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4th Semester ECONOMICS II Notes

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 ECONOMICS II

NATIONAL INCOME
Q. Define National Income. What are the different measures used in calculating national income of
a country.

National income is an uncertain term which is used interchangeably with national dividend, national
output and national expenditure. On this basis, national income has been defined in a number of
ways. In common parlance, national income means the total value of goods and services produced
annually in a country.

In other words, the total amount of income accruing to a country from economic activities in a year’s
time is known as national income. It includes payments made to all resources in the form of wages,
interest, rent and profits.

Definitions of National Income: The definitions of national income can be grouped into two classes:
One, the traditional definitions advanced by Marshall, Pigou and Fisher; and two, modern definitions.

The Marshallian Definition: According to Marshall: “The labour and capital of a country acting on its
natural resources produce annually a certain net aggregate of commodities, material and immaterial
including services of all kinds. This is the true net annual income or revenue of the country or
national dividend.” In this definition, the word ‘net’ refers to deductions from the gross national
income in respect of depreciation and wearing out of machines. And to this, must be added income
from abroad.

The Pigouvian Definition: A.C. Pigou has in his definition of national income included that income
which can be measured in terms of money. In the words of Pigou, “National income is that part of
objective income of the community, including of course income derived from abroad which can be
measured in money.”

This definition is better than the Marshallian definition. It has proved to be more practical also.
While calculating the national income now-a- days, estimates are prepared in accordance with the
two criteria laid down in this definition.

First, avoiding double counting, the goods and services which can be measured in money are
included in national income. Second, income received on account of investment in foreign countries
is included in national income.

Fisher’s Definition: Fisher adopted ‘consumption’ as the criterion of national income whereas
Marshall and Pigou regarded it to be production. According to Fisher, “The National dividend or
income consists solely of services as received by ultimate consumers, whether from their material or
from the human environments. Thus, a piano, or an overcoat made for me this year is not a part of
this year’s income, but an addition to the capital. Only the services rendered to me during this year
by these things are income.”

Fisher’s definition is considered to be better than that of Marshall or Pigou, because Fisher’s
definition provides an adequate concept of economic welfare which is dependent on consumption
and consumption represents our standard of living.

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Modern Definitions: From the modern point of view, Simon Kuznets has defined national income as
“the net output of commodities and services flowing during the year from the country’s productive
system in the hands of the ultimate consumers.”

On the other hand, in one of the reports of United Nations, national income has been defined on the
basis of the systems of estimating national income, as net national product, as addition to the shares
of different factors, and as net national expenditure in a country in a year’s time. In practice, while
estimating national income, any of these three definitions may be adopted, because the same
national income would be derived, if different items were correctly included in the estimate.

Methods of Computing/Measuring National Income:

There are three methods of measuring national income of a country. They yield the same result.
These methods are:

(1) The Product Method.

(2) The Income Method.

(3) The Expenditure Method.

(1) Product Method or Value Added Method: Goods and services are counted in gross domestic
product (GDP) at their market values. The product approach defines a nation's gross product as that
market value of goods and services currently produced within a nation during a one year period of
time.

The product approach measuring national income involves adding up the value of all the final goods
and services produced in the country during the year. Here we focus on various sectors of the
economy and add up all their production during the year. The main sectors whose production value
is added up are:

(i) agriculture (ii) manufacturing (iii) construction (iv) transport and communication (v) banking (vi)
administration and defense and (vii) distribution of income.

Estimation of National Income by the following formula: Y = (P-D) + (S-T) + (X-M) + (R-P1)

Where, Y = National Income, P = Gross Domestic Production, D = Depreciation Allowances

S = Subsidy, T = Indirect Tax, X = Value of Export, M = Value of Import
1
R = Receipt from Abroad, P = Payment to Abroad.

Precautions For Product Method or Value Added Method:

There are certain precautions which are to be taken to avoid miscalculation of national income using
this method. These in brief are:

(i) Problem of double counting: When we add up the value of output of various sectors, we should
be careful to avoid double counting. This pitfall can be avoided by either counting (he final value of
the output or by including the extra value that each firm adds to an item.

(ii) Value addition in particular year: While calculating national income, the values of goods added
in the particular year in question are added up. The values which had previously been added to the
stocks of raw material and goods have to be ignored. GDP thus includes only those goods, and services
that are newly produced within the current period.

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(iii) Stock appreciation: Stock appreciation, if any, must be deducted from value added. This is
necessary as there is no real increase in output.

(iv) Production for self consumption: The production of goods for self consumption should be
counted while measuring national income. In this method, the production of goods for self
consumption should be valued at the prevailing market prices.

(2) Expenditure Method: The expenditure approach measures national income as total spending on
final goods and services produced within nation during an year. The expenditure approach to
measuring national income is to add up all expenditures made for final goods and services at current
market prices by households, firms and government during a year. Total aggregate final expenditure
on final output thus is the sum of four broad categories of expenditures:

(i) consumption (ii) investment (iii) government and (iv) Net export.

(i) Consumption expenditure (C): Consumption expenditure is the largest component of national
income. It includes expenditure on all goods and services produced and sold to the final consumer
during the year.

(ii) Investment expenditure (I): Investment is the use of today's resources to expand tomorrow's
production or consumption. Investment expenditure is expenditure incurred on by business firms
on (a) new plants, (b) adding to the stock of inventories and (c) on newly constructed houses.

(iii) Government expenditure (G): It is the second largest component of national income. It includes all
government expenditure on currently produced goods and services but excludes transfer
payments while computing national income.

(iv) Net exports (X - M): Net exports are defined as total exports minus total imports.

National income calculated from the expenditure side is the sum of final consumption expenditure,
expenditure by business on plants, government spending and net exports.

R = Receipt from Abroad, P = Payment to Abroad.

National Income = C + I +G + (X - M) + (R-P)

Precautions For Expenditure Method:

(i) The expenditure on second hand goods should not be included as they do not contribute to
the current year's production of goods.

(ii) Similarly, expenditure on purchase of old shares and bonds is not included as these also do not
represent expenditure on currently produced goods and services.

(iii) Expenditure on transfer payments by government such as unemployment benefit, old age
pensions, interest on public debt should also not be included because no productive service is rendered
in exchange by recipients of these payments.

(3) Income Approach: Income approach is another alternative way of computing national income,
This method seeks to measure national income at the phase of distribution. In the production
process of an economy, the factors of production are engaged by the enterprises. They are paid
money incomes for their participation in the production. The payments received by the factors and
paid by the enterprises are wages, rent, interest and profit. National income thus may be defined as

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the sum of wages, rent, interest and profit received or occurred to the factors of production in lieu
of their services in the production of goods. Briefly, national income is the sum of all income, wages,
rents, interest and profit paid to the four factors of production. The four categories of payments are
briefly described below:

(i) Wages: It is the largest component of national income. It consists of wages and salaries along with
fringe benefits and unemployment insurance.

(ii) Rents: Rents are the income from properly received by households.

(iii)Interest: Interest is the income private businesses pay to households who have lent the business
money.

(iv)Profits: Profits are normally divided into two categories (a) profits of incorporated businesses and
(b) profits of unincorporated businesses (sole proprietorship, partnerships and producers
cooperatives).

Precautions For Income Approach:

(i) Transfer payments such as gifts, donations, scholarships, indirect taxes should not be included in
the estimation of national income.

(ii) Illegal money earned through smuggling and gambling should not be included.

{iii) Windfall gains such as prizes won, lotteries etc. is not be included in the estimation of national
income.

(iv) Receipts from the sale of financial assets such as shares, bonds should not be included in
measuring national income as they are not related to generation of income in the current year
production of goods.

Q. Explain the relation between National Income and Economic Welfare.

Meaning Pigou defines as “The range of our enquiry becomes restricted to that part of social
(general) welfare that can be brought directly or indirectly into relation with the measuring rod of
money.” Welfare is a state of the mind which reflects human happiness and satisfaction.

On the contrary, non-economic welfare is that part of social welfare which cannot be
measured in money, for instance moral welfare. But it is not proper to differentiate between
economic and non-economic welfare on the basis of money. Pigou also accepts it. According to him,
non-economic welfare can be improved upon in two ways.

(1) By the income earning method. Longer hours of working and unfavorable conditions will affect
economic welfare adversely.

(2) By the income spending method. It is assumed in economic welfare that expenditures incurred
on different consumption goods provide the same amount of satisfaction.

Relation between Economic Welfare and National Income

The effect of national income can be studied in two ways.

1. Change in the size of National Income

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 2. Changes in Distribution of National Income

Changes in the Size of National Income

The change in the size of national income may be given positive or negative. The positive change
in the national income increases its volume. Consequently, people consume more of goods and
services. Which lead to increase in the economic welfare, whilst the negative change in national
income results in reduction of its volume.

1. Resource Concentration: if the increase in national; income is primarily due to the

concentration of some important economic resources in that country then welfare may not
increase for example in the Arab countries the national income is quiet high and also has been
steadily increasing due to large resources of oil and petroleum although a vast majority of
their population still lives in extremely poor conditions.

2. Distribution of national income: If the national income increases or there is loss inequitable
distribution of such national income and wealth, then also welfare of people may not increase.
Example: Although the national income of India is moderately high but only 10% of the people
have got hold upon approximately 90% of India’s national income where as 90% of the people
have got a share of only 10% of national income, resulting in widespread poverty in many
parts of the country.

3. Changes in Prices If the change in national income is due to change in prices, it will be
difficult to measure the real changes in economic welfare. For instance, when the national
income increases as a result of increase in prices, the increase in economic welfare is not
possible for the reason that it is possible that the productivity of goods and services may not
have increased. It is more likely that the economic welfare would decline as a result of increase
in prices. It is only the real income in national income that increases economic welfare.

4. Working Conditions It depends on the manner in which the increase in national income
comes about. The economic welfare cannot be said to have increased, if the increase in
national income is due to explanation of labour, for instance, hike in production by labourers
for longer hours by paying them lesser wages than the minimum. Influencing to put their
women and kids to work by not providing them with facilities of transport to and from the
factories and residence, and that their residence in slums.

5. Per Capita Income National income cannot be a reliable index of economic welfare, if per
capita income is not kept in mind. It is possible that with the hike in national income, the
population may increase at the same pace and thus the per capita income may not increase
at all. In such a condition, the hike in national income will not result in hike in fiscal welfare
and vice versa.

6. Method of Spending The influence of hike in national income on fiscal welfare depends also
on the method of spending adopted by the people. If with the increase in income people
spend on such necessities and facilities as milk, butter, eggs etc. which hikes efficacy, the
economic welfare will increase. But otherwise, the outlay in consuming alcohol, speculating
etc. will decrease the economic welfare. Hence the increase and decrease of fiscal welfare
depends on changes in the tastes of people.

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Conclusion
It is unambiguous from the above study that although the national income and economic welfare
are closely inter-related, yet it cannot be said with certainty that the economic welfare would
increase with the increase in national income and per capita income. The increase or decrease in
economic welfare as a consequence of increase in national income depends on a number of factors
such as the rate of growth of population, the methods of earning income, the conditions of working,
the method of spending, the fashions and tastes etc.

Changes in Distribution of National Income: The changes in the distribution of national income take
place in two ways:

1. By Transfer of Wealth from the Poor to the Rich: When as a result of increase in national
income, the transfer of wealth takes place in the former manner, the economic welfare decreases.
This happens when the government gives more privileges to the richer sections and imposes
regressive taxes on the poor.

2. Transfer of Wealth from the Rich to the Poor: The redistribution of wealth in favor of the
poor is brought about by reducing the wealth of the rich and increasing the income of the poor. The
income of the richer sections can be reduced by adopting a number of measures, e.g., by progressive
taxation on income, property etc., by imposing checks on monopoly, by nationalizing social services,
by levying duties on costly and foreign goods which are used by the rich and so on.

On the other hand, the income of the poor can also be raised in a number of ways, e.g., by fixing a
minimum wage rate, by increasing the production of goods used by the poor, by fixing the prices of
such goods, by granting financial assistance to the producers of these goods, by the distribution of
goods through co-operative stores, and by providing free education, social security and low rent
accommodation to the poor. When the distribution of income takes place in favor of the poor
through these methods, the economic welfare increases.

But it is not essential that the equal distribution of national income would lead to increase in
economic welfare. On the contrary, there is a greater possibility of economic welfare decreasing if
the policy towards the rich is not rational. Heavy taxation and progressive taxes at high rates affect
adversely the productive capacity, investment and capital formation, thereby decreasing the
national income.

Similarly, when through the efforts of the government, the income of the poor increases but if they
spend that income on bad goods like drinking, gambling etc. or if their population increases, the
economic welfare will decrease.

Both these situations are not real and only express the fears, because the government, while
imposing different kinds of progressive taxes on the rich, keeps particularly in view that taxation
should not affect the production and investment adversely. On the other hand, when the income of
a poor man increases, he tries to provide better education to his children and to improve his
standard of living, his welfare increases.

Conclusion: We arrive at the conclusion that as a result of the increase in national income, the
economic welfare will increase provided that the income of the poor increases instead of decreasing
and they improve their standard of living and that the income of the rich decreases in such a way
that their productive capacity, investment and capital accumulation do not decline.

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KEYNESIAN INCOME DETERMINATION
Q. Determine the equilibrium level of National Income in simple Keynesian model with the help of
saving and investment equality.

J.M. Keynes in his famous book, 'General theory', has used two methods for the determination of
national income at a particular time:

(1) Saving Investment Method.

(2) Aggregate Demand and Aggregate Supply Method.

Both these approaches lead us to the determination of the same level of national income.

It may here be mentioned that Keynes model of income determination is relevant in the context of
short run only.

Assumptions: Keynes assumes that in the short run:

(i) The stock of capital, technique of production, forms of business organizations, do not change.

(ii) He also assumes a fair degree of competition in the market.

(iii) There is also absence of government role either as a taxer or as a spender.

(iv) Keynes further assumes that the economy under analysis is a closed one. There is no influence
of exports and imports on the economy.

Determination of National Income By the Equality of Saving and Investment Method: This
approach is based on the Keynesian definitions of saving and investment. According to Keynes, the
level of national income, in the short run, is determined at a point where planned or intended saving
is equal to planned or intended investment. Saving as defined by Keynes is that part of income which
is not spent on consumption (S = Y - C). On the other hand, investment is the expenditure on goods
and services not meant for consumption. (I = Y - C).

According to Keynes, if at any time, the intended saving is less than intended investment, it implies
that people are spending more on consumption. The rise in consumption will reduce the stock of
goods in the market. This will give incentive to entrepreneurs to increase output. Likewise, if at any
time intended saving is greater than intended investment, this would mean that people are spending
lesser volume of money on consumption. As a result of this, the inventories of goods will pile up.
This will induce entrepreneurs to reduce output. The result of this will be that national income would
decrease. The national income will be in equilibrium only when intended saving is equal to intended
investment.

Example and Diagram/Curve:

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The determination of national income is
now explained with the help of saving
and investment curve below:

In figure (31.2), income is measured on

OX axis and saving and investment on OY
axis. SS is the saving curve which shows
intended saying at different levels of
income. The investment curve ll/ is
drawn parallel to the X axis which shows
that investment does not change.

The entrepreneurs intend to invest Rs. 50

crore only irrespective of the amount of
income. Saving (SS) and investment
curves (ll/) intersect each other at point
M. If the conditions stated above remain
the same, the size of equilibrium level of
income is 250 crore.

Disequilibrium: Under the assumed conditions if there is inequality between saving and investment
or disequilibrium, the forces will operate in the economy and restore the equilibrium position.

Let us suppose, that the income has increased from the equilibrium level OL to ON (Rs. 300 crore). At
this level of income, desired saving is greater than the desired investment. When intended saving
exceeds planned or intended investment, the businessmen will not be able to dispose off all their
current output. They will slow down their productive activities. This will result in reducing the
number of workers employed in factories and a decrease in the income. This process will go on until
due to a decrease in income, people's saving is reduced to the level of investment (Rs. 50 crore). The
equilibrium income is Rs. 250 crore.

In the same way, income cannot remain below this equilibrium level of Rs. 250 crore. If at any time,
income falls below the equilibrium level, then it means that people are investing more than they are
willing to save I > S. They will increase productive activities as they are making high profits. The
number of workers employed in the factories will increase. This will result in an increase in income
and higher saving. This rise in national income will go on up to a point where saving and investment
are just in balance and that will be the equilibrium level. At this point, income will have the tendency
of neither to rise nor to fall. It will be in a state of rest. It is, thus, clear that national income is
determined at a point where the intended investment is equal to intended saving.

Q. Explain the concepts of Average Propensity to Consume(APC) and Marginal Propensity to

Consume(MPC). Difference between Average Propensity to Consume(APC) and Marginal
Propensity to Consume(MPC).

Technical attributes of consumption function are:

1. Average Propensity to Consume (APC) 2.Marginal Propensity to Consume (MPC)

1. Average Propensity to Consume (APC): The average propensity to consume (APC) is defined as the
ratio of aggregate or total consumption to aggregate income in a given period of time.

Thus, the value of average propensity to consume, for any income level, may be found by dividing
consumption by income. Symbolically,

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APC = C/Y

Where, С stands for consumption and Y stands for income.

In Table 2, the APC is calculated at various income levels. It is obvious that the proportion of income
spent on consumption decreases as income increases. Since the average propensity to consume is
100%, 95%, 92% and 88%. It follows that the average propensity to save (S/Y) is respectively, 0.5%,
8%, 10% and 12%,

APS = S/Y = 1 – C/Y

Table 2 Schedule of Propensity to Consume:

Income(Y) Consumption(C) Average Propensity Marginal Propensity to
to Consume APC = Consume MPC = ∆C/∆Y
C/у
300 300 300/300 = 1 or 100%

400 380 380/400 = 0.95 or 95% 80/100 =0.8 or 80%

500 460 460/ 500 = 0.92 or 92% 80/ 100 = 0.8 or 80%

600 540 540/ 600 = 0.90 or 90% 80/ 100 = 0.8 or 80%

700 620 620/ 700 = 0.88 or 88% 80/ 100 = 0.8 or 80%

Thus, the proportion of income saved increases as income increases.

The economic significance of the APC is that it tells us what proportion of the total cost of a given
output from planned employment may be expected to be recovered by selling consumer goods
alone. It tells us what proportion of the total amount of goods and services demanded by the
community originates in the demand for consumers goods.

The average propensity to save tells what proportion of the total cost of a given output will have to
be recovered by the sale of capital goods. Other things remaining equal, the relative development of
consumer goods and capital goods industries in an economy depends on the APC and the APS. This
suggests that in highly industrialized economies, the APC is persistently low and the APS is
persistently high.

2. Marginal Propensity to Consume: The marginal propensity to consume (MPC) is the ratio of the
change in the level of aggregate consumption to a change in the level of aggregate income. The MPC,
thus, refers to the effect of additional income on consumption.

MPC can be found by dividing a change (increase or decrease) in consumption by a change (increase
or decrease) in income. Symbolically,

MPC = ∆C/∆Y

Where, ∆ (delta) indicates the change (increase or decrease), and С denote consumption and Y
denote income.

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In Table 2 above, the MPC is calculated at various income levels. It is obvious that the MPC is 0.8 or
80% at all levels. Thus, the MPC is constant here because the linear consumption function is
nonlinear, MPC will not be constant.

Again, the marginal propensity to consume {MPC) is always positive but less than one. This
behavioral characteristic of the MPC is attributed by Keynes to the fundamental psychological law of
consumption that consumption increases less proportionately than income when income increases.

People’s main motivation for not spending the entire increase in income is to save and to create a
hedge against special risks and unforeseen contingencies. Thus, DC < DY always. This means that

MPC = ∆C/∆Y < 1.

Keynes’ hypothesis that the marginal propensity to consume is positive but less than unity 0 < ∆C/∆Y
< 1 has great analytical and practical significance. It tells us not only that consumption is an
increasing function of income but also that it usually increases by less than 100% of any increase in
income. K.K. Kurihara observes that this hypothesis will be found helpful in explaining: (1) the
theoretical possibility of “underemployment equilibrium,” and (2) the relative ability of a highly
developed industrial economy. For the hypothesis implies that the gap between income and
consumption at all high levels of income is too wide to be easily filled by investment, with a possible
consequence that the economy may fluctuate around unemployment equilibrium.

From the marginal propensity to consume (MPC), we can derive the marginal propensity to save
(MPS) by the following formula:

MPS = 1 – MPC or (1 – ∆C/∆Y)

Thus, if the marginal propensity to consume is 0. 8, the marginal propensity to save, according to this
formula, must be 0.2, as MPC + MPS = 1. Again, as MPC is always less than unity, MPS tends to be
always positive.

According to Keynes, the propensity to consume is a fairly stable function of income with the
marginal propensity to consume being positive but less than unity. Keynes, however, did not state
what would be the exact nature of the MPC within the limits laid down.

The MPC may rise, fall or remain constant between the limits set. However, Keynes implicitly stated
that the MPC will not be constant when cyclical fluctuations cause change in objectives factors
determining the propensity to consume. Thus, it may be inferred that during the cyclical upswing,
the MPC will fall while during the downswing, it will rise. Keynes, however, opines that the long-run
MPC has tended to decline as nations have become richer.

The economic significance of the concept of marginal propensity to consume (MPC) is that it throws
light on the possible division of any extra income consumption and investment, thus, facilitating the
planning of investment to maintain the desired level of income. It has further significance in the
multiplier theory.

