As Per Revised Syllabus under CBCGS System

under Mumbai University w.e.f. June, 2017

VtpuVs
BUSINESS
ECONOMICS -11
(BM S / B B I / BFM / BIM C o u rses)
(Second Y e a r : Fourth Sem ester)
(C o re Courses - Com pu lso ry)

S A R A S W A T H Y SW A M I N A TH A N
M.A. (Eco), D.H.E.
Vice-Principal and H ead o f the Department o f Economics,
S. I. E. S. College o f Commerce and Economics,
Sion (E), Mumbai - 400 022.

FIR S T ED ITIO N

V
VIPUL
PRAKASHAN
Published by:
N. V. Maroo
For Vipul Prakashan
161, J. S. Seth Road
Mumbai - 400 004.

Business Economics - II (SFC)

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ISBN: 978 -9 3 - 86825 - 56-8

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MMXVII
(ii)
 Preface
It gives me immense pleasure to present this book on
‘Business Economics - IF for the second year BMS, BBI, BFM,
BIM Courses of the University of Mumbai. The ‘Revised
Syllabus’ comes into effect from the academic year 2017-18.
This book has been written to meet the needs of the students
and faculty members.
The syllabus is divided into four units covering all major
aspects of macro economics. The topics are written in a simple
language but in detail. Books recommended by the University,
journals, magazines and Economic Survey were referred while
preparing the book. Possible questions - both objective and
subjective - have been added at the end of each chapter. I hope
the book will be useful to the students and teachers.
I sincerely thank the publishers Vipul Prakashan and
Mr. Dipen Maroo for their support in bringing out this book.
My thanks are also due to my Principal, Teacher Colleagues,
Librarian and my Family Members for their encouragement.
Suggestions and comments are welcome from teachers and
students for improvement.
Author

(Hi)
 SYLLABUS
No. of
No. Modules / Units
Lectures

1 Introduction to Macroeconomics Data and Theory: 15

Macroeconomics: Meaning, Scope and Importance.

• Circular flow of aggregate income and expenditure: Closed

and Open Economy Models.

• The Measurement of national product: Meaning and

Importance - Conventional and Green GNP and NNP concepts
- Relationship between National Income and Economic
Welfare.

• Short Run Economic Fluctuations: Features and Phases of

Trade Cycles

• The Keynesian Principle of Effective Demand: Aggregate

Demand and Aggregate Supply - Consumption Function -
Investment function - Effects of Investment Multiplier on
Changes in Income and Output.

2 Money, Inflation and Monetary Policy: 15

Money Supply: Determinants of Money Supply - Factors

influencing Velocity of Circulation of Money.

Demand for Money: Classical and Keynesian approaches and

Keynes' liquidity preference theory of interest. ,
Money and prices: Quantity theory of money - Fisher's
equation of exchange-Cambridge cash balance approach.
-
Inflation: Demand Pull Inflation and Cost Push Inflation -
Effects of Inflation - Nature of inflation in a developing
economy.

Monetary policy: Meaning, objectives and instruments,

inflation targeting.

(iv)
l
3 Constituents of Fiscal Policy: 15
Role of a Government to provide Public goods - Principles of
Sound and Functional Finance.

Fiscal Policy: Meaning, Objectives - Contra cyclical Fiscal

Policy and Discretionary Fiscal Policy.

Instruments of Fiscal policy: Canons of taxation - Factors

influencing incidence of taxation - Effects of taxation
Significance of Public Expenditure - Social security
contributions - Low Income Support and Social Insurance
Programmes - Public Debt - Types, Public Debt and Fiscal
Solvency, Burden of Debt Finance.

Union budget: Structure - Deficit concepts - Fiscal

Responsibility and Budget Management Act.
4 Open Economy: Theory and issues of International Trade 15
The basis of international trade: Ricardo's Theory of
Comparative Cost Advantage - Heckscher-Ohlin Theory of
Factor Endowments - Terms of Trade - Meaning and Types -
Factors determining Terms of Trade - Gains from trade - Free
Trade versus Protection.

Foreign Investment: Foreign Portfolio Investment - Benefits

of Portfolio capital flows - Foreign Direct Investment - Merits
of Foreign Direct Investment - Role of Multinational
corporations.

Balance of Payments: Structure - Types of Disequilibrium -

Measures to correct disequilibrium in BOP.

Foreign Exchange and foreign exchange market: Spot and

Forward rate of Exchange - Hedging, Speculation and
Arbitrage - Fixed and Flexible exchange rates - Managed
flexibility.

Total 60

(v)
 Question Paper Pattern
Maximum Marks: 75 Duration: 234 Hrs
Questions to be Set: 05
Note: (1) A ttem pt all Questions. (2) A ll Questions Carry equal marks.

Q -l Answer any Two from Module - 1: 15 Marks

(A) Full Length Question
(B) Full Length Question
(C) Full Length Question
Q-2 Answer any Two from Module - II: 15 Marks
(A) FulH-ength Question
(B) Full Length Question
(C) Full Length Question
Q-3 Answer any Two from Module - III: 15 Marks
(A) Full Length Question
(B) Full Length Question
(C) Full Length Question
Q-4 Answer any Two from Module - IV: 15 Marks
(A) Full Length Question
(B) Full Length Question
(C) Full Length Question
Q-5 Objective Question (Module - 1to IV): 15 Marks
(A) Conceptual Questions (any Four out of six questions) (8)
(B) Multiple Choice Questions (Seven questions at least one . (7)
from each module)

(vi)
 CONTENTS
No. Chapter Pages

Unit - 1: Introduction to Macro Economics

|
IwSero Economics: Meaning, Scope and Importance 1-10
■ 9 *
2. Measurement of National Product 11-31

3. Short Run Economic Fluctuations , 32-40

4, Ihe-Keynesian Principle of Effective Demand 41-50

-• -S;- -Consumption Function 51-62

t Investment Function and Marginal Efficiency of Capital
6. 63-72
(MEC)

___7.- .Theory of Multiplier 73-80

Unit - II: Money, Inflation and Monetary Policy

1
Money Supply 81-93

dem and for Money 94-113

10. Quantity of Theory of Money 114-123

Inflation 124-146
"r Sr ^

JVJonetary Policy 147-157

' &

(vii)
No. Chapter Pages

Unit - III: Constituents of Fiscal Policy

13. Role of Government to Provide Public Goods 158-169

V
14 * Fiscal Policy 170-181

15. Instruments of Fiscal Policy - Taxation 182-196

CT>s*

197-203
■■M

.Public Expenditure
'C

17, .Public Debt 204-212

18. Union Budget 213-228

Unit - IV: Open Economy: Theory and Issues of

International Trade

19. Theories of International Trade 229-241

20. Terms of Trade and Gains from Trade 242-250

21. Free Trade vs. Protection 251-258

2 j/ Foreign Investment 259-264

23. Balance of Payments 265-283

24. Foreign Exchange Market 284-301

Iff* Model Question Paper 302-304

(viii)
Macro Economics: Meaning, Scope, Importance and □"□"DT l

MODULE - I
IN TR O D U CTIO N TO MACRO
ECONOM ICS

Macro Economics: Meaning,

Scope, Importance and
Circular Flow of Income and
Expenditure

INTRODUCTION TO MACRO ECONOMICS

SCOPE AND IMPORTANCE OF MACRO ECONOMICS

CIRCULAR FLOW OF INCOME

CLOSED ECONOMY MODEL (TWO SECTOR MODEL)

CLOSED ECONOMY MODEL (THREE SECTOR MODEL)

OPEN ECONOMY MODEL (FOUR SECTOR MODEL)

QUESTIONS
 2_ V ip u l ’*™ Business Economics - II (SFC)

'INTRODUCTION TO MACRO ECONOMICS:

jjThe term 'macro-economics" is derived from a Greek word
"makros" which means "large .j
Macro-economics deals with an analysis of large aggregates and
their averages in the economy as a whole rather than with
particular items in it.
It analyses the working of the whole economic system, with
reference to the behaviour of large aggregates in the economy, hence
it is called aggregative economics.
\As Prof. K. E. Boulding says, "Macro-economics deals not zvith
individual quantities as such but zvith the aggregates o f these quantities;
not zvith individual incomes but zvith the national income; not zvith
individual prices but zvith the price level; not with individual outputs
but zvith the national output^ '
However, micro-economic theory also deals with "aggregates"
but it deals with small aggregates. For example, it deals with
aggregate demand for a commodity and aggregate supply of that
commodity and explains how its price is determined. But these
"aggregates" considered in micro-economics do not relate to the
entire economy while the "aggregates" considered in macro­
economics arc concerned with large aggregates relating to the
whole economy such as national income, total consumption, total
investment, total employment, general price level etc. It indicates
how the economy as a whole operates and grows.
^SC O PE OF MACRO-ECONOMICS:
\^Macro economics’ deals with the whole economy. It is called
the theory of income and employment. It considers national
aggregates like national income, total (aggregate) consumption,
total (aggregate) savings, total (aggregate) investment, aggregate
employment, effects of changes in investment on national output,
volume of employment, etc.
It is also concerned with the monetary theory, theory of
income and equilibrium, international trade, trade cycles,
business fluctuations, determinants of economic growth, etc.
Macro Economics: Meaning, Scope, Importance and 3

The macro-economic theory also explains the factors determining

the relative shares of various social classes in the form of total rent,
total wage income, total interest and total profit in the total national
income., ^
T h^ sGO^e or subject matter of macro economics can be
summarized as follows:
(1) National income and employment: Macro economics
analyses the factors which influence national income and the
various concepts of national income like GDP, GNP, NNP,
etc. The effects of consumption, investment, government
expenditure etc. on national income and employment are
analysed in macro economics.
(2) Trade cycles: Trade cycles refer to ups and downs in
business. The various phases of trade cycles, the causes,
effects and measures to correct trade cycles are studied in
macro economics.
(3) General price level: Determination of general price level,
concept of inflation, its causes, effects in d control of inflation
form important components of macro economics.
(4) Supply of money and Demand for money: The various
components of money supply, determinants of money
supply. Theories like quantity theory of money are discussed
in macro economies. The reasons for demand for money and
the various approaches to demand for money form a part of
macro economics.
(5) Economic growth and development: J. M. Keynes who
developed macro economics focused on the problem of trade
cycles in capitalist countries. His theories based on the short
run were not applicable to poor ad developing countries.
Hence a new branch of macro economics 'Development
Economics' emerged in the 1950s and 1960s. This branch of
macro economics is mainly concerned with the problem of
developing countries and how to overcome them to accelerate
growth and development.
 4 HTS™Sff VipuVs™ Business Economics - II (SFC)

(6) International trade: In this component, macro economics is

concerned with the various theories of international trade,
balance of payments structure, disequilibrium in balance of
payments and measures to ensure equilibrium. The foreign
exchange market, its functions, determination of exchange
rate, role of central bank in the forex market are also under
the scope of macro economics.
IMPORTANCE OR SIGNIFICANCE OF MACRO
ECONOMICS:
A study of macro economics is very useful on the following
grounds:
(1) Economic system: The dynamic economic system can be
analysed easily with macro economics.
(2) Economic policies: Governments can formulate economic
policies effectively with the help of macro economics. Policies
related to general employment, inflation, national income can
be framed meaningfully by relying on macro economics.
(3) Business cycles: Business cycles or trade cycles can be
analysed through macro economics and solutions for the
problems of trade cycles can be worked out.
(4) Aggregates: The various aggregates like total income,
employment, saving, investment etc. can be analysed with
the help of macro economics.
(5) Study of micro economics: Micro economic concepts and
principles can be studied with the aid of macro economics.
For e.g., the behaviour of a particular business firm can be
formed on the basis of group behaviour.
(6) Interdependence of aggregates: The various aggregates like
national income, money supply, employment etc. are
interdependent and their relationship is complex. To analyse,
to foresee their future behaviour and to frame policies macro
economics is essential.
Thus a study of macro economics is very vital for a proper
understanding of the economy.
Macro Economics: Meaning, Scope, Importance a n d ..... " ‘" W W " 5

CIRCULAR FLOW OF INCOME:

f Circular flow of income explains how national income is
generated in an economy and how it flows from one sector to the
other. There are two models of circular flow of income namely:
(1) closed economy model and (2) open economy model.
CLOSED ECONOMY MODEL:
( a closed economy is one in which there are no exports and
imports. The economy is self-sufficient and self-reliant.
CIRCULAR FLOW OF INCOME IN A TWO SECTOR MODEL: Xj
I The two sector model consists of households and the business
firms. Households are the owners of factors of production. The
business firms produce goods and services. The households
supply the factors of production to the business firms. The
business firms produce goods and services with the help of factors
of production. The flow of factors of production from households
to business firms and flow of goods and services from business
firms to households is known as 'real flow'. i.The business firms
make factor payments for the services of factors of production to
the households. The households use these payments for buying
goods and services from the business firms. The flow of factor
payments from the business firms to the households and flow of
expenditure firm households to business firms is known as
monetaryflo w .
The circular flow of income will be in equilibrium when real
flow is equal to monetary flow. It is assumed that the households
spend their factor rewards entirely on consumption. In other
words there are no savings. Business firms sell whatever they
produce. They distribute their income for factor services i.e., they
do not retain any undistributed profits.
Diagrammatic Representation:
V.The above model can be explained with the help of the
following diagram:
6 V ip u l ’j s™ Business Economics - II (SFC)

Circular flow of income in a two sector model without savings:

Factor Payments
----- ^
^ —^factors of Productfo^p''*^

House Business
Holds Firms

^ ^ ^ o o d s and S e r v i c e s ^ ^

Cor|sumption Expenditure

Fig. 1.1

In the above figure, the inner circle represents the real flow.
Households supply factors of production to business firms and
the business firms in return supply goods and services. The outer
circle represents monetary flow. Business firms make payments
for factor services and this payment is used for consumption
expenditure. When the real flow is equal to the monetary flow,
there is equilibrium in the economy.
Circular flow of income in a two sector model with saving:
^ The earlier model represents circular flow of income without
savings. In reality households save a part of their income in the
financial market. These savings flow to the business firms in the
form of investment. While savings are leakages in the circular
flow of income, investments are injections into the circular flow of
income. Leakages reduce the circular flow of income and
injections enhance the circular flow of income. The following
diagram explains this model.
Macro Economics: Meaning, Scope, Importance and 7

Factor Payments

Factors of Production

Saving Financial Investment Business

House — *------ ------ »
Holds Market Firms

Goods and S«

Consumption Expenditure

Fig. 1.2

The circular flow will be in equilibrium when real flow =

monetary flow and savings = investment.
CLO SED EC O N O M Y M O D EL (TH REE SECTO R M O D EL):
^ The three sectors considered here are:
(1) Households,
(2) Business firms, and
(3) Government.
In any economy households own the factors of production and
provide the services of factors of production to the business firms.
The business firms produce goods and services and supply it to
the households. This is known as real flow- For factor services,
households get payments which they use to buy goods and
services from the firms. This is known as monetary flow. [Both the
households and firms pay taxes to the government and in return
get reward for factor services, transfer income subsidies etc.\from
the government. In this model, while savings and taxes are
leakages, investment and subsidies represent injections into the
circular flow. The three sector model can be explained with the
help of the following diagram:
 8 gynrga" V ip u l ’*™ Business Economics - II (SFC)

House Saving Investment

Financial Business
Holds Sector Firms

°f Goods and SePJ'®®.

ayrr>ent for Goods SerV'<>es

Fig. 1.3

The inner circle represents the real flow while the second circle
indicates the monetary flow. Savings of the households flow to
the financial markets and from there it flows to the business firms
as investments. The outer circle shows the payment of taxes to the
government by the households and business firms and in return
they get wages, transfer payments subsidies etc. from the
government. The economy will be in equilibrium when
Production = consumption
Saving = Investment and
Government's income = Government's expenditure
CIRCULAR FLOW OF INCOME IN AN OPEN ECONOMY:
(FQUR SECTOR MODEL)
An open economy is one in which there are exports and
imports. In other words there is foreign trade. Along with the
other flows in the closed economy model, there will be exports
and imports from the households and business firms to the world
economy and vice versa. The following diagram represents
circular flow of income in an open economy.
Macro Economics: Meaning, Scope, Importance and ^“Ercr 9

Fig. 1.4

Households and business firms export and import goods and

services. For exports they get receipts and for imports they have to
make payments. If exports are more than imports, flow of income
will be more and vice versa. In this model, the leakages are
savings, taxes and imports and the injections are investments
subsidies and exports. The economy will be in equilibrium when
Production = Consumption
Saving - Investment
Government's income = Government's expenditure
Exports = Imports and
Receipts = Payments
Thus the four sector model represents a comprehensive flow of
national income among the various sectors of the economy.

QUESTIONS
(1) Define the following:
(a) Macro economics.
(b) Closed economy.
 g g o Q T .Q "
10 V ip u l ’s™ Business Economics - II (SFC)

(c) Open economy.

(d) Leakage.
(e) Equilibrium.
Fill in the blanks:
(a) An economy which has no foreign trade is known a s ___________ .
(b) _____ ____ is an injection into the circular flow of income.
(c) In a ___________ economy, GDP = GNP.
S (d) Taxes are___________ in the circular flow of income.
' (e) ___________ increase the circular flow of income.
(f) Macro economics is derived from the Greek work___________ .
(g) Macro economics deals w ith___________ .
[Arts.: (a) closed economy (b) Investment (c) closed (d) leakages
(e) Injections (f) Makros (g) Whole economy]
State whether the following statements are true or false:
(a) An open economy is one which has no foreign trade.
(b) In a closed economy, GNP is always greater than GDP.
(c) Subsidies increase the circular flow of income.
(d) In all economies, circular flow of income is always in equilibrium.
(e) Imports reduce the circular flow of income.
(f) Macro economics analyses the behaviour of individual firms.
[Ans.: (a) False (b) False (c) True (d) False (e) True (f) False]
Match the following:
(A) (B)
(1) Open economy (a) Injection
(2) Closed economy (b) Self-reliance
(3) Imports (c) Foreign trade
(4) Exports (d) Leakage
Ans.: (1 -c), (2 - b), (3 - d), (4 - a).
(2) Define macro economics. What is its scope?
(3) Explain the circular flow of income in a two sector model in a closed
economy with savings.
(4) Explain the circular flow of income in an open economy.
(5) Explain the circular flow of income in a three sector model.
(6) Write short notes on:
(a) Circular flow of income in a two sector model without savings.
(b) Meaning and scope of macro economics.
(c) Significance of macro economics.

□ a aVWUt
VM>VL jW
Measurement of National Product ETErET 11

Measurement of National
Product

MEANING AND IMPORTANCE

BASIC CONCEPTS IN NATIONAL INCOME

M ETHODS OF MEASURING NATIONAL INCOME

PROBLEMS IN THE MEASUREMENT OF NATIONAL

INCOME

CONVENTIONAL AND GREEN GNP AND NNP CONCEPTS '

NATIONAL INCOME AND ECONOMIC WELFARE

QUESTIONS
12 a-Brcr V ip u IV ^ e u s in e s s Economics - II (SFC)

MEANING AND IMPORTANCE: ^

National income is the total money value of all final goods and
services produced by an economy during a given period of time.
Different types of goods and services like food grains, milk,
machines, services of teachers, doctors, lawyers etc. are produced
by every economy. They are expressed in different units and it is
not possible to add all in physical terms. Hence they have to be
expressed in terms of money and added to estimate national
income. Thus national income is the total money value of all
goods and services produced during a given year counted without
duplication and expressed in monetary terms. National income
data is always related to a particular time period. It is a flow
concept and it is related to a time period of one year.
Modem economists interpret national income in three ways
namely national product, national income and national
expenditure. National product refers to all goods and services
produced by the economy and exchanged for money during a
year. Thus unpaid services or goods are not included here.
National product is concerned with the transformation of inputs
into output and how the output is exchanged for money. National
income is the payment made to factors of production for their
contributions to production. The factor payments are in terms of
rent, wages, interest and profit. All the factor payments together
add up to the value of goods and services produced during a year.
Thus National income = National product. National expenditure
consists of the expenditure of the community on consumption
goods and capital goods. In other words it is the amount spent by
the factors of production on goods and services. The source of
spending is their factor rewards which is nothing but the national
income. National expenditure = National income. Moreover, as
one man's expenditure is another man's income, the total
expenditure of the economy = total income. Thus production leads
to income which leads to expenditure which in turn leads to
further production and income. Thus there exists a circular flow of
income and expenditure in every economy. From the above
discussion it is clear that National product = National income =
National expenditure. This is termed as triple identity. Thus
 Measurement of National Product □“□ “Dj™ 13

national income refers to the total flow of wealth produced,

distributed and consumed. It is not a stock concept, rather it is a
flow concept. The processes of income generation and distribution
occur simultaneously indicating that it is a continuous process.
Thus national income is defined in three forms, namely
(1) National income is the money value of goods and services
produced by the factors of production during a given period
of time. When national income is defined in this manner it is
termed as production approach.
(2) It is the sum total of income earned by the. factors of
production for their contribution to production. This
approach is known as income approach.
(3) It is also referred as the sum total of expenditure incurred by
the community on consumption and capital goods. This
approach is called as the expenditure approach.
Of all the three definitions, the most popular one is the first one
which expresses national income as the money value of goods and
services produced during a given period of time.
IMPORTANCE OF NATIONAL INCOME ACCOUNTING:
^ National income accounting has special significance in
Economics. Every economy indulges in national income
accounting as it indicates the performance and growth of the
economy, allocation of resources to various sectors, distribution of
national income among the factors of production etc. With the
help of national income and per capita income data, countries can
be characterised as advanced, middle income and poor countries.
They provide the basic structure for constructing macro economic
theory models. For all modem states, national income accounting
is an indispensable guide to formulate policies on various
economic issues.
National income accounting has special significance in
Economics. Though there are many difficulties in the
measurement of national income, every economy indulges in
national income accounting as it is very useful for a variety of
purposes. The importance of national income can be summarized
as follows:
14 H”ETn” VtpuVs™ Business Economics - II (SFC)

(1) Assessment of the economy: National income trends indicate

the performance of the economy. National income trends
indicate the performance of the economy. An increase in real
national income is always used as an indicator of the growth
of the economy.
(2) Distribution of national income: Sectoral distribution of
national income shows the stage of development of the
economy. An economy is said to be advanced if more income
comes from the tertiary and secondary sectors. A larger share
of national income from primary sector indicates the stage of
underdevelopment.
(3) Internal and international comparisons: With the help of
national income data, past and present status of the economy
can be compared. Similarly, it is possible to make international
comparison and rank the countries accordingly.
(4) Formulation of fiscal policies: The various policies of the
government are framed by taking into account national
income data. Budgetary policy, policies related to reduction of
poverty, unemployment, inequality etc. and resource
allocation to various sectors and programmes are based on
national income data.
(5) Economic planning: National income data are vital for
economic planning. The trends in national income and growth
rate are considered while planning. Target fixation and
resource allocation are planned after taking into consideration
the growth rate.
(6) Inflationary trends: National income at current prices is very
useful to estimate inflationary trends in the economy. This
helps the government to take corrective steps.
(7) Business decisions: Business firms use national income data
for decision making related to allocation of resources,
investments, employing factors of production etc. With the
help of national income data, business firms also do
forecasting. An analysis of national income data helps the
business firms to channelise the resources to the sectors which
have better growth prospectus.
Measurement of National Product jg”Brn™ 15

Thus national income data are useful to varied groups like

businessmen, government officials, academicians, national and
international organisations.
BASIC CONCEPTS IN NATIONAL INCOME:
The various concepts related to national income are as follows:
(1) Gross Domestic Product (GDP): It is the value of all final
goods and services produced during a year. When GDP is
estimated according to the prevailing prices, it is termed as
GDP at current prices. If a base year is selected and GDP is
expressed in terms of the base year prices, it is called as GDP
at constant prices. For e.g. if the GDP of India for the year
2002-03 calculated at 2002-03 prices, it is called GDP at current
prices. On the other hand if 1980-81 is selected as the base
year and if GDP is calculated according to 80-81 prices, then it
is known as GDP at constant prices.
GDP is expressed as follows:
GDP = C + I + G + ( X - M ) where
'C' refers to consumption expenditure
T refers to investment expenditure
'G' refers to government expenditure
'X' refers to exports and
'M' refers to imports
(2) GDP at Market Prices and GDP at Factor Cost: GDP at
market price is the value of all final goods and services
produced in a year. While estimating GDP at market price the
prevailing prices are taken into account. It includes the
indirect taxes imposed by the government and excludes the
subsidies given by the government. From GDP at market
price, GDP at factor cost can be obtained by subtracting
indirect taxes and adding subsidies to GDP at market price.
Indirect taxes imposed by the government are included in the
price and national income calculated as per this price will be
more than the actual. On the other hand when subsidies are
provided, the prices of commodities will be less and this will
16 ET'D"'^ V ipul’s™ Business Economics - II (SFC)

reduce the value of GDP. Hence to find out GDP at factor cost
the following formula should be used.
GDP at Factor Cost = GDP - Indirect Taxes + Subsidies
(3) Net Domestic Market: While producing goods and services,
various types of fixed assets are used. They get depreciated
over a period of time and need replacement. Hence firms
generally keep aside a certain amount for wear and tear of
machines. This is known as depreciation allowance. When
this depreciation allowance is deducted from GDP, we get net
domestic product. .’. NDP = GDP - Depreciation allowance.
(4) Gross National Product (GNP): Factors of production earn
factor incomes by providing their services within as well as
outside the country. Factor payments have to be made when
the residents of other countries contribute to production. In
other words production involves both inflow and outflow of
factor incomes. The difference between the two represents net
flow of income into the country. When the inflow is more
than outflow, the net flow will be positive and vice versa.
GNP can be obtained by adding this net factor income to
GDP. .'. GNP = GDP + Net Factor Income.
GDP + (R - P) where
'R' refers to receipts and
'P' refers to payments
(5) Net National Product (NNP): Like net domestic product, net
national product can be obtained by deducting depreciation
allowance from GNP.
NNP = GNP - Depreciation
(6) Net National Product at Factor Cost: This is nothing but the
national income of the economy. It is the value of final goods
and services produced during a year and counted without
duplication. It can also be defined as the sum of factor
incomes earned by the people of a country. It is calculated as
NNP at Factor Cost = NNP - Indirect Taxes + Subsidies
(7) Per Capita Income (PCI): PCI is calculated with the help of
national income figures and size of population. It is a
Measurement of National Product n'“K™Di'“ 17

statistical device. It is used for making international

comparison regarding standard of living enjoyed by the
people of a country. It is calculated as
National income
PCI = --------------------------
Size of population'
It is simply an average. It should not be considered as the
income earned by each individual in the country.
(8) Personal Income and Personal Disposable Income: The
income earned by individuals from various sources is known
as personal income. When personal taxes are deducted from
personal income, it is referred as personal disposable income.
Personal disposable income indicates the amount available
for spending and saving after paying taxes.
METHODS OF MEASURING NATIONAL INCOME:
National income is expressed in terms of aggregate output,
aggregate income and aggregate expenditure. Hence there are
three methods to estimate national income namely production
method, income method and expenditure method. Whatever be
the method adopted, the final figure will be the same as all the
three methods deal with the same flow of goods and services. The
three methods can be discussed as follows:
Production Method: It is also known as the value added
method. The various sectors which produce goods and services
are broadly divided into three sectors namely primary, secondary
and tertiary sectors. Each of these sectors are further divided into
sub sectors. For instance primary sector is divided into
agriculture, fishing, mining, etc. Secondary sector is divided into
manufacturing - large scale and small scale, construction, etc. and
the tertiary sector is classified as transport, communication, trade,
etc. The value of gross output produced by each producing unit in
a sub sector is obtained.
From this gross value, value of raw materials and intermediate
products and depreciation allowance are subtracted to get net
value of the output produced. By adding the net value of all the
producing units in a sub-sector, the total net value of that sub­
sector is derived. By adding the net value generated by all the sub­
18 ski rra ess!
V ip u l ’s™ Business Economics - II (SFC)

sectors, the value added by a sector can be arrived at. Similarly the
net value of all the sectors should be aggregated to find out the net
value added by the entire economy. This aggregate is nothing but
the net domestic product (NDP). If this NDP is at market price,
then NDP at factor cost can be obtained by deducting indirect
taxes and adding subsidies. If the net income from abroad is
added to NDP at factor cost, we can derive Net National Product
at factor cost which is termed as national income.
This method which is also known as the value added method
considers only the value of final goods and services. This is done
to avoid double counting. For e.g. in the case of automobiles like a
car, only the final value of the car is taken into account. The value
of intermediate products are already counted for. Hence only the
value addition made by the car manufacturer is taken into
account. If the value added at each stage is summed up, then the
final value of the product can be obtained. Another aspect of this
method is that it considers only the output produced in the
current year. Transactions in existing commodities are not
considered.
Income Method: This method consists of aggregating the factor
incomes of factors of production. The income generated by factors
of production gets distributed amongst the factors of production
in the form of rent, wages, interest and profit. By slimming up the
total factor rewards national income can be obtained. Here the
income earned by factors of production out of their productive
activities alone are considered. Transfer income like pension of
retired workers are not considered. Broadly labour incomes like
wages and salaries, bonus, allowances, etc. and capital incomes
like rent, interest, dividend, royalty, profits, etc. are added up to
get national income. In the case of self-employed people, income
may accrue from more than one source. Hence in such cases the
concept of mixed income is used. Similarly, when people produce
for subsistence it is very difficult to segregate labour income from
non-labour income. Here also mixed income concept is used. Care
has to be taken to exclude transfer income as they are a part of
personal income and not national income.
Measurement of National Product ErETEr 19

