Mohamed Sathak A.

J College of Engineering Change is the true end of all learning

Fundamentals of Economics – CW3301 – Unit 3 - Question Bank – (2 Marks & 16 Marks)

PART – A
1. Define Money
Money is any item or medium of exchange that is accepted by people for the payment of goods and
services, as well as the repayment of loans. Money makes the world go 'round. Economies rely on
money to facilitate transactions and to power financial growth. Typically, it is economists who define
money, where it comes from, and what it's worth. Here are the multifaceted characteristics of money.

KEY TAKEAWAYS

 Money is a medium of exchange; it allows people and businesses to obtain what they need to live
and thrive.
 Bartering was one way that people exchanged goods for other goods before money was created.
 Like gold and other precious metals, money has worth because for most people it represents
something valuable.
 Fiat money is government-issued currency that is not backed by a physical commodity but by the
stability of the issuing government.
 Above all, money is a unit of account - a socially accepted standard unit with which things are
priced.

2. What are the primary functions of Money?

a. A medium of exchange.
b. A standard of deferred payment.
c. A store of wealth.
d. A measure of value.
3. What are the Sources of Money Demand?

There are two main sources of money demand. They are

1. Transactions Money
2. Asset Demand

4. What is Money Supply and state its components?

The money supply is the value of the total stock of money, the medium of exchange, in circulation.
In short, the money supply is the gold coins in people’s pockets plus the amount of deposits at the
goldsmith.

Money Supply = Gold Stock + Deposits at goldsmith

5. What is the difference between Credit and a Loan?

A loan is a financial product that allows a user to access a fixed amount of money at the outset of the
transaction, with the condition that this amount, plus the agreed interest, be returned within a
specified period. The loan is repaid in regular instalments. The main characteristics of a financial
loan include:

 The transaction has a pre-determined life span.

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 Once all the capital has been repaid through the payment of the instalments (monthly,
quarterly, half-yearly…), the operation is concluded without the possibility of accessing more
money, unless a new loan is arranged.
 Interest is charged on the total amount of money borrowed.
 Loans have a longer term, usually of years.

A credit is a more flexible form of finance that allows you to access the amount of money loaned,
according to your needs at any given time. The credit sets a maximum limit of money, which the
customer can use in part or in full. The customer may use all the money provided, part of it or none
at all. We review the main characteristics of a credit that distinguish it from a loan:

 Interest on credits is usually higher than on a loan.

 Interest is only paid on the amount used, although there may be a minimum fee payable on
the undrawn balance.
 As the money is returned, more will become available, provided that the limit is not
exceeded.
 Unlike the loan, the credit is usually renewed each year in order to allow the customer to
continue to use this credit facility whenever necessary.

The usual ways to obtain finance through a credit are credit cards and credit facilities or lines of
credit, which are generally arranged through a current account in which deposits and withdrawals
can be made up to the agreed limit.

Credits are usually used to cover delays between receipts and payments for companies, to deal with
specific periods of lack of liquidity or for specific purchases. Loans, on the other hand, are often used
to finance the purchase of goods or services.

6. What do you understand by inflation?

Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad
measure, such as the overall increase in prices or the increase in the cost of living in a country.

7. What are the main causes of inflation?

1. Growing Economy
2. Expansion of the Money Supply
3. Government Regulation
4. Managing the National Debt
5. Exchange Rate Changes

8. What are the types of Inflation?

 Demand-Pull Inflation,
 Cost-push inflation,
 Supply-side inflation Open Inflation,
 Repressed Inflation,
 Hyper-Inflation
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9. Define Deflation in brief

Deflation is a general decline in prices for goods and services, typically associated with a
contraction in the supply of money and credit in the economy.

10. What is National Income?

National income is the total value of all the final services and goods produced in an economy during
a specific period of time. It includes both the public and private sectors and encompasses everything
from haircuts to housing, from medical care to national defence. National income is also commonly
referred to as gross domestic product (GDP).

PART - B
1. What is National Income? What are its components and explain the various methods of
measuring National Income?

National income is a measure of the total value of all services and goods produced in a country over
a specific time period. It is an important indicator of economic health and well-being. In this article,
we will discuss the main concepts of national income, as well as provide an example. We will also
outline the formula for calculating national income.

What is National Income?

National income is the total value of all the final services and goods produced in an economy during
a specific period of time. It includes both the public and private sectors and encompasses everything
from haircuts to housing, from medical care to national defence. National income is also commonly
referred to as gross domestic product (GDP).

Concept of National Income:

National income is the money value of all the final services and goods produced in an economy
during a given period of time. It includes the incomes of all factors of production, such as rent,
wages, profits, and interest.
The main concepts of national income are:

Gross Domestic Product (GDP):

This is the market value of all final services and goods produced within a country in a given period
of time.
The formula of GDP is:
GDP = C + G + I + NX
(where G=government spending, C=consumption, I=Investment, and NX=net exports).

Gross Net Product (GNP):

This is the market value of all final services and goods produced by a country’s residents in a given
period of time, regardless of where they are located.
The formula for GNP:
GNP = GDP + NF
(where NF=net factor income from abroad).

