the level of consumption at each level of income.
TABLE: 3.2
CONSUMPTION FUNCTION INCOME Y CONSUMPTION (C) (In crores of rupees)
200 300 220 400 300 500 380 600 540 700 620
The schedule relating to the various amounts of consumption at different levels of income is called the consumption function, it is clear from the above table that consumption is an increasing function of income since both the variables Y and C move in the same direction. Consumption function can be represented diagramatically as below.
35
Figure 3.6 In the above diagram, Y-axis measures consumption, and X axis measures the real income. The curve 'C' represents the consumption function (Propensity to consume). It moves upwards to the right implying that consumption increases as income increases However the increase in consumption C1C2 is less than the increase in income Y1Y2 That part of the income, which is not consumed is saved, SS' is the saving. Hence the consumption function measures the amount saved also. 3.5.1 Technical Attributes of Consumption Function: Keynes considered two technical attributes: 1 The average propensity to consume 2. The MPC The APC is defined as the rate of aggregate or total consumption to aggregate income in a given period of time Symbolically, APC = C/Y Table 3.3
36
It can be seen that APC declines as income increases because the proportion of income spent on consumption decreases.
Figure 3.7 The above diagram represents the APC. The APC is any one point on the CC curve It indicates the ratio of consumption to income. At point A,
1
1
OY
OCAPC The curve becomes flat indicating that as income
increases, APC falls, and vice versa, APS = S / Y = 1 - C / Y The proportion of income saved increases as income increases. MPC refers to the proportion of each small addition to the level of a country's national income that wit be devoted to additional spending on consumer goods. If Y denotes a small change in
37
income, and C denotes a small change in the consumption due to change in income. MPC can be symbolically written as ΔC/ΔY. In the above table, MPC is calculated at different levels of income. It is clear that MPC is always positive but less than one. This attribute of MPC arises from the Keynes fundamental psychological law of consumption, that consumption increases less proportionately than income, when income increases. MPC = ΔC / ΔY < 1 0 < ΔC / ΔY < 1 From the MPC, we can derive the MPS,
C MPS = 1-MPC or ------
Y MPC is significant since it helps us to know the division of extra income into consumption and investment. It facilitates the planning of investment to maintain the desired level of income. It has significance in the multiplier theory also.
Figure 3.8 When income increases from Y1 to Y2, the consumption increases from C1 to C2. The change in income (ΔY) is Y1Y2 and change in consumption is, ΔC = C1 C2. Hence MPC = ΔC / ΔY MPC refers to the slope of the consumption curve. As income increases, the MPC level will fall at higher levels of income, there will be more savings. 3.5.2 Relationship Between APC And MPC 1. When the MPC is constant, the consumption function is linear
i.e. a straight line. APC will be constant only if the consumption
38
function passes through the origin. If it does not pass through the origin. APC will not be constant.
2 MPC refers to the marginal increase in consumption (ΔC) due to a marginal increase in income ΔY. APC refers to the ratio of total consumption C to the total income Y.
3 As income increases, MPC also falls, but it falls to a greater extent than the APC.
4. As income falls, MPC rises. APC also rises but at a slower rate.
3.5.3 Factors affecting the Consumption Function : According to Keynes, consumption function is affected by two factors - subjective and objective. These factors normally do not change in the short run. The subjective factors are endogenous or internal. They refer to psychological characteristics of human nature, social structure, social institutions and social practices. The objective factors affecting the consumption function are endogenous. These factors may change, which may lead to a shift in the consumption function.
a) Subjective Factors; The slope and position of the consumption function are determined by the subjective factors Human behavior regarding consumption function and savings depend on psychological .motives. There are motives, which lead individuals to refrain from spending out of their income. Keynes lists out eight such .motives 1. Motive of Precaution: The desire to build up reserve against
unforeseen contingencies. 2. The Motive of Foresight: The desire to provide for
anticipated future needs i.e. for education, old age etc. 3. The Motive of Calculation: Refers to the desire to enjoy a
larger income at a future date by way of interest and appreciation
4. The Motive of Improvement: The desire to enjoy a gradually
increasing expenditure, so that people can look forward to gradually improving the standard of life.
5. The Motive of Independence: The desire to enjoy a sense of independence and the power to do things.
6. The Motive of Enterprise: The desire to be enterprising and
speculative or establish business deals 7. The Motive of Pride: The desire to posses or to bequeath a
fortune
39
8. The Motive of Avarice: The desire to satisfy miserliness and abstain from expenditure. Subjective motivations are also applicable to the behaviour patterns of business corporations and governmental bodies. Keynes listed the following motives for accumulation. a) The Motive of Enterprise: It refers to the ambitious
plans to expand and secure resources for further investments.
b) The Motive of Liquidity: The desire to face emergencies and difficulties easily.
c) The Motive of Improvement: The desire to enhance income levels and became successful.
d) The Motive of financial Prudence : The desire to ensure adequate financial provision against depreciation and obsolesce and discharge debts.
b) Objective Factors:
Objective factors are subjected to rapid changes and they cause drastic shifts in the consumption function. They are as follows: 1. Windfall Gains or Losses : Consumption levels change due
to windfall gains or losses 2. Fiscal Policy: Change in fiscal policy of the government leads
to change in the propensity to consume. For example imposition of heavy taxes tends to reduce the disposable real income of the community. Hence the level of consumption may change adversely. Also abolishing of certain taxes may lead to an upward shift of the consumption function.
3. Change in expectation regarding the future leads to a change
in the propensity to consume. If people expect a war, they fear a rise in prices in the future. People tend to hoard. This will lead to a shift in the consumption function.
4. The Rate of Interest changes in the rate of interest affects
consumption A rise in the rate of interest may induce people to reduce consumption at each income level because people will save more to take advantage of the high interest levels –
5. Change in the net income: Net income rather than the total income affects the consumption function. Changes in accounting practices will affect the net income and therefore influence the consumption function -
Besides the above factors, Keynes and his followers had introduced a number of factors such as financial policies of corporations, holding of liquid assets, and distribution of income
40
3.5.4 Significance of Keynes Consumption Function According to Hansen, Keynes analysis of consumption function is a major landmark in the history of economic doctrines. Keynes concept of consumption function has revolutionized the entire economic thinking in modem times. The important implications are the following. 1. Importance of Investment: Since consumption is a stable
function, Keynes concluded that employment can increase only if the investment increases. Investment therefore is regarded as a crucial factor determining employment in the short run investment has to De sufficient to fill in the gap between income and consumption if output and employment are to be maintained.
2. Refutes the Say's Law of Market: Keynes was able to
invalidate the Say's law of market which was the basic principle of the classical theory. Keynes showed the consumption expenditure rises less than the rise in income. Hence supply does not create its own demand. All that is produced is not demanded
3. Keynes Theory explains the Trade cycle Phenomenon:
Keynes consumption function provided a satisfactory explanation of the upward and downward swings in the trade cycle. When the MFC is less than usual, the economy is at the upper turning point (down turn from propensity). As consumption falls and savings become more, with increase in income, will ultimately lead to a slump. The lower turning point i.e. from depression to recovery is explained in terms of the failure of people to cut down their consumption as the income decreases.
3. MEC helps to study the nature of income propagation :-
A very important implication is the need for government interference to remedy the problems of overproduction and unemployment.
Check Your Progress :
1. What are the two technical attributes of Consumption function?
2. State the subjective and objective factors of consumption function.
3.6 SUMMARY 1. The classical theory of employment deals with the
determinants of employment propounded by classical writers like Adam Smith, Ricardo, Mill and others.
2 The classical theory was a supply oriented theory. 3 The classical economists were concerned with the long run
problems of growth of the economy, productive capacity and efficient allocation of the given resources at full employment.
4 The main postulates of the classical theory of employment
were the following a) Long term analysis b) Full employment c) Says law of markets d) Interest rate flexibility e) Wage rate flexibility 5 The classical theory believed in full employment as a normal
condition arose from certain basic assumptions - Says Law of Markets.
6. The French economist J. B. Say believed that "supply creates
its own demand". This is the basic assumption in the classical theory of employment. It implied that there will be no problem of lack of demand. Every increase in production is followed by a matching increase in demand.
7. The following are the assumptions of Say's Laws:- a) Optimum allocation of resources b) Perfect equilibrium c) Perfect competition d) Laissez faire policy e) Elastic market f) Market automation g) Circular flow and Say's investment equality. h) Long term 8 Flexible interest rates bring about equilibrium between savings
and investment.
42
9. Wage rate flexibility ensures that there is no unemployment. A self adjusting system of wage rates will push the economy towards full employment stage.
10. J M. Keynes criticizes Say's law of markets on a number of
grounds like unrealistic assumptions of full employment, long run assumption. Say's law is also criticized since it is one sided and neglects the demand side. It is also criticized that interest does not equalize savings and investment. Classical theory neglects the role of money. Keynes also criticized the Lessaize faire policy of classical economists Wage cut policy is not a practiced solution to solve unemployment problems. Moreover the assumptions of perfect competition are unrealistic.
11. Keynes consumption function is a very significant contribution
to modern macro economic theory. In order to explain the concepts of consumption function and the multiplier theory, a study of the fundamental Keynesian principles is important.
12. Keynes in his general theory, brings out the real determinants
of income and employment in a modern economy. According to him, the economy can be in equilibrium at any level of employment. Full employment is one of the different situations in an economy. Under employment equilibrium situations are more common.
13. Keynesian theory is demand oriented. It stresses effective
demand as a crucial factor in determining the levels of income and employment.
14. Keynes gave importance to short run equilibrium. He assumed
that the amount of capital, population, technology etc. do not change in the short run. Therefore, in the short run, the income and output depends upon the volume of employment. The levels of employment depend upon effective demand, which depends upon aggregate spending.
15. Effective demand manifests itself in the total spending of the
community on the consumption and investment goods. Total employment depends on effective demand unemployment is due lo lack of effective demand.
16. Two Factors determine effective demand - Aggregate demand function and aggregate supply function. The intersection of aggregate demand function and aggregate supply function determines the level of income and employment. This point is known as the effective demand. The equilibrium reached thus need not be the full employment equilibrium point. For reaching full employment equilibrium aggregate demand should increase.
43
17. The aggregate demand is made up of two components -
consumption expenditure and investment expenditure. Consumption expenditure is an important component of the total expenditure. Consumption expenditure depends on the size of income and propensity to consume, which is called the consumption function C = f(Y)
18. Keynes considered two technical attributes 1) APC 2) MPC
APC = C/ Y and MPC = C/ Y 19. A number of subjective and objective factors affect the
consumption function.
3.7 QUESTIONS 1 What are the main postulates of the classical theory of income
and employment? 2 What is the Say's law of markets? What are its assumptions? 3. What are the main features of classical theory of employment
and income? 4. Critically examine the classical theory. 5. Discuss the Keynesian theory of employment. 6. What is the Keynesian Consumption function? What are the
various factors affecting the consumption function? 7. Explain the concepts of APC and MPC.
44
4
KEYNESIAN MULTIPLIER AND INVESTMENT FUNCTION, INFLATION
Unit Structure : 4.0 Objectives 4.1 Keynesian Multiplier Theory 4.2 Keynesian Investment Function 4.3 Liquidity Preference Theory of Interest 4.4 Meaning and Definition of Inflation 4.5 Demand-pull inflation 4.6 Cost-push inflation 4.7 Summary 4.8 Questions
4.0 OBJECTIVES 1. To study the Keynesian Multiplier Theory 2. To study the Keynesian Investment function 3. To study the Liquidity Preference Theory of Interest 4. To study and understand the concept of inflation 5. To Study various types of inflation-Demand-pull inflation 6. To study Cost-push inflation
4.1 KEYNESIAN MULTIPLIER THEORY The multiplier theory explains the effect of changes in the investment upon the consumption expenditure and the resulting generation of income. The theory of multiplier is an integral part of the General theory of employment since it establishes a precise relationship between aggregate employment and income and the rate of investment, given the marginal propensity to consume According to the multiplier theory, when there is an increment of aggregate investment, income will increase by an amount, which is K times the increase of investment. It explains the cumulative effects of changes in investment on income through their effects on consumption expenditures. It helps us to understand the dynamic process of income generation. 4.1.1 The Concept of Multiplier: R.F Kahn developed the concept of multiplier in 1931. This was used to explain the effect of an increase in investment on employment. Keynes used the idea to explain the effect of an
45
increase in investment on income Keynes multiplier is known as the investment income multiplier. Multiplier expresses a relationship between an initial increment in investment and the resulting increase in aggregate income. Multiplier is the numerical coefficient which indicates the increase in income which will result in response to an increase in investment It is expressed as the ratio of the realised change in aggregate income to the given change in investment K = ΔY / Δl where K = investment multiplier ΔY = represents change in income Δl = represents change in investment Given the multiplier coefficient K we can measure the resulting change in the level of income due to change in investment). ΔY = K .ΔI If the investment increases by Rs. 1000, and income by Rs.500, Multiplier = 5 According to Samuelson, multiplier means "the number by which the change in investment must be multiplied in order to present us with the resulting change in income The most important factor in the multiplier effect is the consumption function. When investment increases income increases. As income increases, consumption also increases Consumption expenditures become additional income to factors of production, which produce consumers goods. Incomes further increase due to induced consumption as so on. However, the whole of the increased income is not consumed. The process will continue until the increasing ratio of income to expenditure gradually works itself out. MPC is less than unity. This is the reason why consumption does not change in the same manner as the increase in income. The value of the multiplier depends on the marginal propensity to consume. The lower the value of the MPC, the greater the value of the multiplier and vice-versa. The formula for multiplier is given as 1 K = ————;——r Or 1 - MPC
1 - y
C
Where 'K' is the multiplier coefficient ΔC / ΔY = MPC 1 - MPC = MPS In other words K=1/MPS
46
i.e the reciprocal of the MPS 4.1.2 The Working of the Multiplier Process : Sequence analysis helps us to understand the working of the multiplier. For ex., during a given period, if the investment goes up by Rs.10 crores income goes up by Rs. 10 crores. Suppose MPC is 0.5 or 50%, Rs.5 crores will be spent for consumption by the people who receive this income. The amount spent on consumption means a further amount of income received within the economy. Those people who received Rs. 5 crores now will spend 50% of that income in consumption i.e.Rs.2.5 crores in the second round. In the third round, Rs.1.25 crores will be generated and so on. The interval between consumption responses is the multiplier period". As we move from one multiplier period to another, the addition to the income gradually diminishes. The process will continue till the total increment in income becomes so large that it results in additional savings which is equal to the increase in investment. This process can be explained with the help of a formula. ΔY = ΔI (I + C + C2 + C3 + ……..+Cn) ΔY = increase in income, Δl, initial increase in investment, c = MPC Since the absolute value of C is less than 1, the sum of the infinite geometrical progression is
1 + C + C2 + C3 + ……….. + Cn = C1
1
C = MPC, where C is less than one, 1 Change in income = - ——— x change in investment 1 - MPC
2/1
110
051
110x
xY
= 10 x 2 = Rs. 20 crores Given the MPC to be 0 .5 an initial investment of Rs 10 crores will lead to Rs. 20 increase in the income. In the above example, Keynes ignores time lags. Modern economists on the other hand feel that it takes time for the impact of the initial investment to make itself felt throughout the entire economy. The multiplier effects of investment on income can be diagrammatically shown
47
Figure 4.1 The C curve is the consumption curve and it is drawn on the assumption that MPC is constant at all levels of income i.e.. 0.5. The level of effective demand is determined by consumption and investment outlays i.e. consumption and investment. This is super imposed on the C curve. The 45 degree line OY shows that Income = Consumption + Savings. The original equilibrium is at E where the consumption + Investment curve intersects the 45 degree line. The equilibrium level of income is O. As new investment is injected, the line shifts to C + I + Δ I. The new equilibrium point is at E1 and the new equilibrium income is OY,. Taking the original example, an initial outlay of Rs. 10 leads to an increase in income to Rs. 20, where K = 2. Hence the increase in income (Δ Y) is a multiplier of the increase in investment (Δ l). 4.1.3 Assumptions of the Multiplier Theory : The following are the assumptions of the multiplier theory : 1. Constant Marginal Propensity to Consume. 2 Monetary and fiscal policies remain stable so that they do not
affect the propensity to consume. 3 The multiplier period is absent. 4 Excess capacity exists in the economic system. The
assumption is that the economy operates at less than full employment.
5 Closed economy is another assumption. The effect of international economic transactions are ruled out.
6 There should be a net increase in investment. 7 Consumer goods are available in sufficient quantities. 4.1.4 Leakages of the Multiplier : There are serious limitations in applying the concept of multiplier in practice. Certain forces, which operate in an economy, reduce the strength of the process of income propagation. -Leakages reduce the income generated. They are 1. Increase in the MPS: The higher the marginal propensity to
save, the greater the leakages of additional income out of the income. In a dynamic economy, the MPC or MPS is not constant. With increases in income MPS rises. As a result, the multiplier value may fall.
2. Debt Cancellation: Paying back of debts taken by people
reduces the value of the multiplier since consumption is reduced.
48
3. Hoarding Idle Cash Balances: If people prefer to hold liquid cash than spend it on consumption goods, it will lead to a leakage from the income stream and reduce the value of the multiplier.
4. Imports: the income spent on imports will not lead to income
generation within the domestic country, and hence leads to a restriction of the value of the multiplier.
5. Purchase of Old Shares and Securities: If the newly generated
income is used to buy old stocks, shares and securities, consumption will be less and as a result, the value of the multipliers will be low.
6. Inflation: Rise in the prices adversely affects the real
consumption of people. Hence consumption will not increase during inflation. This also affects the value of the multiplier.
4.1.5 Criticism : 1. It is a static phenomenon: it does not explain the dynamic
change. It explains the process of income propagation from one point of equilibrium to another under static assumptions. The actual sequence of events is not explained.
2. It is a timeless phenomenon: Keynes assumed an
instantaneous relationship between income, consumption, and investment. However, there are time lags between consumption and income. Hence according to modern economists, multiplier effect takes time to make an impact.
3. No Empirical Evidence: There is no empirical evidence to
prove the operation of multiplier effect. It does not tell us anything about the real world.
4. It gives too much importance to Consumption: The
emphasis is exclusively on consumption. 5. The theory has neglected the derived demand phenomenon of
investment in capital goods sectors. It fails to establish a relationship between the demand for capital goods and consumption goods.
4. Some economists like Prof. Hazhtt hold that the multiplier
concept is only a myth There cannot be a precise mechanical relationship between investment and income
Check Your Progress :
1. Examine the working of the multiplier process. 2. Explain the factors which reduces the strength of the process
4.2 INTRODUCTION OF THE INVESTMENT FUNCTION In modern macroeconomic analysis, the term investment refers to real investment. A firm invests when it uses steel or other material to build plant or when new machines are purchased. This is real investment. When a person buys shares or deposits money in the money in the bank, it tends to be financial investment. Investment leads to the production of new capital goods - plant and equipment. Capital formation takes place if the newly produced capital goods leads to a net addition to the given stocks of capital assets over and above their replacement requirement (depreciation). Investment may be either gross investment or net investment. Gross investment is defined as a flow of expenditure or new fixed capita! assets or an addition to inventories over a given period of time. Since we are not considering inventories, gross investment means the investment expenditure on fixed capital. A part of the new capital will be needed simply to replace the depreciated capital stock This must be deducted to find out the net addition to the existing capital stock Therefore, Net investment = Gross investment Depreciation of Fixed Capital investment can also be classified into autonomous investment and induced investment. Autonomous investment does not change with the changes in income i.e. it is independent of income. It takes place in construction of roads, building etc. Autonomous investment depends on population growth and technical progress than on the level of income. Most of the investment activity of the government is autonomous in nature Induced investment changes with changes in income, 4.2.1 Determinants of Investment : Investment function refers to inducement to invest or investment demand. According to the classical economists, investment demand is a decreasing function of the rate of interest.
50
FORMULA I = f (i) where I = Investment (i) = rate of interest According to Keynes, the volume of investment depends upon two factors, 1) The marginal efficiency of capital and 2) The rate of interest. The marginal efficiency of capital is called the expected rate of profit. Prospective investors Prospective investors will compare the marginal efficiency of capital with the rate of interest Inducement to investment depends on these two factors. If investment is to be profitable, the expected rate of profit must not be less than the current rate of interest in the market. New investment will take place if the expected rate of profit is greater than the rate of interest. The rate of interest does not change in the short run. Hence inducement to invest basically depends on the marginal efficiency of capital. 4.2.2 Marginal Efficiency of Capital: To examine the profitability of ventures, Keynes introduced the concept of marginal efficiency of capital. Marginal efficiency of a given capital asset is the highest rate of return over the cost expected from an additional or marginal unit of that capital asset According to Kurihara, marginal efficiency of capital is the ratio between the prospective yields of additional capital assets and their supply price, expressed as e = Q / P Where e = marginal efficiency of capital Q = the expected yield of return P = The supply price of this asset. Hence the marginal efficiency of capital depends upon two factors - 1) The prospective yield from the capital asset, 2)the supply price of this asset. "Prospective yield" means the amount of annual income an investor expects to obtain from selling the output of his investment or capital assets after deducting the running expenses In other words, the prospective yield of a capital asset is the aggregate net return expected from it during its life time The total expected life of a capital asset can be divided into a series of periods i.e. years. The annual returns or annuities can be represented by Q1, Q2, Q3, Q4 . The series of annuities or returns is called prospective yield of investment. An investor has to consider the supply price of an asset. The supply price of a particular type of asset is the cost of producing a totally new-asset of that kind Combining the two concepts. Keynes defines marginal efficiency of capital as "being equal to that rate of discount which would make
51
the present value of the series of annuities given by the return expected from the capital asset during its life just equal to its supply price In other words, the marginal efficiency of a capital asset is the rate at which the prospective yield expected from one additional unit of the asset must be discounted if it is just equal to the cost i.e. the supply price of the asset The following equation signifies the concept of MEC. FORMULA
C = n
n
r
R
r
R
r
R
r
R
)1(......
)1()1(1 3
3
2
21
C = Supply price of capital assets R1, R2, R3 ......... Rn are the annual prospective yields from the capital asset, 'r' is the rate of discount or the marginal efficiency of capital, 'r' is the internal rate of return on R that asset. The term
1
1
)1( r
R represents the current value of the annuity or yield
receivable at the end of the first year, discounted at the rate 'r'. If the rate of discount is assumed to be 10%. each rupee which we expect to get after a year is worth 90.91 paise now i.e. 90.91 paise currently invested at 10% will become one rupee within a year. In the same way, (1 + e)2 represents the current value of annuity or return expected at the end of the second year discounted af the rate of r. An example can be taken to explain how the marginal efficiency of capital is calculated If we suppose that the supply price cost of a machine is Rs, 1600 and its economic life is two years, the prospective yield on this machine in each year is Rs. 1440 and its disposal value is also Rs.1440. The marginal efficiency of capital can also be obtained.
1600 = 2)1(
1440
)1(
1440
rr
1600 (1 + r)2 = 1440 (1 + r) + 1440
1600 (1 + 2r + r2) = 1440 + 1440r + 1440
1600 + 3200r + 1600r2 + 1440 + 1440r + 1440
1600r2 = 1760 - 1280 = 0 By using the formula for the root of anabatic equation ax2 + bx + c = 0
x = a
acbb
2
42
52
r = )1600(2
)1280()1600(4)1760(1760 2
r = - 1.6 or r = 0.5 Since 'r' cannot be negative r = 0.5 or r = 50% If this is the rate of return, investment in the machine will be profitable, if the cost of borrowing funds (rate of interest) is less than 50% i.e. given the cost of capital asset at Rs. 1600, MEC was calculated at 50%. Suppose the ratio of interest is 18%. investment will be profitable. . MEC Schedule (curve) MEC falls as investment increases due to fall in the prospective yield and increase in the supply price of the capital assets. The marginal efficiencies of all types of capital assets which may be made during a given period of time represents the schedule of MEC or the investment demand schedule. MEC Schedule Investment Rs. MEC % 20000 15 50000 12 75000 10 It is clear from the above table that as investment increases MEC goes on falling. The downward slope of the curve shows the inverse relationship between investment and MEC i.e. an increase in investment will lead, to a fall in MEC.
VOLUME OF INVESTMENT
Figure 4.2 The more elastic the MEC curve, the greater the investment given a fall in the interest rate. Usually the MEC curve tends to be inelastic. MEC curve shifts if the profit expectations change or the technology improves. Keynes believed that investment responds to changes in expectation and shifts in MEC rather than the rate of interest.
53
MEC and The Rate of Interest: MEC is expressed as a ratio and compared to the rate of interest. There is a comparison between the expected rate of profit and the rate of interest. In effect it is a comparison between the supply price of an asset and its demand price. Keynes makes a distinction between the demand price and the supply price of a capital asset. The demand price of an asset is defined as the sum of the expected future yields discounted at the current rate of interest. We have already seen that supply price = the sum of prospective yields discounted by the MEC. In symbolic terms, demand price of an asset can be put as follows.
n
n
i
Q
i
Q
i
Q
i
QDP
)1(.....
)1()1()1( 3
3
2
21
DP = demand price, Q1, Q2, Q3,... Qn = the prospective yield or annuities, i = current rate of interest. For Example, the market value of an asset., which promises to yield Rs. 1600 at the end of one year and Rs. 1210 at the end of 2 years will be estimated at higher than Rs 2000, when the interest rate is less than 10%. If the market rate of interest is 5% the present value of capital asset will be
2)05.0(1(
1210
05.1
1100 = 1047.62 + 1097
= 2144.62 This is the demand price of a capital asset. The effect of the relative positions of demand and supply on the behaviour of investor in taking decisions will be as follows 1) When MEC = interest rate, SP = DP - neutral 2) If MEC > DP > SP - favourable 3) When MEC < DP < SP – unfavourable The two strategic variables in investment decisions are the MEC and the rate of interest. MEC of an asset falls as I in that asset increases. The reasons are, 1 The prospective yield of that asset will fall as more units are
produced. More production will lead to the units competing with each other to meet the demand for the product.
