Central Bank

Definition: It is a bank which has monopoly over issuing of currency notes; it keeps all the reserves of foreign exchange and gold; it settles financial transactions between banks and it controls the money supply and money market.

Function of Central Bank

The main functions of central bank are as under: I.

Issue the Currency Notes: -

entral bank issues the currency notes in the country. It has the monopoly of issuing currency notes in a country. There are two methods of issuing currency notes in the country that are as under:

!eserve apital "ethod. #ixed #iduciary "ethod. Reserve Capital Method: $hile issuing notes by this method the central bank has to keep a certain percentage of notes issued in the form of gold and silver etc. %s in &akistan' ()& *(tate )ank of &akistan+ has to keep ,-. as reserves in the form of gold against each !s./-issued. (uch method is followed by the countries like &akistan' India' 0ermany and 1( *1nited (tate+ etc.

Fixed Fiduciary Method: 1nder this method the parliament of a country allows to issue the currency notes up to a specific limit without keeping any reserves against such issued notes. If more than such notes are issued an e2ual amount of gold has to be kept. This system is applied in case of 13 *1nited 3ingdom+ 4orway and 5apan.

II. Bank of

overn!ent: -

entral )ank is also called )ank of 0overnment because all the payments and receipts of the govt. are made by central bank. entral bank keeps the deposits of all the govt. departments. entral bank serves as an agent to 0ovt. It sells and purchase govt. securities. III.

"he Bank of Banks: -

entral bank is a banker to banks. Therefore' it is the function of central bank to establish a suitable and proper type of banking structure in a country.

entral bank provides loans to commercial banks.

The central bank serves as a learing 6ouse for the commercial banks.

I#. Custodian of Forei$n %xchan$e and

old Reserves: -

"ost of the entral banks have to keep gold while issuing notes. In addition to gold the foreign exchange reserves are also with the central bank

The fluctuations in exchange rate will not occur when central bank interference in
foreign exchange market by selling and purchasing foreign exchange.

The deficit in )7& can be removed in a better way.

#. &ender of last Resort: The central bank serves as a last resort for the commercial banks' particularly when they do not have access to other sources. In addition to commercial banks' it also serves as a lender of last resort for the govt.

#I. Controller of Money Market: The changes in money and credit do have a variety of effects on the economy. Therefore' central bank has to control the supply of money and take some steps for this purpose:

Bank rate 'olicy: 8uring Inflation central bank increases its bank rate and during deflation central bank decreases the bank rate.

(pen Market syste!: 8uring Inflation central bank sells the bands' securities etc. in the market to control the inflation and during deflation purchased the bands' securities etc. to control the deflation in the economy.

Chan$es in Reserve Ratio: $hen central bank want to control the inflation in the economy increases the reserve ratio for the commercial banks. $hile during deflation central bank decrease the reserve ratio for the commercial banks.

"rade Cycle
)ccordin$ to *a+eler )usiness cycles are 9ust the names of prosperity and adversity; good trade and bad trade. )ccordin$ to ,. C. Mitchel Trade cycles are the fluctuations in the aggregate economic activity. %ny trade cycle starts from depression' enters into revival' then converts itself into boom and finally turns into recession. )ccordin$ to -. R. *icks Trade cycles represent fluctuations in the real national income of the economy. (uch fluctuations occur because of economic growth' conse2uent upon changes

in labor force' innovations and inventions' capital assumptions and natural resources. : ;conomic %ctivity )oom !evival !ecession

8epression 7 Time <

'hases of "rade Cycle

% Trade cycle is furnished with four phases. They are:

I. Depression: In this situation' the level of income and employment falls. The demand for goods and services falls. %s a result' the prices of goods and services fall. The profits of producers decrease. In nut shell' during depression' the level of prices' consumption' income' employment' wages and interest rate' etc. reach the lowest level. &rices onsumption Income 8ecreased $ages ;mployment II.