Expenditure Method: Factors of production earn income by

rendering their services to various productive activities. The
income thus earned by them is either spent or saved. The
expenditure is incurred on two types of goods namely
consumption goods and capital goods. The expenditure incurred
on only final goods and services is taken into account to avoid
double counting. Expenditure on goods produced in the earlier
period and expenditure on financial assets are excluded. The total
expenditure consists of consumption expenditure and capital or
investment expenditure. Both the types of expenditure are
incurred by the private sector and the government. The private
consumption expenditure refers to the expenditure incurred by
households on consumption goods. Government's consumption
expenditure refers to its expenditure on education, health services,
administration, etc. Capital or investment expenditure is incurred
by both the private sector and the government. Investment
expenditure consists of three types namely inventory investment,
net fixed investment and replacement investment. The increase in
the stock of capital goods in the economy is represented by the
inventory and net fixed investment while the latter refers to the
investment for wear and tear of capital goods. All the three
together constitute gross domestic investment. When replacement
investment is deducted from this, net domestic investment can be
obtained. To calculate gross national investment, net foreign
investment should be added to gross domestic investment. The
above concepts can be represented as follows:
Gross Domestic Expenditure = Consumption Expenditure +
Investment Expenditure
= Consumption Expenditure + {Inventory Investment + Net
Fixed Investment + Replacement Investment}
Net Domestic Expenditure = Gross Domestic Expenditure -
Replacement Investment
Gross National Expenditure — Gross Domestic Expenditure +
Net Foreign Investment
The above three methods throw light on the various
dimensions of the economy. The product method indicates
sectoral distribution of national income. Through the income
20 s r ir s r V ip u l ’s™ Business Economics - II (SFC)

method, distribution of national income among the factors of

production can be analysed. The expenditure method gives an
idea about the levels of consumption and investment expenditure
and with the help of which the standard of living of the people,
the level of economic development etc. can be examined.
Whatever be the method adopted, the final figure should be the
same due to triple identity (Output = Income = Expenditure). It
would be ideal to calculate national income by all the three
methods as they provide a check to test the accuracy of one
another.
PROBLEMS IN THE MEASUREMENT OF NATIONAL
INCOME:
Estimation of national income is indispensable for every
economy. It indicates the growth performance of the economy. It
is the chief guide for the government for formulating various
policies. Estimation of national income, however is a very difficult
task. Various difficulties are encountered while calculating
national income. The main difficulties are as follows:
(1) Conceptual Difficulties:
(a) What type of services are to be included in national income is
an age old controversy. Generally services which are paid for
are taken into account in national income estimation. Certain
household services like washing, cooking, etc. are not counted
in national income statistics. Similarly, mothers taking care of
their children is not considered. However, if they are left in
creches and payments are made then it is included. If
household activities are commercialised then they will be
included. Here there is no addition of services. Still national
income will be on the higher side. While exclusion of unpaid
services leads to underestimation of national income inclusion
of the same when they are paid will lead to over estimation.
(b) Market does not directly determine the prices of government
services. It is very difficult to estimate objectively the value of
government services to different sections. Due to this
limitation, precise measurement of national income is not
possible.
Measurement of National Product iTW 'W ” 21

(c) While generating national income, problems of pollution and

environmental degradation are faced. A part of the national
income should be deducted for this. But it is not done by most
of the countries. Similarly services of government like
defence, law and order etc. use the resources of the economy
to maintain safety and security of the nation. But while
estimating GDP, they are shown as if they add to the
resources of the country.
(d) Improvements in quality of goods are not considered in
national income estimates. Goods like car, television,
computers, etc. have shown significant improvements in
quality accompanied by falling prices. While some
adjustments are made for qualitative changes, it is not a
comprehensive one. It is also difficult as new goods and more
varieties enter the market regularly.
(2) Statistical Problems: The accuracy of national income
depends upon the availability of statistical data. In the case of
developing countries like India, lack of reliable data is a major
problem. Statistical problems arise due to the following
reasons:
(a) Non-monetised sector exists in developing countries. In this
sector barter system exists. It is very difficult to estimate the
transactions in financial terms.
(b) Some goods and services are not traded in the market. They
are retained for self-consumption. Especially in the case of
agriculture subsistence farming is practised. Hence estimating
the value of output is difficult.
(c) Due to illiteracy and lack of training, people do not maintain
records of their productive activities. Lack of records leads to
underestimation of national income.
(d) In the case of advanced economies, economic activities are
classified properly. However, in the case of poor countries,
there is no proper classification of various economic activities
and in many cases there is overlapping. For e.g. farmers
generally combine agriculture with some other occupation.
This is due to the seasonal nature of agriculture. Sometimes
22 □'"Ei'gr V ipul’s™ Business Economics - II (SFC)

they also move to urban areas and employ themselves in

other activities in the lean season. All these affect proper
valuation of national income.
(e) The data collected often is inadequate and incomplete.
Especially in the case of primary sector, accurate information
is very difficult to get. In the case of developing countries like
India, information about small-scale industries, self­
employed, household's expenditure, etc. are not adequately
available. These problems lead to underestimation of national
income.
(f) Regional disparity is an important characteristic of
underdeveloped countries. There are also geographical
diversities. It is not possible to collect accurate information in
the midst of such problems.
Despite the difficulties national income measurement is
undertaken by all countries. Advanced countries are able to give a
better estimate of national income compared to developing
countries. Developing countries are also trying to improve
national income accounting by encouraging education, training
and better accounting systems and by introducing monetisation
on a larger sale.
REAL v/s NOMINAL GNP:
Real GNP measures the changes in the output of the economy
according to the prices of a base year. It is also called GNP at
constant prices. It shows the change in the output alone as the
price is kept constant. It is the real indicator of economic growth.
In India, every year the Central Statistical Organisation (CSO)
gives national income at constant prices and at current prices. The
year 2004-05 was the base year till recently. At present CSO
considers 2011-12 as the base year for calculating real national
income. The output of the current year is valued at the prices of
2011-12 to calculate real GNP. This is done to eliminate the effects
of inflation. Nominal GNP, on the other hand refers to the value of
output according to the prices of the current year. For example, to
get nominal GNP of 2012-13, the physical quantity of output
produced in 2012-13 and the prices of 2012-13 are taken into
account.
Measurement of National Product gT grST 23

Real GNP is the actual indicator of economic growth. Nominal

GNP does not reflect the real increase in national income. The
changes in nominal income may be due to two factors namely:
(1) due to change in the quantity of output produced. (2) due to
change in the prices of goods and services. Suppose there is an
increase in nominal GNP, it may be because of an increase in the
output or prices or both. It does not give a clear picture about the
growth rate.
GREEN GNP AND NNP C O N C E P T S ^
Conventional and Green GNP:
National income accounting in the conventional sense refers to
the value of all goods and services produced in the economy
during a given period of time. There are three methods to measure
national income namely income method, output method and
expenditure method. These conventional methods consider
national income in terms of the value of total output produced or
income of factors of production or the aggregate expenditure
incurred in the economy. This method of accounting according to
some economists is defective. Conventional method does not
consider the cost of pollution or depletion of resources while
producing goods and services or other factors which have an
adverse effect on the sustainable development of the economy and
hence on the welfare of the people. Hence a new method of
accounting namely 'Green Accounting' has come into existence.
Green GNP accounting takes into account environmental
factors in the national income accounting. While producing goods
and services there is depletion of natural resources like forests and
cultivable lands pollution of air, water, etc. These factors affect the
bio-diversity and well-being of the people.. They also result in
huge climate change disrupting normatHfe. Hence it is argued
that costs have to be assigned to these factors and they have to be
deducted from the gross domestic or gross national product to
obtain the correct value of national income. While deducting the
cost of these adverse effects, certain benefits derived from the eco­
system should be added. For example forests prevent soil erosion,
mangroves help in prevention of floods, etc. Monetary values
24 nrjn™Er V lp u l ’s™ Business Economics - II (SFC)

have to be imputed to such benefits and should be added to

national income accounting.
Many economists argue that it is very difficult to adopt green
accounting method. This is because assigning values to pollution,
depletion of resources, contribution of forests, rivers, etc. is a very
difficult task. Even if values are assigned, accuracy will be
questionable. Though the concept of 'Green Accounting' is
becoming popular, countries are yet to devise a method and adopt
it. This method whenever it is adopted will be useful for
sustainable development and promotion of welfare.
NATIONAL INCOME AND ECONOMIC WELFARE: \
National income is the money value of all goods and services
produced in an economy during a given period of time.
Estimation of national income is a difficult task but an essential
one for every economy. It is useful to measure the performance of
an economy, to make comparisons between the countries and
different time periods of the same country, to formulate economic
policies etc. National income data have always been used to
indicate the growth of the economy and there by the economic
welfare of the people. Welfare refers to the happiness of the
people. Traditionally it is believed that higher the income, greater
will be the welfare of the people and vice versa. In recent times
there is often a debate whether a higher national income
necessarily leads to greater economic welfare. Hence modem
economists have developed a new concept called 'Net Economic
Welfare' to make National income data a more meaningful one.
NET ECONOMIC WELFARE (NEW):
The concept of 'Net Economic Welfare' measures the actual
welfare of the people by including and excluding certain items in
national income accounting. Traditional or conventional national
income data does not include certain items like services of a
housewife which are very helpful and give immense happiness to
the family members. Hence they should be included. Certain
items like harmful effects of pollution have to be calculated and
subtracted as they reduce the welfare of the people. NEW can be
calculated as follows:
Measurement of National Product 25

NEW = Real GNP - Depreciation + (Items which increase

welfare) - (Items which reduce welfare).
Items to be included: National income accounting generally
does not include certain things which increase the welfare of the
people. They have to be added to estimate NEW. Some of them
are:
(1) Services of housewives: One of the major exclusion in the
usual national income accounting is the services of
housewives. Their services are immense value to the family
members and promote their happiness. To estimate NEW
services of housewives ought to be added.
(2) Personal services: Personal services like singing, dancing,
painting, cooking etc. provide satisfaction to people and
improve their happiness. They are not included in the
traditional national income accounting as they are not
marketed but provided to oneself. Such services enhance
welfare and need to be included.
(3) Leisure: When people work no doubt it results in production
of goods and services. At the same time leisure enjoyed by
them improves their happiness and eventually results in
higher productivity and production. Hence it should be
added.
(4) Social services: Social services provided by some people or
organisations without any monetary rewards are not included
in national income accounting. However such services e.g., a
teacher teaching a poor student without fee enhances welfare
and should be included.
Items to be excluded: Certain items though included in
traditional national income accounting reduces the welfare of the
people. They need to be deducted. They are:
(1) Costs of economic growth: Production of various goods and
services result in increase in national income. At the same time
production also leads to air, water and noise pollution. All
these affect the health and welfare of the people. Hence costs.
have to be assigned to such pollution and that should be
deducted from national income to estimate 'NEW'. The costs
26 Ercra’" Viput’s™ Business Economics - II (SFC)

of environmental degradation is known as 'costs of economic

growth'.
(2) Regrettable costs: This refers to the expenditure incurred by
the government on maintaining the courts, police and defense.
Though such expenditure is necessary, economists argue that
they do not directly promote the welfare of the people. In the
modem days governments incur a huge expenditure to fight
against terrorism, communal violence, etc. Such unproductive
expenditure reduces the welfare of the people. Hence they
need to be deducted.
'NEW' is a better indicator compared to GNP to measure
the welfare of the people. At the same time it is not a
conclusive one. There are a number of other factors
contributing to welfare which are not reflected in national
income accounting or NEW. They are:
(1) The composition of national output and distribution of
national income are important determinants of economic
welfare. If the national output mainly consist of arms and
ammunition, harmful products like liquor, cigarettes and
goods consumed by the richer section, then welfare will be
less.
(2) Then the goods consumed by the poor will be neglected
and general economic welfare will be less. If production of
goods and services is increased through automation
leading to displacement of labour, welfare will be less.
(3) Similarly increase in national income through exploitation
of labour and reduction in quality of goods will result in
reduction of economic welfare.
(4) The distribution of national income is equally important in
determining welfare. If there is equality in the distribution
of income and wealth, then welfare will be high. On the
contrary, gross inequalities lead to a very low level of
economic welfare.
In the modem times, economists are of the opinion
economic welfare can be enhanced through education,
Measurement of National Product 27

environmental protection, better standard of living and

equal opportunities to all.

CASE STUDY
The Mother Economy
The patriarchal attitude of economics, which does not take
unpaid work into account, needs to be corrected:
Gross domestic product, or GDP, is one of the most used, or
perhaps abused, terms in economics. The trouble is that too many
people use it without realising that it's ultimately a theoretical
construct and not a real number.
In the simplest terms, GDP is defined as the value of goods and
services produced in a country during the course of a year. The
problem lies in defining what has a value and what doesn't.
As an old GDP joke goes, when a man or a woman marries his
or her housekeeper, the GDP of the country goes down. This
happens because the housekeeper was paid for doing the house
work. The spouse won't be.
On a serious note, the joke shows a big loophole in the way the
GDP is calculated. The calculation takes only paid work into
account.
The trouble is that unpaid work forms a very important and
large part of the economy even though most people do not realise
it.
As Kate Raworth writes in Doughnut Economics—Seven Ways
to Think Like a 21st-Century Economist: "If you have never really
thought of it before, then it's time you met your inner housewife
(because we all have one). She lives in the daily dealings of
making breakfast, washing the dishes, tidying the house,
shopping for groceries, teaching the children to walk and to share,
washing clothes, caring for elderly parents, emptying the rubbish
bins, collecting kids from school, helping the neighbours, making
the dinne'r, sweeping the floor, and lending an ear."
28 v r u r nKSrjr V ip u l ’*™ Business Economics - II (SFC)

Most of us do these things and don't get paid for it.

Nevertheless, they are a very important part of the lives that we
live.
Raworth is British and hence, invocates the term inner
housewife. In India, there are real housewives (not that they are
not there in Britain) who just take care of the home. As per the
National Sample Survey (NSS), for women in the age of 25-54, the
labour force participation rate varies between 26 to 28 per cent in
urban areas and 44 per cent in rural areas. Hence, most Indian
women don't work in the conventional sense of the term. But they
run their homes. Even young girls who are not married are
expected to contribute towards house work.
All this never gets counted towards the GDP. As Raworth
writes: "In sub-Saharan Africa and South Asia... when the state
fails to deliver, and the market is out of reach, householders have
to make provisions for many more of their needs directly.
Millions of women and girls spend hours walking miles each
day, carrying their body weight in water, food or firewood on
their heads, often with a baby strapped to their back and all for
no pay." And given that there is no pay, the work does not reflect
in the GDP.
In fact, economists have even put numbers to this unpaid work.
"A 2014 survey of 15,000 mothers in the USA calculated that, if
women were paid the going hourly rate for each of their roles -
switching between housekeeper and day-care teacher to van
driver and cleaner - then stay-at-home mums would earn around
$120,000 each year. Even mothers who do head out to work each
day would earn an extra $70,000 on top of their actual wages."
This unpaid work, which is a very important part of a
running a household smoothly as well as bringing up a child, is
not reflected in the GDP. And that is a real problem. This
patriarchal attitude of economics as it is practised, needs to be
corrected in the years to come.
Source: Mumbai Mirror, 11th June, 2017
Measurement of National Product □™EjTE|,“ 29

Questions:
(1) 'Unpaid services are important to promote welfare.' Do you
agree? Discuss.
(2) What are the problems involved in accounting for unpaid
services in national income accounting?

QUESTIONS
(1) Define the following concepts:
(a) GDP.
(b) GNP at Factor Cost.
(c) NNP.
(d) National Income.
(e) National income at constant prices.
(f) National income at current prices.
(g) Net economic welfare.
(h) Green GNP.
Fill in the blanks:
Net factor income from abroad is ___________in GNP.
Gross domestic product at factor cost___________indirect taxes.
(e) Gross national product at market prices*__________ subsidies.
(d) To get net national product at market prices, we must deduct
-------- '_____ consumption from the gross national product at market
prices.
(e) The net profits of government enterprises a re ___________in national
income.
(f) Transfer incomes are___________from national income.
(g) The value of output within a country is called____________ .
(h) National income is a ___________concept.
„ (I) The y e a r___________ is used by the CSO as the base year for
calculating national income at constant prices.
(j) NEW stands fo r___________.
(k) Leisure has to b e ___________while calculating ‘NEW’.
(I) Costs of economic growth are to be ___________ while calculating
NEW.
(m) Economic welfare will be ________ __ if the production of defence
goods and harmful goods are more.
[A ns.: (a) included (b) excludes (c) excludes (d) capital (e) included
(f) excluded (g) domestic income (h) flow (i) 2011-12 (j) Net economic
welfare (k) included (I) Excluded (m) Less]
30 □"ETET
,=a ™: ™ VipuVs™ Business Economics - II (SFC)

State whether the following statements are true or false:

(a) National income includes the net factor income from abroad.
(b) To get the gross domestic product at market prices, we must express
GDP in terms of market prices which include indirect taxes. At the
same time, we must exclude subsidies.
(c) To get the net national product at market prices, we must not deduct
the capital consumption.
fl) The net national product at market prices is the same as the net
national product at factor cost.
(e) National income is a flow concept.

(g)
(f) PCI and PDI are one and the same.
Services of housewives have to be includes to calculate Net Economic
Welfare.
(h) Value of hobbies and recreation are included in national income
accounting.
[Ans.: (a) True (b) True (c) False (d) False (e) True (f) False (g) True
(h) False]

(A) (B)
(1) Gross domestic product (a) C + I + G + (X-M) + (R-P).
(2) Net national product (b) C + I + G.
(3) National income estimates in (c) Excluded in national income
India estimates.
(4) Gross national product (d) GNP - Depreciation
(5) Services of a housewife (e) Included in national income at
factor cost
(6) Subsidies (f) Central Statistical Organisation
[Ans.: (1 - b; 2 - d; 3 - f, 4 - a; 5 -c , (6 - e)]
(2) Define national income. Explain the various concepts of national income.
(3) Discuss the various methods of measuring national income.
(4 )ty What are the various problems involved in measuring national income?
(5) Prove that National Output = National Income = National Expenditure.
(6) Explain Real v/s Nominal GNP.
(7) Why is it necessary to calculate national income at constant prices? How is
it useful?
(8) Calculate GDP, GNP, NNP, NY at factor cost from the following data:
(1) Expenditure of the household on = Rs. 50,000 crores
consumption goods
(2) Governments’ expenditure on = Rs. 2,50,000 crores
consumption goods
(3) Total investment expenditure = Rs. 6,50,000 crores
(4) Depreciation allowance = Rs. 10,000 crores
(5) Exports = Rs. 1,50,000 crores
Measurement of National Product g,“P™nT
" 31

(6) Imports = Rs. 1,80,000 crores

(7) Indirect taxes = Rs. 40,000 crores
(8) Subsidies = Rs. 50,000 crores
(9) Net income from abroad = Rs. 25,000 crores
(9) Calculate GDP, GDP at factor cost, GNP, NNP and National income at
factor cost:
(a) Value of goods produced by the = $500 billion
agricultural sector
(b) Value of output produced by the mining = $200 billion
sector
(c) Value of output produced by the industrial = $ 400 billion
sector
(d) Value of services rendered = $1000 billion
(e) Value of services of housewives = $1500 billion
(f) Depreciation allowance = $100 billion
(9) Exports = $500 billion
(h) Imports = $700 billion
(i) Indirect taxes = $300 billion
(j) Subsidies = $600 billion
(k) Net income from abroad = $800 billion
(10) Collect national income data from the Economic Survey of 2016-17 and
analyse the various concepts related to national income.
(11) Define Net Economic Welfare and how is it calculated?
(12) Explain the concept of ‘NEW’. What are the items to be included and
excluded?
(13) Write a short note on national income and economic welfare.
(14) “NEW is the best indicator of welfare”. Do you agree? Discuss.
(15) Write a short note on Green GNP.
 32 ETCTH™ V ipul’s™ Business Economics - II (SFC)

Short Run Economic

Fluctuations

INTRODUCTION

xpA TIJRES/CH A RA CTERISTICS OF TRADE CYCLES

vPffASES OF TRADE CYCLES

IMPACT OF BUSINESS CYCLES ON ECONOMIC GROWTH

AND DEVELOPMENT

ROLE OF GOVERNMENT IN VARIOUS PHASES

QUESTIONS
Short Run Economic Fluctuations 33

INTRODUCTION:
Trade cycles or business cycles refer to the ups and downs in
business. Business is always characterised by fluctuations rather
than stability. Trade cycles indicate the progress attained by a
country during a given period of tirrte. It also indicates the
uncertainties involved in business and their effects on the
economy. Trade cycles occur regularly in a capitalist economy. In
other words they are recurring in nature. The fluctuations
manifest themselves in terms of changes in income, employment
savings, prices and investment. These fluctuations in the various
economic indicators are called business cycles or trade cycles.
Trade cycles follow a wave-like movement to indicate that
prosperity will be followed by depression and depression
followed by prosperity. The various phases of trade cycle are
nothing but the upswing and downswing. The term trade cycle is
defined by many economists. According to J. M. Keynes “A trade
cycle is composed o f periods o f good trade, characterised by using prices,
low unemployment altering with periods o f bad trade characterised by
falling prices and high unemployment."
Trade cycles or business cycles are wave like movement in the
economic activities of a country. The fluctuations in variables like
income, output, prices, etc. reflect the wavelike movement.
FEATURES/CHARACTERISTICS OF TRADE CYCLES:
^ Business cycles exhibit certain specific features. They are as
follows:
(1) Business cycles are recurrent in nature.
(2) It refers to wave like fluctuations in economic activities.
(3) The various economic variables like output, employment
income prices etc. move in the same direction. Either they rise
or fall together.
(4) Prosperity and depression follow each other alternately.
(5) Both prosperity and depression have the seeds of their own
destruction.
 34 nrg™Er V ipul’s™ Business Economics - II (SFC)

(6) During the uptrend or downtrend, prices, output,

employment etc. change. Along with these changes, money
supply, velocity of circulation etc. also change.
(7) Due to globalization, in the recent times trade cycle in one
country gets transmitted to other countries very easily. While
prosperity helps rich countries, recession or depression affects
them very severely.
(8) Business cycles are recurrent in nature. At the same time, no
two business cycles are the same. Some may be steeper than
others and each one is influenced by different socio-economic
factors.
PHASES OF TRADE CYCLES:
There are four phases of trade cycle namely: (1) Depression
(2) Recovery (3) Prosperity (4) Recession. The following diagram
depicts these four phases.

>
O
£

Time Period

Fig. 3.1

In the above diagram, SS represents steady growth of the

economy.
Depression is indicated by the lowest point. Then recovery
starts leading to prosperity and then peak. The down trend begins
afterwards resulting in recession and depression. Then the whole
Short Run Economic Fluctuations , ~ =~ =» ”

cycle continues. The various phases of trade cycle can be

explained as follows:
(1) Depression: This phase is also known as trough. It is
characterized by Inw investment, low production, lojvv leveLof
employment and low profits. Business pessimism prevails in
the economy.
(2) Recovery: Positive signals to revive the economy appear
during this phase. Demand starts increasing leading to an
increase in investment, production, employment etc.
(3) Boom or Peak: When the trade cycle reaches its highest point,
it is known as boom or peak. During this stage demand for
goods and services will be more than supply. Profits tend to
rise at a faster rate compared to the increase in cost of
production. Capacity utilization will be very high and the
level of investment will continue to rise.
(4) Recession: It refers to the downward trend. If GNP of the
economy declines in two quarters in succession, it is said to be
recession. A fall in demand will lead to fall in investment,
employment, output profits etc. Massive unemployment
occurs during recession times. When recession reaches its
lowest point, it is termed as depression.
Thus, trade cycle is a wave like movement resulting in
fluctuations in the various economic parameters like employment,
income, etc. Government intervention at the right time helps the
economy to revive and be on the path of progress.
The government uses both monetary and fiscal policy to
control trade cycles. During recession and depression time
deliberate measures like incurring more public expenditure and
implementing public welfare programmes are undertaken by the
government to revive the economy. During the boom period the
government adopts a dear money policy and controls its
expenditure to avoid inflation.
 36 n™a,"Er V ip u l ’s™ Business Economics - II (SFC)

IMPACT OF BUSINESS CYCLES ON ECONOMIC GROWTH

AND DEVELOPMENT:
Business cycles impact the growth and development of an
economy in various ways. Due to globalization in the present era,
trade cycles anywhere in the world will affect other countries. The
classic example is the financial crisis in USA in 2008 and the
recession that followed. Along with USA other countries were also
affected. During the recovery and boom period trade cycles have a
positive impact on the growth and development of the economy
as follows:
(1) During recovery, due to the increase in public investment i.e.
Government's investment economic activities get a boost and
they start increasing.
(2) Production, employment and national income start rising.
(3) As the growth process gets accelerated, resource mobilization
and utilization becomes better. .
(4) A well performing economy becomes an attractive destination
< for foreign investors. Flow of foreign capital adds to the
resources of the economy.
When the economy reaches the boom or prosperity period, the
level of income, output and employment is quite high. Profits
investment, saving etc. remain at a high level. However after a
certain point saturation sets in leading to the downswing. Hence it
is said that the seeds of recession are sown during prosperity.
Both recession and depression are painful. The effects of
downswing are:
(1) Decline in investment resulting in low production,
employment and income. "
(2) Saving and capital formation get affected.
(3) Flow of foreign capital declines.
(4) Overall pessimism prevails in the economy.
(5) Unemployment, inequality and poverty tend to increase
affecting social harmony.
 Short Run Economic Fluctuations s ’s n r 37

(6) Trade and investment flows with other countries also get
affected.
Thus trade cycles affect the growth and development of the
economy significantly.
^feOLE OF GOVERNMENT IN VARIOUS PHASES:
The role of government was not given much significance till the
Great Depression of 1930's. During the Great Depression the
market could not revive the economy. The government had to
interfere. From that time onwards the role of government in
controlling trade cycles has become imperative.
Modem governments use both monetary and fiscal measures
to control trade cycles:
(1) Monetary measures: Monetary measures influence money
supply, credit creation and rate of interest. During inflation
the central bank will use a dear money policy. Under this
credit creation by banks will be controlled by using
quantitative and qualitative methods. The weapons used are
bank rate, CRR, open market operation, variation in margin
requirements etc. During recession and depression period'an
easy monetary policy is followed to increase credit supply to
revive the economy.
(2) Fiscal measures: Fiscal measures deal with government's
revenue, expenditure and public debt. During prosperity time
the government will impose more taxes, spend less and
mobilize public debt. On the contrary, during recession time
the government's expenditure will be more. Taxes will be
reduced and repayment of public debt will be done.
Government has to play a very active role during recession
and depression. During these times private investment will be
low due to low profits. Hence public investment has a crucial
role to play in reviving the economy.
In the present era, all governments adopt a combination of
fiscal and monetary measures to control trade cycles effectively.
 38 nrn™gr V ipul’s™ Business Economics - II (SFC)

CASE STUDIES
CASE STUDY 1:
A CRUDE TROUBLE BREWING:
What's in Store: Analysts say rise in prices will be short-lived,
next year will bring more trouble for commodities.
The world's leading oil producers are preparing for the
possibility of oil prices halving to $20 a barrel following the recent
fall in crude prices, the lowest iron ore prices in a decade, and
losses on global stock markets.
Brent crude dipped below $40 a barrel for the first time since
February 2009 on Tuesday after the Organisation of Petroleum
Exporting Countries (OPEC) last week failed to agree a cut in
production quotas in the face of slumping prices and a mounting
global supply glut. Prices, however, rose 36 cents to $40.62 a barrel
on Wednesday on strong Japanese economic data and lower crude
oil storage figures from the US.
However, warnings by commodity analysts that the respite
could be short-lived were underlined when Russia said it would
need to make additional budget cuts if the oil price halved over
the coming months.
Russia and Saudi Arabia — the world's two biggest oil
producers —both increased spending when oil prices rose to well
above $100 a barrel. The fall from a recent peak of $115 a barrel in
August 2014 has left all OPEC members in financial difficulty.
Hopes that OPEC would announce production curbs to push
prices up were dashed when the cartel met in Vienna last Friday,
triggering the latest downward lurch in the cost of oil.
Lord Browne, the former chief executive of BP, refused to rule
out the possibility that oil could halve again in price. Asked if oil
could hit $20 a barrel, Browne - who ran BP from 1995 to 2007
during a period when the cost of crude rose from $10 to $100 a
barrel, said in the short term nothing was impossible. He added:
"In the long run, $20 is probably wrong, but that's as far as I'd
go."
Short Run Economic Fluctuations 39

Weak export figures from China was also a reason for low
prices of commodities. Iron ore's 10 year low was accompanied by
declines in zinc, lead and nickel, leaving mining firms to bear the
brunt of a renewed sell-off in equity markets. "There is little on
the horizon that looks like it can provide a salve for commodity
bum s," said Connor Campbell of UK-based financial spread
betting company Spreadex.
The consultancy.Capital Economics said: "Any recovery next
year will depend on reductions in non-OPEC supply and on
stronger demand. On this basis, while we are lowering our end
2016 forecast for Brent from $60 to $55, we continue to expect oil
prices to stage a partial recovery next year."
Source: Hindustan Times, December 10, 2015.

Questions:
(1) What are the causes for dip in oil prices?
(2) What impact the fall in oil prices will have on global economy
in general and OPEC's economy in particular?
CASE STUDY 2:
85K JO BS TO GO AT ANGLO AMERICAN:
In the biggest restructuring by a mining company in reaction to
the commodities rout, UK-based Anglo American has announced
plans to cut its workforce by 85,000 and dispose of around 35
mines in response to the plunging price of iron ore and other
metals. It will halve the number of business units from six to three:
the De Beers diamond operation, industrial metals and bulk
commodities.
Source: Hindustan Times, December 10, 2015.

Questions:
(1) What will be the effects of the above restructuring? Will it
lead to recession?
 40
Viput’s™ Business Economics - II (SFC)

QUESTIONS
(1) Define the following:
(a) Recession.
(b) Boom.
(c) Depression.
(d) T rade cycle.
(e) Recovery.
Fill in the blanks:
J& ) Boom is a n ___________phase of trade cycle.
‘ (b) The level of unemployment is very high during.
‘ (g ) Trade cycle refers to __________ and . in business.
(d) A combination o f---------------- policy and policy is useful
to control trade cycles.