Net Domestic Product (NDP):

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This is the market value of all final services and goods produced within a country in a given period
of time, minus depreciation.
The formula for NDP:
NDP = GDP – Depreciation

Net National Income (NNI):

This is GDP minus depreciation. Depreciation is the wear and tear on capital equipment and
buildings.
The formula for NNI:
NNI = GDP – Depreciation

National Income (NI): This is NNI minus indirect taxes plus subsidies. Indirect taxes are taxes on
the sale of services and goods. Subsidies are payments made by the government to producers.

Personal Income (PI): This is NI minus corporate income taxes plus transfer payments. Transfer
payments are payments made by the government to individuals that do not require the recipient to
provide any good or service in return.

The formula for PI:

PI = GDP – NIT
(where NIT=net indirect taxes).

Disposable Income (DI): This is PI minus personal income taxes.

National income is a very important concept because it allows us to measure the economic well-
being of a nation. It is also used in macroeconomic models to determine things like the level of
employment and inflation.

There are several ways to measure national income. The most common method is the GDP approach,
which simply adds up all of the final services and goods produced in an economy. Another common
method is the income approach, which adds up all of the incomes of the factors of production.

National Income Formula:

National income Formula is
Y = C + I + G + (X-M)
Where
Y = national income
C = consumption
I = investment
G = government spending
X = exports
M = imports.
National income can be measured in either physical units or currency units. Physical units are things
like tons of steel or the number of cars. Currency units are things like dollars or euros.
All these concepts are important in the calculation of national income. National income is a very
important concept because it gives us an idea of how well the economy is doing. It also helps us to
compare the standard of living between different countries.
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National income is usually measured in terms of GDP because it is the most comprehensive measure
of economic activity. However, there are times when it is more useful to measure national income in
terms of GNP.
Measurement of National Income

There are three methods to calculate National Income:

 Income Method
 Product/ Value Added Method
 Expenditure Method

Income Method

In this National Income is measured as flow of income.

We can calculate NI as:

Net National Income = Compensation of Employees+ Operating surplus mixed (w +R +P +I) +

Net income + Net factor income from abroad.

Where,

W = Wages and salaries

R = Rental Income

P = Profit

I = Mixed Income

Product/ Value Added Method

In this National Income is measured as flow of goods and services.

We can calculate NI as:

NATIONAL INCOME = G.N.P – COST OF CAPITAL – DEPRECIATION – INDIRECT

TAXES

Expenditure Method

In this National Income is measured as flow of expenditure.

We can calculate NI through Expenditure method as:

National Income=National Product=National Expenditure.

Conclusion:

In conclusion, national income is a key concept in economics that refers to the total value of all
services and goods produced in a country over a specific period of time. It is important to understand
how national income is calculated and what factors can affect it in order to make informed economic
decisions.
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2. What is the Circular Flow Model?

The circular flow model is an economic model that presents how money, goods, and services move
between sectors in an economic system. The flows of money between the sectors are also tracked to
measure a country’s national income or GDP, so the model is also known as the circular flow of
income.

Summary

The circular flow model, also known as the circular flow of income, describes how money and
economic resources flow in cycles between different sectors in an economic system.

In the basic (two-factor) circular flow model, money flows from households to businesses as
consumer expenditures in exchange for goods and services produced by the businesses, then flows
back from businesses to households for the labour that individuals provide.

The five-sector model consists of

(i) households (the public sector),

(ii) businesses,
(iii) government,
(iv) the foreign sector, and
(v) the financial sector.

Understanding the Circular Flow Model

Mohamed Sathak A.J College of Engineering Change is the true end of all learning
The idea of circular flow was first introduced by economist Richard Cantillon in the 18th century and
then progressively developed by Quesnay, Marx, Keynes, and many other economists. It is one of
the most basic concepts in macroeconomics.

How an economy runs can be simplified as two cycles flowing in opposite directions. One is goods
and services flowing from businesses to individuals, and individuals provide resources for
production (labour force) back to the businesses.

In the other direction, money flows from individuals to businesses as consumer expenditures on
goods and services and flows back to individuals as personal income (wages, dividends, etc.) for the
labour force provided. This is the most basic circular flow model of an economy. In reality, there are
more parties participating in a more complex structure of circular flows.

Circular Flow Models with Sectors

Two-Sector Model

The model described above is the two-sector model, which is the most basic model containing only
two sectors: individuals or households and businesses. In the two-sector model, it is assumed that
households spend all their incomes as consumer expenditures and purchase the goods and services
produced by businesses. Thus, there are no taxes, savings, or investments that are associated with
other sectors.

Three-Sector Model

In the three-sector model, the government is added to the two-sector model. In this model, money
flows from households and businesses to the government in the form of taxes. The government pays
back in the form of government expenditures through subsidies, benefit programs, public services,
etc.

Four-Sector Model

The four-sector model contains the foreign sector, which is also known as the overseas sector or
external sector. The overseas sector turns a closed economy into an open economy. It is connected to
the other sectors through two flows of money: foreign trade (imports and exports) and foreign
exchange (inflow and outflow of capital). Like the other sectors, each flow of money is paired with a
flow of a factor of production or goods and services.

Five-Sector Model

The fifth sector – the financial sector – is added to complete the circular flow model. It includes
banks and other institutions that provide borrowing and lending services to the other sectors. Savings
and investments are assumed in the five-sector model, which flow from other sectors with residual
cash into the financial institutions, then out to the sectors that need money. As long as lending
(injection) is equal to borrowing (leakage), the circular flow reaches an equilibrium and can continue
forever.