Revival (R Recovery: -

;conomy gradually converts itself into revival. The producers' who face big losses during depression' leave the business. The remaining firms indulge themselves in the replacement of existing machines. In this way' the demand for capital goods will rise and the recovery emerges. %ccordingly' the price level' wages' interest rate' rates of profit' employment and production all starts rising gradually. &rices onsumption Income $ages ;mployment

Increasing

III. 'rosperity (R Boo!: The revival culminates into boom or prosperity. In the period of revival when profits rise' the firms get loans from the banks. In this way prices and costs rise very sharply. (imply' during boom' the price level' consumption expenditures' income of people' wages' profits' employment and output reach the highest level. &rices onsumption Income $ages ;mployment

Increased

I#. Contraction (R Recession: The boom does not last for ever. The banks tighten their policy of advancing loans. 7n the other hand' the firms who have produced a lot has to be sold at decreased prices. (uch as all phenomena result in great losses to the producers. )eing disappointed' there is a big cut in the output and employment. The recessionary trends develop in the economy and the economy reaches to the depression. &rices onsumption Income 8ecreasing $ages ;mployment

'roperties of "rade Cycle

The properties of trade cycle are as under:

I. )$$re$ate %cono!ic )ctivity: #luctuations in aggregate economic activity represent trade cycles. If there are downswing and upswing trends in a particular sector of the economy' they will not represent trade cycles. II.

"he 'eriod of 'hases: -

The period of phases with respect to their duration and intensity are not alike. In some cycles' the period of depression is acute and prolonged as compared with the period of prosperity. $hile in some cycles' the economy rapidly turns from depression to revival while in others it may be of a slower nature. %ccording to lament 5uggler a trade cycle completes its all phases in the period of = or /- years. $hile' according to 3andretiff' a cycle lasts for >- years.

III. "he Nature of Diffusion of %ffects: The effects of trade cycle do not remain confined to a particular segment of the economy; rather they are spread over to all the sectors of economy. "oreover' the changes in phases of trade cycle do have the effects on wages' prices' rents' profits' consumption' savings and investment.

I#. International in Nature: -

Trade cycles are international in nature. It means that the prosperity in one country will have the effect on the other countries. %s' it happened during /=,-?s 0reat 8epression when unemployment spread over to all the capitalist economies.

#. .ocial %ffect: The trade cycles generate' in addition to economic' the social effect. %s during depression' suicides increase because of economic stringencies while in prosperity the birth rate rises because of economic easiness.

*o/ can trade cycle +e reduced0

Trade cycle has always been a crucial issue for the policy makers to control the trade cycle. (ome of the measures are presented as:

I. Fiscal 'olicy: #iscal policy is an economic policy which consists of government expenditures and taxes. This policy can be adopted to remove boom or inflation and depression. %ccordingly' to remove boom or inflation' strict fiscal policy can be adopt. In this way' investment' national income and prices will decrease. 7n the other hand' during deflation or depression easy fiscal policy is adopted. In this way' investment' national income and prices will increase.

II. Monetary 'olicy: "onetary policy is an economic policy which consists of open market operations' changes in bank rate and changes in reserves etc. 8uring inflation or boom strict monetary policy can be followed by raising the bank rate' selling government securities and raising the reserve ratios of banks. 7n the other hand' during deflation or depression easy monetary policy can be followed by reducing the bank rate' purchasing the government securities and decreasing the reserve ratios of banks.

III. Buffer .tock .che!es: (uch schemes consist of official purchase and sale of food grains. 8uring depression when the prices of agricultural goods are falling the government should purchase such commodities at reasonable prices. 7n the other hand' during boom government should sell the products at its disposal at lower prices. In this way the boom will not perpetuate.

,hy did trade cycle appear in the econo!y0 "heories of "rade Cycles
There are different theories about the trade cycle. 6owever some of them are as under:

i.

.unspot "heory: -

%ccording to 7rthodox &hilosophers' trade cycles are generated due to changes in climate and weather conditions. (uch changes bring certain spot on the face of sun which result in decreasing the heat out of the sun. In this way' the agricultural production will be affected and will have a negative effect on industrial production.

ii.

'sycholo$ical "heory: -

%ccording to psychological theory trade cycles occur due to the business expectations and psychological behavior of businessmen. If the business community is optimistic about future business life' they will increase@decrease investments' production and employment and due to this trade cycles appear in the economy.

iii. iv.