[andSfiscal] eXpanS'0nary (b) dePression (c) ups and downs (d) monetary

State whether the following statements are true or false:

A a) Trade cycles are recurrent in nature.
(b) Recession, if not controlled will lead to depression.
, . (c) Trade cycles in developed countries affect the developing and
underdeveloped countries due to globalization.
, <d) Trade cycles occur at regular intervals.
[Ans.: (a) True (b) True (c) True (d) False]
(2) Explain the characteristics of trade cycles.
(3) What are various phases of trade cycles? Explain with suitable diagrams.
(4) What are effects of trade cycle on economic growth and development?
(5) Write short notes on:
(a) Features of trade cycles.
(b) Phases of a trade cycle.
The Keynesian Principle of Effective Demand orcrop 41

The Keynesian Principle

of Effective Demand

INTRODUCTION

DISTINCTION BETWEEN CLASSICISM AND

KEYNESIANISM

AGGREGATE DEMAND AND AGGREGATE SUPPLY

DETERMINATION OF EFFECTIVE DEMAND

QUESTIONS
42 V ip u l ’s™ Business Economics - II (SFC)

INTRODUCTION:
The study of Macro Economics is basically the study of how
under different conditions men, material and other resources in
an economy could be employed, so that income gets generated
and output could be produced to satisfy demands of people at a
point of time or over a period of time. Employment therefore is
the source of income to workers and others who possess or own
resources which can be made available for employment
(capitalists or factor owners). Moreover it is only through
increasing employment that national output and income could be
increased and it will ensure the fullest possible utilization of the
available resources and achievement of maximum social welfare.
For a long time the classical economists believed that the
operation of market forces would result automatically in full
employment. The theoretical concept of capitalization and a
detailed analysis of the functioning of a free enterprise system at
the macro economic level are associated with classical economists
like Adam Smith, David Ricardo, and all their followers. From the
writings of these two great economists emerged a body of
important doctrines of political economy which was widely and
popularly known as "The Classical System". These economic
doctrines enjoyed widespread authority during the late 18th and
19th centuries.
The major conclusion of the classical macro economic theory
was that the equilibrium level of output would necessarily be the
full employment level of output indicating that there would be no
involuntary unemployment at the real wage rate prevailing in the
economy.
J. M. Keynes did not accept the classical theory of employment
based on the long run. According to him, "In the long run we are all
dead" and short run equilibrium is a more realistic one. He
developed a new theory of income and employment which is
widely accepted by modem economists and they consider the
magnum opus of Keynes "The General theory of Employment,
Interest and Money" as the Keynesian Revolution. J. M. Keynes
refuted Say's law of markets and argued that general over
production and unemployment cannot be ruled out. He believed
The Keynesian Principle of Effective Demand □'“Epsa'" 43

that full employment situation is not a normal feature of a

capitalist economy and automatic adjustments will not be
possible.
Keynesian theory of employment is a short run theory. In the
short run size of population, capital stock, labour efficiency
techniques of production etc. are assumed to be constant. In such
a situation the level of national income will increase with an
increase in the level of employment of labour and vice-versa. In
fact income and employment influence each other. Higher the
level of employment, higher the national income which in turn
leads to more demand for labour. Employment level in any
economy is determined by aggregate demand and aggregate
supply. Hence income is also determined by aggregate demand
and supply.
Distinction between Classicism and Keynesianism:
The main differences between classicism and Keynesianism
can be listed as follows:
Classicism Keynesianism
(1) Classical economics is based on Keynes' theories are based on
supply side. demand side.
(2) Here long run is considered. According to Keynes short run is
the reality as "in the long run we
are all dead".
(3) In classical economics full Less than full employment
employment is a normal equilibrium is the normal
situation. situation.
(4) Classical economists advocated Keynes advocated controlled
pure capitalism. capitalism.
(5) They favoured balanced budget. Keynes suggested that budget
should be adjusted according to
economic condition.
(6) Money was considered as a Store of value function of money
medium of exchange. was considered.
44 H 13 § V lp u l ’s™ Business Economics - II (SFC)

(7) Classical economists considered According to Keynes the

rate of interest as the equilibrium between saving and
equilibrating factor between investment is due to level of
saving and investment. income and not rate of interest.
(8) Classical school advocated Keynes suggested government
laissez-faire policy intervention to stabilize the
economy.

Principle of Effective Demand:

The Keynesian theory of employment is based on the principle
of effective demand. According to Keynes effective demand
determines the level of employment in an economy. Higher the
effective demand, greater would be the volume of employment.
Deficiency of effective demand results in unemployment.
Effective demand refers to the total demand for goods and
services. Total demand consists of consumption demand and
investment demand. Effective demand is indicated by the
expenditure of the public on consumption goods and investment
goods.
Effective demand, according to Keynes is determined by
aggregate demand function and aggregate supply function. It is
determined at the point where the aggregate demand curve
intersects the aggregate supply curve. This equilibrium point
determines the level of employment in an economy.
Aggregate demand function:
Aggregate demand refers to the total demand for goods and
services by the public during a given period of time. Firms or
industries employ people to produce goods and services. Number
of people employed or level of employment depends upon the
income they get by selling the goods and services. Higher the
income expected, higher will be the level of employment and vice
versa. In other words if total expenditure of the public on goods
and services is more, then employment will also be more and vice
The Keynesian Principle of Effective Demand 45
0 "W 0 "

versa. Aggregate demand function is defined as a schedule or a

curve showing the amount of proceeds expected from the sale of
output at various levels of employment. An increase in
employment will lead to more output and income. Therefore the
aggregate demand function increases with the increase in
employment. The aggregate demand curve represents this direct
relationship between the two. The curve is shown as follows:

In the above diagram DD is the aggregate demand curve

sloping upwards. It indicates that as level of employment
increases, aggregate demand function or expected proceeds tend
to increase. While the individual demand curve slopes
downwards, the aggregate demand curve slopes upwards. This is
because the demand for consumption and investment goods will
rise with an increase in employment. Though the curve is sloping
upwards, it is not steep to the right. This is because when income
rises, expenditure will also increase but at a diminishing rate due
to tendency of people to save a part of their income.
Aggregate Supply Function:
Production of goods and services involves cost of production
which includes normal profit. Business firms would like to
recover this cost of production when they employ labour.
46 E
assT,=
Hs Er V « p « I’s™ Business Economics - II (SFC)

Aggregate supply function refers to the schedule of minimum

amount of proceeds which is necessary to induce the
entrepreneurs to employ labour. Aggregate supply function
indicates the minimum amount of sales proceeds to be obtained
by the firms to produce a certain level of output. The aggregate
supply curve shows an upward trend as follows:

Fig. 4.2

The aggregate supply curve AS slopes upwards to the right.

When more and more people are employed the cost will increase
and hence minimum proceeds required will rise in a greater
proportion due to increasing cost and diminishing returns. Hence
the curve becomes steeper when it slopes upwards. At point T, the
supply curve becomes a vertical straight line. It indicates that full
employment has been attained. After this point increase in cost
will not lead to more employment.
Determination of effective demand:
Effective demand is determined at the point where aggregate
demand curve intersects the aggregate supply curve. This
effective demand determines the level of employment and the
economy will be at stable equilibrium. The determination of
effective demand is shown below:
The Keynesian Principle of Effective Demand □'-crn' 47

Fig. 4.3

E is the point where aggregate demand is equal to aggregate

supply. E is the point of effective demand. OM is the equilibrium
level of employment. At point E minimum proceeds required is
equal to expected proceeds. Before point E, aggregate demand is
more than aggregate supply. This implies that expected proceeds
are more than minimum proceeds. After point E, aggregate
supply is more than aggregate demand. Here the sales proceeds
expected are less than the minimum proceeds. Thus, 'E' is the
equilibrium point where both are equal.
In above diagram, equilibrium is attained at point 'E' where
volume of employment is OM. It is not at the full employment
level. The full employment level here is OMi. This is indicated by
the supply curve which is vertical from point 'T'. According to
Keynes full employment equilibrium is very rare while less than
full employment equilibrium is the reality.
Keynesian theory of employment is based on effective demand.
Effective demand depends on aggregate demand function and
aggregate supply function. The factors determining both are
explained through the following chart:
48 @ r@ ” i r v i p u i ’s™ Business Economics - II (SFC)

Level of Income
V
Level of Employm ent

I
Effective demand

Aggregate Demand Function Aggregate Supply Function

I------------------1-------1---------- 1
Consumption Investment
Expenditure Expenditure
' _L
I I I------ ------ 1
Size of Propensity Rate of
income to consume . interest
' I------ ------ 1
Supply Price Prospective
S ubjective O bjective 0f yield
factors factors Capita| asset

Demand for Supply of

money money

I
T ransactionary motive
Precautionary motive
Speculative motive

Theory of employment developed by Keynes is summarized as

follows:
(1) Level of output and income depends on level of employment
which is determined by effective demand.
(2) Effective demand depends on aggregate demand function
and aggregate supply function.
(3) Of the two functions, aggregate supply remains stable. Hence
aggregate demand is the most influential factor.
(4) Aggregate demand consists of consumption and investment
expenditure.
(5) Consumption expenditure depends on the level of income
and prosperity to consume.
(6) Objective and Subjective factors influence propensity to
consume.
.
(7) Investment expenditure is influenced by marginal efficiency
of capital and rate of interest.
The Keynesian Principle of Effective Demand n™grnf" 49

(8) Marginal efficiency of capital is determined by supply price

of the capital asset and prospective yield from the capital
asset.
(9) Demand for money and supply of money influence rate of
interest.
(10) While supply of money is fixed by the Central bank demand
for money is influenced by three motives namely
precautionary motive, transactionary motive and speculative
motive.
According to J. M. Keynes consumption expenditure remains
relatively stable in the short run. Hence aggregate demand is
mainly influenced by investment expenditure. Thus level of
employment and output mainly depends on investment
expenditure in the short run.

QUESTIONS
(1) Define the following:
(a) Aggregate demand.
(b) Consumption goods.
(c) Investment goods.
(d) Marginal efficiency of capital.
(e) Full employment.
(f) Effective demand.
Fill in the blanks:
(a) Aggregate demand consists of ___________ and ___________
- demand.
Consumption demand depends upon th e ___________ .
(c) Higher the___________ higher will be the level of investment.
Aggregate demand and aggregatesupply determine_.
(§}"* When income increases consumption will increase in a ___________
*" proportion.
s 'tf) Investment will be high if MEC is ___________ rate of interest.
[A rts.: (a) consumption and investment (b) level of income (c) MEC
(d) effective demand (e) lesser (f) greater than]
State whether the following statements are true or false:
^ (a ) Keynesian economics is based on the short run.
(b) Classical school believed in full employment.
50 a - e=!=r c r V ip u l ’s™ Business Economics - II (SFC)

(c) In the short run aggregate demand influences employment and

income rather than aggregate supply.
{d) Savings increase with a rise in income.
(e) Less than full employment equilibrium is very rare in reality.
(f) While classical economics is based on supply side, Keynesian
economics is based on demand side.
(g) Full employment always exists in advanced countries.
[Ans.: (a) True (b) True (c) True (d) True (e) False (f) True (g) False]
Match the following:_________________________
(A) (B)
(1) Adam Smith (a) General Theory
(2) Consumption demand (b) Marginal efficiency of capital
(3) J. M. Keynes (c) Income
(4) Investment demand (d) Wealth of Nations_________
Ans.: (1 - d; 2 - c; 3 - a, 4 - b)
(2) Define effective demand. How is it determined?
(3) Explain aggregate demand and aggregate supply in detail.
(4) Distinguish between classicism and Keynesianism.
(5) Comment on the following statements:
(a) Keynesian Theory of employment is different from the classical theory
of employment.
(b) Underemployment equilibrium rather than full employment equilibrium
exists in capitalist countries.
(Q) Aggregate demand consists of consumption expenditure and
investment expenditure.

□ □ □yyyc
w u tj |*ML:
Consumption Function □"Brer 51

Consumption Function

IN T R O D U C TIO N

PR O PER T IES OR TEC H N IC A L A T TR IB U T ES

A SSU M PTIO N S '

FA C TO R S D ET ER M IN IN G C O N SU M PTIO N FU N C T IO N

IM PLIC A T IO N S

Q U ESTIO N S
 52 SOTS' VipuVs™ Business Economics - II (SFC)

IN T R O D U C TIO N :
The theory of consumption function explains the functional
relationship between consumption and income. John Maynard
Keynes based his theory of consumption function on a
fundamental psychological law. In his own words "The
fundamental psychological law upon which we are entitled to
depend with great confidence, both a priori from our knowledge
of human nature and from the detailed facts of experience, is that
men are disposed as a rule and on the average to increase their
consumption as their income increases, but not only by as much as
the increase in their income". According to Keynes, consumption
expenditure of households depends mainly on their current
income. Many factors like interest rate, taxation, amount of
wealth, expectations of the consumers about the future prices etc.
influence consumption expenditure. However, in the opinion of
Keynes, consumption expenditure mainly depends upon the
current level of income.
The functional relationship between the two is expressed as:
C = f(y), where V refers to consumption, 'y' refers to income
and '{' refers to functional relationship. According to Keynes,
whenever income increases, consumption will also increase but in
a lesser proportion. This is because people have a tendency to save
a part of their income when income increases. Households save a
part of the incremental income to protect themselves against
uncertainties like sickness, unemployment, purchase of assets, etc.
Thus increase in income will lead to increase in consumption but
in a lesser proportion.
Consumption function is also known as propensity to
consume. It indicates the changes in consumption expenditure at
various levels of income. Consumption function is further
explained through average propensity to consume and marginal
propensity to consume.
Consumption function shows the functional relationship
between income and consumption. It is expressed as C = f(Y)
where ‘C is consumption, y is income and ' f functional
relationship. This relationship between income and consumption
can be a linear one or nonlinear one.
Consumption Function I'BTB’ 53

Linear Consumption Function: Consumption expenditure will

increase with an increase in income. As income continues to rise,
consumption expenditure will increase but at a diminishing rate.
This is because people have a tendency to save a part of their
income. In the case of linear consumption function consumption
will increase at a constant rate with the rise in income.
Symbolically it is expressed as
C = a + cY
where 'C' is consumption,
'a' is autonomous consumption even when income is zero

'c' is marginal propensity to consume

'Y' is income
In the case of linear consumption function marginal propensity
to consume remains constant. Linear consumption function can be
explained diagrammatically as follows:

Fig. 5.1

Here the 45° line shows that consumption is equal to income at

all levels. The line C = a + cY represents the consumption line.
This line starts above the origin from Y axis indicating that
consumption can never be zero. It is always positive.
When income is zero, consumption is possible by using past
savings or by borrowings.
54 □T^THT VipuVs™ Business Economics - II (SFC)

The consumption line C = a + cY intersects the 45° line at point

E. At this point c = y. Here consumption is OA and income is OM.
When income increases to OMi, consumption will increase from
OA to OB. It is obvious from the figure that increase in
consumption is less than increase in income i.e. AB < MMi. The
gap between the 45° line and C = a + cY line represents saving.
Here PD shows saving. The level of saving keeps on rising with
rise in income.
Non Linear Consumption function: Nonlinear consumption
function indicates that consumption will rise with increase in
income but not in a constant proportion. The following diagram
represents a non-linear consumption function.

Fig. 5.2

Here the consumption curve KC is a curvature. Initially it lies

above the income line i.e. 45° line. At point E, consumption is
equal to income. After that, the gap between the 45° line and the
consumption curve keeps on widening. It indicates that when
income continues to rise, consumption will increase but at a
diminishing rate and savings will increase at an increasing rate.
The non-linear consumption function represents the Keynesian
Version. Hence it is called Keynesian Consumption Function.
Consumption Function n’“Erjgr 55

PROPERTIES OR TECHNICAL ATTRIBUTES:

Average Propensity to Consume (APC) and Marginal Propensity
to Consume (MPC):
Average propensity to consume is the ratio of total
consumption expenditure to total income. It is expressed as,
C
APC = y

If the total income is Rs. 1000 crore, consumption is Rs 600

crore then
_ 600
APC "1000
= 0.6 or 60%
It indicates households spend 60% of their income on
consumption.
Marginal propensity to consume is the ratio of change in
consumption to change in income. It is expressed as
AC
MPC

where 'AC' refers to change in consumption & AY refers to

change in income. Suppose income increases from Rs. 1000 crore
to Rs. 2000 crore and consumption changes from Rs. 600 crore to
Rs. 1000 crore then
Change in consumption
MPC change in income
400
1000
= 0.4 or 40%
 56 □™gn,g ” Vipul's™ Business Economics - II (SFC)

When income rises both APC & MPC will fall. However MPC
will fall at a faster rate than APC. The counterparts of APC and
MPC are Average propensity to save (APS) and Marginal
propensity to save (MPS). They are expressed as follows:

APS

where, 'S' refers to sayings and 'Y' refers to income.

where, 'AS' refers to change in savings and 'AY' refers to

change in income. Further
APC + APS = 1 and, MPC + MPS = 1
In the case of rich people, MPS will be greater while in the case
of the poor people MPC will be greater than MPS. The above
concept can be illustrated with the help of the following table:
APS M PS
Consumption (Rs. APC MPC
Income
crore)
(sly) (As/Ay)
(c/y) (Ac/Ay)
(1-APC) (1- MPC)
1000 1000 1 . 0 — _ .
1800 800
2000 1800 .1 .2
2000 - 9 1000 " 8
2500 700
3000 2500 .17 .3
3000 ~'83 1000 “ -7
3000 500
4000 3000 .25 .5
4000 =’75 1000 " 5
3200 200
5000 3200 . 5000 ~M .36 1000 ~ -2 .8

The above table clearly illustrates that when income rises,

consumption also rises but at a lesser rate. Further when income
rises both APC and MPC are falling. But MPC is falling at a faster
rate than APC.
Consumption Function 0 1§ §™ 57

APC and MPC can be diagrammatically explained as follows:

Fig. 5.3 Fig. 5.4

C
In fig. 5.3, APC is represented. APC is y •At point E on the CC
curve, consumption is equal to OR and income is equal to OY.
. OR
••APC " OY
In fig. 5.4, MPC is shown. When income increases from OY to
OYi, consumption rises from OR to ORi.

MPC = . It is obvious from the figure that RRi is less

than YYi. MPC is measured in terms of the slope of the
consumption curve.
ASSUM PTIONS OF CONSUMPTION FUNCTION:
The concept of consumption function is based on the following
assumptions:
(1) The government adopts a policy of laissez-faire i.e. policy of
non-intervention.
(2) The economy is working under normal conditions. It is
assumed that there are no abnormal conditions like war,
drought, depression, etc.
(3) Psychological and institutional factors like tastes and
preferences, habits, price level, population size, distribution
58 etcth” V ip w l’s™ Business Economics - II (SFC)

of income and wealth etc do no change in the short run. The

above factors are assumed to be stable.
■ The above assumptions when fulfilled, consumption function is
valid i.e. consumption depends on income and it will increase
when income increases but at a lesser rate.
'■FACTORS DETERMINING CONSUMPTION FUNCTION:
Consumption function or propensity to consume is influenced
by a variety factors. They are classified as objective and subjective
factors. The objectives factors are as follows:
(4) Size of income: Consumption expenditure mainly depends
upon the size of money income. Higher the income, higher
will be the level of consumption and vice versa.
(5) Price level: An inverse relationship exists between price level
and consumption expenditure. An increase in the general
price level reduces the real income of the people and reduces
the level of consumption and vice versa.
(6) Distribution of income: Consumption would be higher if the
national income is distributed equitably and vice versa.
(7) Propensity to save: If the households have a greater tendency
to save rather than spend, then consumption will be less and
vice-versa.
(8) Future expectations: Households tend to buy more and even
hoard in the current period if they expect shortages in future
due, to war, droughts etc. At such times they spend more on
consumption goods and hence consumption expenditure
would be low.
(9) Tastes and fashions: Changes in tastes and fashions affect
consumption pattern of people. Changes will be profound in
the long run rather than in the short run.
(10) Fiscal policy: Fiscal policy refers to the policy of the
government regarding taxation, public expenditure and
public debt. Changes in fiscal policy has a direct influence on
level of consumption. For example, if the tax rates are
increased, consumption expenditure will decline and vice
versa.
Consumption Function p^Ergar 59

(11) Rate of interest: Consumption will be low if rate of interest is

high and vice versa.
(12) Windfall gains or losses: Unexpected gains like winning a
lottery will enhance consumption & vice versa.
(13) Ownership of Assets: If people own considerable amount of
assets, then they have a sense of security and spend more
from the current income on consumption and vice-versa.
(14) Corporate policies: Policies of corporates also influence
consumption expenditure. If they adopt a liberal dividend
policy, shareholders level of income will rise leading to a
higher level of consumption. On the other hand a
conservative policy of the business firms will reduce
consumption.
(15) Other factors: Level of indebtedness repayment of loans, etc.
also reduce the level of consumption.
Apart from the above objective factors, certain subjective
factors also influence consumption function. They induce people
to save rather than spend and hence they have a tendency to
reduce consumption expenditure. The subjective factors are
termed as motives and they are as follows:
(a) Motive of precaution against illness, accident and
unemployment, etc.
(b) Motive of future expectations and needs.
(c) Motive of accumulation of wealth.
(d) Motive of independence.
(e) Motive of investment and enhanced income.
(f) Motive of speculation.
(g) Motive of accumulating assets for the future generation.
(h) Motive of miserliness.
Like individuals, business firms also save in order to expand
their business, to maintain liquidity, to be financially prudent etc.
All these factors increase the prosperity to save and reduce
consumption expenditure. According to Keynes some subjective
factors like tendency to show off, demonstration effect i.e. poor
60 gf-grop VtpuVs™ Business Economics - II (SFC)

and middle income group trying to imitate the lifestyle of the rich
people etc. increase consumption expenditure.
According to J. M. Keynes, most of these factors remain stable
in the short run. Hence according to him, consumption function
also remains stable in the short run.
IMPLICATIONS OF CONSUMPTION FUNCTION:
The implications of consumption function are as follows:
(1) Significance of investment: Consumption function indicates
the gap between income and consumption. According to
Keynes whenever income increases consumption will also
increase but in a lesser proportion. The gap between the two
indicates savings and savings have to be converted into
investment to maintain higher level of income and
employment. Thus consumption function implies the
significance of investment. ‘
(2) Turning points of trade cycle: The turning points of trade
cycle can be explained through consumption function. When
consumption lags behind the increase in income, the economy
will move from boom to recession. Conversely recovery from
depression occurs due to increase in the consumption
expenditure of the people.
(3) Repudiation of Say's Law of Market: J. B. Say's law of market
states that "supply creates its own demand". According to
Keynes increase in income does not lead to increase in
consumption in the same proportion. Therefore supply will be
more than demand leading to a glut of goods and services in
the market. In the opinion of Keynes, it is demand which
creates supply and not vice versa.
(4) Over saving gap: The gap between income and consumption
represents savings and the gap widens with every increase in
income. Thus there can be an over saving gap affecting the
growth of the economy if enough investment opportunities are
not available.
(5) Income propagation: According to Keynes, the value of
multiplier will be high if MPC is high and vice-versa. Since
Consumption Function □™Bra™ 61

MPC is less than one, when investment increases, the increase

in national income will be lesser.
(6) Fall in marginal efficiency of capital: When income rises,
consumption rises in a lesser proportion. Thus aggregate
supply will be more than aggregate demand. Lack of demand
will affect profitability. Hence there will be a decline in
marginal efficiency of capital.
(7) Underemployment equilibrium: Classical economists
believed in full employment equilibrium. J. M. Keynes rejected
this and through consumption function proved that under
employment equilibrium is the reality as demand is less than
supply.
(8) Importance of state intervention: Consumption function
highlights the need for government intervention. When
supply is more than demand, it indicates over production.
This will lead to unemployment. To avoid this state
intervention is absolutely necessary.

QUESTIONS

(1) Define the following:

(a) Consumption function , ( ‘
(b) APC f t ' ‘ ’ . o . ' • -'" w
(c) APS ^ V . _ , ...‘U
(d) MPC
(e) MPS ! ■ 1 r '
(2) State whether the following statements are true or false:
An increase in income always leads to an increase in consumption.
(b) Income and consumption are inversely related.
" (c) Consumption function remains stable in the short run.
‘ (d) When income increases, consumption will rise more than
* proportionately.
(e) When income rises both APC and MPC will rise.
(f) The value of MPC always varies between zero and one.
J g ) MPC is high in the case of rich people and low in the case of poor
people.
(h) Consumption function implies full employment.
62 H T W i T V ipul’tt™ Business Economics - II (SFC)

c (i) Consumption function justifies Say’s Law of markets.

A ns.: (a) True; (b) False; (c) True; (d) False; (e) False; (f) True; (g) False;
(h) False; (i) False.
(3) Explain the concept of consumption function.
(4) Differentiate between APC & MPC and APS & MPS
(5) Discuss the factors which influence consumption function.
(6) Calculate APC, APS, MPC and MPS from the following data:________
In c o m e (R s . c ro re s) 1000 2000 3000 4000 5000
C o n su m p tio n (R s . c ro re s ) 800 1600 2400 3200 4000
(7) Calculate APC, APS, MPC and MPS from the following data:
In c o m e (R s . c ro re s ) 1000 2000 3500 5500 8000 12000
C on su m p tio n (R s . c r o r e s ) 900 1700 2300 2700 2900 3000
(8) Construct a hypothetical schedule of income and consumption and
calculate APC, APS, MPC and MPS.
(9) What are the assumptions and implications of consumption function?
Investment Function and Marginal Efficiency of 63

Investment Function and

Marginal Efficiency of
Capital (MEC)

INTRODUCTION

TYPES OF INVESTM ENTS

MARGINAL EFFICIENCY OF CAPITAL

INVESTM ENT DEMAND CURVE

QUESTIONS
64 @™l! S T Vipul's™ Business Economics- II (SFC)

INTRODUCTION:
The theory of employment developed by J. M. Keynes
emphasises on a high level of effective demand to maintain a high
level of employment. Effective demand is the summation of
consumption demand and investment demand. While
consumption demand refers to the demand for final or
consumption goods, investment demand refers to the demand for
capital goods. Consumption demand depends upon the level of
income and prosperity to consume. Investment demand on the
other hand depends up marginal efficiency of capital and rate of
interest. In the short run consumption demand remains stable.
Hence level of employment is mainly influenced by investment
demand.
Of the two factors determining investment demand, rate of
interest remains stable in the short run. Hence marginal efficiency
of capital is the most influential factor in determining the level of
investment demand and employment.
When real investment increases, demand for factors of
production will rise leading to more employment and more
national income. In economics, investment refers to real
investment not financial investment.
TYPES OF INVESTM ENTS:
Investments are of various types. They are:
Autonomous investment and induced investment:
Autonomous investment refers to those investments which
are made without reference to income or profit or rate of
interest. It is not profit oriented. Investments made by the
government in roads, railways, etc. are autonomous
investments. Investments made due to technological
developments, population growth, discovery of new
resources also belong to this category. Autonomous
investments are said to be income inelastic.
Induced investments refer to all those investments which
are done with profit motive. Generally private sector
investments are induced investments. Induced investments
will be more if profits are more and vice versa. When income
Investment Function and Marginal Efficiency o f ..... 65

of the people rises, consumption expenditure will rise leading

to more induced investment. Therefore induced investment is
income elastic. When income rises, investment will be more
and vice versa.
Autonomous and induced investment can be represented
as follows:

In the above diagram AA represents autonomous

investment. AA is parallel to X axis indicating it does not
change with the change in income. It represents induced
investment. It is an upward sloping curve showing that
investment will increase with a rise in income and vice versa.
(2) Gross investment and Net investment: Gross investment
refers to the total investment in fixed assets during a period
of time. Investments on machines, factories, buildings, etc.
are considered in gross investment.
Net investment is gross investment minus depreciation of
capital assets. Along with depreciation, expenditure on
maintenance of machines and fixed assets and also any loss
to fixed capital due to fire, flood, etc. Thus net investment is
gross investment minus depreciation, maintenance
expenditure and losses.
(3) Real investment and financial investment: The term
investment can imply two things namely financial
66 nrn~Er V ip u l ’s™ Business Economics - II (SFC)

investment and real investment. When people invest in

shares, debentures, bonds etc. it is termed as financial
investment. They are investing on already existing assets and
it is a mere transfer of ownership from one person to the
other. Real investment on the contrary refers to that
investment which increases the stock of capital assets like
machines, equipments, construction of new factories, etc.
Real investment also includes construction of new roads,
railways, canals, bridges, etc.
Investment demand depends upon marginal efficiency of
capital and rate of interest.
Of the two factors determining investment demand, rate
of interest remains stable in the short rim. Hence marginal
efficiency of capital is the most influential factor in
determining the level of investment demand and
employment.
MARGINAL EFFICIENCY OF CAPITAL:
\The term marginal efficiency of capital, popularly referred as
'MEC' refers to the expected rate of profitability from a capital
asset, lit is defined as the rate of return expected over and above
the cost of an additional or marginal unit of a capital asset. The
capital asset here refers to a brand new asset and not the existing
one. Similarly 'return' is related to the expected one and not the
existing or actual return.
MEC depends on two factors namely prospective yield from
the capital asset and supply and supply price of the asset.
Prospective yield refers to the total net return expected from the
asset over its lifetime. It refers to the net income received by
selling the output produced by the capital asset. Net return here
implies that the cost of using the asset is deducted from the gross
income. For example, if a machine has a lifespan of twenty years,
the expected net return for each year should be estimated and the
aggregate of net return for the twenty years will give the
prospective yield of the capital asset.
Along with the prospective yield, supply price of the capital
asset is also taken into account before investing on the capital
Investment Function and Marginal Efficiency o f ..... SjjjHSTii" 67

asset. Supply price refers to the cost of the brand new capital
asset. Any investor would compare the prospective yield and the
supply price of the asset and he would like to invest when the
prospective yield is more than the cost or supply price of the
asset.
MEC, according to J. M. Keynes is the rate at which the
prospective yield from a new capital asset to be discounted to
make it equal to the supply price of the asset. In the words of
Keynes, "MEC is that rate of discount which would make the
present value of the series of annuities given by the returns
expected from the capital asset during its life just equal to supply
price". The formula used here to equalize prospective yield to
supply price is as follows:
Ql Q2 Q3 Qn
Cr _ (1 +. _\1 + It
r)i + (1 +, r)2 + (1 + r)3 .......
..... (1 + r)«
where Cr refers to the supply price of the asset. It is also known
as the replacement cost Qi, Ch-.-Qn represent the annual returns
from the capital asset. The term Y refers to the rate of discount
which will equalize the prospective yield to the supply price of
the asset. Thus Y is the marginal efficiency of capital. In the

above formula the term ^ ^ '^ 7 represents the returns to be

received at the end of the first year discounted at the rate of Y .
Similarly the other terms in the formula stand for the returns in
the respective years. To find V or marginal efficiency of capital
the formula can be rearranged as follows:

^ “ (l + r)1
C r(l + r) = Qi

The above formula can be explained with the help of an

example. Let us assume the supply price of an asset is Rs. 1000
 68 Erj3'“!|r V ip u l Vf™ Business Economics - II (SFC)

crores. It's prospective yield at the end of one year is Rs. 1250
crores. .'. 'r' can be calculated as follows:

1250
~ 1000 1
= 0.25 or 25%.
Thus, MEC = 25%.
When MEC is known, the prospective yield can be calculated.
Suppose supply price = Rs. 1000 crores and MEC = 0.25 then
prospective yield can be calculated as follows:

= 1000 (1 + 0.25) = Qj
= 1250
Thus MEC is the rate at which prospective yield is discounted
to make it equal to the supply price of the capital asset. Once MEC
is calculated, the investor will compare it with the rate of interest.
As long as MEC is greater than the rate of interest, the investment
project will be undertaken.
MEC is influenced by prospective yield and supply price of the
asset. Of these two factors supply price is stable in the short run.
It is the prospective yield which is not stable in the short rim
according to Keynes. Therefore any fluctuation in private
investment in a capitalist economy is attributed to fluctuations in
the prospective yield. Prospective yield is highly fluctuating in
nature because it is concerned with the returns in the future
which by itself is uncertain and incalculable. Despite this
investors always try to estimate prospective yield before investing
in a new project.
Private investment is influenced by MEC. Higher the MEC,
higher will be the level of investment and vice-versa. Just like
Investment Function and Marginal Efficiency of ig™nT
"gr 69

investment is influenced by MEC, MEC is also influenced by the

level of investment. When more and more investments are made
on a particular capital asset, MEC will start declining. When
demand for an asset increases, supply also starts rising. When
supply is more, competition amongst the sellers will reduce its
price or prospective yield. At the same time the cost of producing
such asset will rise as more and more such asset is produced.
Thus on the one hand prospective yield is declining and on the
other hand supply price is rising. Hence MEC will decline when
investment rises.
INVESTM ENT DEMAND CURVE:
The relationship between level of investment and MEC can be
explained with the help of the following schedule and diagram:
Levels of investment MEC
(Rs.) (%)
5000 20
10,000 15
15,000 12
20,000 10
25,000 8

The schedule shows that as investment increases MEC

declines. When the above schedule is plotted on a graph the MEC
curve is obtained. It is shown as follows:

V
\
MEC
j — — ------------>
--------------- >
q q, q 2 x
Volume of Investment

Fig. 6.2 Fig. 6.3

70 ETETET
s* as asi V ip u l's ™ Business Economics - II (SFC)

In the above diagram, the MEC curve slopes downwards from

left to right indicating the inverse relationship between
investment and MEC. When investment is OQ, MEC is OR.
When investment increases to OQi and OQ 2 MEC declines to ORi
and OR 2 , MEC declines to ORi and OR 2 . When more and more
investment takes place, prospective yield has a tendency to
decline and supply price has a tendency to rise. Hencex the
investment demand curve has a negative slope.
In fig. 6.2, y axis represents both MEC and RI. Given a certain
rate of MEC and RI, the equilibrium level of investment can be
determined at the point where MEC = RI. In the above diagram
when the rate of interest is ORi, level of investment will be OQ.
When the rate of interest falls to ORi and OR2 , investment will
increase to OQi and OQ 2 . Thus the MEC curve or the investment
demand curve shows the level of investment at various rates of
interest.
Though investment changes with the change in the rate of
interest, how much it will change depends upon the elasticity of
the investment demand curve. If it is highly elastic, then changes
in investment will be significant when rate of interest changes. If
the investment demand is inelastic, then the changes in
investment with the change in the rate of interest will be less.
Fig. 6.3 explains the change in investment due to changes in
MEC given the rate of interest. When the entrepreneurs expect the
profits to rise, MEC curve will shift to the right. In the figure
original curve is MEC. The new curve MECi indicates the change
in MEC due to rise in profit expectations and hence more
investments will be undertaken. Now the investment will rise to
OQi. On the contrary, MEC 2 indicates a fall in profit expectations
and hence investment will decline OQ 2 .
Thus investment depends on two factors namely MEC and RI.
As long as MEC is greater than RI, investments will be
undertaken. Investments will fall when MEC is less than that of
RI. Thus investment depends on both MEC and RI. Of the two
factors, rate of interest remains stable or sticky in the short run.
MEC on the other hand is a volatile factor. Hence private
investment is by and large influenced by MEC in the short run.
Investment Function and Marginal Efficiency of n™n~Er 71

Factors influencing MEC:

MEC is influenced by both short run and long run factors.
Short run factors:
(1) Propensity to consume: If propensity to consume rises, MEC
will rise and vice versa.
(2) Increase in income: If income of the people rises, if tax rates
are reduced, then MEC will increase and vice versa.
(3) Future expectation: If demand for goods and prices are
expected to rise and costs are expected to fall then MEC will
rise and vice versa.
(4) Availability of liquid funds: If the investors have huge liquid
funds, then investments are easy and hence MEC will be high
and vice.versa.
(5) Business conditions: MEC will be high if there is business
optimism and it will be low if pessimism prevails in the
economy.
Long run factors:
(1) Technological advancements: This will lead to efficient
methods of production. Hence MEC will be the rise.
(2) Additional demand: If the existing capacity is fully used and
if demand rises, new investment is required. Hence MEC will
be high.
(3) Population growth: Increase in population will increase the
demand for goods and services leading to higher MEC.
(4) Infrastructural development: Government's initiative to
develop infrastructure will give rise to many business
opportunities. Hence MEC will be high.
(5) Changes in economic policy: If the government adopts a
favourable economic policy business prospects will improve
and this has a positive impact on MEC.
(6) Current level of investment: If current level of investment is
low in an industry, there are good business prospects in that
industry the MEC will be high and vice versa.
 72 grcrgl™ Viput’s™ Business Economics - II (SFC)

Thus is the short run investment function is mainly influenced

by MEC, rather than rate of interest.

QUESTIONS
(1) Define the following concepts:
(a) MEC.
(b) Prospective yield.
(c) Supply price.
Fill in the blanks:
(a) Private investment depends upon___________and___________ .
(b) MEC depends upon___________ and___________ .
(c) -------- i-------- influencing investment remains stable in the short run.
(d) The MEC curve will shift___________ when there is a rise in MEC.
[A rts.: (a) MEC and Rl (b) Prospective yield and supply price of the asset
(c) Rate of interest (d) to the right]
State whether the following statements are true or false:
(a) Keynesian theory is a short run theory.
(b) MEC is a highly volatile factor influencing investment function.
(c) Level of investment is interest inelastic.
(d) MEC has a tendency to decline when investment rises.
(e) Autonomous investments are done by private sector
(f) Induced investments are profit oriented.
(g) Economics is concerned with real investment.
[A ns.: (a) True (b) True (c) False (d) True (e) False (f) True (g) True]
(2) Explain the principle of MEC with suitable diagrams.
(3) Draw the investment demand curve and explain the relationship between
MEC, Rl and investment.
(4) Explain the different types of investments.
(5) What factors influence MEC?
(6) Solve the following case study.
The supply price of a capital asset is Rs. 5 crore. The market rate of
interest is 8% and MEC is 10%. When the following changes take place,
how the investor will react? ’
(a) Given the MEC, Rl rises to 12%.
(b) Rl remains stable at 8%, MEC rises to 15%.
(c) When MEC is equal to Rl?
Theory of Multiplier

Theory of Multiplier

INTRODUCTION

ASSUM PTIONS OF MULTIPLIER

WORKING OF MULTIPLIER

REVERSE MULTIPLIER

LEAKAGES OF MULTIPLIER

CRITICISMS/LIMITATIONS OF MULTIPLIER

QUESTIONS
 74 □"’grg™ V ipul’s™ Business Economics - II (SFC)

INTRODUCTION:
The theory of multiplier is one of the path breaking
contributions of J. M. Keynes. Multiplier explains the relationship
between investment and income. According to J. M. Keynes an
increase in investment will lead to multiple increase in aggregate
income. Multiplier is defined as the relationship between an initial
increase in investment and the final increase in aggregate income.
In other words, it is the ratio of change in income to the change in
investment. Change in investment leads to change in income via
consumption expenditure. Symbolically it can be represented as
w , • 1- AY
Multiplier = . Suppose AI = Rs. 5 crores, AY = Rs. 20 crores then
multiplier value = 4. It implies that an increase in investment will
lead to increase in income by four times. Thus change in income
will be more than the change in investment.
J. M. Keynes developed this theory in 1929. Keynesian
multiplier is known as investment or income multiplier. R. F.
Khan gave another version in 1931 which came to be known as
employment multiplier. Employment multiplier explains the
relationship between increase in primary employment to the total
employment. It explains how employment of one person leads to
the number of people indirectly employed. While investment
multiplier of Keynes is represented by k, employment multiplier
of R. F. Khan is denoted by k
The value of multiplier depends upon marginal propensity to
consume (MPC). MPC refers to the change in consumption due to

change in income. It is expressed as MPC = — . There is a direct

relationship between MPC and multiplier. Higher the MPC,
higher will be the value of multiplier and vice versa. The
following formula is used to calculate the value of k.
. 1
1 - MPC ' can a^so exPressed as
Theory of Multiplier grETsr 75

1 1
Suppose, MPC = cj, then k = = i = ! = i -25
1 5 -j
If investment increases by Rs. 10 crores then increase in income
will be
AY = AI x k
= 10x1. 25
= Rs. 12.5 crores.
Thus multiplier is the reciprocal of marginal propensity to save
which is nothing but the change in savings due to change in
income. The following table clearly indicates the direct

MPC MPS (1 - MPC) k (1/MPS)

0 1 1

1/4 3/4 4 /3

1/2 1 /2 2

3 /5 . 2/5 2.5

3/4 1 /4 4

9/10 1 /1 0 10

9 9 /1 0 0 1/1 0 0 100

1 0 00

VV i l C l l 1 V J.1 v U l^ l^ U u v J/ * u iw -v ^

= 0, it implies that there is no change in consumption due to

change in income. The additional income here is not causing any
change in consumption. Hence k = 1 and therefore aggregate
income will increase only by the initial increase in investment. On
the other hand when MPC = 1, it implies that the entire increase in
income is used for consumption. Therefore, multiplier value will
be infinity and the change in income will also be infinity. MPC = 0
or MPC = 1 are extreme cases. In reality MPC varies between zero
and one and multiplier value varies between 1 and infinity.
 76 “ “ “ Vipul's™ Business Economics- II (SFC)

^A SSU M PTIO N S OF MULTIPLIER:

The theory of multiplier assumes the following conditions:
(1) The economy is a closed economy i.e., there is no foreign
trade.
(2) There is no government intervention..
(3) Full employment does not exist.
(4) MPC remains constant throughout the process of income
generation or propagation.
(5) There is no change in monetary and fiscal policy.
(6) Excess capacity exists in the consumer goods industry.
(7) Increase in investment and increase in income are
instantaneous.
WORKING OF MULTIPLIER:
The process of income propagation due to multiplier effect can
be explained with the help of an example. Let us assume that the
initial investment increases by Rs. 4000 crores in the transport

sector and MPC = ^ . The value of multiplier and increase in

aggregate income can be calculated as follows:

•MPS = i ; t = - ? S = i = 4 .
4
AY = AI x k = 4000 x 4 = Rs. 16,000 crores.
Thus an initial increase in investment of Rs. 4000 crores will
increase aggregate income by Rs. 16,000 crores. This is because
when investment is increased in one sector, it increases the income
of the people in this sector as well as people in other sectors.
Moreover one man's income is another man's expenditure. This
results in more demand for goods and services, increase in
consumption expenditure and finally the multiplier effect takes
place.
In the above example, when investment increases by Rs. 4,000
crores, people employed in this sector get an income of Rs. 4000
crores. Out of this they will spend %th on consumption (MPC is
Theory of Multiplier □’“□T
“ET 77

given as 3/4). Therefore, in the first round increase in

consumption is Rs. 3,000 crores (3/4 x 4,000). This consumption
expenditure of people in this sector becomes income for another
group. They will spend 3/4 of this income of Rs. 3,000 crores i.e.
Rs. 2,250 crores on consumption. In the next round this
consumption expenditure will become income for another group
of people and they will spend %th on consumption. This process
will continue and the final increase in income will be Rs. 16,000
crores.
Diagrammatic Representation: The theory of multiplier can be.
explained with the help of the following diagram:

Fig. 7.1

In the above figure, the 45° line OA is the income line. The C
curve represents the consumption curve. C+I curve indicates
investment and consumption. This curve C+I intersects the 45°
line at point E. E is the equilibrium point and the equilibrium level
of income is OYi. When investment increases, the C+I curve shifts
upwards. It intersects the 45° line at point E'. The new equilibrium
point is E' and the equilibrium level of income is OY 2 . The increase
in investment is M 1M 2 and the increase in income is YiY2. It is
obvious from the figure that Y 1Y 2 > MiM 2 - Thus, a small change in
 78 WWW Vtpul’s™ Business Economics - II (SFC)

investment brings about a larger change in income due to

multiplier effect.
REVERSE MULTIPLIER:
Reverse multiplier explains how a small reduction in
investment will lead to a larger fall in income. When investment is
reduced in one sector or industry, the people employed in the
industry would be affected. Their income and consumption
expenditure will fall. This would affect other sectors and finally
the aggregate income will decline much more than the fall in
investment.
LEAKAGES OF MULTIPLIER:
Certain factors reduce the value of MPC and multiplier. They
are called as leakages. They are as follows:
(1) Debt Cancellation/Repayment: If people use a part of the
increased income for repayment of debt, then MPC will be
low and multiplier value will be low.
(2) Inflation: The increase in income may be enough to buy the
same quantity of goods or less due to rise in prices. Hence,
there is no real increase in consumption.
(3) Taxation: If tax rates are increased consumption will fall,
reducing MPC and multiplier.
(4) Imports: Imports drain away the money from the domestic
economy. Imports do not add to the income stream of the
economy.
(5) Liquidity Preference: If people have high liquidity
preference, spending will be less reducing the value of MPC.
(6) Purchase of old securities: If the rise in income is used for
buying old securities, then consumption will be less reducing
multiplier value.
All the above leakages have to be plugged, if multiplier has to
be effective. Lesser the leakages, greater would be the increase in
income due to increase in investment.
Theory of Multiplier ErErgg™ 79

CRITICISMS/LIMITATIONS OF MULTIPLIER:
Keynesian theory of multiplier is not free from criticisms. The
following are the major ones.
(1) Assumptions like closed economy, constant MPC, absence of
government intervention etc. are considered unrealistic.'
(2) When investment increases, income will increase. This will
lead to more demand for goods and services. If supply is not
increased, inflation will set in.
(3) If there is a net decline in investment, then multiplier will not
work.
(4) Leakages like imports, taxation, debt repayment etc. affect the
working of multiplier.
(5) Once the economy attains full employment, increase in
investment will result in inflation rather than increase in
income.
(6) It is a static theory and not suitable for dynamic economies.
(7) Multiplier focusses only on autonomous investment.
Exclusion of induced investment is a major limitation
according to the critics.
Despite all the criticisms, the multiplier theory has a special
place of significance in macro economics. It helps to analyse trade
cycles and highlights the importance of government intervention
when private investments fall. Multiplier theory is used by
modem economists to support the ever increasing public
expenditure of welfare states in the present era. It has also paved
the way for further developments in macro economics.

QUESTIONS
(1) Define the following:
(a) Multiplier.
(b) MPC.
(c) MPS.
Fill in the blanks:
The theory of multiplier given by J. M. Keynes is known as
___________multiplier.
 so WWW V ipul’s™ Business Economics - II (SFC)

(b) Employment multiplier was given b y ___________ .

(c) The size of multiplier depends upon___________ .
(d) If MPC is 1/2 , then MPS is ___________and K is
[A rts.: (a) Investment/Income (b) R. F, Khan (c) MPC (d) Vz, 2]
State whether the following statements are true or false:
„ <a) Multiplier value is either equal to zero or one.
(b) Higher the MPC, higher the value of multiplier.
f (c) Multiplier has no leakages and limitations.
Higher the MPC, higher the value of multiplier.
[A ns.: (a) False (b) True (c) False (d) True]

(A) (B)
f f ) Investment multiplier (a) Zero and one
(2) Size of multiplier (b) MPC
(3^\/alue of MPC (c) J. M. Keynes
■b)
(2) Explain the following:
(a) Assumptions and limitations of multiplier.
(b) Leakages of multiplier.
(3) Define multiplier. Explain the working of multiplier with a suitable example
and diagram.
(4) If initial increase in investment is Rs. 100 crores, MPC = 3/4, what is the
increase in aggregate income? ’
(5) Initial increase in investment is Rs.5000crores. If MPC is 4/5, what is the
value of multiplier and increase in aggregate income? Explain the working
of multiplier.
(6) ‘Higher the MPC, higher the value of multiplier’ - Explain.
Money Supply g"'gr§r 81

MODULE - II
MONEY, IN FLA TIO N AND
M ONETARY PO LIC Y

Money Supply

INTRODUCTION

CONSTITUENTS OF MONEY SUPPLY

DETERMINANTS OF MONEY SUPPLY v /

FACTORS INFLUENCING VELOCITY OF CIRCULATION OF

M O N EY _^^

QUESTIONS
82 g”igr||” V ipul’s™ Business Economics - II (SFC)

Money is one of the greatest inventions of mankind. Every

branch of knowledge has its own inventions. In Economics, the
most important invention is money. Money is defined in terms of
its functions. It acts as a medium of exchange, measure of value,
store of value and standard of deferred payments. It is rightly
defined as "Money is what money does." All economic activities
of every economy revolve around money. In fact it is impossible
to imagine any economic activity without the use of money. It
plays such a crucial role today, that the modem economy is called
as the "Money economy."
The term "Supply of Money" refers to the total amount of
money in circulation at a particular point of time. It is the total
stock of money held by the public. The term public refers to
individuals, business firms and the governments. Supply of
money refers to that stock of money with the public which is in
circulation. It implies that money in disposable form only is
considered under money supply. That stock of money which is
kept as a reserve by the banking system and the government is
not included in money supply. Thus supply of money can be
defined as "The total amount of money in circulation in an
economy at a given point of time."
Money supply is viewed in two ways namely as a stock and as
a flow variable. When money supply is measured at a point of
time it is a stock concept and when it is measured over a period of
time it is termed as a flow concept. The total amount of money in
circulation consists of the currency with the public and the
deposits of the banking system. A unit of money passes through a
no. of hands in the process of transactions. The average no. of
times a unit of money passes from one hand to another during a
given period of time is called velocity of circulation of money.
Growth of money supply within limits is essential for any
economy to accelerate economic growth and it is a crucial factor to
be considered for ensuring price stability.
CONSTITUENTS OF MONEY SUPPLY:
The total amount of money in circulation during a given period
of time is termed as money supply. There are various approaches
regarding the components of money supply i.e. what items should
Money Supply 83

be considered under money supply. Two approaches namely

traditional approach and modem approach are very important.
They can be analyzed as follows:
Traditional Approach:
The traditional approach is based on the medium of exchange
function of money. It is a narrow approach. The main constituents
of money supply according to this approach are:
(1) Coins and Currency Notes.
(2) Deposits withdrawable by means of cheques i.e. Bank
Money.
(1) Coins and Currency Notes: Coins and currency notes are
legal tender money. Generally they are issued by the central
bank of the country which has the monopoly of note issue. In
some countries, the treasury is also involved in issuing coins
and currency notes. For e.g. In India, one rupee coin is issued
and managed by the central government. Other coins and
currency notes are issued by the Reserve Bank of India. Coins
and currency notes are also called high powered money as
they are issued by the central bank and the central
government. While issuing currency notes, different countries
follow different systems of note issue. The main system of
note issue are:
(a) Full Reserve System: When the issue of currency notes is
fully backed by reserves of gold and silver, it is known as
full reserve system. It is also called 100% reserve system
as the issue of currency notes is fully backed by precious
metals.
(b) Proportional Reserve System: Under this system, a
proportion of note issue is backed by gold and silver and
balance by approved securities. This system was adopted
by India in 1927 and it was in vogue till 1957.
(c) Minimum Reserve System: In this system the central
bank is required to maintain a minimum amount of gold
reserves. In 1957, the Reserve Bank of India adopted this
system. Under this system, the central bank has to
maintain a reserve of Rs 200 crores. Of this, gold holdings
 garisrnr V ip t t l ’s™ Business Economics - II (SFC)

must be worth Rs 115 crores and the balance Rs 85 crores

in terms of foreign securities. By maintaining this reserve,
the RBI can print any amount of currency notes. This
system is quite popular due to its features namely
economy and elasticity.
(d) Maximum Fiduciary System: The monetary authority
fixes the maximum limit for the issue of notes. It is
statutorily fixed by the monetary authority.
(e) Fixed Fiduciary System: Under this system the central
bank is authorized to issue a certain amount of currency
notes against government securities. When currency
notes have to be issued over and above this, it should be
backed by gold and silver. The government and the
central bank issue coins and currency notes. The actual
amount of money in circulation however is influenced by
a variety of factors like nature and volume of trade,
method of payment, development of the banking system,
banking habits of the people, price level, choice of the
community either to pay in cash or in cheque etc.
Bank Money: Another constituent of money supply is bank
money. Bank money refers to the demand deposits with the
commercial banks, which are withdrawable by means of
cheques. These deposits can be transferred to others or they
can be used for making payments through cheques. Thus,
deposits can be made as a medium of exchange through
cheques. Deposits with the banks are of two types namely
demand deposits and time deposits. While demand deposits
can be withdrawn through cheques, time deposits can be
withdrawn only after the maturity period. Thus according to
the traditional approach only demand deposits should be
included in money supply.
The deposits of the public are used by commercial banks to
provide credit to the various sectors of the economy. In the
process of credit creation, more deposits are created by
commercial banks leading to an increased money supply. Of
the two constituents of money supply, bank money accounts
for a larger proportion in the case of advanced countries. This
Money Supply n,”Era,w 85

is due to the development of the banking system and the

banking habits of the people. In the case of countries like
India, bank money accounts for nearly 50% of the total money
supply. This is because of the insufficient development of the
banking system and banking habits of the people and also due
to their preference to make payments in terms Of cash. This
shows the underdeveloped nature of the Indian economy.
Modern Approach:
The modem approach is a wider concept. According to this
approach, money supply should include both money and near
money assets. Thus, money supply according to this approach
consists of coins, currency notes, demand deposits, time deposits,
deposits with non-banking financial intermediaries, shares, bonds
and bills of exchange. In fact, all those assets which have liquidity
are considered under money supply. The modem approach has
the following four versions:
(1) Prof. M ilton Friedman's Approach: Prof. Milton Friedman,
the famous monetary economist has given a wider approach
to the constituents of money supply. According to him,
money supply consists of coins, currency notes, demand
deposits, time deposits and all government securities which
are marketable. According to Prof. Milton Friedman, time
deposits should also be included as they have liquidity. They
can be made available as loan at a particular rate of interest
before the maturity period. Hence, money supply should
include both money and near money assets.
(2) Gurley-Shaw Approach: This approach includes other near
money items like deposits with non-banking financial
intermediaries along with the other items.
(3) Radcliffe Approach: This approach considers all items which
have liquidity under money supply. It includes currency
notes, all types of deposits with banks and financial
intermediaries, other near money assets like shares, bonds
and also the borrowing facilities available in the economy.
(4) Central Bank Approach: According to this approach, money
supply consists of coins, currency notes, time and demand
86 EnETEj™ V lp M l’5™ Business Economics - II (SFC)

deposits with commercial banks, deposits in the non-banking

financial companies, bills of exchange, shares, bonds,
government securities and the credit provided by the various
institutions. This approach is considered as a wider and
practical approach.
Thus, the modem approach considers money and all near
money assets as constituents of money supply.
DETERMINANTS OF MONEY SUPPLY:
Money supply consists of coins, currency notes and demand
deposits. While coins and currency notes are issued by the central
bank, demand deposits are created by commercial banks through
the process of credit creation. The central bank has the monopoly
of note issue and it also controls the credit created by commercial
banks to ensure stability in the economy. In the case of developing
countries, the amount of coins and currency notes is more than
that of bank money and it is vice-versa in the case of advanced
countries. Apart from the control of the central bank and the
government, there are other factors which influence money
supply. According to Prof. Chandler, the following are the major
determinants of money supply in an economy:
(1) Monetary Base.
(2) Extent of monetization.
(3) Community's Choice.
(4) Cash Reserve Ratio.
(5) Budgetary Policy of the Government.
These major determinants of money supply can be explained as
follows: •
(1) Monetary Base: Monetary base is one of the fundamental
determinants of money -supply. It refers to the variety of
assets owned by the central bank which forms the basis for
the issue of currency notes. The amount of currency notes
issued by the central bank depends upon the size of the
monetary base. Larger the monetary base, higher would be
the supply of money and vice-versa. Monetary base consists
of following components:
Money Supply gpgargr 87

(a) Monetary Gold Stock: The monetary gold stock consists

of three components namely:
(i) the stock of gold accumulated over a period of time,
(ii) the net addition made to the stock of gold from the
current domestic production of gold. Here net
addition is calculated as: domestic production of
gold - (real cost of production and amount of gold
used for non-monetary purpose),
(iii) the net of import and export of gold. If the monetary
gold stock is more, the central bank can issue more
currency notes.
(b) Reserve Assets: The reserve assets owned by the central
bank also influences money supply. The assets owned by
the central bank are in the form of government bonds,
securities, foreign exchange reserves etc. An increase or
decrease in any one of these would affect money supply.
For e.g. if there is favourable balance of payments, the
flow of foreign exchange will increase leading to an
increase in money supply. There will be contraction of
money if there is adverse balance of payments position.
(c) Credit Outstanding of the Central Bank: The ^central
bank can control money supply by varying the loans
provided and investments made by it. Central banks
invest in government securities and bonds. The sale and
purchase of these securities will affect money supply.
Whenever the central bank purchases securities, it makes
payment for the same leading to an increase in money
supply. By adjusting its investments and credit
sanctioned by it, money supply is influenced by the
central bank.
(2) Extent of Monetization: Supply of money also depends on
the extent of monetization. Monetization refers to the use of
money as a medium of exchange. In a barter exchange goods
are exchanged for goods. Monetization is nothing but the
conversion of a barter economy into a money economy.
Advanced countries are fully monetized. Under developed
88 Erjsrn'” V tpul’s™ Business Economics - II (SFC)

countries even today have non-monetized sectors. Money

supply depends upon the extent of monetization. Money
supply would be more in a monetized economy compared to
a non-monetized economy, the extent of monetization is an
index of monetary economy. There is a direct correlation
between the extent of monetization and money supply.
(3) Community's Choice: The choice of the community
regarding the mode of payment influences money supply
significantly. If the community decides to make payment in
terms of cash, then money supply would be less as the
transaction would be over then and there. On the contrary, if
payments are made by cheques, banks will be able to create
credit and there will be more money supply in the economy.
Commercial bank keeps a certain amount of the deposits as a
reserve ratio and uses the balance money for credit creation.
Lower the cash reserve ratio, higher will be the credit creation
and hence more will be the money supply and vice-versa. In
the case of advanced countries, most of the payments are
made in terms of cheques. Hence, there is more credit
creation and more money supply. In the case of less
developed countries, people prefer to make payments by cash
rather than by cheque. Hence, money supply is less. The
choice of the community also depends upon the banking
habits of the people, development of the banking system,
income level, etc.
(4) Cash Reserve Ratio: It is a major determinant of bank money.
It is statutorily fixed by the central bank. It is the ratio of a
bank's cash holdings to its total deposit liabilities. The credit
creating capacity of commercial banks depends upon the cash
ratio, amount of deposits and no. of other factors. Cash
reserve ratio is a very important determinant of credit
creation. An inverse relationship exits between cash reserve
ratio and credit creation. If the ratio is high, then commercial
banks have to keep a larger amount as a reserve and less will
be available for credit creation. If the ratio Ls less, banks will
be able to create more credit as more funds will be available.
This ratio is used by the central bank to control the credit
Money Supply grgrgr 89

created by commercial banks and thereby the total money

supply in the economy.
(5) Budgetary Policy of the Government: The Budgetary policy
of the government deals with public revenue, public
expenditure and public debt. All these have an impact on
money supply. The effects of budgetary policy on money
supply are as follows:
(a) One of the important sources of revenue for the
government is taxation. When more taxes are levied,
money flows from the public to the government. Hence
money supply will be less. On the contrary when taxes
are reduced money supply will be more.
(b) Public Expenditure refers to the expenditure incurred by
the government. In the recent times expenditure incurred
by modem governments has increased considerably due
to a no. of factors. This has resulted in more money
supply.
(c) The budgetary policy of the government can be a surplus
one or deficit one. If it is a surplus budget, then it implies
that the revenue of the governments more than its
expenditure. Hence there will be contraction of money
supply. On the other hand if it is a deficit budget, then
expenditure will be more than revenue leading to an
expansion in money supply.
(d) When the expenditure of the government is more than its
revenue, then it resorts to borrowing which is known as
public debt. When the government borrows from the
public there will be reduction in money supply and when
it repays there will be expansion of money supply.
(e) Modem governments incur huge expenditure. When
revenue is not sufficient to meet the expenditure, they
resort to deficit financing. Deficit financing refers to the
borrowings of the government from the central bank.
Deficit financing leads to an increase in monetary base
there by increase in money supply.
90 (^“nror Vtpul's™ Business Economics - II (SFC)