Demand Price
54
2 The supply price of the asset will rise as more of the assets are produced. Investment will be in equilibrium when MEC becomes equal to the given current rate of interest. This is given by the following diagram
Figure 4.3 At i1 rate of interest investment is OM1 . At this level of investment, MEC = i1 . If the rate of interest falls to i2, investment will rise to OM2. However change in profit expectation can shift the MEC curve also.
Figure 4.4 This is shown by the above diagram. Due to rise in profit expectation, MEC curve shifts to MEC1. As a result investment also increases to i2. MEC is the prime factor in determining investment, since rate of interest is rather rigid during the short period. Factors Affecting MEC : A number of short run and long run factors affect the marginal efficiency of capital. Short run Factors: 1 . Expectation about demand, price and cost of Production: It
there is an expectation of demand to increase and hence
55
prices to rise, a high MEC leads to increased investment and vice versa
2. Business Optimism and Pessimism: If the atmosphere is one
of optimism , entrepreneurs will estimate MEC to be high. 3. Changes in Income: Unexpected windfall gains suddenly
increases income levels. This will induce an increase in MEC. 4. An increase in the propensity to consume will raise the MEC
and vice-versa: Increased demand for consumption goods will induce the demand for capital goods
Long Run Factors : 1. Population Growth: Increase in population leads to increase in
demand. MEC will increase as a result. 2. Technological Advancement: Improvement and growth of new
technology leads to new products, new markets etc This will have a favourable impact on the MEC.
3. Development of Infrastructure : Developing the infrastructure also has a positive-impact on the MEC in the long run.
Check Your Progress : 1. State which two factors determine the investment demand. 2. Examine the factors which affect MEC.
4.3 LIQUIDITY PREFERENCE THEORY OF INTEREST According to Keynes interest is a monetary phenomenon Rate of interest is determined by the interaction of the demand for and supply of money Keynes showed that the demand tor money is inversely related to the rate of interest Keynes looked at the demand for money not just as a medium of exchange but as an asset. According to Keynes, the rate of interest is determined by the intersection of the supply schedule of money (total quantity of money) and the demand schedule for money (the liquidity preference). According to Keynes rate of interest is a reward paid for parting with liquidity. The demand for money is a demand for liquidity. Liquidity preference means that people prefer to hold wealth in the form of liquid cash rather than the other non-liquid
56
assets like bonds, securities, bills of exchange etc. 4.3.1 There are three motives which lead to liquidity preference; 1. The transaction motive . 2 The speculative motive 3 The precautionary motive , According to Keynes. the demand for money is positively correlated with income i.e. an increase in the levels of income implies a rise in the demand for money and vice-versa There is a negative correlation between the demand for money and the rate of interest. A rise in the rate of interest reduces the demand for money. In symbolic terms, L1 is expressed as the demand for money for transactions and precautionary motives L1 depends on income mainly. It is not influenced by the changes in the rate of interest L2 is the speculative motive of demand for money which is influenced by the changes in the rate of interest. 'L' stands for total demand for money. L= L1 +L2 This remaps fixed in Keynes theory. The money supply at any time is determined by the action of monetary authority. If M is the total supply of money and M, the total quantity of money held by people for transactions and precautionary motives and M2 the quantity of money held for speculative purposes: 'V is the total level of income and r is rate of interest, then M1 =L1 (Y)...................... (2) Money for Transaction M2 =L2 (r) .... Money supply related to speculative demand Liquidity function M = M1 + M2
= L1 (Y).+ L2(r) M = L(r, y) This M = L(r, y) implies that the quantity of money held depends of the rate of interest and the level of income. 4.3.2 Liquidity Preference Schedule: The demand for money can be explained with the help of a diagram. The liquidity preference schedule shows the functional relationship between the amount of money demanded for all motives and the rate of interest.
57
Figure 4.5 (a) Figure 4.5 (b)
Figure 4.5 The diagram 4.5 (a) shows a liquidity function. It slopes downwards. It shows an inverse relationship between the amount of money demanded and the rate of interest. At low rates of interest, people prefer to hold money Figure 4.5 (b) shows the shifts in the liquidity function. Liquidity preferences also change with the changes in liquidity function i.e. it increases or decreases as the liquidity function changes Rate of Interest determination:
58
Figure 4.6 (a) Figure 4.6 (b) The interaction between the liquidity preference function and the supply of money leads to the equilibrium rate of interest. In the diagram 4.5 OR is the equilibrium rate of interest Rate of interest can change either due to change in demand or supply of money. This is depicted in the diagram 4.6 (a) and 4.6 (b). 4.3.4 Shortcomings of the Liquidity Preference Theory : The liquidity preference theory of interest has been vigorously criticised by Hansen and others. 1. Indeterminateness : according to Prof Hansen. Keynes
interest theory is also indeterminate like the classical theory. To know L1, we should know the income level and to know the income level, we must know the rate of interest. Hence Keynesian theory suffers from the same problem as the classical theory.
2. One Sided: Real factors which determine the rate of interest
are neglected. Interest is a purely monetary phenomenon in Keynes theory. Real factors like productivity time preferences are neglected.
3. Ignored Saving: The impacts of saving on the rate of interest
are ignored. According to Jacob Viner, there is an exaggerated importance of expectation in Keynes theory. A complete theory of interest must recognize the fact that "without savings there can be no liquidity to surrender."
4. Empirical Contradiction: The theory does not have the
empirical validity. According to 'he theory, the rate of interest should be the highest during depression due to failing prices or rising value of money But it is found that the rate of interest is
59
lowest during depression, 4 The theory suffers from vagueness and is narrow in scope.
Moreover it is unrealistic also The existence of different rates of interests cannot be explained with the help of the liquidity preference theory Since the theory is a short term theory it fails to explain long term interest rate determination
Check Your Progress :
1. Explain the three motives which lead to liquidity preference.
Types of Inflation : Demand –pull and Cost –push inflation
4.4 MEANING AND DEFINITION OF INFLATION : A continuous rise in the general price level over a long period time has been the most common feature of both developed and developing economies. Some authors consider inflation as the ‗dominant economic problem‘ in modern times. In a broad sense of the term, inflation means a considerable and persistent rise in the general level of prices over a long period of time. However, there is no universally acceptable definition of inflation. According to Pigou, ― Inflation exists when money income is expanding more than in proportion to increase in earning activity.‖ Crowther defined inflation as, ―a state in which the value of money is falling, that is, prices are rising.‖ Some recent definitions of inflation are as follows : According to Ackley, ― Inflation is a persistent and appreciable rise in the general level or average of prices.‖ According to Samuelson, ―Inflation denotes a rise in the general level of prices.‖ Harry G. Johnson defines inflation as ―a sustained rise in prices.‖ Types of inflation : There are two important causes of Inflation i.e. Demand-pull and Cost-push.
4.5 DEMAND-PULL INFLATION :
It may be defined as a situation where the total monetary demand
60
persistently exceeds total supply of real goods and services at current prices, so that prices are pulled upwards by the continuous upward shift of the aggregate demand function. The demand-pull theorists point out that inflation might be caused by an increase in the quantity of money, when the economy is operating at full employment level. As the quantity of money increases, the rate of interest will fall and consequently, investment will increase. This increased investment expenditure will soon increase the income of the various factors of production. As a result, aggregate consumption expenditure will increase leading to an effective increase in the effective demand. With the economy already operating at the level of full employment, this will immediately raise prices, and inflationary forces may emerge. Thus, when the general monetary demand rises faster than the general supply, it pulls up prices. By using the aggregate demand and aggregate supply curves, the demand-pull process be shown diagrammatically as follows ;
Figure 4.7
Demandpull inflation In the above figure, the X-axis measures real output and Y-axis measures the price level. Aggregate demand curves are D,D1,and D2 whereas S curve represents Aggregate supply function , which slopes upward from left to right and at point F it becomes a vertical straight line. At this point the economy reaches at full employment level. Hence real output remains same or inelastic at this point. D curve intersect S curve at point F, where real output or income is at full employment and OP is the price level. When aggregate demand increases from D to D1
and D2, the real output or income will remain same but the price level tends to increase from OP to OP1 and further to OP2.
Pri
ce l
ev
el
61
In short the inflationary process can be described as follows : Increasing demand increasing prices – increasing costs – increasing income – increasing demand – increasing prices – and so on. Causes of Demand-pull inflation : 1. Increase in public expenditure – There may be an increase in
the public expenditure (G) in excess of public revenue. This might have been possible through public borrowings from banks or through deficit financing, which implies an increase in the money supply.
2. Increase in Investment - There may be an increase in the autonomous investment (I) in firms, which is in excess of the current savings in the economy. Hence, the flow of total expenditure tends to rise, causing an excess monetary demand, leading to an upward pressure on prices.
3. Increase in MPC – There may be an increase in the marginal propensity to consume (MPC), causing an excess monetary demand. This could be due to the operation of demonstration effect and such other reasons.
4. Increasing export and surplus Balance of Payments – In an open economy, increasing demand for exports leading to increasing money income in the home economy. Whereas in the domestic market there is reduction in the domestic supply of goods because products are exported. If an export surplus is not balanced by increased savings, or through taxation, domestic spending will be in excess of the value of domestic output.
5. Diversification Resources – A diversification of resources from consumption goods sector either to the capital good sector or the military sector will lead to an inflationary pressure because the current flow of real output decreases on account of high gestation period involved in these sectors. The opportunity cost of war goods is quite high in terms of consumption goods meant for the civilian sector. This leads to an excessive monetary demand for the goods and services against their real supply, causing the increase in prices.
A) Cost-push inflation : Some economists holds the view that inflation is initiated not by an increase in demand but by an increase in costs, as factors of production try to increase their share of the total product by raising their prices. Such a price rise is termed as cost-push inflation as prices are being pushed up by the rising factor costs.
4.6 COST-PUSH INFLATION It is sometimes also called as wage inflation as wages constitute nearly seventy percent of the total cost of production. When wages rises it will lead to rise in cost of production and a consequent rise in the price level.
62
Cost-push inflation can be diagrammatically explained as follows.
Real Output
Figure 4.8 Cost push inflation In the above figure, demand curve D represent the aggregate demand function and SS represents aggregate supply function. The full employment level of income is OY. At this F is the point of intersection between aggregate demand and aggregate supply function. When aggregate supply function shifts upward to S1 it will become a vertical straight line at point G at full employment level. The new equilibrium point A is determined at OY1 level of output, which is less than full employment level at P1 level of prices. This means that with a rise in the price level unemployment increases. A further shift in the aggregate supply curve to S2 due to further increase in wages lead to further increase in price to P2 and fall in income level to OY2. Cost-push inflation may occur either due to wage-push or profit-push. When there are monopolistic labour organizations, prices may rise due to wage-push. When there are monopolies in the product market, the monopolists may be induced to raise the prices in order to fetch high profits. Then there is profit-push in raising the prices. Check Your Progress :
1. Define Inflation. 2. What are the various causes of demand-pull inflation? 3. Explain the causes of cost-push inflation.
4.7 SUMMARY 1. Keynes consumption function is a very significant contribution
to modern macro economic theory. In order to explain the concepts of consumption function and the multiplier theory, a study of the fundamental Keynesian principles is important.
2. Keynes in his general theory, brings out the real determinants
of income and employment in a modern economy. According to him, the economy can be in equilibrium at any level of employment. Full employment is one of the different situations in an economy. Under employment equilibrium situations are more common.
3. Keynesian theory is demand oriented It stresses effective
demand as a crucial factor in determining the levels of income and employment
4. Keynes gave importance to short run equilibrium. He assumed
that the amount of capital, population, technology etc. do not change in the short run Therefore, in the short run, the income and output depends upon the volume of employment. The levels of employment depend upon effective demand, which depends upon aggregate spending
5. Effective demand manifests itself in the total spending of the
community on the consumption and investment goods. Total employment depends on effective demand unemployment is due lo lack of effective demand.
6. Two Factors determine effective demand - Aggregate demand
function and aggregate supply function. The intersection of aggregate demand function and aggregate supply function determines the level of income and employment. This point is known as the effective demand. The equilibrium reached thus need not be the full employment equilibrium point. For reaching full employment equilibrium aggregate demand should increase.
7 The aggregate demand is made up of two components -
consumption expenditure and investment expenditure. Consumption expenditure is an important component , of the total expenditure. Consumption expenditure depends on the size of income and propensity to consume, which is called the consumption function. C = f(Y)
8 Keynes considered two technical attributes 1) APC 2) MPC
APC = C/ Y ' MPC = ΔC/ ΔY 9 A number of subjective and objective factors affect the
64
consumption function. 10 The multiplier theory explains the effect of changes in the
investment upon the consumption and the resulting generation of income. The theory of multiplier is a very important part of the General theory of employment.
11 Multiplier is the numerical coefficient which indicates the
increase in income due to an increase in the investment. K = ΔY/ l.
13 Sequence analysis is used to understand the working of the
multiplier. 14 However there can be certain leakages from the multiplier
which undermine the value of the multiplier.. 15. The unit ends with a criticism of the multiplier principle. 16. investment plays a crucial role in macro economic theories.
Fluctuation m employment and income occur due to changes in inducement to invest.
17. The factors which determines the investment demand are 1)
MEC, 2) Rate of interest. Marginal Efficiency of a given capital asset is the highest rate of return over the cost expected from an additional or marginal unit of the capital asset MEC depends on 1) the prospective yield of capital asset 2) the supply price of this asset
18. A comparison of the expected rate of profit and rate of interest
is important in investment decision. This leads to a comparison between the supply price of one asset and its demand price. Where. MEC = interest rate, SP = DP....... neutral
MEC < i, DP > SP Favorable for investment MEC < i, DP < SP Unfavorable for investment .Investment will be in equilibrium when MEC becomes equal to
the given rate to interest . 19. Short run and Long run factors affect MEC 20. The unit concludes with a discussion of Keynes liquidity
preference theory of interest. Interest, according to Keynes is a purely monetary phenomenon. Rate of interest is determined by the intersection of the supply schedule of money and the demand schedule of money. Money is demanded for three purposes - transaction purposes, precautionary and speculative purposes. The first two depend on the levels of income, whereas the speculative demand depends on the rate of interest. 'M' the total supply of money is given by the
65
monetary authority. M = L (r y) i.e. the quantity of money held depends on the rate
of interest and the level of income. The interaction of the liquidity preference function and the supply of money leads to equilibrium rate of interest. The rate of interest may change either due to shifts in the liquidity function or due to charges in the supply of money.
21. Keynes liquidity preference theory also suffers from a number
of drawbacks.
4.8 QUESTIONS 1 Discuss the Keynesian theory of employment. 2 What is the Keynesian Consumption function? What are the
various factors affecting the consumption function? 3 Explain the concepts of ARC and MPC. 4. What is multiplier? Explain the working of the multiplier. 5. Give a critical evaluation of the Keynesian multiplier theory. 6. Explain the objective and subjective factors affecting
consumption. 7. Write notes on a. Leakages in the working of the multiplier. b. ARC and MPC. 8. What is investment function? 9. Explain the factors which determine investment 10. a) What is MEC? b) What are the factors which affect MEC in the short run and
long run? 11. How does MEC and the rate of interest determine the volume
of investment? 12. Explain the role of MEC and interest rate in Keynesian theory
of employment. 13. Critically explain the liquidity preference theory of interest .
Write notes on 1) Motives of demand for money 2) MEC
66
5 Module 3:
MONEY SUPPLY
Unit structure : 5.0 Objectives 5.1 Introduction and Definition of Money 5.2 Functions of Money 5.3 Meaning and Definition of Money Supply 5.4 The Constituents of money supply 5.5 Reserve Bank of India‘s Measures of money supply 5.6 Determinants of money supply 5.7 Velocity of circulation of money 5.8 Summary 5.9 Questions
5.0 OBJECTIVES 1. To study the meaning and definition of money 2. To understand the various functions of money 3. To study the meaning and definition of money supply 4. To study the constitution of money supply 5. To Know the RBI‘s measures of money supply 6. To study the determinants of money supply 7. To study the velocity of circulation of money supply
5.1 INTRODUCTION OF MONEY Due to the difficulties of the barter system, money came into existence. Initially, we use metallic money, which was replaced by the paper money over a period of time. Today there are a wide variety of assets, which are used as money or near money. Before explaining what constitutes money, we will try to understand some of the important definitions, of money and then functions of money Definition of money : Different economists have defined money differently. Some of them focus on the exchange function of money while some others consider the general acceptability of money as a medium of exchange. Following are some of the important definitions of money - Crowther Money can be anything that is generally acceptable as a means of exchange and that at the same time act a measure and store of Value.
67
Marshall Money constitutes ail those things, which are at any time and space generally accepted without doubt or special enquiry as a means of purchasing commodities and services and of defraying expenses. Robertson Money is anything, which is widely accepted in payments for goods or in discharge of other kinds of business obligations Walker Money is what money does. From the above definitions, we may enlist following features of money: 1 Money must have a general acceptability. 2. Money should act as a medium of exchange in buying and
selling operations 3. Money should be capable of storing the value for the future
5.2 FUNCTIONS OF MONEY MONEY IS A MATTER OF FUNCTIONS FOUR, A MEDIUM, A MEASURE, A STANDARD, A STORE. Money performs following important functions: - 1. Medium of Exchange: Perhaps the most important function of
money is to serve as a medium of exchange in buying and selling goods. Under barter system, exchange required finding of two people wanting each other's goods, (double coincidence of wants) The existence of money has eliminated such requirement and the exchange transactions have become very simple. A man having wheat can sell it for money and buy anything that he wants with that money. He does not have to find a man having the commodity of his need.
2. Measure of Value: Money serves as a common measure of
value for all the commodities and service's. The value of every commodity can be expressed in terms of money. This simplifies the exchange transactions of all the commodities on one hand, and helps to compare the values of different commodities, on the other hand. For example, it is very easy to compare the values of say Radio and a Cassette player once we express them it terms of money. We can easily conclude that the cassette player of Rs 4500 is more valuable than a Radio of Rs.2300.
3 Store of Value: In the absence of money, it would be difficult to
store the value for the future Money makes it very convenient to store the value for the future Money does not require more
68
space, it is durable and is readily exchangeable with the other commodities and services whenever required.
4 Standard of Deferred Payments: Money also performs one
more important function of the modem times. With the invention of money, it is possible to express future payments in terms of money. A borrower borrows some amount of money today and assures to repay the same with some interest in future. All the credit transactions related to trade and commerce of modem economy are based on this function of money.
5. Other functions: Apart from the above-mentioned important
functions of money, there are some other ways in which money helps the modem economies. It facilitates the distribution of National income among different factors of production in the form of the rewards for the services rendered by them. Thus, the labour class gets wages, the capitalists get interest, the landowners get rent and the entrepreneurs get profits in the form of money.
Check Your Progress :
1. Define money. 2. State the four functions of money supply.
5.3 MEANING AND DEFINITION OF MONEY SUPPLY Money supply refers to the stock of money available for the spending purpose which is held by the people of a country. The money may be available in the various forms. 1 Coins and notes which are issued by the government and the
central bank of the country and which are in circulation. This portion of money supply is known as legal tender.
2. Demand deposits with the commercial banks, which are
withdrawable at any time. To withdraw the demand deposits the customers need not give a prior notice to the bank.
3. Time deposits and other kinds of less liquid assets also may
be included in the concepts of the money supply. These
69
concepts will be analyzed in the latter part of the study material.
From the concept of money supply, some types of financial assets are excluded These are. – 1 That part of currency notes and coins which lies with the
commercial banks and with the central bank as reserves. This is because this part of money is not included m circulation.
2 The monetary gold held by the central bank of the country
does not get circulated in the economy It becomes a part of international money So it is excluded from the concept of money supply.
3 All those cash balances held either by the banks or by the
government of which are in the treasury of a country are also excluded from the concept of money supply. This is because, they are kept for the administrative and non-commercial activities and are not circulated in the economy.
In short, m its very narrow sense, money supply is defined as the money available with the public in the form of currency (notes and coins) and the demand deposits with the banks. Two dimensions of the Concept of money supply : The concept of money supply should be analysed in two ways: a Stock concept b Flow concept The stock concept of money supply refers to the money available in circulation for spending purposes. The stock concept includes the money held by the public alone. The money in terms of currency notes, coins and demand deposits held by the public at any given point of time is called the stock of money. The flow concept refers to the money supply over a period of time. Here the velocity or the speed of money in circulation is taken into consideration The velocity of money is defined as the number of times money changes hands from one person to another. In an economy, over a period of time, money changes hands. That means it is spent and re-spent same units of money are used again and again in a year. For example, Rs. 100 crores of currency notes may get circulated in the economy, on an average for five times, making the total money supply to be 500 crores-within a year. Here the velocity of money is five. The flow concept of money supply is calculated as follows: -
70
Money supply by the flow concept = MV where, M stands for stock of money and V stands for the velocity of money i.e. the number of times money changes hands.
5.4 THE CONSTITUENTS OF MONEY SUPPLY There are two views about the constituents or the components of money supply A group of economists has defined money supply in a very narrow sense and the other group has defined money supply in a very broad sense. Following is a brief analysis of the various views on the constituents of money supply. i) Traditional View ii) Modem view.
i) Traditional View According to this view, the concept of money supply includes only two things – A Currency notes and coins issued either by the government of a
country or a central hank of a country.'- The currency notes and coins have an important feature of general acceptability. Generally the central bank of a country has a monopoly of note issue. In some countries the government also issues notes In India, one rupee note and coins are issued by the government of India. The issuing of notes is possible under various systems.
* Under the gold reserve or silver reserve system, the
issue of paper currency notes is backed by 100% gold or silver deposits. That means the central banks keep the reserves equal to the amount of notes issued by them in terms of gold or silver. If the notes worth 20 crores are issued, gold or silver worth 20 crores is kept as reserves.
* Under the system of fixed Fiduciary Issue, the amount of
paper currency notes to be issued is fixed by law and the reserves are kept in the form of government securities.
* Under the maximum fiduciary issue system, the
maximum limit for the note-issue is fixed legally and it is covered by the security of government securities
* Some countries follow the system of proportional gold
reserve under which a certain % of gold reserves are kept against the note issue and the rest of the reserves are kept in the form of treasury bills, Government securities, etc.
71
* India follows a system of what is called as the minimum percentage gold reserves. Under this system, a minimum % of gold reserves are kept against the note issue and the rest of the reserves are kept in the form of different assets of the central bank.
b) Demand deposits of the commercial banks can be withdrawn
by a cheque whenever demanded. They constitute another important part of money supply according to the traditional view. The share of demand deposits of the banks in the total money supply depends upon the level of development of the country. In the developed countries like the U.S.A., 80% of the total money supply is in the form of demand deposits. This is because, a large number of transactions take place in the form of cheque payments in such countries. Actual handling of cash is much less.
Thus, the traditional approach to the money supply is highly narrow and includes strictly those assets which are highly liquid in nature like the legal tender money and the demand deposits of the commercial banks. This approach considers money only as a medium of exchange. So only those constituents of money which have a general acceptability as a medium of exchange are included in the traditional aspect of supply, of money. ii) Modern View : A modem view to money supply is much wider and it includes in the concept of money supply different types of money and near money assets. Apart from the medium of exchange function of money, the store of value function of money is also considered important by the followers of this approach. The constituents of money supply according to the modern approach include. – a Currency notes and coins b Demand deposits of the commercial banks c Fixed deposits :- The modern approach to supply to supply of
money includes the saving and time deposits of the commercial banks. The-time deposits are those deposits which are withdrawable only at the expiry of the time for which the deposits are kept
d Treasury bills and the other bills held by the commercial banks.
e Post office saving deposits f National saving certificates g Equity shares h. Government securities and bonds i Many other assets which are near money assets. The followers of the modern concept of money supply were the economists like Milton Friedman, Gurley and Shaw, and the
72
Radcliff committee members. According to Milton Friedman, the money supply concept should include time and savings deposits of the commercial banks apart from the currency and demand deposits Gurley and Shaw were of the opinion that even the assets of the non-bank financial institutions and bonds and shares of different kinds are also to be included in the concept of money supply. The Central bank approach to the constituents of money supply includes all the funds lent by a number of financial institutions Thus, the modern view regarding the money supply includes all those assets which are highly liquid along with those assets which have limited liquidity. But the economists like Gurley and Shaw are of the opinion that the near money assets like those mentioned above (C to i) are also important constituents of money supply. As a result, this approach is a wider approach.
5.5 THE RESERVE BANK OF INDIA’S MEASURES OF MONEY SUPPLY :
The concept of money supply as adopted by the RBI has changed since 1977 This is called the measures of money supply. Under this concept, money supply is defined as follows – M1 → C + DD + OD C Currency Notes DO Demand deposits of commercial banks OD Other deposits with the RBI M2 → M1 + SD =C+DD + OD + SD SO : Saving bank deposits M3 → M1 + TD . = C + DD + OD.+ TD TD : Time deposits with all the commercial and co-operative banks M4 → M3 + TDP A 3 = C + DD + OD + TD + TDP TDP : Total deposits with Post office Thus, the RBI has taken all possible deposits in the concept of money supply. Even by including post office saving deposits, RBI has broadened the concept of money supply. Post office saving deposits being less liquid, for all official matters, M3 is considered to be the most relevant measure of supply in India. The RBI working Group has made some changes in the concept of money supply in India in the year 1998. According to the
73
recommendations of this group, the measure of money M is totally abolished and now there are only three measures of money supply. M1 = C + DD + OD (same as earlier) M2 = M1 + Saving deposits + CDs issued by the banks + term deposits maturing within one year. M3 = M2 + term deposits over one year maturity + term borrowings of banks Check Your Progress :
1. Money supply is a stock as well as flow concept-Explain. 2. Examine the traditional view of money supply. 3. Explain the modern view of money supply. 4. What are the RBI‘s measures of money supply.