"heory of under consu!ption: *a/trey "heory of "rade cycle: -

%ccording to this theory' trade cycles occur because the rich society decreases their consumption and create over savings. %s a result' they do not purchase all of the goods produced in the economy and caused for trade cycle in the economy. %ccording to 6awtrey money and banking system is responsible for trade cycle. %s if there is prosperity in the economy' the commercial banks and other institutions increase the supply of money. To expand their business the businessmen get loans from banks and boom will occur in the economy. 7n other hand when commercial banks pursue a tight credit policy in boom' it puts the firms into troubles. The raw material and intermediate goods have to be sold at reduced prices and prices fall. In this way' the economy will be in the grip of depression.

v.

"he (ver Invest!ent "heory: -

7ver investment in the capitalist economies is responsible for economic fluctuations@trade cycle. %t lower interest rates' the producers borrow heavily and increase investment. )ut when banks increase the rate of interest and it becomes expensive to get loans and economy ultimately leads to depression.

vi.

.chu!peter1s "heory of "rade cycle: -

%ccording to (chumpeter' trade cycles occur due to inventions and innovations on the part of entrepreneurs. In other words' when there is over supply of goods' there prices come down. 6ence' the wages and incomes of people decrease and the economy enters in the phase of depression. 8uring depression' new inventions and innovations are adopted. %s a result' the economy will recover which ultimately converts itself into boom.

vii.

2eynes "heory of "rade cycle: .a!uelson1s "heory3Interactive of Multiplier and )cceleration3Modern "heory: -

This theory is based on the theory of income A employments. $here' he explains the behavior of a trade cycle. onsumption' investment and concept of a multiplier bring changes in the economic activities. viii.

)usiness cycles come into being because of interaction of multiplier and accelerator. %s because of multiplier effect' 4I changes multiple times of change in investment. $hile any change in income will affect investment through accelerator principle. In this way' according to (amuelson' there is an endless se2uence of changes in income and output.

Multiplier:

%ccording to 3eynes theory of income' Income changes many times due to change in investment. : B f *I+ $hen I increase B : increase I decrease B : decrease 3B : I

)ccelerator:
%ccording to lark' Investment changes many times due to change in Income. I B f *:+ $hen : increase B I increase : decrease B I decrease $B I :

)ssu!ption of Modern "heory:

The autonomous consumption expenditures worth !s. /- crore are taking
place each year' i.e.' C B !s. /- crore The autonomous investment expenditures worth !s. /- crore are taking place each year' i.e.' IC B !s. /- crore The value of "& B D@,

The value of 7!*accelerator coefficient+ is D' i.e.' w B D There is one period lag between income and expenditure which means to
say that current income generates consumption in the next year. &erE Eiod T / D , H > I K %utonomous onsumption C ///////%utonomous Investment IC DDDDDDDInduced onsumption c: "& BD@, E E ,-GD@, D-EBDBD=-GD@, I-EDBIBH/K-GD@, //,EIB//, B>, DH=GD@, /IIE//, B/II B>, ,-DGD@, D-/E/II BD-/ B,> ,-/GD@, D-/ED-/ BD-/ BInduced Investment *e:+:wBD E D-GDBHH-GDBJ>,GDB/-I >,GDB/-I ,>GDBK-GDB4ational Income :B CFICF c:Fe: /-FD-F-F-B,/-FD-FD-FHB=/-FD-FI-FJB/K/-FD-F>,F/-I BDH= /-FD-F/IIF/-I B,-D /-FD-FD-/FKB,-/ /-FD-FD-/FBD,/

Result:
The table shows that from first period to >th period' 4I goes on to increase. The increase in 4I represents that the economy is moving towards revival. In the >th period' 4I of the economy gets maximum' which shows boom or prosperity. In the Ith period' the trend of fall in income starts' while in the Kth period' 4I has fallen down. This represents contraction or recession.

Balance of 'ay!ents 4B('5

Definition: )alance of payments is systematic record of all economic transactions completed between the residence of a country and the residence of the rest of the world.