On the whole, fiscal operations of the government have

significant impact on money supply. The impact can be
summarized as follows:
(a) Higher the taxes, lesser will be the money supply and vice-
versa.
(b) Increase in public expenditure automatically leads to an
increase in money supply.
(c) Deficit budget will lead to expansion of money supply, while
a surplus budget will result in contraction of money supply.
(d) Money supply will contract when public debt is mobilized
and it will expand when debt is repaid.
(e) Deficit financing, the technique used by the government to
c o v * its deficit, always leads to an increase in money supply.
VELOCITY OF CIRCULATION OF MONEY:
One of the important functions of money is medium of
exchange. It facilitates easy transactions of goods and services. In
the process of transactions, one unit of currency circulates from
one person to another. The average number of times a unit of
currency passes from one hand to another during a given period
of time is known.as velocity of circulation of money. Symbolically
it is represented as "V ". Suppose the total number of notes in
circulation is Rs 5000 crores. If on an average the note is spent 10
times then the total value of transactions is equal to 5000*10 = Rs
50,000 crores. Thus the supply of money over a period of time can
be easily estimated. If the quantity of money in circulation is
represented as "M " and velocity of circulation of money as "V ",
then the total supply of money is M x V = MV.
The velocity of circulation of money is interpreted in two ways:
(1) Income velocity of money: Income velocity of money is the
ratio which shows the average number of times a unit of
money is received as income, symbolically it is expressed as
Y
v = M where Y refers to national income and M refers to total
money supply.
 Money Supply gpgpgr 91

(2) Transactions velocity of money: Transactions velocity of

money indicates ratio between the value of transactions of
goods and services during a given period and the total
PT
amount of money in circulation. It is expressed as V =
where "PT" refers to the total value of transactions and "M "
refers to the quantity of money supply.
The velocity of circulation of money is influenced by a variety
* p f factors. They are as follows:
^ A C T O R S INFLUENCING VELOCITY OF CIRCULATION OF
‘ MONEY:
(1) Regularity of Income: Velocity of circulation of money will
be high when income is regular and stable. A regular and
stable income induces people to spend more. Hence velocity
will be high. On the other hand if income is irregular and
unstable, people will not be confident to spend and they
would like to save more. This will result in low velocity of
circulation of money.
(2) Time Interval of Income Receipts: Income is received by
people on a monthly or weekly or daily basis. The shorter the
duration between two pay days, higher will be the velocity of
circulation of money. This is because the need to hold cash
balances will be less. People have a tendency to keep more
liquidity if the gap between two days is longer. This will lead
to low velocity of circulation of money.
(3) Methods of Payments: Velocity also depends upon the
method of payment. If payments are made in lumpsum then
transaction would be over then and there, then velocity will
be low. On the contrary if payments are made in terms of
instalments then velocity will be high. '
(4) Liquidity Preference of the People: Liquidity preference
refers to the desire of the people to hold liquid cash with
themselves. If the liquidity preference is high, then they will
hold more cash balances, spend less and hence velocity will
be low. If the liquidity preference is less then velocity will be
92 nrn-or V ip u l ’s™ Business Economics - II (SFC)

high. Thus there exists an inverse relationship between

liquidity preference and velocity of circulation of money.
(5) Distribution of Income: Velocity also depends upon the
distribution of national income. In any society the rich people
have a tendency to save more compared to the poor. Hence in
their case velocity will be less. The poor people have a
tendency to spend money as soon as they receive it. Hence
velocity will be high.
(6) Development of Banking and Financial Institutions: In
those economies where the banking and financial sectors are
well developed, business transactions will take place on a
larger scale. Banks and financial institutions provide ample
opportunities for investment and credit for business
transactions. In the case of under developed countries, the
financial sector is not well developed leading to less
transactions and low velocity of circulation of'bank money.
Hence velocity of circulation of coins and currency notes will
be high.
(7) Business Conditions: Business conditions like boom,
depression etc. affect velocity of circulation of money. During
boom, transactions will be more and there will be a sense of
optimism about business conditions. Due to this velocity will
be high. On the other hand during depression, business
pessimism will prevail leading to poor transactions resulting
in low velocity of circulation of money. Thus velocity will be
high during boom and less during depression.
(8) Speed in Transactions of Money: The speed with which
money is transacted also influences money supply. If the
banking sector is technologically advanced and efficient, it
can provide multiple facilities within no time. Remittance of
cash, clearing of cheques etc. will take place very quickly. In
such a case transactions would be more and hence velocity of
circulation of money will be high. Velocity will be low in the
absence of such an efficient system.
Money Supply g rg r-g r 93

QUESTIONS
(1) Define the following concepts:
(a) Supply of money.
(b) Velocity of circulation of money.
(c) Monetary base.
(d) Deficit financing.
(e) Cash reserve ratio.
(2) Fill in the blanks:
(a) Supply of money is a ___________as well as a ___________ .
(b) The speed with which money circulates in the economy is known as

(c) ___________system is followed by the RBI to issue currency notes.

[A ns.: (a) flow, stock (b) velocity of circulation of money (c) Minimum
reserve]
(3) State whether the following statements are true or false:
Money is what money does.
(b) In India, RBI follows the proportional resen/e system to issue currently
- notes.
(c) Higher the CRR, lesser will be the money supply inthe economy.
(<*) During depression, velocity of circulation of money will be high.
^ [A ns.: (a) True (b) False (c) True (d) False]
(4) Define money. Explain the concept of money supply.
(5) Explain the traditional approach to supply of money.
(6) Discuss the different systems of note issue.
(7) Analyse in detail the modern approach to supply of money.
(8) What are the various determinants of money supply?
(9) Define velocity of circulation of money. What factors influence it?

□
vt»vL
□ □
:X!£&
94 Erorg- VipuVs™ Business Economics - II (SFC)

Demand for Money

INTRODUCTION

DEMAND FOR MONEY - CLASSICAL AND KEYNESIAN

APPROACHES

KEYNES' LIQUIDITY PREFERENCE THEORY OF INTEREST

QUESTIONS
Demand for Money gp§|"n" 95

DEMAND FOR MONEY:

The concept of "demand for money" occupies a significant
place in macroeconomics due to its influence on price level,
income and interest. Why do people demand money is often a
subject of debate in economics. Money performs a variety of
functions. Demand for money arises because of the functions
performed by it. Two functions of money namely medium of
exchange function and store of value function are fundamental to
the concept of demand for money. The classical school considered
money as a medium of exchange and believed that money is
demanded for transaction purposes. J. M. Keynes on the other
hand emphasized on the "store of value" function of money and
according to him people demand money to hold it in the form of
cash balances as it is the most liquid asset and can be converted
into any asset without loss of time or value.
(1) The Classical Approach to Demand for Money.
(2) The Neo-Classical Approach to Demand for Money.
(3) The Keynesian Approach to Demand for Money.
(4) Milton Friedman's Approach to Demand for Money.
(1) The Classical Approach to Demand for Money:
The Classical approach is based on the medium of exchange
function of money. According to the classical economists, money
is essentially demanded by people for transaction purposes.
Money helps to carry out various economic activities and
facilitates transaction of goods and services. Demand for money
according to classical economists is due to the medium of
exchange function of money. This approach was given by
economists like David Hume, J . S. Mill and Irving Fisher.
The transaction approach to demand for money is clearly
explained by Irving Fisher through his famous equation of
exchange. It is expressed as
MV = PT
96 s r ir ir vtpuv* ™ Business Economics - II (SFC)

Where, M = Money Supply,

• V = Velocity of Circulation of Money,
P = Price level, and
T = Total Volume of Transactions.
In the above equation, MV represents value of money supply in
the economy during a given period of time. It is obtained by
multiplying the quantity of money in circulation by velocity of
circulation of money. MV represents the supply side. PT
represents the demand side and it is equal to the value of all
transactions in the economy. When the volume of trade is
multiplied by the average price level, PT is obtained. Through this
equation, Fisher clearly emphasizes the fact that value ofgoods
and services transacted in the economy is equal to the value of
money paid for them.
The equation MV = PT is an identity which is used by Fisher to
explain the demand for money.
The equation of exchange is based on a number of
assumptions. They are:
(a) Full employment of resources exists in the economy.
(b) Variables 'V' and 'T' in the equation are assumed to be
constant. The changes in 'M' do not affect V and T.
(c) Velocity of circulation of money is an independent factor
and M, P and T do not influence it.
(d) Velocity of circulation of money remains constant in the
short run. It is influenced by institutional and
technological factors, which do not change in the short run.
Hence, 'V' remains constant.
(e) The quantity of money 'M' is fixed by the central bank. It is
considered as an exogenous variable and is assumed to be
a given quantity during a particular period of time.
Demand for Money grErgr 97

In the equation MV = PT, MV represents the supply side, while

PT represents the demand side. At the point of equilibrium,
demand for money is equal to supply of money. The equation can
be rewritten to show the relationship between demand for money,
price level, velocity of money and transactions.
MV = PT
PT
M

Here M refers to supply of money and it is equal to demand for

money at the point of equilibrium. Therefore, M here refers to
demand for money and is denoted as Md. From the equation it is
clear that demand for money varies directly with P and T and
indirectly with V. Symbolically it can be written as:
PT
Md = y-

Thus, demand for money is determined by the volume of

transactions, velocity of circulation of money and price level.
The cash transaction approach given by Irving Fisher was
criticized for two reasons:
(a) In the equation MV = PT, T refers to all transactions
namely transactions of goods and services, shares,
securities, etc. The value of capital assets is highly
fluctuating in nature. Hence, it is unrealistic to assume that
'T' will remain constant.
(b) It is not possible to have a general price level, which can
cover both transactions in goods and services and capital
assets.
The highlights of the classical approach are:
(a) Demand for money arises due to the medium of exchange
function of money.
(b) Money is demanded mainly for transaction purposes.
98 □"Brer Viput’s™ Business Economics - II (SFC)

(c) Demand for money depends upon the volume of

transactions, velocity of circulation of money and price
level.
(2) The Neo-Classical Approach to Demand for Money:
An alternative approach to Fisherian approach was
propounded by the neo-classical economists. This approach was
developed by the Cambridge economists Alfred Marshall and A.
C. Pigou. The neo-classical approach is based on the store of value
function of money. It is also known as the cash balance approach.
According to Marshall and Pigou, demand foe money implies the
desire of the people to hold cash balances. Cash balances help the
people to transact goods and services at any point of time. The
total demand for money in an economy is nothing but aggregate
of the individuals demand to hold cash balances. Thus, store of
value function of money ,is the basis for cash balance approach,
k ~ £<UU btxj on (/—
Demand for money, in the neo-classical approach is expressed
as a fraction of the annual income, which people want to keep in
the form of cash balances. While the fraction of the annual real
income which people want to hold is represented as 'K', the
annual real income is denoted as 'Y'. The equation given by the
Cambridge school is
Md = KPY
Where
K = proportion of the nominal income which people
desire to hold in the form of cash balances
P = price level
Y = real national income
PY - nominal income
The above equation implies that demand for money is
proportional to nominal income. When there is a change in
nominal income, demand for money will also change.
 Demand for Money g™g”g™ 99

The relationship between demand for money and income can

be depicted with the help of the alongside diagram.

Fig. 9.1

The above diagram indicates that Ma is a linear function of

nominal income i.e. demand for money is directly proportional to
nominal national income.
The Cambridge School of economists considered income as the
main factor in influencing the demand for money. Critics argue
that there are other factors like rate of interest; wealth owned by
individuals, expectations about future prices etc would affect the
demand for money. These factors were not taken into account
while determining the demand for money. Income elasticity of
demand for money and price elasticity of demand were assumed
to be unitary by the Cambridge economists. The critics argue that
the two are far from unitary in reality. Despite the criticisms, the
Cambridge approach is considered important for establishing the
relation between demand for money and level of income.
^ ^ T h e Keynesian Approach to Demand for Money:
J. M. Keynes has given the theory of demand for money in his
book 'The General Theory of Employment, Interest and Money'.
His approach emphasizes both the medium of exchange and store
of value functions of money. According to him, people demand
money to hold it in the form of cash balances. They want to hold it
as it is the most liquid asset and can be converted into any type of
100 VipuVs™ Business Economics - II (SFC)

asset at any given time. The desire of the people to hold liquid
cash is called 'liquidity preference'. Liquidity preference gives rise
to demand for money and according to Keynes, money is
demanded for its own sake.
The Liquidity preference of the people depends upon three
motives namely L , + (_2_:r f\<r! cV s. 1 ■
(a) Transactions motive, t ^
j (b) Precautionary motive, and (-0
(c) Speculative motive. Off” ' -^ - *4? ' y
(a) Transactions Motive: Individuals and business firms demand
money to meet their day-to-day transactions. This is known as
transactions motive demand for money. People receive
income at a particular time but the expenditure is continuous.
To meet their day-to-day expenditure certain amount has to
be maintained by the people. How much money will be
maintained depends upon the level of income, time interval
between two paydays and the method of payment. The
transaction motive is classified into income motive and
business motive. Income motive refers to the demand for
money by the consumers. The consumer's demand for money
depends upon the level of income, price level and their
spending habits. Higher the income and higher the price
level, the demand for money would be high and vice versa.
Demand for money will also fluctuate according to the
spending habits of the people. More the tendency to spend on
consumption more will be the demand for money and vice
versa. Moreover, the time interval between the paydays also
influences the demand for money by households. The longer
the time interval, the higher would be the demand for money
and vice versa.
Business motive refers to the demand for money by
business firms. Business firms demand money to make
payments for purchase of raw materials, incur transport
charges, pay salaries to labor, etc. Like individuals they also
Demand for Money g™nT“g™ 101

get income at a particular point of time but their expenditure

is continuous. The amount of money held under this motive
depends upon turnover of the business firms. If the turnover
is more, the demand for money will be high and vice versa.
The transactions motive demand for money is the sum of
the demand for money for income and business motives. This
demand is influenced by the level of income. It is not affected
by the changes in the rate of interest. It is therefore said to be
income elastic and interest inelastic. It is represented as Lt =
f(y) where Lt refers to the demand for money for transactions
motive and y refers to level of income.
v-\o o ,
(b) Precautionary Motive: The precautionary motive demand for
, ,
money refers to the desire of the people to hold cash balances
to meet unforeseen emergencies. Future is uncertain and
problems like unemployment, sickness etc may crop up. To
meet these contingencies, certain amount has to be
maintained. Like individuals, business firms also wish to hold
cash reserves to meet uncertainties. Future uncertainty related
to income and expenditure is the main key in this motive.
This motive emphasizes the store of value function of money.
Like the transactions motive, this motive is also influenced by
the level of income and the business turnover. It is therefore
income determined. It is not influenced by changes in the rate
of interest. Hence, it is said to be income elastic and interest
inelastic. It is represented symbolically as Lp = f(y).
Both transactionary and precautionary motives are income
determined and interest inelastic. J. M. Keynes represents
these two as Li = Lt + Lp sii
income it is expressed as Li =
to income and f is function,
money for transactionary
termed as demand for active
active cash balances is a
represented diagrammaticall)
102 ^"ETBT V ip u l ’s™ Business Economics - II (SFC)

►X

Fig. 9.2

The above diagram indicates the positive relationship

between income and demand for active cash balances. When
income is OXi the demand for money is OYi and when
income increases to OX 2 demand for money increases to OY2 .
The demand for active cash balances is income
determined. It is income elastic. It is not influenced by the
changes in the rate of interest. Hence, it is said to be interest
inelastic. The relation between the two is depicted by the
following diagram.

Y+

v>
0)
k.
o
c
o
Q>
CO
O'

-> X
Dem and fo r M oney

Fig. 9.3
Demand for Money Ernngr 103

The vertical straight line indicates that the demand for

active cash balances is not influenced by the changes in rate of
interest.
(c) The Sp< ipeculative demand for money
is termed as the demand for money for idle cash balances.
This demand for money is based on the store of value
function of money. People wish to hold cash reserves for
speculation. They want to take advantage of the fluctuations
in the rate of interest or in the prices of securities. The
fluctuations give rise to speculation and the cash held under
this motive is used by people to make quick profits. The
profits or losses to be incurred by the people will depend
upon their calculations about the market movements.
The demand for money for idle cash .balances is influenced
by the rate of interest. It is said to be interest elastic. The
relationship between the two is inverse. At higher rates of
interest, demand will be less and vice versa. When people
hold liquid cash, the income in terms of interest in foregone.
This is nothing but the opportunity cost of holding cash
reserves. Idle cash by itself does not give any return. Hence,
the demand for money for speculative motive depends the
rate of interest. If the rate of interest is high, less money will
be demanded for speculative motive and vice versa. When the
rate of interest is high, it is better to invest rather than keeping
the cash balances for speculation. The opportunity cost of
holding liquid cash is very high when interest rate is very
high. When the interest rate is low, demand for idle cash
balances will be high as the opportunity cost is less. Thus, this
demand for money is interest elastic..
The demand for money for speculative motive is further
explained by Keynes by taking into account the relationship
between the prices of bonds and rates of interest. There exists
an inverse relationship between interest rate and bond prices.
People buy bonds when their prices are low and the interest
rates are high and sell when the bond prices go up and
interest rates are low. The difference is the profit, which arises
due to the fluctuations in the market. The relation between
 nrnrgr Vtpui's™ Business Economics - II (SFC)

rates of interest and bond prices can be explained with the

help of an example. Let us assume that the price of a bond
issued by the government is Rs. 200. The interest offered by
the government is 12%. If the market rate of interest increases
to 16%, the price of bond will fall. To calculate the market
price of the bond, the following formula is used:
R
P =~xN
m
Where,
P = Market price of the bond,
R = Return on securities,
M = Market rate of interest, and
N = Original price of the bond.
Applying the formula, the new price of the bond is
12
P = j £ x 200

= Rs. 150
Thus, when the rate of interest increases, the price of the
bond falls. On the contrary, let us assume that the market rate
of interest falls to 8%. Here the price of bond will increase. It
can be calculated as follows:
12
P =-g- x 200

= Rs. 300
Thus, relationship between bond prices and rate of interest
can be summarized as follows:
(1) When the rate of interest is high, demand for idle cash
balances will be low because:
(a) The opportunity cost of holding idle cash is high.
(b) It is the time to buy securities, as their prices would
be low.
Demand for Money i t s tҤ p 105

(2) When the rate of interest is low, demand for idle cash
balances would be more because:
(a) The opportunity cost of holding cash is less and
(b) As the security prices go up, it is better to sell and
make profits.
Demand for idle cash balances depends upon the rate of
interest. Symbolically it is expressed as L2 = f(i). The graphical
representation is as follows:

------------------------------- ----------------- ►X
0 Q Q, Q2
Demand fo r Money

Fig. 9.4

In the above diagram, LLi is the liquidity preference curve

explaining the inverse relationship between demand for
money for speculative motive and rate of interest. When the
rate of interest is OR, demand for money is OQ. When it falls
to ORi, demand for money rises to OQi. Demand rises further
to OQ 2 when the rate of interest falls to OR 2 .
, At this rate of interest, the demand curve becomes
perfectly elastic. It indicates that the demand for money for
speculative motive becomes infinite when the rate of interest
is very low. L 1L 2 portion of the curve represents the
relationship between very low rate of interest and demand for
 106 g-D'-g' V ipui’s™ Business Economics - II (SFC)

money for speculative motive. This is known as 'Liquidity

Trap'.
TOTAL DEMAND FOR MONEY: £
The total demand for money is the summation of the demand
for money for all the three motives. While the demand for active
cash balances for transaction and precautionary motives is income
elastic and interest inelastic, the demand for money for
speculative motive is interest elastic and income inelastic. The
total demand for money can be expressed as follows:
Md = Li(y) + L2(I)
Where,
Md = Aggregate Demand for Money
Li(y) = Demand for money for active cash balances
which is a function of income
L2(I) = Demand for money for idle cash balances
which is a function of the rate of interest and level of income
From the above it can be stated that the demand for money is a
function of rate of rate and level of income. Therefore,
L = f(y, I)
The aggregate demand for money can be graphically
represented as given on the next page:
In the panel, Fig. 9.5(a) shows the demand for money for
transactions and precautionary motive. The liquidity preference
curve is a vertical straight line indicating that the demand for
money is interest inelastic.
Fig. 9.5(b) shows the demand for money for speculative motive.
It slopes downwards from left to right indicating the inverse
relationship between rate of interest and the demand for money
for speculative motive.
Demand for Money gTM
Efssr 107

>
<D
'C
o
5
O
~ •£o
k.

■co ^
> £ (0 o
cT E w
ii o
__i -----------
Oo
tu
,o

M---------------
DC DC OC

;sejd)U| jo e*ey

LO

«a>
o
c
>,«
0) (0
C JO
b £ sz
S CD —

ii O (0
L.
O—(0
X ®
Q >
Q
LJ *3
o
m

> ;saja*u| jo a*ey

Fig. 9.5(c) represents the aggregate demand for money, which

is the summation of figures 9.5(a) and 9.5(b). The aggregate
demand curve L is obtained by super imposing the Li curve over
the L2 curve. The total demand curve slopes downwards from left
to right indicating the inverse relationship between demand for
 108 ErETH™ V ip u l ’s™ Business Economics - II (SFC)

money and rate of interest. When the rate of interest falls, demand
for money rises and vice versa. When the rate of interest reaches
its minimum, demand for money becomes perfectly elastic
resulting in liquidity trap.
While the classical approach analyzed the transactions motive,
Keynes made it comprehensive by including the speculative
motive. The Keynesian approach was criticized by economists on
the ground that he considered assets only in the form of either
bonds or cash. In reality, people hold it in combination of bonds
and cash. Moreover, economists like Friedman, Baumol and Tobin
formulated another approach considering a portfolio of assets like
shares, bonds, physical assets etc. rather than cash and bonds.
While Keynes considered demand for money for transaction
motive as interest inelastic modem economists argue that the
transaction demand for money is interest elastic. Despite the
criticisms, Keynesian approach occupies a special place of
significance in the theory of money.
LIQUIDITY PREFERENCE THEORY OF INTEREST:
Economists have propounded various theories to explain the
determination of rate of interest. Three theories are noteworthy
namely the Classical Theory, the Keynesian Theory and the
Loanable Funds Theory. According to the classical theory, rate of
interest is determined by demand for and supply of capital. The
theory advocated by J. M. Keynes is known as the liquidity
preference theory. Rate of interest according to Keynes is
determined by demand for and supply of money. The loanable
funds theory given by the neo-classical economists consider
demand for and supply of loanable funds as the determinants of
rate of interest.
J. M. Keynes regarded interest as purely a monetary
phenomenon. He defined interest as the reward for parting with
liquidity. According to him rate of interest is determined by
demand for money and supply of money. People demand money
to satisfy their liquidity preference i.e., the desire to hold liquid
cash. Liquidity preference arises due to three motives namely
transactionary motive, precautionary motive and speculative
motive. Total demand for money is the money to satisfy these
three motives. Here, demand for money refers to the demand for
Demand for Money @"S"0" 109

money to hold cash. Other things being equal, if liquidity

preference rises i.e., demand for money rises, then rate of interest
will increase and vice versa.
(a) Transactions Motive: Individuals and business firms demand
money to meet their day-to-day transactions. This is known as
transactions motive demand for money. People receive
income at a particular time but the expenditure is continuous.
To meet their day-to-day expenditure certain amount has to
be maintained by the people. How much money will be
maintained depends upon the level of income, time interval
between two paydays and the method of payment. The
transaction motive is classified into income motive and
business motive. Income motive refers to the demand for
money by the consumers. The consumer's demand for money
depends upon the level of income, price level and their
spending habits. Higher the income and higher the price
level, the demand for money would be high and vice versa.
Demand for money will also fluctuate according to the
spending habits of the people. More the tendency to spend on
consumption more will be the demand for money and vice
versa. Moreover, the time interval between the paydays also
influences the demand for money by households. The longer
the time interval, the higher would be the demand for money
and vice versa.
Business motive refers to the demand for money by
business firms. Business firms demand money to make
payments for purchase of raw materials, incur transport
charges, pay salaries to labor, etc. Like individuals they also
get income at a particular point of time but their expenditure
is continuous. The amount of money held under this motive
depends upon turnover of the business firms. If the turnover
is more, the demand for money will be high and vice versa.
The transactions motive demand for money is the sum of
the demand for money for income and business motives. This
demand is influenced by the level of income. It is not affected
by the changes in the rate of interest. It is therefore said to be
income elastic and interest inelastic. It is represented as Lt =
110 Ercra™ V ip u l's ™ Business Economics - II (SFC)

f(y) where Lt refers to the demand for money for transactions

motive and y refers to level of income.
(b) Precautionary Motive: The precautionary motive demand for
money refers to the desire of the people to hold cash balances
to meet unforeseen emergencies. Future is uncertain and
problems like unemployment, sickness etc may crop up. To
meet these contingencies, certain amount has to be
maintained. Like individuals, business firms also wish to hold
cash reserves to meet uncertainties. Future uncertainty related
to income and expenditure is the main key in this motive.
This motive emphasizes the store of value function of money.
Like the transactions motive, this motive is also influenced by
the level of income and the business turnover. It is therefore
income determined. It is not influenced by changes in the rate
of interest. Hence, it is said to be income elastic and interest
inelastic. It is represented symbolically as Lp = f(y).
(c) The Speculative Motive: The Speculative demand for money
is termed as the demand for money for idle cash balances.
This demand for money is based on the store of value
function of money. People wish to hold cash reserves for
speculation. They want to take advantage of the fluctuations
in the rate of interest or in the prices of securities. The
fluctuations give rise to speculation and the cash held under
this motive is used by people to make quick profits. The
profits or losses to be incurred by the people will depend
upon their calculations about the market movements.
The demand for money for idle cash balances is influenced
by the rate of interest. It is said to be interest elastic. The
relationship between the two is inverse. At higher rates of
interest, demand will be less and vice versa. When people
hold liquid cash, the income in terms of interest in foregone.
This is nothing but the opportunity cost of holding cash
reserves. Idle cash by itself does not give any return. Hence,
the demand for money for speculative motive depends the
rate of interest. If the rate of interest is high, less money will
be demanded for speculative motive and vice versa. When the
rate of interest is high, it is better to invest rather than keeping
Demand for Money gripor in

the cash balances for speculation. The opportunity cost of

holding liquid cash is very high when interest rate is very
high. When the interest rate is low, demand for idle cash
balances will be high as the opportunity cost is less. Thus, this
demand for money is interest elastic.
Supply of money is determined by the central bank. While
demand for money is in the hands of public, supply of money is
totally under the control of the central bank. Demand remaining
the same, if supply increases, rate of interest will fall and vice
versa. This supply of money along with the demand for money
determines the rate of interest. This can be explained with the help
of the following diagram:

DD for and S S of Money

Fig. 9.6

In the above figure, MN is the supply curve. It is a vertical

straight line indicating that money supply is constant. LP curve is
the liquidity preference curve. Both the curves intersect each other
at point E. OR is the equilibrium rate of interest. Supply remaining
the same, if demand for money rises, then the LP curve will shift
to right. The new LPi curve intersects the supply curve at point Ei.
Now the rate of interest is ORi. Thus, an increase in liquidity
preference will increase the rate of interest and vice versa when
liquidity preference falls. When demand for money remains the
same, if there is an increase in supply then rate of interest will fall
 112 V ip M l’s™ Business Economics - II (SFC)

and vice versa. Thus Keynesian theory of interest considers

demand for and supply of money as the determinants of rate of
interest.
L im ita tio n s /C ritic is m s o f th e L iq u id ity P re fe re n ce T h e o ry o f
In terest:

(1) Keynes considered interest as the reward for parting with

liquidity. According to Professor Henry Hazlitt, without
saving, there is no question of parting with liquidity.
According to Hazlitt interest is the reward for saving not for
parting with liquidity.
(2) Keynes gave importance to demand for money and supply of
money. He ignored other factors like productivity time
preference etc. Hence, it is considered as incomplete and one
sided.
(3) According to the critics, if Keynesian theory is true, then
during depression rate of interest should be the highest as
liquidity preference is very high during depression and
during inflation it is the vice versa. But in reality it is not so.
During depression rate of interest is very low and during
inflation it is quite high.
(4) This theory is said to be vague and contradictory. Nowadays
time deposits give interest and at the same time they are also
liquid. Hence, there is no parting of liquidity.
(5) Another criticism is that interest is the reward for
productivity of capital rather than for parting with liquidity.
(6) Keynes' theory is said to be indeterminate. According to
Keynes, rate of interest is determined by demand for money
i.e., liquidity preference and supply of money. Liquidity
preference is determined by income level and rate of interest
influences the level of income. Thus, liquidity preference
cannot be determined unless the income level is known and
income is influenced by rate of interest. Thus, what
determines rate of interest is not clear.
(7) Other factors which influence liquidity preference, apart from
the three motives are not considered in this theory. Hence, it
is said to be a narrow approach.
Demand for Money srsrsr 113

Despite its limitations, Keynesian theory has its own

significance. The modem theory of interest is a synthesis of the
classical theory and the Keynesian theory. Both real and monetary
factors are considered in the modem theory. Thus, Keynesian
theory has been useful in further developments.

QUESTIONS
(1) Define the following concepts: .
(a) Precautionary motive.
(b) Speculative motive.
(c) Liquidity trap.
(d) Liquidity preference.
Fill in the blanks:
(a) According to J. M. Keynes, demand formoney isinfluenced by

(b) Demand for money for active cash balances is ____________elastic.