5.6 DETERMINANTS OF MONEY SUPPLY The total money supply in the economy depends upon various factors. They are called as the determinants of money supply. Following is a brief analysis of the factors on which money supply depends. 1) Reserve or high powered money. High powered or Reserve money (H) is a base of money
supply. It includes only the currency (C). cash reserves of the banks (R) and other deposits with the RBI (OD)
H = C + R + OD High powered money is a major determinant
of money supply in the economy 2) Money Multiplier: The high powered money along with the money multiplier
determine the total supply of money. Money multiplier depends upon the people's preference to hold cash If more cash is held by the people, banks will have less cash, their credit creation capacity will be low So availability of money in the economy will also be low. The value of money multiplier will also depend upon the reserve requirements. The commercial banks have to keep certain % of their deposits with the Central bank. Their credit creation capacity decreases due to this and hence the supply of money, in the economy also gets reduced. Thus
74
higher the value of money multiplier, higher will be the money supply and vice versa.
3) Community's choice : Total money supply also depends upon the choice of
community - whether to hold money in terms of cash or in terms of deposits of commercial banks. If the community holds larger part of money m cash, it that money does not enter into the credit creation process. But if the community keeps their money in the banks and make transactions by cheques more money will be held by the banks which can be circulated in the economy through of credit creation process.
4) Velocity of circulation (v): The number of times money changes hands or the velocity of
money is an important determinant of money supply. The Higher the velocity of money, the more will be the supply of money and vice versa.
5) Fiscal and monetary policy : Fiscal policy is the policy which influences economy through
taxation, public expenditure, public debt and deficit financing. The decisions of the fiscal authorities also have an influence on the supply of money. Increase in public expenditure or reduction in the rates of taxes or deficit financing may increase the supply of money. On the other hand, introduction of new taxes, and fall in the government expenditure will reduce the total money supply in the economy.
Monetary policy of the Central Bank is also an important
determinant of money supply A cheap money policy by the central bank increases the availability of money in the economy and a restrictive money policy reduces the total money supply (discussed in detail in the next unit.)
6) Liquidity Preference : Liquidity preference is the desire of people, to hold money in
cash. More the liquidity preference, less is the money available for circulation and less will be total money supply.
5.7 VELOCITY OF CIRCULATION OF MONEY The velocity of money is the number of times money Changes hands during a given period of time, generally one year The money supply in the economy is greatly affected by the velocity of money in circulation. The more the velocity of the money, more is the money supply in the economy. The velocity or speed of money depends upon many factors
75
(1) Regularity of Income In a Community, if people are receiving income quite regularly
and at a regular interval, the velocity of money is quite high. The people would spend money frequently as they receive the money regularly. In the community where people receive their income irregularly, the velocity of money will be less because the people will tend to hold more cash than spending it.
(2) Liquidity preference The liquidity preference means the desire of people to hold
cash. If people want to hold more money in cash or they have more liquidity preference, less will be the velocity of money.
(3) Savings The more the savings or less the consumption's, the lower is
the velocity of money in circulation More money saved means people hold more money in cash and do not spend. This reduces the movement of money .in the circulation.
(4) Development of banking and financial institutions in a country with more banking and financial institutions,
money changes hands quite frequently. People's savings are mobilised more quickly by the banking and financial institution. This increases the velocity of money in circulation.
(5) Trade Cycles The velocity of money also Changes in accordance with the
phases of the trade Cycle. During prosperity, the volume of transactions is more, money Changes hands more quickly. This increases the degree of velocity of money. On the other hand, during the depression situation or in deflation, the volume of transactions is quite less. This reduces the degree of velocity of money
(6) Level of income The velocity of money is quite high among the low income
groups people. This is because they have to spend most of their incomes on the immediate' needs. This is not so with high income groups. This group can withhold their consumption as many of their wants are satisfied. As a result the velocity of money in circulation may be low.
Check Your Progress :
1. What are the determinants of money supply? 2. Which factors affect the velocity of circulation of money?
5.8 SUMMARY a. Money is considered as a medium of exchange. b. Over the years money has performed many more functions
than just being an exchange medium. c. Money supply is the total stock of money circulated in the
economy. It is a stock as well as flow concept. d There are two different views regarding the constituents of
money supply- traditional or narrow and modern or broad. e. As per the recommendations of the RBI‘s Working Group
1998, the revised measures of money supply are M1, M2 and M3.
f. Total money supply in the economy depends upon many
factors which are called as the determinants of money supply. g. The velocity of circulation of money is the average number of
times money changes hands during a given period of time, generally a year.
5.9 QUESTIONS 1) Define Money supply. Discuss its constituents. 2) What are the determinants of money supply? 3) How is the traditional approach to money supply different from
the modern approach? 4) Write short notes on :- . a) Velocity of money . b) Functions of money c) Determinants of money supply d) Constituents of money supply.
77
6 DEMAND FOR MONEY
Unit Structure : 6.0 Objectives 6.1 The Classical approach to demand for money 6.2 The Fisher‘s Equation of Exchange 6.3 The Neo-classical approach to demand for money 6.4 The Keynesian approach to demand for money 6.5 The concept of Liquidity trap 6.6 The Friedman‘s Theory of demand for money 6.7 Summary 6.8 Questions
6.0 OBJECTIVES 1. To study the Classical approach to demand for money 2. To study the Fisher‘s equation of exchange 3. To study the Neo-classical approach to demand for money 4. To study the Keynesian approach to demand for money 5. To understand the concept of liquidity trap 6. To study the Friedman‘s version of demand for money
6.1 THE CLASSICAL APPROACH TO DEMAND FOR MONEY
The classical economists emphasized the medium of exchange function of money According to the classical economists like J.S. Mill. David Hume and Irving Fisher, the demand for money arises since money facilitates the exchange of real goods and services among individuals. Hence money is demanded for buying and selling goods and services or for spending over a period of time The classical economists believed that the demand for money depends on objective factors like the volume of exchange transactions of goods and services produced and supplied during a given period of time, the amount of money needed to buy the goods and services and by the velocity of circulation. Since the volume of goods and services changes from time to time, the demand for money also changes The classical approach to the demand for money can be grouped into the Fisher‘s cash -- Transactions Approach and the Cambridge economists' cash-Balances approach
78
6.2 THE FISHER’S APPROACH TO DEMAND FOR MONEY
Irving Fisher's Equation of Exchange is one of the most prominent explanations which analyse the demand for money. According to Fisher, the demand for money means the amount of money to be held to undertake a given volume of transactions over a period of time. Fisher's equation of exchange is given as MV = PT, where M is the money supply, V the transaction velocity, T transactions and 'P‘ the price level. 'PT' in the equation represents the demand for money and MV stands for the supply of money. The
demand for money (Md) is equal toV
PT. It means that the demand
for money is equal to 'P' multiplied by 'T' over a period of time and divided by V The demand for money depends on the amount of money which people have to hold in order to carry on a volume of transactions over a period of time. According to Fisher 'V and 'T' are constant during the short period As a result, the demand for money varies with changes in 'P'. According to Fisher the supply of money
(Ms) is equal to V
PT. Since the demand for money (Md) is equal
V
PT it means that the demand for money is always equal to the
supply of money. Fisher‘s version of demand for money stresses the role of money in spending and not saving The demand for money changes in proportion to the changes in the price level. V also determines the demand for money.
6.3 THE NEO-CLASSICAL OR CAMBRIDGE APPROACH TO DEMAND FOR MONEY :
The Cambridge approach or the cash balances approach was given by Marshall, Pigou, Robertson and Keynes. These economists stressed the store of value function of money. This approach concentrates on what individual want to hold for satisfying the transaction motive and precautionary motive. According to this approach, the demand for money refers to the cash balances held by all individuals in an economy. The following factors influence the decisions of individuals in holding cash.
(i) The prevailing prices of goods and services and the expected changes.
(ii) The existing interest rates and expected changes in future.
(iii) The wealth in the hands of the people. These factors remain constant according to the Cambridge
79
economists. The total demand for money or cash balances is a certain proportion of national income. The demand for money can be expressed as, Md = KPY, where MD is the demand for money, K is the constant proportion of income Y. It is the proportion of national income which people desire to keep in the form of cash balances and Py is the nominal national Income. According to the Cambridge economists the demand for money is the constant proportion (K) of Y. Wherever there is a change in the price level or in the real national income, the demand for money also changes in equal proportion For example if MD is Rs. 2000 crores and the money income is Rs 6000 crores per year K = 1/3 per year. This imples that on an average the public likes to hold money amounting to 1/3 of the annual income. Check Your Progress :
1. Distinguish between Cash transaction and Cash balance approach to demand for money.
J M Keynes introduces his theory on the demand for money through his book titled, the "General Theory of Employment. Interest and Money" in 1936. According to Keynes money was demanded due to three main motives i.e. the transactions motive, the precautionary motive and the speculative motive. The speculative motive of demand for money is a special contribution of Keynes.
(i) The transaction motive :
It refers to the transaction demand for money as a medium of exchange for carrying on current trade and business transactions. Money is demanded for transaction purposes since it is received at discrete intervals of time and expenditure goes on continuously. Keynes classified the transactions motive into (a) income motive and (b) business motive. (a) The income motive : People hold cash to bridge the gap between the receipt of
80
income and expenditure. The income in the form of salary or wages is recovered at a certain time like once in a week or once in a month. But expenditure goes on throughout all the time. To meet day-to-day expenditure a part of the income has to be held in the form of liquid cash. The following factors decide the amount of money held by people: (i) Level of Income As the level of income increases, the
transaction demand for money of the individual will increase and vice versa.
(ii) Tune Interval: The longer the time interval between the
receipt of income and expenditure, the higher the amount of money held by people for transaction purposes.
(iii) The standard of Living : The higher standard of living, the
larger the amount of money held and vice versa. (b) The business Motive : The businessmen and the firms also hold cash balance in order to bridge the interval between the time of incurring business costs or expenses and the receipt of the sale proceeds. The larger the volume of turnover or transactions for the business firms, the greater will be the amount of money held for this purpose. The amount of money held by the business firms depends on the size of their income and their turnover. The aggregate demand for money for satisfying the transaction motive is the sum total of the individuals demand for cash as well as the individual firm's demand for cash. This aggregate demand for money will depend upon total size of national income, the level employment and the price level. The transactions demand for money primarily depends on the level of income. The transaction demand for money which is income-elastic can be expressed in the following manner. L = (fy) where Lt with transaction demand for money, T stands for function of and y stands for the national income. The figure below shows the transaction demand for money.
81
Figure 6.1 In the above figure, dd is rising indicating that, with the increase in national income, the demand for money for transaction purposes also rises, (ii) The Precautionary Motive : Besides the money kept also for transaction purposes, people hold additional amount of money to meet unexpected or unforeseen contingencies, emergencies or unexpected events. Money held for such precautions is known as precautionary motive. The accessibility of individuals and firms to the credit market determines the amount of money held for this purpose. If borrowing is easy or the assets of the people can be easily connected into cash, the amount of money held for this motive will be very low and vice versa. Uncertainty regarding future will make individuals and firms keep aside money for precaution purposes. The precautionary motive of demand for money depends on the income level ie. L = f(y), where 'Lp‘ stands for precautionary motive, T a function of and y, the level of income, (iii) Speculative motive : People hold money as a store of wealth or liquid asset for investment and lending, with a view to make speculative gains. People speculate about the future prices of bonds or securities or future interest rates. People prefer to hold securities where prices are expected to rise in future and vice-versa. People make capital gains from speculative about the prices of bond or securities or future interest rates. According to Keynes. the speculations motive is the desire to earn profit by knowing better than the market what the future will bring forth The individuals have to choose between holding money or other assets Uncertainly regarding the behavior of the future interests and price of bonds leads to speculation. If the rate of interest is high and the prices of bonds are low, the lower will be liquidity preference. In such a case money will be lent or bonds will be purchased. There is an inverse relation between the prices of bonds and interest rate. If the interest rate is expected to rise, or the prices of bonds to fall, people sell the bonds or assets and hold more cash. The people will buy the bonds when their prices actually fall In the other hand, if the people expect the rate of interest to fall, or prices of bonds to rise, people will buy bonds whose prices are expected to go up. This leads to a fall in liquidity preference. This shows that speculative demand for money is interest elastic. – L = f(i) where. L2 is the demand for money for speculative purpose, (i) the rate of interest
82
Liquidity preference (Speculative demand for money)
Figure 6.2
The above figure shows the inverse relation between the rate of interest and the speculative demand for money. It slopes downwards from left to right indicating that when the rate of interest is high, the demand for money is low and vice versa.
6.5 THE LIQUIDITY TRAP If the rate of interest goes below a certain acceptable minimum people will not part with liquidity. The liquidity trap is defined as the set of points on the liquidity preference curve, where the
percentage change in the demand for money M
M in response to a
percentage change in the rate of interest i
i approaches infinity. In
other words, the demand for money becomes perfectly elastic at very low rates of interest. The figure below makes clear this situation
Figure 6.3 This indicates that the rate of interest remains constant even when there is an increase in the quantity of money. The actual rate of
83
interest cannot fall below Or. The Total Demand for money : The total demand for money, or the community demand for money can be put as. L = L1 + L2 where 'L' refers to the overall demand for money, 'L1' the demand for money for satisfying the transaction motive and the precautionary motive and L2 the total demand for satisfying the speculation motive.
6.6 FRIEDMAN’S THEORY OF DEMAND FOR MONEY According to Milton Friedman who restated the quantity theory of money and prices there are four determinants of demand for money (i) the level of prices (ii) the level of real income and output (iii) the rate of interest (iv) rate of change in general price level. Friedman Classifies the holders of money into (a) ultimate wealth holders (b) business enterprises His theory is relevant to the ultimate wealth holders Friedman has given a very broad concept of wealth which includes all sources of income or services. According to Friedman, the demand for money is a demand for capital asset since money like capital assets provides services and returns. Bonds are monetary assets in which the people can hold their wealth and enjoy fixed interest income. The return on bonds is the sum of the coupon rate of interest and the anticipated capital gains or losses due to the expected change in the market rates of the interest People can also hold their wealth in the form of equity shares and enjoy returns in the form of dividend income and capital gains or losses Milton Friedman gave his demand function in the following manner
Md = f (w. h. rm rb , re , P.P
P, u)
This is the nominal money demand function. The demand for real money balances can be derived by dividing the nominal money demand by the price level
Md = f (w. h, rm, rb, re, P .P
P, u)
Where. .P
Md = demand for real money balances.
w =wealth of the individual h = the proportion of human wealth to the total wealth held by the individuals rm = the rate of return on money or interest rb = the rate of interest on bonds re = the rate of return on equity shares p = the price level
84
P
P = change in the price level
u = Institutional factors. The simplified version of Friedrnan's demand function for money can be written as,
.P
Md = f (r, Yp, u)
The demand-function of Friedman, though it looks similar to Keynes equation is different from Keynes in some ways :- (1) Keynes gave importance to current income whereas Friedman
gave importance to wealth (2) Friedrnan's theory does not consider unstable elements like
the Keynes speculative demand for money (3) Friedman did not consider the possibility of a liquidity trap
situation. Check Your Progress :
1. What is the Keynesian approach to demand for money? 2. Explain the concept of Liquidity trap. 3. What are the Friedman‘s determinants of demand for
6.7 SUMMARY 1. The demand for money is a derived demand, since it is
demanded for the functions that it performs. Broadly speaking the different approaches to the demand for money are (i) The classical approach (ii) The Neo-Classical approach (i)i) The Keynesian approach (iv) The Modern Approach
2. According to the classical view of demand for money or the
Fishers' version, money is demanded for transaction purposes. Fisher explains the transaction demand for money in the following form
MV = PT Md = PT/V It means that the demand for money is the product of the
85
volume of transaction (T) over a period of time multiplied by the average price level (P) and divided by the velocity (V).
3. Fisher assumes V and T1 to remain constant during the short
period. Hence, the demand for money varies with changes in 'P'. The Cambridge economists gave importance to the store of value function of money. According to the neo-classical or Cambridge economists, the demand for money is the amount of money people desire to hold. The demand for money can be expressed as Md = KPY. The demand for money is a constant proportion (K) of y. Wherever there is a change in the price level or in the real national income, the demand for money also changes in equal proportion.
4. According to Keynes' view on the demand for money there are
three motives of demanding income i.e. Transactionary, precautionary and speculative motive. The transaction and precautionary motives of demand for money depend on the level of income whereas the speculative demand depends on the rate of interest. The speculative motive is a negative function of the rate of interest. When the price of bonds is low or the rate of interest is high, people prefer bonds to liquidity and as the prices of bonds rises, people prefer liquidity to bonds.
5. When the rate of interest is very low, i.e., below the acceptable
minimum people prefer to hold cash balances. This Situation is known as the 'Liquidity Trap.' The total demand for money according to Keynes is L = L (y) + L (r)
6. According to Milton Friedman there are four determinants of
demand for money (i) the level of prices (ii) the level of real income and output (iii) the rate of interest (iv) the rate of change in general price level. Friedman presented a broad picture of wealth which includes all sources of incomes or services.
Milton. Friedman gave his demand function in the following manner
Md = f (2, h, rm, rb, re, P .P
P, u)
^Dividing the nominal demand function by the price level, gives us the real money balances.
Md = f (2, h, rm, rb, re, P .P
P, u)
The simplified version of the equation is as follows Md / P = f (r, Yp. u)
86
6.8 QUESTIONS 1 Explain the cash transaction approach to demand for money. 2 Explain the neo-classical or the cash balances approach to the
demand for money. 3. What are the three motives of demand for money according to
Keynes. 4 Write a note on Friedman's version of the demand for money. 5 Write notes on - (a) The liquidity trap (b) Speculative Motive (c) Fisher's equation of exchange.
87
7 Module 4 :
BANKING AND FINANCIAL MARKETS COMMERCIAL BANKS
Unit structure : 7.0 Objectives 7.1 Introduction of the commercial banks 7.2 Functions of the commercial banks 7.3 Liquidity Vs Profitability objectives of the commercial banks 7.4 Credit creation process of the commercial banks 7.5 Commercial banking development in India since 1969 7.6 Summary 7.7 Questions
7.0 OBJECTIVES 1. To understand the concept of commercial banks 2. To study the functions i.e. banking and non banking of
commercial banks 3. To study the conflict between liquidity and profitability
objectives of the commercial banks 4. To study the credit creation process of the commercial banks 5. To study the commercial banking development in India since
1969 ( Nationalisation of commercial banks)
7.1 INTRODUCTION There are various types of banks like the commercial banks, co-operative banks, agricultural banks, industrial banks, etc. Each of them are established with some specialized purpose For example, the foreign exchange banks is specialized in the provision of the foreign currency, the industrial banks deal with the supply of credit to the industrial sector, etc Commercial bank can be defined as a joint stock company which deals with the money by accepting deposits from the people and by lending money to the entrepreneurs for various activities. The commercial banks act as a link between the savers and the investors. The people having surplus money may not be interested in the investment, while the people who wish to invest the money may not have surplus funds. These two types of people have to be brought together or at least the surplus funds of the people are to made available to the investors The commercial banks are the
88
important institutions undertaking the task of encouraging the people to save their surplus funds in the form of the bank deposits by paying them interest on their savings and then to circulate' these funds among the investors and charging interest rate from them In the process, the commercial banks make profits. The commercial banks can not print the notes. The printing of money is an exclusive right to the central bank of the country. But the commercial banks are the profit earning institutions. They play an important role in the creation of credit in the economy by reutilizing the existing deposits of their customers. Thus, the commercial banks are not only the traders of money but they are also the creators of credit. In the further discussion we will try to understand how this is done.
7.2 FUNCTIONS OF THE COMMERCIAL BANKS The functions of the commercial banks may be subdivided into two categories A) Banking Functions B) Non-banking or Subsidiary functions 7.2.1 Banking functions of the commercial banks i) Accepting deposits- The commercial banks accept deposits from the people and pay them the interest rate on their deposits. The rate of interest vanes in accordance with the amount of deposits and the duration for which the deposits are kept with the bank. There are various kinds of deposits. A Demand deposits- These are withdrawals at any time or
whenever the depositor demands Either a very low interest rate is paid on such deposits or no interest is-paid A depositor can withdraw any number of times from his demand deposit account There are generally no restrictions on the withdrawals
B Saving bank deposits - These deposits are generally opened
by the salaried people An account can be opened with a small sum of money. A very little interest rate is paid on these accounts
C Fixed or Time deposits - Under these deposits, money is
kept for a certain fixed period of time, say, a year, three months, five years, etc. These deposits can earn more interest rate and, the fixed deposits are the important way in which the people keep their savings. There is a restriction in the number of withdrawals from the time deposits and if these, deposits
89
are withdrawn before the expiry of the time, the depositor has to pay a penalty.
D Recurring deposits : Here a depositor is supposed to save a
certain amount in his recurring deposit account every month or every year The purpose of these deposits is mainly to inculcate the saving habits among the people. These deposits also earn a reasonably high rate of interest.
ii) Giving loans: The commercial banks are the important financial institutions So they mobilize the money from the saving agents and lend these to the customers who want to borrow the money for productive purposes. The commercial banks generally lend money for short or medium term. They .lend money to various productive sectors like industry, trade, commerce, tourism, export and import activities and also to the agricultural sector While lending money to the customers, the commercial banks have to follow the rules and regulations fixed by the central bank of the country, they can lend money in accordance with their deposits, they also have to keep some amount of their deposits as reserves .This means that they cannot lend 100% of their deposits but have to maintain a part of their deposits in the liquid form. We will study more about the credit creation capacity of the commercial banks later in the following discussion. The commercial banks give loans in various forms – a. Call loans - These are the loans which are given for a very
short period of time i.e. 24 hours. They are generally given to the stock brokers and agents.
b. Bill of Exchange - The bill of exchange is used in the
business payments. Here the person who is supposed to make payments (debtor) gives a written promise to the person to whom the money is to be paid (creditor) to make payment in a particular. . time period say, between one month and three months. The creditor can immediately discount these bills from the commercial banks. That means the creditor can take -, this written promise to the commercial bank, get cash in exchange but pay some amount as a discounting rate. The creditor gets the cash immediately but he has to accept a slightly less amount than what the discount bill is meant for.
c. Overdraft facility - The commercial banks also allow their
regular depositors to withdraw more money than what they have in their account. Some interest rate is charged only on the amount which is over and above the actual deposits of the borrower in the bank.
d. Loans - The commercial banks provide direct loans to the
customers who have a sound investment project and a
90
capacity to pay back the loans. The commercial banks even cam money by, charging rate of interest on these loans
7.2.2 Non-banking Functions of the commercial banks i) Agency services - The commercial banks act as agents of
their customers and they perform various services for them. They may collect cheques on behalf of them, they may sell and purchase securities and other financial assets, they may carry correspondence on behalf of their customers.
it) Collection - The commercial banks also collect cheques,
drafts, dividends, bills and other type of receipts of their customers The banks may charge some service charges for providing these services but the customers get a lot of help from the commercial banks in speedy provision of these services.
iii) Payments - With a request from the customers, the
commercial banks can also make certain payments on behalf of the customers. They can pay the insurance premium, rents, taxes, electricity bills, telephone bills, etc if they are instructed to do so by their customers.
iv) Utility services - The commercial banks provide many utility
services like underwriting facilities, locker facilities, draft facility, foreign exchange dealings, guarantor, etc.
v} Publication of data and other statistical information - The
commercial banks may also be engaged in the collection and publication of statistical information regarding the important financial indicators. ,
Thus we can summarize the functions of the commercial banks in the following chart –
CHART 7.1
7.3 LIQUIDITY VS PROFITABILITY OF THE COMMERCIAL BANK :
91
The commercial banks are the profit earning institutions. They try to maximise their profits by accepting the deposits and then lending the money to those who need loans for the productive purpose. In doing so they try to maximize the difference between the rate of interest which they pay to the depositors and the rate of interest they charge from the people who borrow from the banks. At the same time they have to use maximum amount of their deposits for lending the money. However, the commercial banks have to keep certain amount of their deposits in cash or in the liquid form because the depositors may demand, their money at any time. The people will loose the confidence in the bank if they 00 not get their money in cash whenever they want if, for example, a situation arises in which the commercial bank tends, most of the deposits in the form of industrial loans to maximise the profits and then fails to give cash to its customer who has a current account in the bank, and wants to withdraw a pan of deposits in his account. This would go against the reputation of the bank and perhaps the bank would have to close its business. So a proper and safe ratio between the liquid cash and advances to the customers has to be kept by each commercial bank. Thus, the liquidity (maintaining cash balances in anticipation of the demand from the deposit holders of the bank) and profitability (lending money to the borrowers by charging rate of interest) are the two principles on which the efficient working of the commercial banks depends Liquidity is the cash field by the commercial banks. The lending and investments of the banks should be so planned that there should be enough liquid assets in the hands of commercial banks The liquid assets can be converted into cash without a loss of much time. Profitability is the rate of return that the commercial banks get either by investing the money or the rate of interest which they can charge on the loans and advances given by them to their customers. The liquid assets do not get any rate of return Therefore, there e a clash between the liquidity objective and the profitability-objective of the commercial bank. More the liquidity, less is the profitability. But as the commercial banks also have to think about their depositors, it is mandatory for them to keep certain amount as cash reserves.