It has been observed that the MPC is higher in the case of poor than in that of rich people. Therefore,
in underdeveloped countries, the MPC tends to be high, whereas in advanced countries it tends to be
low. Consequently, the MPC is high in rich sections and is low in poor sections of the community.
The same is true of rich nations and poor nations.

Graphical Measurement of APC and MPC:

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Diagrammatically, the
average propensity to consume is
measured at a single point on the С
curve. In Fig. 4, it is determined at
Point A (where C/Y gives APC).

The marginal propensity to consume,

on the other hand, is measured by the
slope or gradient of the С curve, i. e.,
the consumption function schedule or
curve. To ascertain the slope of the С
curve, we draw a horizontal line
through A, the previous consumption Income point, and then measure vertically to the tangent P,
the changed consumption-income point. We shall find that the ratio of the vertical length PM to the
horizontal length AM is 0.8.

Empirical relationship between APC and MPC:

i. When the MPC is constant, the consumption function is linear, i.e., a straight line curve. The
APC will also be constant only if the consumption function passes, through the origin. When it
does not pass through the origin, the APC will not be constant.

ii. As income rises, the MPC also falls, but it falls to greater extent than the APC.

iii. As income falls, the MPC rises. The APC will also rise but at a slower rate.

Comparison between APC and MPC:

Basis APC MPC

Meaning It is the ratio of consumption It is the ratio of change in consumption

expenditure (C) to the expenditure (∆C) to change in income (∆Y)
corresponding level of income over a period of time.
(Y) at a point of time.

Value more than APC can be more than one as MPC cannot be more than one as change
one long as consumption is more than in consumption cannot be more than
national income, i.e. till the change in income.
break-even point.

Response to When income increases, APC falls When income increases, MPC also falls but
change in but at a rate less than that at a rate more than that of APC.

income of MPC.

Formula APC = C/Y MPC= ∆C/∆Y

Q. Define Consumption Function. What are the factors that govern propensity to consume?

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One of the important tools of the Keynesian economics is ,the consumption function. This chapter
deals with the consumption function, its technical attributes, its importance and its subjective and
objective determinants along with Keynes's Psychological Law of consumption.

MEANING OF CONSUMPTION FUNCTION: The consumption function or propensity to consume

refers to . income consumption relationship. It is a "functional relationship between two aggregates,
i.e., total consumption and gross national income.” Symbolically, the relationship is represented as C
= f- (Y), 'where C is consumption, Y is income, and f is the functional relationship. Thus the
consumption function indicates a functional relationship between C and Y, where C is dependent
and Y is the independent variable, i.e., C is determined by Y.' This relationship is based on the ceteris
paribus (other things being equal) assumption, as such only income consumption relationship is
considered and all possible influences on consumption are held constant.

In fact, propensity to consume or consumption function is a schedule of the various amounts of

consumption expenditure corresponding to different levels of income. A hypothetical consumption
schedule is given in Table I.

Table I shows that consumption is an increasing function income because consumption, expenditure
increases with increase in income. Here it is shown that when income is zero during the depression,
people spend out of their past savings on consumption because they must eat in order to live. When
income is generated in the economy to the extent of Rs. 60 crores, it is not sufficient to meet the
consumption expenditure of the community so that the consumption expenditure of Rs. 70 crores is
still above the income amounting to Rs 60 crores. (Rs. 10 crores are dis-saved). When both
consumption expenditure and income equal Rs 120 crores, it is the basic consumption level.

TABLE I : CONSUMPTION SCHEDULE (Rs. Crores)

Income (Y) Consumption C = f (Y)
0 20
60 70
120 120
180 170
240 220
300 270
360 320

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After this, income is shown to increase by 60 crores and consumption by 50 crores. This implies a
stable consumption function during the short-run as assumed by Keynes. The above Figure illustrates
the consumption function diagrammatically. In the diagram, income is measured horizontally and
consumption is measured vertically. 45° is the unity-line where at all levels income and consumption
are equal. The C curve is a linear consumption function based on the assumption that consumption
changes by the same amount (Rs 50 crores). Its upward slope to the right indicates that consumption
is an increasing function of income. B is the break-even point where C= Y or OY1 = OC1. When
income rises to 0 YI consumption also increases to OC2, but the increase in consumption' is less than
the increase in income, C1 C2 < Y1 Y2. The portion of income not consumed is saved as shown by the
vertical, distance between 45° line and C curve, i.e., SS’. "Thus the consumption function measures
not only the amount spent on consumption but also the amount saved. This is becauset't1e
propensity to save is merely the propensity not to consume. The 45° line may therefore be regarded
. as a zero-saving line, and the shape and position of the C curve indicate the division of income
between consumption and saving”.

The factors that govern propensity to consume:

# 1. Income: Income is by far the most important factor that determines a community’s propensity to
consume.

As its income rises or falls, consumption spending also rises and falls. The figures given afore show
changes in consumption caused by an increase in income (with no change in the propensity to
consume) and changes in consumption caused by a change in the propensity to consume (with no
change in income).

# 2. Distribution of Income: Another factor determining how much will be spent for consumption
out of a given income of the community is the way in which income is distributed. There is great
inequality in the distribution of income in the modern capitalist societies with the result that the rich
find it easy to save. This widespread inequality of income lowers the overall propensity to consume
as the rich have already fulfilled most of their basic wants. A more equal distribution of wealth will
raise the propensity to consume.

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# 3. Financial Policies of Corporations: The policies of joint stock companies and corporations with
respect to dividend payments and investment also affect consumption in various ways. If
corporations and companies keep, more reserves and distribute less of their profits as dividends, it
will lower the disposable income with consumers. On the other hand, if more income is distributed
in the form of dividends, more will be spent on consumption.

# 4. Changes in Expectations: Expectations of the people regarding future events also affect their
propensity to consume. Individuals may rush to purchase goods much in excess of current needs if
they expect a war or fear a shortage on account of any other reason. Thus, the amount of
consumption as a ratio of current income will rise and consumption function will shift upwards
(without any rise in income).

# 5. Windfall Gains or Losses: Sudden and unexpected gains and losses in income affect
consumption accordingly. It is believed that the well-to-do increase their consumption well above
the normal level as a result of windfall gains. In the late twenties, there were huge windfall gains on
account of the boom conditions in the American economy and the consumption function shifted
upwards. Keynes gave specific recognition to the possibility that consumption spending might be
influenced not only by income but by capital gains also.

# 6. Fiscal Policy: The fiscal policy of the Government relating to taxation, expenditure and public
debt, and the changes therein have significant effects on the consumption function. The
Government’s fiscal policy resulting in highly progressive tax system bring about more equitable
distribution of income, thereby shifting the consumption function upwards, as more equal
distribution of wealth increases the propensity to consume. On the other hand, a regressive tax
structure (involving heavy indirect taxes) will reduce total consumption in the economy.

# 7. Demographic Factors: Even at a given level of income the expenditure of consumers may vary
widely from one family to another. These variations in expenditure are due to demographic factors,
which include factors like; the size of the family, stage in the family ‘life cycle’, place of residence,
occupation etc. Large families spend more than small families—families with children of college
going age have a different pattern of expenditure than rural families. Demographic changes like age,
sex composition of families occur over a long period and may, therefore, be ignored in short run
analysis.

# 8. Terms of Credit on Consumer Durables: Terms of credit specially relating to consumer durables
like electric gadgets—machines, radios, television-sets, cars, scooters etc.—constitute an important
influence on consumption expenditure. Recently, not to speak of advanced economies, even in
developing economies like India, there has been considerable increase in the volume of purchases of
consumer durables financed by consumer credit; as such its cost and availability have assumed great
importance. Besides, the rate of interest, the size of down payments, length of the periods during
which balances must be paid are important considerations affecting consumer expenditures.

# 9. Wages and Propensity to Consume: Classical economists laid stress on the stimulating effects of
wage-cuts on the propensity to consume. Their argument was that a general reduction in wages will
result in a general reduction in prices (because marginal costs fill on account of the pressure of lower
wage rates). The lower prices will increase consumption. But such an approach represented a vague
attempt to apply certain principles relating to price and demand for particular products to the
problem of total consumption.

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MONEY AND IT’S SUPPLY AND PRICE LEVEL
Q. What are the functions of money?

In Money and the Mechanism of Exchange (1875), William Stanley Jevons famously analyzed money
in terms of four functions: a medium of exchange, a common measure of value (or unit of account),
a standard of value (or standard of deferred payment), and a store of value. Most modern
textbooks now list only three functions, that of medium of exchange, unit of account, and store of
value, not considering a standard of deferred payment as it is a distinguished function, but rather
subsuming it in the others.

Medium of exchange: When money is used to intermediate the exchange of goods and services, it is
performing a function as a medium of exchange. It thereby avoids the inefficiencies of a barter
system, such as the "coincidence of wants" problem. Money's most important usage is as a method
for comparing the values of dissimilar objects.

Measure of value: A unit of account (in economics) is a standard numerical monetary unit of
measurement of the market value of goods, services, and other transactions. Also known as a
"measure" or "standard" of relative worth and deferred payment, a unit of account is a necessary
prerequisite for the formulation of commercial agreements that involve debt.

Money acts as a standard measure and common denomination of trade. It is thus a basis for quoting
and bargaining of prices. It is necessary for developing efficient accounting systems.

Standard of deferred payment: While standard of deferred payment is distinguished by some texts,
particularly older ones, other texts subsume this under other functions. A "standard of deferred
payment" is an accepted way to settle a debt – a unit in which debts are denominated, and the
status of money as legal tender, in those jurisdictions which have this concept, states that it may
function for the discharge of debts. When debts are denominated in money, the real value of debts
may change due to inflation and deflation, and for sovereign and international debts via debasement
and devaluation.

Store of value: To act as a store of value, a money must be able to be reliably saved, stored, and
retrieved – and be predictably usable as a medium of exchange when it is retrieved. The value of the
money must also remain stable over time. Some have argued that inflation, by reducing the value of
money, diminishes the ability of the money to function as a store of value.

Q. Define inflation. What are the causes of inflation? Discuss the effects of inflation on output,
employment and the distribution of income.

Inflation is often defined in terms of its supposed causes. Inflation exists when money supply
exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit
budget may be financed by the additional money creation. But the situation of monetary expansion
or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’.

Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price
of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the
general level or average of prices’. In other words, inflation is a state of rising prices, but not high
prices.

It is not high prices but rising price level that constitute inflation. It constitutes, thus, an overall
increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other

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words, inflation reduces the purchasing power of money. A unit of money now buys less. Inflation
can also be seen as a recurring phenomenon.

While measuring inflation, we take into account a large number of goods and services used by the
people of a country and then calculate average increase in the prices of those goods and services
over a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may
reflect the short term workings of the market.

It is to be pointed out here that inflation is a state of disequilibrium when there occurs a sustained
rise in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may
be both slow and rapid. However, it is difficult to detect whether there is an upward trend in prices
and whether this trend is sustained. That is why inflation is difficult to define in an unambiguous
sense.

Causes of Inflation: Inflation is mainly caused by excess demand/ or decline in aggregate supply or
output. Former leads to a rightward shift of the aggregate demand curve while the latter causes
aggregate supply curve to shift leftward. Former is called demand-pull inflation (DPI), and the latter
is called cost-push inflation (CPI). Before describing the factors, that lead to a rise in aggregate
demand and a decline in aggregate supply, we like to explain “demand-pull” and “cost-push”
theories of inflation.

(i) Demand-Pull Inflation Theory: There are two theoretical approaches to the DPI—one is classical
and other is the Keynesian.

According to classical economists or monetarists, inflation is caused by an increase in money supply

which leads to a rightward shift in negative sloping aggregate demand curve. Given a situation of full
employment, classicists maintained that a change in money supply brings about an equiproportionate
change in price level.

That is why monetarists argue that inflation is always and everywhere a monetary phenomenon.
Keynesians do not find any link between money supply and price level causing an upward shift in
aggregate demand.

According to Keynesians, aggregate demand may rise due to a rise in consumer demand or
investment demand or government expenditure or net exports or the combination of these four
components of aggregate demand. Given full employment, such increase in aggregate demand leads
to an upward pressure in prices. Such a situation is called DPI. This can be explained graphically.

Just like the price of a commodity, the level of prices is determined by the interaction of aggregate
demand and aggregate supply. In Fig. 4.3, aggregate demand curve is negative sloping while aggregate
supply curve before the full employment
stage is positive sloping and becomes
vertical after the full employment stage is
reached. AD1 is the initial aggregate
demand curve that
Page
intersects the aggregate supply curve AS at
point E1.

The price level, thus, determined is OP1. As

aggregate demand curve shifts to AD2, price
level rises to OP2. Thus, an increase in
of
17 82 Compiled by Rahul Kumar Singh
aggregate demand at the full employment stage leads to an increase in price level only, rather than
the level of output. However, how much price level will rise following an increase in aggregate
demand depends on the slope of the AS curve.

(ii) Causes of Demand-Pull Inflation: DPI originates in the monetary sector. Monetarists’ argument
that “only money matters” is based on the assumption that at or near full employment excessive
money supply will increase aggregate demand and will, thus, cause inflation.

An increase in nominal money supply shifts aggregate demand curve rightward. This enables people
to hold excess cash balances. Spending of excess cash balances by them causes price level to rise.
Price level will continue to rise until aggregate demand equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate
demand may rise if there is an increase in consumption expenditure following a tax cut. There may
be an autonomous increase in business investment or government expenditure. Government
expenditure is inflationary if the needed money is procured by the government by printing additional
money.

In brief, increase in aggregate demand i.e., increase in (C + I + G + X – M) causes price level to rise.
However, aggregate demand may rise following an increase in money supply generated by the
printing of additional money (classical argument) which drives prices upward. Thus, money plays a
vital role. That is why Milton Friedman argues that inflation is always and everywhere a monetary
phenomenon.

There are other reasons that may push aggregate demand and, hence, price level upwards. For
instance, growth of population stimulates aggregate demand. Higher export earnings increase the
purchasing power of the exporting countries. Additional purchasing power means additional
aggregate demand. Purchasing power and, hence, aggregate demand may also go up if government
repays public debt.

Again, there is a tendency on the part of the holders of black money to spend more on conspicuous
consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.

(iii) Cost-Push Inflation Theory: In addition to aggregate demand, aggregate supply also generates
inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI.
CPI is usually associated with non-monetary factors. CPI arises due to the increase in cost of
production. Cost of production may rise due to a rise in cost of raw materials or increase in wages.

However, wage increase may lead to an increase in productivity of workers. If this happens, then the
AS curve will shift to the right- ward not leftward—direction. We assume here that productivity does
not change in spite of an increase in wages.

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Such increases in costs are passed on to
consumers by firms by raising the prices of
the products. Rising wages lead to rising costs.
Rising costs lead to rising prices. And, rising
prices again prompt trade unions to demand
higher wages. Thus, an inflationary wage price
spiral starts. This causes aggregate supply
curve to shift leftward.

This can be demonstrated graphically where

AS1 is the initial aggregate supply curve. Below
the full employment stage this AS curve is
positive sloping and at full employment stage
it becomes perfectly inelastic.

Intersection point (E1) of AD1 and AS1 curves

determine the price level (OP1). Now there is
a leftward shift of aggregate supply curve to
AS2. With no change in aggregate demand, this causes price level to rise to OP2 and output to fall to
OY2. With the reduction in output, employment in the economy declines or unemployment rises.
Further shift in AS curve to AS3 results in a higher price level (OP3) and a lower volume of aggregate
output (OY3). Thus, CPI may arise even below the full employment (YF) stage.

Causes of Cost-Push Inflation:

It is the cost factors that pull the prices upward. One of the important causes of price rise is the rise
in price of raw materials. For instance, by an administrative order the government may hike the price
of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an
upward pressure on cost of production.

Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by
OPEC compels the government to increase the price of petrol and diesel. These two important raw
materials are needed by every sector, especially the transport sector. As a result, transport costs go
up resulting in higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand
higher money wages as a compensation against inflationary price rise. If increase in money wages
exceed labour productivity, aggregate supply will shift upward and leftward. Firms often exercise
power by pushing prices up independently of consumer demand to expand their profit margins.

Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of
production. For instance, an overall increase in excise tax of mass consumption goods is definitely
inflationary. That is why government is then accused of causing inflation.

Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion
of natural resources, work stoppages, electric power cuts, etc., may cause aggregate output to
decline. In the midst of this output reduction, artificial scarcity of any goods created by traders and
hoarders just simply ignite the situation.

The effects of inflation on different groups of society are discussed below:

(1) Debtors and Creditors: During periods of rising prices, debtors gain and creditors lose. When
prices rise, the value of money falls. Though debtors return the same amount of money, but they pay

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less in terms of goods and services. This is because the value of money is less than when they borrowed
the money.

Thus the burden of the debt is reduced and debtors gain. On the other hand, creditors lose. Although
they get back the same amount of money which they lent, they receive less in real terms because
the value of money falls. Thus inflation brings about a redistribution of real wealth in favor of
debtors at the cost of creditors.

(2) Salaried Persons: Salaried workers such as clerks, teachers, and other white collar persons
lose when there is inflation. The reason is that their salaries are slow to adjust when prices are rising.

(3) Wage Earners: Wage earners may gain or lose depending upon the speed with which their
wages adjust to rising prices. If their unions are strong, they may get their wages linked to the cost of
living index. In this way, they may be able to protect themselves from the bad effects of inflation. But
the problem is that there is often a time lag between the raising of wages by employees and the rise
in prices.

So workers lose because by the time wages are raised, the cost of living index may have increased
further. But where the unions have entered into contractual wages for a fixed period, the workers
lose when prices continue to rise during the period of contract. On the whole, the wage earners are
in the same position as the white collar persons.

(4) Fixed Income Group: The recipients of transfer payments such as pensions, unemployment
insurance, social security, etc. and recipients of interest and rent live on fixed incomes. Pensioners get
fixed pensions. Similarly the rentier class consisting of interest and rent receivers get fixed payments.
The same is the case with the holders of fixed interest bearing securities, debentures and deposits.

All such persons lose because they receive fixed payments, while the value of money continues to
fall with rising prices. Among these groups, the recipients of transfer payments belong to the lower
income group and the rentier class to the upper income group. Inflation redistributes income from
these two groups towards the middle income group comprising traders and businessmen.

(5) Equity Holders or Investors: Persons who hold shares or stocks of companies gain during
inflation. For when prices are rising, business activities expand which increase profits of companies.
As profits increase, dividends on equities also increase at a faster rate than prices. But those who
invest in debentures, securities, bonds, etc. which carry a fixed interest rate lose during inflation
because they receive a fixed sum while the purchasing power is falling.

(6) Businessmen: Businessmen of all types, such as producers, traders and real estate holders
gain during periods of rising prices. Take producers first. When prices are rising, the value of their
inventories rise in the same proportion. So they profit more when they sell their stored commodities.
The same is the case with traders in the short ran. But producers profit more in another way.

Their costs do not rise to the extent of the rise in the prices of their goods. This is because prices of
raw materials and other inputs and wages do not rise immediately to the level of the price rise. The
holders of real estate’s also profit during inflation because the prices of landed property increase much
faster than the general price level.

(7) Agriculturists: Agriculturists are of three types: landlords, peasant proprietors, and landless
agricultural workers. Landlords lose during rising prices because they get fixed rents. But peasant

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proprietors who own and cultivate their farms gain. Prices of farm products increase more than the
cost of production.

For prices of inputs and land revenue do not rise to the same extent as the rise in the prices of farm
products. On the other hand, the landless agricultural workers are hit hard by rising prices. Their
wages are not raised by the farm owners because trade unionism is absent among them. But the
prices of consumer goods rise rapidly. So landless agricultural workers are losers.

(8) Government: The government as a debtor gains at the expense of households who are its
principal creditors. This is because interest rates on government bonds are fixed and are not raised to
offset expected rise in prices. The government, in turn, levies less taxes to service and retire its debt.
With inflation, even the real value of taxes in reduced. Thus redistribution of wealth in favor of the
government accrues as a benefit to the tax-payers.

Since the tax-payers of the government are high- income groups, they are also the creditors of the
government because it is they who hold government bonds. As creditors, the real value of their
assets declines and as tax-payers, the real value of their liabilities also declines during inflation. The
extent to which they will be gainers or losers on the whole is a very complicated calculation.

Effects on Production: When prices start rising, production is encouraged. Producers earn wind-fall
profits in the future. They invest more in anticipation of higher profits in the future. This tends to
increase employment, production and income. But this is only possible up to the full employment
level.

Further increase in investment beyond this level will lead to severe inflationary pressures within the
economy because prices rise more than production as the resources are fully employed. So inflation
adversely affects production after the level of full employment.

The adverse effects of inflation on production are discussed below:

(1) Misallocation of Resources: Inflation causes misallocation of resources when producers divert
resources from the production of essential to non-essential goods from which they expect higher
profits.

(2) Changes in the System of Transactions: Inflation leads to changes in transactions pattern of
producers. They hold a smaller stock of real money holdings against unexpected contingencies than
before. They devote more time and attention to converting money into inventories or other financial
or real assets. It means that time and energy are diverted from the production of goods and services
and some resources are used wastefully.

(3) Reduction in Production: Inflation adversely affects the volume of production because the
expectation of rising prices along with rising costs of inputs brings uncertainty. This reduces
production.

(4) Fall in Quality: Continuous rise in prices creates a seller’s market. In such a situation,
producers produce and sell sub-standard commodities in order to earn higher profits. They also
indulge in adulteration of commodities.