.urplus in 4B('5: If the receipts of a country are greater than its payments the result is (urplus. !eceipts L &ayments

Balance in 4B('5: If the receipts of a country and its payments are e2ual the result is )alance. !eceipts B &ayments

Deficit in 4B('5: If the receipts of a country are less than its payments the result is 8eficit. !eceipts M &ayments (imply whenever' the foreign payments of a country are more than the foreign receipts of the country' the deficit in )7& rises. In other words' whenever the demand for foreign exchange is more than the supply of foreign exchange the deficit in )7& occurs.

Causes of Deficit in 4B('5

The causes of deficit in )7& are as under:

I. Inco!e "ype of Dise6uili+riu!: The deficit may arise because of changes in income level of a country. If in a country the incomes are rising more than the rest of the world' because of rise in incomes the consumption in the country will increase and the exports will decrease. In this way foreign receipts will come down and deficit in )7& occurs.

II. 'rice "ype of Dise6uili+riu!: The changes in price level are also responsible for )7& deficit. If in a country due to demandEpull inflation or costEpush inflation' the price level rises' the domestic products will become expensive. In this way' the exports of a country may fall and the imports of a country may increase. In this way' receipts will come down and payments will increase and caused for deficit in )7&.

III. Capital Move!ent: The capital movement is also responsible for deficit in )7&. %s due to political instability the domestic capital is flowing out then the foreign payments of a country may increase. If the foreign capital is not coming to the country' the receipts of a country may also go down. Thus the changes in capital movement at capital accounts of )7& are also responsible for deficit in )7&.

I#. .tructural Chan$es: The structural changes which occur in an economy are also responsible for deficit in )7&. They are as: If in a country' the population increases' the exports will decrease and imports will increase. If in a country' the natural resources are depleted the exports may come down. If in the world' the substitutes are developed' they may have the effect of reducing the exports of a country. If a country is engaged in the process of economic development' it has to import machinery' raw material and a variety of goods. In this way the country will have to spend foreign exchange on their importation.

Measures to Re!ove Deficit in B('

(imply to remove deficit in )7&' a country should increase its exports and decrease its imports. They are discussed below:

I. "o

ive .u+sidies to %xporters: -

%ny country which faces deficit in )7& should give subsidies to the exporters. They may also consist of granting of loans at reduced rates to the exporters as well as providing insurance facilities and shipment services etc. "oreover' if countries follow the policy of subsidiNing the other countries may also follow it. In this way the benefits of subsidies will not be availed.

II. Restrictions on I!ports: %ny country which faces deficit in )7& may also impose restrictions on imports by increasing the import duties' imposition of exchange control etc. In this way the imports will decrease.

III. Deflation: The country which is facing deficit in )7& should follow the policy of deflation. This policy can be adopted with the help of tight fiscal policy by decreasing 0ovt. expenditures and increasing taxes. This will have the effect of decreasing the incomes and expenditures of the people. In this way' there will be a deflation in the economy. %s a result the imports will decrease and exports will increase

I#. Devaluation: In /==H' the $orld "onetary onference was held at )rettonwoods. In this conference it was decided that &ound (terling *O+' 8ollar *P+ and gold will be used for international transaction. The rate of exchange so determined would remain fixed. 6owever' a country which faces deficit in )7& was allowed to devaluate its currency up to /-. without permission of International "onetary #und *I.".#+ and more than this with the permission of I"#. In this way the exports will increase and imports will decrease. %ccordingly' the deficit will be cured.

#. International Monetary Fund 4I.M.F5: %s the international level' the institution named as I"# has been set up. This institution has been assigned to perform the following functions: To serve as a pool of international reserves. To keep an eye on exchange rates of currencies.

 To provide assistance to those countries who face persistent deficit in their )7&. In this respect I"# has initiated a lot of and with the help of these farcicalities the member of I"# who faces deficit in )7&' can get loan from I"# and use it to remove its deficit.

#I. Depreciation: 1nder )rettonwood (ystem it was decided that the rate of exchange between currencies will remain fixed. )ut in /=K/' %merican &resident 4ixon suspended the convertibility of 8ollar into gold. Thus' since /=K,' the world is having the managed #lexible ;xchange !ate of (ystem. 1nder #lexible (ystem' the deficit in the )7& is automatically washed through the policy of 8epression.

#II. )ppreciation: The policy of appreciation is opposite to that of depreciation. It comes into being when the country faces surplus in )7& under the flexible exchange rate system.