Implications of the Circular Flow Model

As a fundamental concept of macroeconomics, the circular flow model has been widely applied in
different studies, with significant impacts on the understanding of economics. Four examples are
listed below to show the significance of the model.
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Measurement of national income:

The sectors in the circular flow model are the components of the calculation of national income. The
expenditure approach calculates a nation’s GDP as the sum of the household consumption
expenditures, private domestic investment, government consumption and investment expenditures,
and net exports (GDP = C + I + G + [X-M]).

Knowledge of interdependence:

The circular flow model underpins the knowledge of interdependence between sectors in an
economic system. The activities and money flows cannot take place without interaction with another
sector.

Unending nature of economic activities:

Money and economic resources flow in cycles indefinitely with an equilibrium of aggregate income
and expenditures.

Injections and leakages:

The circular flow of an economy is balanced when the total injections equal the leakages. If
injections overweight leakages, the country’s national income will grow. If injections are below
leakages, the national income will decrease.

3. Define Keynes concepts of equilibrium aggregate Income and output in an economy.

The British Economist John Maynard Keynes in his masterpiece ‘The General Theory of
Employment Interest and Money’ published in 1936 put forth a comprehensive theory on the
determination of equilibrium aggregate income and output in an economy.
The Keynesian theory of income determination is presented in three models:
The two-sector model consisting of the household and the business sectors.
The three-sector model consisting of household, business and government sectors.
The four-sector model consisting of household, business, government and foreign sectors

Explain circular flow in a simple two-sector model by J.M. Keynes.

Two-sector model by J.M.Keynes:

Though two sector economy model is hypothetical and does not exist in reality; it provides a simple
and convenient basis for understanding the Keynesian theory of income determination.
Assumptions:

a) There are only two sectors in the economy Households (with only consumption) and Firms
(investment outlays):
b) Households spent their entire factor incomes to consume all final goods and services
c) The firms hire factors of production from the households; they produce and sell final goods
and services to the households and they do not save.
d) The total income produced, Y, accrues to the households and equals to their disposable
personal income (Yd) i.e., Y = Y d.
e) All prices (including factor prices), supply of capital and technology remain constant.
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f) There are no corporations, corporate savings or retained earnings.
g) The government sector does not exist and hence there are no taxes, government expenditure
or transfer payments.
h) The economy is a closed economy, (i.e., foreign trade does not exist).
i) All investment outlay is autonomous (not determined either by the level of income or the
rate of interest)
j) All investment is net (i.e. National Income equals the Net National Product).

Circular Flow of Income and Expenditure of the Two - Sector Economy

k) Households: Households own all factors of production and they sell their factor services to
earn factor incomes which are entirely spent to consume all final goods and services
produced by business firms. (Y = Y d.)
l) Firms: The business firms are assumed to hire factors of production from the households;
they produce and sell goods and services to the households and they do not save.
m) The circular broken lines with arrows show factor and product flows and present ‘real flows’
n) The continuous line with arrows shows ‘money flows’ which are generated by real flows.
o) These two circular flows-real flows and money flows-are in opposite directions
p) The value of real flows equal the money flows because the factor payments are equal to
household incomes.
q) There are no injections into or leakages from the system.
r) Since the whole of household income is spent on goods and services produced by firms,
household expenditures equal to the total receipts of firms which is equal to the value of
output.
Factor Payments = Household Income = Household Expenditure = Total Receipts
of Firms = Value of Output.

Equilibrium under two sector model

s) Equilibrium output occur when the desired amount of output demanded by all the agents in
the economy exactly equals the amount produced in a given time period.
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t) An economy can be said to be in equilibrium when the production plans of the firms and the
expenditure plans of the household’s match.
Conclusion:

The theory of income determination in a two-sector model is the simplest representation of the key
principles of Keynesian economics

4. Explain the role of Consumption Function in the Keynesian theory of income determination

Consumption Function:

The positive relationship between consumption spending and disposable income is described by
the consumption function. (Or)
Consumption function expresses the functional relationship between aggregate consumption
expenditure and aggregate disposable income, expressed as:

C = f (Y)

a) The private demand for goods and services accounts for the largest proportion of the
aggregate demand in an economy and plays a crucial role in the determination of national
income.
b) According to Keynes, the total volume of private expenditure in an economy depends on the
total current disposable income of the people and the proportion of income which they decide
to spend on consumer goods and services.
c) The consumption function, proposed by Keynes is as follows:

C = a + bY

Where, C = aggregate consumption expenditure;

Y = total disposable income;
a is a constant term i.e. the positive value of consumption at zero level of disposable income; b, the
slope of the function, (∆C /∆Y) is the marginal propensity to consume
The Keynesian Consumption Function
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From the above graph:

a) The consumption function shows the level of consumption (C) corresponding to each level of
disposable income (Y) and is expressed through a linear consumption function, as shown by
the line marked C = f(Y)
b) When income is low, consumption expenditures of households will exceed their disposable
income and households dissave i.e. they either borrow money or draw from their past savings
to purchase consumption goods.
c) The intercept for the consumption function, a, can be expressed as a measure of the effect on
consumption variables other than income.