(5) Hoarding and Black-marketing: To profit more from rising prices, producers hoard stocks of
their commodities. Consequently, an artificial scarcity of commodities is created in the market. Then
the producers sell their products in the black market which increase inflationary pressures.

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(6) Reduction in Saving: When prices rise rapidly, the propensity to save declines because more
money is needed to buy goods and services than before. Reduced saving adversely affects investment
and capital formation. As a result, production is hindered.

(7) Hinders Foreign Capital: Inflation hinders the inflow of foreign capital because the rising costs
of materials and other inputs make foreign investment less profitable.

(8) Encourages Speculation: Rapidly rising prices create uncertainty among producers who
indulge in speculative activities in order to make quick profits. Instead of engaging themselves in
productive activities, they speculate in various types of raw materials required in production.

Q. Discuss the anti-inflationary measures taken by government to curb inflation.

Some of the important measures to control inflation are as follows: 1. Monetary Measures 2. Fiscal
Measures 3. Other Measures.

Inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand.
Inflation can, therefore, be controlled by increasing the supplies of goods and services and reducing
money incomes in order to control aggregate demand.

The various methods are usually grouped under three heads: monetary measures, fiscal measures
and other measures.

1. Monetary Measures: Monetary measures aim at reducing money incomes.

(a) Credit Control: One of the important monetary measures is monetary policy. The central bank
of the country adopts a number of methods to control the quantity and quality of credit. For this
purpose, it raises the bank rates, sells securities in the open market, raises the reserve ratio, and
adopts a number of selective credit control measures, such as raising margin requirements and
regulating consumer credit. Monetary policy may not be effective in controlling inflation, if inflation is
due to cost-push factors. Monetary policy can only be helpful in controlling inflation due to demand-
pull factors.

(b) Demonetization of Currency: However, one of the monetary measures is to demonetize

currency of higher denominations. Such a measures is usually adopted when there is abundance of
black money in the country.

(c) Issue of New Currency: The most extreme monetary measure is the issue of new currency in
place of the old currency. Under this system, one new note is exchanged for a number of notes of the
old currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted when
there is an excessive issue of notes and there is hyperinflation in the country. It is a very effective
measure. But is inequitable for its hurts the small depositors the most.

2. Fiscal Measures: Monetary policy alone is incapable of controlling inflation. It should, therefore,
be supplemented by fiscal measures. Fiscal measures are highly effective for controlling government
expenditure, personal consumption expenditure, and private and public investment.

The principal fiscal measures are the following:

(a) Reduction in Unnecessary Expenditure: The government should reduce unnecessary

expenditure on non-development activities in order to curb inflation. This will also put a check on
private expenditure which is dependent upon government demand for goods and services. But it is
not easy to cut government expenditure. Though this measure is always welcome but it becomes

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difficult to distinguish between essential and non-essential expenditure. Therefore, this measure
should be supplemented by taxation.

(b) Increase in Taxes: To cut personal consumption expenditure, the rates of personal, corporate
and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes
should not be so high as to discourage saving, investment and production. Rather, the tax system
should provide larger incentives to those who save, invest and produce more.

Further, to bring more revenue into the tax-net, the government should penalize the tax evaders by
imposing heavy fines. Such measures are bound to be effective in controlling inflation. To increase
the supply of goods within the country, the government should reduce import duties and increase
export duties.

(c) Increase in Savings: Another measure is to increase savings on the part of the people. This will
tend to reduce disposable income with the people, and hence personal consumption expenditure. But
due to the rising cost of living, people are not in a position to save much voluntarily.

Keynes, therefore, advocated compulsory savings or what he called ‘deferred payment’ where the
saver gets his money back after some years. For this purpose, the government should float public
loans carrying high rates of interest, start saving schemes with prize money, or lottery for long
periods, etc. It should also introduce compulsory provident fund, provident fund-cum-pension
schemes, etc. All such measures increase savings and are likely to be effective in controlling inflation.

(d) Surplus Budgets: An important measure is to adopt anti-inflationary budgetary policy. For this
purpose, the government should give up deficit financing and instead have surplus budgets. It means
collecting more in revenues and spending less.

(e) Public Debt: At the same time, it should stop repayment of public debt and postpone it to
some future date till inflationary pressures are controlled within the economy. Instead, the
government should borrow more to reduce money supply with the public.

Like monetary measures, fiscal measures alone cannot help in controlling inflation. They should be
supplemented by monetary, non-monetary and non-fiscal measures.

3. Other Measures: The other types of measures are those which aim at increasing aggregate supply
and reducing aggregate demand directly.

(a) To Increase Production: The following measures should be adopted to increase production:

(i) One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.

(ii) If there is need, raw materials for such products may be imported on preferential basis to increase
the production of essential commodities,

(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be
maintained through agreements with trade unions, binding them not to resort to strikes for some
time,

(iv) The policy of rationalization of industries should be adopted as a long-term measure.

Rationalization increases productivity and production of industries through the use of brain, brawn
and bullion,

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(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc.
should be provided to different consumer goods sectors to increase production.

(b) Rational Wage Policy: Another important measure is to adopt a rational wage and income
policy. Under hyperinflation, there is a wage-price spiral. To control this, the government should
freeze wages, incomes, profits, dividends, bonus, etc.

But such a drastic measure can only be adopted for a short period as it is likely to antagonize both
workers and industrialists. Therefore, the best course is to link increase in wages to increase in
productivity. This will have a dual effect. It will control wages and at the same time increase
productivity, and hence raise production of goods in the economy.

(c) Price Control: Price control and rationing is another measure of direct control to check
inflation. Price control means fixing an upper limit for the prices of essential consumer goods. They
are the maximum prices fixed by law and anybody charging more than these prices is punished by law.
But it is difficult to administer price control.

(d) Rationing: Rationing aims at distributing consumption of scarce goods so as to make them
available to a large number of consumers. It is applied to essential consumer goods such as wheat,
rice, sugar, kerosene oil, etc. It is meant to stabilize the prices of necessaries and assure distributive
justice. But it is very inconvenient for consumers because it leads to queues, artificial shortages,
corruption and black marketing. Keynes did not favor rationing for it “involves a great deal of waste,
both of resources and of employment.”

From the various monetary, fiscal and other measures discussed above, it becomes clear that to
control inflation, the government should adopt all measures simultaneously. Inflation is like a hydra-
headed monster which should be fought by using all the weapons at the command of the
government.

Q. What is Deflation? Distinguish between inflation and deflation.

Many people accept inflation as a fact of life. However, under certain economic situations, the
opposite phenomenon actually takes place, and is known as “deflation.”

Deflation is the reduction of prices of goods, and although deflation may seem like a good thing
when you’re standing at the checkout counter, it’s not. Rather, deflation is an indication that
economic conditions are deteriorating. Deflation is usually associated with significant
unemployment, which is only corrected after wages drop considerably. Furthermore, businesses’
profits drop significantly during periods of deflation, making it more difficult to raise additional
capital to expand and develop new technologies.

“Deflation” is often confused with “disinflation.” While deflation represents a decrease in the prices
of goods and services throughout the economy, disinflation represents a situation where inflation
increases at a slower rate. However, disinflation does not usually precede a period of deflation. In
fact, deflation is a rare phenomenon that does not occur in the course of a normal economic cycle,
and therefore, investors must recognize it as a sign that something is severely wrong with the state
of the economy.

What Causes Deflation?

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Deflation can be caused by a number of factors, all of which stem from a shift in the supply-demand
curve. Remember, the prices of all goods and services are heavily affected by a change in the supply
and demand, which means that if demand drops in relation to supply, prices will have to drop
accordingly. Also, a change in the supply and demand of a nation’s currency plays an instrumental
role in setting the prices of the country’s goods and services.

Although there are many reasons why deflation may take place, the following causes seem to play
the largest roles:

1. Change in Structure of Capital Markets: When many different companies are selling the same
goods or services, they will typically lower their prices as a means to compete. Often, the capital
structure of the economy will change and companies will have easier access to debt and equity
markets, which they can use to fund new businesses or improve productivity.

There are multiple reasons why companies will have an easier time raising capital, such as declining
interest rates, changing banking policies, or a change in investors’ aversion to risk. However, after
they have utilized this new capital to increase productivity, they are going to have to reduce their
prices to reflect the increased supply of products, which can result in deflation.

2. Increased Productivity: Innovative solutions and new processes help increase efficiency,
which ultimately leads to lower prices. Although some innovations only affect the productivity of
certain industries, others may have a profound effect on the entire economy.

For example, after the Soviet Union collapsed in 1991, many of the countries that formed as a result
struggled to get back on track. In order to make a living, many citizens were willing to work for very
low prices, and as companies in the United States outsourced work to these countries, they were
able to significantly reduce their operating expenses and bolster productivity. Inevitably, this
increased the supply of goods and decreased their cost, which led to a period of deflation near the
end of the 20th century.

3. Decrease in Currency Supply: As the currency supply decreases, prices will decrease so that
people can afford goods. How can currency supplies decrease? One common reason is through central
banking systems.

For instance, when the Federal Reserve was first created, it considerably contracted the money
supply of the United States. In the process, this led to a severe case of deflation in 1913. Also, in
many economies, spending is often completed on credit. Clearly, when creditors pull the plug on
lending money, customers will spend less, forcing sellers to lower their prices to regain sales.

4. Austerity Measures: Deflation can be the result of decreased governmental, business, or

consumer spending, which means government spending cuts can lead to periods of significant
deflation. For example, when Spain initiated austerity measures in 2010, preexisting deflation began
to spiral out of control.

5. Deflationary Spiral: Once deflation has shown its ugly head, it can be very difficult to get the
economy under control for a number of reasons. First of all, when consumers start cutting spending,
business profits decrease. Unfortunately, this means that businesses have to reduce wages and cut
their own purchases. In turn, this short-circuits spending in other sectors, as other businesses and
wage-earners have less money to spend. As horrible as this sounds, it continues to get worse and the
cycle can be very difficult to break.

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Inflation v. Deflation
BASIS FOR COMPARISON INFLATION DEFLATION

When the value of money decreases Deflation is a situation, when

the value of money increases in
Meaning in the international market, then this
the international market.
situation is termed as inflation.

Decrease in the general price

Effects Increase in the general price level.
level.
National income Does not declines Declines
Gold prices Falls Rises
Demand pull inflation, cost push Debt deflation, money supply
Classification
inflation, stagflation and deflation. side deflation, credit deflation.
Good for Producers Consumers
Rise in the level
Consequences Unequal distribution of income.
of unemployment.
A little bit of inflation is a symbol of Deflation is not good for an
Which is evil?
economic growth of the country. economy.

Q. Critically explain Fisher’s Quantity Theory of Money/ the Cash Transactions Approach. Mention
the alternative approach also as stated by the Cambridge economist OR Examine The Cambridge
Equations: The Cash Balances Approach of Quantity Theory of Money.

The quantity theory of money states that the quantity of money is the main determinant of the price
level or the value of money. Any change in the quantity of money produces an exactly proportionate
change in the price level. In the words of Irving Fisher, “Other things remaining unchanged, as the
quantity of money in circulation increases, the price level also increases in direct proportion and the
value of money decreases and vice versa.” If the quantity of money is doubled, the price level will
also double and the value of money will be one half. On the other hand, if the quantity of money is
reduced by one half, the price level will also be reduced by one half and the value of money will be
twice.

Fisher has explained his theory in terms of his equation of exchange:

PT=MV+ M’ V’

Where P = price level, or 1 IP = the value of money; M = the total quantity of legal tender money; V
= the velocity of circulation of M; M’ – the total quantity of credit money; V’ = the velocity of
circulation of M; T = the total amount of goods and services exchanged for money or transactions
performed by money.

This equation equates the demand for money (PT) to supply of money (MV=M’V). The total volume
of transactions multiplied by the price level (PT) represents the demand for money.

According to Fisher, PT is SPQ. In other words, price level (P) multiplied by quantity bought (Q) by the
community (S) gives the total demand for money. This equals the total supply of money in the
community consisting of the quantity of actual money M and its velocity of circulation V plus the
total quantity of credit money M’ and its velocity of circulation V’. Thus the total value of purchases
(PT) in a year is measured by MV+M’V’. Thus the equation of exchange is PT=MV+M’V’. In order to

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find out the effect of the quantity of money on the price level or the value of money, we write the
equation as

P=( MV+M’V’)/T

Fisher points out the price level (P) (M+M’) provided the volume of T remain unchanged. The truth of
this proposition is evident from the fact that if M and M’ are doubled, while V, V and T remain
constant, P is also doubled, but the value of money (1/P) is reduced to half.

Fisher’s quantity theory of money is explained with the help of Figure 65.1. (A) and (B). Panel A of
the figure shows the effect of changes in the quantity of money
on the price level. To begin with, when the quantity of money is
M, the price level is P.

When the quantity of money is doubled to M2, the price level is

also doubled to P2. Further, when the quantity of money is
increased four-fold to M4, the price level also increases by four
times to P4. This relationship is expressed by the curve P = f (M)
from the origin at 45°.

In panel В of the figure, the inverse relation between the

quantity of money and the value of money is depicted where
the value of money is taken on the vertical axis. When the
quantity of money is M1 the value of money is HP. But with the
doubling of the quantity of money to M2, the value of money
becomes one-half of what it was before, 1/P2. And with the
quantity of money increasing by four-fold to M4, the value of
money is reduced by 1/P4. This inverse relationship between
the quantity of money and the value of money is shown by
downward sloping curve 1/P = f (M).

Assumptions of the Theory:

Fisher’s theory is based on the following assumptions:

1. P is passive factor in the equation of exchange which is affected by the other factors.

2. The proportion of M’ to M remains constant.

3. V and V are assumed to be constant and are independent of changes in M and M’.

4. T also remains constant and is independent of other factors such as M, M, V and V.

5. It is assumed that the demand for money is proportional to the value of transactions.

6. The supply of money is assumed as an exogenously determined constant.

7. The theory is applicable in the long run.

8. It is based on the assumption of the existence of full employment in the economy.

Criticisms of the Theory:

The Fisherian quantity theory has been subjected to severe criticisms by economists.

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1. Truism: According to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of
exchange is a simple truism because it states that the total quantity of money (MV+M’V’) paid for
goods and services must equal their value (PT). But it cannot be accepted today that a certain
percentage change in the quantity of money leads to the same percentage change in the price level.

2. Other things not equal: The direct and proportionate relation between quantity of money and
price level in Fisher’s equation is based on the assumption that “other things remain unchanged”. But
in real life, V, V and T are not constant. Moreover, they are not independent of M, M’ and P. Rather,
all elements in Fisher’s equation are interrelated and interdependent. For instance, a change in M may
cause a change in V.

Consequently, the price level may change more in proportion to a change in the quantity of money.
Similarly, a change in P may cause a change in M. Rise in the price level may necessitate the issue of
more money. Moreover, the volume of transactions T is also affected by changes in P. When prices
rise or fall, the volume of business transactions also rises or falls. Further, the assumptions that the
proportion M’ to M is constant, has not been borne out by facts. Not only this, M and M’ are not
independent of T. An increase in the volume of business transactions requires an increase in the
supply of money (M and M’).

3. Constants Relate to Different Time: Prof. Halm criticizes Fisher for multiplying M and V
because M relates to a point of time and V to a period of time. The former is a static concept and the
latter a dynamic. It is therefore, technically inconsistent to multiply two non-comparable factors.

4. Fails to Measure Value of Money: Fisher’s equation does not measure the purchasing power
of money but only cash transactions, that is, the volume of business transactions of all kinds or what
Fisher calls the volume of trade in the community during a year. But the purchasing power of money
(or value of money) relates to transactions for the purchase of goods and services for consumption.
Thus the quantity theory fails to measure the value of money.

5. Weak Theory: According to Crowther, the quantity theory is weak in many respects. First, it
cannot explain ’why’ there are fluctuations in the price level in the short run. Second, it gives undue
importance to the price level as if changes in prices were the most critical and important phenomenon
of the economic system. Third, it places a misleading emphasis on the quantity of money as the
principal cause of changes in the price level during the trade cycle.

Prices may not rise despite increase in the quantity of money during depression; and they may not
decline with reduction in the quantity of money during boom. Further, low prices during depression
are not caused by shortage of quantity of money, and high prices during prosperity are not caused
by abundance of quantity of money. Thus, “the quantity theory is at best an imperfect guide to the
causes of the trade cycle in the short period” according to Crowther.

6. Neglects Interest Rate: One of the main weaknesses of Fisher’s quantity theory of money is
that it neglects the role of the rate of interest as one of the causative factors between money and
prices. Fisher’s equation of exchange is related to an equilibrium situation in which rate of interest is
independent of the quantity of money.

7. Unrealistic Assumptions: Keynes in his General Theory severely criticized the Fisherian
quantity theory of money for its unrealistic assumptions. First, the quantity theory of money for its
unrealistic assumptions. First, the quantity theory of money is unrealistic because it analyses the
relation between M and P in the long run. Thus it neglects the short run factors which influence this

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relationship. Second, Fisher’s equation holds good under the assumption of full employment. But
Keynes regards full employment as a special situation. The general situation is one of the
underemployment equilibrium. Third, Keynes does not believe that the relationship between the
quantity of money and the price level is direct and proportional.

Rather, it is an indirect one via the rate of interest and the level of output. According to Keynes, “So
long as there is unemployment, output and employment will change in the same proportion as the
quantity of money, and when there is full employment, prices will change in the same proportion as
the quantity of money.” Thus Keynes integrated the theory of output with value theory and
monetary theory and criticized Fisher for dividing economics “into two compartments with no doors
and windows between the theory of value and theory of money and prices.”

8. V not Constant: Further, Keynes pointed out that when there is underemployment
equilibrium, the velocity of circulation of money V is highly unstable and would change with changes
in the stock of money or money income. Thus it was unrealistic for Fisher to assume V to be constant
and independent of M.

9. Neglects Store of Value Function: Another weakness of the quantity theory of money is that
it concentrates on the supply of money and assumes the demand for money to be constant. In order
words, it neglects the store-of-value function of money and considers only the medium-of-exchange
function of money. Thus the theory is one-sided.

10. Neglects Real Balance Effect: Don Patinkin has criticized Fisher for failure to make use of the
real balance effect, that is, the real value of cash balances. A fall in the price level raises the real value
of cash balances which leads to increased spending and hence to rise in income, output and
employment in the economy. According to Patinkin, Fisher gives undue importance to the quantity of
money and neglects the role of real money balances.

11. Static: Fisher’s theory is static in nature because of its such unrealistic assumptions as long
run, full employment, etc. It is, therefore, not applicable to a modern dynamic economy.

The Cambridge Equations: The Cash Balances Approach:

The Cambridge cash balances equations of Marshall, Pigou, Robertson and Keynes are discussed as
under:

Marshall’s Equation: Marshall did not put his theory in equation form and it was for his followers to
explain it algebraically. Friedman has explained Marshall’s views thus: “As a first approximation, we
may suppose that the amount one wants to hold bears some relation to one’s income, since that
determines the volume of purchases and sales in which one is engaged. We then add up the cash
balances held by all holders of money in the community and express the total as a fraction of their
total income.”

Thus we can write: M = kPY

where M stands for the exogenously determined supply of money, k is the fraction of the real money
income (PY) which people wish to hold in cash and demand deposits, P is the price level, and Y is the
aggregate real income of the community. Thus the price level P = M/kY or the value of money (the
reciprocal of price level) is

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 1/P = kY/M

Pigou’s Equation: Pigou was the first Cambridge economist to express the cash balances approach in
the form of an equation:

P = kR/M

where P is the purchasing power of money or the value of money (the reciprocal of the price level), k
is the proportion of total real resources or income (R) which people wish to hold in the form of titles
to legal tender, R is the total resources (expressed in terms of wheat), or real income, and M refers
to the number of actual units of legal tender money.

The demand for money, according to Pigou, consists not only of legal money or cash but also bank
notes and bank balances. In order to include bank notes and bank balances in the demand for
money, Pigou modifies his equation as

P = kR/M {c + h(1-c)}

where c is the proportion of total real income actually held by people in legal tender including token
coins, (1-c) is the proportion kept in bank notes and bank balances, and h is the proportion of actual
legal tender that bankers keep against the notes and balances held by their customers.

Pigou points out that when k and R in the equation P=kR/M and k, R, c and h are taken as constants
then the two equations give the demand curve for legal tender as a rectangular hyperbola. This
implies that the demand curve for money has a uniform unitary elasticity.

This is shown in Figure 2 where DD1 is the demand curve for money and Q1M1, Q2M2, and Q3M3 are
the supply curves of money drawn on the assumption that the
supply of money is fixed at a point of time. The value of money or
Pigou’s purchasing power of money P is taken on the vertical axis.

The figure shows that when the supply of money increases from
OM1 to OM2, the value of money is reduced from OP1 to OP2. The
fall in the value of money by P1P2 exactly equals the increase in the
supply of money by M1M2. If the supply of money increases three
times from OM1 to OM3 the value of money is reduced by exactly
one-third from OP1 to OP3. Thus the demand curve for money DD1 is
a rectangular hyperbola because it shows changes in the value of
money exactly in reverse proportion to the supply of money.

Robertson’s Equation: To determine the value of money or its

reciprocal the price level, Robertson formulated an equation similar
to that of Pigou. The only difference between the two being that instead of Pigou’s total real
resources R, Robertson gave the volume of total transactions T. The Robertsonian equation is M =
PkT or P = M/kT

Where P is the price level, M is the total quantity of money, k is the proportion of the total amount
of goods and services (T) which people wish to hold in the form of cash balances, and T is the total
volume of goods and services purchased during a year by the community.