7.4 CREDIT CREATION PROCESS OF COMMERCIAL BANKS
The commercial banks, as we have seen earlier, are the profit earning institutions. They have to utilize the deposits kept by the people with them, convert these deposits into the advances and then earn the rate of return on these loans. The process by which
92
the commercial banks turn their primary deposits into the secondary or active deposits and earn profit is called a process of multiple credit creation. In this part of the unit, we will first understand all the concepts related to the credit creation process and then we will actually learn how the banks can create money out of the existing deposits. The money accepted by the banks from its depositors in the form of cheque or cash is called as the primary deposits. These deposits, are passive in nature. With the help of the primary deposits, the commercial banks can advance loans of different types. These are called as the secondary or derivative deposits. These deposits are active in nature and it is these deposits that bring out the profitability to the commercial bank. The process of multiple credit creation can be explained with the help of following assumptions :- 1 There are many banks operating in the economy. 2 People deposit money with the bank 3 There is a sufficient demand for the bank loans 4. The banks keep a part of their deposits in terms of cash
reserves which are legally fixed by the central bank. Suppose Bank A receives Rs. 20.000 as the primary deposits (money deposited by a customer in the bank). Suppose the banks are required to keep 20% as a reserve requirement prescribed by the central bank The balance sheet of the bank A will look something like this
Assets Liabilities
Fresh deposits 20.000 Fresh cash 20.000
Total 20,000 Total 20,000
Now suppose that Bank A wants to advance loans, it has to keep 20% of its deposits as a cash reserve requirement The remaining amount can be given as loans. Now the balance sheet will look as follows :
Assets Liabilities
Reserves 4,000 Deposits 20.000
Loans 16,000
93
Total 20.000 Total 20.000
Now if Bank A gives loans worth Rs 16.000, the total money supply in the economy also has increased by 16.000/- A person who borrows Rs 16,000 may make his payments by cheque which may be deposited in Bank B. The balance sheet of Bank B will look something like this :-
Balance sheet of Bank B
Assets Liabilities
Reserves 3.200 Deposit 16,000
Loans 12,800
Total 16,000 Total 16,000
So now Rs. 12,800 are added into the money supply. This process continues and from the primary deposits of Rs. 20,000 many times more secondary deposits are created which is called as the process of multiple credit creation.
Following table briefly explains the process of multiple credit creation in a given period of time.
Table : 7.2
Banks
Primary Deposits
Loans
Reserves
A 20000 .16000 4000
B ' 16000 12800 3200 C 12800 10240 2560
D 10240 8192 2048 E 8192 6553.60 16.38.40 F - G -
H , .
etc etc etc
Total of the banking system 100000 80000 20000
Thus, at the end of the process of multiple credit creation, the primary deposits increase by 5 time and become worth Rs. 1,00,000; the loans given to the investors are worth Rs. 80.000/- and the reserves with the central bank are Rs. 20.000/- which is 20% of the total deposits. The value of multiplier is 5 in the above example and hence the secondary deposits are 5 time more than the primary deposits.
94
The value of multiplier (k) is found out with the help of following formula.
RK
1
Where K-multiplier R - reserve ratio In the above example R = 20%.
520
100
100/20
1
%20
1K
Value of multiplier is K = 5. 7.4.1 Limitations to the credit creation process of commercial
banks Though the commercial banks can create credit with the help of the deposits, their capacity to create credit is limited by many factors. They can not expand credit indiscriminately. Following are some of the limitations on the credit expansion capacity of the commercial banks (1) Cash Reserve Ratio The commercial banks can expend the credit with the help of
cash in their hands. A part of cash with the commercial banks has toe kept with the central bank. Higher this part (CRR), lower is the capacity of commercial banks to expand credit.
(2) Amount of Primary Deposits The commercial banks can not print notes. They have to
depend totally on the deposits kept with them their customers. These are the primary deposits. More the volume of these deposits, grater is the credit expansion and vice versa.
(3) Caution The banks have to keep certain amount of deposits in cash to
meet the regular demand by customers. Sometimes, to gain confidence of the public, the commercial banks may keep a larger amount of deposits in terms of cash than legal requirement. This limits their capacity to expand credit.
(4) Policy of the Central bank The central bank may influence the credit creation capacity of
the commercial banks. It may either follow cheap money policy to enforce commercial banks to expand credit or it may follow dear money policy to make commercial banks restrict their credit creation capacity.
(5) Banking habits of the people
95
In a community where the people make their transactions more with the help of cheques than cash, the commercial banks can expand credit more rapidly. This is because they do not have to maintain more cash reserves in this situation and can use a large amount of primary deposits for credit creation. But exactly opposite will be the case, if the people of a community have more preference towards making cash transactions.
Check Your Progress :
1. Define a commercial bank. 2. Distinguish between Banking and non banking functions of a
commercial bank. 3. In the process of credit creation banks creates money-
Explain. 4. State the limitations to the credit creation activities of
7.5 COMMERCIAL BANKING DEVELOPMENT IN INDIA SINCE 1969
The role of the public sector in commercial banking has been greatly enhanced through progressive nationalisation of banks. The first bank which was nationalised and became the Central Bank of India was the Reserve Bank of India, from 1 January, 1949. Two more banks were nationalised in 1955 followed by 8 more banks in 1959. After that 14 major Indian scheduled banks were nationalised in July 1969 and of 6 more in April 1980. As a result of nationalisation, the public sector banks occupy a dominant place in commercial banking in India. Among the commercial banks, the State bank of India ( SBI ) group of banks is the largest chain of commercial banks in India. During the last more than three decades since 1969, tremendous change have taken place under which banks have performed not only their traditional functions but also innovating, improving and coming out with the innovative and variety of services to cater to the emerging needs of their customers. 1. Branch expansion : There has been a considerable rise in the
number of banking branches. The number of bank branches
96
increased from 4151 during First Plan Period to 68,561 by June 2003. Thus there was a more than fifteen fold increase in the number of banking branches. The averages population per bank branch has been reduced from 87,000 in 1951 to 16,000 during the same time indicating that the commercial banks are making their best efforts to reach the masses.
2. Banks in unbanked areas : After nationalisation of banks they
were supposed to open their branches in unbanked areas to reduce regional disparities. Since 1969 ( till March 2001 )of the 53,516 offices were opened by Indian banks, out of which more than half were opened in unbanked centers. Such unbanked states are Assam, Manipur, Meghalaya, Nagaland, Orissa, Tripura, U. P., Bihar, J & K, West Bengal account for the large part of these new offices.
3. Expansion of Banking in Rural Areas : Until 1969,
commercial banks did not make any attempt to expand in rural areas. The share in the total number of banking offices in rural areas was 22.4 percent out of 8262 branches. It has gone up to 56.1 per cent by March 1994.
4. Branches in Foreign countries : Indian banks have also
opened their branches in foreign countries i. e. In 24 countries, with a network of 93 branches, 3 off-shore banking units, 5 joint ventures, 16 subsidiaries and 14 representative offices. These branches specialise in various areas of international banking including financial of foreign trade. By helping the Indian exporters, they form an integral part of the domestic banking system.
5. Deposits Mobilisation : There was more than twenty fold
increase in bank deposits after nationalisation of banks. The bank deposits increased from Rs. 662crores as on June 1951 to Rs. 1,120,853crores by March 2003. Deposits mobilised by banks are utilised for loans and advances for borrowers, investments in government securities and other approved securities, investment in mutual funds, leasing and other related activities.
6. Increase in Investment : Commercial banks have to invest a
part of their deposits in government securities, bonds and debenture of government associated bodies as a liquidity requirement stipulated by the Reserve Bank of India. The investment of bank in government and other approved securities has been increase from Rs. 1,361crore in June 1969 to Rs. 5,47,546 crores in March 2003.These investment of deposits by banks in securities are used by the government for financing the plan programs.
97
7. Differential Interest Rate Scheme : Under this scheme Banks charge nominal rate of interest of 4 per cent from low-income groups which needs financial assistance for productive activities. Public sector banks required to fulfill the target of lending of at least one percent of the total advances in each financial year to the weak section of the society. The scheme covers poor borrowers having an annual income of not more than Rs. 6,400 in rural areas and Rs.7,200 in other areas and not having more than 2.5 acres of non irrigated or one acre of irrigated land.
8. Lead Bank Scheme : Under this scheme, a particular area is
assign for the operation to the commercial bank. The lead bank of a particular district has been assigned the responsibility to assess the resources and potential for expansion of branches and diversification of credit facilities in the district allotted to them.
9. Regional Rural Banks ( RRBs ) : Regional Rural Bank, first
established in the country on October 2, 1975 form an integral part of the rural financial architecture in India. Though these banks proved as weak financial institution but in recent years some reforms were introduced to improve their profitability, viability, competitiveness and efficiency besides re-capitalisation of weak RRBs.
10. Lending to priority sectors and weaker sections : The
priority sector lending has been made available to agriculture, small scale industries, road and water transport operations at concessional rate. The amount given by public sector banks to the priority sector has been increased from Rs. 441crore in June 1969 to Rs. 1,34,107 crore by September 2000.
The higher credit to agriculture and housing sector constituted more than two-thirds of incremental priority sector lending. Higher credit to small scale sector lending has increased from 22.6 per cent in 2005-06 as compared to 12.6 percent during 2004-05.
11. Deposit Insurance : To established public confidence in Indian Banking, Deposit Insurance Corporation has started functioning in 1962. The Corporation re-named as Deposit Insurance and Credit Guarantee Corporation. The limit of insurance cover per depositor for deposits in an insured bank has been fixed at Rs. 1,00,000.
12. Para banking activities : The economic reforms introduced in
1992 allowed banks to introduce varieties of para- banking activities. It mainly includes leasing, hire purchase, factoring
98
etc. The Reserve Bank of India advised their certain banks to select their certain branches to undertake these activities.
13. Social Banking : Under the concept of social banking, banks
are coming forward to help weaker section of society. In order to improve living standard of the poor, banks are financing more loans to the small and marginal farmers, landless labourers, rural artisans, scheduled caste and scheduled tribes etc.
14. Merchant Banking : The major activities undertaken by the
banks under merchant banking mainly include manning public issues of equities and debentures, extending underwriting and stand by support, management of fixed deposit and advising on various non-resident equity/ debenture issues.
15. Bank entry in Insurance Business : The amendment in the
Insurance Development Authority Act opens the way for private sector entry into the insurance sector. Any scheduled commercial bank can enter into insurance business with prior permission of the Reserve Bank of India.
16. Abolition of Banking Service Recruitment Board : Earlier
established Banking Service Recruitment Board have been abolished to provide liberty to the banks to recruit best suited human resource to face competition. Accordingly banks are free to formulate their own recruitment policies.
17. Customer service : In recent years, Banks shown qualitative
improvement in the services rendered to its customers. PGRAMS is an exhaustive software for computerising public grievances redressal mechanism which also provide for on line lodging and monitoring of grievances.
18. Varieties of Attractive Scheme : Commercial banks in recent
years have introduced a number of attractive schemes. These include mainly Regional Loan Schemes, Credit cards, Travelling cheques, Investment Advisory Services, Travel Agency Work etc.
19. Technology Banking : To modernised the banking
operations, new technology and computerisation of bank accounts has been introduced. In recent years efforts have been made to computerised more and more bank branches and installed Advanced Ledger Posting Machine in order to obtain greater efficiency in banking operations. One of the easiest ways to save time and generate more business is through E-Banking ( Electronic Banking ). The wide use of electronics in Banking working transactions is called as E-
99
Banking. It involves elimination of paper-based transaction and radical change in the operations of banking services. It is expected to results in high productivity and efficiency for the bank. E-Banking is forecasted as the future of banking business in the new millennium. It is operated through internet, extranet and over the internet. It is the banking without tellers, ques, restricted office hours etc.
20. Opening of Private sector banks : The Reserve Bank of India
has recently permitted setting up of private sector banks in the country. These banks will be governed by the provisions of the Banking Regulation Act 1949 with regard to their authorised, subscribed and paid up capital. Example of such banks are UTI Bank, IDBI Bank, ICICI Banking Corporation Ltd, HDFC Bank etc.
21. Development of New Specialised Financial Institutions : In
order to lend long term loans to industries several specialised financial institutions have been established. Some of the important institutions established under this category are Industrial Development Bank of India ( IDBI ), Industrial Finance Corporation ( IFC ), Industrial Credit and Investment Corporation Of India ( ICICI ) etc.
22. Banking Ombudsman Scheme : This scheme is in operation
since 1995. It banking Ombudsman is an independent body with legal powers to settle disputes quickly and inexpensively. It works under the control and supervision of the Reserve Bank of India ( RBI ). RBI has appointed 15 Banking Ombudsman all over the country. Any customer whose grievance has not been resolved by bank to his satisfaction can approach Banking Ombudsman. The Scheme has been revised by RBI, in consultation with Government of India, with an important amendment of Arbitration and Reconciliation Procedure which empowers the Banking Ombudsman to act as an Arbitrator. For popularising the Scheme, advertisement in daily newspapers is issue from time to time. The Chief Executives of the Banks have been requested to ensure that the awards of the Banking Ombudsman are honoured without raising unnecessary objections.
23. Banking on Profitability : An analysis of financial position of
Public Sector Banks as on 31st March 2003 reveals that all the 27 Public Sector Banks posted net profit aggregating Rs. 12,295.46 crores during the year ended 31st March 2003 as against an aggregate net profit of Rs. 8301.24 crores during the year ended 31st March 2002.
7.6 SUMMARY
100
a. The commercial banks are-the oldest institutions dealing with lending and borrowing of funds.
b. They perform two main functions of accepting deposits and
lending money. C The financial development of a country depends upon the
expansion of commercial banks. D The commercial banks create the secondary or derivative
deposits with the help of multiple credit creation process. E There are many limitations to the process of multiple credit
creation. F The role of the public sector in commercial banking has been
greatly enhanced through progressive nationalisation of banks. As a result of nationalisation, the public sector banks occupy a dominant place in commercial banking in India.
7.7 QUESTIONS 1 What are commercial banks? How are they different from the
central bank? 2 Discuss the functions of the commercial banks 3 Explain with the help of an example the process of multiple
credit creation. 4 Write short notes :- a) Liquidity and profitability of the commercial banks. b) Functions of the commercial banks. c) Credit creation by the commercial banks. 5. What are the objectives of nationalization of commercial
banks?
101
8
CENTRAL BANK
Unit Structure : 8.0 Objectives 8.1 Introduction of the Central bank 8.2 Meaning and definition of a central bank 8.3 Difference between a central bank and a commercial bank 8.4 Functions of a central bank 8.5 Meaning of Monetary policy 8.6 Objectives of Monetary policy 8.7 Conflicts among the objectives of Monetary policy 8.8 Instruments and techniques of Monetary policy 8.9 Limitations of Monetary policy 8.10 Summary 8.11 Questions
8.0 OBJECTIVES 1. To understand the central bank 2. To study the meaning and definition of a central bank 3. To differentiate between a central bank and a commercial
bank 4. To study the traditional and promotional functions of the
central bank 5. To study the meaning of Monetary policy 6. To study the objectives of Monetary policy 7. To study the conflict between the objectives of the Monetary
policy 8. To study the quantitative and qualitative credit control
instruments and techniques of monetary policy 9. To study the limitations of Monetary policy
8.1 INTRODUCTION OF THE CENTRAL BANK In the modern times, the central bank is the most important institution in the financial structure of an economy. It is the agent of the government and through the central bank the policies of the government regarding monetary and fiscal issues are implemented. The activities of a central bank play very important role in the proper functioning of economy and in the fiscal functions of the government. The Riksbank in Sweden was established in the year 1668 which was example*of early central banks. The Bank of England
102
was established in 1694 which became a full-fledged central bank in 1844. The Bank of England happened to be the first Central Bank in the history of central banking on the guidelines of which many other central banks were established. So the history of central bank coincides with the development of Bank of England. 6y the end of 19th Century, almost every European country had a central bank Today every independent country has a Central bank. Many of these central banks were established after 1940.
8.2 MEANING AND DEFINITION OF A CENTRAL BANK
The definition of the Central bank is derived from its functions. Since the functions of central bank are various, it is difficult to define central bank in the exact manner. Following are some of the important definitions: De Cock : A central bank is a bank which constitutes the
apex of the monetary and banking structure of its country.
D.C. Rowan : The central bank is an institution which is often but not always owned by the state, which has an overriding duty of conducting the Monetary Policy of the government
Vera Smith : The banking system in which a single bank has either a complete or residuary monopoly in the note issue is called a central banking system.
Thus different economists have defined Central banking differently taking into consideration the functions to be performed by the central bank. From the definitions of the central bank we may understand the functions of central bank as follows: - Regulation of currency according to the requirement of business. - Keeping the cash reserve of commercial banks. - Performing general banking and agency functions for the government. - Management of the stock of foreign exchange for the country. - Granting loans or credit to the commercial banks and other financial institutions as per the need. - Settling the balance between the different banks in the country. - Supervising the activities of commercial banks and other financial institutions. - Controlling credit flow in the economy in accordance with the needs of business.
103
8.3 DIFFERENCE BETWEEN A CENTRAL BANK AND A COMMERCIAL BANK.
A commercial bank is basically a profit earning institution and hence its main objective is to earn maximum profits. The central bank mainly thinks about the impact of its operations on the working of financial and banking structure of the economy. The commercial banks can be many and they mainly deal with the general public. The Central bank is only one and it does not carry on the normal banking service like accepting deposits, giving loans to the general public In 'fact, the central bank does not come into contact with the general public. To conclude in the words of M.H De Cock " A further requisite of a real Central bank is that it should not, to any great extent, perform such banking functions as accepting deposits from the general public and accommodating regular commercial customers with discounts and advances. It is now almost generally accepted that a central bank should conduct direct dealings with the public only much forms and to such extent as, in a circumstances of a particular country it considers absolutely necessary for the purpose of carrying out its monetary and banking policy"
8.4 FUNCTIONS OF A CENTRAL BANK The functions of a central bank can be studied under two heads :- I] Regular/Traditional Functions II] Promotional Functions. 8.4.1 Traditional Functions of a central bank. 1) Bank of Issue :- Issuing of Currency notes is the sole responsibility of the government of any bank and on behalf of government the central bank issues currency notes. Earlier, each bank was allowed to issue currency note. But over the years, the entire responsibility was given to the central bank. So note issuing is one of the most important functions of the central bank. The monopoly of note issue was given to the central bank because of the following reasons : - to control the excessive credit expansion i.e. to control the
supply of money in the economy - To bring about confidence and uniformity with regard to
currency notes. - For proper supervision and control over the entire activity of
note issuing and circulation. - To solve the problems related to monetary management single
handed. - To give a special power to the central bank so that it stands
different from the other banks.
104
2) Government's banker: The central bank acts as a banker, adviser and agent to the government of that country. As a Banker the Central Bank does regular banking jobs for the government. It accepts deposits in terms of cash, cheques or drafts for different levels of government central, state and local. It becomes the depositor of the government money It also gives loans to the government whenever needed. It accepts the tax on behalf of government The temporary loans are adjusted against the tax receipts. The management of treasury bills is .done through the central bank. It also controls and manager foreign exchange affairs for the government Thus, it provides those services to the government that commercial banks would provide to their customers. So it is called the banker to the government As an adviser to the government, a central bank undertakes surveys in the economy and guides the government to act in a particular way to solve country's-financial problems. It gives advice to the government on monetary, matters, money markets and capital markets. The government may also seek an advice from the central bank on the issues related to balance of payments, deficit financing, foreign exchange reserves, etc As an agent to the government, a central bank has to perform many activities. It has to execute the Monetary Policy of the Government, it has to manage public debt, deal with the government securities, represent the government on the issues regarding international finance and foreign exchange, deficit financing. 3) Banker's Bank : The.' central bank acts as an agent not only for the government but also for the other commercial banks of the country. It is the apex of the entire financial structure and the banking institutions. So it is the head of all the banks and hence it controls and supervises the activities of all these institutions. Under this role of the central bank following activities are done :- a) The central bank accepts and keeps cash reserve of the
commercial banks. b) The central bank discounts bills of commercial banks to make
credit available to them whenever they need. c) The central bank is considered to be the lender of last resort
for the commercial banks because it is the ultimate source of credit or financial assistance to the banks.
105
d) The central bank acts as a clearing agency for the commercial banks. Each commercial bank keeps a minimum stipulated amount of cash reserves with the central bank. So all the claims of that commercial bank with the central bank are cleared through these reserves.
e) Inter-bank transactions are also settled down through the
central bank. So all the financial transactions of the member banks or commercial banks between each other are facilitated through the central bank. This helps in clearing the claims without actually using the cash.
4) Controller of Credit: The central bank being an apex of all financial and banking institutions has to control the credit flow in the economy. This is essential to maintain stability in the economy Controlling of credit means to make money available in a large quantity when the economy needs it and vice versa. For example during-the boom period, when more funds are demanded, the central bank should be in a position to make funds available. During the slack season, when funds are not demanded in the larger quantity, a central bank should be in a position to reduce their supply. This is needed for maintaining economic stability. As a controller of credit, the central bank of a country controls and manages the direction use and volume of credit in the economy. (A detail analysis of credit control is done in the next unit). This is done with the help of many instruments like bank rate, open market operations, variable reserve ratio, selective credit control measures, etc. 5) Custodian of foreign exchange reserves. The exchange rate stability is one of the important objectives of any country. To achieve this objective, it is necessary to regulate and manage the foreign exchange reserves of a country in the best possible way. The central bank of a country also has a responsibility of maintaining foreign exchange reserves. Under the gold standard system, the central bank was supposed to maintain stable exchange rate by increasing or decreasing the money supply in the economy Even after the breakdown of gold standard, the central bank is supposed to control the buying and selling of foreign currency and all other matters related to foreign exchange transactions. The gold reserves & foreign exchange reserves are kept as a basis for issuing notes by the central bank by maintaining and controlling the foreign exchange reserves. All those are the traditional functions of the central bank/Central bank of any country - whether a developed or an underdeveloped country. Apart from these regular functions, the
106
central bank of a developing country has to perform certain additional functions. Due to the slow pace of development of many sectors in the economy, a central bank of such countries has to perform some typical functions which are known as promotional functions of the central bank. 8.4.2 Promotional Functions of a central bank. Through the promotional functions, the central banks of developing countries help the governments to achieve the objectives of economic development and dynamic growth of a country. Since the central banks in the developing countries were established very late in 1940s and 1950s and since these countries have aimed at rapid economic development, the central banks also have been one of the instruments to achieve this objective. Following is a brief analysis of promotional functions of the central bank : 1) Expansion of banking system. The developing countries have slow expansion of their banking sector. The rural areas do not have adequate banking facilities. The central bank of such countries has to play an important role to expand the banking sector. Generally, the commercial banks are not interested in providing credit to the agricultural sector and small scale industrial sector. By making it compulsory to direct a part of credit towards rural areas, the central bank can make the commercial banks to play an important role. 2) Establishment of New Financial institutions. The industrial sector of the developing countries needs financial-resources. To ensure adequate credit to these sectors, the central bank takes initiative to start new financial institutions. For example, the RBI played an important role in establishing financial institutions like IDBI, NABARD, LIC, etc., which are now actively involved in providing loan facilities to the industrial sector. 3) Development of money and capital market. A money market is a place where the short term loans are given. A capital market is a place where long term loans are given. The money and capital market function with different types of financial institutions. In the developing countries, the central bank plays an important role in establishment and development of such institutions. The central bank also monitors the development of these markets. It makes available various credit instruments because of which lending and borrowing of money is facilitated. 4) Promote Investment: With the help of appropriate monetary policies, the central bank encourages savings from the people and make the funds available for the investors. By adopting the differential interest rate policy, the central bank promotes the development of priority
107
sectors in the economy. For example; the RBI insists on charging low interest rate on the loans provided to the small scale industries, export sector, agriculture and other priority sectors. By making it legally compulsory to do so, the RBI makes the commercial banks to follow a policy of different interest rates to different sectors. Check Your Progress :
1. Define a Central Bank. 2. Differentiate between traditional and promotional functions of
a central bank. -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
8.5 MONETARY POLICY Monetary Policy is an important instrument in the hands of the central bank. Many macro-economic goals can be achieved through Monetary Policy. It is this policy instrument through which the central bank tries to achieve broad objectives like price stability, full employment, exchange rate stability, etc. According to H.G. Johnson, monetary Policy is a policy employing the central bank's control of the supply of money as an instrument for achieving the objectives of general economic policy. It is through the monetary Policy that the availability, cost and use of money in the economy are influenced This policy empowers the central bank to regulate the supply of money in the economy and direct the use of money and credit to the most productive areas
8.6 OBJECTIVES OF MONETARY POLICY Since the Monetary Policy is a part a general economic policy of the government it assists the government to achieve general economic objectives, put forward through economic planning The role played by the Monetary Policy depends upon the nature of economy, level of development of the economy and specific requirements of each sub-sectors in the economy The objectives of Monetary Policy in general are discussed below':- 1) Economic Growth: Economic growth is defined as a continuous increase in the production of goods and services in the economy, and hence in the national income of a country. To achieve this objective, the Monetary Policy may contribute in the following way .- • the central bank encourages saving and investment in the
economy.
108
• By attracting more and more savings through innovative
saving encouragement schemes, the central bank can increase the saving percentage in the economy.
• By making regular and cheaper credit available to the
industrial sector it can make investment levels go up. • By promoting the development of banking and non-banking
financial institutions, the central bank can develop the financial system of a country.