Components of Keynesian Theory

1. AGGREGATE DEMAND (or) AGGREGATE EXPENDITURE (AD):
a) The aggregate demand (C+ I) refers to the total spending in the economy i.e., it is the sum
of demand for the consumer goods (C) and investment goods (I) by households and firms
respectively.
b) Aggregate demand represents realized value by the households
c) Aggregate demand depends on household’s plan to consume and to save.
d) The AD curve is linear and positively sloped indicating that as the level of national
income rises, the aggregate demand (or aggregate spending) in the economy also rises.
e) The AD line is flatter than the 45-degree line because, as income rises, consumption also
increases, but by less than the increase in income.
2. AGGREGATE SUPPLY (or) AGGREGATE INCOME(AS):
a) Aggregate Supply refers to the total supply of goods and services available in a market
from producers.
b) Aggregate supply represents aggregate value expected by business firms
c) Aggregate supply depends on the producers’ plan to produce goods and services.
3. Equilibrium will be established at a point where: The aggregate demand is equal to the
aggregate supply (or) The aggregate expenditure equals aggregate income (or) The
households’ plan must coincide with producers’ plan (or) Expected value by the firms equals
realized value by the households.
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4. Determination of Equilibrium Income: Two Sector Model
5. The figure depicts the following

a) Income is measured along the horizontal axis and the components of aggregate demand,
C and I, are measured along the vertical axis.
b) Since the autonomous expenditure component (I) does not depend directly on income, the
aggregate expenditure schedule (C+I) lies above the consumption function by a constant
amount.
c) Equilibrium level of income is such that aggregate demand equals output (which in turn
equals income).
d) Only at point E and at the corresponding equilibrium levels of income and output (Y0),
does aggregate demand exactly equal output.
e) At that level of output and income, planned spending precisely matches production. Once
national income is determined, it will remain stable in the short run.
Since C + S = Y, the national income equilibrium can be written as: Y = C + I
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In Panel B:
a) The saving schedule ‘S’ slopes upward because saving varies positively with income.
b) The vertical distance between the aggregate demand (C+I) and consumption line (C) is
equal to planned investment spending, I.
c) The vertical distance between the consumption schedule and the 45° line also measures
saving (S = Y- C) at each level of income.
d) In equilibrium Y0, planned investment equals saving i.e., the saving schedule (S)
intersects the horizontal investment schedule (I)
e) Above the equilibrium level of income, Y2, saving exceeds planned investment, while
below Y1, level of income, planned investment exceeds saving.
Note:

a) This condition applies only to an economy in which there is no government and no

foreign trade. I.e., aggregate demand equals consumption plus investment, Y = C + I.
b) Since income is either spent or saved, Y = C + S.
c) Putting the two together, we have C + S = C + I, or S = I.

INVESTMENT MULTIPLIER:
a) The multiplier refers to the phenomenon whereby a change in an injection of expenditure
will lead to a proportionately larger change (or multiple change) in the level of national
income.
b) Multiplier explains how many times the aggregate income increases as a result of an
increase in investment. When the level of investment increases by an amount say ∆I, the
equilibrium level of income will increase by some multiple amounts, ∆ Y.
c) The ratio of ∆Y to ∆I is called the investment multiplier,

Y
k  I

d) The size of the multiplier effect is given by ∆ Y = k ∆I.

In our two-sector model, a change in aggregate demand may be caused by change in
consumption expenditure or in business investment or in both.
Since Consumption expenditure is a stable function of income, changes in income are
primarily from changes in the autonomous components of aggregate demand, especially
from changes in the unstable investment component.

An increase in investment causes an upward shift in the aggregate demand function.

Effect of Changes in Autonomous Investment:
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From the above graph

a) An increase in autonomous investment by ∆ I shifts the aggregate demand schedule from
C+I to C+I+∆I.
b) Thus, due to the operation of the investment multiplier equilibrium shifts from E to E1 and
the equilibrium income increases more than proportionately from Yo to Y1.
c) The increase in national income (∆Y) is the result of increase in investment (∆I), the
multiplier is called ‘Investment multiplier’.
For example,
If a change in investment of Rs. 2000 million causes a change in national income of Rs. 6000
million, then the multiplier is 6000/2000 =3.
Thus, multiplier value 3 tells us that for every Rs. 1 increase in desired investment expenditure,
there will be Rs. 3 increases in equilibrium national income.
Multiplier expresses the relationship between an initial increment in investment and the resulting
increase in aggregate income.
4.Explain the principles of Taxation and their types

Principles of taxation

Adam Smith
The 18th-century economist and philosopher Adam Smith attempted to systematize the rules that
should govern a rational system of taxation. In The Wealth of Nations (Book V, chapter 2) he set
down four general canons:

I. The subjects of every state ought to contribute towards the support of the government, as
nearly as possible, in proportion to their respective abilities; that is, in proportion to
the revenue which they respectively enjoy under the protection of the state.…
II. The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time
of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the
contributor, and to every other person.…
III. Every tax ought to be levied at the time, or in the manner, in which it is most likely to be
convenient for the contributor to pay it.…
IV. Every tax ought to be so contrived as both to take out and keep out of the pockets of the
people as little as possible over and above what it brings into the public treasury of the state.…
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Although they need to be reinterpreted from time to time, these principles retain remarkable
relevance. From the first can be derived some leading views about what is fair in the distribution
of tax burdens among taxpayers. These are:

(1) the belief that taxes should be based on the individual’s ability to pay, known as the ability-
to-pay principle, and

(2) the benefit principle, the idea that there should be some equivalence between what the
individual pays and the benefits he subsequently receives from governmental activities. The
fourth of Smith’s canons can be interpreted to underlie the emphasis many economists place on a
tax system that does not interfere with market decision making, as well as the more obvious need
to avoid complexity and corruption.