If we take P as the value of money instead of the price level as in Pigou’s equation, then Robertson’s
equation exactly resembles Pigou’s P = kT/M.

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Keynes’s Equation: Keynes in his A Tract on Monetary Reform (1923) gave his Real Balances Quantity
Equation as an improvement over the other Cambridge equations. According to him, people always
want to have some purchasing power to finance their day to day transactions.

The amount of purchasing power (or demand for money) depends partly on their tastes and habits,
and partly on their wealth. Given the tastes, habits, and wealth of the people, their desire to hold
money is given. This demand for money is measured by consumption units. A consumption unit is
expressed as a basket of standard articles of consumption or other objects of expenditure.

If k is the number of consumption units in the form of cash, n is the total currency in circulation, and
p is the price for consumption unit, then the equation is n= pk

If k is constant, a proportionate increase in n (quantity of money) will lead to a proportionate

increase in p (price level).

This equation can be expanded by taking into account bank deposits. Let k’ be the number of
consumption units in the form of bank deposits, and r the cash reserve ratio of banks, then the
expanded equation is n=p (k + rk’)

Again, if k, k’ and r are constant, p will change in exact proportion to the change in n.

Keynes regards his equation superior to other cash balances equations. The other equations fail to
point how the price level (p) can be regulated. Since the cash balances (k) held by the people are
outside the control of the monetary authority, p can be regulated by controlling n and r. It is also
possible to regulate bank deposits k’ by appropriate changes in the bank rate. So p can be controlled
by making appropriate changes in n, r and k’ so as to offset changes in k.

Criticisms of the Cash Balance Approach: The cash balances approach to the quantity theory of
money has been criticized on the following counts:

1. Truisms: Like the transactions equation, the cash balances equations are truisms. Take any
Cambridge equation: Marshall’s P=M/kY or Pigou’s P=kR/M or Robertson’s P=M/kT or Keynes’s p=n/k,
it establishes a proportionate relation between quantity of money and price level.

2. Price Level does not Measure Purchasing Power: Keynes in his A Treatise on Money (1930)
criticized Pigou’s cash balances equation and also his own real balances equation. He pointed out that
measuring the price level in wheat, as Piogu did or in terms of consumption units, as Keynes himself
did, was a serious defect.

The price level in both equations does not measure the purchasing power of money. Measuring the
price level in consumption units implies that cash deposits are used only for expenditure on current
consumption. But in fact they are held for “a vast multiplicity of business and personal purposes.” By
ignoring these aspects, the Cambridge economists have committed a serious mistake.

3. More Importance to Total Deposits: Another defect of the Cambridge equation “lies in its
applying to the total deposits considerations which are primarily relevant only to the income
deposits.” And the importance attached to k “is misleading when it is extended beyond the income
deposits.”

4. Neglects other Factors: Further, the cash balances equation does not tell about changes in
the price level due to changes in the proportions in which deposits are held for income, business and
savings purposes.

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5. Neglect of Saving-Investment Effect: Moreover, it fails to analyze variations in the price level
due to saving-investment inequality in the economy.

6. k and Y not Constant: The Cambridge equation, like the transactions equation, assumes k and
T (or R or T) as constant. This is unrealistic because it is not essential that the cash balances (k) and
the income of the people (Y) should remain constant even during the short period.

7. Fails to Explain Dynamic Behaviour of Prices: The theory argues that changes in the total
quantity of money influence the general price level equi-proportionally. But the fact is that the
quantity of money influences the price level in an essential erratic and unpredictable way. Further, it
fails to point out the extent of change in the price level as a result of a given change in the quantity of
money in the short period. Thus it fails to explain the dynamic behaviour of prices.

8. Neglects Interest Rate: The cash balances approach is also weak in that it ignores other
influences, such as the rate of interest which exerts a decisive and significant influence upon the price
level. As pointed out by Keynes, the relation between quantity of money and price level is not direct
but indirect via the rate of interest, investment, output, employment and income. This is what the
Cambridge equation ignores and hence fails to integrate monetary theory with the theory of value
and output.

9. Demand for Money not Interest Inelastic: The neglect of the rate of interest as a causative
factor between the quantity of money and the price level led to the assumption that the demand for
money is interest inelastic. It means that money performs only the function of medium of exchange
and does not possess any utility of its own, such as store of value.

10. Neglect of Goods Market: Further, the omission of the influence of the rate of interest in the
cash balances approach led to the failure of neoclassical economists to recognise the interdependence
between the commodity and money markets. According to Patinkin, “They laid an undue
concentration on the money market a corresponding neglect of the commodity markets, and a
resulting ‘dehumanising’ of the analysis of the effects of monetary changes.”

Q. Do you consider Cash Balances Approach of Quantity Theory of Money to be superior to the
Transaction Approach of Quantity Theory of Money?

The Cambridge cash balances approach to the quantity theory of money is superior to Fisher’s
transaction approach in many respects. They are discussed as under:

1. Basis of Liquidity Preference Theory of Interest: The cash balances approach emphasizes the
importance of holding cash balances rather than the supply of money which is given at a point of time.
It thus led Keynes to propound his theory of liquidity preference and of the rate of interest, and to the
integration of monetary theory of value and output.

2. Complete Theory: The cash balances version of quantity theory is superior to the transactions
version because the former determines the value of money in terms of the demand and supply of
money. Thus it is a complete theory. But in the transactions approach, the determination of value of
money is artificially divorced from the theory of value.

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3. Discards the Concept of Velocity of Circulation: The cash balances approach is superior to the
transactions approach because it discards the concept of the velocity of circulation of money which
‘obscures the motives and decisions of people behind it.

4. Related to the Short Period: Again the cash balances version is more realistic than the
transactions version of the quantity theory, because it is related to the short period while the latter is
related to the long period. As pointed out by Keynes, “In the long run we may all be dead.” So the
study of the relationship between quantity of money and price level during the long run is unrealistic.

5. Simple Equations: In the cash balances equations, transactions relating to final goods only are
included where P refers to the level of final goods. On the other hand, in the transactions equation P
includes all types of transactions. This creates difficulties in determining the true price level. Thus the
former equations are simpler and realistic than the latter.

6. New Formulation in Monetary Theory: Further, the Cambridge equation regards the cash
balances held by the people as a function of the level of income. The introduction of income (f or R or
T) in this equation as against V (the velocity of circulation of money) in the transaction equation has
made the cash balances equation realistic and led to new formulations in monetary theory. “It points
out that changes in the level of money income can come about through changes in the price level,
through changes in real output or through both at once.”

7. Explains Trade Cycles: Hansen regards k in the Cambridge equation superior to Fin Fisher’s
equation for understanding cyclical fluctuations. According to him, “Drastic and sudden shifts in the
desire to hold money, reflected in a change in k, may produce large and quickly moving changes in the
level of income and prices.

In the Cambridge analysis, a shift in k may start an upward or downward movement.” For instance,
when k (the fraction of total real income that people wish to hold in cash balances) increases
because of low business expectations, the price level falls, and vice versa.

8. Study of Subjective Factors: As a corollary to the above, V in Fisher’s equation is mechanistic

while k in the Cambridge equation is realistic. The subjective factors behind variations in k have led to
the study of such factors as expectations, uncertainty, motives for liquidity, and the rate of interest in
modern monetary theory. In this sense, it can be justifiably said that, “the Cambridge equation moves
us on from the tautology represented by the equation of exchange to a study of economic behaviour.”

9. Applicable under All Circumstances: Fisher’s transactions approach holds true only under full
employment. But the cash balances approach holds under all circumstances whether there is full
employment or less than full employment.

10. Based on Micro Factors: The Cambridge version is superior to the Fisherian version because
it is based on micro factors like individual decisions and behaviours. On the other hand, the Fisherian
version is based on macro factors like T, total velocity of circulation, etc.

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BANKING
Q. Do commercial banks create credit? Are there any limitations to their credit creation capacity?

A central bank is the primary source of money supply in an economy through circulation of currency.
It ensures the availability of currency for meeting the transaction needs of an economy and
facilitating various economic activities, such as production, distribution, and consumption.

However, for this purpose, the central bank needs to depend upon the reserves of commercial
banks. These reserves of commercial banks are the secondary source of money supply in an
economy. The most important function of a commercial bank is the creation of credit.

Therefore, money supplied by commercial banks is called credit money. Commercial banks create
credit by advancing loans and purchasing securities. They lend money to individuals and businesses
out of deposits accepted from the public. However, commercial banks cannot use the entire amount
of public deposits for lending purposes. They are required to keep a certain amount as reserve with
the central bank for serving the cash requirements of depositors. After keeping the required amount
of reserves, commercial banks can lend the remaining portion of public deposits.

Let us learn the process of credit creation by commercial banks with the help of an example.

Suppose you deposit Rs. 10,000 in a bank A, which is the primary deposit of the bank. The cash
reserve requirement of the central bank is 10%. In such a case, bank A would keep Rs. 1000 as
reserve with the central bank and would use remaining Rs. 9000 for lending purposes.

The bank lends Rs. 9000 to Mr. X by opening an account in his name, known as demand deposit
account. However, this is not actually paid out to Mr. X. The bank has issued a check-book to Mr. X to
withdraw money. Now, Mr. X writes a check of Rs. 9000 in favor of Mr. Y to settle his earlier debts.

The check is now deposited by Mr. Y in bank B. Suppose the cash reserve requirement of the central
bank for bank B is 5%. Thus, Rs. 450 (5% of 9000) will be kept as reserve and the remaining balance,
which is Rs. 8550, would be used for lending purposes by bank B.

Thus, this process of deposits and credit creation continues till the reserves with commercial banks
reduce to zero.

This process is shown in the Table-1:

From Table-1, it can be seen that deposit of Rs. 10,000 leads to a creation of total deposit of Rs.
50,000 without the involvement of cash.

The process of credit creation can also be learned with the help of following formulae:

Total Credit Creation = Original Deposit * Credit Multiplier Coefficient

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Credit multiplier coefficient= 1 / r where r = cash reserve requirement also called as Cash Reserve
Ratio (CRR)

Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10

Total credit created = 10,000 *10 = 100000

If CRR changes to 5%,

Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20

Total credit creation = 10000 * 20 = 200000

Thus, it can be inferred that lower the CRR, the higher will be the credit creation, whereas higher the
CRR, lesser will be the credit creation. With the help of credit creation process, money multiplies in
an economy. However, the credit creation process of commercial banks is not free from limitations.

The following points highlight the eleven major limitations of credit creation by commercial banks.

# 1. Cash Reserve Ratio: The credit creation power of banks depends upon the amount of cash they
possess. The larger the cash, the larger the amount of credit that can be created by banks. Thus, the
bank’s power of creating credit is limited by the cash it possesses.

# 2. Availability of Adequate and Proper Securities: If proper securities are not available with the
public, a bank cannot create credit. As Crowther has written—”the bank does not create money out
of thin air, it transmutes other forms of wealth into money.”

# 3. Keeping of Reserve with the Central Bank: Every affiliated and attached bank has to keep
certain reserves with the Central Bank of the country. The Central Bank keeps on changing the
percentages of these reserves from time to time. When the Central Bank increases the percentages
of these reserves, then the power of the commercial banks to create credit is reduced in the same
proportion.

On the other-hand if the Central Bank reduces the percentage of these reserves, the power of the
Commercial Banks to create credit is increased in the same proportion.

# 4. Banking Habits of the People: The banking habits of the people are an important factor which
governs the power of credit creation on the part of banks. If people are not in the habit of using
cheques, the grant of loans will lead to the withdrawal of cash from the credit creation stream of the
banking system. This reduces the power of banks to create credit to the desired level.

# 5. Volume of Currency in Circulation: Volume of currency in circulation is an important factor of

creation of credit. If the primary deposits are large, then the derivative deposits created on their
basis will also be large. But the volume of primary deposits is closely connected with the actual
volume of currency in circulation.

If the volume of currency in circulation increases the volume of primary deposits will increase
enabling the Commercial banks to create a large volume of derivative deposits. On the other-hand if
the volume of currency in circulation decreases, the volume of primary deposits with the bank will
also decrease leading to a decrease in the volume of derivative deposits created by the banks.

# 6. If heavy with-drawl of Cash by the Borrowers: If the borrowers will withdraw money in cash,
then the balance of deposits will be disturbed. With the withdrawal of cash, the excess reserves of
the banks are automatically reduced. This reduces the power of credit creation.

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# 7. Existence of Cash Transactions in the Economy: This system of doing transaction sets another
limitation on the power of the banks to create credit. In under-developed area most of the
transactions have to be effected in cash. This puts a question as to what extent banks power to
create credit is reduced.

But as the economy develops, the ratio of currency to total money supply decreases and that of bank
money increases. This increases correspond-ingly the banks power of credit creation in the economy.

# 8. Economic Conditions of Trade and Business: Banks cannot continue to create credit limitlessly.
Their power to create credit depends upon the economic climate present in the country. If there are
boom times, there is a greater scope of profitable investment and thus greater demand for bank
loans on the part of businessmen.

The banks will, therefore, be able to create a greater volume of credit at such a time. Similarly,
during the period of depression the scope of profitable investment is limited. Hence, the investors
will be less inclined to borrow from the banks. Therefore, the banks power to create credit will be
automatically reduced.

# 9. If Good Collateral Securities are not Available: We are aware that every loan made by the bank
must be backed by some valuable security like stocks, shares, bills and bonds etc. If these collateral
securities are not available in sufficient number the banks cannot expand their lending activities and
consequently cannot expand credit in the economy.

# 10. It is Essential to Maintain Statutory Liquidity Ratio: The Commercial Banks under law are
required to maintain a second line of defence in the form of the liquid assets. In India it has become
essential to keep 34% of the assets in liquid forms. The liquid assets have been considered as
government bonds and securities, treasury bills and other approved securities which can be
encashed quite easily in emergency.

Such restrictions reduce the lendable resources with the banks and curtail their power to create
credit to that extent.

# 11. If the Behaviour of Other Banks is Not Co-operative: If some of the banks do not advance
loans to the extent required of the banking system, the chain of credit expansion will be broken. The
effect will be that the banking system will not operate properly.

Q. Discuss the functions of central bank with special reference to its development functions.

The central bank does not deal with the general public directly. It performs its functions with the
help of commercial banks. The central bank is accountable for protecting the financial stability and
economic development of a country.

Apart from this, the central bank also plays a significant part in avoiding the cyclical fluctuations by
controlling money supply in the market. As per the view of Hawtrey, a central bank should primarily
be the “lender of last resort.”

On the other hand, Kisch and Elkins believed that “the maintenance of the stability of the monetary
standard” as the essential function of central bank. The functions of central bank are broadly divided
into two parts, namely, traditional functions and developmental functions.

These functions are shown in Figure-4:

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The different functions of a central bank (as discussed in Figure-4) are explained as follows:

(a) Traditional Functions: The traditional functions of the central bank include the following:

(i) Bank of issue: Possesses an exclusive right to issue notes (currency) in every country of the
world. In the initial years of banking, every bank enjoyed the right of issuing notes. However, this led
to a number of problems, such as notes were over-issued and the currency system became
disorganized. Therefore, the governments of different countries authorized central banks to issue
notes. The issue of notes by one bank has led to uniformity in note circulation and balance in money
supply.

(ii) Government’s banker, agent, and advisor: Implies that a central bank performs different
functions for the government. As a banker, the central bank performs banking functions for the
government as commercial banks performs for the public by accepting the government deposits and
granting loans to the government. As an agent, the central bank manages the public debt, undertakes
the payment of interest on this debt, and provides all other services related to the debt.

As an advisor, the central bank gives advice to the government regarding economic policy matters,
money market, capital market, and government loans. Apart from this, the central bank formulates
and implements fiscal and monetary policies to regulate the supply of money in the market and
control inflation.

(iii) Custodian of cash reserves of commercial banks: Implies that the central bank takes care of
the cash reserves of commercial banks. Commercial banks are required to keep certain amount of
public deposits as cash reserve, with the central bank, and other part is kept with commercial banks
themselves.

The percentage of cash reserves is deeded by the central bank! A certain part of these reserves is
kept with the central bank for the purpose of granting loans to commercial banks Therefore, the
central bank is also called banker’s bank.

(iv) Custodian of international currency: Implies that the central bank maintains a minimum
reserve of international currency. The main aim of this reserve is to meet emergency requirements of
foreign exchange and overcome adverse requirements of deficit in balance of payments.

(v) Bank of rediscount: Serve the cash requirements of individuals and businesses by
rediscounting the bills of exchange through commercial banks. This is an indirect way of lending
money to commercial banks by the central bank. Discounting a bill of exchange implies acquiring the
bill by purchasing it for the sum less than its face value.

Rediscounting implies discounting a bill of exchange that was previously discounted. When owners
of bill of exchange are in need of cash they approach the commercial bank to discount these bills. If
commercial banks are themselves in need of cash they approach the central bank to rediscount the
bills.

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(vi) Lender of last resort: Refer to the most crucial function of the central bank. The central bank
also lends money to commercial banks. Instead of rediscounting of bills, the central bank provides
loans against treasury bills, government securities, and bills of exchange.

(vii) Bank of central clearance, settlement, and transfer: Implies that the central bank helps in
settling mutual indebtness between commercial banks. Depositors of banks give checks and demand
drafts drawn on other banks. In such a case, it is not possible for banks to approach each other for
clearance, settlement, or transfer of deposits.

The central bank makes this process easy by setting a clearing house under it. The clearing house
acts as an institution where mutual indebtness between banks is settled. The representatives of
different banks meet in the clearing house to settle inter-bank payments. This helps the central bank
to know the liquidity state of the commercial banks.

(viii) Controller of Credit: Implies that the central bank has power to regulate the credit creation
by commercial banks. The credit creation depends upon the amount of deposits, cash reserves, and
rate of interest given by commercial banks. All these are directly or indirectly controlled by the central
bank. For instance, the central bank can influence the deposits of commercial banks by performing
open market operations and making changes in CRR to control various economic conditions.

(b) Developmental Functions: Refer to the functions that are related to the promotion of banking
system and economic development of the country. These are not compulsory functions of the
central bank.

(i) Developing specialized financial institutions: Refer to the primary functions of the central
bank for the economic development of a country. The central bank establishes institutions that serve
credit requirements of the agriculture sector and other rural businesses.

Some of these financial institutions include Industrial Development Bank of India (IDBI) and National
Bank for Agriculture and Rural Development (NABARD). These are called specialized institutions as
they serve the specific sectors of the economy.

(ii) Influencing money market and capital market: Implies that central bank helps in controlling
the financial markets Money market deals in short term credit and capital market deals in long term
credit. The central bank maintains the country’s economic growth by controlling the activities of these
markets.

(iii) Collecting statistical data: Gathers and analyzes data related to banking, currency, and foreign
exchange position of a country. The data is quite helpful for researchers, policymakers, and
economists. For instance, the Reserve Bank of India publishes a magazine called Reserve Bank of India
Bulletin, whose data is useful for formulating different policies and making macro-level decisions.

Credit Control functions of Central Bank

The chief objective of the central bank is to maintain price and economic stability. Price instability—
both inflation and deflation—has harmful effects. Moreover, fluctuations in overall economic
activity, that is, trade cycles entail a lot of human sufferings.

Main reason for the fluctuations in prices as well as in overall economic activity is the changes in
aggregate demand. Aggregate demand, especially the investment demand, depends upon the supply
of money. And credit these days is the important constituent of the money supply. Thus the supply

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of credit greatly affects the prices, national income and employment through changes in investment
demand.

Now it is the responsibility of the central bank of a country to guide the money market, i.e., the
commercial banks regarding supply of credit so as to maintain stability in prices as well as in overall
economic activity. To overcome inflation it has to restrict the supply of credit and to prevent or get
rid of depression and deflation it has to expand the credit. There are various methods by which the
central bank can control the supply of credit in the economy.

These methods are:

(a) Varying the bank rate;

(b) Engaging in open market operations; and

(c) Changing the reserve ratio, and

(d) Exercising selective credit controls.

It is through controlling the supply of credit and cost of credit (i.e., rate of interest on it) that the
central bank of a country tries to bring about stability in prices as well as in overall level of economic
activity. The central bank is the monetary authority of the country and monetary policy is one of the
important measures which are taken to avoid and cure both depression and inflation.

To remedy inflation central bank tries to restrict the supply of credit by raising the bank rate and
using other weapons of credit control. To overcome depression it tries to expand credit by lowering
the bank rate and cash reserve ratio and also by buying securities from the open market.

In India Reserve Bank which is the central bank of the country has been making important
contribution to the achievement of the objective of price stability. To achieve price stability Reserve
Bank has been setting forgets of expansion in money supply which are consistent with the growth of
output. Control of inflation by checking excessive expansion in credit supply has been the major
concern of monetary policy imposed by Reserve Bank of India.

Q. Essentials of a sound banking system.

As pointed out by Crowther, “The secret of successful banking is to distribute resources between the
various forms of assets in such a way as to get a sound balance between liquidity and profitability, so
that their is cash (on hand or quickly realizable) to meet every claim, and at the same time enough
income for the bank to pay it way and earn profits for its shareholders.” But modern bankers also
consider a few other essentials which are discussed below.

1. Liquidity: One of the essentials of a sound banking system is to have a higher degree of
liquidity. The bank holds a small proportion of its assets in cash. Therefore, its other assets must
possess the criterion of liquidity so that they may be turned into such easily. A commercial bank is
under an obligation to pay its depositors cash on demand. This is only possible if the bank possesses
such securities which can be easily liquidated. Central banks have made it obligatory on the
commercial banks to keep a certain proportion of their assets in cash to ensure liquidity.