• The non-monetised sectors and parts of the economy can be brought under the banking operations so that the monetisation level of an economy goes up.
By taking appropriate actions to control unwanted expansion or contraction in the money supply 3} Price Stability : Economic growth along with price stability is an important objective of any developing or developed country. By economic stability, we do not mean constant prices over a period of time. But a reasonable rise in prices is also essential for inducement to investment. Price stability implies that the goods and services are available at a reasonable price to the people and also an investment is encouraged to ensure economic growth. By controlling supply of money, the central bank aims at controlling inflationary and deflationary situations. The inflation or rapidly rising prices have negative effects on saving capacity of the people, distribution of income among the people becomes more unequal, balance of payments problems may be created. Deflation or falling prices also may result in discouragement to investment, unemployment and instability in the economy. It is for these reasons that the prices should increase at a stable rate. Through monetary Policy, the central bank tries to maintain the level of prices. 4) Full Employment: The Great Depression 6f 1930s made the world aware the dangers of uncontrolled market economy. The depressionary situation lead to unemployment problem and hence, the monetary Policy through its instruments must aim at full employment. The level of employment in the economy depends upon the level of investment which in turn depends upon the many factors - one important factor being the interest rate structure. Monetary Policy can control the interest rate structure in such a way as to increase the rate of investment. The availability of quick and cheap credit facilities is also necessary for which existence of adequate number of financial institutions is required. The central bank through its
109
monetary Policy can influence the establishment of financial institutions in both the money and capital markets. 5) Exchange Rate stability : A smooth working of economy not only requires an internal balance but also an external balance. Exchange rate stability is an important pre-condition for promoting international trade. By maintaining the value of domestic currency, the monetary Policy of a country can influence the exchange rate between the domestic and foreign currency Necessary actions should be taken whenever there is a problem regarding balance of payments. 6) Neutrality of Money : Maintaining neutrality of money is another important objective of the monetary Policy. According to this objective money should not influence the economy and it should remain only as s medium of exchange. This objective, however, has lost its validity in the recent times. Money does have a positive role to play it does influence many other economic variables and so money can not remain neutral. The Monetary Policy can not achieve all these objectives simultaneously. There is a conflict between different objectives. That means the steps taken through the Monetary Policy to achieve a particular objective may go against the other objective For example, rapid economic growth and price stability may not be achieved together. Growth requires investment, rapid investment is possible when the price level is rising rapidly and if the prices are rising, stability can not be maintained. So the monetary authorises have to compromise between these two objective The objective of rapid economic growth also clashes with the objective of exchange rate stability or balance of payment equilibrium. Rapid growth implies more imports of heavy goods and machinery which in turn may increase our import fill in brief, all the objectives of Monetary Policy cannot be achieved together. The authorities have to maintain some kind of balance between them. Depending upon current situation, the importance of certain objective may be more than that of the other.
8.7 CONFLICT AMONG THE OBJECTIVES OF MONETARY POLICY
All the objectives of monetary policy can not be achieved Simultaneously. While giving importance to one objective of monetary policy, we have to sacrifice the other objective. •This is called a trade off or conflict among different objectives. Following are some areas of conflict. (1) Full employment and Price Stability
110
An eminent economist Phillips has brought to the forth a trade off between fall employment and stable prices. According to him. in order to achieve higher rates of employment, a country has to accept higher inflation rates-Particularly in the short run. To increase employment opportunities, a country has to increase the level of investment. This results in an increase in the price level during the gestation period (a period between the investment and actual, output). Because of this, the monetary authorities have to choose or maintain a balance between these two objectives. (2) Full employment and Growth Growth is a continuous increase in country's national income. Growth is not only possible by increasing resources, of a country but also by improving technology In the earlier case when a country grows by increasing its resource base, employment opportunities may be generated. But in the latter case not many opportunities for labour may be generated because improving technology needs more use of capital and not so much of labour. Here growth is possible without increase in employment. This trade off however, is not so serious (3) Full Employment and Balance of payments Economic growth along with the full employment brings about an increase in income of the people on the one hand, and increase in the price level of the country on the other hand. This increases the imports and discourages exports because the exports now become more expensive, This results in the disequilibrium in the balance of payments of a country To solve the problem of balance of payments, the domestic expenditure has to be brought down which ultimately may lead to fall in the level of employment. Thus, a country can either give priority of full employment or to the equilibrium in balance of payments, but it can not achieve both of them together. (4) Economic growth and exchange stability One of the ways to achieve faster economic growth is by importing capital and other required goods from the countries. This, however, has a negative impact on the rate of exchange between the domestic and foreign currency. Thus both these objectives can not go hand in hand. Check Your Progress:
1. What is monetary policy? 2. There is no conflict between the objectives of monetary
As seen earlier, the central bank along with its monetary Policy has to guide the economy and achieve certain important macro-economic objectives. There are many monetary instruments with the help of which the monetary authorities control, direct and guide the banking sector of the country. These instruments are :- A. Quantitative / General credit control instruments: i) Bank Rate, ii) Open market operations iii) Variable Reserve Requirement a) CRR b) SLR B Qualitative / Selective credit control instruments. i) Margin Requirements. ii) Regulation of Consumer Credit iii) Direct Action. w) Rationing of credit v) Moral suasion Following is the analysis of all the instruments of credit control. 8.8.1 Quantitative Credit control The Monetary Policy influences the cost and availability of credit through various methods During the busy season when credit requirement is more, the monetary Policy is framed in such a way that more credit will be available and vice versa. Those traditional instruments which affect the volume or quantity of credit, are called quantitative credit control instruments These are as follows . i) Bank Rate : A bank rate of interest at which the central bank advances loans to the commercial banks It is that minimum rate at which the central bank discount first, class bills of exchange The bank rate is an important rate because it is on this rate that the other rates of interest in the economy depend The other rates of interest are those which are charged by the commercial banks from their customers. A central bank uses bank rate to achieve its monetary objectives Suppose the central bank v/ants to expand credit facilities, it will bring down the bank rate and advance loans to the commercial banks at a cheaper rate. Since the Commercial bank get loans cheaply or at lower interest rate they will also charge less from their customers. Other rates of interest in the economy will also go down. This will increase the demand for credit, more money will be borrowed, more investment will take place.
112
On the other hand, if the central bank wants to contract credit available in the market, it will increase the bank rate, other rates of interest will also go up, credit will be costlier, there will be less borrowings and so there will be a contraction of credit. We can explain the process of bank rate policy with the help of example. Suppose the current bank rate is 5%. If there is a deflation in the economy, investments have to be encouraged, more credit has to be made available. Under this situation the central bank will reduce the bank rate say to 3%. commercial banks can get loans from the central bank cheaply, the other rates of interest will also come down. The demand for bans or advances will go up and economy will be brought out of deflation. If, on the other hand, there is inflation in the economy, money is available in more than adequate quantity, the central bank will raise the bank rate, commercial banks will find it costly to borrow from the central bank, they will also increase other rates of interest, borrowing will be costlier to the investors also so investment will come down and so money supply in the economy will also come under control, ii) Open market operations : This is another instrument of the Monetary Policy of the central bank. O.M.O. imply the buying and selling of government securities to the commercial banks. Whenever the central bank wants to reduce the credit availability in the in the market, it will sell the government securities to the commercial banks. The banks will pay cash and the credit available with the banks will be reduced. This will restrict the credit creation capacity of the commercial banks and hence the availability of credit in the market will be reduced. Whenever the central bank wants to expand credit, it will buy the government securities from the commercial banks, give them cash which is utilized by the commercial banks for credit expansion This will increase the availability of cre.dit in the economy iii) Variable Reserve Requirements : By law. the commercial banks are required to maintain a certain % percentage of their deposits in cash with the central bank. This % can be changed by the central bank as per the current-situation. This is called variable reserve requirements. When there is too much of money m the economy, the central bank follows a policy by which the % of cash reserves to be maintained with the central bank is increased. A * larger part of cash reserves of the commercial banks is maintained with the
113
central bank and the credit creation capacity of the commercial banks goes down. Exactly opposite procedure is followed when the central bank wants to expand the credit availability in the economy, it officially reduces the % of reserves the banks have to keep with the central bank. More cash lies with the commercial banks, their credit creation capacity increases and the economy expands rapidly The CRR is a very effective measure of credit control It is an immediate measure, there is no time lag between the policy measure taken and the effect of that measure. The CRR doesn't require organized bill market. But still there are a few problems related to CRR
1) frequently changes in CRR are not advisable 2) Depending upon the size of bank and amount of its reserves,
the effect of CRR may be different. 3) CRR reduces the credit creation capacity as well as the profit
earning capacity of the commercial banks. 4) In the depressionary period, when all the economic variables
are falling, the CRR also proves to be an ineffective measure. Sometimes the commercial banks have to maintain a certain
percentage of their holdings in terms of government securities and other liquid assets. This is known as statutory liquidity Ratio (SLR). The SLR can go up as high as 40% of the total deposit.
8.8.2 Selective Credit Control: As we have seen earlier, the quantitative or general credit control measures influence the availability and quantity of credit in the economy. The quantitative credit control measures or selective credit control measure influence the use of credit. The selective credit control measures are applicable only to certain specified economic activities and they are not general. These credit control measures are basically to grant credit at lower of interest to particular activity to discourage demand for the non-essential goods, to minimize the wastage of reserves Following are different selective credit control measures 1) Margin Requirements :- Margin is a difference between the market price of financial assets and the amount of loan raised against those assets. For example if the market price of an asset is Rs 10.000 and the margin requirement is 10%, then the loans borrowed against the assets will be of Rs. 9.000/-. This % can be changed. The margin requirements are useful to stop the hoarding activity in case of
114
essential goods. Higher the margin requirement, lower is the loan that can be raised against their assets. 2) Regulation of consumer credit: The method of credit control was first adopted in the USA. Under this method, the purchase of consumer durable like houses, electrical appliances, furniture, etc. is regulated. A large part of consumers credit is used for buying these durables. During inflation, demand for these good also is on the increase. So to control the inflationary trend, the central bank may put a regulation on the amount of credit sanctioned for the consumer durables 3) Direct Action : Direct action refers to all those direction and guidelines given by the central bank on all the commercial banks regarding lending and investment. The central bank may enforce these directions either by refusing discounting facilities or advancing loans to the commercial banks or also by penalizing the banks which are not following the orders. 4) Rationing of credit: Under this measure, a central bank has a power to allow only a fixed amount of accommodation or advances to a commercial bank. In the situations of excessive credit expansion, the central bank can restrict the credit facilities given to the commercial bank. In the socialist countries, this method is used quite often. 5) Moral suasion: Moral suasion implies an exerting a pressure or an influence over the commercial banks in the framing of their policies. If there is an atmosphere of co-operation and understanding between the central bank and the commercial banks, it is possible for the central bank to make commercial banks to follow certain rules and orders just by an informal request. For example, during the inflationary conditions, a central bank may request the commercial banks to contract loans and not to grant too many loans to control the supply of money in the economy.
8.9 LIMITATIONS OF MONETARY POLICY The Conflicts between different objectives of monetary policy and various other difficulties faced by the instruments of monetary policy are responsible for making monetary policy less effective under certain circumstances. Following are some of the important limitations of the monetary policy :- (1) Monetary policy alone can not solve some of the problems like
rising inflation. This policy has to be accompanied by the other policy instruments like fiscal, industrial or income policies.
115
(2) In the underdeveloped countries, there is an existence of dualism m the money market That is, the money market is grouped into two sectors; organised and unorganised. The monetary policy has no influence over the unorganised part of money market.
(3) Similarly, in a large part of the underdeveloped countries, cash
transaction are still preferred to the cheque payments. This also reduces the hold of monetary policy in the economy.
(4) In most of the countries, the central bank acts as an agent of
the government and advocates the policies of government rather than functioning independently This brings about the bias in the policy decisions of the central bank. The monetary policy of central bank can not be based purely on the economic or rational grounds.
(5) An existence of parallel economy in the form of black money is
also an important limitation of the monetary policy. In India, the size of parallel economy or unaccounted money is about 50% of the Gross Domestic products of India.
(6) It is also found out that the monetary policy becomes less
effective during either depression or boom period. Other policies like fiscal policy may be more useful to bring the economy out of depression.
Check Your Progress:
1. Distinguish between Quantitative and Qualitative credit control instruments.
8.10 SUMMARY In this unit we have focused on the functions of a central bank in both developed and developing countries. We may conclude with the help of following points. a) The central bank is the apex institution in the entire financial
structure b) The concept of central bank is defined in many ways
depending upon its functions. c) The primary or traditional functions of the central bank include
the right to note issue, controlling of credit, acting as
116
government's agent, bankers' bank and custodian of foreign exchange reserves.
d) The promotional functions of a central bank are important
particularly in the developing countries where the central bank has to take important steps to develop different sectors in the economy.
e) The monetary Policy is an important instrument in the hands of central banks to control credit flow in the economy.
f) Many macro-economic objectives like economic growth, price stability, exchange ratio stability, etc. can be achieved through monetary Policy.
g) There are conflicts among various objectives of monetary Policy.
h) Bank rate policy, open market operations and variable reserve requirements are the general or quantitative credit control measures.
i) Selective or qualitative credit controls aim at restricting and directing the use of credit,
j) Through the credit control techniques, the central bank enforces the economic objectives on the activities of commercial banks.
8.11 QUESTIONS 1) Define central bank. Discuss its functions. 2) What is a difference between a central bank and a commercial
bank? Why a central bank an apex institution? 3) Discuss the role of central bank in developing countries. 4) Write short notes on : a) Traditional Functions of a central bank. b) Promotional Functions of a central bank. 5) What is Monetary Policy? Discuss its objective in detail. 6) What are the various objectives of a monetary Policy? Can all
the objectives be achieved simultaneously? What are the limitations and conflicts?
7) Discuss the qualitative and quantitative methods of credit control?
8) What is the difference between general and selective credit controls? Which of the two is superior?
9) Write short notes :- a) Bank Rate Policy. b) Open Market Operations. c) Variable Reserve Requirement. d) General credit control Measures. e) Selective Credit Control Measure, f) Objectives of Monetary Policy.
117
9 INDIAN MONEY MARKET AND CAPITAL MARKET
Unit Structure : 9.0 Objectives 9.1 Introduction of the Money Market 9.2 Features/Defects of Indian Money Market 9.3 Instruments of Indian Money market 9.4 Meaning and definition of Capital market 9.5 Primary market 9.6 Secondary market 9.7 Role of capital market in economic development 9.8 Securities and Exchange Board of India (SEBI) 9.9 Summary 9.10 Questions
9.0 OBJECTIVES 1. To study the Indian money market 2. To study the features/defects of Indian money market 3. To study the various instruments used by Indian money
market 4. To Study and understand the meaning and definition of Indian
capital market 5. To study the Primary market/ New issue market 6. To study the Secondary market/ stock market 7. To study the importance of the capital market in economic
development of the country 8. To study the SEBI
9.1 INTRODUCTION OF INDIAN MONEY MARKET Indian money market is the market for lending and borrowing of short-term funds. It is the market where the short-term surplus investible funds of banks and other financial institutions are demanded by borrowers comprising individuals, companies and the government. Commercial banks are both suppliers of funds in the money market and borrowers. The Indian money market consists of two parts: the unorganised and the organised sectors. The unorganised sector consists of indigenous bankers and non banking financial companies (NBFC‘s). The organised sector comprises the Reserve Bank, the State Bank of India and its associate banks, the 20 nationalised banks and private sector banks, both Indian and foreign.
118
The organised money market in India has a number of sub-markets, each one of which deals in a particular type of short term credit. i) Call money market : It is the market for very short-term funds. It is also known as money at call and short notice. This market has actually two segments, viz. a) the call market or overnight market, and b) short notice market. The rate at which funds are borrowed and lent in this market is called the call money rate.
Call money rates are market determined, i.e. by demand for and supply of short term funds. The public sector banks account for about 80 per cent of the demand and foreign banks and Indian private sector banks account for the balance of 20 per cent of borrowings. Non-banking financial institutions such as IDBI, LIC, GIC, etc. enter the call money market as lenders and supply up to 80 per cent of the short term funds. The balance of 20 per cent of the funds is supplied by the banking system. While some banks operate both as lenders and borrowers, others are either only borrowers or only lenders in the call money market. ii) Bill market in India : In this market short term bills- normally up to 90 days-are bought and sold. It is further divided into commercial bill market and treasury bill market. In India, the 91-day treasury bills are the most common market where government raises funds for the short period. There are also 182, 364 days treasury bills. And even 14 day intermediate treasury bills. Reserve Bank of India has the responsibility to guide and control the institutions of the money market.
9.2 FEATURES / DEFECTS OF THE INDIAN MONEY MARKET
1. Existence of Unorganised money market : This is the major
defect of the Indian money market. These indigenous bankers and Non Bank Financial Companies do not distinguish between short term and long term finance and even there is no distinction between the purposes of finance. People attracted towards this market because of less documentation and easy sanctions. They are outside the supervision and control of RBI.
2. Absence of integration : Indian money market was divided into
several segments or sections which were loosely connected with each other. The relations between these sections were not cordial. But now, according to the Banking Regulation Act, 1949, all banks have been treated equally by RBI as regards licensing, opening of branches, share capital, the type of loans and
119
advances etc. In this way, the Indian money market is getting closely integrated.
RBI is in a position to control the operations of the organised
sector. RBI guides and direct them in their lending policies and regularly inspects the books of scheduled commercial banks. However, RBI‘s control and monitoring of the commercial banking sector are not always fully effective.
3. Differential rates of interest : There are too many rates of
interest – the borrowing rate of the Government, the deposit and lending rates of commercial banks, deposit and lending rates of cooperative banks, the lending rates of DFI‘s, etc. These rates of interest are different because of the immobility of funds from one section of the money market to another.
4. Absence of well-organised banking system : Before
Independence, there were only a few big banks in the country and they have been concentrated in big towns and cities. There were different rates of interest in different regions and lack of mobility of funds leads to slow branch banking and expansion.
After Independence and passing of the Banking Regulation Act,
1949, the RBI has been controlling the banking system. Through mergers and amalgamations the number of banks has been considerably reduced. After nationalisation of banks in 1969, branch banking has been speeded up.
Despite of the various steps taken by the RBI to strengthen the
Indian banking system, RBI has failed to control and guide it. The cases like Harshad Mehta, Ketan Parikh shows that the Indian banking system is still far from being a well organised and effectively supervised system
5. Seasonal stringency of money : There are wide seasonal
fluctuations in the Indian money market. During the busy season i.e. from November to June, when funds are required to move crops from villages to cities, the rate of interest is high. Whereas during slack season, from July to October, banks have large surplus funds and the rate of interest is low. RBI attempts to reduce these fluctuations by pumping money into the money market during busy seasons and withdrawing the same during slack seasons.
6. Absence of the Bill market : A well organised Bill market is
necessary for linking up the various credit agencies to RBI. Bill market was not developed in India because of practice of banks keeping a large amount of cash for liquidity purposes, preference of industry and trade for borrowing rather than rediscounting bills, the improper drafting of the bazaar hundis,
120
the system of cash credit as the main form of borrowing from banks, the preference of cash transactions in certain lines of activity, the absence of warehousing facilities for storing agricultural produce etc.
RBI introduced a bill market scheme known as the New Bill
Market Scheme in 1970. It was not developed fully as was expected.
Development of a bill market is extremely useful to the country
from the point of expanding credit as well as from the point of monetary policy.
market determined, i.e. by demand for and supply of short term funds. Despite of all the efforts of the RBI to moderate the fluctuations in the call money rates, they have continued to be highly volatile.
The high rates reflect the huge demand for short term funds by
the banking system specially to meet the RBI requirement of minimum CRR. RBI attempts to moderate the fluctuations through supporting the market with additional funds, however it has only a limited success in its efforts.
8. Availability of credit instruments : Till 1985-86, the Indian
money market did not have adequate short term paper instruments. Apart from call money market, there was only the treasury bill market. At the same time there were no specialist dealers and brokers dealing in different kinds of paper instruments. RBI started introducing new paper instruments such as 182 days treasury bills, later converted to 364 days treasury bills, certificate of deposits (CDs) and commercial paper(CPs).
9.3 INSTRUMENTS OF THE INDIAN MONEY MARKET (The Reforms of the Indian money market) On the Recommendations of the Sukhmoy Chakravarty
Committee on the Review of the Working of the monetary system, and the Narsimham Committee Report on the Working of the Financial System in India, 1991, RBI has initiated a series of money market reforms to overcome the defects of the Indian money market.
1. Relaxation of Interest rate regulation : Following the
recommendations of the Narsimham Committee in 1991, interest rates were deregulated and banking and financial institutions were told to determine and adopt market related
121
rates of interest. The present position of interest rate regulations is : i) RBI continued to reduce the bank rate from 10 per cent in
1990-91 to 6 per cent in 2006-07 because of improved liquidity position with the banking system and also because of the need to stimulate the economy.
ii) RBI depends more on the repo rate than the bank rate to influence the volume of lending by banks. Repo rate is the rate at which RBI purchases securities from the market.
iii) Interest rates on domestic term deposits have been broadly decontrolled.
iv) The administered interest rates in India has been dismantled.
2. Introduction of new instruments in the money market : The
91 day Treasury bill has been the traditional instrument through which Government of India raised funds from the market for short periods and in which commercial banks invested their short term funds. From January 1993, the Government introduced the system of selling 91 day treasury bills through weekly auctions. Besides these treasury bills, other new instruments have been introduced as follows:
a) 182 days treasury bills: are having variable interest rates and
are sold through fortnightly auctions. The yield of these long-dated papers had become attractive for a highly liquid instrument. These were replaced by 364 day Treasury bills. They have been reintroduced during 1999-2000.
b) 364 days Treasury bills: The 364 day Treasury bills have
become an important instrument of Government borrowing from the market and also leading money market instrument. The fortnightly offerings of these bills bring in, annually, about Rs. 20,000 crs. to the Government. These bills are entirely held by the market and RBI does not subscribe to them.
RBI introduced two more Treasury bills in 1997 : i) 14 day Intermediate Treasury Bills : from April 1997 at a
discount rate equivalent to the rate of interest on ways and means advances to the Government of India – these bills cater to the needs of State Governments, foreign central banks and other specified bodies.
ii) A new category of 14 day Treasury bills sold through auction
for the first time in June 1997, to meet the cash management requirements of various sections of the economy.
122
c) Dated Government securities : The Government of India have decided to sell dated securities (of 5 year and 10 year maturity) on an auction basis. As against the traditional method of borrowing through dated securities with fixed coupon rates, the Government switched over to auctioning them at market related interest rates. These relates to new borrowing and recycling of old below-market rate securities which mature during the year. They are now auctioned and naturally they carry market related interest rates.
d) Repos and Reverse Repos : Repos are now a regular
feature of RBI‘s market operations. If the banking system experiences liquidity shortage –and consequently, the rate of interest is rising, RBI comes to assist the banking system by repurchasing Government securities. When Government securities are repurchased from the market, payment is made by RBI to commercial banks, and this add to their liquidity and enables them to expand their credit to industry and trade.
Since November 1996, RBI has introduced Reverse Repo,
i.e. to sell dated government securities through auction at fix cut-off rate of interest. The objective is to provide short term avenue to banks to park their surplus funds – when there is considerable liquidity in the money market and the call rate has a tendency to decline
Liquidity Adjustment Facility (LAF) :This policy of using
Repos and Reverse Repos is now called the Liquidity Adjustment Facility. RBI has adopted LAF as an important tool for adjusting liquidity through Repos and Reverse Repos on a day to day basis.
e) Certificates of deposits (CDs) : The CDs were issued by
banks in multiple of Rs.25 lakhs to expand the investor base for CDs, the minimum value was reduced and is presently Rs. 1 lakh. The maturity is between 3 months and one year. They are issued at a discount to the face value and the discount rate is freely determined according to market conditions. CDs are freely transferable after the date of issue. The CDs became immediately popular with banks for raising resources at competitive rates of interest.
f) Commercial Paper (CP) : is issued by companies with a
net worth of Rs. 10 crs. later reduced to Rs 5 crs. The CP is issued in multiples of Rs. 25 lakhs subject to a minimum issue of Rs. 1 cr. The maturity of CP is between 3 to 6 months. The CPs are issued at a discount to face value and the discount rate is freely determined. The maximum
123
amount of CP that a company can raise was limited to 29 per cent of the maximum permissible bank finance.
Check Your Progress : 1. What do you understand by Indian money market? 2. Indian money market is free from all the defects-Examine. 3. What reforms have been taken place to improve the
conditions of Indian money market? -----------------------------------------------------------------------------------------
Capital market : Primary market and Secondary market
9.4 MEANING AND DEFINITION OF CAPITAL MARKET The term capital market refers to as ―‖an organised mechanism concerned with transfer of money, capital or financial resources from investors to entrepreneurs engaged in industry or commerce‖. Capital market consists of channels through which the savings of peoples are made available to industrial and commercial purposes so as also to public authorities on long term basis. The demand for long term funds comes mainly from the private companies, agriculture and government. The government both at the central and state level require capital not only for economic overheads such as power, transport, irrigation etc., but also for basic industries or even consumer goods industries. The supply of funds mainly comes from individual savings, corporate savings, banks, insurance companies such as the Life Insurance Corporation (LIC) and General Insurance Corporation (GIC) and Financial Intermediaries. Features of capital market : 1. Deals in Long term securities : Capital market deals in long
term securities like share, debentures and bonds. 2. Deals in marketable and non marketable securities :
Marketable securities are those which can be easily transferred like shares, debentures or government bonds etc. Non marketable securities are those which can not be transferred like term deposits with banks and other financial institutions.