Balance of "rade
The record of only visible goods transaction completed between the residence of a country and the residence of the rest of the world' is known as )alance of Trade.

"er!s of "rade 4"("5

!atio between the value of exports and value of imports is known as terms of trade. Qalue of < T7TB Qalue of " Qalue of < B &rices of goods ;xport G R of goods export Qalue of " B &rices of goods Import G R of goods import

.urplus3Favora+le "(": If value of < is greater than value of " the terms of trade is favorable. In other words when the receipts of a country is more than its payments the result is surplus in T7T. Qalue of < L Qalue of " 7! !eceipts L &ayments

Deficit37nfavora+le "(": If value of " is greater than value of < the terms of trade is unfavorable. In other words when the payments of a country is more than its receipts the result is deficit in T7T. Qalue of " L Qalue of < 7! &ayments L !eceipts

Causes of Deficit3 7nfavora+le of "("

The causes of deficit@unfavorable of T7T are as under: I. %xport of )$ri oods: 1nlikely the exports of &akistan are agri. goods like cotton and rice etc. In international markets there are heavy fluctuations in the prices of these goods. If the

prices of such goods fall' as such goods canSt be stored and they have to be sold even at lower prices. %ccordingly' T7T goes deficit.

II. &o/ Inco!e and 'rice %lasticities of De!and: There is very low income and price elasticities of demand for the exports of &akistan. Therefore' even at lower prices our exports do not increase. Thus when we have poor income and price elasticities of demand the T7T is going deficit.

III. Desire for Industriali8ation: The poor countries have the desire to industrialiNe themselves as soon as possible. #or this purpose they have to import raw material' machinery and automobiles. It means that under developing countries sold at lower prices and purchased at higher prices. In such situation T7T is going deficit.

I#. Increase in 'opulation: In the poor countries there is a big population pressure and ma9or part of increase in population is comprised of unskilled labor. There' the wages because of such rising labor are going down. %nd the exports of poor countries are also getting cheaper with the result that T7T is going deficit.

#. &ack of "rade 7nions: In under developing countries the trade unions have always been weak and ineffective. %s a result the wages can be depressed down. $ith this the domestic goods will be produced cheaper and exported at lower prices. In this way' the T7T will remain deficit.

#I. .upply of $oods and Market .tructure: The competitive conditions prevail in the export sectors of under developing countries. %s a result' the prices of export goods are low. Thus when the exports of under developing countries command lower prices and imports at higher prices the T7T goes deficit.

Measures to I!prove "("

The T7T can be improved by doing this: The country should export manufactured goods' rather agri. goods and primary goods. In order to industrialiNe their economies the under developing countries should depend upon their own resources. They should reduce their dependence on imports. The population of the country should be controlled so that the demand for imports could decrease.

'u+lic Finance
%ll &olicies' all measurements' 0ovt. loans and 0ovt. expenditures are related to 4.I is known as &ublic #inance.

Financial 'olicy: ollecting of taxes that are known as revenues' the policy of getting loans inside and outside of the country and how spent itT Is known as financial policy.

Difference +et/een 'rivate and 'u+lic Finance

The difference between private and public finance is as under:

I. "he order of Inco!e and %xpenditure: ;ach person first arrange@estimate his income and than spend according to his income. $hile' 0ovt. first arrange@estimate its expenditures and than get its income by applying taxes during a financial year.

II. 'eriod of the Bud$et: ;ach person may arrange his budget daily' weekly' monthly and yearly )ut 0ovt. budget is always for one year. #inancial year of &akistan is /st 5uly U ,/st 5une.

III. Internal and %xternal Resources: ;ach person gets his income only internal resources while govt. gets its income with both internal and external resources.

I#. Deficit (R .urplus Finance: 1sually the govt. budget is deficit but common personSs budget is always surplus. Their budget can never be deficit.

#. %xtraordinary Chan$es: The changes occurred in govt. budget are extra ordinary and it is more than common personSs budget. It effect on the economic condition of the state. $hile' common personSs budget do not effects on the economic condition of the state.

#I. 'rovision for Future: ommon persons save their income for problem which may arise in the future. $hile' 0ovt. not save its income.