2. Safety: Another essential of a sound banking system is that it must be safe. Since the bank
keeps the deposits of the people, it must ensure the safety of their money. So it should make safe

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loans and investments and avoid unnecessary risks. If the debtors of the banks do not repay the loans
in time and it loses on its investments, the bank shall become insolvent. As a result, its depositors lose
money and suffer hardships. Thus the bank must ensure the safety of its deposits.

3. Stability: A sound banking system must be stable. It should operate rationally. There should
neither be undue contraction nor expansion of credit. If the bank restricts the creation of credit when
trade and industry need it the most, it will harm the interests of the business community. On the other
hand, if it expands credit when the economic conditions do not permit, it will lead to boom and
inflation. So the banking system should follow a stable lending policy. The central bank of the country
can help in achieving stability in the banking operations of the commercial banks by a judicious credit
control policy.

4. Elasticity: But the stability of banking operations should not be interpreted as rigidity. Rather,
the banking system should have sufficient elasticity in its lending operations. It should be in a position
to expand and contract the supply of loanable funds with ease in accordance with the directives of the
central bank of the country.

5. Profitability: A sound banking system should be able to earn sufficient profits. Profits are
essential for it to be viable. It has to pay the corporation tax like any other company, pay interest to
its depositors, dividend to shareholders, salaries to the staff and meet other expenses. So unless the
bank earns, it cannot operate soundly. For this purpose, it must adopted judicious loan and investment
policies.

6. Reserve Management: Sound banking system must follow the principle of efficient reserve
management. A bank keeps some amount of money in reserve for meeting the demand of its
customers in case of emergency. Though the money kept in reserve is idle money, yet the bank cannot
afford the risk of keeping a small amount in reserve.

There are, however, some statutory limits laid down by the central bank in maintaining minimum
reserves with itself and with the bank. But how much reserve money should a bank maintain is
governed by its own wisdom, experience and the size of the bank. The bank should manage its
reserve policy effectively and efficiently without keeping too much or too little cash. It has to balance
between profitability and safety.

7. Expansion: A sound banking system must be spread throughout the country. It should not be
concentrated only in big towns and cities but in rural areas and backward regions. It is only by
widespread expansion of the banking system that the deposits can be mobilised and credit facilities
can be made available to trade, industry, agriculture, etc. This is especially the case in a developing
country where the banking system must provide these facilities through its expansion in all areas. This
is essential for capital formation and economic growth.

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PUBLIC FINANCE AND EXPENDITURE
Q. Under what circumstances does the government borrow from the public? Do they have any effect
on the economy?

The important role of public borrowing in economic development is relatively a recent phenomenon
and has much to do with the collapse of the principle of laissez faire, the rise of modern welfare
states and the imperatives of accelerated economic development of a considerable part of the
world. Public borrowing is a debt or loan taken by the government from its own people as well as
from foreign countries or both. As mentioned in the Encyclopedia Britannica, public debt refers to
“obligations of governments, particularly those evidenced by securities, to pay certain sums to the
holders at some future date.” Government needs to borrow when current revenue falls short of
public expenditure since current public revenue is usually insufficient to meet the current and
development expenditure of the modern government, the government has no alternative except to
borrow money.

When a government raises loans internally or externally, it incurs a liability known as "public debt‟.
Public borrowing or public debt is an important source of revenue to a modern government. It is,
however, an instrument for temporarily augmenting revenue or purchasing power in exchange for
an obligation on the part of the government to repay the principal sum borrowed plus a stipulated
rate of interest on it, at a specified future date.

Now-a-days public debt is defined as a kind of deferred tax through which public enjoys the
advantages of the public expenditure much before it is met out of the current revenue and it refers
to those obligations of the state as borrower and private investor of capital as lender where state
promises to pay the lender the amount borrowed with interest after a given period of time.

Another view is expressed by Buchanan who regarded that all public debt (both external and
internal) is detrimental to the welfare of both current and future generations of the society.

Prof. Cal S. Shoup defines public debt or government borrowing as, “the receipt from the sale of
financial instrument by the government to individuals or firms in the private sector induce the
private sector to release man power and real resources for the welfare of the public.”

Similarly, Prof. P E Taylor defines, “the debt is the form of promises by the Treasury to pay to the
holders of these promises a principal sum and in most instances interest on that principal. Borrowing
is resorted to in order to provide funds for financing a current deficit.”

Prof. J K Mehta has rightly mentioned, “public debt carries with it the obligation on the part of the
government to pay money back to the individuals from whom it has been obtained.” Taylor
continues “government debt arises out of borrowing by the Treasury from banks, business
organizations and individuals.”

It follows from the above discussions that the developmental challenges of modern-day
governments have necessitated incurring heavy dozes of public expenditure and thereby huge
amount of public debt. As a result, public debt has grown in size and magnitude, resulting in
numerous complex classifications, which has placed the topic of public debt at the heart of the public
finance.

There are many different reasons for government borrowing.

• Tax revenues are less than predicted. borrowing means the government can meet a
temporary shortfall by borrowing, rather than having to immediately cut back on spending.
Like an overdraft facility, government borrowing gives the government more flexibility and

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 means they can maintain wages and spending commitments without having to keep cutting
spending.

• Automatic fiscal stabilizers’. In a recession, government tax revenues fall (e.g. people earn
less so pay less income tax). Also the government have to spend more on unemployment
benefits. Therefore, in an economic downturn, borrowing rises. To eliminate borrowing in a
recession would make the recession worse and increase inequality. If the government couldn’t
borrow in a recession, the unemployed may not get any benefits and have no income. Also,
higher taxes and lower spending would reduce domestic demand and make the recession
even worse. (automatic fiscal stabilizers)

• Investment. The government may invest in public sector investment. For example, building
schools, hospitals, better roads. This investment can give a return on the investment which
helps to boost productive capacity and increase economic growth. In this case, the
government is acting like a firm who takes out a loan to finance investment.

• Political. The biggest tendency to borrow comes from political pressures. Voters generally like
to hear the promise of lower taxes and increasing spending. A manifesto to tackle a budget
deficit (higher taxes and lower spending) is unlikely to be popular. Voters often are supportive
of the general idea of reducing government debt, but when it comes to actual policies like
lower benefits, higher pension age, increased VAT rate, then it is likely to hit some particular
pressure group with a vested interest in maintaining low tax and spending. For a government
to increase borrowing is generally less politically damaging than increasing taxes. (though
ironically, I feel austerity can be politically popular at all the wrong times)

• War. During a war, government spending is stretched leading to higher borrowing. The highest
rates of borrowing occurred during the two world wars. Also, during wars, it may be easier to
sell bonds as you can play the patriotic card to encourage people to finance government
borrowing.

• It’s Cheap. Governments like the UK can usually borrow at very low interest rates, especially
during an economic downturn. This is because people have confidence government bonds are
secure and so are willing to lend at low interest rates.

• Economic Growth tends to reduce real debt burden. In the early 1950s, UK public sector debt
was over 200% of GDP. However, over next few decades, economic growth helped to reduce
the burden of debt. Assuming constant economic growth of 3% a year, the government can
borrow more, but maintain the same % of tax revenue on interest payments. See: Debt as %
of GDP You could think of a mortgage. People take out a 30 year mortgage to buy a house.
Over time, economic growth and inflation, tend to reduce the real burden of mortgage
payments.

Effects of Public Debt : The effects of public debt depends up on such factors like the sources of
loan, funds, the purposes for which the borrowing is done, the terms and conditions at which the
debt is floated, the volume of existing public debt, the interest rates, the types of loans employed
and lastly the general economic conditions of the community. In assessing the effects of public
borrowing, it should be kept in mind that there is a distinction between the effects of public
borrowing (while mobilizing the resources) the effects of public debt (while spending the funds) and
the implications of the debt redemption (while repaying both the principal and the interest).

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The government may borrow from the general public. In that case, the purchasing power is
transferred from the private hands to the public hands and so the public borrowing may tend to curb
consumption as well as investment in the private sector. But normally, the individuals purchase
government bonds out of their idle cash balances and hence it shall not serve as a good anti-
inflammatory measure. If the government bonds are purchased by the non banking financial
institutions like insurance companies, trusts, etc., it will reduce their cash holdings. This may cause
the interest rate to rise and the volume 39 of investment to decline as the availability of loans in the
money market is reduced. The government borrowings may be made from commercial banks which
may lead to additions in the quantum of money supply in the country as the banks can use these
bonds as collateral for borrowings from the central bank.

a) Effects on Consumption- The people purchase public bonds out of their past savings or out of
their present income which they could otherwise spent in purchasing some other commodity. In the
latter case, people refrain from consumption and buy public loan. Therefore, the consumption is
affected in the same way as it is affected by taxes. In times of war there may be pressure to induce
individual to curtail consumption and to subscribe government loan. There can be other special
inducements offered, such as tax exemption, higher interest rates etc. to encourage people to invest
their money in public debts and thus refrain from consumption.

b) Effects on Investments – Production If the people buy government bonds by withdrawing

money from their industrial concerns, or by selling debentures and shares of industrial concerns or
financial institutions and even commercial banks subscribe to government securities out of funds
meant for investment or for accumulation of stocks. Then the investment is adversely affected, leading
to adverse effects on production. But if the government uses this money in some productive
enterprises, the total investments available for production may not be unfavorably affected. On the
contrary, if the government spends it on unproductive works the total investment may be adversely
affected, consequently with adverse effects on 40 production. If the loans are utilized productively, it
will increase the income of the community leading to an increase in consumption and there by, an
increase in production.

c) Effect on Distribution- If the public loans are subscribed by the rich people only and if the
government spends that amount on the economic welfare of the poor people, it will lead to narrowing
down of inequalities and will lead to an equal distribution of income among the people. But this will
not be possible if the burden of public debt along with interest payment falls on the poor people also.
But if the bond holders and tax payers are identical there would not be a redistribution of income. It
means that re-distribution of income will take place only if the tax payers and the bond holders belong
to the different groups. d)Effect on Economic Activity and Employment-

Public debt has its effects on the economic activities and employment situations in a country. One of
the aims of public debt should be to improve the economic activities and employment situations.
When public debts are incurred the quality of money in the hands of the people and their purchasing
power is curtailed which adversely affects the country’s price level and employment situations. Thus
public debt is one of the most effective means of controlling the inflationary trend of the economy.
In times of depression when the level of prices, production and consumption decreases, the
unemployment increases and the financial institutions are under stress, the government takes loan
and spends the money on development programmes. This will increase the 41 amount of money in
the hands of the people and improve economic activities and employment situation and the
depression will disappear.

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e)Effect on National Income- If the borrowed funds are spent on capital goods, it will accelerate
production and consequently cause a rise in national income. The increase in national income will be
high in proportion to the investment so made because there will be a multiple of the increment of
the investment due to multiplier effect.

f)Effect on Liquidity- Government securities are highly negotiable and highly liquid form of assets
which can be converted into money for any purpose and at any time. Commercial banks who posses
these securities can use them for their credit expansion. But in times of inflation the central bank
may resort to devices meant to restrict the credit control capacity of the commercial banks.

Q. What do you mean by Tax? What are the relative merits and demerits of direct and indirect taxes?
Discuss shifting of Tax.

A tax is a compulsory payment levied on the persons or companies to meet the expenditure incurred
on conferring common benefits upon the people of a country.

Two aspects of taxes follow from this definition:

(1) A tax is a compulsory payment and no one can refuse to-pay it.

(2) Proceeds from taxes are used for common benefits or general purposes of the State. In other
words, there is no direct quid pro quo involved in the payment of a tax.

This implies that an individual cannot expect or demand that the Government should render him a
specific service in return for the tax paid by him. However, this does not imply that Government does
nothing for the people from whom it receives taxes.

In fact Government spends the tax money for the general or common benefits of all the people
rather than conferring any special benefit on a particular tax payer. To quote Taussig, “The essence
of a tax, as distinguished from the other charges by Government is the absence of any direct quid
pro quo between the tax payer and the public authority.”

Tax should be carefully distinguished from a fee. Fee is also compulsory payment made by a person
who receives in return a particular benefit or service from the Government. For paying fee on a
television or radio, a person gets the benefits of programmes relayed by the Government on
television or radio. Likewise, students who pay the education fee in schools and colleges, obtain the
benefits of teaching arranged by the Government.

The amount of fee is always less than the cost of service rendered by the Government in return and
therefore covers only a part of the cost of service rendered. Thus, even in case of fee, there is a
general public interest or common benefit of the service rendered by the Government. In this case,
the Government undertakes a service for the common benefits of the citizens and obtains a fee from
those who avail of that service to cover a part of the cost of service rendered.

The merits and demerits of direct and indirect taxes on an economy.

Taxes may be classified as direct and indirect. Direct taxes are levied on a person’s or a firm’s income
or wealth and indirect taxes on spending on goods and services. Thus, direct taxes are paid directly
by the person or firm on whom the assessment is made, while indirect taxes are paid indirectly by
consumers in the form of higher prices. Direct taxes cannot be legally evaded but in direct taxes can
be avoided because people can reduce their purchases of the taxed goods and services.

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Direct Taxes

Definition of Direct Tax: A direct tax is referred to as a tax levied on person’s income and wealth and is
paid directly to the government, the burden of such tax cannot be shifted. The tax is progressive in
nature i.e. it increases with an increase in the income or wealth and vice versa. It levies according to
the paying capacity of the person, i.e. the tax is collected more from the rich and less from the poor
people. The tax is levied and collected either by the Central government or State government or the
local bodies.

The plans and policies of the Direct Taxes are being recommended by the Central Board of Direct
Taxes (CBDT) which is under the Ministry of Finance, Government of India.

There are several types of Direct Taxes, such as: Income Tax; Wealth Tax; Property Tax; Corporate
Tax; Import and Export Duties.

Advantages:

(i) It is easy to determine the incidence of the tax – a person or institution who actually pays and
suffers the burden of tax.

(ii) Direct taxes tend to be progressive – people in the higher income group pay a greater
percentage than poorer people, e.g., income tax is graduated so that high income earners pay a larger
percentage; also a selective wealth tax would only apply to those owning more than a certain level of
wealth.

(iii) Direct taxes are easy to collect. Consider, for example, the PAYE system which is used to collect
income tax from most wage and salary earners.

(iv) Direct taxes are important to the government’s economic policy. If the government is fighting
inflation it can impose, for example, high levels of income tax to restrict consumer demand. If the
government is concerned about unemployment it can reduce the levels of income tax to increase
consumer demand and increase production.

Disadvantages:

(i) Direct taxation may be a disincentive to hard work. High rates of income tax, for example, may
discourage people from working overtime or trying to gain promotion at work. Some economists
blame the ‘brain drain’ (i.e., the emigration of highly qualified persons, such as scientists and
doctors) on India’s high levels of taxation.

(ii) Direct taxation discourage savings because, after paying tax, individuals and companies have less
income available to save. This means that investment, which relies on the level of savings, is low
and this could cause less production and employment.

(iii) This type of taxation encourages tax evasion – to avoid paying so much tax.

(iv) There is no element of choice about paying the tax – it is unavoidable.

Indirect taxes
Definition of Indirect Tax: Indirect Tax is referred to as a tax charged on a person who consumes the
goods and services and is paid indirectly to the government. The burden of tax can be easily shifted

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to the another person. The tax is regressive in nature, i.e. as the amount of tax increases the demand
for the goods and services decreases and vice versa. It levies on every person equally whether he is
rich or poor. The administration of tax is done either by the Central Government or the State
government.

There are several types of Indirect Taxes, such as: Central Sales Tax; VAT (Value Added Tax); Service
Tax; STT (Security Transaction Tax); Excise Duty; Custom Duty; Agricultural Income Tax.

Advantages:

(i) Indirect tax is fairly easy to collect.

(ii) It is easy to determine the incidence of an indirect tax.

(iii) The government can use it to discourage certain types of consumption. A high rate of tax on
tobacco can, for example, affect smoking habits.

(iv) Indirect taxation is a good way of raising revenue when levied on goods with an inelastic demand,
such as necessities.

(v) Tourists do not pay income tax. But they spend money on goods and services. This adds to the tax
revenue of the government.

(vi) Consumers have a choice as to whether they pay the tax. They can avoid paying the tax by not
consuming the goods which are being taxed.

(vii) Indirect taxes do not have a discentive effect on work.

Disadvantages:

(i) Indirect taxes are regressive. A regressive tax is one which causes a poor person to pay a higher
percentage of his or her income as tax than a rich person. For instance, the tax ingredient of the price
of a new television set would be the same for the poor and the rich person, but as a percentage of the
poor person’s income, it is far greater.

(ii) These taxes are not impartial. In recent years, certain groups of consumers have complained
that they are being heavily penalised by taxation, e.g., drinkers, smokers and drivers.

(iii) Indirect taxes may contribute to inflation. The imposition of an indirect tax on an item like
petrol will increase its price. Since petrol is an essential input in a large number of industries, this may
set off an inflationary spiral. Moreover, trade unions demand higher wages to maintain the real
incomes of workers.

SHIFTING OF TAX

Forward tax shifting – This refers to shifting the tax burden to the consumer through increase in
selling prices. For instance when the government increases the amount of tax levied on products
such as beer or cigarettes companies increase prices of these goods.

Backward shifting – This occurs when a producer of a taxed commodity transfers the money burden
of tax to the supplier of factors of production, who in turn is paid a lower price for the factors of
production. E.g. farmers are at times paid lower prices for their produce when a tax is imposed on
the processor of the produce.

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 Factors determining tax shifting:

(i) Elasticity of demand and supply – The more the elasticity, the lower the incidence on the sales.
The higher the incidence on supply.

(ii) Nature of markets: In an oligopolistic market (i.e sellers and many buyers) tax shifting to
buyers is high since few sellers can team up to determine the market price. In a situation where there
are many buyers and sellers, a large portion of tax will be borne by sellers. For a monopolistic market,
the entire tax burden falls on the shoulders of the buyer.

(iii) Government policy on pricing: In the case of government price control, the supplier cannot
increase prices hence cannot shift tax burden to buyers and vice versa.

(iv) Geographical location: If taxes are imposed on certain regions, it is hard to shift them to
consumers because consumers' will move to regions with low taxes.

(v) Nature of tax (direct or indirect tax): Direct tax eg PAYE cannot be shifted whatsoever while
indirect taxes can be shifted through increase in prices.

vi) Rate of tax: If too high, shifting can occur backwards or forwards, if too low, it may be absorbed
by the manufacturer.

(vii) Time available for adjustment: The person who can adjust faster (buyer or seller) will be able to
shift tax e.g if the buyer cash shift to substitute goods, the seller will bear the tax burden. (viii) The
tax point

Q. Distinguish between direct and indirect taxes.

1. The tax, which is paid by the person on whom it is levied is known as the Direct tax while the
tax, which is paid by the taxpayer indirectly is known as the Indirect tax. The direct tax is levied
on person’s income and wealth whereas the indirect tax is levied on a person who consumes
the goods and services.

2. The burden of the direct tax is transferable while that of indirect tax is non-transferable.

3. the incidence and impact of direct tax falls on the same person, but in the case of indirect tax,
the incidence and impact falls on different [persons.

4. The evasion of tax is possible in case of a direct tax if the proper administration of the
collection is not done, but in the case of indirect tax, the evasion of tax is not possible since
the amount of tax is charged on the goods and services.

5. The direct tax is levied on Persons, i.e. Individual, HUF (Hindu Undivided Family), Company,
Firm, etc. On the other hand, the indirect tax is levied on the consumer of goods and services.

6. The nature of a direct tax is progressive, but the nature of the indirect tax is regressive.

7. Direct tax helps in reducing the inflation, but the indirect tax sometimes helps in promoting
the inflation.

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 8. Direct tax is collected when the income for the financial year is earned or the assets are valued
at the date of valuation. As against this, the indirect taxes are collected, when the purchase or
sale of goods or services are rendered.

9. Direct tax is imposed on and collected from the assessee. Unlike indirect tax is imposed on
and collected from consumer but deposited to the exchequer by the dealer of goods or
provider of services.

Q. Discuss Taxable Capacity.

The concept of taxable capacity has been defined differently by different economists. In the words
of Sir Josiah Stamp: "Taxable capacity is that maximum amount which the community is in a position
to bear towards the expenses of public authorities without having a really unhappy and!
downtrodden existence and without dislocating the economic, organization too much".

According to Findlay Shiraz: "It is the optimum tax ability of a nation, the maximum amount of
taxation that can be raised and spent on the economic welfare in that community".

Dalton calls it a dim and "contused conception". He writes in his book "Principles of Public Finance":

"Absolute taxable capacity is a myth and should be banished from all serious discussions of public
finance".

For the various definitions of taxable capacity given by eminent writers on Public Finance, we gather
that by taxable capacity is meant the maximum amount which a nation can contribute towards the
support of the government without inflicting damage on the power and will to produce.

The amount of tax burden which the citizens of a country are ready to bear is not rigidly fixed. It can
increase or decrease with a change in the distribution of wealth, the size of population, method of
taxation, etc. etc.

In other words, we can say that the limit of taxable capacity is a relative and not an absolute
quantity.

Factors of Taxable Capacity

(i) The size of population: Taxable capacity is very much affected by the increase in national
income and by the rate of growth in population. If the increase in national income is greater than the
growth in population, the par capita income goes up. The taxable capacity of the individuals rises. If
the rate of growth of population is higher than the national income, the taxable capacity decreases.