Distribution of tax burdens

Various principles, political pressures, and goals can direct a government’s tax policy. What
follows is a discussion of some of the leading principles that can shape decisions about taxation.

Horizontal equity

The principle of horizontal equity assumes that persons in the same or similar positions (so far as
tax purposes are concerned) will be subject to the same tax liability. In practice this equality
principle is often disregarded, both intentionally and unintentionally. Intentional violations are
usually motivated more by politics than by sound economic policy (e.g., the tax advantages
granted to farmers, home owners, or members of the middle class in general; the exclusion of
interest on government securities). Debate over tax reform has often centred on whether
deviations from “equal treatment of equals” are justified.

The ability-to-pay principle

The ability-to-pay principle requires that the total tax burden will be distributed among
individuals according to their capacity to bear it, taking into account all of the relevant personal
characteristics. The most suitable taxes from this standpoint are personal levies (income, net
worth, consumption, and inheritance taxes).
The ability-to-pay principle also is commonly interpreted as requiring that direct personal taxes
have a progressive rate structure, although there is no way of demonstrating that any particular
degree of progressivity is the right one. Because a considerable part of the population does not
pay certain direct taxes—such as income or inheritance taxes—some tax theorists believe that a
satisfactory redistribution can only be achieved when such taxes are supplemented by direct
income transfers or negative income taxes (or refundable credits). Others argue that income
transfers and negative income tax create negative incentives; instead, they favour public
expenditures (for example, on health or education) targeted toward low-income families as a
better means of reaching distributional objectives.
Indirect taxes such as VAT, excise, sales, or turnover taxes can be adapted to the ability-to-
pay criterion, but only to a limited extent—for example, by exempting necessities such as food
or by differentiating tax rates according to “urgency of need.” Such policies are generally not
very effective; moreover, they distort consumer purchasing patterns, and their complexity often
makes them difficult to institute.

The benefit principle

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Under the benefit principle, taxes are seen as serving a function similar to that of prices in
private transactions; that is, they help determine what activities the government will undertake
and who will pay for them. If this principle could be implemented, the allocation of
resources through the public sector would respond directly to consumer wishes.
In fact, it is difficult to implement the benefit principle for most public services because citizens
generally have no inclination to pay for a publicly provided service—such as a police department
—unless they can be excluded from the benefits of the service. The benefit principle is utilized
most successfully in the financing of roads and highways through levies on motor fuels and road-
user fees (tolls). Payroll taxes used to finance social security may also reflect a link between
benefits and “contributions,” but this link is commonly weak, because contributions do not go
into accounts held for individual contributors.

Economic efficiency

The requirement that a tax system be efficient arises from the nature of a market economy.
Although there are many examples to the contrary, economists generally believe that markets do
a fairly good job in making economic decisions about such choices as consumption, production,
and financing. Thus, they feel that tax policy should generally refrain from interfering with the
market’s allocation of economic resources. That is, taxation should entail a minimum of
interference with individual decisions. It should not discriminate in favour of, or against,
particular consumption expenditures, particular means of production, particular forms of
organization, or particular industries. This does not mean, of course, that major social and
economic goals may not take precedence over these considerations. It may be desirable, for
example, to impose taxes on pollution as a means of protecting the environment.

Clarity

Tax laws and regulations must be comprehensible to the taxpayer; they must be as simple as
possible (given other goals of tax policy) as well as unambiguous and certain—both to the
taxpayer and to the tax administrator. While the principle of certainty is better adhered to today
than in the time of Adam Smith, and arbitrary administration of taxes has been reduced, every
country has tax laws that are far from being generally understood by the public. This not only
results in a considerable amount of error but also undermines honesty and respect for the law and
tends to discriminate against the ignorant and the poor, who cannot take advantage of the various
legal tax-saving opportunities that are available to the educated and the affluent. At times,
attempts to achieve equity have created complexity, defeating reform purposes.

Stability

Tax laws should be changed seldom, and, when changes are made, they should be carried out in
the context of a general and systematic tax reform, with adequate provisions for fair and orderly
transition. Frequent changes to tax laws can result in reduced compliance or in behaviour that
attempts to compensate for probable future changes in the tax code—such as
stockpiling liquor in advance of an increased tariff on alcoholic beverages.

Cost-effectiveness

The costs of assessing, collecting, and controlling taxes should be kept to the lowest level
consistent with other goals of taxation. This principle is of secondary importance in developed
countries, but not in developing countries and countries in transition from socialism, where
resources needed for compliance and administration are scarce. Clearly, equity and economic
rationality should not be sacrificed for the sake of cost considerations. The costs to be minimized
Mohamed Sathak A.J College of Engineering Change is the true end of all learning

include not only government expenses but also those of the taxpayer and of private fiscal agents
such as employers who collect taxes for the government through the withholding procedure.

Convenience

Payment of taxes should cause taxpayers as little inconvenience as possible, subject to the
limitations of higher-ranking tax principles. Governments often allow the payment of large tax
liabilities in instalments and set generous time limits for completing returns.