(c) Speculative motive is influenced b y ____________ .
(d) The relationship between speculative motive andvery low rate of
interest is explained b y ___________.
[A ns.: (a) liquidity preference (b) income tc) rate of interest (d) liquidity
trap] j -
State whether the following statements are true or false:
(a) The liquidity preference approach to demand for money was given by
J. M. Keynes. j
(b) Demand for active cash balances depends upon the level of income.
[A ns.: (a) True (b) True]
(2) What is meant by liquidity preference? How does it influence demand for
money? j
(3) Explain the liquidity preference approach to demand for money.
(4) Distinguish between the demand for active cash balances and demand for
idle cash balances.
(5) Explain the speculative demand for money.
(6) Explain the liquidity preference theory of interest.
(7) Write short notes on:
(a) Demand for active cash balances.

(c)
(b) Liquidity trap. ■
Classical approach to demand for money.
114 Vtpul’s™ Business Economics - II (SFC)

10

Quantity Theory of
Money

INTRODUCTION

CASH TRANSACTION APPROACH - FISH ER'S EQUATION

OF EXCHANGE

CRITICISM S OF CASH TRANSACTION APPROACH

CAM BRIDGE CASH BALANCE APPROACH

CRITICISM S OF CASH BALANCE APPROACH

QUESTIONS
Quantity Theory of Money § 0 § f 115

INTRODUCTION:
The Quantity theory of money explains the relationship
between quantity of money and price level. According to the
theory the quantity of money in circulation influences the price
level and thereby the value of money. The main proposition of the
theory is that changes in quantity of money bring about a direct
and proportionate change in the price level. Price level, and value
of money are inversely related. Value of money is nothing but the
purchasing power of money. When price level rises, value of
money falls. Therefore quantity theory of money states than an
increase in the quantity of money will lead a proportionate
increase in price level and proportionate fall in the value of
money.
"Double the quantity of money, other things being equal, prices
will be twice as high as before and the value of money on half.
Halve the quantity of money, other things being equal, prices will
be one half of what they were before and the value of money
double". Thus there is direct relationship between quantity of
money and price level and indirect relationship between quantity
of money and value of money.
There are two approaches to the quantity theory of money
namely (1) the Transaction approach and (2) the Cash balance
approach. The two approaches are analysed as follows:
CASH TRANSACTION APPROACH:
An American economist by name Irving Fisher developed this
approach. He considered money as a medium of exchange. He has
explained it in terms of an equation known as Fisher's equation of
exchange. The equation given by him is MV = PT
MV
P = Here M refers to total quantity of money in
circulation.
V refers to velocity of circulation of money
P refers to the price level
T refers to total volume of trade or transactions
116 jg“52"g2“ V lp w l’s™ Business Economics - 1! (SFC)

i.e. total quantity of goods and services exchanged for money.

According to Irving Fisher 'V' and 'T' in this equation remain
constant and they are influenced by factors outside the equation.
Therefore P and M are directly related to each other. When 'M'
changes, P will also change proportionately and directly. In this
equation 'M' is an independent variable while P is a dependent
variable and it is passive in nature. According to Fisher Changes
in 'M' do not affect V and T and similarly changes in 'V' or T do
not affect 'M'. The equation can be explained with the help of an
example.
Let us assume M = Rs. 10 lakhs, V = 10, T = Rs. 5 lakhs.
_ MV 10 lakhs x 10
Then P = = 51akhs = Rs. 20 per unit

If the quantity of money i.e. 'M' is doubled to Rs. 20 lakhs then

20 lakhs x 10 „
P = 5 lakhs = **- 40 Per unit
Thus other things remaining the same, price level varies in
direct proportion to the quantity of money.
CRITICISM S OF THE CASH TRANSACTION APPROACH:
There are many criticisms of this approach. The main ones are:
(1) Mere Truism: In the equation MV = PT, MV represents total
money payments for goods and services and PT represents
total value of goods and services. Thus it states the obvious
facts and it is a mere mathematical identity. Critics argue that
the assumption that 'V' and T ' are constant in the equation
makes it a useless truism.
(2) Constancy of 'V " and T: Assuming 'V' and T ' as
independent variables and not affected by changes in M is
said to be unrealistic. In fact all the four variables are inter
related and influence each other.
(3) M and P relationship: Critics agree that changes in M will
bring about changes in P. However they do not agree that
there is a direct and proportionate relationship between the
two. In fact the critics argue that the relationship is an indirect
one. When 'M' changes, there will be a change in rate of
Quantity Theory of Money srsrsr 117

interest which will affect investment, factor rewards and

expenditure. These changes ultimately lead to changes in the
price level.
(4) Variations in price level: The equation cannot explain why
prices of some goods rise at a faster rate than the prices of
certain other goods and prices of some goods remain the
same even when 'M' changes.
(5) One sided: This approach gives importance to supply of
money ignoring the demand side. Value of money can be
determined by considering both demand and supply of
money.
(6) Unitary elasticity: Fisher's equation assumes that the
elasticity of demand for money is unity. In reality it is not so.
Price fluctuations occur due to changes in the elasticity of
demand for money.
(7) Medium of exchange: This approach considers money only
as a medium of exchange. Other function of money namely
store of value is completely ignored. An increase in money
supply not accompanied by spending will not lead to an
increase in the price level. In other words hoarding of money
will lead to fall in price not a rise in price.
(8) Full employment: The equation of exchange is based on the
assumption of full employment which does not exist. Less
than full employment is the reality. When the economy has
less than full employment, an increase in money supply will
lead. Here there may not be changes in the price level. The
critics argue that a change in M will affect P only after full
employment is attained.
(9) Time period: This approach is based on the long rim.
According to the critics long run is a myth while short run is
the reality. In the words of Keynes "In the long run we are all
dead".
(10) Other factors: According to Keynes changes in saving
investments, income and expenditure lead to changes in
quantity of money and price level. The former is the cause
while the latter is the effect. Economist Chandler argued that
118 gp^rig1” Vipul's t™ Business Economics - II (SFC)

M, V and T are the immediate determinants of price level and

not the ultimate determinants.
Despite the above criticisms, the equation has an element of
truth i.e. prices tend to rise when there is excess money supply in
the economy.
CASH BALANCE APPROACH:
The cash balance approach explains the quantity theory of
money by considering money as a store of value. This approach
was developed by the Cambridge economists namely Alfred
Marshall, Pigou, Robertson and Keynes. They used the general
theory of value to explain this approach. According to them value
of anything is determined by demand and supply. Value of
money is also determined by demand for and supply of money.
Value of money is determined at the point where demand for
money is equal to supply of money. The relationship between
quantity of money and price level is explained in terms of
Cambridge equations also termed as cash balance equations.
DEMAND FOR AND SUPPLY OF MONEY:
According to this approach demand for money refers to the
demand for holding cash balances due to their purchasing power.
People hold money to buy goods and services. The total cash
balances held by people represents the total demand for money.
These cash balances represent a fraction of the annual real national
income. This demand for money is for satisfying transactionary
motive and precautionary motive. Transactionary motive refers to
the demand for money for day to day transactions. Precautionary
motive refers to the demand for money for emergencies and
unforeseen contingencies.
Supply of money consists of currency notes and bank money.
While currency notes are issued by the central bank, bank money
depends upon deposits of the public, credit creation by banks,
monetary policy, etc. The value of money according to cash
balance approach is determined by demand for money and supply
of money. Demand for money remaining constant, price level will
vary directly with the quantity of money. In other words value of
money will vary indirectly with the quantity of money. Supply of
Quantity Theory of Money sgӤrar 119

money remaining the same, if there is an increase in demand for

money, then people will hold more cash balances. This will lead to
a decline in expenditure and hence a fall in price or rise in the
value of money.
The determination of value of money is explained through the
following equations:
(1) Alfred M arshall's Equation: M arshall's' cash balance
equation is M = KY where M refers to quantity of money
which consists of currency and demand deposits. Y refers to
Total real income and 'K' represents that fraction of the total
income which people want to hold as cash balances. Value of
money can be obtained as follows:
KY
P= here P refers to purchasing power of money P will
vary directly with 'K' and indirectly with 'M'. According to
Marshall 'K' is a more influential factor than M.
(2) A. C. Pigou's equation: The equation given by Pigou is as
follows:

Here P refers to purchasing power of money or value of

money.
K refers to that proportion of national income which
people want to hold as cash balances. R stands for the annual
real national income of country expressed in terms of a single
commodity. M refers to the quantity of money. According to
Pigou, P i.e. value of money varies directly with K and
inversely with M.
The equation was modified by Pigou to include bank
deposits as follows:
KR{C + h (l - c)}
P_ M
Here C refers to the proportion of cash which people hold
in terms of legal tender. (1 - C) stands for the proportion of
120 CrETEr VipuVs™ Business Economics - il (SFC)

bank balances which people hold, h stands for the proportion

of the cash reserves to deposits held by the banks.
In this equation 'P' (value of money) varies directly with K
or R and inversely with M. The equation can be modified if
M
price level has to be calculated as P = here 'P' refers to
price level not value of money.
(3) Robertson's equation: Quantity theory of money is explained
by Robertson in the following equation
M
M = KPT ••P =

Here M refers to supply of money. T refers to the annual

volume of transactions in goods and services.
K refers to the proportion of 'T' which people want to hold
as cash balances.
P refers to price level. Here P changes directly with M and
inversely with changes in K or T. Robertson's equation is
different from Fishers equation.
M
Robertson's equation is P = ^ . Fisher's equation is
MV
P = y . While P, M and T are more or less similar in both the

equations K and V are reciprocal to each other i.e. V = ^ or

Keynes' equation:-J. M. Keynes has given the equation as

n
n = pk or p = . Here 'n' stands for the quantity of money in
circulation p stands for price of a consumption unit. K stands
for the amount of consumption units which people want to
hold as balances. If k is constant, then 'p' will vary directly
with a change in 'n'. p will vary inversely with change in k.
Quantity Theory of Money grcrjar 121

To include bank deposits, the equation was modified by J. M.

Keynes as p = k ^ .

Here V refers to cash reserve ratio maintained by banks, k1

refers to quantity of consumption units which people want to
hold in the form of deposits in banks.
C RITICISM S OF THE CASH BALANCE APPROACH:
The cash balance approach rightly pointed out the importance
of demand for money in determining the value of money.
Moreover it had also identified the motives behind demand for
money. The supporters of this approach claim that this is a better
version than the cash transaction approach. The critics however
do not spare this approach and pointed out the following
limitations:
(1) It considers only the consumption goods to explain the value
of money. Capital goods have been ignored.
(2) Demand for money is influenced by three motives namely
transactionary, precautionary and speculative. This approach
has not considered the speculative motive.
(3) Demand for various goods and its effects on prices, income
and employment are not analysed here.
(4) In this approach the cash balances held by the people is
assumed to be influenced by real income. Other factors which
influence cash balances like price level, banking habits of the
people etc. are not considered.
(5) The extent of change in price level due to change in quantity
of money is not explained clearly.
(6) Rate of interest influences investment, output and price level.
The role of rate of interest and its influence on other factors
are not considered here.
(7) One of the assumptions of this approach is that elasticity of
demand for money is unity. This is true under static
conditions not under dynamic conditions which is the reality.
(8) According to this approach value of money depends on the
value of 'K'. In reality 'K' itself depends on value of money.
122 BTCi"'Er VipuVs™ Business Economics - II (SFC)

(9) Various factors like consumption, saving, investment etc.

affect value of money which are not considered here.
(10) This- approach divides the economy into real and monetary
sectors. According to the critics it is not required as the two
sectors are interdependent.
(11) This approach does not explain clearly the phases of a trade
cycle.
Despite the criticism, this approach has its own merits and has
its significance in monetary economics.
DISTINCTION BETWEEN CASH TRANSACTION
APPROACH AND CASH BALANCES APPROACH:
Cash transaction approach Cash balance approach
(1) This approach was given by This approach was given by
Irving Fisher. Cambridge economists.
(2) This considers money as a Here money is considered as a
medium of exchange. store of value.
(3) Supply of money is Supply of money is considered
considered as a flow. as a stock.
(4) The equation here is MV =
MV The equation here is P =
PT. .-.P = —
(Given by Robertson)
(5 ri According to this approach According to this approach value
value of money will change of money will change whenever
whenever there is a change there is a change in demand for
in quantity of money. money or supply of money or
both.

Both the approaches explain the relationship between quantity

of money and price level or value of money in their own way.

QUESTIONS
(1) Define the following concepts:
(a) Value of money.
(b) Quantity of money.
(c) Transactionary motive.
(d) Precautionary motive.
Quantity Theory of Money g™grEr 123

(2) State whether the following statements are true or false:

.(a) The cash transaction approach was developed by J. M. Keynes.
(bj The cash balance approach considers money as a store of value.
/ M
(c) The equation of exchange given by Irving Fisher was P = .
Fisher’s equation of exchange implies that price level varies directly
with the quantity of money.
[Ans.: (a) False (b) True (c) False (d) True]
(3) Fill in the blanks:
(a) The equation of exchange MV = PT was given b y _______.
M b ) The Cambridge economists developed______ approach to quantity
theory of money.
(c) Cash transaction approach considered money as a _______ .
(d) Value of money according to Keynes is determined b y _______and

(e) __ function of money is given importance in cash balances

, approach.
[Ans.: (a) Irving Fisher (b) cash -balances (c) medium of exchange
(d) demand for and supply of money (e) Store of value]
(4) Distinguish between cash transaction approach and cash balances
approach.
(5) Explain the cash transaction approach in detail.
(6) Critically examine the classical approach to quantity theory of money.
(7) Explain the cash balances approach through Cambridge equations.
(8) Write short notes on:
(a) Fisher’s equation of exchange.
(b) Criticisms of cash balance approach.
(c) Limitations of cash transaction approach.
124 ig^Erign Vipul's™ Business Economics - II (SFC)

11

Inflation

INTRODUCTION

TYPES OF INFLATION

CAUSES OF INFLATION

EFFECTS OF INFLATION

MEASURES TO CONTROL INFLATION

DEFLATION

NATURE OF INFLATION IN A DEVELOPING COUNTRY

QUESTIONS
Inflation gr'nT“g,“ 125

The term inflation refers to a general rise in prices. To be more

precise it refers to a persistent rise in the general price level.
Inflation is defined by economists in various ways. According to
Prof. Crowther "inflation is a state in which the value of money is
falling i.e. prices are rising". According to Prof. Hawtrey "inflation
refers to the issue of too much currency". Inflation is defined by
Edward Shapiro as "a persistent and appreciable rise in the
general level of prices". Some economists consider inflation as a
purely monetary phenomenon while others consider it as a post
full employment phenomenon. Generally, it is regarded as
situation where too much of money chases too few goods.
TYPES OF INFLATION:
Inflation has been classified into various types on the following
grounds:
(1) On the basis of rate of inflation:
(a) Creeping inflation: When the rate of inflation is 3
percent per annum, it is termed as creeping inflation.
This is considered as mild inflation and it is said to be a
tolerable one. A mild inflation is said to be good for the
economy as the rise in price will lead to more profits
leading to more investments.
(b) Walking inflation: When the inflation rate is between 3­
6% it is termed as walking inflation.
Prof. Samuelson clubbed creeping and walking
inflation together and termed it as moderate inflation.
According to him moderate inflation should not be
allowed to become galloping inflation. Otherwise
moderate inflation will not have serious repercussions on
the economy as long as it is under control.
(c) Running inflation: When the rate of inflation is between
10-20% it is called running inflation.
(d) Galloping inflation: Here the price rise would be more
’ than 20%. It is a serious problem as it will erode the
purchasing power of the people and affect all the sectors
of the economy.
126 HT
"Ej"‘K|T
" V ip M l’s™ Business Economics - II (SFC)

(e) Hyper inflation: In this case price level will rise every
moment. The change in price would be difficult to
measure as the rise in price would be very severe. In
terms of percentage it would be more than 1000% per
year. Austria, Hungary, the former U.S.S.R., Poland and
Germany experienced hyper inflation during the First
World War period. Germany experienced severe hyper
inflation in 1924. The nature of this type of inflation was
indicated by Prof. Samuelson's statement that "we used
to go to the store with money in our pockets and come
back with food in our baskets. Now we go with money in
baskets and return with food in our pockets. Everything
is scarce except money." Hyper inflation is a very serious
problem as it always creates severe distortions in the
economy.
The above types of inflation can be depicted
diagrammatically below:

Fig. 11.1

(2) On the basis of government's intervention: Inflation is

classified into open inflation and repressed inflation based on
government's response. Repressed inflation is one in which
the government takes measures to control inflation. Open
inflation refers to a situation where the government does not
Inflation a”grg|" 127

interfere in Controlling inflation. It is left to market forces to

regulate the rise in prices.
(3) On the basis of coverage, inflation is divided into sporadic
inflation and comprehensive inflation: When inflation
occurs in a particular sector of the economy, it is said to be
sporadic in nature. If it covers the entire economy, it is termed
as comprehensive inflation.
(4) Time period is also used to classify inflation as peacetime
inflation, war time inflation and post war inflation. Peacetime
inflation occurs due to excessive expenditure of the
government. When government invests on a number of
projects, money supply increases and the demand for goods
and services also start increasing. If supply is not
forthcoming, then prices tend to rise. This is termed as
peacetime inflation. War time inflation refers to the rise in
prices during war time. During the period of war resources of
the country would be diverted towards defence purposes.
Hence the supply of civilian goods will be affected leading to
inflation. In the postwar period, the pent up demand of the
people gets released. It leads to more demand for goods and
services resulting in a rise in the price level.
(5) On the basis of causes, inflation is of the following types:
(a) Credit inflation: When commercial banks create credit, it
results in more money supply leading to more demand
for goods and services. If supply of goods and services is
not forthcoming, then prices will rise sharply.
(b) Scarcity inflation: Scarcity of goods and services due to
fall in production or due to artificial hoarding leads to
scarcity induced inflation.
(c) D eficit inflation: When government's expenditure
exceeds its revenue, it has a deficit budget. To meet the
excess expenditure, it resorts to deficit financing. Deficit
financing refers to creation of new money by the central
bank. Under economic planning many projects and
schemes are launched by the government to accelerate
the growth rate. This leads to more money supply, more
 ir w “i r Vipw P s™ Business Economics - II (SFC)

demand for goods and rise in the price level. This

inflation due to deficit financing is called deficit inflation.
(d) Currency inflation: When the supply of money is more
than the supply of goods and services, then prices tend to
rise which is known as currency inflation.
(e) Profit inflation: Profit inflation is induced by the excess
profits earned by the entrepreneurs. Generally during
inflation, the entrepreneurial class earns more profit due
to rise in prices. This increase in the profits encourage
them to invest more. Alongwith an increase in
investment, real goods and services should increase.
Otherwise the economy will be affected by profit
inflation.
(f) Tax inflation: Due to increase in the rates of commodity
taxes like excise duty, sales tax etc. prices of goods tend
to rise. This is known as tax inflation.
(g) Wage inflation or cost inflation: When prices rise due to
a rise in the cost of production it is said to be cost
inflation. Cost of production consists of various
components like wages, rent, interest and normal profit.
Of this wages are an important component. Cost inflation
often occurs due to a rise in the wage rate of the workers.
(h) Foreign trade induced inflation: When a country
experiences export boom, if supply does not keep pace
with the demand for exports, then prices will start
shooting up. Moreover increased exports will lead to
more export earnings. This in turn will result in rise in
prices which is termed as export induced inflation. This is
one of the types of foreign trade inflation. Another type
of inflation is the import price like inflation wherein the
rise in the price of imported components will lead to a
rise in the price of the final product. This is known as
import induced inflation.
Apart from the above types of inflation, economists give
lot of importance to two types of inflation namely demand
Inflation ITU'"!' 129

pull inflation and cost push inflation. They can be elaborated

as follows:
(i) Demand-pull Inflation: The concept of demand pull
inflation was developed by J. M. Keynes. It refers to that
type of inflation which arises due to aggregate demand
for goods and services being more than the supply of
goods and services. The demand for goods and services
may be more due to increase in money supply. Demand
pull inflation is generally associated with the level of full
employment. Full employment refers to a situation where
the resources of the economy are fully employed. In such
a situation, if money supply increases, demand for goods
and services will increase. However, supply cannot be
increased as resources are fully utilised. Other factors like
increase in public expenditure, increase in investments
increase in export earnings etc. can lead to an increase in
demand and this in turn lead to demand pull inflation.
Demand-pull inflation can be explained with the help of
the following diagram:

A g g r e g a te D e m a n d
A n d A g g r e g a te S u p p ly

Fig. 11.2
130 S”WW V ipul’s™ Business Economics - II (SFC)

Equilibrium price is determined at the point where

demand for goods is equal to its supply. In the above
diagram initially the demand curve intersects the supply
curve at point E. The equilibrium price is OP. When
demand increases from DD to DjDi, supply increases
from OQ to OQi. Still price rises from OP to OPi. The
supply curve slopes upwards upto point E2 and
afterwards it becomes a vertical straight line. It implies
that the economy has attained full employment situation.
If demand increases further, price level will continue to
rise further. At the full employment level, the
equilibrium price is OP2 and the quantity demanded and
supplied is equal to OQ 2 . If demand increases further,
supply cannot be increased. As a result, price level will
continue to rise further. This rise in price level is known
as demand pull inflation. Initially, when demand rises,
supply increases. But at the same time price level also
increases. This is termed as bottleneck inflation. In the
diagram this is indicated upto point E2. After that full
employment is attained and when demand rises, supply
does not increase leading to demand pull inflation.
According to Keynes, inflation which occurs after full
employment is attained is known as true inflation.
Increase in public expenditure, increase in marginal
propensity to consume of the people, higher investment,
increased earnings through exports and diversification of
resources from the civilian sector to the defence sector or
from consumer goods to capital goods industries are
- considered as the factors responsible for demand pull
inflation.

(j) Cost-push Inflation: Cost-push inflation refers to the rise

in the price level due to a rise in cost of production.
Contrary to demand pull inflation, some economists are
of the opinion that a rise in cost of production is the root
Inflation 131

cause for inflation and this inflation is also termed as

'cost inflation'. Cost-push inflation may occur due to a
rise in the wage rate or due to a rise in the rate of profit.
Of the various components of cost of production, wages
are a major component. When the demand for labour is
more, wage rates tend to rise. It adds to the cost of
production and the employers try to pass on this burden
to the consumers by including it in the price. Due to this
cost of living will increase and the workers will ask for a
further revision in wages. This again will result in rise in
prices. It may start in a particular sector but may spread
to other sectors of the economy soon. Cost push inflation
can be explained with the help of the following diagram.

N a tio n a l O u tp u t/R e a l In c o m e
( S u p p ly a n d D e m a n d )

Fig. 11.3

In the above diagram, the aggregate demand curve

DD intersects the aggregate supply curve SS at point E.
132 H'-Engn V ip u l ’s™ Business Economics - II (SFC)

The equilibrium price is OP and the quantity demanded

and supplied is OQ. When the cost of production
increases due to a rise in the wage rate, the supply curve
will shift upwards. The new supply curve SiS intersects
the demand curve at point A. Now the price is OPi and
the equilibrium quantity is OQi. It is obvious here that
the price has increased while the quantity has declined.
This will lead to reduction in employment. To maintain
full employment, the government may increase its
expenditure. When government increases its expenditure
demand for goods and services will increase. The
demand curve will shift to D 1 D 1. The supply curve SiS
will intersect D 1D 1 at point Ei. The new equilibrium price
is OP2. The rise in price will induce the trade unions to
demand higher wages. Hence, cost of production will rise
shifting the supply curve to S2 S. If demand remains the
same then S2S will intersect DiDj at point B and the new
price is OP3. If government increases its expenditure
again to main full employment, then once again demand
curve will shift upwards to D2D2 and the new price will
be OP4. Thus, full employment and output can be
maintained only with the rise in the price level.
Cost-push inflation generally occurs due to a rise in
the wage rate. However, it may also occur due to a rise in
profit margin. Sometimes wages and profit margins may
increase at the same time and the combined effect of this
will result in rise in prices. When profits are determined
on the basis of mark-up over cost of production and
when the mark up is increased it may result in inflation.
This inflation is termed as mark-up inflation.
Demand-pull inflation sometimes may lead to cost-
push inflation and vice-versa. It is very difficult to
ascertain which one leads to the other. When demand-
pull inflation occurs, workers demand more wages
leading to cost-push inflation. This cost-push inflation in
turn may lead to mark-up inflation. Hence it is very
difficult to identify whether inflation is due to cost-push
or demand-pull.
 g"sn r 133
Inflation

(k) Stagflation: This is a new type of inflation which

emerged in post second world war period. It refers to a
situation where a significant rise in the price level is
accompanied by a high rate of unemployment. It implies
the co-existence of stagnation and inflation in the
economy. During such times, economies experience what
is called 'Jobless Growth'.
The term stagflation refers to a situation of high
inflation along with a high rate of unemployment leading
to a low growth rate of national income. Stagflation, first
emerged in the developed world in the seventies. Due to
the oil crisis in 1973, countries like USA, UK, France and
Germany experienced a high rate of inflation and
unemployment. The fourfold increase in the price of oil
led to rise in price of manufactured goods, rise in
unemployment and decline in real national income. The
supply shock resulted in cost push inflation and low
growth rate. This trend persisted between 1973 to 1975.
Though the economies were revived back soon, in 1979
the same problem emerged again due to crisis in Iran and
it continued till 1981. Apart from the oil crisis other
factors like depreciation of dollar, fall in the supply of
agricultural output, rise in wages of workers etc
contributed to stagflation in USA during 1973 to 1975.
Different countries had different reasons for experiencing
stagflation though rise in oil price was very much
responsible for stagflation. The US economy was reviving
and on the path of expansion during 1982-1988. During
this period there was a fall in both inflation and
unemployment.
Causes of Stagflation:
According to economists stagflation occurs due to
demand and supply side factors like inflation. The major
factors are:
(1) Increase in money supply: Increase in money supply
due to liberal credit policy results in inflation.
134 crcra' V ipul’s™ Business Economics - II (SFC)

(2) Deficit financing: Deficit financing leads to more

money supply leading to more demand for goods and
services and higher prices.

(3) Government's policies: If the changes in

government s policies lead to more income in the
hands of people, then demand will rise pushing the
price level upwards. For e.g., if government
employees are given hike in salaries, farmers are
given relief from payment of loans and are offered
better prices for their produce etc. it will increase the
demand for goods resulting in inflation.

(4) Rise in the price of crude oil and increase in cost of

production: The price of crude oil in 1973 increased
significantly affecting many countries. USA
experienced stagflation in the 70's due to this oil
shock. When oil prices go up, cost of production of
many goods and services rise affecting production
and employment.

(5) Subsidies: Modem governments provide subsidy for

a number of things like food subsidy, power subsidy,
educational subsidy etc. All these increase
government expenditure resulting in more money
supply and inflation.

(6) Rise in cost of production: When cost of production

rises, prices of goods and services tend to rise. Many
factors like rise in the wage rate, hike in tax rates,
shortage of materials, lack of skilled labour, hike in
fuel prices etc. increase the cost of production
resulting in inflation and stagnation.

(7) Regulation and protection: Through various policies

government regulates production and distribution
Inflation
igra"Er 135

which affects the supply side. Along with this,

labourers are given protection through minimum
wages act, social security measures, etc. This results
in low productivity and less supply.

Effects/Consequences of Stagflation:

Stagflation represents a combination of stagnation and

inflation. Phillips curve established the inverse
relationship between inflation and unemployment.
Stagflation on the contrary implies the coexistence of
both at the same time thus rejecting the Phillips curve.
Generally when prices rise, profits will rise leading to an
increase in investment. The increase in investment will
lead to more production, employment and income.
However during stagflation, this does not happen. Prices
rise without any increase in investment. Stagnation in
production results in unemployment.
The consequences/effects of stagnation can be
summarised as follows:
(1) Stagnation in investment and production affect
growth rate.
(2) Higher levels of unemployment pose a threat to
the stability of the economy.