(ii) The distribution of national income: Taxable capacity is also influenced by the distribution of
national income within a country. If there is unequal distribution of wealth in the country, the taxable
capacity of the nation will be high, but if the income is equally distributed, then the taxable capacity
will be low. A man earning an income of $50,000 a month is able to pay more to the government than
thirty persons earning $300 per month.

(iii) Character of taxation: If taxes are devised wisely, then they give less resentment from people
and bring forth a large yield.

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(iv) Purpose of taxation: Purpose of taxation has a direct bearing on taxable capacity of a nation.
If citizens of country are satisfied with purpose. of taxation i.e., the increase in welfare of people, then
they show greater willingness to pay taxes to government. Whereas, if they find that revenue will be
spent for unproductive purposes, they hesitate to pay taxes.

We conclude, therefore, that if state spends revenue for purposes such as education, sanitation,
fighting for famine, diseases, etc., then taxable capacity of nation expands to its utmost and if
revenue is spent for unproductive purpose like war, then taxable capacity shrinks.

(v) Psychological factor: Psychological factor, is a very important factor in determining taxable
capacity of a nation. If people are satisfied that government is doing its utmost to raise standard of
living of masses and in maintaining prestige of country, then they try to sacrifice their lives what to
say of money for the government. A simple approach to patriotism brings forth tons of gold.

(vi) Standard of living of people: If standard of living of people is high, they work more efficiently
so that they may enjoy a still better standard of living. When they work enthusiastically, they receive
higher wages from their employers. Taxable capacity tends to increase then.

(vii) Effect of inflation: If country is in grip of inflation, purchasing power of people is reduced,
taxable capacity of nation shrinks considerably. But if value of money is high and country is not faced
with unemployment, then taxable capacity of people is quite high.

Conclusion: We have discussed above various factor on which taxable capacity of a nation depends.
We cannot single out any factor and say that taxable capacity is determined solely by this factor
alone. The fact is that various factors influence taxable capacity and we have to take them all into
consideration while judging maximum amount which citizens of a country can pay. We cannot deny
this fact that it is quite difficult to measure taxable capacity. But this does not mean we should not
make an attempt because it is beset with many difficulties.

Q. Define “Deficit Finance”. In what circumstances does the government resort to ‘deficit
financing’? What role does it play in a developing economy? Discuss its merits and demerits on
economy.

Meaning of Deficit Financing: Deficit financing in advanced countries is used to mean an excess of
expenditure over revenue—the gap being covered by borrowing from the public by the sale of bonds
and by creating new money. In India, and in other developing countries, the term deficit financing is
interpreted in a restricted sense.

The National Planning Commission of India has defined deficit financing in the following way. The
term ‘deficit financing’ is used to denote the direct addition to gross national expenditure through
budget deficits, whether the deficits are on revenue or on capital account.

The essence of such policy lies in government spending in excess of the revenue it receives. The
government may cover this deficit either by running down its accumulated balances or by borrowing
from the banking system (mainly from the central bank of the country).

Purpose of deficit financing There are some situations when deficit financing becomes absolutely
essential. In other words, there are various purposes of deficit financing.

1. To finance war:- Deficit financing has generally being used as a method of financing war
expenditure. During the war time through normal methods of raising resources. It becomes
difficult to mobilize adequate resources. Therefore government has to adopt deficit financing.

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2. Remedy for depression :- In developed countries deficit financing is used as on instrument of
economic policy for removing the conditions of depression. Prof. Keynes has also advocated for
deficit financing as a remedy for depression and unemployment.

3. Economic development:- The main objective of deficit financing in an under developed country
like India is to promote economic development. The use of deficit financing in fact becomes
essential for financing the development plan especially in underdeveloped countries.

4. Mobilization of Resources :- deficit financing is also used for the mobilization of surplus, ideal and
unutilized resources in the country.

5. For granting subsidies :- In a country like India government grants subsidies to the producers to
encourage them to produce a particular type of commodity, granting subsidies is a very costly
affair which we cannot meet with the regular income this deficit financing becomes must for it.

6. Increase in aggregate demand :- Deficit financing loads to increase in aggregate demand through
increased public expenditure. This increase the income and purchasing power of the people as a
consequence there is an increase availability of goods and services and the production and
employment level also increase.

7. For payment of interest:- Loan which are taken by the govt. are supposed to be repaid with their
interest for that government needs money deficit financing is an important tool to get the income
for the repayment of loan along with the interest.

8. To overcome low tax receipts.

9. To overcome the losses of public sector enterprises

10. For implementing anti poverty programme.

Effects of Deficit Financing: Deficit financing has several economic effects which are interrelated in
many ways:

1. Effect on Price Level: Deficit financing as defined by Indian planning commission involves the net
addition to money supply in the economy. Increased government expenditure made possible by
deficit financing generates, additional purchasing power to the people in the form of wages, rent,
interest payment; profit etc.

This in turn raises the demand for the goods and services. In the absence of a matching increase,
“aggregate supply of goods and services deficit financing leads to rise in gene al price level.” This
happens during the time of war.

However surprise that deficit financing is used for development activities, which in turn produce
more goods and services in future. In such situation inflationary impact of deficit financing is
neutralized by corresponding increase in output. But usually a time lag creeps between investment
made and output realized.

During this gap inflationary rise in price occur. Prof. W. A. Lewis visualizes a three stage impact of
deficit financing in an economy. In the first stage, by using deficit financing, capital goods industry is
developed and created.

Since there exist a long gestation period in the investment in capital goods industry, price rise
sharply. In the second stage, the rise in price, force the people to reduce their consumption. This

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result in forced saving and thereby enhance investment. In the third stage the initial capital
formation materialized in the 1st stage, starts generating production of consumer goods to the
market which help to reduce price level.

Therefore Lewis argues that deficit financing is dangerous and painful only in the first stage. Its
inflationary potential is therefore self-destructive. This may be true but when deficit financing cross
the safe limit, it leads to cost push inflation that is often considered as a tonic to economic
development.

In this context, Sir T. T Krishnamachary, the former Finance Minister of India rightly pointed out that
“deficit financing is a medicine to be taken in small dose; it is not a food that would sustain the
system”. Therefore government should take necessary steps to ensure reasonable rises in price.

2. Effect on Employment: Prof. J.M. Keynes argues that the root cause of unemployment in a
developing economy is the deficiency in effective demand.

Therefore Keynes suggested public expenditure, financed through deficit financing, as an instrument
to increase effective demand and remove unemployment during dispersion. For this he proposed
the implementation of public works programme, which may inject additional purchasing power in
the hand of the people and increase the level of effective demand.

Through multiplier effect, this will further increase employment and correspondingly the effective
demand of the community. During period of 1930’s depression, countries like USA and UK resorted
to deficit financing to fight the problem of massive unemployment. However Keynes analysis does
not hold good in a developing economy.

His analysis is based on two conditions. The multiplier effect of deficit financing on employment
depends on two conditions. They are:

(a) Existence of excess capacity in industrial as well as agricultural sector, and

(b) Relative elastic supply of working capital. However these two conditions are non- existent in
developing economics.

Therefore deficit financing is ineffective in fighting the unemployment problem of developing

economies owing to the absence of the two conditions. Moreover factors like market imperfections
lack of entrepreneurship infra-structure bottlenecks etc., obstruct the effective functioning of deficit
financing as a tool to fight unemployment.

3. Effect on Distribution of Income: Deficit financing adversely affects the distribution of income.
Deficit financing is inflationary in character. Hence deficit financing and inflation affect different
sections of the society differently.

The business classes will be benefitted out of rise in price and increased profit earnings. On the
contrary wage earners and fixed income group suffer on account of reduction in purchasing power
resulting from sharp rise in price and decreased value of money. As a result inequality in the
distribution of income increases.

A redistribution of income take place in favour of the industrial and business class during periods of
price rise resulting from deficit financing. Therefore deficit financing is fundamentally against the
principle of equitable distribution of income.

However if deficit financing is used for financing development plans, this will accelerate production
and productivity in the economy. So in the long run deficit financing will not generate any adverse

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effect upon the economy. Therefore deficit financing will be a useful instrument of development
finance if it is judiciously employed.

Advantages and Disadvantages of Deficit Financing:

The most easiest and the popular method of financing is the technique of deficit financing. That is
why it is the most popular method of financing in developing countries.

Advantages

Firstly, massive expansion in governmental activities has forced governments to mobilize resources
from different sources. As a source of finance, tax-revenue is highly inelastic in the poor countries.
Above all, governments in these countries are rather hesitant to impose newer taxes for the fear of
losing popularity. Similarly, public borrowing is also insufficient to meet the expenses of the state.

As deficit financing does not impinge any trouble either to the taxpayers or to the lenders who lend
their surplus money to the government, this technique is most popular to meet developmental
expenditure. Deficit financing does not take away any money from anyone’s pocket and yet provides
massive resources.

Secondly, in India, deficit financing is associated with the creation of additional money by borrowing
from the Reserve Bank of India. Interest payments to the RBI against this borrowing come back to
the Government of India in the form of profit. Thus, this borrowing or printing of new currency is
virtually a cost-free method. On the other hand, borrowing involves payment of interest cost to the
lenders.

Thirdly, financial resources (required for financing economic plans) that a government can mobilize
through deficit financing are certain and known beforehand. The financial strength of the
government is determinable if deficit financing is made. As a result, the government finds this
measure handy.

Fourthly, deficit financing has certain multiplier effects on the economy. This method encourages the
government to utilize unemployed and underemployed resources. This results in more incomes and
employment in the economy.

Fifthly, deficit financing is an inflationary method of financing. However, the rise in prices must be a
short run phenomenon. Above all, a mild dose of inflation is necessary for economic development.
Thus, if inflation is kept within a reasonable level, deficit financing will promote economic
development —thereby neutralizing the disadvantages of price rise.

Finally, during inflation, private investors go on investing more and more with the hope of earning
additional profits. Seeing more profits, producers would be encouraged to reinvest their savings and
accumulated profits. Such investment leads to an increase in income—thereby setting the process of
economic development rolling.

(b) Disadvantages/ Adverse Effects Of Deficit Financing

Deficit financing is not free from its defects. It has its adverse effect on economy. Important evil
effects of deficit financing are given below.

1. Leads to inflation :- Deficit financing may lead to inflation. due to deficit financing money
supply increases & the purchasing power of the people also increase which increases the aggregate
demand and the prices also increase.

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2. Adverse effect on saving:- Deficit financing leads to inflation and inflation affects the habit of
voluntary saving adversely. Infect it is not possible for the people to maintain the previous rate of
saving in the state of rising prices.

3. Adverse effect on Investment :- deficit financing effects investment adversely when there is
inflation in the economy trade unions make demand for higher wages for that they go for strikes and
lock outs which decreases the efficiency of Labour and creates uncertainty in the business which a
decreases the level of investment of the country.

4. Inequality :- in case of deficit financing income distribution becomes unequal. During deficit
financing deflationary pressure can be seen on the economy which make the rich richer and the poor,
poorer. The fix wage earners are badly affected and their standard of living deteriorates thus no gap
b/w rich & poor increases.

5. Problem of balance of payment :- Deficit financing leads to inflation. A high price level as
compared to other countries will make the exports more expensive and thus they start declining. On
the other hand rise in domestic income and price may encourage people to import more commodities
from abroad. This will create a deficit in balance of payment and the balance of payment will become
unfavorable.

6. Increase in the cost of production :- When deficit financing leads to the rise in the price level
the cost of development projects also rises this means a larger dose of deficit financing is required on
the port of government for completion of these projects.

7. Change in the pattern of investment:- Deficit financing leads to inflation. During inflation
prices rise and reach to a very high level in that case people instead of indulging into productive
activities they start doing speculative activities.

Q. Briefly discuss the canons of public expenditure/ Principles of Public Expenditure. What are the
causes of rapid growth of public expenditure in the recent years?

There are several principles suggesting maximization of gains of public expenditure. These principles
are called canons of public expenditure.

1. Canon of Benefit: According to Prof. Findlay Shirra's public expenditure should bring with it
important social advantages such as increased production, equitable distribution, social justice and
maximum social welfare.

Canon of Benefit is the fundamental canons of public spending. According to this canon public
money should be spent so as to promote Maximum Social Advantage (MSA). Every expenditure
should be directed to achieve maximum social advantage to the community.

Benefits from public expenditure may be identified with achievement of proper allocation of
economic resources, proper distribution of income and wealth in society and stability of price level
and growth of economy.

According to this principle “public expenditure in every direction must be carried just so far, that the
advantage to the community of a further small increase in any direction is just counter balanced by
the disadvantage of a corresponding small increase in taxation or in receipts from any other source
of public income”.

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This canon implies that public expenditure should be planned in such a way as to yield maximum
social advantage and social welfare to the community as a whole and not to a particular group of the
community.

2. Canon of Economy: It implies that public expenditure should be incurred carefully and
economically. Economy here means avoidance of extravagance and wastages in public spending.
Public expenditure must be productive and efficient.

Hence, it must be incurred only on very essential items of common benefit, without duplication, in a
way that involves minimum cost. An efficient system of financial administration is, therefore, very
essential in any country.

3.Canon of Sanction: Another important principle of public expenditure is that before it is actually
incurred, it should be sanctioned by a competent authority. Unauthorized spending is bound to lead
to extravagance and over-spending. It also means that the amount must be spent on the purpose
for which it was sanctioned. As a rule, therefore, money must be spent on the purpose for which it is
sanctioned by the highest authority and accounts be properly audited.

4. Canon of Surplus: Findlay Shirras states “ Other things being equal, public expenditure should
be made in such a way that society gets major benefits which, in turn, may increase production,
protect against external aggressions maintain the internal order, and may possibly reduce the
economic inequalities.”

This canon suggests that saving is a virtue even for the government, so an ideal budget is one which
contains an element of surplus by keeping public expenditure below public revenue. In other words,
it means that the government should avoid deficit budgeting in the interest of its own
creditworthiness.

5. Canon of elasticity: Another same principle of public expenditure is that it should be fairly
elastic. It should be possible for public authorities to vary the expenditure according to the needs. A
rigid level of expenditure may prove a source of trouble and embarrassment in bad times. Alteration
in the upward direction is not difficult. But elasticity is needed most in the downward direction. It is
not so easy to cut down expenditure. When the economy axe is applied, it is a very painful process.
Retrenchment of a widespread character creates serious social discontent. Perfect elasticity is out of
question. But a fair degree of elasticity is essential if financial breakdown is to be avoided at the time
of shrinking revenue.

6.Canon of Productivity: Public expenditure should stimulate productivity. Public expenditure should
be made in such a way that it fosters capital formation and generated employment opportunities
along with increases levels of productivity and employment opportunities.

7. Canon of Equitable Distribution: Public expenditure should help equitable distribution of wealth.
The government should make expenditure so as to provide more benefit to the backward section
of the society.

8. Canon of Certainty: The areas in which public expenditure is to be made should be certain so that
the development works may be carried out properly. The government should determine with
certainty the allocation of public expenditure to various uses.

9. Canon of Co-ordination: The items and amounts on which public expenditure is to be made by
central, state and local self governments should be clearly demarcated. There should be proper
coordination among different governments so that dual expenditure on same item can be avoided.

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10. Miscellaneous: Some other canons are:

i. While making expenditure various works should be given priority according to their relative
importance.

ii. Mode of expenditure should also be kept in mind.

iii. Both short term and long term effects of public expenditure should be kept in mind

iv. While making public expenditure, population of the country, its area, its physical resources etc.
should be kept in mind.

Causes of Rapid Growth of Public Expenditures

1. Income Elasticity and Increase in Per Capita Income: According to Musgrave, a rising share of
public expenditure in national income is associated with a rise in per capita income.

Thus, an increase in per capita income over a period of time may cause a relative rise in public
expenditure. This is because the demand for public goods tends to expand with the rise in per capita
income. Usually, it rises faster than the latter. Hence, the income elasticity of public expenditure
(IEPE) for the U.S.A. was 4.8 for the period 1890-1963 and 4.5 for the U.K. in 1890-1955.

2. Welfare State Ideology and Wagner’s Law: The modern State is a welfare state. It aims at
promoting the economic, political, and social well-being of its citizens. It makes every effort to improve
the living standard of the common people. For this purpose, it has to undertake may functions and
services never visualized before.

Even in an avowedly capitalistic economy, there has been increasing State intervention through
legislative and administrative measures for augmenting production and improving distribution. Many
wants which were formerly satisfied individually by private means are now satisfied collectively
through public expenditure.

In the classical era, the State was assumed to have a very limited function under the laissez faire
policy. The functions of the State were restricted to justice, police, and army.

Today, however, the role of the State has changed under the welfare criterion and there is a
persistent trend towards an extensive and intensive increase in the scale of governmental
performance. Apart from performing old functions more efficiently and on a larger scale, a modern
State constantly undertakes new functions and added responsibilities day by day.

It now embraces many new ideas such as social insurance, unemployment relief, and provisions for
underprivileged classes. In order to reduce inequalities of income, the State has to spend a large sum
on free and cheap medical aid, subsidized food and housing, free education. Especially in
underdeveloped countries such as India, the State expenditure on these social services is rising fast.

In India, for instance, expenditure on social service is rising fast. In India, for instance, expenditure on
social services has gone up from Rs. 419 crores in the First Plan to Rs. 2,772 crores in the Fourth Plan.
In the Seventh Plan, it was envisaged to be Rs. 29,350 crores.

Fundamentally, public expenditure in modern times shows an increasing trend on account of the
“ever- increasing scale of State activity”. This tendency, in economic literature, is known as
“Wagner’s law of increasing expansion of State activities”.

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3. Effects of War and the Need for Defence: The tremendous growth in public expenditure may
also be attributed to wars and threats of war in modern times. In the Second World War, countries
like England incurred heavy war expenditures, amounting to £ 15 million per day. Wars and threats of
war and the consequent defence needs compel governments to spend more and more on the
production of war goods.

Due to the invention of nuclear weapons, there is always the danger of foreign aggression.
International political situation is uncertain and insecure. Modern States are already facing a cold
war. As such, every nation has to prepare itself for strong defence.

The defence expenditure is thus continuously rising. It contains expenditure on war materials,
maintenance and growth of armed forces, naval and air wings, expenses on the development of
military art and practice, pensions to retired war personnel, interests on war debt, cost of
rehabilitation, etc.

Peacock and Wiseman have referred to the ‘displacement effect’ in the post-war period when higher
taxes and higher revenue collection drive of the war period are continued by the government,
finding them easy and attractive. The displacement effect may further be supplemented by a ‘scale
hypothesis’, i.e., adoption of new social welfare schemes by the government on a permanent basis.

4. Resource Mobilization and Ability to Finance: When the government innovates more and
more methods of taxation and resource mobilization, its ability to finance public expenditure increases
and the size of public expenditure grows. Public sector outlays could be increased by more taxation
yields, public debt, foreign aid and deficit financing.

5. Inflation: With the rising prices, the government has to keep on increasing public expenditure
to carry out its functions and maintain the supply of public goods intact. During inflation, the
government has to pay additional DA to its employees which obviously call for an extra burden on
public expenditure.

6. The Role of Democracy and Socialism: The recent growth of democracy and socialism
everywhere in the world has caused public expenditure to increase very much. A democratic structure
of government is inevitably more expensive than a totalitarian government. In India, democracy has
certainly become a costly affair. Expenditure on elections and bye-elections is increasing.

The number of ministries and executive offices has also been increasing. Further, the ruling party has
to fulfill its promises and launch upon new policies and programmes to achieve socialist objectives,
in order to create a favorable image in the public. This also requires increasing State expenses in
order to provide new amenities and opportunities to the people at large.

7. The Urbanization Effect: 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 these days. Likewise, the expenditure on courts, prisons etc. is increasing, especially in
the urban sector.

8. The Rural Development Effect: In an underdeveloped country, the government has also to
spend more and more for rural development. It has to undertake schemes like community
development projects and other social measures.

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9. The Population Effect: A high growth of population naturally calls for increase in the expenses
as all State functions are to be performed more extensively. Rising population also poses various
problems in poor countries.

The State will have the added responsibility of solving such problems as food, unemployment,
housing and sanitation. Further, overpopulated countries like India will have to check the population
growth. The State has, therefore, to spend more and more on family planning campaigns every year.

10. The Growth of Transport and Communication: With the expansion of trade and commerce,
the State has to provide and maintain a quick and efficient transport system. Transport being a public
utility, the State has to provide it cheaply also. Hence, railway and passenger transport is nationalised.

Government has, therefore, to run transport services even at a loss. This obviously calls for a high
expenditure for maintenance and expansion. Further, the government in a poor country has to
spend a lot on constructing new railway lines, new roads, national highways, bridges and even canals
to connect the different areas with a smooth transport system as a precondition of growth.

11. The Planning Effect: In a less developed economy, the government adopts economic planning
for the development of the country. In a planned economy, thus, when the public sector is expanding
its role, public expenditure obviously shows an increasing trend.

In India, for instance, the public sector outlay during the First Five Year Plan was just Rs. 1,960
crores, which is now estimated at Rs. 2, 47,865 crores during the Eighth Plan period (1992-97).

Q. Discuss the principles of Maximum Social Advantage of Public expenditure. Also discuss the
objectives of Public debt.

The fiscal or budgetary operations of the state have manifold effects on the economy. The revenue
collected by the state through taxation and the dispersal of public expenditures can have significant
influence on the consumption, production and distribution of the national income of the country.