124
3. Deals individual and Institution Investors : The capital market comprise the institutional investors mainly include are Life Insurance Corporation of India, Unit Trust of India, Mutual funds etc.
4. Comprise primary and secondary market : Primary market
concerned with sale of new shares, and secondary market concerned to sale and purchase of existing shares.
5. Conduct through Intermediaries : which mainly include as
under writers, stock brokers, mutual fund etc. Special features : 6. Greater reliance on debt instruments as against equity and in
particular, borrowing from financial institutions. 7. Issue of debentures, particularly convertible debentures with
automatic or compulsory conversion into equity without the normal option given to investors.
8. Flotation of mega issue for the purpose of takeover,
amalgamation, etc and avoidance of borrowing from financial institutions for the fear of their discipline and conversion clause by the bigger companies.
9. Avoidance of underwriting by some companies to reduce the
costs and avoid scrutiny by financial institutions. 10. Fast growth of mutual funds and subsidiaries of banks for
financial services leading to larger mobilisation of savings from the capital market.
Classification of Capital Market: The capital market can be classified broadly on the basis of status
and stages. i) On the basis of status of the market : a) Organised capital market : The constituent of organised form
of capital market includes central bank of the country, long term financing of commercial banks, special financial institutions and stock market.
b) Un-organised capital market :It consists of indigenous bankers, money lenders, chit-funds, hire-purchase and investment companies. It supplies funds mainly to small business units.
ii) On the basis of stages: a) Primary market: is the market wherein funds are raised by
issue of shares, debentures and bonds issued by industrial enterprises. Such type of market concerned with new issues. Capital market originates as primary market in the initial
125
stage but later on secondary market develops to support the primary market.
b) Secondary market: It is the market which facilitates transfer of ownership of securities. It makes purchase and sale of securities easy and creates liquidity. In developed economies secondary market plays significant role.
9.4 PRIMARY MARKET : NEW ISSUE MARKET The New Issues market plays a role for attracting investible resources in the corporate sector. Corporate sector raises capital from this market for setting up new enterprises or for the expansion and diversification of the existing ones. Floating of New Issues : Prior to 1992, the Capital Issues (Control) Act 1947 regulated the primary or New Issue market. The Act was administered by the Controller of Capital Issues, (CCI). The Act required prior approval or consent for issues of capital to the public and pricing of issues. The timing of new issues, composition of securities and other aspects of the issues were also regulated. 1992 : The Capital Issues (Control) Act, 1947 was repealed, allowing issuers of securities to raise capital from the market without requiring any consent from any authority either for floating the issues or for pricing it. 1992 and After : The new issue of capital has been brought under SEBI‘s purview and the issuers are required to meet SEBI‘s guidelines for disclosure and investor protection. Ways of Floating New Issues : i) By the issue of prospectus to the public: It is an open
invitation to the public to subscribe to the issue by giving the details in the prospectus regarding the company, the issue, the underwriters, etc.
ii) By private placement: The issue is not offered to the public for subscription but placed privately with a few big financiers – including brokers who may sell them to clients or to the public.
iii) By the right issue to the existing shareholders of the company: Invitation to the existing shareholders to subscribe to a part or whole of the new issue.
Types of Issues: Initial issues: issues of the new companies. It is raised by issuing ordinary and preference shares. Further issues: issues by the existing companies. It can be raised by issuing ordinary shares, preference shares and debentures. Major forms of New Issues: Depending on the raising of capital of ownership or debt, the new
126
issues may take the form of equity shares – ordinary shares and preference shares and debentures. i) Ordinary shares :- These are ownership securities. These
involve permanent investment, but could be viewed as liquid by exercising the option of selling these in the secondary market.
ii) Preference shares :- It is an ownership security, but carries a fixed rate of return.
iii) Debentures/Bonds :- A creditorship security with a fixed rate of return and fixed maturity period.
Services associated with New Issues: i) Origination: The proposal of the company raising capital
through new issues needs to be evaluated by investigating viability and the prospects of the new project. A careful scrutiny of new issues proposal in technical, financial and marketing aspects improves the acceptability by the public and institutional investors.
ii) Underwriting: The underwriting is to ensure the success of new issues by guaranteeing subscription of a stipulated amount of new issues. The part of the public issues which is not subscribed by the public is taken up by the underwriter.
iii) Distribution These services are rendered by the intermediaries like brokers, merchant bankers who mediate between the issuers of securities and the individual savers and the institutional investors willing to subscribe to the issues.
9.6 SECONDARY CAPITAL MARKET : STOCK EXCHANGES
Stock Exchange is defined as ―any body or individuals whether incorporated or not, constituted for the purpose of assisting, regulating or controlling in the business of buying, selling or dealing in securities‘. There are at present 21 stock exchanges in India recognised under the Securities Contract (Regulation) Act, 1956. There is also Over The Counter Exchange of India – OTCEI and National Stock Exchange (NSE). OTCEI was set up in 1992 and the National Stock Exchange started its operations in 1994. The number of ‗listed‘ companies was 9877 by the year 1998-99. The ‗listed‘ securities are securities that appear on the approved lists of stock exchanges. Bombay Stock exchange is the leading exchange distinguished by its size, its share in the listed companies and market capitalisation i.e., the market value of the issues listed. Functions of Stock exchanges :
127
Stock Exchanges help the corporate sector in raising funds equity and debt from the market. Stock Exchanges extend facilities for trading i.e., buying and selling in corporate securities and public sector bonds. The prime function of a stock exchange is to offer ‗liquidity‘ to the existing securities. Stock Exchanges provide an opportunity to all concerned to invest in securities as and when they like. This opens a way for the continuous inflow of funds into the market. Investment in new issues is facilitated greatly by operations of the secondary market. Secondary Capital Market: Reform measures during 1990s: -Open outcry trading system replaced by on-line screen-based electronic trading. 23 stock Exchanges have 8000 trading terminals. -Trading and settlement cycles shortened from 14 days to 7 days. -1992: Regulation of Insider trading- SEBI formulated the Insider trading regulations prohibiting insider trading. -Structural changes: a) boards of various stock exchanges have been made broad based to represent different interests. b) permitted corporate and institutional members and also a member to be a member of another stock exchange. -Depositories Act, 1996 passed to provide legal framework for the establishment of depositories to record ownership details in book entry form and to facilitate the dematerialisation of securities. -Disclosure standards have been strengthened: a) Disclosure of information having a bearing on the performance/operations of a company is required to be made available to the public. b) The stock exchanges have to disclose carry forward position- script wise and broker wise at the beginning of carry forward session. -Setting up Trade/Settlement Guarantee fund: a) to ensure timely completion of settlements b) 10 stock exchange have set up trade/settlement guarantee fund. - Permission given to Foreign Institutional Investors (FIIs) to operate in the primary and secondary segments of the Indian capital market. - Indian companies have been allowed to raise capital markets – in the form of instruments such as Global Depository Receipts (GDR), American Depository Receipts (ADR), Foreign Currency
128
Convertible bonds (FCCBs) and External Commercial Borrowings (ECBs). - Companies allowed to buy back their own shares for capital restructuring. National Stock Exchange (NSE) : was incorporated in November 1992 with an equity capital of Rs.25 crore. It started operations in November 1994. The NSE initially began with debt instruments like PSU bonds, UTI units, Treasury Bills, Government Securities and call money. Equities and debentures also have been added on the trading list lately. NSE is a country-wide, screen-based, on-line trading system conforming to international standards. Objectives : i) The establishment of a nationwide trading facility for equities,
debt and hybrids. ii) Facilitation of equal access to investors across the country. iii) Fairness, efficiency and transparency of securities trading. iv) Shorter settlement cycles and book entry settlement. v) Meeting international securities market standards. Operations : The NSE has its control centre located at Mumbai. NSE members all over India are linked via satellite and cables to the system. The automated quotation system allows brokers to buy and sell electronics. It has set up a Clearing Corporation (CC) designed on the basis of the National Clearing Corporation in the USA. The CC clears and settles all trades. It guarantees all the trades put through NSE. It is able to determine who owes what and to whom. Since all the securities are physically stored in the Central Securities Depository (CSD), book entries suffice to conclude deals. Financial data about every deal concluded by the NSE flows into the National Settlement System (NSS) computers every day after trading hours. In early 1996 the NSE got linked up with internet; now price movements in any of the Indian stock markets are available to the net users. Internet subscribers all over the world can now deal on NSE. Securities and Exchange Board of India (SEBI) : The Securities and exchange Board of India (SEBI) was set up on April 12, 1988, to act as a unifying force in bringing together the scattered legislation and offer better protection to the Indian Stock investor. Initially, the SEBI was set up as a non-statutory body. Statutory powers were conferred by the SEBI Act, 1992. Securities Trading Corporation of India (STCI) : The STCI was promoted by RBI as its majority owned subsidiary in May 1994 with a paid up capital of Rs. 500 crores. The objective was to foster the development of an active secondary market for
129
Government Securities and to deepen the debt market in general. RBI fully divested its holdings in STCI by 2002. Presently, the STCI is owned by commercial banks and financial institutions. Clearing Corporation of India Ltd. (CCIL): The CCIL commenced operations from February 15, 2002. It has been set up for clearing and settlement of transactions in government securities. The CClL provides guaranteed settlement and has put in place risk management systems. Credit Rating Institutions : Credit Rating is a symbolic indicator of an expert opinion by a rating agency on the relative willingness and ability of the issuer of a debt instrument to meet the debt servicing obligations in time and in full. Equities are not rated as their risk is not measurable and the equity holders as the owners have to bear the residual risk. Following are some Credit Rating agencies: a) CRISIL: Credit Rating Information Services of India Limited b) ICRA: Investment Information and Credit Rating Agency of
India Limited. c) CARE: Credit Analysis and Research Limited.
9.7 ROLE OF CAPITAL MARKET IN ECONOMIC DEVELOPMENT
1. Basis for industrialisation :- Capital market grants long
term and medium term loans to entrepreneurs to enable them to establish, expand and modernise business units. The capital market promotes healthier industrialisation in the economy.
2. Faces business risks :- Investment of capital is full of risk.
Those who subscribe in the capital market undertake risk. There are fair chances for the investor to earn profit as well as to incur losses. Development of healthy capital market faces such risk and provides basis to bear the loss of capital.
3. Accelerating the speed of growth :- Availability of funds for
medium and long period on easy and favourable condition encourages the entrepreneurs to launch profitable ventures in the field of trade, industry, commerce and agriculture. It helps to speed up the rate of growth.
4. Building sound financial structure :- The individuals
business and financial institutions dealing in long and medium term funds are important constituents of capital market. These institutions have spread their large network of activities in every part of the country and supply required funds to the industrial enterprise. A healthy capital market is
130
responsible for encourage of individual to save and mobilise savings for industrial investment.
5. Promoting organised stock market :- An organised stock
market emerges only in a sound capital market. Industrial and business enterprises subscribes for the shares, debenture and securities liberally if organised stock market facilitates their transfer, purchase and sale. It also helps in the subscription of capital issue. Broker as the agents of the investor and middlemen offer valuable services in the purchase and sale of securities.
6. Generating liquidity :- Liquidity refers to convertibility of
instruments dealing in the capital market into cash. In case of financial requirement, shares of the public companies can be sold in the market and the funds can be obtained. A sound capital market develops under the structure of sound capital market where securities can easily be converted into cash. Government securities termed as gilt edge securities are the most liquid assets.
7. Availability of foreign capital :- A sound capital market is
the true indicator of the financial health of the country. Foreign do not hesitate in making investment in such an economy if the capital market is capable enough to present true picture of financial health of the economy. Easy and available on favourable terms and conditions of foreign capital accelerate the pace of economic growth and development.
9.8 SECURITIES AND EXCHANGE BOARD OF INDIA ( SEBI )
To develop and regulate the Indian capital market, Securities and Exchange Board of India was constituted by Department of Economic Affairs, Government of India on 12th April, 1988. Initially SEBI was set up as a non-statutory body but in January 1992 it was made a statutory body. SEBI was authorised to regulate all merchant banks on issue activity, lay guidelines and supervise and regulate the working of mutual funds and oversee the working of stock exchanges in India. The Capital Issues (Control) Act,1947 governed capital issues in India to ensure sound capital structure for corporate enterprises, to promote rational and healthy expansion of the joint stock companies in India and to protect the interests of the investing public from the fraudulent practices of fast operators. The capital issues control was administered by the Controller of Capital Issues (CCI) according to the principles and policies were laid down by the Central Government. The Narasimham Committee on the Reform
131
of the Financial System in India(1991) recommended the abolition of CCI and wanted SEBI to protect the investors and take over the regulatory function of CCI. The Government of India accepted this recommendation, repealed the Capital Issues (Control) Act, 1947 and abolished the post of CCI. SEBI was given the power to control and regulate the new issue market as well as the old issue market. Primary Market Reforms in India :- SEBI has introduced various guidelines and regulatory measures for capital issues. Companies issuing capital in the primary market are now required to disclose all material facts and specific risk factors with their projects, they should also give information regarding the basic of calculation of premium leaving the companies free to fix the premium. SEBI has also introduced a code of advertisement for public issues for ensuring fair and truthful disclosures. In recent years, private placement market has become popular with issuers. Low cost of issuance, ease of structuring investments and saving of time lag in issuance has led to the rapid growth of private placement market. To reduce the cost of issue, SEBI has made underwriting of issue optional, subject to the condition that if an issue was not underwritten and was not able to collect 90% of the amount offered to the public, the entire amount collected would be refunded to the investors. The lead managers have to issue due diligence certificate which has now been made part of the offer document. SEBI has raised the minimum application size and also the proportion of each issue allowed for firm allotment to institutions such as mutual funds. SEBI has also introduced regulations governing substantial acquisition of shares and take-overs and lays down the conditions under which disclosures and mandatory public offers have to be made to the shareholders. Merchant banking has been statutorily brought under the regulatory framework of SEBI. They have now a greater degree of accountability in the offer document and issue process. In order to induce companies to exercise greater care and diligence for timely action in matters relating to the public issue of capital, SEBI has advised stock exchanges to collect from companies making public issues, a deposit of one per cent of the issue amount which could be forfeited in case of non-compliance of the provisions of the listing agreement and non-despatch of refund orders and share certificates by registered post within the prescribed time. SEBI has advised stock exchanges to amend the listing agreement to ensure that a listed company furnishes annual statement to the stock exchanges showing the variations between financial
132
projections and projected utilisation of funds in the offer documents and the actual utilisation. This would enable the share-holders to make comparisons between promises and performance. Secondary Market Reforms in India :- SEBI has started the process of registration of intermediaries, such as the stock brokers and sub-brokers under the provisions of the Securities and Stock Exchange Board Act,1992. The registration is on the basis of certain eligibility norms such as capital adequacy, infrastructure, etc. SEBI has notified regulations on insider trading under the provisions of SEBI Act. Such regulations are meant to protect and preserve the integrity of stock markets and, in the long run, help inspire investor confidence in the stock exchange. Since 1992, SEBI has constantly reviewed the traditional trading systems in Indian Stock exchanges. It is simplifying procedures and achieving transparency in costs and prices at which customer‘s orders are executed, speeding up clearing and settlement and finally, transfer of shares in the name of buyers. The Government has allowed foreign institutional investors (FIIs) such as pension funds, mutual funds, investment trusts, asset or portfolio management companies etc. to invest in the Indian capital market provided they are registered with SEBI. To prevent excessive speculation and volatility in the stock market, SEBI has introduced rolling settlements from 2001, under which settlement has to be made every day. This, however, has not succeeded extreme volatility in the stock market. Strengthening of SEBI :- In January 1995, the Government of India amended SEBI Act,1992 so as to arm SEBI with additional powers for ensuring the orderly development of capital market and to enhance its ability to protect the interest of the investors. The important features of the ordinance are as follows: 1. To enable SEBI to respond speedily to market conditions and
to reinforce its autonomy, SEBI has been empowered to file complaints i courts and to notify its regulations without prior approval of the Government.
2. SEBI is now provided with regulatory powers over companies
in the issuance of capital, the transfer of securities and other related matters.
3. SEBI is now empowered to impose monetary penalties on
capital market intermediaries and other participants for a listed range of violations. The amendment proposes to create adjudicating mechanism within SEBI for leaving penalties and
133
also constitute a separate tribunal to deal with cases of appeal against orders of the adjudicating authority.
4. SEBI is now given the power to summon the attendance of
and call for documents from all categories of market intermediaries, including persons from the securities market. Likewise, SEBI has now power to issue directions to all intermediaries and persons connected with the securities markets with a view to protect investors or secure the orderly development of the securities market.
Check Your Progress : 1. What are the features of Indian capital market/ 2. Explain the classification of Indian capital market. 3. What are the ways of floating New Issues? 4. Explain the functions of Stock exchanges. 5. Write a note on :a)National Stock exchange b) SEBI ------------------------------------------------------------------------------------------
9.9 SUMMARY 1. Indian money market is the market for lending and borrowing
of short-term funds. It is the market where the short-term surplus investible funds of banks and other financial institutions are demanded by borrowers comprising individuals, companies and the government.
2. There are several defects of the Indian money market like
existence of unorganised sector, seasonal stringency etc. 3. Several instruments are used by Indian money market. 4. Capital market refers to as ―an organised mechanism
concerned with transfer of money, capital or financial resources from investors to entrepreneurs engaged in industry or commerce‖.
5. Primary market is also called as New Issue Market. The New
Issues market plays a role for attracting investible resources in the corporate sector.
134
6. Secondary market is also called as Stock market. Stock Exchange is defined as ―any body or individuals whether incorporated or not, constituted for the purpose of assisting, regulating or controlling in the business of buying, selling or dealing in securities‘.
9.9 QUESTIONS 1. Define the Indian money market and explain the features of it. 2. Explain fully all the instruments of Indian money market. 3. Explain the Indian capital market. 4. What are the various types of capital market? 5. Explain the role of capital market in economic development of
the country. 6. Write a note on SEBI.
135
10 Module 5
NATURE AND SCOPE OF PUBLIC FINANCE
Unit Structure : 10.0 Objectives 10.1 Meaning and Definition of public finance 10.2 Scope and subject matter of public finance 10.3 Public finance Vs Private finance 10.4 Meaning of public revenue 10.5 Sources of public revenue (Tax and Non tax revenue) 10.6 Canons of Taxation 10.7 Meaning of Direct and Indirect taxes 10.8 Merits and Demerits of Direct taxes 10.9 Merits and demerits of Indirect taxes 10.10 Summary 10.11 Questions
10.0 OBJECTIVES 1. To study the meaning and definition of public revenue 2. To study the scope and subject matter of public finance 3. To differentiate between Public finance and Private finance 4. To study the meaning of public revenue 5. To study the Tax and Non tax sources of public revenue 6. To study the Canons of taxation 7. To study the meaning of Direct and Indirect taxes 8. To study the merits and demerits of Direct taxes 9. To study the merits and demerits of Indirect taxes
10.1 MEANING AND DEFINITION OF PUBLIC
FINANCE Public Finance lies on the boarder line between economics and politics. It deals with problems relating to the raising and spending of money by public authorities. Public authorities include the Central Government, State Government and local bodies. Different definitions by different economists offer a broad idea about the meaning of public finance. This can be understood by studying some leading definitions. H. Dalton : " Public finance is concerned with the income
and expenditure of public authorities, and with the adjustment of the one to the other.‖
136
Philip Taylor : " Public finance is the fiscal science, its policies
are fiscal policies, its problems are fiscal problems.‖
R. Musgrave : "The complex problems that centre around the
income and expenditure process of the government is referred to as public finance."
J. Buchanan : "Public finance studies the economic activity of
the government as a unit.' Findlay Shirras : " Public finance is the study Of the principles
underlying the spending and raising of funds by public authorities."
The above definitions show that the public finance is a systematic analytical study of the economic behaviour of the government as a relationship between multiple social wants and scarce productive resources having alternative uses, aiming at the attainment of the general wellbeing of the citizens.
10.2 SCOPE AND SUBJECT MATTER OF PUBLIC FINANCE
The study of public finance is divided into five parts. 10.2.1 Public Revenue : Public revenue deals with the methods of raising funds through both tax and non-tax sources. Public revenue includes the classification of public revenue, the canons or principles of taxation, incidence and effects of taxations, etc 10.2.2 Public expenditure : Here we deal with the principle and problem relating to the allocation of public expenditure It involves the study of principles, justification and effects of public expenditure. 10.2.3 Public debt: Here we are concerned with the public debts created by public borrowing, methods of public borrowing, methods Of public borrowing, impact or effects of public debt and retirement and management of public debt. 10.2.4 Financial Administration : This deals with the organisation of Financial machinery to raise and spend funds, preparation and sanction of budget, evaluation of budget, etc. 10.2.5 Fiscal Policy: This refers to measures to avoid economic fluctuations and promote economic stability. It is also concerned with measures to promote growth and development.
137
In addition to the income and expenditure of the government, the scope of public finance includes the following functions of the budgetary policy of a government. According to Musgrave, the three functions of budget policy are— 10.2.a The Allocation Function : is the adjustment in the allocation of resources In an economy by means of revenue and expenditure policies, to achieve certain objectives. 10.2.b. This Distribution Function : is concerned with the measures to be taken for bringing about an equitable distribution of income in an economy. 10.2.c. The Stabilisation Function: is concerned with the measures to be taken to maintain the price stability and full employment. Thus, public finance plays a very great role in the modern economics to promote maximum social welfare. It deals with various aspects of financial operations of the government.
10.3 PUBLIC FINANCE VS PRIVATE FINANCE Public Finance refers to the financial operations of the government, while private finance refers to the financial operations of an individual economic unit such as a firm or a house In certain respects, public finance is similar to private finance, while, in other respects, they differ from each other, 10.3.1. Similarities between Public Finance and Private Finance a Satisfaction of wants : Both the private and public sectors are engaged in satisfaction
of wants of the society to Maximum return. Since both public and private sectors have limited resources
they try to obtain maximum return by making optimum use of their limited resources.
c Borrowing Both the public and private finance resort to
borrowing from different sources, when the revenue falls short of expenditure.
d Financial Activities : Both private and public Sectors are
engaged in similar activities like production, saving, investment, capital accumulation, etc.
In order to finance these operations they attempt to increase the size of resources
10.3.2 Difference between Public Finance and Private Finance : a Income-expenditure adjustment:
138
In case of private finance, expenditure is within the limits of income. An individual plans his expenditure pattern on the basis of the income he expects to receive. But in case of public finance, income is adjusted to expenditure. The government first decides the expenditure and then arranges for collecting the necessary revenue.
b Objective: The motive of the government is to maximize the welfare of
the community. That is government is interested in promotion of 'social welfare', whereas the motive of private finance is to maximize individual welfare. That is private individual is guided by 'private motive'.
c. Nature of resources: The government has many sources to raise revenue, while
private individual has limited sources. The government can raise revenue through tax and non-tax sources. Moreover, whenever necessary government cart issue currency to meet the raising expenditure. The government can borrow, at more liberal terms, both internally and externally, whereas individual earn his income, from work and property. When expenditure exceeds income individual can borrow only internally. Thus the capacity of the government to raise revenue is much larger than that of the individual.
d Methods of collecting revenue : Government can raise revenue by using force. It can compel
people to pay taxes and even lend money during war. But individual can earn his revenue only voluntarily. He cannot use force to get income.
e Foresightedness Government is far sighted. It being permanent institution, has
a long term perspective It is the custodian of the interest of future generation. So through budget, government make provision for long term projects like railways and power projects. But while planning the budget individual is short sighted in his perspective. He thinks only for the present or near future
f. Secrecy vs publicity . Private finance is a secret affair. Individual maintains secrecy
with regard to sources of income and expenditure. But public finance is an open and public affair. Government budget is given widest publicity. It is widely discussed, appreciated as well as criticised.
In short public finance is a wider affair. The rules of private
finance cannot be applied to public finance. Dalton said that,
139
due to these differences. Public finance and private finance are studied as separate branches of economics.
Check Your Progress :
1. Define Public finance. 2. Public finance plays a very important role to maximize social
welfare – Explain. 3. Distinguish between Public finance and Private finance.
10.4 MEANING OF PUBLIC REVENUE The income of the government from all sources is called public revenue. According to Dalton public income can be classified as— 1. Public Revenue and 2. Public Receipts 1. Public Revenue : Consists of taxes, revenue from administrative activities like tines, fees, income from public enterprises, gifts and grants. This is public revenue in the-narrow sense. 2. Public Receipts : Includes public revenue plus the receipts from public borrowings the receipts from the sale of public assets and printing and issuing new currency notes Thus public revenue includes other sources of public income. This is public revenue in the broad sense. In India receipts of government are divided into Revenue receipts and Capital receipts. Revenue receipts include current receipts such as taxes, profit, interest receipts, dividends revenue from various administrative services. Whereas Capital receipts include borrowing internal as well as external, recoveries of loans, etc.