(3) Inflation erodes the purchasing power of the

currency affecting the fixed income group
severely.
(4) Insecurity of jobs on the one side and inflation on
the other side force people to save more rather
than spend. Lack of demand further aggravates
the situation.
 136
VipuVs™ Business Economics - II (SFC)

The solution to stagflation lies in adopting a

combination of monetary, fiscal and general
measures.
Stagflation in India:
In India the term stagflation refers to a situation of
slow growth rate or recession along with a high rate of
inflation. Indian economy experienced stagflation during
1991 to 1994. Factors on both demand and supply side
were responsible for stagflation. Some of the notable
factors were decline in public sector investment,
restrictions on imports, high rate of interest, increase in
money supply, rise in the price of oil and administered
prices like prices of coal, steel, cement, etc. All these
factors resulted in slow growth rate accompanied by a
high rate of inflation. Reforms were introduced by the
government to reduce money supply and fiscal deficit to
control demand and to boost supply various measures
were initiated. Due to these reforms the growth rate
improved paving the way for lower rate of inflation and
unemployment. In the recent years, financial crisis in
USA in 2008 resulted in a situation of jobless growth. To
overcome this, reform process was strengthened further.
Smce June 2014 oil price has started declining which led
to fall in the rate of inflation. Further reforms have also
been initiated to boost the growth rate and employment.
CAUSES OF INFLATION:
Inflation arises due to a variety of factors. It is a complex
phenomenon. It is very difficult to attribute one particular cause
for the rise in prices. The most important causes of inflation are:
(1) Factors influencing the demand side:
(a) Expansion of money supply: Money supply will expand
whenever banks create too much credit, government
adopts deficit financing and incurs huge defence
expenditure. The increased money supply will lead to
more demand for goods and services causing inflationary
spiral in the economy.
Inflation gpgrgn 137

(b) Increase in disposable income: Disposable income refers

to the income available to the person for spending after
meeting the tax commitments. Whenever disposable
income increases due to a reduction in tax rate or increase
in income, demand for goods and services will increase
leading to inflation.
(c) External demand: When demand from foreigners rise,
availability of goods to the domestic population will be
affected leading to rise in prices.
(d) Rise in expenditure: Increase in the expenditure of the
households and business firms will also lead to inflation.
Households tend to spend more when there is an
increase in their disposable income, use their past savings
for present consumption etc. When demand for goods
and services increases, investment of the entrepreneurs
will increase leading to more employment, more income
and more demand for goods and services. This increased
demand will result in a rise in the price level.
(e) Future expectations: If people expect the prices to rise in
future, more will be demanded at present causing an
increase in the price level.
(2) Factors influencing the supply side: Inflation arises when
demand for goods and services is more than the supply of
goods and services. Supply may not keep pace with demand
due to the following factors:
(a) Inadequate resources: Lack of resources in terms of
labour, raw materials, spare parts etc. will lead to
shortage of production of goods and services resulting in
inflation.
(b) Hoarding and black marketing: Traders resort to
hoarding and black marketing when they expect shortage
of goods and services. This leads to artificial scarcity and
prices tend to rise. Households also would like to store
more if they expect scarcity of goods. This will result in
more demand leading to further rise in the price level.
138 V ip ul ’s™ Business Economics - II (SFC)

(c) Natural calamities: Natural calamities like floods,

droughts etc. affect the supply of foodgrains and raw
materials resulting in a rise in the price level.
(d) Exports: If more goods are diverted to the external
market, there will be shortage of supply in the domestic
market inducing the prices to go up.
(e) Full employment situation: If the economy has attained
already full employment of resources, supply cannot be
increased with an increase in demand. This will lead to
an inflationary spiral in the economy.
Thus inflation could emerge due to factors operating on either
demand side or supply side or both.
EFFECTS OF INFLATION:
Inflation is one of the serious socio-economic problems. It
affects the different sections of the economy differently. Inflation
has been rightly remarked as "public enemy number one" by
presidents Ford and Carter. The various effects of inflation are as
follows:
A mild inflation, according to Keynes is beneficial for the
economy. If there is mild inflation, the moderate rise in price will
encourage entrepreneurs to increase investments and production.
This is because of the increase in profits. Increased production will
lead to more employment and more income and more demand for
goods and services. The beneficial effects will not last forever.
When the rate of inflation becomes higher, serious consequences
will emerge. The following are the effects of inflation on
productive activities.
EFFECTS OF INFLATION ON PRODUCTION:
(1) Adverse effects on capital formation: Inflation reduces the
savings of the public as the cost of living rises. Less savings
leads to less investment and poor capital formation. This will
result in less production, employment and income.
(2) Production distortions: Inflation distorts the pattern of
production by diverting resources to the production of non­
essential goods from essential goods. The goods demanded
Inflation n™nr,jgr“ 139

by the rich gets priority while the mass consumption goods

get neglected.
(3) Hoarding and black marketing: The supply of goods and
services gets affected due to widespread hoarding and black
marketing. Traders, businessmen and even households try to
hoard goods. This leads to scarcity and pushes up the price
level further. Traders and businessmen indulge in
widespread black marketing to make quick profits.
(4) Speculation: Inflation leads to speculative activities and
disrupts productive activities. Businessmen focus on
speculation rather than on production as they aim at making
quick profits.
(5) Profit orientation and quality deterioration: Inflation results
in a seller's market whose main objective is profit
maximisation. In the process quality of goods and services is
ignored.
(6) Erosion in the value of money: Inflation reduces the
purchasing power of money. The confidence of the public
gets eroded and this leads to flight of capital to other
countries. This results in low investment and low production.
EFFECTS OF INFLATION ON DISTRIBUTION OF INCOME
AND WEALTH:
Inflation affects different sections of the society differently. It is
generally said to be redistributing income in favour of the rich
people at the expense of the poor. Cost of production of goods
tends to increase during inflation. However, prices would rise
more than the rise in cost of production ensuring higher profits for
businessmen. During inflation, traders, businessmen and
speculators gain the maximum. Windfall gains accrue to the
flexible income groups. The worst affected section during inflation
is the fixed income group. Wage-earners, pensioners and those
live on fixed savings constitute the fixed income group. Their real
income will decline due to inflationary spiral in the economy.
Through trade unions, labourers try to get higher wages to protect
them against inflation. This leads to cost-push inflation, further
140 Era'll" VipuVs™ Business Economics - II (SFC)

eroding the purchasing power of the people. Pensioners and

unorganised labour suffer severely during inflation.
Inflation affects debtors and creditors differently. Debtors
benefit during inflation due to the fall in the value of money when
they pay back their loans. During the period of inflation in real
terms they will be paying less. The creditors on the other hand
lose during inflation as they receive the money when the value of
money is less.
Investors are also affected by inflation. Those who invest in
shares are bound to reap good returns due to increase in the
profits of the companies. On the other hand, those who invest in
assets yielding fixed returns like debentures, fixed deposits etc.
would be adversely affected.
Farmers benefit during inflation. The rise in the price of farm
products enable the farmers to get a higher level of income.
Though cost of production increases, prices rise at a faster rate
ensuring greater profits for the farm community. Generally these
benefits go to the rich farmers rather than the poor farmers.
Thus inflation redistributes income in favour of businessmen,
debtors and farmers at the expense of fixed income groups,
creditors and consumers. The poor people are the worst affected
during inflation as inflation erodes their purchasing power and
lowers their standard of living. The gap between the rich and the
poor widens during inflation.
EFFECTS OF INFLATION ON CONSUMPTION AND
WELFARE:
Inflation reduces the consumption of goods and services and
affects the general welfare of the people. Higher prices reduce
consumption of goods and lowers the standard of living of the
people.
SOCIAL AND POLITICAL EFFECTS OF INFLATION:
Apart from economic effects, inflation also creates certain social
and political effects. Inflation helps the rich to become richer and
makes the poor people poorer. Inequality widens leading to social
injustice. Inflation provides lot of scope for businessmen and
traders to earn quick profits. It gives rise to a seller's market
Inflation
§"W W 141

providing ample scope to sell sub-standard products at high

prices. Adulteration, black marketing and hoarding of goods
prevail on a large scale. People start losing faith in the government
due to the hardships imposed by inflation and they start revolting
against the government. Thus social harmony and political
stability are at stake if inflation is not effectively controlled by the
government.
Thus effects of inflation are many and generally inflation has
adverse effects unless it is a mild one. If inflation persists for a
long time, it disturbs the planning process, reduces the
competitiveness of the economy in the international market and
lowers the external value of the currency. To avoid the economic,
social and political effects of inflation, all efforts should be taken
to control it at the earliest.
MEASURES TO CONTROL INFLATION:
Inflation is a complex phenomenon. Variety of measures have
to be used to control inflation. Inflation is the result of
disequilibrium between demand and supply. Hence the measures
are directed towards factors influencing demand and supply
sides. The following measures are generally adopted to control
inflation.
(1) Monetary Measures.
(2) Fiscal Measures and
(3) Other Measures.
These measures can be explained as follows:
(1) Monetary Measures: Generally, inflation is considered as a
monetary phenomenon. It arises due to excessive money
supply in the economy. The central bank controls money
supply by controlling the credit created by commercial banks.
The central bank uses two methods - quantitative and
qualitative methods - to control the credit created by
commercial banks. The quantitative method controls the total
volume of credit created by the banking system. Bank rate,
open market operation, cash reserve ratio are used to control
the volume of credit. On the other hand, qualitative method
aims at controlling the quality or direction of credit.
142 n™ETEr VipuVs™ Business Economics - II (SFC)

Consumer credit regulation, varying the margin

requirements, rationing of credit etc. are some of the
instruments used here. These measures help in allocating the
funds to the productive sectors of the economy.
(2) Fiscal Measures: The measures related to taxation, public
expenditure and public debt are known as fiscal measures.
During inflation, the government can vise taxation, public
expenditure and public debt in the following ways:
(a) To reduce the excess demand, the government can
increase the tax rates and can also introduce new taxes.
To mop up the excessive purchasing power in the hands
of the rich people direct tax rates can be increased.
(b) Reduction in public expenditure will lead to a reduction
in demand for goods and services and thereby prices can
be stabilised.
(c) Public debt is an effective anti-inflationary measure. The
borrowings of the government from the public will
absorb the excess money supply leading to less demand
for goods and services thereby resulting in decline in
prices.
To control inflation effectively, modem governments use a
combination of both fiscal and monetary measures.
(3) Other Measures:
(a) Incentives are offered by the government to the
producers of essential items.
(b) Efforts are undertaken to increase the production of
agricultural and industrial goods. By increasing supply,
excess demand for goods and services can be easily
managed.
(c) Controlling the prices of essential items and rationing of
essential goods are also adopted.
(d) Through public distribution system, essential items are
supplied at subsidised prices.
Inflation nrS™!!’ 143

(e) Import of essential items may be resorted to face the

shortage. It is a short term measure and it also depends
on the balance of payments position.
(f) If inflation is due to a rise in wage rates then the
government can bring about a wage freeze to avoid
further rise in prices.
Thus inflation has to be tackled from various angles. All the
above measures in the right combination are required to
effectively control inflation. The long term solution to control
inflation would be to accelerate economic growth. This requires a
high level of savings and investment, suitable technology and
optimum utilisation of resources.
DEFLATION:
Deflation refers to a situation where prices keep declining
accompanied by a fall in employment, output and income. It
occurs when there is a sustained fall in the price level. It is the
opposite of inflation. Sometimes prices fall due to the measures
taken by the government. However, such decline in prices are not
termed as deflationary. Only when .the decline in prices is
accompanied by a decline in output, employment etc., the
situation is termed as deflation.
Both Inflation and Deflation affect the economy significantly.
However, of the two, inflation is considered to be better than
deflation. During inflation, prices no doubt rise. However at the
same time investment saving, employment etc. tend to rise. In the
case of deflation, along with fall in the price level investments,
employment, income etc. tend to decline. This will affect the
economy severely. While it is possible to control inflation through
fiscal and monetary measures, it is difficult to control deflation.
Hence it is often said that deflation is worse than inflation.
NATURE OF INFLATION IN A DEVELOPING COUNTRY:
Developing countries like India often have to face the problem
of inflation. While advanced countries experience inflation after
full employment is attained, developing countries face inflation
even before full employment is attained. Factors operating on both
demand and supply side are responsible for this.
144 grgrcr V ipul’s Business Economics - II (SFC)

Factors on the demand side:

(1) Size of population: India with 1.2 billion population ranks
second in this World next to China. Huge population increases
the demand for goods and services. Inadequate supply leads
to inflation.
(2) Rise in income: As income rises demand for goods and
services constantly on the rise leading to inflation.
(3) Public expenditure: The expenditure of the governments in
developing countries is always increasing due to various
reasons like subsidies, interest payments, defence expenditure,
etc. While some are productive expenditure, unproductive
expenditure is also quite high. Rise in government expenditure
leads to more money supply creating inflation.
(4) Credit Creation: Commercial banks and financial institutions
create credit and facilitate development. However excessive
credit results in inflation.
(5) Investment projects: Projects involving huge capital is
undertaken both by public and private sectors. If the projects
involve a long gestation period and not completed on time, it
will lead to more money supply and inflation.
(6) Flow of foreign capital: Foreign capital add to supply of
money in the economy creating more demand and hence
inflation.
Factors on the supply side:
(1) Low agricultural output: Due to the backwardness of the
agricultural sector, supply is scarce leading to inflation.
(2) Inadequate infrastructure: Infrastructural facilities like power
supply, transport, communication, etc. are inadequate creating
shortage of goods and services.
(3) Import prices: Developing countries depend on imports for
oil, technology, capital goods, etc. Rise in the price of imports
or shortage of such imports directly contribute to inflation.
(4) Imperfect markets: Goods market and financial markets are
not matured in developing countries. This also creates
inadequate supply leading to inflation.
Inflation
innr 145

(5) Rise in cost of production: Increase in input prices often

create shortages resulting in inflation.
(6) Natural calamities: Floods, droughts, etc. affect production
causing a mismatch between demand and supply leading to
inflation.
Thus developing countries face inflation due to factors on both
demand and supply sides. Effective measures are required to
control the inflationary spiral in such economies.

QUESTIONS
(1) Define the following:
(a) Inflation.
(b) Value of money.
(c) Full employment.
(d) Deficit financing.
(e) Stagflation.
(f) Deflation.
(g) Demand pull inflation.
(h) Cost push inflation.
(i) Monetary policy.
(j) Fiscal policy.
Fill in the blanks:
/ W During inflation, value of money___________.
(b) Inflation which occurs due to excess demand over supply is known as
-X ­ ___________inflation.
- (c) ___________is worse than inflation.
CRR is ___________to control inflation.
__ _________is a combination of inflation and stagnation.
[A ns.: (a) falls (b) demand pull (c) Deflation (d) increased (e) Stagflation/
State whether the following statements are true or false:
(a) During inflation the government repays the debt to control inflation.
b) Bottlenecks on the supply side alone leads to inflation.
(c) Deflation is worse than inflation.
(d) Inflation redistributes income in favour of rich people at the cost of the
. poor.
^ ( e ) A mild inflation is good for the economy.
(f) Monetary measures alone are effective in controlling inflation.
c [A ns.: (a) False (b) False (c) True (d) True (e) True (f) False]
 V lp u l ’s™ Business Economics - II (SFC)
146 B " s rs "
Match the following:
(A) (B)
(1) Monetary policy (a) Fiscal policy
(2) Inflation (b) Central bank
(3) Quantitative credit control (c) Fall in value of money
(4) Public expenditure (d) Bank rate
A ns.: (1 - b; 2 - c; 3 - d, 4 - a)
(2) What are the causes of inflation? Explain in detail.
(3) Trace the effects of inflation on production and general welfare.
(4) What are effects of inflation on distribution and general economicwelfare?
(5) Discuss the measures to be taken to control inflation.
(6) “A combination of monetary and fiscal measure are required to control
inflation.” Discuss.
(7) Define stagflation. What are the causes and effects of stagflation?
(8) Write a brief note on stagflation in India.
(9) D is tin g u is h betw een:
(a) Demand pull and Cost push inflation.
(b) Inflation and Deflation.
(10) W rite s h o rt n o te s on:
(a) Causes of inflation.
(b) Effects of inflation on production.
(c) Deflation.
(d) Types
Stagflation.
(e) of inflation.
(f) * Nature of inflation in developing countries.
QE2D
VHKFL VIPtiL
Monetary Policy i™irw 147

Monetary Policy

INTRODUCTION

MEANING

OBJECTIVES

INSTRUMENTS

INFLATION TARGETING

QUESTIONS
148 nn@~gr V ipul’s™ Business Economics - II (SFC)

INTRODUCTION:
Modern states are termed as welfare states. They perform a
variety of functions to ensure a high level of socio economic
welfare. Development of various sectors of the economy,
improving the standard of living of the people, maintaining a
higher level of employment and income etc. are some of the prime
objectives of modem governments. In short stabilising the
economy at higher levels of output and employment has become
the most important concern of the governments at present. This is
termed as Economic Stabilisation. Before 1930's it was believed
that the invisible hand of the market mechanism would ensure
economic stability and there was no need for the government to
interfere in economic activities. This belief did not work during
the depression of 1930's. Government's intervention was
advocated by J. M. Keynes to bring about a revival in the
economy. Since then economic stabilisation has been targeted by
all governments and to achieve this, a number of measures have
been taken.
Macro economic policy guides the governments in attaining
economic stability. The two important instruments of macro
economic policy are:
(1) Monetary policy, and
(2) Fiscal policy.
The main goal of macro economic policy is economic
stabilisation. At the same time there are certain other objectives
also to be achieved in the process of ensuring economic
stabilisation. The main objectives of macro economic policy can
be outlined as follows:
(1) Attaining full employment and ensuring a high level of
output.
(2) Maintaining a stable price level and
(3) Accelerating the rate of economic growth.
Monetary and fiscal policies are used by governments to
achieve these objectives. The operation and effectiveness of the
two policies can be analysed as follows:
Monetary Policy 149

(1) MONETARY POLICY:

Monetary policy is concerned with money supply, credit
creation by banks and rate of interest. It is formulated and
implemented by the Central bank. In India, for e.g.- the Reserve
Bank of India is mainly responsible for implementing the
monetary policy. Till the Great Depression of 1930's, this policy
was mainly used to ensure economic stability. By controlling
money supply and credit creation, stability was ensured in the
economy. However, during the 1930's monetary policy was not
effective in brining about a recovery. It lost its predominant
position to fiscal policy. At present a combination of fiscal and
monetary policies is used to achieve the objectives of macro
economic policy.
Monetary policy is pursued by modem governments to achieve
certain specific objectives. The objectives differ from country to
country and from time to time. It depends upon the stage of
development and the economic situation in the economy during a
particular period of time. However, the main objectives of
monetary policy are:
(a) Accelerating economic growth.
(b) Maintaining price stability.
(c) Attaining full employment and maintaining it.
(d) Ensuring stability in the rate of exchange.
The objectives of monetary policy can be analysed further as
follows:
(a) Monetary Policy and Economic Growth: Economic growth
refers to the increase in national income. To induce growth,
capital formation should be high. Monetary policy promotes
capital formation by mobilising resources and making it
available to investors at the right time and at reasonable rate
of interest. The Central banks adopt a flexible policy to
promote capital formation and economic growth. During
inflation it adopts a dear money policy to control the supply
of credit and during depression it adopts a cheap money
policy.
150 n™nri|T
“ Vipul's™ Business Economics - II (SFC)

(b) Monetary Policy and Price Stability: Monetary policy aims at

controlling fluctuations in the price level as instability in the
price level produces adverse effects on the economy. Various
measures are used by the central bank to control inflation or
deflation. While' a mild inflation is better for the economy, a
running or galloping inflation is harmful for the economy.
Similarly, it is necessary to control deflation by taking prompt
action. Otherwise it will result in depression. While ensuring
price stability, the government and the central bank should
ensure that growth is not affected and business cycles are
actually controlled. When price stability is given importance,
the government may have to compromise on the objective of
full employment as price stability and full employment are
not compatible with each other.
(c) Monetary Policy and Full Employment: Full employment
refers to a situation where the productive resources of the
economy are fully employed. It also implies the absence of
involuntary unemployment. It however, does not mean 100%
employment. When there is full employment in the economy,
a higher level of income, output and improvement in
standard of living become possible. This objective is given
importance by many advanced countries in recent times.
(d) Monetary Policy and Exchange Rate Stability: Till 1970's,
exchange rate stability was emphasised by monetary policy.
Under the gold standard it was given much importance. It
was considered necessary to promote international trade and
control movement of capital between nations. Some
economists are of the opinion that exchange rate stability can
be attained only by sacrificing internal price stability. At
present this objective is considered secondary and many
governments prefer a flexible exchange rate policy so that
adjustments can be made as per the requirements of the
economy.
The Central bank tries to achieve these objectives by using the
various tools of the monetary policy. The objectives are said to be
conflicting in nature. For e.g. price stability and full employment
do not go hand in hand with each other. If full employment has to
Monetary Policy nT
“lg,"Er
be attained then more investments have to be made. This
obviously will lead to more employment, more income and more
demand for goods and services. If supply of goods and services
does not match with the increase in demand, there will be
inflation in the economy. If price stability is more important, then
money supply and credit creation may be controlled leading to a
decline in investments. This will affect the level of employment.
Thus there exists a conflict between the various objectives of
monetary policy. However, if the Central bank and the
government take appropriate measures to control inflation and at
the same time encourage investment, it is possible to achieve price
stability and a higher level of employment, if not full employment.
Every economy, depending upon its stage of development and
economic compulsions gives priority to a particular objective.
While the advanced countries give importance to achieving and
maintaining full employment, developing countries like India
consider economic growth as the main objective of monetary
policy.
Instruments of Monetary Policy:
The various instruments used by the Central bank can be
divided into two types namely:
(1) Quantitative Instruments, and
(2) Qualitative Instruments.
While the quantitative instruments help the Central bank to
control the quantity of credit, the qualitative weapons are used to
control the direction of credit.
(1) Quantitative Instruments: The quantitative credit control is
also called as the general credit control. The main weapons
used under this method are:
(a) Bank Rate: It is the rate at which the Central bank
discounts the securities of commercial banks. It is also
called as the discount rate. Bank rate influences the cost
of credit changes in the discount rate bring about changes
in the short term and long term interest rates and thereby
the level of economic activity. Capital movement
between countries is also influenced by the changes in
152 □ '“Ejrigr Vipul's™ Business Economics - II (SFC)

bank rate. Thus, it influences both availability and cost of

credit. During inflation the Central bank increases the
bank rate. Due to this credit from the Central bank
becomes costlier. Commercial banks are discouraged
from borrowing from the Central bank. When the bank
rate is increased, other lending rates will also rise making
credit costlier. Hence, investments will decline leading to
a fall in employment, income and demand for goods and
services. This in turn will reduce the price level. Thus a
rise in bank rate leads to a reduction in price level and
during depression the bank rate is reduced to push up
the price level and bring about a revival in the economy.
For the bank rate to succeed, the commercial banks
should not have excess reserves with them and they
should have adequate securities to be discounted with
the Central bank.
(b) Open Market Operations: It refers to buying and selling
government securities by the Central bank. During
inflation, the bank will sell securities and during
depression it will purchase securities from the public and
financial institutions. The Central bank uses this weapon
to overcome seasonal stringency in funds. During
inflation when there is too much money supply in the
economy, the Central bank sells securities. These
securities are purchased by the commercial banks. This
reduces their cash reserves leading to a reduction in
credit creation. During depression, the Central bank buys
securities from the commercial banks and money flows
from the Central bank to the commercial banks. This
increases their cash reserve which in turn leads to
expansion of credit. This in turn will lead to increase in
investment, production and employment. Demand for
goods and services will increase leading to a rise in the
price level. Thus, this weapons helps the Central bank to
control the liquidity in the economy.
(c) Cash Reserve Ratio: It is a powerful instrument in the
hands of the Central bank to control credit. The
commercial banks have to keep a certain percentage of
Monetary Policy □'"lira1" 153

their deposits with the Central bank. It is a statutory

requirement to ensure liquidity and solvency of the
banks. By adjusting the cash reserve ration, credit
creation by commercial banks can be controlled. During
inflation the Central bank increases the cash reserve ratio,
the funds available for credit creation will decrease. On
the contrary when the cash reserve ratio is reduced
during depression, the credit creating capacity of banks
will increase. For e.g., the Reserve Bank of India over a
period of time reduced the CRR from 15% in 1991 to 4%
in 2013 to improve liquidity.
(d) Statutory Liquidity Ratio (SLR): Statutory liquidity ratio
refers to the percentage of net demand and time liabilities
that must be held by the commercial banks in the form of
approved government securities. Through SLR, the
central bank can control the credit created by commercial
banks and it can also easily mobilise resources for the
government. During inflation, SLR is increased to
contract credit created by commercial banks and during
depression SLR is reduced to expand credit creation. In
the case of the Indian economy for example SLR was
38.5% in 1991. Gradually it has been reduced. At present
SLR is 19.5%.
(e) Repo Rate: Repo refers to repurchase option. When a
repo is transacted, securities are sold by the seller to the
investor with an agreement to repurchase it at a
predetermined rate and date. In simple terms, it refers to
the rate at which the central bank gives loans and
advances to commercial banks against their securities.
During inflation, repo rate is increased and during
recession, it is lowered to regulate the availability and
cost of credit. For example, in India, the RBI revised the
repo rate 13 times during the period March 2010 to
January 2012 to regulate liquidity in the market. In the
recent times this weapon is often used by the RBI to
control money supply in the economy. At present the
repo rate is 6.5%.
154 STBTISr Vtpul’s™ Business Economics - II (SFC)

(f) Reverse Repo: Reverse repo refers to the rate at which

commercial banks park their funds with the central bank.
In other words, it is the rate at which the central bank
borrows from the commercial banks. While repo helps to
inject liquidity into the market, reverse repo helps to
absorb liquidity from the market. When repo is revised
by the RBI, reverse repo gets automatically revised. The
difference between the two rates is always 100 basis
points or 1%. Both repo and reverse repo are very useful
to control credit and ensure stability. The current reverse
repo rate is 5.75%.
(2) Qualitative Instruments: Qualitative credit control is also
known as selective credit control. This method is used to
control the flow of credit to particular sectors of the economy.
Here, the direction of credit is regulated by the Central bank.
There are various weapons of selective credit control like
variation in margin requirements, ceiling on credit, moral
suasion differential rate of interest etc. The selective credit
control is used as a complementary to quantitative credit
control to discourage the flow of credit to unproductive
sectors and speculative activities and also to attain price
stability.
The Central banks use a combination of quantitative and
qualitative credit control methods to bring about economic
stability. The various weapons in the hands of the Central
bank are adjusted according to the requirements of the
economy. During inflation the Central bank takes the
following steps:
(a) Increases the bank rate.
(b) Sells securities.
(c) Increases the cash reserve ratio.
(d) Rises the margin requirements.
(e) Controls credit for unproductive and speculative
purposes.
During depression the bank follows the reverse procedure.
Generally, it is believed that monetary policy is effective in
Monetary Policy 155

controlling inflation and not so effective in controlling

depression. During the 1930's, monetary policy alone could
not bring about a revival. Fiscal policy acquired prominence
during that time. From that time onwards to bring about
economic stability both monetary and fiscal policies are used
by modern governments.
Inflation Targeting:
Monetary policy is concerned with money supply, bank credit
and cost of credit or rate of interest. It is framed by the central
bank to achieve objectives like price stability, economic growth,
full employment, etc. Monetary policy is used by the central bank
to control inflation, ensure price stability and promote economic
growth. Price stability and economic growth are conflicting in
nature. When price stability is given importance, money supply
and credit will be controlled affecting growth. If growth has to be
accelerated, more money supply and credit should be made
available compromising price stability. Hence the Central bank
has the responsibility of striking a balance between these two
objectives. In recent times central banks use 'inflation targeting' to
achieve the balance.
Inflation targeting refers to the policy of the central bank fixing
a certain rate of inflation as the target. The central bank estimates
the expected rate of inflation, makes it public as the target rate. If
the actual rate of inflation is different from the target rate, then
measures are taken to achieve the targeted rate. Targeting the
inflation rate according to economists will ensure transparency
commitment and greater accountability of central bank in the
implementation of monetary policy. Inflation targeting in a way is
nothing but forecasting inflation. Price index is used to measure
inflation. In the case of inflation targeting also a particular price
index needs to be selected. Generally consumer price index is
used.
Many countries are experimenting with inflation targeting. The
Reserve Bank of India has announced an inflation target of 4%
with +/-2 percent as the tolerance level. This inflation target is for
a period of five years from 2016 to 2021. The government sets the
target in consultation with the Reserve Bank of India. Inflation
156 CTEril'” V ip u l ’s™ Business Economics - II (SFC)

rate in the range of 2% to 6% is considered as a reasonable rate.

Such a rate is expected provide stability to 1 encourage
consumption and investment. '
The success of inflation targeting depends on a number of
factors. Some of them are:
(1) Well-developed financial system.
(2) Autonomy for the Central bank.
(3) Adequate and accurate availability of data.
(4) Sufficient technological advancement and technical
capacity to forecast inflation.
(5) Non-interference of the Government in the working of the
Central bank.
(6) Deregulation of the administered price mechanism, etc.
Inflation targeting is a complex exercise. It is increasingly
adopted by countries as it reduces uncertainty and creates a
conducive environment for economic growth.

QUESTIONS
(1) Define the following:
(a) Monetary policy.
(b) Bank rate.
(c) Open market operation.
(d) Cash reserve ratio.
(e) Statutory liquidity ratio.
(f) Repo rate.
(g) Reverse repo rate.
(h) Inflation targeting.
Fill in the blanks:
(a) During recession time CRR is ___________ .
' J b ) Bank rate is a ___________ credit control weapon.

<d)
» Inflation target fixed by the RBI at present is ___________ .
’ The inflation target of 4% is valid for a period o f ___________ years
from ___________to ___________ .
[Ans.: (a) reduced (b) quantitative (c) 4% (d) 5, 2016 to 2021]
Monetary Policy irirw 157

State whether the following statements are true or false:

- (a) Objectives of monetary policy are conflicting in nature.
_ -(b) A mild inflation is good for the economy.
(&) Monetary policy alone can control inflation.
[Ans.: (a) True (b) True (c) False]
(2) Define monetary policy. What are its instruments?
(3) Distinguish between:
(a) Quantitative credit control and qualitative credit control.
(4) Write short notes on:
(a) Fiscal policy. *
(b) Inflation targeting.
158 § r § r ir vtPuvs ™
[ Business Economics - ii (SCF)

MODULE - III
C O N ST IT U E N T S OF FISC A L
P O LIC Y

13

Role of Government to
Provide Public Goods

IN T R O D U C TIO N

C A U SES O F M A R K ET FA ILU R E

G O V ER N M EN T IN T ER V EN T IO N

PR IN C IPLES O F SO U N D A N D FU N C T IO N A L FIN A N C E

Q U ESTIO N S
Role of Government to Provide Public Goods n^grnr 159

INTRODUCTION:
Every economy has a limited stock of resources viz. land,
labour, capital, technology, etc. These have to be used for the
production of various goods and services in the best possible
manner. Goods and services are scarce in relation to wants. If the
resources are abundant then all economic goods will become free
goods like air, water, etc. In such an economy, markets do not
have a role to play as there is no scope for price mechanism.
Economics, as a subject will have no relevance. However, the
problem of scarcity exists even in the richest of the rich countries.
Today's world is a world of scarcity filled with economic goods.
Due to the problem of scarcity, choice has to be exercised by
every economy in the utilisation of resources and satisfaction of
wants. The choice has to be made in such a way that optimum
resource allocation can be ensured. What to produce, how to
produce and for whom to produce are the three main issues faced
while making a choice. This implies that every economy must
make the right choice about factor inputs and output.
It implies the effective use of scarce resources in such a manner
that maximum wants can be satisfied. If there is no efficiency then
people may be worse off than before. Ensuring efficiency in
resource utilisation is the essence of economics.
Efficient resource allocation depends upon the kind of market
structure prevalent in the economy. The markets are broadly
classified as perfect competition, monopoly, monopolistic
competition and oligopoly. Each one has its own features. Of all
the market structures perfect competition is the ideal one. Under
perfect competition the principle of marginal cost pricing is
followed. Here price is equal to marginal cost. This ensures
optimum allocation of resources and maximization of economic
welfare. However perfect competition in reality does not exist.
Moreover marginal cost pricing may not result in optimum
allocation of resources due to certain factors like monopoly power,
public goods, external diseconomies, economies etc. Efficiency is
also measured in terms of the average cost incurred by the firm.
Under perfect competition, firms produce at a lower average cost
compared to a monopoly firm. Hence they can be considered
160 grH'-g™ V ip ul’s™ Business Economics - II (SCF)

efficient. However each firm is small in size and the scope of

getting huge economies of scale is limited. Hence a competitive
firm achieving allocative efficiency and sustaining it is doubtful. A
monopoly firm on the contrary has greater scope to reap
economies of scale, introduce innovations which may lead to
allocative efficiency.
Perfect competition is said to be better than monopolistic
competition as the latter has excess capacity, selling costs, etc.
Oligopoly market is characterized by price rigidity, cut throat
competition, formation of cartels to avoid competition etc. Though
perfect competition is preferable, the more realistic market
structures are monopoly, monopolistic competition and oligopoly.
In any economy, the allocation of resources should be efficient to
maximise welfare.
The concept of market failure assumes significance in this
context. If the market economy fails to achieve efficient allocation
of resources then it is termed as 'market failure'. The imperfect
nature of market does not ensure allocative efficiency. Market
imperfections and resultant inefficient resource allocation gives an
opportunity for the government to interfere and ensure efficiency.
CAUSES OF MARKET FAILURE:
Market failure implies the failure of the market economy in
allocating resources efficiently. Under perfect competition
allocative efficiency exists. All firms under perfect competition
accept the price set by the industry which is equal to marginal
cost. Under marginal cost pricing, the price paid by the consumer
is equal to the cost incurred in producing the last or marginal unit.
Hence consumers reap consumer's surplus under perfect
competition and this increases the welfare of the consumers.
However, in reality perfect competition is a rarity. The following
factors are responsible for market failures:
(a) Public goods: Public goods are certain goods which have
some special features. They do not imply the goods produced
by the public sector. They can be explained by classifying
goods as rival goods and non-rival goods. A rival good is one
which can be consumed by only one person at a time.
Role of Government to Provide Public Goods □ ’"irjg™ 161

Another person cannot have the same unit simultaneously.