The fiscal operations of the government resolve themselves into a series of transfers of purchasing
power from one section of the community to another, along with the variations in the total incomes
available in the community. In fact, the fiscal activities of the state affect the allocation of resources,
the use of resources from one channel to another, hence, the level of income, output and
employment.

Hence, it is desirable that some standard or criterion should be laid down to judge the
appropriateness of a particular operation of public finance — the government’s revenue and
expenditures. In a modern welfare state, such a criterion can obviously be nothing else but the
economic welfare of the people.

It follows, thus, that the particular financial activity of the state which leads to an increase in
economic welfare is considered as desirable. It may be considered as undesirable if such an activity
does not cause an increase in the welfare or even sometimes, it may be the cause of a reduction in
the general economic welfare. The guiding principle of state policy has been technically desirable as
the Principle of Maximum Social Advantage by Hugh Dalton.

According to Dalton, the principle of maximum social advantage is the most fundamental principle
lying at the root of public finance. Hence, the best system of public finance is that which secures the
maximum social advantage from its fiscal operations. Maximum social advantage is the maxim for

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the states. The optimum financial activities of a state should, therefore, be determined by the
principle of maximum social advantage.

It is obvious that taxation by itself is a loss of utility to the people, while public expenditure by itself
is a gain of utility to the community. When the state imposes taxes, some disutility or dissatisfaction
is experienced in the society. This disutility is in the form of sacrifice involved in the payment of taxes
— in parting with the purchasing power.

Similarly, when the state spends money, some utility is created in the society. Some satisfaction is
experienced by a group of people in the society on whom, or for whom, the public expenditure is
incurred by the state. This is the social benefit of welfare of the public expenditure.

As such, the maximum social advantage is achieved when the state in its financial activities maximize
the surplus of social gain or utility (resulting from public expenditure) over the social sacrifice or
disutility (involved in payment of taxes.) The principle of public finance, thus, requires the state to
compare the sacrifice and benefits of the society in its fiscal operations.

The principle of maximum social advantage implies that public expenditure is subject to diminishing
marginal social benefits and taxes are subject to increasing marginal social costs. Thus, an
equilibrium is reached when social advantage is maximized, i.e., when the size of the budget is such
that marginal social benefits of public expenditures are equal to the marginal social sacrifice of
taxation.

Dalton states, “Public expenditure in every direction should be carried just so far, that the
advantages to the community of a further small increase in any direction is just counter-balanced by
the disadvantage of a corresponding small increase in taxation or in receipts from any other sources
of public expenditure and public income.”

Thus, a rational state seeks to maximize the net social advantage of its fiscal operations. The social
net advantage is maximum when the aggregate social benefits resulting from public expenditure is
maximum and the aggregate social sacrifice involved in raising the public revenue is minimum.
According to the principle of maximum social advantage, thus, the public expenditure should be
carried on up to the marginal social sacrifice of the last unit of rupee taxed.

Diagrammatic Representation: In technical jargon, the maximum social net advantage is achieved
when the marginal social sacrifice (disutility) of taxation and the marginal social benefit (utility) of
public expenditure are equated. Thus, the point of equality between the marginal social benefit and
the marginal social sacrifice is referred to as the point of aggregate maximum social advantage or
least aggregate social sacrifice.

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The equilibrium point of maximum
social advantage may as well be
illustrated by means of a diagram, as in
Fig. 1.

In Fig. 1, MSS is the marginal social

sacrifice curve. It is an upward sloping
curve implying that the social sacrifice
per unit of taxation goes on increasing
with every additional unit of money
raised. MSB is the marginal social
benefit curve. It is a downward sloping
curve implying that the social benefits
per unit diminishes as the public
expenditure increases.

The curves MSS and MSB intersect at point P. This equality (P) of MSS and MSB curves is regarded as
the optimum limit of the state’s financial activity. It is easy to see that so long as the MSB curve lies
above the MSS curve, each additional unit of revenue raised and spent by the state leads to an
increase in the net social advantage.

This beneficial process would then be continued till marginal social sacrifice (MSS) becomes just
equal to the marginal social benefit (MSB). Beyond this point, a further increase in the state’s
financial activity means the marginal social sacrifice exceeding the marginal social benefit, hence the
net social loss.

Thus, only under the condition of MSS = MSB, the maximum social advantage is achieved.
Diagrammatically, the shaded area APB (the area between MSS and MSB curves, till both intersect
each other) represents the quantum of maximum social advantage. OQ is the optimum amount of
financial activities of the state.

Further, the ideal of maximum social advantage is attained by the state, if the following principles of
financial operation are followed in the budget.

1. Taxes should be distributed in such a way that the marginal utility of money sacrificed by all the tax-
payers is the same.

2. Public spending is done, such that benefits derived from the last unit of money spent on each item
becomes equal.

3. Marginal benefits and sacrifices must be equated.

To sum up, all fiscal operations, both as regards revenue and expenditure, should be treated as a
series of transfer of purchasing power that must ultimately increase the economic welfare of the
people. In this context, Dalton enunciated the principle of maximum social advantage and asserted
that financial operations of the government must be in accordance with this principle in a welfare
state.

Objectives of Public Debt

In India, most government debt is held in long-term interest bearing securities such as national
savings certificates, rural development bonds, capital development bonds, etc. In industrially

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advanced countries like the U.S.A., the term government or public debt refers to the accumulated
amount of what government has borrowed to finance past deficits.

In such countries the government debt has a very simple relationship to the government deficit the
increase in debt over a period (say one year) is equal to its current budgetary deficit. But, in India,
the term is used in a different sense.

The State generally borrows from the people to meet three kinds of expenditure:

(a) Public Debt to Meet Budget Deficit: It is not always proper to effect a change in the tax system
whenever the public expenditure exceeds the public revenue. It is to be seen whether the transaction
is casual or regular. If the budget deficit is casual, then it is proper to raise loans to meet the deficit.
But if the deficit happens to be a regular feature every year, then the proper course for the State
would be to raise further revenue by taxation or reduce its expenditure.

(b) Public Debt to Meet Emergencies like War: In many countries, the existing public debt is, to
a great extent, on account of war expenses. Especially after World War II, this type of public debt had
considerably increased. A large portion of public debt in India has been incurred to defray the
expenses of the last war.

(c) Public Debt for Development Purposes: During British rule in India public debt had to be
raised to construct railways, irrigation projects and other works. In the post-independence era, the
government borrows from the public to meet the costs of development work under the Five Year Plans
and other projects. As a result the volume of public debt is increasing day by day.

The Burden of Public Debt

When a country borrows money from other countries (or foreigners) an external debt is created. It
owes its all to others. When a country borrows money from others it has to pay interest on such
debt along with the principal. This payment is to be made in foreign exchange (or in gold). If the
debtor nation does not have sufficient stock of foreign exchange (accumulated in the past) it will be
forced to export its goods to the creditor nation. To be able to export goods a debtor nation has to
generate sufficient exportable surplus by curtailing its domestic consumption.

Thus an external debt reduces society’s consumption possibilities since it involves a net subtraction
from the resources available to people in the debtor nation to meet their current consumption
needs. In the 1990s, many developing countries such as Poland, Brazil, and Mexico faced severe
economic hardships after incurring large external debt. They were forced to curtail domestic
consumption to be able to generate export surplus (i.e., export more than they imported) in order to
service their external debts, i.e., to pay the interest and principal on their past borrowings.

The burden of external debt is measured by the debt-service ratio which returns to a country’s
repayment obligations of principal and interest for a particular year on its external debt as a
percentage of its exports of goods and services (i.e., its current receipt) in that year. In India it was
24% in 1999. An external debt imposes a burden on society because it represents a reduction in the
consumption possibilities of a nation. It causes an inward shift of the society’s production
possibilities curve.

Q. Discuss meaning and objectives of fiscal policy.

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Meaning of Fiscal Policy: The fiscal policy is concerned with the raising of government revenue and
incurring of government expenditure. To generate revenue and to incur expenditure, the
government frames a policy called budgetary policy or fiscal policy. So, the fiscal policy is concerned
with government expenditure and government revenue.

Fiscal policy has to decide on the size and pattern of flow of expenditure from the government to the
economy and from the economy back to the government. So, in broad term fiscal policy refers to
"that segment of national economic policy which is primarily concerned with the receipts and
expenditure of central government." In other words, fiscal policy refers to the policy of the
government with regard to taxation, public expenditure and public borrowings.

The importance of fiscal policy is high in underdeveloped countries. The state has to play active and
important role. In a democratic society direct methods are not approved. So, the government has to
depend on indirect methods of regulations. In this way, fiscal policy is a powerful weapon in the
hands of government by means of which it can achieve the objectives of development.

Main Objectives of Fiscal Policy In India: The fiscal policy is designed to achieve certain objectives
as follows :-

1. Development by effective Mobilization of Resources: The principal objective of fiscal policy

is to ensure rapid economic growth and development. This objective of economic growth and
development can be achieved by Mobilization of Financial Resources.

The central and the state governments in India have used fiscal policy to mobilize resources.

The financial resources can be mobilized by :-

1. Taxation : Through effective fiscal policies, the government aims to mobilize resources by way
of direct taxes as well as indirect taxes because most important source of resource
mobilization in India is taxation.

2. Public Savings : The resources can be mobilized through public savings by reducing
government expenditure and increasing surpluses of public sector enterprises.

3. Private Savings : Through effective fiscal measures such as tax benefits, the government can
raise resources from private sector and households. Resources can be mobilized through
government borrowings by ways of treasury bills, issue of government bonds, etc., loans from
domestic and foreign parties and by deficit financing.

2. Efficient allocation of Financial Resources: The central and state governments have tried to
make efficient allocation of financial resources. These resources are allocated for Development
Activities which includes expenditure on railways, infrastructure, etc. While Non-development
Activities includes expenditure on defence, interest payments, subsidies, etc.

But generally the fiscal policy should ensure that the resources are allocated for generation of goods
and services which are socially desirable. Therefore, India's fiscal policy is designed in such a manner
so as to encourage production of desirable goods and discourage those goods which are socially
undesirable.

3. Reduction in inequalities of Income and Wealth: Fiscal policy aims at achieving equity or
social justice by reducing income inequalities among different sections of the society. The direct taxes
such as income tax are charged more on the rich people as compared to lower income groups. Indirect

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taxes are also more in the case of semi-luxury and luxury items, which are mostly consumed by the
upper middle class and the upper class. The government invests a significant proportion of its tax
revenue in the implementation of Poverty Alleviation Programmes to improve the conditions of poor
people in society.

4. Price Stability and Control of Inflation: One of the main objective of fiscal policy is to control
inflation and stabilize price. Therefore, the government always aims to control the inflation by
Reducing fiscal deficits, introducing tax savings schemes, Productive use of financial resources, etc.

5. Employment Generation: The government is making every possible effort to increase

employment in the country through effective fiscal measure. Investment in infrastructure has resulted
in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units
encourage more investment and consequently generates more employment. Various rural
employment programmes have been undertaken by the Government of India to solve problems in
rural areas. Similarly, self employment scheme is taken to provide employment to technically qualified
persons in the urban areas.

6. Balanced Regional Development: Another main objective of the fiscal policy is to bring about
a balanced regional development. There are various incentives from the government for setting up
projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax
holidays, Finance at concessional interest rates, etc.

7. Reducing the Deficit in the Balance of Payment: Fiscal policy attempts to encourage more
exports by way of fiscal measures like Exemption of income tax on export earnings, Exemption of
central excise duties and customs, Exemption of sales tax and octroi, etc.

The foreign exchange is also conserved by Providing fiscal benefits to import substitute industries,
Imposing customs duties on imports, etc.

The foreign exchange earned by way of exports and saved by way of import substitutes helps to
solve balance of payments problem. In this way adverse balance of payment can be corrected either
by imposing duties on imports or by giving subsidies to export.

8. Capital Formation: The objective of fiscal policy in India is also to increase the rate of capital
formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in
vicious (danger) circle of poverty mainly on account of capital deficiency. In order to increase the rate
of capital formation, the fiscal policy must be efficiently designed to encourage savings and discourage
and reduce spending.

9. Increasing National Income: The fiscal policy aims to increase the national income of a
country. This is because fiscal policy facilitates the capital formation. This results in economic growth,
which in turn increases the GDP, per capita income and national income of the country.

10. Development of Infrastructure: Government has placed emphasis on the infrastructure

development for the purpose of achieving economic growth. The fiscal policy measure such as taxation
generates revenue to the government. A part of the government's revenue is invested in the
infrastructure development. Due to this, all sectors of the economy get a boost.

11. Foreign Exchange Earnings: Fiscal policy attempts to encourage more exports by way of Fiscal
Measures like, exemption of income tax on export earnings, exemption of sales tax and octroi, etc.

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Foreign exchange provides fiscal benefits to import substitute industries. The foreign exchange earned
by way of exports and saved by way of import substitutes helps to solve balance of payments problem.

Conclusion On Fiscal Policy: The objectives of fiscal policy such as economic development, price
stability, social justice, etc. can be achieved only if the tools of policy like Public Expenditure,
Taxation, Borrowing and deficit financing are effectively used.

Though there are gaps in India's fiscal policy, there is also an urgent need for making India's fiscal
policy a rationalized and growth oriented one.

The success of fiscal policy depends upon taking timely measures and their effective administration
during implementation.

INTERNATIONAL TRADE
Q. What is free trade Policy. What are the advantages and disadvantages of free trade policy?

The concept of Free trade refers to a situation where there are no barriers in trade between two
countries. This not only helps both the nations, it also paves the way for cooperation and trade in
more areas and removing mistrust and ill will that is always there in an atmosphere riddled with
sanctions, tariffs and embargos. Free trade does not take place overnight and this is why nations are
entering into economic pacts and agreements to slowly and gradually remove all such artificial
tariffs. Free trade encourages transparency and healthy competition. Nations have come to realize
that others can be superior to them in production of certain goods and services while they can be
superior in other areas.

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To help nations of the world prosper through international trade, GATT has paved the way for World
Trade Organization that sets the guidelines for international trade and puts into place a robust
mechanism for the resolution of disputes between member countries.

Protection refers to policies, rules and regulations that help a nation place barriers in the form of
tariffs while trading with any other country. It is sometimes also a ploy by a country to safeguard the
interests of its domestic producers as cheap imported commodities tend to shut down factories
making that commodity inside the country. Though at times Protection is adopted to serve national
interests, there are times when countries cry foul as they face non economic tariffs. For example,
carpets made in India are world famous and India exports them to many countries including Europe
and the US. But suddenly US chose to place barriers in this trade citing use of child labor in the
manufacture of carpets in India.

One of the easiest ways to reduce imports of commodities is to raise the price of imports by putting
in place tariffs. This helps domestic producers as they remain competitive in the domestic markets.

Other ways of Protection are to place quota restrictions on commodities so that the quantity
entering the country is miniscule which does not affect local producers.

Free Trade Policy: it’s Advantages with Disadvantages!

Policy of non-interference by government in foreign trade is referred to as “free trade”. Free trade
policy implies absence of any artificial restriction on or obstacle to the freedom of trade of a country
with other nations.

According to Adam Smith, the term “free trade” is used to denote “that system of commercial policy
which draws no distinction between domestic and foreign commodities and, therefore, neither
imposes additional burdens on the latter, nor grants any special favour to the former.”

In other words, free trade implies complete freedom of international exchange. Under such a policy
there are no barriers to the movement of goods among countries and exchange can take its perfectly
natural course.

Classical economists like Adam Smith, Ricardo and others pleaded for free trade for the welfare of
the world.

Advantages of Free Trade

1. Comparative cost advantage: Free trade is the natural outcome of the comparative costs
advantage. It permits an allocation of resources, and manpower in accordance with the principle of
comparative advantage, which is just an extension of the principle of division of labour.

“The fact of free trade establishes an overwhelming presumption that the commodities obtained
from abroad in exchange for export are so obtained at lower cost than which the domestic
production of their equivalents would entail. If this were not the case, they would not be imported,
even under free trade,” says Jacob Viner.

It has been maintained that the gain from free international trade would be the largest due to
international specification based on comparative advantage. Free trade leads to the most efficient
conduct of economic affairs. In a plea for free trade, they also said that even if some countries do
not follow the policy of free trade, an industrial country should follow it unilaterally and it will gain
thereby.

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2. More factor earnings: Under free trade, factors of production will also be able to earn more,
as they will be employed for better use. Hence, wages, interest and rent will be higher under free
trade than otherwise.

3. Cheaper imports: Free trade procures import at cheap rates. It seems to be an attractive
argument in favour of trade at least from the customer’s point of view. However, it ignores the
question of employment and the interests of producers in the importing country. Here it has been
pointed out that under free trade, when consumers gain through lower prices producers also gain as
the factors of production are directed to more gainful and specialized production which gives better
earnings.

4. Enlarged market: Free trade widens the size of the market as a result of which greater
specialization and a more complex division of labour become possible. This brings about optimum
production with costs reduced everywhere, benefiting the world as a whole.

5. Competition: Free trade policy encourages competition from abroad which induces domestic
producers to become more alert and improve their efficiency.

6. Restricted exploitation: Free trade prevents growth of domestic monopolies and consumers’
exploitation due to competition from abroad.

7. Greater welfare: Free trade permits large varieties of consumption goods and improves
consumer’s welfare.

Haberler concludes that, “international trade has made a tremendous contribution to the
development of less developed countries in the nineteenth and twentieth century’s and can be
expected to make in the future if it is allowed to proceed freely.”

Arguments against Free Trade

Despite these virtues, several people justify trade restrictions. Following arguments are often cited
against free trade:

i. Advantageous not for LDCs: Firstly, free trade may be advantageous to the advanced
countries but not to the backward economies. Free trade has brought enough misery to the poor, less
developed countries, if past experience is any guide. India was a classic example of colonial
dependence of UK’s imperialistic power prior to 1947. Free trade principles have brought colonial
imperialism in its wake.

ii. Destruction of Home Industries/Products: Secondly, it may ruin domestic industries. Because
of free trade, imported goods become available at a cheaper price. Thus, an unfair and cut-throat
competition develops between domestic and foreign industries. In the process, domestic industries
are wiped out. Indian handicrafts industries suffered tremendously dining the British regime.

iii. Inefficiency becomes Perpetual: Free trade cannot bring all-round development of industries.
Comparative cost principle states that a country specializes in the production of a few commodities.
On the other hand, inefficient industries remain neglected. Thus, under free trade, an all-round
development is ruled out.

iv. Danger of Overdependence: Fourthly, free trade brings in the danger of dependence. A
country may face economic depression if its international trading partner suffers from it.

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The Great Depression that arose in 1929-30 in the US economy swept all over the world and all
countries suffered badly even if their economies were not caught in the grip of the then Depression.
Such overdependence following free trade also becomes catastrophic during war.

v. Penetration of Harmful Foreign Goods: Finally, a country may have to change its consumption
habits. Because of free trade, even harmful commodities (drugs, etc.,) enter the domestic market. To
prevent such, restrictions on trade are required to be imposed.

In view of all these arguments against free trade, governments of less developed countries in the
post-Second World War period were encouraged to resort to some kind of trade restrictions to
safeguard national interest.

Q. Discuss the rationale of the protectionist policy in developing economy. Are there any arguments
given against protection. Differentiate Protectionism from Free Trade.

PROTECTIONISM

Protectionism in economics refers to the Government’s policy of restraining trade in between

countries that means between home country and foreign countries through methods such as tariffs
on imported goods, restricted quotas on imported goods, providing subsidies and tax benefits to the
home business and home industries from the face of unfair competition from foreign countries.

Arguments in favour of Protectionism:

1. Infant Industry Argument: An infant industry is one which has been started rather late or newly
or which has not been mature enough to face competition from long established foreign
industries therefore it is argued that such infant industries during initial stages of their growth
require high protection from the government because their cooperative cause during the
transition period as such it cannot compete with established foreign exporters.

2. Diversification Argument: when there is unbalance economy as a result of accession

specialization, it leads to overdependence of a country on other countries which may be very
dangerous both politically and economically. Therefore, in order to bring about a harmonious
and balanced growth of economic self-sufficiency, it is necessary to diversify through
protection.

3. Promotion of Employment Argument: Imposition of tariffs restricts certain imports so that

some money is saved in the domestic economy which will be spend upon the purchase of
products of protected home industries and as the protected home industries will have a
multiplied effect in other sectors of production also.

4. Balance of Payment argument: Restrictions on import through high rate of import tariffs and
import quotas.

5. Anti-Dumping Argument: Selling goods at low prices in foreign countries to capture the market
is called dumping. A foreign country may resort to dumping with a view of capturing market in
other countries by selling the same product at a much high price but selling the imported
products at a very low price in other countries of the world. In such cases protection through

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 imposing high tariff can be made in order to protect the home producers against the dumping
of foreign goods in the home country. Eg. Chinese goods.

6. Pauper-Labour Argument: Sometimes protection is advocated in a developed country to

safeguard the interest of their labour and it is argues that in the absence of protection there
will be an unhealthy competition faced by the countries having dear labour economy for those
having cheap labour. Adverse country’s government may think that the standard of living of
their people will be undermined if the cheap goods are imported form low wage countries and
therefore protection may be imposed to protect the standard of living to maintain the high
wages for the country’s labour.

7. Revenue Earning Argument: Protection measures through high rate of tariffs and duties on
imported goods and services, it is argued that it is needed so that the government can earn a
good amount of revenue from import duties and taxes which can be utilized for the
development of country’s economy.