Economic goals

The primary goal of a national tax system is to generate revenues to pay for the expenditures of
government at all levels. Because public expenditures tend to grow at least as fast as the national
product, taxes, as the main vehicle of government finance, should produce revenues that grow
correspondingly. Income, sales, and value-added taxes generally meet this
criterion; property taxes and taxes on nonessential articles of mass consumption such as tobacco
products and alcoholic beverages do not.
Types of Taxes

Direct and indirect taxes

Taxes are most commonly classified as either direct or indirect, an example of the former type
being the income tax and of the latter the sales tax. There is much disagreement among
economists as to the criteria for distinguishing between direct and indirect taxes, and it is unclear
into which category certain taxes, such as corporate income tax or property tax, should fall. It is
usually said that a direct tax is one that cannot be shifted by the taxpayer to someone else,
whereas an indirect tax can be.

Direct taxes

Direct taxes are primarily taxes on natural persons (e.g., individuals), and they are typically
based on the taxpayer’s ability to pay as measured by income, consumption, or net wealth.
What follows is a description of the main types of direct taxes.
Individual income taxes are commonly levied on total personal net income of the taxpayer
(which may be an individual, a couple, or a family) in excess of some stipulated minimum. They
are also commonly adjusted to take into account the circumstances influencing the ability to pay,
such as family status, number and age of children, and financial burdens resulting from illness.
The taxes are often levied at graduated rates, meaning that the rates rise as income rises. Personal
exemptions for the taxpayer and family can create a range of income that is subject to a tax rate
of zero.
Taxes on net worth are levied on the total net worth of a person—that is, the value of his assets
minus his liabilities. As with the income tax, the personal circumstances of the taxpayer can be
taken into consideration.

Indirect taxes

Indirect taxes are levied on the production or consumption of goods and services or on
transactions, including imports and exports. Examples include general and selective sales
taxes, value-added taxes (VAT), taxes on any aspect of manufacturing or production, taxes on
legal transactions, and customs or import duties.
Mohamed Sathak A.J College of Engineering Change is the true end of all learning

General sales taxes are levies that are applied to a substantial portion of consumer expenditures.
The same tax rate can be applied to all taxed items, or different items (such as food or clothing)
can be subject to different rates. Single-stage taxes can be collected at the retail level, as the U.S.
states do, or they can be collected at a pre-retail (i.e., manufacturing or wholesale) level, as
occurs in some developing countries. Multistage taxes are applied at each stage in the
production-distribution process.
The VAT, which increased in popularity during the second half of the 20th century, is commonly
collected by allowing the taxpayer to deduct a credit for tax paid on purchases from liability on
sales. The VAT has largely replaced the turnover tax—a tax on each stage of the production and
distribution chain, with no relief for tax paid at previous stages. The cumulative effect of the
turnover tax, commonly known as tax cascading, distorts economic decisions.

Proportional, progressive, and regressive taxes

Taxes can be distinguished by the effect they have on the distribution of income and wealth.
A proportional tax is one that imposes the same relative burden on all taxpayers—i.e., where
tax liability and income grow in equal proportion. A progressive tax is characterized by a more
than proportional rise in the tax liability relative to the increase in income, and a regressive tax is
characterized by a less than proportional rise in the relative burden. Thus, progressive taxes are
seen as reducing inequalities in income distribution, whereas regressive taxes can have the effect
of increasing these inequalities.
The taxes that are generally considered progressive include individual income taxes and estate
taxes. Income taxes that are nominally progressive, however, may become less so in the upper-
income categories—especially if a taxpayer is allowed to reduce his tax base by
declaring deductions or by excluding certain income components from his taxable income.
Proportional tax rates that are applied to lower-income categories will also be more progressive
if personal exemptions are declared.
Income measured over the course of a given year does not necessarily provide the best measure
of taxpaying ability. For example, transitory increases in income may be saved, and during
temporary declines in income a taxpayer may choose to finance consumption by reducing
savings. Thus, if taxation is compared with “permanent income,” it will be less regressive (or
more progressive) than if it is compared with annual income.
Sales taxes and excises (except those on luxuries) tend to be regressive, because the share of
personal income consumed or spent on a specific good decline as the level of personal income
rises. Poll taxes (also known as head taxes), levied as a fixed amount per capita, obviously are
regressive.
5.What is money and explain in detail about the different types of money and its functions

“Money & types of money” can be defined as the most commonly accepted form of exchange
for goods and services. Money can be virtually anything as long as it is capable of satisfying the
three conditions, that is, medium of exchange, store of value, and unit of account. In the
following banking awareness study notes, we shall understand more about money and its related
aspects.

o The standard money is a monetary unit which is declared by the government to serve as
the base of its currency system.
o The word “currency” refers to the aggregate coins and paper notes (paper money).
o The term “paper money” sums the banknotes issued by the Central Bank, that is the
Reserve Bank of India (RBI). Paper money is generally accepted in daily transactions as
a mode of exchange for goods and/ or services.
o Bill of exchange and cheques are also considered as paper money.
Mohamed Sathak A.J College of Engineering Change is the true end of all learning