10.5 SOURCES OF PUBLIC REVENUE Sources of Public Revenue are broadly classified into A. Tax Revenue B Non-Tax Revenue
140
A. Tax Revenue : The revenue raised by the government through various direct and indirect taxes is known as tax revenue Direct taxes are imposed on income and wealth E.g. income tax, wealth lax, etc. whereas Indirect taxes are imposed on purchase or sale of commodities e.g. Sales tax, Excise and custom duties, etc. The main-characteristics of tax are
a. A tax is a compulsory payment to the government. b Refusal to pay tax is a punishable offence. c There is no direct quid-pro-quo between the tax payers
and the government as there is no direct benefit against payment. The tax-payer cannot claim reciprocal benefit against taxes paid.
d Tax has to be paid regularly and periodically as determined by the taxing authority, e. Every tax involves some sacrifice on the part of the tax payer
In modern public finance, the tax revenue accounts for a larger share in the total public revenue Taxes imply forced saving. Progressive taxes help to reduce inequalities of income and wealth. Taxation affects production, consumption and distribution. Tax discourages conspicuous consumption. It can be used as an effective instrument to achieve price stability Taxes constitute an important source of development finance B. Non Tax Revenue : The revenue received form sources other than tax revenue is
known as non-tax revenue. As compared to tax revenue, non-tax revenue accounts for a smaller share in the total revenue Following are the important sources of non-tax revenue
a. Fees : A fee is charged by government for rendering a service
to the people e g Court fees, passport fees, license fees for issuing driving licenses, import licenses, etc Generally fees are charged to recover the cost of service le a fee is lump sum payment in exchange of receiving services. Fees are paid by those who receive .some special advantages. There exists quid-pro-quo. So fees differ from tax.
b. Prices : Government offers various goods and services for
which it charges the price Therefore this is the revenue earned by selling something e.g. Railway Tickets.
Prices are different from Fees Prices are a payment for
business whereas fees are paid for administrative services. Prices are voluntary payments whereas fees are compulsory payments. But both are made for special services- Fees may not cover the cost of services whereas price is never lesser than" the cost of production.
141
c. Fines and Penalties : Fines and penalties are levied and collected from offenders of laws as punishment. The main object of such levies is not to earn income but to prevent the offending of laws. Hence they are an insignificant source of revenue. Fines and penalties are arbitrarily determined. They are not related to government activities.
d. Special Assessment: When the government undertakes
public projects like construction of roads, drainage system, etc. it may confer special benefits to those possessing properties nearby. The values of these properties may rise. So the government imposes a special levy in proportion to the increase in the value of the property, so as to recover a part of the cost of the project.
The special assessments are known as 'betterment levy' in
India. Betterment levy is imposed on land when its value is enhanced by the construction of social overhead capital. Special assessment is levied once for all on unearned income. There is direct quid pro quo.
e. Profits of Government Enterprises : This is an important source of revenue to the government e.g.
surplus form Railways, Telephones, Profits of the State undertakings like HMT, STC etc. are an important sources of revenue to the government.
Profits from government enterprises depends on the prices
charged by them for their goods and services and the surplus derived. The price policy of state undertakings should be self supporting and reasonably profit oriented. Many public enterprises like postal services run on a cost-to-cost basis. The prices are charged just to cover the cost of rendering such services. However when the government has absolute monopoly, prices having high profit element are charged.
f. Grants and Gifts :These are voluntary contributions and form
a very small part of public revenue. Quite often, patriotic people or institutions may make gifts to the government. Specially during war-time or an emergency, gifts have some significance
In modern times, grants from one government to another has a
greater importance Local governments receive grants from state governments and state governments from the center to enable them to carry out their functions.
When grants are made by one country's government to another, it is called 'Foreign aid. Usually poor countries receive such aid from advanced countries e.g. military aid, economic aid.
142
food aid technological aid etc. However such grants are normally conditional. There are lot of uncertainties and difficulties associated with such grants. Funds acquired by way of grants are not significant. So far we studied the sources of public revenue. Public receipts would include public revenue and the following three items. 3 Deficit Financing 4 Borrowings 5 Miscellaneous sources. 3. Deficit Financing : Implies an excess of public spending over
public revenue. The gap is filled by printing more currency. However this method is inflationary because it increases the supply of money without a corresponding increase in real output. This leads to the rise in price level. Most of the developing countries are resorting to this method in order to finance their rising expenditure.
4. Borrowings : In order to cover budgetary deficit, a
government may borrow from individuals and financial institutions within the country and also from foreign countries and international financial institutions. Loans taken by a government from internal sources may be voluntary or compulsory. However on all borrowings government has a repayment liability with interest.
5. Miscellaneous Sources : This includes income received by
government by sale of public assets, claim of government to private properties, unclaimed bank deposits, etc. Government often owns property in the forms of lands and buildings and earns rent and land revenue from it. Government sometimes also sell its assets like land, gold etc. in the market. However this is an insignificant source of its income.
10.6 CANONS OF TAXATION The characteristics or qualities which a good tax should possess are described as canons of taxation. Canons of taxation refer to the administrative aspect of a tax. They relate to the rate of tax, the amount of tax, the method of levy and the collection of a tax. Canons refer to the qualities of an isolated tax and not the tax system as a whole. According to Adam Smith, there are four canons (maxims) of taxation. They are as follows : 1 Canon of equality or equity, 2 Canon of certainty,
143
3. Canon of economy, and 4. Canon of Convenience To these four canons, economists like Bastable have added a few more, which are as under 5. Canon of elasticity, 6 Canon of productivity, 7 Canon of simplicity, 8 Canon of diversity, and 9. Canon of expediency We shall briefly describe them as follows : 1. Canon of Equality or Equity : This implies that burden of taxation must be equitably distributed in relation to the ability of tax-payers. Taxation must ensure social justice The rich people should bear a heavier burden of tax and the poor a lesser burden. Hence, a tax system should contain progressive tax rates based on the tax payer's ability to pay and scarifies 2. Canon of Certainty : There should be an element of certainty on the part of the movement. The tax-payer must be certain about the amount of tax. tax-payer of payment. If the tax payer is certain about the time of payment and also the effectively terms and conditions of payment he can plan his tax to manage vehement must also be certain about the expected revenue so its budget effectively. Thus the certainty aspect of taxation refers to the certainty of effective incidence, certainty of liability and certainty of revenue. 3. Canon of economy : the cost of collection of tax should be as minimum as possible. If the cost of collection is high, the net revenue available to the government would be less. E g in India, the administrative cost of collecting income tax is very high and it is a potential source of black money. Lack of economy in tax collection would result in huge administrative cost, insufficient revenue, disrupts the smooth functioning of business and hard work, saving and investments are discouraged. 4. Canon of convenience : Tax should be levied and collected at an appropriate time The tax payer should find it easy and convenient to make payment E.g. income-tax should be deducted at the time of paying salaries. Taxes on agricultural income should be deducted after harvest. Tax should be collected in a convenient manner from the tax-payer so that it is least felt. These four canons determine the efficiency of a tax. However, an efficient tax is also one which facilitates an optimum allocation of resources and encourages economic growth. To above mentioned
144
Smith's canons of taxation, Bastable have added the following canons 5. Canon of Simplicity : The individual taxes as well as fax system should be simple so that it is easy for the common man to understand and pay it conveniently. The process of administration of a tax should not be too elaborate. The Indian tax system is so complicated that tax payers do not understand their liability. 6. Canon of productivity: This implies two things. Firstly, taxes should be productive i.e. They should bring sufficient revenue to the stale. Otherwise it is meaningless. Secondly, taxes should stimulate productive effort of the community and should not discourage production. Tax should act as an incentive to production. For Example import duties protect and encourage a country's infant industries and domestic output. 7. Canon of Diversity : There should be multiple tax system so as to mobilise revenue from all possible sources. The tax system should be diverse in nature so that the tax-payer is not burdened with high incidence of tax in the aggregate. 8. Canon of Elasticity or Canon Of Flexibility or Canon of buoyancy : The tax system should be flexible or elastic so that it can be adjusted according to the requirements of the economy. It should automatically bring additional revenue with the increase in national income. This canon of Flexibility or buoyancy is an index of the efficiency and stability of the state. 9. Canon of Expediency : A tax should have economic, social and political support. It should be acceptable in the economy, otherwise, it would not bring adequate revenue e.g. Tax on agricultural income. India lacks social, political or administrative expediency. Hence there is no agricultural tax in India, though India is an agricultural economy. The government must pay due attention to these canons while levying tax. Based on its objectives, the government should give priority to the most important canon as compared to a less important one as it might be difficult to satisfy all the canons. Check Your Progress :
1. What do you mean by public revenue? 2. Distinguish between Tax and Non tax revenue. 3. What are the characteristics of a good tax system?
10.7 MEANING OF DIRECT AND INDIRECT TAXES Taxes have been classified into two - Direct and Indirect a. Direct tax is one which is paid by the person on whom it is
legally imposed and the burden of which cannot be shifted to any other person. According to J.S. Mill, a direct tax is "One which is demanded from the very persons who. it is intended or desired, should pay it." The person from whom it is collected cannot shift its burden to somebody else Thus, the impact, i.e. the initial burden and the incidence, i.e. the ultimate burden of a direct tax is on the same person. The tax-payer is the tax-bearer e.g. income tax is a direct tax
b An indirect tax is one in which the burden can be shifted to
others. According to J.S. Mill, indirect taxes are those * which are demanded from one person in the expectation and the intention that he shall indemnify himself at the expense of another " Thus the impact and incidence of indirect taxes are on different persons. Hence, in case of indirect taxes, the taxpayer is not the tax-bearer. For example, commodity taxes or sales tax. excise duties, custom duties, etc. are indirect taxes.
The gist of the distinction thus lies in its shifting. A tax which cannot be shifted is direct and one which can be shifted is indirect Mrs. U. Hicks classifies taxes on the basis of administrative arrangements. In case of direct taxes there is direct relationship between the tax payer and the revenue authorities. Whereas in case of indirect taxes there is no direct relationship between the tax payers and the revenue authorities. These taxes may be collected through traders or manufacturers. The modern classification of taxes is done on the basis of assessment. Taxes are assessed on the basis of income received and expenditure incurred. Hence, taxes which are based on income are called direct and those which are levied on outlays are called indirect taxes.
10.8 MERITS AND DEMERITS OF DIRECT TAXES A Merits of Direct taxes : 1) Equity : Direct taxes are considered to be just and equitable.
This is because the burden of such taxes can be equitably distributed among different sections of the society. This is
146
done accordingly to their 'ability to pay'. Hence, greater amount of money is collected from the rich and a smaller amount, from the poor.
2) Elasticity and productivity : Direct taxes are elastic because
their gradation is such that automatically income from those taxes goes up when income of the taxpayer increases and vice-versa. Thus 'built-in-Flexibility' principle is incorporated in all direct taxes. Direct taxes are productive because they provide incentive to earn more. Since there is minimum exemption limit, the people work hard to earn income
3) Economy in collection : Direct taxes are economical in the
sense that the cost incurred in the collection of tax amount is less since the employers themselves act as honorary tax collectors. The employers cut the amount of tax from the salaries of their employees and pay it to the department concerned. This saves a lot of public money. That is why they are called economical.
4) Certainty : All the direct taxes satisfy the canon of certainty
The taxpayers are certain as how much they are required to pay on the one hand and on the other hand, the government can calculate as to how much revenue it is going to get and accordingly, it can adjust its income and expenditure
5) Progressive : Direct taxes can serve as an instrument to
reduce inequalities of income and wealth. They may achieve the objective of social justice, because they -are based on ability to pay principle of taxation.
6) Anti-inflationary : Direct taxes can serve as good instrument
of anti-inflationary fiscal policy designed to maintain the price stability. The excessive purchasing power during inflation can be seized away from the community through increased direct taxes
7) Educative : Direct taxes have an educative value-as they
create a civic sense among the tax-payers. Citizens realise their duty to pay tax and because of the direct burden of taxes they become conscious and keep vigil on how the public income is spent by government in a democratic country.
B Demerits of Direct taxes: 1) Pinching : Since direct taxes are to be paid in lump sum they
pinch the taxpayers more and cause resentment. 2) Inconvenient: Direct taxes are not convenient as the returns
from income tax, wealth tax have to be filed in time and
147
complete records have to be maintained up-to-date It is also very inconvenient to pay these taxes as they are collected in lump sum. The tax laws are so complex having different interpretations that common people do not understand them.
3) Evasion and corruption : Evasion is possible under direct
taxation by concealing real income and wealth and filing false returns. Since the assessment of direct taxation depends on voluntary declaration of the tax payer, it is a tax on honesty. Dishonesty is rewarded. Tax evasion also leads to corruption.
4) Uneconomical: An elaborate machinery is required for the
collection of direct taxes, as each assessee has to be contacted and checked to prevent tax evasion. The cost of collecting direct taxes is very high when the tax-base is narrow.
5) Narrow based : A large section of the people remain
untouched by direct taxes, mainly the poor sections. Hence, they may not bring adequate revenue to the government especially in developing countries.
6) Arbitrary: The nature and base for direct taxes are arbitrarily
fixed by the government. The gradation and progression of direct taxes are based on the value judgement of the finance minister.
7) Discourage hard work and efficiency - The main
disadvantage of direct taxes is that it kills the incentive to work hard, save and invest It discourages efficiency as there is no quid-pro-quo in the payment of direct taxes.
These demerits of direct taxation are mainly due to
administrative difficulties and inefficiencies The extent of direct taxation should depend on the economic state of the country A rich country has greater scope for direct taxation than a poor country. However, direct taxation is an important aspect of modern financial system.
10.9 MERITS AND DEMERITS OF INDIRECT TAXES A Merits of Indirect taxes : 1) Less Pinching : Since indirect taxes are not felt directly, they
cause less resentment Since, indirect taxes are hidden, the tax payer does not realise how much tax he has paid on his total' purchases
148
2) Can become progressive: Indirect taxes on luxuries and semi-luxuries are progressive in effect, as they fall on the rich people's consumption expenditure.
3) Convenient: Indirect taxes are more convenient to pay. These
taxes, generally being on commodities, are wrapped up in prices, hence, the tax-payer does not feel the burden directly.
4) Broad based: Indirect taxes have a broader scope than direct
taxes. The low income group of the society which are exempted from direct taxes can be easily caught in the net of taxation through indirect taxes to render the sacrifice according to their ability-to-pay.
5) Forced Saving: Indirect taxes take away the consumer's
surplus and divert the saving of the community to the government. This helps to promote capital formation.
6) Social value: Indirect taxes help to discourage the
consumption of harmful commodities like cigarettes, tobacco, etc. They help in the effective allocation of resources. They help in the effective allocation of resources. They help to improve the social morale and public health.
7) Evasion not easy: Indirect taxes are included in prices and
hence they cannot be evaded. 8) Complementary: Indirect taxes can serve as a
complementary to direct taxes Additional revenue can be easily obtained through indirect taxes without revealing its burden to the public. If a person escapes from direct taxation, he will be caught in the net of indirect taxes.
9) Promotes economic development: Indirect taxes help to
bring about effective changes in the pattern of production and consumption through proper allocation of resources. High indirect taxes discourage the production of luxuries. The production of necessaries will be encouraged. Export can be encouraged by abolishing export duties and Import can be discouraged through import duties. Thus indirect taxes can help to promote economic development.
B Demerits of Indirect taxes : 1) Inequitable and regressive: Indirect taxes are unjust and
inequitable as they are regressive in effect. Since they are charged at a proportional rate on commodities of general consumption their burden falls more heavily upon the poor sections of the people. They are not levied according to the principle of ability to pay
149
2) Less economic and less productive: Indirect taxes do not confirm to the canons of economy and productivity. As these taxes involve many stages, the cost of collection is usually high in relation to the revenue collected. Further, an indirect tax is not as productive as a direct tax.
3) Inflation productive: Indirect taxes prove to be inflationary
when excessively relied upon. They sometimes benefit more the traders than the government when prices tend to go up by more than the amount of the tax.
4) Distinctive effect: Indirect taxes discourage savings when
people have to spend more with a rise in the prices of commodities.
5) Un-educational: Indirect taxes are invisible as they are
hidden in prices. There is no link between the tax-payers and the government. Hence, they do not promote civic sense and have no educative value.
Check Your Progress :
1. Differentiate between Direct taxes and Indirect taxes.
10.10 SUMMARY 1) Public finance lies on the border line between economics and
politics 2) Public finance deals with financial activities of the government. 3) Study of public finance is divided into five parts: a) Public revenue. b) Public expenditure c) Public debt. d) Financial administration. e) Fiscal policy. 4) Scope of public finance includes following functions of the
budgetary policy of the government: a) The allocation function. b) The distribution function.
150
c) The stabilisation function. 5) In following respects public finance is similar to private finance a) Satisfaction of wants. b) Maximum return. c) Borrowing d) Financial activities. 6) Public finance is different from private finance in following
respects a) Income : expenditure adjustment b) Objective c) Nature of resources d) Methods of collecting revenue e) Foresightedness f) Secrecy vs Publicity 6) Income of the Government from all sources is called public
revenue.
7) Sources of public revenue can be classified into— a) Tax revenue and b) Non-tax revenue.
8) Qualities of a good tax are described as Canons of taxation.'
9) According to A. Smith there are four Canons (Maxims) of taxation :
a) Canon of equity b) Canon of certainty c) Canon of economy d) Canon of convenience
10) Other economists have added few more canons : a) Canon of elasticity b) Canon of productivity c) Canon of simplicity d) Canon of diversity e) Canon of expediency 11) Taxes have been classified into: a) Direct taxes and b) Indirect taxes.
12) Direct taxes have following merits : a) Equity b) Elasticity and productivity c) Economy in collection d) Certainty e) Progressive f) Anti-inflationary g) Educative
13) Demerits of direct taxes are : a) Pinching b) Evasion and corruption
151
c) Inconvenient d) Uneconomical e) Narrow based f) Arbitrary g) Discourage hard work and efficiency.
14) Indirect taxes have following advantages: a) Less pinching b) Can become progressive. c) Convenient d) Broad based e) Forced saving f) Social value g) Evasion not easy h) Complementary i) Promotes economic development
15) Disadvantages of Indirect taxes are: a) Inequitable and regressive b) Less economic and less productive. c) Inflation productive d) Disincentive effect e) Un-educational
10.11 QUESTIONS 1) What is Public Finance? 2) Discuss the scope and subject matter of public finance. 3) Examine the similarities and Dissimilarities between public and
private finance. 4) Distinguish between public and private finance. 5) What are the various sources of public revenue? 6) Discuss various canons of taxation 7) Explain merits and demerits of direct taxes. 8) Describe various merits and demerits of indirect taxes. 9) Write notes on : a) Tax revenue and non lax-revenue b) Canons of taxation c) Merits and demerits of direct taxes d) Merits and demerits of indirect taxes.
152
11
PUBLIC EXPENDITURE, PUBLIC DEBT AND DEFICIT
Unit Structure : 11.0 Objectives 11.1 Meaning of Public expenditure 11.2 Revenue and Capital expenditure 11.3 Causes of Public expenditure growth 11.4 Canons of public expenditure 11.5 Meaning of Public debt 11.6 Types of Public debt 11.7 Burden of Internal debt 11.8 Burden of external debt 11.9 Various types of deficits 11.10 Federal Finance in India 11.11 Summary 11.12 Questions
11.0 OBJECTIVES
1. To study the meaning of public expenditure 2. To understand the difference between Revenue expenditure
and Capital expenditure 3. To study the causes of growing public expenditure 4. To know the canons of public expenditure 5. To study the meaning of public debt 6. To study various types of public debt 7. To study the burden of Internal debt 8. To study the burden of External debt 9. To study various types of deficits 10. To understand the concept of Federal Finance in India
11.1 MEANING OF PUBLIC EXPENDITURE: Public expenditure is that expenditure incurred by the public authorities like Central, state and local governments to satisfy those common wants which the people in their individual capacity are unable to satisfy efficiently. Public expenditure tends to satisfy collective social wants. Public expenditure has an important role to play in modern economic activities. The government must ensure supply of
153
essential goods and services. Collective wants cannot be provided by the private sector economically and efficiently. Hence, public expenditure is essential to fulfill the inadequacy of investment.
11.2 REVENUE AND CAPITAL EXPENDITURE Technically, in the structure of a budget, most governments classify public expenditure into two Current (Revenue) expenditure and capital expenditure. All sorts of administrative and defence expenditure and debt services are called current expenditure. They are also called as non developmental expenditure. They are intended for continuing the existing flow of goods and-services and maintaining the capital of the community intact. On the other hand, capital expenditures are intended for the creation of net productive assets in the economy. They contribute to increased productive capacity of the nation and therefore, are known as developmental expenditures. Expenditures on construction of dams, public works, state enterprises, agricultural and industrial development, etc. are instances of capital expenditure.
11.3 CAUSES OF PUBLIC EXPENDITURE GROWTH There has been a persistent and continuous increase in public expenditure in countries all over the world. The classical ideology of keeping the government spending at the lowest possible level has lost its appeal in the modern days. According to Adolf Wagner, a German economist, ―there .is a continuous tendency of both intensive and extensive increase in the functions of the government, new functions are continuously being undertaken and old functions are being performed more efficiently and on a larger scale.‖ This observations of Wagner, popularly known as 'Wagner's Law', is universally valid. Wagner argued that there exists a direct functional relationship between the activities of the state and the size of public expenditure. Along with the growth of the economy, the government activities grow faster. Thus Wagner's law reveals a universally true inductive generalization about the continuous and substantial growth of public expenditure. Following factors are responsible for such tremendous and continuous increase in spending of modern governments. 1. Acceptance of welfare state: The concept of welfare state
has been accepted by all the governments the world over. The
154
adoption of welfare state has multiplied the responsibility of the government. In a welfare state the note of government has significantly widened, in fact there is hardly any Held of economic activity in which the government is not concerned directly or indirectly. Huge expenditure has to be incurred by the government,s welfare items like education, public health, social security measures like old age persons, unemployment allowances, subsidies, etc. In short the acceptance of welfare state has brought about a change in the attitude of the government towards Public expenditure which has grown many times.
2. Impact of Great Depression : The great Depression of 1930,
has widened the economic role of the government. In order to rectify the bad effects of depression such as unemployment, investment deficiency, etc. the government has to play an active role in stabilising the economic activity. Thus, to fight the depression government is required to incur huge expenditure
3. Defence expenditure : Defence has been a traditional
function of the government. In modern times there is qualitative and quantitative changes in the expenditure on defence. Such expenditure has to be incurred not only during war time but also during peace time. All the countries have always to remain ready for arty emergency. Naturally, huge expenditure becomes inevitable. If the actual war breaks up there is further manifold increase in this expenditure. Above all modern wars have become a costly affair Increasing amounts have to be spent on modern weapons and other requirements. The war arms-race among the countries of the world causes limitless expansion of expenditure defence.
4. Democratic Institutions : Democracy is a costly affaires the
government has to spend huge amounts on various institutions to ensure smooth functioning of the system. There is a chain of such institutions right from village gram panchayats to the central government at the national level. Large amount becomes necessary for conducting periodical elections, allowances of elected representatives, etc. Further expenditure has to be incurred on constitutional posts. The acceptance of democracy is one of the causes of growth of public expenditure.
5. Growing population : A high growth of population naturally
calls for increase in public expenditure as all state functions are to be performed more extensively Rising population also poses various problems in poor countries. The government will have the added responsibility of solving such problems as food, unemployment, housing and sanitation. Further, over-
155
populated countries like India will have to check the population growth. Therefore, the government has to spend more and before on family planning campaigns every year. s
6. Urbanization : The spread of urbanization is an important
factor leading to the relative growth of public expenditure in modern times. With the growth of urban areas, there has been an increasing tendency of expenditure on civil administration. Expenses on water supply, electricity, provision of transport, maintenance of roads, schools and colleges, traffic controls, public health, parks and libraries, playgrounds etc have increased enormously in these days. Likewise, the expenditure on courts, prisons etc. is increasing especially in urban areas.
7. Development project: In an underdeveloped country, the
government has to spend more and more on developmental projects, especially in rural areas. It has to undertake schemes like community development projects and other social measures for rural development. Huge investment has to be incurred on infrastructure and basic industries for rapid economic development of a country. This has increased the public expenditure
8. Rising Prices : Inflationary tendencies have become a
common feature of the post world war. The government is required to spend increasing amounts on completion of the existing projects and on new ones. During inflation the government has to pay additional D.A. to the employees which obviously calls for an extra burden on public expenditure. Thus inflationary price rise is one of the important factors that leads to growth of public expenditure.
9. International responsibility: In modern times all nations have
to become members of international institutions like UNO and IMF. They have to make subscriptions for their membership. They have to maintain their delegates on these institutions, attend and host their conferences. They also have to maintain their embassies and ambassadors in foreign countries. This further increases their expenditure.
10. Public borrowing : To finance the development projects the
government has to borrow internally as well as externally. Interest payment and servicing-of these debts along with repayment of the principle has increased the expenditure of modern governments.
Thus the various factors like extension of traditional functions,
acceptance of new functions and increasing importance of government in economic activities have caused increase for public expenditure.
156
11.4 CANONS OF PUBLIC EXPENDITURE The expression canon of public expenditure is used for the fundamental rules or principles governing the spending policy of the government. Findlay Shirras has suggested Four Canons of Public Expenditure viz. 1) Canon of benefit. 2) Canon of economy 3) Canon of Sanction 4) Canon of Surplus. Other economists have also suggested certain canons such as 5) Canon of economic growth. 6) Canon of productivity 7) Canon of elasticity 8) Canon of equitable distribution. 1) Canon of benefit.: This canon implies that public expenditure
should be incurred in a such way that it promotes maximum social advantage. The ultimate purpose of public expenditure should be social benefit. Hence public expenditure should be directed to those areas which maximise the benefits of the society as a whole and not as an individual group
2) Canon of economy: Public expenditure should be productive
and efficient It should be incurred economically avoiding extravagance and wastes. It should avoid duplication and involve minimum cost. It should be incurred on essential items of common benefit. It should ensure optimum utilisation of resources.
3) Canon of sanction: All public expenditures should be
incurred after the approval of a proper authority. This sanction is required for proper allocation of resources and to avoid the misuse of funds. The expenditures must be audited to ensure that money is spent for the purpose for which it is sanctioned.
4) Canon of Surplus: This principle implies that the government
should create a surplus in budget and avoid deficit. An ideal budget is one which contains a surplus by keeping the public expenditure below public revenue. This ensures the credit worthiness of the government.