#II. .ecret and (pen Bud$et: &rivate budget is always secret but govt. budget is always open and advertised and discussed in %ssembly.

.ources of Federal
/+

overn!ent

"ax Revenues: i. Fees: -

Through directA indirect taxes' wealth tax' property tax' gift tax' sales tax and excise duty etc. The money which people paid to govt. in return of some govt. services is known as fees. ii. 'rices: The money is paid in return of goods A services which are provided by the govt. to the people according to the prices of the goods A services is known as &rices.

95 Non "ax Revenues: i. ii. .tate 'roperty: 'roductive : %nterprise: 0ovt. has its state property' by selling its property to the public at low prices get income. #or ;xample: oal' (alt and Iron etc. 0ovt. is also investment in productive works and gets income #or ;xample: Telephone and &ost office etc.

'rinciples3Canons of "axation
The principles of taxation are as under;

I. Canon of %6uality: ;very person had to pay tax according to his income not on a fixed rate of tax. &oor persons had to pay less tax according to their incomes and rich persons had to pay more tax according to their incomes.

II. Canon of Certainty: The payee must be sure that how much tax he had to payT $here he payT %nd when he paysT The payee must have the knowledge of tax and its procedure.

III. Canon of Convenience: The tax must take when the payee has the income. 6e had to pay nearby areas.

I#. Canon of %cono!y: The expenditures which are paid to collect the taxes must be less than taxes that mare taxes are collected.

#. Canon of .i!plicity3'rocedure of "ax: The procedure of tax must be easy that every person can easily know and understand its procedure.

#I. Canon of 'roductivity: The system of tax must be according to the needs of the govt. and the income which is collected from taxes must be use there where from more income come.

#II. Canon of %lasticity: The govt. should keep &rogressive@&roportional tax in mind to applying tax on the persons.

#III. Canon of Flexi+ility: The govt. should give the flexibility to the persons according to their income that when income increase than tax increase and when income decrease than tax decrease.

I;. Canon of Develop!ent: The money which is collected by taxes must be use there where from more income come and increase development in the country.

"axes
The amount which is paid to govt. by the people and firms is known as taxes. )ut against such payments the people and firms can not expect any direct return from government.

"ypes of "axes
The taxes are divided into following types:

I. Direct "ax: 8irect tax is such a tax which has to be paid by the person whom upon it has been imposed. #or ;xample: Income tax' $ealth tax and property tax in &akistan. The payee can not shift the burden of such tax to somebody else.S

II. Indirect "ax: Indirect tax is such a tax which has to be paid by the person whom upon it has not been imposed. The payee can shift the burden of the tax to somebody else. #or ;xample: ustoms duty' (ales tax and ;xcise duty in &akistan.

III. 'ro$ressive "ax: The progressive tax is a tax which changes along with change in income of the persons. The rate of tax on higher incomes is more while it is low in case of low income.

I#. 'roportional "ax: 1nder proportional taxes a uniform tax rate is imposed on all the incomes of people. If in a country the income tax rate is /-.' all the persons will have to pay /-. tax.S

#. Re$ressive "ax: It is a tax whose rate falls along with increase in incomes of the people. Thus' it is opposite to progressive tax. It also denotes that the poor have to sacrifice more as compared with the rich.

,hy did

overn!ent )pply "axes0

overn!ent %xpenditures
The govt. applies taxes to complete the following:

I. Defense: The govt. spends its much income on the defense of its country. &akistan spends D-. of its budget on its defense. The most income is spent on defense in TodaySs world.

II. "o Maintain Discipline: It is governmentSs duty to maintain discipline in the country and for this purpose govt. spends its income to maintain the discipline in the country.

III. %ducation: ItSs governmentSs duty to provide education to every citiNen. #or this purpose govt. established school' college and universities to provide education and spends its income for this purpose.

I#. *ealth: The govt. is also spends its income to provide health facilities to the people and for this purpose built new hospitals and provide modern machinery.

#. 'u+lic /orks: The govt. is also spent its income for public works as like build public parks and public libraries for the people

#I. Co!!unication and "ransportation: The govt. is also try to provide the best resources of communication and transportation to the people and for this purpose spend its income and builds new roads and airports etc.