Money & Types – Meaning & Overview

The word “currency” refers to the aggregate of coins and paper notes (paper money). The
currency in broad view is the tangible medium of exchange. Almost 180 currencies exist around
the world, as per the United Nations. However, the British pound is the oldest currency in the
world, which is still in use, dating back to the 8th century.
The various types of money are:

o Commodity Money
o Fiat Money
o Fiduciary Money
o Commercial Bank Money
o Metallic Money
o Paper Money
o Reserve Money

Money & Types (Terminologies)

Commodity Money

o It is the easiest, most likely, and the oldest type of money. It builds on scarce natural
resources that work as a source of exchange, storage value, and unit of account.
o Commodity money is closely related to (and originates from) a barter system, in which
goods and services are directly interchanged for other goods and/ or services.
o Commodity money is a way of simplifying the process, as it acts as a commonly
accepted medium of exchange.
o The significant thing about commodity money is that its value is described by the actual
value of the commodity itself.
o Few examples of money are gold coins, shells, spices, beads, etc.

Fiat Money

o Fiat money is a type of paper money. It is the money which has a face value more than
its real value.
o The actual value of money is worthless. It is accepted by the people on the order of the
government.
o The face value is decided by the government and the money is not exchanged into
standard money.
o The fiat money is used as a medium of exchange and as a standard of value. It may be
paper money or any kind of commodity.
o The real value of fiat money is not equal to its face value.
o This type of money is issued across the world.

Fiduciary Money

o It is known for its value on the confidence that it will be commonly considered as a
mode of exchange.
o Like fiat money, the fiduciary money is not considered a legal tender by the government.
o In case asked by the bearer, the issuer of the fiduciary money guarantees to exchange it
back for a commodity or fiat money.
o As long as the parties involved are confident that the assurance will not be broken, they
may use the fiduciary money just like the regular fiat or commodity money.
Mohamed Sathak A.J College of Engineering Change is the true end of all learning

o Examples of fiduciary money are bank notes, drafts, cheques.

Commercial Bank Money

o It can be regarded as claims against the financial entities, which may be utilized to buy
goods and/ or services.
o The commercial bank money is created through so-called fractional reserve banking
o Fractional reserve banking is when the commercial banks provide loans and/ or
advances worth greater than the value of the real currency they possess.

Metallic Money

o Pieces of metals like gold, silver, bronze, and copper came to be used as money in both
ancient as well as current times. It can be classified as metallic money.
o The value of these in exchange of goods is equivalent to their actual/ intrinsic value.
o Metallic money can be categorized into full bodied coins and token coins.

Paper Money

o Paper money refers to the bank notes and government notes which are used as money.
o The distribution of the paper money started in order to replace the metallic money.
o In the modern days, paper notes inherited the characteristics of token money, being
commonly acceptable without reference to that of the metallic equivalent.

Representative Money

o All token coins and paper notes that can be readily converted into full-bodied coins or
equivalent bullion (gold, silver, etc.) at a fixed rate, are known as representative money.
o Such a kind of money was accepted in India in 1927 when rupee notes and coins were
easily able to convert into gold.

Unlimited Legal Tender

o Money described by the central government to be legal tender to an unlimited extent is

called unlimited legal tender.
o Under such a system, creditors are required to accept payments in this money to an
unlimited extent.
o The rupee notes and coins are unlimited legal tender in India.

Limited Legal Tender

o In cases when coins and notes are legal tender only to a limited extent, they are known
as limited legal tender.
o All the small coins in the country are legal tender to the extent of one rupee.
Mohamed Sathak A.J College of Engineering Change is the true end of all learning

Optional Money

o All the instruments and notes like the bills of exchange, promissory notes, cheques, etc.
are often accepted in the discharge of liabilities and obligations despite the fact they are
not legal tender.
o In collection, these instruments can be termed as “Optional Money”.
o The acceptability of this kind of money is based on the mutual consent of all the parties
involved in the transaction.

Bank Money

o Bank deposits that can be withdrawn through cheques are generally known as bank
money.
o Most of the banks create deposits when they extend loans to individuals or firms. These
deposits are also known as bank money.
o All the banknotes issued by the banks contribute to another part of the bank money.

Credit Money

o Most of the loans extended by the banks to the individuals and/ or businesses are usually
held by them in the form of bank deposits.
o Such deposits can be withdrawn by using instruments like cheque, just like primary
deposits made by depositors. It is called credit money.

Money & Types in terms of Supply (M1, M2, and M3…)

M0 and M1, also referred to as narrow money, include coins and notes in circulation and other
equivalent money that are easily convertible into liquid cash.
M2 encapsulates M1 in addition to short-term time deposits in the banks and 24-hour money
market funds.

Reserve Money (M0)

Circulating Currency + Bankers’ savings in the accounts of the RBI + Other deposits with the
RBI = Net RBI loans given to the government + RBI credit to the commercial sector + RBI’s
debits on banks + RBI’s net in foreign assets + government’s currency debts to the public –
RBI’s net non-monetary liabilities

M1:

Currency held by the public + Banking system’s demand deposits + Other deposits with the RBI

M2:

M2 is a wider classification of money as compared to M1, it includes assets that are highly
liquid, excluding cash.
And M2: M1 + Savings banks’ deposits in savings accounts
Mohamed Sathak A.J College of Engineering Change is the true end of all learning

M3

It is a quantity of the money supply in addition with M2 as well as institutional money

market funds, large time deposits, short-term repurchase agreements, and other larger liquid
assets.
M3:
M1 + Time deposits in the banking sector = net bank credit to the central/ state government +
Bank credit to the commercial sector + net foreign holdings of the banking system +
government’s currency debts to the public – net monetary debts of the banking sector

M4:
M3 + Entire deposits with post office savings banks (excluding National Savings Certificates)

Functions of Money
 A medium of exchange.
 A standard of deferred payment.
 A store of wealth.
 A measure of value.