5) Canon of economic growth: Growth with stability is an
important objective which governs public expenditure. Developed countries can maintain the present high rate of economic growth and under-developed countries can focus on raising the growth rate and attainment of a higher standard of living through public expenditure.
157
6) Canon of productivity: Public expenditure must be
productive so that income and employment can be generated. A large part of public expenditure should be allocated for developmental purpose.
7) Canon of elasticity: This canon implies that the government
spending policy should be fairly elastic according to the changes in the circumstances and requirements of the economy.
8) Canon of equitable distribution : Public expenditure policy
of the government should aim at reducing inequalities of income and wealth in the economy. Thus the expenditure policy should provide maximum benefits for the weaker sections of the society.
Check Your Progress :
1. What do you mean by public expenditure? 2. Distinguish between Revenue and capital expenditure. 3. What are causes of increasing public expenditure in modern
governments? 4. Which rules govern the spending policy of the government?
11.5 MEANING OF PUBLIC DEBT Public debt means the loans raised by the government internally or / and externally. Loans may be obtained from individuals, banks, financial institutions like IMF, World Bank. etc. Public debt is considered to be an important source of income to the government in times of financial crisis, emergencies like war, droughts, etc. or when current revenue fall short of public expenditure. Public borrowing take the form of government bonds or securities of various kinds. Securities are contract between the government and the lenders and by issuing securities government incurs a liability to repay both the interest and the principal amount as per the contract. Thus public debt refers to financial obligations of government to pay sums to the lenders at some future date.
158
11.6 TYPES OF PUBLIC DEBT Government loans are of different types. They may differ in respect of time of repayment. the purpose, condition of repayment, etc. Thus public debt may be classified into following types a Internal and External Debt b Productive and unproductive Debt c. Compulsory and voluntary Debt. d Redeemable and Irredeemable Debt. e Funded and unfunded Debt f Short-term, Medium term and Long term Debts. a. Internal and External Debt : Place of borrowing is the basis
of this classification Government borrowings within the country from financial institutions or public selling bonds and securities are called internal debt. Under internal debt, the availability of total resources m the country does not rise. The resources are just transferred from financial institutions or public to the government. Thus internal debt involves a mere transfer of funds from private hands to government within the country. It has no direct net money burden.
External debt refers to borrowings by government from abroad
i.e. from foreign countries and international financial institutions. External debt increases the foreign exchange resources of the borrowing country when the loans are received in terms of foreign currencies. But when these loans are repaid along within interest, the foreign exchange is reduced to that extent. External debt helps to promote capital formation and industrialization especially for developing countries like India
b. Productive and unproductive Debt: Public debt is said to be
productive when it is raised for productive purpose and is used to add to the productive capacity of the economy; When government loans are invested in the construction of railways, irrigation projects, power generation etc it adds to the productive capacity of the economy and provides continuous income to the government The interest and principal amount is paid out of income earned by the government from these projects. Thus productive loans are self-liquidating and does not cause any burden on the community.
Whereas unproductive debts are those which do not add to the
productive capacity of the economy. Such debts are not self-liquidating and therefore are a burden on the community. The public debts which are raised for war, social services, famine
159
relief, etc. are unproductive debt. Such debts are not bad because they may lead to well-being of the community.
c. Compulsory and Voluntary Debt: Compulsory debts are raised by using coercive methods In modem public finance, compulsory loan is a rare phenomenon, unless there are some special reasons like war or crisis The rate of interest on such loans may be low. In India compulsory Deposit Scheme is an example of compulsory debt.
Generally public debts are voluntary in nature. In this case
government makes an announcement regarding the floating of loans.
This announcement may be accompanied by some kind of
publicity. The government floats a loan by issuing certificates, bonds, etc. Individuals, bank and other financial institutions lend to the government willingly by purchasing these securities.
d. Redeemable and Irredeemable Debt : The debts which the
government promises to pay off at some future date are called redeemable debts. The government has to make arrangement for repayment of interest and principal amount within a specific lime period.
Where as in case of irredeemable debt no definite date for
final repayment is promised but the rate of interest is paid regularly. Hence the government makes arrangements for interest payment only. Such debts create a burden as taxes would be raised to pay the debt in the future,
e. Funded and Unfunded Debt: Funded debt is a long term
debt, exceeding the duration of at least d year. It consists of securities which are marketable on the stock-exchange. Funded debt is an obligation to pay a fixed sum of interest, subject to an option of the government to repay the principal, in such the creditor bond holder has right only on interest.
On the other hand, unfunded debts are for a comparatively
short duration. They are generally repaid within a year The rate of interest is low. These debts are incurred to meet temporary needs of the government,
f. Short-term, Medium term and Long term Debts : Short
term debt matures within a duration of 3 to 9 months and the rate of interest on such loans is low. The treasury bills of government of India, which usually have a maturity period of 90 days, are the best example of such debts.
160
On the other hand, long-term debts are repayable after a long period time, generally 10 years or more. Such loans are raised for developmental programs and to meet other long-term needs of public authorities.
Medium term debt has a maturity period between short-term
and long-term loans. The role of interest is intermediate. They are generally raised for welfare programs.
11.7 BURDEN OF INTERNAL DEBT Internal debt constitutes a redistribution of resources within the community. There is no change in the total resources of the country. 11.7.1 Direct Money Burden : There is no direct money burden caused by internal debts as all payments cancel out each other in the aggregate community as a whole. Whatever is taxed from one section of the community tot servicing debts is distributed among the bond holders by way of repayment of loans and interest. The incomes of the creditors increase to the extent to which the incomes of the tax payers reduce. The aggregate position of the community remains the same. 11.7.2 Direct Real Burden : Internal debt involves a direct real burden based on the transfer of incomes. If the tax-payers and bond-holders are the same the distribution of wealth remains unaltered. Hence there will not be any net real burden on the community. If the tax-payers and bond-holders belong to different income groups, there will be a change in the distribution of income resulting in inequalities of income. If this inequality of income increases, the net direct real burden of the community increases. If the proportion of taxes paid by the rich is smaller than the proportion of public securities held by them, then there will be direct real burden of internal debts. 11.7.3 Unjustified transfers : The servicing of internal debt involves transfers of income from the younger to the older generations and from the active to the inactive enterprises. The government imposes taxes on enterprises and earnings from productive efforts for the benefit of the idle, inactive, old and leisurely class of bond holders. Hence, work and productive risk taking efforts are penalised for the benefit of accumulated wealth. This adds to the net real burden of debts.
161
11.7.4 Indirect Real Burden : internal debt involves an additional indirect real burden on the community This is because the taxation required for servicing the debts reduces the tax-payer's ability to work and save and affects production adversely. The government may also economise social expenditure thereby, reducing the economic welfare of the people. Taxation will reduce the personal efficiency and desire to work more than their increase caused by debt payments. Thus there would be a net loss in the ability and desire to work. The creditor class will also not have any incentive to work hard due to the prospect of receiving interest on bonds. This would further cause a loss to production and increase the indirect burden of debt. The indirect real burden of public debt can be reduced by the following: 3.4.a. Minimizing the cost of servicing through a low rate of interest. 3.4.b. Issue of new money for the servicing of debts. 3.4.c. Self liquidating public debts. Public debt used for productive purposes like public works programmes, creation of socio-economic overheads etc. will raise the ability to work; save and invest. This would help to reduce both direct and indirect real burden imposed by taxation for servicing debts.
11.8 BURDEN OF EXTERNAL DEBT External debt is beneficial in the initial stages as it increases the resources available to the country. But its repayment and servicing creates a burden on the debtor country. 11.8.1. Direct money Burden and Direct Real Burden : Direct Money burden of external debt is the sum of money payments in the form of interest and principal to external creditors Direct real burden is the loss of economic welfare i.e. the sacrifices of the consumption of goods and services due to increased taxation. Given the direct money burden; the direct real burden will vary according to the proportion in which the various sections of the community contribute to payments If the relative burden of taxation falls heavily on the rich then the direct real burden to the community as whole will be less. If the relative burden of taxes falls heavily on the poor, then the direct real burden to the community as a whole will be more. 11.8.2. Decline in Domestic Resources: The transfer of resources of foreign countries at the time of payment would reduce the availability of domestic resources. This would reduce consumption and affect economic welfare.
162
There may also be a drain on foreign exchange reserves. If the export earnings are inadequate and the propensity to import is inelastic, then the borrowing country will have a greater problem in repaying foreign loans. The debtor country will be forced to raise additional foreign loans just for servicing. This would affect their progress and welfare. 11.8.3. Purpose of External debt: The burden to the community depends upon the purpose of external debt. External debts incurred for war expenditure and other such unproductive uses will add to the net real burden of the community. In case of short term loans, the current generation will repay. But in case of long-term loans, the burden will fall on posterity. External debts for productive purposes like investments in social and economic overheads, expansion of export sector, etc. wilt provide benefits to the debtor country. The posterity will also reap the fruits of such economic growth and earn additional income The real burden incurred in repayment of such external debt is not much. External debts incurred for development purposes is a profitable venture. 11.8.4. Decline in the value of currency : The repayment of external debt involves an increase in the demand for the currency of the creditor country. This will raise the exchange rate of the creditor country's currency, causing a decline in the external countries currency value and aggravate the problem of foreign exchange crisis. The creditor country may also be adversely affected if it is induced to import more from the debtor country. This may hinder the growth of their domestic industries and cause unemployment m 11.8.5. Indirect Burden : 'The indirect burden of external debt is that it affects production adversely due to the following reasons: . a. Disincentive effects of taxation b Contraction of public expenditure
11.9 TYPES OF DEFICITS 1. Budget deficit : Budget deficit is the difference between total expenditure and total receipts of the central government It is the excess of total expenditure, meaning revenue expenditure plus capital account expenditure, total receipts from revenue and capital account Such deficit is financed by newly treated money and thus add to money supply in the economy. It can be a major cause of
163
inflationary rise in prices. However this is considered as a narrow measure of deficit. 2. Revenue deficit : It is the deficit between revenue receipt and revenue expenditure. The revenue receipts are derived from tax and non tax sources like fees, profits, etc. The revenue expenditure covers administration, justice, defence and subsidies. Such expenditures create no assets and therefore it must be met by revenue which creates no liabilities. If revenge deficit is covered by borrowing, pressure on revenue expenditure in the form of payment of high interest, increases and this leads to further rise in revenue deficit. Thus may lead the country into internal debt trap. However, in India for the last several years, there has been revenue deficit, due to increase in current expenditures such as general administration, defence, interest payments and so on. 3. Fiscal deficit: It is an important measure of deficit. Fiscal deficit is the excess of total government expenditure over revenue receipts and non-borrowing types of capital receipts like recoveries of loans and grants. In other words, fiscal deficit is equal to budgetary deficit plus governments market borrowings and liabilities. Thus fiscal deficit is total of budgetary deficit and governments market borrowings and liabilities. It a more comprehensive measure of budgetary imbalances. It captures the entire short fall in the fiscal operations of the government. Fiscal deficit fully reflects the indebtedness of the government. It is financed by borrowing, both internal and external and by money financing, i.e. by borrowing from the central bank. 4. Primary deficit : The primary deficit is obtained by deducting interest payments from the fiscal deficit Thus primary deficit is equal to fiscal deficit less interest payments It indicates real position of government finances as it excludes the interest burden of the loans taken in the past. 5. Monetized deficit: This is concerned with the way by which government deficit leads to expansion of money. It is measured by rise in net holdings of treasury bills by the central bank and its contribution to the market borrowings by the government. The Chakravarty Committee recommended this concept of deficit. It indicates impact of fiscal operations on changes in reserve money and therefore potential changes in money supply. Of course, this concept is narrower than that of fiscal deficit.
164
Federal Finance in India (With respect to latest available Report) :- Financial relations under the Constitution : India has a federal structure, in which a clear distinction is made between the Union and State functions and sources of revenue, but the residual powers belong to the Centre. Although the States have been assigned certain taxes which are levied and collected by them, they also share in the revenue of certain Union taxes, and there are certain other taxes which are levied and collected by the Union but the proceeds of which wholly go to the States. In addition, the States receive grants-in-aid of their revenue from the Union which further increase the amount of transfers between the two levels of governments. The transfer of resources from the Central Government to the States is an essential feature of the present financial system of India.
A) Distribution and Allocation of Central Revenue :
1. There are certain duties which are levied by the Union but
are collected and appropriated by the States. For e.g. stamp
duties and excise duties on medical preparations containing
alcohol or narcotics.
2. There are certain taxes which are levied and collected by the
Union, but the entire proceeds of which are assigned to the
States, in proportion determined by the Parliament. For e.g.
succession and estate duties, terminal taxes on goods and
passengers, taxes on railway freight and fares, taxes on
transactions in stock exchanges and future markets, the
taxes on the sale and purchase of newspapers and
advertisements therein.
3. Central tax on income and Union excise duties were levied
and collected by the Union but were shared by it with the
States in a prescribed manner.
4. The proceeds of additional excise duties on mill-made
textiles, sugar and tobacco, which were levied by the Union
in 1957 in replacement of State‘s sales taxes on these
commodities, are wholly distributed among the States.
B) Grants-in-aid : As important welfare and development
functions are entrusted to the States, gaps between their
revenues and expenditure have to be corrected through
transference of resources from Centre. This is done partly by
arrangements for tax sharing. But grants-in-aid by the Union
165
for specific purposes or general aid have come to occupy an
important place in Union-State financial relations in India.
C) Loans : The States are authorised to raise loans in the
market but they also borrow from the Union Government
which gives the later considerable control over State
borrowing and expenditure.
First Eleven Finance Commission Awards : The appointment of a Finance Commission at intervals of five years or less has great significance for the financial relations between the Union and the States. Periodical examination of the division of resources and suitable modifications in it imparts a degree of flexibility to the finance of both the Centre and the units. The recommendations of the Finance Commissions are in the nature of awards and both the Centre and the States have to accept them. So far there have been eleven Finance Commission Awards. Twelfth Finance Commission Award (2005-10) : The Twelfth Finance Commission was constituted by the President under the Article 280 of the Indian Constitution, with Dr, C. Rangarajan as Chairman. The Award of the Twelfth Finance Commission: Vertical imbalance and devolution :- In India, vertical imbalance has always existed because the Central government has been assigned more revenues while the States have been entrusted with more and larger responsibilities. Accordingly, correcting vertical imbalance necessitates transfers from the Central Government to the State Governments taken together. The 12th Finance Commission considered all the relevant factors as regards receipts and expenditures of the Centre and of the States, the level of over-all transfers relative to Centre‘s gross revenue receipts, the relative balance between tax devolution and grants, etc. It decided an increase of the sharable pool to 30.5 percent to accommodate the additional excise duty in lieu of sugar, tobacco and textiles. Horizontal sharing : The horizontal aspect of transfer relates to the sharing of the total sharable pool between the States. In practice, there are considerable horizontal imbalances States differ in area, size of population, income tax base, forest and mineral wealth, etc. Horizontal imbalances have to be corrected while distributing Central resources among all the States in the country. The 12th Finance Commission considered the recommendations of previous commissions and also the memoranda submitted by various States regarding:
166
a) The contribution of the use of population as a factor b) The use of income distance criteria c) Continuation of area as a factor d) Retaining the tax effort and index of fiscal discipline criteria.
Accordingly the following five states would get the largest share of the total sharable revenue. State % age share U.P. 19.3 Bihar 11.0 Andhra Pradesh 7.4 West Bengal 7.1 Madhya Pradesh 6.7 The above States would get 51.5% whereas the rest 23 states would share the balance 48.5% of the sharable pool. Grants-in-aid : The 12th Finance Commission has recommended non-plan revenue deficit grants, under Article 275 of the Constitution to be given to 15 States whose total non-plan revenue deficit was assessed at Rs. 56,856 crs. for the period 2005-10. The other grants-in-aid recommended by the 12th Finance Commission are as follows: - Grants for education for 8 States : Rs. 10,172 crs. Over the
award period, with a minimum of Rs. 20 crs. In a year for any eligible State.
- Grants for health for 7 States : Rs. 5,887 crs. Over the award period, with a minimum of Rs.10 crs. In a year for any eligible State.
- Grants for maintenance of roads and bridges : Rs. 15,000 over the award period
- of public buildings : Rs. 5,000 crs. - of forests : Rs. 1,000 crs. - Grants for heritage conservation : Rs. 625 crs. Over the award
period - Grant for specific needs : Rs. 7,100 crs. Over the award period
for specific needs. Local Bodies – Panchayats and Municipalities : The 12th Finance Commission felt that there was a case to augment the consolidated fund of the States through additional grants from the Centre, keeping in view the special circumstances of the states. Besides, there was a clear need to provide an impetus to the decentralization process. Accordingly the Commission recommended a sum of Rs. 25,000 crs. For the award period, (2005-10) as grants-in-aid to supplement the resources of municipalities and the Panchayats. It has emphasized that, of the grants allocated to Panchayats, priority should be given to
167
expenditure on the operation and maintenance costs of water supply and sanitation and at least 50 percent of the grants provided to each State for the urban local bodies should be earmarked for the scheme of solid waste management. Financing of Calamity Relief Expenditure : After a careful study of the present system of disaster management, the 12th Finance Commission recommended the continuance of the scheme of National Calamity Relief Fund (NCRF) in its present form with contributions from the Centre and the States in the ratio 75:25. The Commission fix the size of the CRF for the award period, 2005-10 at Rs. 21,333 crs., of which the Centre‘s share would be Rs. 16,000 crs. and the balance would be share of the States (Rs. 5,333 crs.) The 12th Finance Commission has also recommended continuance of the scheme of the National Calamity Contingency Fund (NCCF) in its present form with core corpus of Rs. 500 crs. The outgo from the NCCF may continue to be replenished by way of collection of National Calamity Contingency Duty and levy of special surcharges. Debt Relief to States : The 12th Finance Commission recommended the following scheme of debt relief
a) Rescheduling of all Central loans outstanding as on end
March 2005 into fresh loans for 20 years carrying 7.5 percent
interest with effect from the year a State enacts the Fiscal
Responsibility Legislation.
b) A debt write-off linked to reduction in revenue deficit of every
State. The quantum of write-off of repayment would be linked
to the absolute amount by which the revenue deficit is
reduced in each successively year during the award period.
Sharing of Profit Petroleum : i) The Centre should share profit petroleum from NELP areas with the States from where the mineral oil and mineral gas are produced and the share should be 50:50. ii) The revenue earned by the Central Government on contracts signed under the coal bed methane policy should also be shared with the producing states in the same manner as profit petroleum. Thirteenth Finance Commission : The Government of India has constituted the 13th Finance Commission under the Chairmanship of Mr. Vijay Kelkar to recommend on the devolution of Central taxes to the States for the five year period, 2010-2015. The Commission is expected to submit its award to the Central Government by October 2009. Apart from the usual terms of reference to the Commission, the government of India has mandated the Commission to come up
168
with a revised road map on fiscal adjustment after reflecting the Central Government‘s off-budget liabilities on oil, food, and fertilizer bonds in the mainstream fiscal accounting. Check Your Progress :
1. Define public revenue. 2. Explain briefly various kinds of public debt. 3. Differentiate between internal and external public debt. 4. What are the various types of deficits?
11.11. SUMMARY: 1) Public expenditure is end of all financial activities of the
government. 2) Public expenditure is the expenditure incurred by public
authorities to maximise social welfare. 3) Public expenditure is classified into: a) Current or Revenue expenditure. b) Capital expenditure. 4) Causes for continuous rise in public expenditure are a) Acceptance of welfare slate b) Impact of great depression. c) Defence expenditure d) Democratic institutions e) Growing population f) Urbanization
g) Development projects. h) Rising prices i) International responsibility j) Public borrowing
5) Canons are the Fundamental rules governing the spending
policy of the government 6) F. Shirras has suggested four canons of public expenditure : a) Canon of benefit b) Canon of economy c) Canon of sanction d) Canon of surplus
169
7) Other economist have suggested certain canons such as : a) Canon of economic growth b) Canon of productivity c) Canon of elasticity d) Canon of equitable distribution 8) Public debt is an important source of income to the
government in times of financial crisis. 9) Public debt means loans raised by the government internally
or/and externally. 10) The public debt may be classified into following types : a) Internal and external debt b) Productive and unproductive debt c) Compulsory and voluntary debt d) Redeemable and Irredeemable Debt e) Funded and unfunded debt f) Short-term, medium-term and long-term debt 11) Internal debt constitutes redistribution of resources within the
community and therefore aggregate position of the community remains the same.
12) External debt is beneficial in the initial stages as it increases
availability of resources to the country. But its repayment and servicing creates a burden on the debtor country.
13) Deficit financing is used by the government for acquiring
financial resources for economic development. 14) When government cannot raise sufficient revenue through
taxation it resorts to deficit financing. 15) Conceptually government deficit refers to government
expenditure exceeding government revenue in the policy making process and its economic evaluation.
16) Government deficit can be an indicator of the need for and the
extent of fiscal adjustment for balancing either on the expenditure or on the revenue side of the budget.
17) in the Indian context to understand the monetary impact of
government deficit and its interaction with public debt it is useful to review the following concepts of government deficits:
a) Budget deficit b) Revenue deficit c) Fiscal deficit . d) Primary deficit e) Monetized deficit
170
11.12 QUESTIONS 1) Explain the meaning of public expenditure and bring out
important classification of public expenditure. 2) Discuss important causes for the rise in public expenditure.
Explain the canons of public expenditure. 3) Examine various types of public debt. 4) a What do you understand by burden of public debt? b . Analyze the burden of internal and external debt. 5) Distinguish between: a) Internal and External debts. b) Productive and dead weight debts. c) Voluntary and compulsory debts. d) Redeemable and irredeemable debts. e) Burden of internal and external debts. 6) What is deficit financing? 7) Explain various concepts of fiscal deficit. 8) Write notes on the following: a) Budget deficit b) Revenue deficit c) Fiscal deficit d) Primary deficit e) Monetized deficit 9) Explain the Centre-State financial relations in India.
171
REVISED SYLLABUS ECONOMICS ( Paper – II )
MACRO ECONOMICS For S.Y.B.A.
( To be implemented from the academic year 2009 – 2010 for IDE students. )
SECTION – I
Module 1 : Introduction Distinction between Micro Economics and Macro Economics ; Circular Flow of Economic Activities ; Concepts of National Income Aggregates : GNP, NNP, GDP, NDP ; Per Capita Income, Personal Income and Disposable Income ; Methods of Measurement of National Income ( With special reference to India ). Price Indices. ( 12 lectures ) Module 2 : Determination of Employment Say‘s Law , Keynesian Concepts of Aggregate Demand, Aggregate Supply and Effective Demand ; Consumption Function and Investment Multiplier ; Investment Function ; Savings and Investment : ex –ante and ex – post ; Types of Inflation : Demand – pull and Cost – push inflation. (12 lectures ) Module 3 : Money [a] Meaning and Functions of Money [b] Supply of Money ; Constituents of Money Supply ;
Determinants of Reserve Money and Money Supply ; Velocity of Circulation of Money ; Money multiplier ; Measures of Money Supply in India ( including Liquidity Concepts ).
[c] Demand for Money : Classical and Keynesian Approach. [d] Value of Money : Quantity Theory of Money : Cash
Transactions and Cash Balances Versions ; Friedman‘s Quantity Theory of Money.
( 12 lectures )
SECTION – II
Module 4 : Banking and Financial Markets Commercial Banks : Functions, Multiple Credit Creation Process ; Commercial Banking Developments in India since 1969. Central Bank : Functions, Objectives and Instruments of Monetary Policy ( with special reference to India.) Money Market : Features of Indian Money Market ; Instruments of Money Market. Capital Market : Primary Market and Secondary Market ; Role of Capital Market in Economic Development ; Securities and Exchange Board of India ( SEBI ).
172
( 20 lectures ) Module 5 : Public Finance and Fiscal Policy Nature and Scope of Public Finance ; Sources of Public Revenue ; Canons of Taxation ; Direct and Indirect Taxes ; Public Expenditure : Revenue Expenditure and Capital Expenditure ; Public Debt ; Concepts of Deficit ; Federal Finance in India ( with respect to latest available Report ). ( 16 lectures ) References :
1. Stonier A. W. & D. C. Hague ( 2004 ), A Textbook of Economic Theory, Pearson Education , Delhi.
2. Dwiwedi , D. N. ( 2001 ), Macroeconomics : Theory and Policy , Tata McGraw – Hill Publishing company Ltd, New Delhi.
3. McConnel , C. R. & H. C. Gupta (1984 ), Introduction to Macro Economics , Tata McGraw – Hill Publishing Company Ltd, New Delhi.
4. Gupta, S. B. (1994 ), Monetary Economics, S. Chand and Company , Delhi.
5. Bhole, L. M. (1999 ), Financial Institutions and Markets, Tata McGraw Publishing Company , Delhi.
6. Musgrave, R. And P. Musgrave (1983), Public Finance : Theory and Practice, Singapore.
7. Hyman, D. N. (1973), The Economics of Governmental Activity , Halt Rinehart & Winston, New York.
8. Bagchi, A. (ed) (2005), Readings in Public Finance , Oxford University Press, New Delhi.
9. Pathak, B. V. (2003), Indian Financial System, Pearson Education, Delhi.
10. Datt, R. & K. P. M. Sundaram (2001), Indian Economy : Environment and Policy , S. Chand & Company Ltd., New Delhi.
11. Dhingra, I. C. (2001) , The Indian Economy ; Environment and Policy , S. Chand & Company Ltd., New Delhi.
12. Misra, S. K. & V. K. Puri (2001), Indian Economy : Its Development Experience, Himalaya Publishing House, Mumbai.