Arguments against Protection

Despite these virtues, several people justify trade restrictions. Following arguments are often cited
against free trade:

i. Advantageous not for LDCs: Firstly, free trade may be advantageous to the advanced
countries but not to the backward economies. Free trade has brought enough misery to the poor, less
developed countries, if past experience is any guide. India was a classic example of colonial
dependence of UK’s imperialistic power prior to 1947. Free trade principles have brought colonial
imperialism in its wake.

ii. Destruction of Home Industries/Products: Secondly, it may ruin domestic industries. Because
of free trade, imported goods become available at a cheaper price. Thus, an unfair and cut-throat
competition develops between domestic and foreign industries. In the process, domestic industries
are wiped out. Indian handicrafts industries suffered tremendously dining the British regime.

iii. Inefficiency becomes Perpetual: Free trade cannot bring all-round development of industries.
Comparative cost principle states that a country specializes in the production of a few commodities.
On the other hand, inefficient industries remain neglected. Thus, under free trade, an all-round
development is ruled out.

iv. Danger of Overdependence: Fourthly, free trade brings in the danger of dependence. A
country may face economic depression if its international trading partner suffers from it.

The Great Depression that arose in 1929-30 in the US economy swept all over the world and all
countries suffered badly even if their economies were not caught in the grip of the then Depression.
Such overdependence following free trade also becomes catastrophic during war.

v. Penetration of Harmful Foreign Goods: Finally, a country may have to change its consumption
habits. Because of free trade, even harmful commodities (drugs, etc.,) enter the domestic market. To
prevent such, restrictions on trade are required to be imposed.

In view of all these arguments against free trade, governments of less developed countries in the
post-Second World War period were encouraged to resort to some kind of trade restrictions to
safeguard national interest.

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Free Trade vs Protectionism
• Free trade is an ideal situation while protectionism is the order of the day in international trade

• Protectionism takes many shapes and sometimes, countries crying foul as they are made to suffer
hardships cannot even prove it

• WTO has been set up to pave the way for free trade by gradually removing all artificial barriers
between member countries

• Free trade encourages healthy competition whereas protectionism leads to jealousy and ill will.

Q. Distinguish between internal trade and international trade.

Nevertheless, there are several reasons to believe the classical view that international trade is
fundamentally different from inter-regional trade.

1. Factor Immobility: The classical economists advocated a separate theory of international

trade on the ground that factors of production are freely mobile within each region as between places
and occupations and immobile between countries entering into international trade. Thus, labour and
capital are regarded as immobile between countries while they are perfectly mobile within a country.

There is complete adjustment to wage differences and factor-price disparities within a country with
quick and easy movement of labour and other factors from low return to high sectors. But no such
movements are possible internationally. Price changes lead to movement of goods between
countries rather than factors. The reasons for international immobility of labour are—difference in
languages, customs, occupational skills, unwillingness to leave familiar surroundings, and family ties,
the high travelling expenses to the foreign country, and restrictions imposed by the foreign country
on labour immigration.

The international mobility of capital is restricted not by transport costs but by the difficulties of legal
redress, political uncertainty, ignorance of the prospects of investment in a foreign country,
imperfections of the banking system, instability of foreign currencies, mistrust of the foreigners, etc.
Thus, widespread legal and other restrictions exist in the movement of labour and capital between
countries. But such problems do not arise in the case of inter-regional trade.

2. Differences in Natural Resources: Different countries are endowed with different types of
natural resources. Hence they tend to specialize in production of those commodities in which they are
richly endowed and trade them with others where such resources are scarce. In Australia, land is in
abundance but labour and capital are relatively scarce. On the contrary, capital is relatively abundant
and cheap in England while land is scarce and dear there.

Thus, commodities requiring more capital, such as manufactures, can be produced in England; while
such commodities as wool, mutton, wheat, etc. requiring more land can be produced in Australia.
Thus both countries can trade each other’s commodities on the basis of comparative cost differences
in the production of different commodities.

3. Geographical and Climatic Differences: Every country cannot produce all the commodities
due to geographical and climatic conditions, except at possibly prohibitive costs. For instance, Brazil
has favorable climate geographical conditions for the production of coffee; Bangladesh for jute; Cuba

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for beet sugar; etc. So countries having climatic and geographical advantages specialize in the
production of particular commodities and trade them with others.

4. Different Markets: International markets are separated by difference in languages, usages,

habits, tastes, fashions etc. Even the systems of weights and measures and pattern and styles in
machinery and equipment differ from country to country. For instance, British railway engines and
freight cars are basically different from those in France or in the United States.

Thus goods which may be traded within regions may not be sold in other countries. That is why, in
great many cases, products to be sold in foreign countries are especially designed to confirm to the
national characteristics of that country. Similarly, in India right-hand driven cars are used whereas in
Europe and America left-hand driven cars are used.

5. Mobility of Goods: There is also the difference in the mobility of goods between inter-regional
and international markets. The mobility of goods within a country is restricted by only geographical
distances and transportation costs. But there are many tariff and non-tariff barriers on the movement
of goods between countries. Besides export and import duties, there are quotas, VES, exchange
controls, export subsidies, dumping, etc. which restrict the mobility of goods at international plane.

6. Different Currencies: The principal difference between inter-regional and international trade
lids in use of different currencies in foreign trade, but the same currency in domestic trade. Rupee is
accepted throughout India from the North to the South and from the East to the West, but if we cross
over to Nepal or Pakistan, we must convert our rupee into their rupee to buy goods and services there.

It is not the differences in currencies alone that are important in international trade, but changes in
their relative values. Every time a change occurs in the value of one currency in terms of another, a
number of economic problems arise. “Calculation and execution of monetary exchange transactions
incidental to international trading constitute costs and risks of a kind that are not ordinarily involved
in domestic trade.”

Further, currencies of some countries like the American dollar, the British pound the Euro and
Japanese yen, are more widely used in international transactions, while others are almost
inconvertible. Such tendencies tend to create more economic problems at the international plane.
Moreover, different countries follow different monetary and foreign exchange policies which affect
the supply of exports or the demand for imports. “It is this difference in policies rather than the
existence of different national currencies which distinguishes foreign trade from domestic trade,”
according to Kindleberger.

7. Problem of Balance of Payments: Another important point which distinguishes international

trade from inter-regional trade is the problem of balance of payments. The problem of balance of
payments is perpetual in international trade while regions within a country have no such problem.
This is because there is greater mobility of capital within regions than between countries.

Further, the policies which a country chooses to correct its disequilibrium in the balance of payments
may give rise to a number of other problems. If it adopts deflation or devaluation or restrictions on
imports or the movement of currency, they create further problems. But such problems do not arise
in the case of inter-regional trade.

8. Different Transport Costs: Trade between countries involves high transport costs as against
inter- regionally within a country because of geographical distances between different countries.

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9. Different Economic Environment: Countries differ in their economic environment which
affects their trade relations. The legal framework, institutional set-up, monetary, fiscal and
commercial policies, factor endowments, production techniques, nature of products, etc. differ
between countries. But there is no much difference in the economic environment within a country.

10. Different Political Groups: A significant distinction between inter-regional and international
trade is that all regions within a country belong to one political unit while different countries have
different political units. Inter-regional trade is among people belonging to the same country even
though they may differ on the basis of castes, creeds, religions, tastes or customs.

They have a sense of belonging to one nation and their loyalty to the region is secondary. The
government is also interested more in the welfare of its nationals belonging to different regions. But
in international trade there is no cohesion among nations and every country trades with other
countries in its own interests and often to the detriment of others. As remarked by Friedrich List,
“Domestic trade is among us, international trade is between us and them.”

11. Different National Policies: Another difference between inter-regional and international
trade arises from the fact that policies relating to commerce, trade, taxation, etc. are the same within
a country. But in international trade there are artificial barriers in the form of quotas, import duties,
tariffs, exchange controls, etc. on the movement of goods and services from one country to another.

Sometimes, restrictions are more subtle. They take the form of elaborate custom procedures,
packing requirements, etc. Such restrictions are not found in inter-regional trade to impede the flow
of goods between regions. Under these circumstances, the internal economic policies relating to
taxation, commerce, money, incomes, etc. would be different from what they would be under a
policy of free trade.

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ECONOMIC GROWTH AND DEVELOPMENT
Q. Differentiate between economic growth and economic development. Discuss the factors of
economic growth.

The fundamental differences between economic growth and development are explained in the
points given below:

1. Economic growth is the positive change in the real output of the country in a particular span
of time economy. Economic Development involves a rise in the level of production in an
economy along with the advancement of technology, improvement in living standards and so
on.

2. Economic growth is one of the features of economic development.

3. Economic growth is an automatic process. Unlike economic development, which is the

outcome of planned and result-oriented activities.

4. Economic growth enables an increase in the indicators like GDP, per capita income, etc. On
the other hand, economic development enables improvement in the life expectancy rate,
infant mortality rate, literacy rate and poverty rates.

5. Economic growth can be measured when there is a positive change in the national income,
whereas economic development can be seen when there is an increase in real national
income.

6. Economic growth is a short-term process which takes into account yearly growth of the
economy. But if we talk about economic development it is a long term process.

7. Economic Growth applies to developed economies to gauge the quality of life, but as it is an
essential condition for the development, it applies to developing countries also. In contrast
to, economic development applies to developing countries to measure progress.

8. Economic Growth results in quantitative changes, but economic development brings both
quantitative and qualitative changes.

9. Economic growth can be measured in a particular period. As opposed to economic

development is a continuous process so that it can be seen in the long run.

Factors that Determine Economic Growth and Development of a Country!

The process of economic growth is a highly complex phenomenon and is influenced by numerous
and varied factors such as economic, political, social and cultural factors. It is believed by some
economists that the capital is the only requirement for growth and therefore the greatest emphasis
is laid on capital formation to bring about economic development. But this is wrong. As Professor
Nurkse rightly remarks, “Economic development has much to do with human endowments, social
attitudes, political conditions and historical accidents. Capital is a necessary but not a sufficient
condition of progress.”

The following are various factors which determine economic growth and development:

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(a) Human Resource: Refers to one of the most important determinant of economic growth of a
country. The quality and quantity of available human resource can directly affect the growth of an
economy.

The quality of human resource is dependent on its skills, creative abilities, training, and education. If
the human resource of a country is well skilled and trained then the output would also be of high
quality.

On the other hand, a shortage of skilled labor hampers the growth of an economy, whereas surplus
of labor is of lesser significance to economic growth. Therefore, the human resources of a country
should be adequate in number with required skills and abilities, so that economic growth can be
achieved.

(b) Natural Resources: Affect the economic growth of a country to a large extent. Natural
resources involve resources that are produced by nature either on the land or beneath the land. The
resources on land include plants, water resources and landscape.

The resources beneath the land or underground resources include oil, natural gas, metals,
nonmetals, and minerals. The natural resources of a country depend on the climatic and
environmental conditions. Countries having plenty of natural resources enjoy good growth than
countries with small amount of natural resources.

The efficient utilization or exploitation of natural resources depends on the skills and abilities of
human resource, technology used and availability of funds. A country having skilled and educated
workforce with rich natural resources takes the economy on the growth path.

The best examples of such economies are developed countries, such as United States, United
Kingdom, Germany, and France. However, there are countries that have few natural resources, but
high per capita income, such as Saudi Arabia, therefore, their economic growth is very high.
Similarly, Japan has a small geographical area and few natural resources, but achieves high growth
rate due to its efficient human resource and advanced technology.

(c) Capital Formation: Involves land, building, machinery, power, transportation, and medium of
communication. Producing and acquiring all these manmade products is termed as capital formation.
Capital formation increases the availability of capital per worker, which further increases capital/labor
ratio. Consequently, the productivity of labor increases, which ultimately results in the increase in
output and growth of the economy.

(d) Technological Development: Refers to one of the important factors that affect the growth of
an economy. Technology involves application of scientific methods and production techniques. In
other words, technology can be defined as nature and type of technical instruments used by a certain
amount of labor.

Technological development helps in increasing productivity with the limited amount of resources.
Countries that have worked in the field of technological development grow rapidly as compared to
countries that have less focus on technological development. The selection of right technology also
plays an role for the growth of an economy. On the contrary, an inappropriate technology- results in
high cost of production.

(e) Social and Political Factors: Play a crucial role in economic growth of a country. Social factors
involve customs, traditions, values and beliefs, which contribute to the growth of an economy to a
considerable extent.

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For example, a society with conventional beliefs and superstitions resists the adoption of modern
ways of living. In such a case, achieving becomes difficult. Apart from this, political factors, such as
participation of government in formulating and implementing various policies, have a major part in
economic growth.

f) Corruption: Corruption is rampant in developing countries at various levels and it operates as

a negative factor in their growth process. Until and unless these countries root-out corruption in their
administrative system, it is most natural that the capitalists, traders and other powerful economic
classes will continue to exploit national resources in their personal interests.

The regulatory system is also often misused and the licenses are not always granted on merit. The
art of tax evasion has been perfected in the less developed countries by certain sections of the
society and often taxes are evaded with the connivance of the government officials.

g) Desire to Develop: Development activity is not a mechanical process. The pace of economic
growth in any country depends to a great extent on people’s desire to develop. If in some country
level of consciousness is low and the general mass of people has accepted poverty as its fate, then
there will be little hope for development. According to Richard T. Gill, “The point is that economic
development is not a mechanical process; it is not a simple adding- up of assorted factors. Ultimately,
it is a human enterprise. And like all human enterprises, its outcome will depend finally on the skill,
quality and attitudes of the men who undertake”.

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BALANCE OF PAYMENT
Q. What is Balance of Payment? What are the causes of adverse balance payment? Explain briefly
the various methods used by a country to rectify chronic disequilibrium balance of payments.
Differentiate between balance of trade and balance of payment

Balance of payment can be defined as systematic record of all economic transactions between the
residence of one country and the residence of another country during a given period of time.
Economic transactions can broadly be categorized in to four heads which are:

1. VISIBLE ITEMS : visible items include all those tangible goods which can be imported and exported.
These are visible as they are made up of some matter or material. this is known as merchandise
also.

2. INVISIBLE ITEMS: invisible items include all types of services like shipping, banking, tourist etc.

3. UNILATERAL TRANSFERS: These are those payments which are made without expecting anything in
return of it like donations ,gifts etc.

4. CAPITAL TRANSFERS: Capital transfers are concerned with capital receipts and capital payments. It
includes the transfer of assets.

Causes of adverse balance payment

1. Fall in export demand: When demand for the country’s goods fall in the foreign market. Due
to changes in the taste and preferences of the consumers export decreases and the BOP will be
unfavorable. However the deficit in BOP due to fall in export demand is more inclined in
underdeveloped countries than advance countries.

2. Growth of population : In underdeveloped countries aggregate consumption demand rises

due to rapid growth of population consequently imports of goods increases and the export
decreases. This creates the deficit in the balance of payment of less developed countries.

3. Inflation: Increase in prices due to higher wages and higher prices of raw materials etc. makes
export costlier. The export in this case decreases and at the same time demand for imports
increases. This results in deficit BOP.

4. Huge international borrowings : A country may tend to have an adverse BOP when it borrows
heavily from other country while the lending country will tend to have a favourable BOP.

5. Development programmes :The other reason for adverse BOP in developing countries is a
large investment in development schemes. These development schemes require import of huge
quantity of capital goods ,technical knowledge and essential raw materials. This increases imports
which makes BOP unfavorable.

6. Change in foreign exchange rates : When external value of the domestic currency goes up
imports become cheaper and exports costlier. Thus imports encouraged and exports discouraged
leading to disequilibrium of BOP.

7. Demonstration effect : It is another most important factor causing deficit in BOP of a country
especially of an underdeveloped country. When people of underdeveloped countries come into

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 the contact with those of advanced countries they start adopting western style and pattern of
consumption. Due to this reason their import increases and it leads to adverse BOP.

Methods of Correcting Disequilibrium in the Balance of Payments

There are several methods to correct BOP disequilibrium. The methods can be classified in to two
groups:
1. Monetary methods : Monetary methods of correction effect the BOP by changing the value or
flow of currencies both domestic and foreign. Following are the monetary methods:

(a) Deflation : Deflation means a reduction in the quantity of money so as to bring about a fall in
the prices and the money income of the people .Falling prices encourage exports and discourage
imports .Hence deflationary policy restores equilibrium in BOP.

Deflation is not considered as a suitable method of correcting adverse BOP because it reduces
income and causes unemployment in the country.

(b) Devaluation: It means decreasing the value of domestic currency in respect of a foreign
currency. Devaluation is done by the government of the country which has unfavourable BOP. It is
done deliberately to get its advantages . The government officially declares devaluation indicating the
extent of decrease in the value of currency. specific currency will be determined with which it is
devalued. Devaluation is irreversible. The country cannot change the value of currency frequently.

With a decrease in the value of its currency the country has to pay more in exchange for a foreign
currency. In this case the export becomes cheaper at the same time import becomes expensive.
With this export increases and import decreases. However the success of devaluation depends on
the following:

(i) The elasticity of demand for the country’s export should be high.

(ii) The elasticity of demand for country’s import should be fairly elastic.

Devaluation as a method of correcting adverse BOP suffers from the following defects:

(i) It reduces the public confidence in country’s currency as it is an indicator of country’s weakness.

(ii) It increases the burden of public debt

(iii) It encourages inflationary tendencies in the home country.

(c) Exchange Depreciation : Depreciation refers to decline in the rate of exchange of one currency
in terms of other currency. It is similar to devaluation but not done by the government. It is done in
the exchange market with the help of demand and supply of the currency. It takes place in a flexible
exchange rate system. It is automatic and can correct the adverse BOP of the country. But method of
exchange depreciation suffers from following defects:

(i) It is not suitable for a country which has adopted a fixed exchange rate system

(ii) It makes international trade risky and thus reduces the volume of trade.

(iii) The terms of trade go against the country whose currency depreciates

(iv) Depreciation may generate inflationary pressure by making the commodity more expensive.

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 (d) exchange control : It is the most widely used method for correcting adverse BOP. It
refers to the control by the central bank over the use of foreign exchange. In this method all
the exporters are directed by the Central bank to surrender the foreign exchange earnings
and it is rationed out among the licensed importers, It means only license holders can import
goods.

Exchange control, does not remove the process of adverse BOP, It simply does not allow the
situation to worsen. Hence it is not considered a proper method to correct adverse BOP.

(e) Capital movement: In flow of capital from the individuals and government of other
countries as well as borrowings from international financial institutions like World bank,IMF
etc. can be used to correct the deficit in BOP.

(f) Pegging operation: Pegging down the value. The central bank depending on the need
may artificially increase or decrease the value of currency temporarily. Pegging operation can
be done any no. of times. It is reversible. It offers the flexibility to the government to manage
the currency of value for its advantage.

2. Non monetary measures : Non monetary measures deal with the real sector for correcting
disequilibrium in BOP. Following are the important non monetary measures:

(a) Export promotion : To control adverse BOP the country may adopt export promotion measures
which are as follows:

(i) Cash assistance and subsidies can be given to exporters to increase export

(ii) Export duties may be reduced to encourage exports.

(iii) Goods meant for exports can be exempted from all types of taxes

(iv) Export oriented industries can be encouraged by providing better infrastructure, better raw
material, making favourable loan facilities etc.

(b) Import substitutes : The economy can develop technology of import substitution.
Industries producing import substitutes can be encouraged by capital goods ,better
technology etc. Policy of import substitution can help the country to become self reliant.

(c) Import licensing : The government can have strong control over the exports by having
strict rules and regulations for providing licenses to importers.

(d) Import quotas : Fixing import quotas may be a better device for correcting the adverse
BOP as they have the immediate effect of restricting imports .Import quotas are important
non tariff barriers. They are positive restrictions on incoming of goods.

(e) Tariff : It is a tax duty imposed on imports .The objective is to make imports expensive
.It reduces the demand for imports and the deficit in BOP gets corrected.

(f) Monetary policy: The central bank can reduce the volume of credit by raising the bank
rate, by selling securities in open market and by increasing cash reserve ratio. This will make
borrowing from commercial banks costlier .It will lead to fall in investment and hence fall in
income and employment and output. Any such decrease in income decreases the demand for
imports and disequilibrium in BOP can be corrected.

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 (g) Fiscal policy: A restricted fiscal policy can also be used to wipe out BOP deficit by
reducing the total expenditure in the economy and increase in direct taxes will reduce the
disposable income and hence there will be reduction in demand for imports. The decrease in
government expenditure will also have the same effect on decreasing the demand for
imported goods.

Every country has to use the combination of monetary and non monetary methods to correct BOP
disequilibrium and also prevent retaliation from any developed country.

The following are the major differences between the balance of trade and balance of payments:

1. A statement recording the imports and exports done in goods by/from the country with the
other countries, during a particular period is known as the Balance of Trade. The Balance of
Payment captures all the monetary transaction performed internationally by the country
during a course of time.

2. The Balance of Trade accounts for, only physical items, whereas Balance of Payment keeps
track of physical as well as non-physical items.

3. The Balance of Payments records capital receipts or payments, but Balance of Trade does not
include it.

4. The Balance of Trade can show a surplus, deficit or it can be balanced too. On the other hand,
Balance of Payments is always balanced.

5. The Balance of Trade is a major segment of Balance of Payment.

6. The Balance of Trade provides the only half picture of the country’s economic position.
Conversely, Balance of Payment gives a complete view of the country’s economic position.

7. When there is either deficit or surplus balance of payment it is said to be in disequilibrium.

When a country is incurring more payments from abroad than it has to make then it is
considered favourable balance of payment which is in surplus. Contrary to it if a country makes
more payments abroad than what it receives then BOP is said to be unfavorable because it is
in deficit.

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