6. What Is the IS-LM Model?

The IS-LM model, which stands for “investment-saving” (IS) and “liquidity preference-money
supply” (LM) is a Keynesian macroeconomic model that shows how the market for economic
goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a
graph in which the IS and LM curves intersect to show the short-run equilibrium between interest
rates and output.
Mohamed Sathak A.J College of Engineering Change is the true end of all learning

KEY TAKEAWAYS

 The IS-LM model describes how aggregate markets for real goods and financial markets
interact to balance the rate of interest and total output in the macroeconomy.
 IS-LM stands for “investment-saving” (IS) and “liquidity preference-money supply” (LM).
 IS-LM can be used to describe how changes in market preferences alter the equilibrium
levels of gross domestic product (GDP) and market interest rates.

Understanding the IS-LM Model

British economist John Hicks first introduced the IS-LM model in 1937, not long after fellow
British economist John Maynard Keynes published The General Theory of Employment, Interest,
and Money in 1936. Hicks’ model served as a formalized graphical representation of Keynes’
theories, though it is used mainly as a heuristic device today.123
The three critical exogenous, i.e. external, variables in the IS-LM model are liquidity, investment,
and consumption. According to the theory, liquidity is determined by the size and velocity of
the money supply. The levels of investment and consumption are determined by the marginal
decisions of individual actors.4
The IS-LM graph examines the relationship between output, or gross domestic product (GDP),
and interest rates. The entire economy is boiled down to just two markets—output and money—and
their respective supply and demand characteristics push the economy toward an equilibrium point.

Characteristics of the IS-LM Graph

The IS-LM graph consists of two curves: IS and LM. GDP is placed on the horizontal axis,
increasing to the right. The interest rate makes up the vertical axis.5

The IS Curve
The IS curve depicts the set of all levels of interest rates and output (GDP) at which total
investment (I) equals total saving (S). At lower interest rates, investment is higher, which translates
into more total output (GDP), so the IS curve slopes downward and to the right.3
Mohamed Sathak A.J College of Engineering Change is the true end of all learning

The LM Curve
The LM curve depicts the set of all levels of income (GDP) and interest rates at which money
supply equals money (liquidity) demand. The LM curve slopes upward because higher levels of
income (GDP) induce increased demand to hold money balances for transactions, which requires a
higher interest rate to keep money supply and liquidity demand in equilibrium.5

The Intersection of the IS and LM Curves

The intersection of the IS and LM curves shows the equilibrium point of interest rates and output
when money markets and the real economy are in balance.3 Multiple scenarios or points in time
may be represented by adding additional IS and LM curves.
In some versions of the graph, curves display limited convexity or concavity. Shifts in the position
and shape of the IS and LM curves, representing changing preferences for liquidity, investment, and
consumption, alter the equilibrium levels of income and interest rates.

Limitations of the IS-LM Model

Many economists, including many Keynesians, object to the IS-LM model for its simplistic and
unrealistic assumptions about the macroeconomy. It cannot account for simultaneous
high unemployment and inflation in the economy. It is also undercut by the change by central
banks to using an interest-rate rule rather than targeting the money supply.5
Even Hicks later admitted that the model’s flaws were fatal, and it was probably best used as “a
classroom gadget, to be superseded, later on, by something better.”6 Subsequent revisions have
taken place for so-called “new” or “optimized” IS-LM frameworks.5
The model is a limited policy tool, as it cannot explain how tax or spending policies should be
formulated with any specificity. This significantly limits its functional appeal. It has very little to
say about inflation, rational expectations, or international markets, although later models do attempt
to incorporate these ideas. The model also ignores the formation of capital and labor productivity.

Is the IS-LM model actually used?

If the IS-LM model is used today, it is as a shortcut enabling quick decision making. Because it is
too simplistic, it is not useful for formulating tax or spending policies. Even its creator, John Hicks,
called it “a classroom gadget” and expected it to be eventually replaced by something more
sophisticated.

Why does the LM curve slope upward?

The LM curve slopes upward because a higher gross domestic product (GDP) causes greater
demand to hold money for transactions. This, in turn, raises interest rates, so that money supply and
liquidity can stay in equilibrium.

Who developed the IS-LM model?

A British economist named John Hicks developed the IS-LM model in 1936, basing it on theories
published by another British economist, John Maynard Keynes, only a few months earlier.

The Bottom Line

The IS-LM model is a tool for looking at how the market for economic goods intersects with the
loanable funds market. It depicts the short-term equilibrium point between interest rates and output,
with its three variables being liquidity, investment, and consumption.
Because it is a highly simplistic device, it is only useful when snap decisions must be made, as it
lacks the sophistication necessary for setting tax and spending policies.
Mohamed Sathak A.J College of Engineering Change is the true end of all learning
Mohamed Sathak A.J College of Engineering Change is the true end of all learning