He can buy another unit and consume it. For example let us
assume that consumer X is having a pizza. At the same time
consumer Y cannot have the same pizza. Thus the
consumption of pizza by one person reduces the availability
of the goods to the other person. Such goods are known as
private goods. Public goods on the other hand are non-rival
goods. Public goods are enjoyed by all the people at the same
time. Examples of public goods are public gardens, flood
control projects, defence etc. In the case of these goods,
consumption is neither restricted to a particular group nor
does it prevent some group from consuming it while others
are enjoying it. Thus public goods are non-rival goods.
Apart from non-rivalry, another feature of public good is
the non-excludability of their consumption. This implies that
it is difficult to exclude people who are not willing to pay for
it while distributing pubic goods. For example, when the
government strengthens the national security, the benefits are
available to all the people including those who do not pay for
it. Similarly when a new road is developed the principle of
non-excludability exists. This feature of public goods leads to
market failure and inability to achieve Pareto efficiency.
When public goods are made available, some people enjoy
the benefit without paying for it. In the case of public goods,
it is difficult to exclude such people and make it available
only to those who are willing to pay for it. Hence the people
who do not want to pay for such goods create a 'free rider's
problem.' It means some people take advantage of the
situation and enjoy the benefits without paying for it. Since
everybody is not paying for it, firms will not have incentive
produce public goods on a large scale or they may produce
very little of that. Hence resource allocation may be
inefficient.
(b) Monopoly power: Monopoly market is an imperfect market.
The monopoly firm is the single seller in the market. It faces a
down sloping demand curve. The monopoly firm attains
equilibrium at the point where MR = MC and the MC curve
162 — . V ipu l’s Business Economics - II (SCF)

cuts MR from below. However price is not equal MC. Under

monopoly price or average revenue is higher than marginal
cost. The essential condition for efficient resource allocation
and maximization of welfare is marginal cost pricing. That is
price should be equal to marginal cost. This condition is not
satisfied under monopoly. Hence allocative efficiency is not
possible under monopoly. Moreover a monopoly firm does
not produce the optimum output. This also indicates that
there is no optimum use of resources.
Under monopoly, factors of production are not paid
according to their marginal productivity. This is reflected by
the price fixed by the firm which is higher than the marginal
cost. This implies exploitation. Hence supply of labour to the
monopoly firm would be less. For efficient allocation of
resources, price of a product should be equal to marginal cost
and reward, paid to the factor of production should be equal
to its marginal product. Absence of these two conditions
imply monopoly market is inconsistent with allocative
efficiency and maximization of welfare. Like product market,
in the factor market also if monopoly exists there will be
distortions in resource allocation. When there is no efficiency
in resource allocation, production of goods may not be
according to the preferences of the consumers causing
reduction in welfare.
(c) Externalities: Externalities refer to external economies and
diseconomies of production and consumption. When a firm
expands its production, it derives certain benefits. At the
same time other firms also may derive certain benefits which
are termed as external economies. The other firms do not
make any payment for the benefits received to the firm
expanding production. On the other hand when some firms
expand production, they may have unfavourable effects on
others. The expanding firm does not make any payment for
the unfavourable effects. When such externalities exists, the
price of the product will not reflect social costs or benefits.
The concepts of private cost, private benefits, social costs
and social benefits are used to explain the effects of
Role of Government to Provide Public Goods H'-O'-ET 163

externalities on maximization of welfare. Private cost refers to

the cost incurred by a firm for producing a commodity while
private benefit refer to the benefits enjoyed by the firm
producing the good. Social costs refer to the cost borne by the
society and social benefits imply the advantages enjoyed by
the entire society.
When a firm expands its production, some other firms may
also benefit creating external economies of scale. For example
when an automobile unit expands its output, the firm will
derive certain benefits. At the same time it will lead to
increase in demand for steel, paints, air-conditioners, music
system, etc. All those firms which supply these items will also
increase their production giving rise to further benefits.
Similarly when a metro rail or monorail is introduced, the
railways provide greater service to the people. While deriving
benefits due to the increased service, they also enhance the
value of property all along their route. The benefits are
enjoyed by the people without paying for it. Thus the cost
incurred by the firm will cover the actual cost and not the
benefit accrue to the people. Thus there is said to be a
divergence between private cost and social cost. In this case
private marginal cost will be higher than the social marginal
cost. As a result there will be less production of the
commodity. Social welfare can be maximized when private
cost is equal to social cost and private marginal utility is equal
to social marginal utility. When there are external economies,
there is no equilibrium between private cost and social cost
and private and social benefit. This will lead to misallocation
of resources resulting in less social welfare.
When diseconomies of scale occur private marginal cost
will be less than the social marginal cost. For example leather
units or textile units may pollute the nearby water bodies by
not treating their waste water. This will have adverse effects
on the health of the people using the polluted water. The firm
may not pay to the people affected by its production.
Similarly when noise pollution is created by factories their
cost do not reflect the harm caused to the society. Hence in
164 S f"!™ !' Vtpul's™ Business Economics - II (SCF)

such cases private marginal cost will be less then the social
marginal cost. The absence of equilibrium between the two
will result in loss of welfare.
Like production, there are economies and diseconomies in
consumption. For example if a person has a well maintained
private garden, others benefit in terms of less pollution. Here
social marginal utility will be more than the private marginal
utility. On the other hand if there are diseconomies of
consumption then social marginal utility will be less than
private marginal utility. Examples of diseconomies in
consumption are loud music, conspicuous consumption etc.
In both the cases price will not reflect the actual marginal
utility.
When there are externalities, resource allocation will not be
efficient and hence maximization of welfare will not be
possible.
(d) Information asymmetry: The concept of asymmetric
information correlates the relationship between risks and
information. Business firms face variety of risks and
uncertainties while doing their business. In common language
risks and uncertainties are used as synonyms. However in
economics they are interpreted differently. In business
environment, risks refer to the uncertainty of the outcome of a
business decision. Business firms will not be able to estimate
precisely the outcome of their decisions. The outcomes
depend on a variety of factors. In some cases, by using
advanced statistical techniques, firms may be able to assign
probabilities to the outcomes. Past experience may also help
them to do so. In certain decisions the firm will not be able to
ascertain the outcome. Hence probabilities cannot be
assigned. Such business decisions where the outcomes cannot
be estimated are known as uncertainties. Some of the risks
can be faced by taking insurance against them. For example
fire insurance, shipping insurance etc help the firms to
minimise the risk involved in business. Uncertainties, where
the outcome cannot be predicted are non-insurable. Both risks
and uncertainties arise due to lack of complete information.
Role of Government to Provide Public Goods 165

Asymmetric information refers to a situation where when

two parties are involved in a business transaction, one party
has less information than the other. In other words it implies
a situation where dissemination of knowledge is not equal
and complete. This will result in adverse selection of a
product or service i.e. buying a product or service of a poor
quality.
Asymmetric information arises due to lack of information.
It is generally found in second hand market for products like
automobiles. For example in the second hand market for cars,
the buyer will not have complete knowledge about the car
while the seller will have all the information. Though the
buyer and seller may negotiate the price, the buyer,
eventually may be paying a higher price due to asymmetric
information. This kind of transaction where the buyer pays a
higher price for a low quality product is termed as 'Adverse
Selection'.
Similar situation may arise in the case of the banking sector
. when they give credit to different types of customers. When
the banks do not have complete information about the
borrower when they extend loans, there is a high risk of
default resulting in accumulation of non-performing assets.
Many borrowers may use the funds for unproductive
purposes leading to losses and default. Banks may not be in a
position to supervise and regulate them. Sometimes the
government's policies may also restrict them from taking
strict action against defaulters. Similar cases may happen in
the insurance sector, wherein the insurance companies may
lack information about the insured resulting in adverse
selection. When one party in a transaction suffers due to lack
of information and not in a position to take action against the
other party, there is said to be 'moral hazard. Thus
asymmetric information results in business decisions with a
high degree of risk. Asymmetric information is thus one of
the factors leading to market failure.
(e) Inequality: Equality in the distribution of income and wealth
is another essential requirement to promote welfare and
 166 V ipu l’s™ Business Economics - II (SCF)

maximize it. Inequality or the gap between the rich and the
poor, according to J. M. Keynes would result in under
consumption or over saving in a market economy resulting in
further distortions and trade cycles. While production of
goods and services is important to ensure growth, the
distribution of the same in a fair and equitable manner is
equally important to ensure maximization of social welfare. If
glaring inequality persists, capital formation would be
affected and labour will not have any incentive to put in their
best efforts. Inequality will lead to market failure resulting in
allocative inefficiency and less welfare.
Government intervention and market efficiency:
A market economy is based on price mechanism which is turn
depends on the competition in the market. The market forces are
supposed to ensure equilibrium, optimum use of resources and
maximization of welfare. In reality market failure occurs and
distortions creep in. Hence the scope for government intervention
surfaces. The government by interfering should ensure efficient
use of resources along with equity. The intervention of the
government to maximize welfare can be as follows:
(1) Fiscal policy can be used to ensure efficient resource
allocation. Taxes can be levied on goods which cause external
diseconomies and subsidies can be extended those goods
whose production cases external economies.
(2) Strict regulatory measures can be taken to reduce
diseconomies. For example effective implementation of
pollution control measures, traffic control measures etc. can
promote social welfare.
(3) In the case of consumption also, taxes and subsides can be
used to correct diseconomies and economies. If the
consumption of a commodity, causes diseconomies taxes can
be composed to rectify that. On e the other hand if
consumption of the good causes economies, subsidies should
be provided. This will result is reduction in price, more
demand and more production.
Role of Government to Provide Public Goods WWW 167

(4) Dissemination of information enable people to make right

decisions. Through this the problem due to asymmetric
information can be minimised.
(5) When the private sector fails to produce adequate quantity of
a good desired by the people, the public sector should be
encouraged to produce such goods to satisfy the demands of
the public.
(6) Suitable legislations can be passed and implemented to
prevent unfair trade parities by monopoly and oligopoly
firms.
All the above measures can ensure efficient allocation of
resources and maximization of welfare.
PRINCIPLES OF SOUND AND FUNCTIONAL FINANCE
The emergence of fiscal policy as a powerful fiscal weapon can
be explained with the help of the above two concepts. The
classical economists believed in the concept of sound finance.
They were staunch supporters of the laissez-faire policy.
According to them "that government is the best government which
governs the least". They advocated balanced budget. As per the
concept of sound finance, the revenue and expenditure of the
government should be balanced. If the budget is a surplus one, it
indicates excessive taxation imposing burden on the people.
Deficit budget on the other hand implies more expenditure on the
part of the government which will result in inflation. Balanced
budget was considered as an index of financial efficiency of the
government. Hence, in the classical era, fiscal policy was not given
much importance. The classical belief was based on the automatic
functioning of the market mechanism. According to J. B. Say one
of the classical economists "supply creates its own demand" and
hence there was no need for government intervention. The
government should confine itself only to basic functions like
internal security, protecting the country from external aggression
etc. It should not interfere in the functioning of the economic
system. Since the functions of the government were restricted to
the minimum, the classical economists advocated a balanced
 168 srsrsr VipuVs™ Business Economics - Ii (SCF)

budget. In the classical school of economics balanced budget was

considered as the principle of sound finance.
This concept of sound finance was replaced by the Keynesian
concept of functional finance since the Great Depression of 1930's.
J. M. Keynes believed in controlled capitalism. According to him
the state should interfere through its fiscal policy to influence
resource allocation and to attain full employment. This policy of
Keynes came to be called as functional finance. Though Keynes
contributed to the development of functional finance, it was Prof.
A. P. Lerner who popularised it to a greater extent. He defines
functional finance as follows: "The principle of judging fiscal
measures by the way they work or functions in the economy, we
may call functional finance." Functional finance advocates the use
of the budget policy to produce desirable effects on the whole
economy. It is not particularly concerned whether the budget is a
deficit or a surplus one. Through budget if the government can
improve the performance of the entire economy, it is said to be
functional finance.
The concept of functional finance as developed by Prof.
Lerner emphasises on the following aspects:
(1) The main objectives of functional finance should be full
employment and price stability.
(2) Public debt is justified only when it is necessary to absorb the
surplus funds from the private sector.
(3) Deficit financing i.e. borrowing from the Central bank can be
adopted to cover the budget deficit.
(4) All the fiscal operations of the government should result in
overall development of the economy.
Thus, the concept of functional finance is different from the
concept of sound finance. In the modem days it is very difficult to
find a nation favouring the policy of balanced budget or sound
inance. By and large all economies especially the developing
countries have deficit budget and often use the various
instruments of fiscal policy to achieve the objectives and brine
about growth and stability. '
Role of Government to Provide Public Goods irww 169

QUESTIONS
(1) Define the following terms:
(a) Market failure. (b) Public goods.
(c) Private goods. (d) Externalities.
(e) Private cost. (0 Social cost.
(g) Private benefit. (h) Social benefit.
(i) Economies of scale. 0) Diseconomies of scale
(k) Information asymmetry. (I) Moral hazard.
(m) Sound finance. (n) Functional finance.
State whether the following statements are true or false:
- (a) Perfect competition always ensures optimum use of resources.
Externalities affect resource allocation and result in less welfare.
(c) Government intervention helps to reduce the impact of market failure.
' [A ns.: (1) False; (2) True; (3) True]
(2) Explain the factors causing market failure.
(3) What are the various ways by which government can avoid market failure?
(4) Write short notes on:
(a) Information asymmetry.
(b) Externalities.
(c) Public goods.
(d) Monopoly power.
(e) Government intervention and market efficiency.
(f) Sound finance vs. functional finance.

DDQ
170 □"Era™ V lp u l ’s™ Business Economics - II (SCF)

14

Fiscal Policy

INTRODUCTION

OBJECTIVES AND INSTRUMENTS

CONTRA CYCLICAL FISCAL POLICY AND

DISCRETIONARY FISCAL POLICY

LIM ITATIONS

QUESTIONS
Fiscal Policy grgn<gr 171

Modem states are termed as welfare states. They perform a

variety of functions to ensure a high level of socio economic
welfare. Development of various sectors of the economy,
improving the standard of living of the people, maintaining a
higher level of employment and income etc. are some of the prime
objectives of modem governments. In short stabilising the
economy at higher levels of output and employment has become
the most important concern of the governments at present. This is
termed as Economic Stabilisation. Before 1930's it was believed
that the invisible hand of the market mechanism would ensure
economic stability and there was no need for the government to
interfere in economic activities. This belief did not work during
the depression of 1930's. Government's intervention was
advocated by J. M. Keynes to bring about a revival in the
economy. Since then economic stabilisation has been targeted by
all governments and to achieve this a number of measures have
been taken.
Macro economic policy guides the governments in attaining
economic stability. The two important instruments of macro
economic policy are:
(1) Monetary policy, and
(2) Fiscal policy.
The main goal of macro economic policy is economic
stabilisation. At the same time there are certain other objectives
also to be achieved in the process of ensuring economic
stabilisation. The main objectives of macro economic policy can
be outlined as follows:
(1) Attaining full employment and ensuring a high level of
output.
(2) Maintaining a stable price level and
(3) Accelerating the rate of economic growth.
Monetary and fiscal policies are used by governments to
achieve these objectives. The operation and effectiveness of the
two policies can be analysed as follows:
 172 nT
“ETEr V ip u l ’s™ Business Economics - II (SCF)

(1) MONETARY POLICY:

Monetary policy is concerned with money supply, credit
creation by banks and rate of interest. It is formulated and
implemented by the Central bank. In India, for e.g. the Reserve
Bank of India is mainly responsible for implementing the
monetary policy. Till the Great Depression of 1930's, this policy
was mainly used to ensure economic stability. By controlling
money supply and credit creation, stability was ensured in the
economy. However, during the 1930's monetary policy was not
effective in brining about a recovery. It lost its predominant
position to fiscal policy. At present a combination of fiscal and
monetary policies is used to achieve the objectives of macro
economic policy.
} . (2) FISCAL POLICY:
Fiscal policy is a powerful instrument in the hands of the
government to achieve a number of socio-economic objectives.
Through fiscal policy the government can influence production,
distribution, consumption and resource allocation. Fiscal policy is
formulated and implemented by the government to achieve
certain pre-determined objectives. Fiscal policy is concerned with
public revenue, public expenditure and public debt. The
government mainly uses the budget policy to bring about
desirable changes in the economy. Through taxation, the
government mobilises resources to meet its ever increasing
expenditure. At the same time taxes reduce private spending.
When the government incurs public expenditure, it leads to more
employment, higher level of output - and income. Along with
taxation and public expenditure, public debt also serves as a
useful weapon to the government to mobilise more resources and
also to bring about economic stability. Thus, through fiscal policy
economic growth and development can be accelerated.
Fiscal policy is pursued by modern governments to achieve
certain objectives. The objectives differ from country to country
depending upon their own economic condition and priorities.
However, the main objectives are:
(1) To achieve optimum allocation of resources.
Fiscal Policy DTDTH 173

(2) To increase effective demand and thereby to achieve full

employment and maintain it.
(3) To ensure price stability.
(4) To bring about greater equality in the distribution of income
and wealth.
To achieve these objectives a number of instruments of fiscal
policy are available to the government. The main instruments can
be analysed as follows:
(1) Taxation: Apart from being the main source of revenue to the
government, taxation is a powerful fiscal weapon in the hand
of the government. Through taxation the government can
influence production, consumption, distribution and
allocation of resources. Governments impose both direct and
indirect taxes. To ensure equity, generally a progressive
system of taxation is followed. Under this system, taxes are
levied on the principle of ability to pay. Hence the rich are
taxed more than the poor. By giving suitable tax incentives
production of mass consumption goods is encouraged.
Consumption of certain goods is encouraged by reducing the
tax rate while the consumption of harmful goods is
discouraged by hiking the tax rate in every budget. Resource
allocation to the various sectors and to the various regions is
also influenced by tax incentives. Economic equality, stability,
accelerating economic growth and employment generation
can be enhanced through taxation.
(2) Public Expenditure: The expenditure incurred by the
government can have a profound influence on various aspects
of the economy. Various types of expenditure are incurred by
the government in the process of discharging its functions.
Some of the major items of expenditure of the government are
administrative expenses, defence expenditure, expenditure
incurred for the development of agriculture, industry,
transport, communication, subsidies to be provided to the
various sectors, interest payments etc. If the public
expenditure is productive, it has favourable effects on the
economy. In the case of advanced countries public
expenditure is incurred during depression to increase
174 !? r i3 r § r v * p u r * ™ Business Economics - II (SCF)

effective demand and thereby to bring about a revival in the

economy. In the case of developing countries, if public
expenditure is used to strengthen social and economic
infrastructure, the productive capacity of the economy can be
enhanced significantly. By spending on social welfare
programmes like education, health facilities sanitation etc.
and also by focussing on social security measures like old age
pension, unemployment allowance etc. the government can
reduce inequalities in the distribution of income and wealth.
By providing subsidies, the production of essential goods can
be encouraged. If the public expenditure is unproductive,
than the economy will suffer from adverse consequences like
inflation, misallocation of resources, shortages, greater
inequality etc. Thus the effects of public expenditure as a
fiscal weapon depends upon the way it is incurred by the
government.
(3) Public Debt: When the expenditure of the government
exceeds its revenue, it resorts to public debt. It is also helpful
to the government to finance a war or to meet unexpected
expenditure due to natural calamities etc. Apart from a source
of revenue to the government, it is also useful to the
government to control inflation. The government borrows
from both internal and external sources. The funds thus
mobilised should be used for productive purposes like
development of infrastructure, industrial sector, agriculture
etc. then such public debt becomes self-financing. The projects
will start yielding income which can be used for repayment.
Thus economic growth can be accelerated through public
debt without additional burden. While depending upon
public debt, the government has to be careful in utilising the
funds. If the funds are used for unproductive purposes, then
the burden of public debt will be very high.
(4) D eficit Financing: Deficit financing is another useful fiscal
weapon for modem governments to achieve their socio­
economic objectives. Deficit financing is resorted by
governments when their expenditure exceeds their revenue. It
refers to borrowing from the Central bank or running down
cash balances of the Central government with the Central
Fiscal Policy n™Ejn,Er 175

bank. Whenever the government borrows from the Central

bank, securities are issued by the government against which
currency notes are issued by the Central bank. The
government can use the funds for exploiting the unused and
underutilised resources. Deficit financing leads to more
money supply. Due to this demand for goods and services
will increase. If adequate supply is not forthcoming, then
there will be inflation in the economy. In the case of advanced
countries, during depression deficit financing is used to bring
about a revival in the economy. In the case of developing
countries like India, if the funds are used for long gestation
projects, then it may prove to be inflationary.
FISCAL POLICY DURING INFLATION AND DEFLATION:
The problems of inflation and depression are addressed by
modem governments through fiscal policy. The budgetary policy
of the government is adjusted in such a way that inflationary and
deflationary tendencies can be controlled. Various instruments of
the fiscal policy namely taxation, public expenditure and public
debt are used by the government to bring about stability in the
economy.
Inflation refers to a situation of a continuous rise in the price
level. It arises due to a variety of factors. Some of them are,
increase in money supply, increase in demand for goods and
services, excessive credit creation, too much of deficit financing
increase in cost of production and due to scarcity of goods and
services. To control inflation, generally government adopts a
surplus budget policy. To have a surplus budget, either taxes are
increased or expenditure of the government is reduced or both are
done at the same time. The policy adopted by the government
during inflation is also termed as contractionary fiscal policy.
Taxation policy is used by the government to control the rise in
prices beyond a safe limit. As long as the inflation is a mild one, it
helps the economy in a positive way. Once it becomes running
inflation, it has serious repercussions for the economy. During the
period of inflation, government uses the progressive system of
taxation. Under this system the rich people are taxed more, while
the poor people are taxed lightly or exempted totally. It is based
176 a^nr VipuVs™ Business Economics - II (SCF)

on the principle of ability to pay. By increasing direct taxes like

income tax, wealth tax etc. the disposable income of the people
can be reduced. This will lead to decline in demand for goods and
services and thereby prices can be stabilised. New taxes which are
anti-inflationary in character like expenditure tax can also be
levied by the government.
Along' with taxation, government can also use public
expenditure to control inflation. Inflationary pressures can be
effectively controlled by reducing unproductive expenditure like
defence expenditure subsidies, administrative expenses etc.
Though it is not easy to reduce public expenditure especially the
popular ones like subsidies, conscious and continued efforts
should be made by the government to reduce unproductive
expenditure.
CONTRA CYCLICAL FISCAL POLICY AND
DISCRETIONARY FISCAL POLICY:
Public finance is interpreted in two ways namely 'sound
finance' and 'functional finance'. Classical economists considered
public finance as sound finance. According to them public
finance's main function was to mobilise resources and enable the
government to discharge its functions. They believed in a free
enterprise system and suggested that the functions of the
government should be restricted to the minimum like defence,
maintaining law and order etc. They advocated a balanced
budget.
The Great Depression of 1930's and Keynesian Economics
shifted the nature of public finance from sound finance to
functional finance. During the depression of 1930's and the second
world war time, public finance had become significant as market
mechanism failed to bring about stability. The government had to
interfere through fiscal operations. All modem governments use
the tools of public finance namely taxation, public expenditure
and public debt to control business fluctuations and also to
achieve growth and development.
In the modem era, tools of public finance are used by
governments to accelerate growth rate, reduce poverty,
unemployment, inequality etc. By adopting a progressive system
Fiscal Policy Sjrgrn' 177

of taxation governments mobilize revenue and at the same time

ensure equity. Public expenditure of all economies - developed or
developing - has been increasing rapidly due to various factors
like rise in population, provision of subsidies, development
projects, rising defence needs, etc. It is used by government to
influence production and consumption. Public debt, again is a
potent fiscal weapon to absorb excess money supply in the
economy and helps to control inflation. All the three tools are used
in combination to face the evil effects of trade cycles. Thus public
finance plays a significant role in the modem times in economic
development.
LIM ITATIONS OF FISCAL POLICY:
Fiscal policy is widely used by modem governments to achieve
the various objectives. Fiscal policy gained its popularity after the
great depression of 1930's. However over a period of time, the
complexities of modem states required a combination of fiscal and
monetary policy and not exclusive dependence on fiscal policy.
This is because fiscal policy has its own limitations. They are:
(1) The objectives of fiscal policy namely full employment and
price stability are conflicting in nature. If the government
aims at full employment it may incur more expenditure
leading to inflation. On the contrary if price stability is
given importance the government may curtail its
expenditure and increase the tax rates to curb demand then
investment, production etc. would be affected and hence
full employment is not possible.
(2) Fiscal policy is used during inflation and deflation. When
these fluctuations occur, there is a time lag to introduce
corrective measures as it cannot be immediately
recognized. In the meantime the problem persists and often
gets aggravated. Even after the fiscal . measures are
introduced to correct inflation or deflation, the impact will
be felt only after some time as there is a time lag here also.
(3) Public authorities should be able to assess the situation
precisely and take corrective measures. Often it is difficult
to estimate the quantum of expenditure required the limits
178 grn-g™ V ip u l ’s Business Economics - II (SCF)

of taxation, subsidies to be given etc. In these circumstances

the effects of fiscal policy cannot be estimated.
(4) Economic situations may warrant the government to adopt
strict measures and ensure fiscal prudence. However
political pressures, fear of losing popular vote banks etc.
may not allow the government to adopt strict measures. For
example, subsidies once given to a particular sector are
difficult to withdraw. Similarly imposing a tax on
agricultural income in India is next to impossible due to
social and political factors. In such cases fiscal policy
becomes ineffective.
The limitations of fiscal policy indicate that it should be
combined with monetary policy to achieve the objectives. Both are
complimentary to each other and not mutually exclusive. During
depression time, deficit budget of the government should be
supplemented by a cheap monetary policy and during inflation a
surplus budget should be adopted along with a dear monetary
policy to bring about economic stability. Thus a combination of
both monetary and fiscal policy is preferable to achieve the
various socio-economic objectives.

CASE STUDY
Just 18,359 (taxpaying) crorepaties in India
Just 18,359 individuals — barely a quarter of the number of
people who visit Select Citywalk Mall in the capital on a Saturday
— reported annual earnings of Rs. 1 crore or higher in 2011-12 and
paid tax on it, according to income tax data released last week by
the Finance Ministry. •
Consumption and spending data for the year, especially of
luxury products, shows how deceptive these numbers may be and
blows holes in the government's official estimate of the number of
taxpayers.
For instance, just four luxury car makers, Audi, BMW,
Mercedes-Benz and Jaguar-Land Rover, reported sales of 25,645
units in 2011-12 of cars having an average price tag of Rs. 40 lakh
each.
Fiscal Policy @"‘grnr 179

That year, in Mumbai, an estimated 1,880 luxury apartment

units in the price range of Rs. 10 crore-Rs. 100 crore were reported
to have come up for sale.
Or that just one luxury product mall, Delhi's DLF Emporio,
reported revenue from operations at Rs. 113 crore and net profit
stood at Rs. 61 crore in 2012-13 (data for 2011-12 was unavailable),
almost entirely from the sale of high-end luxury products such as
watches, bags and apparel.
The government's estimate of 18,359 assesses reported to be
earning Rs. 1 crore or above corresponds to just 0.06 per cent of
the total 28.7 million individual tax assesses, according to data
made public by the government until assessment year 2012-13
(financial year 2011-12).
Considering that there were 814 million people eligible to vote
in the 2014 Lok Sabba election, an academic tax payer-voter ratio
translates into there being just one taxpayer for every 28 voters (if
latest voters data from the 2014 general elections were to be used).
Estimation of wealth in India based on spending data under­
lines the discrepancy.
For instance, a 2013 Kotak Wealth Management and CRISIL
report titled Top of the Pyramid' estimated the number of Indian
ultra-high net worth households — each with a minimum net
worth of Rs. 25 crore — at 81,000 in 2011-12, a growth of 30 per
cent over the previous year.
This number is broadly corroborated by the 20 per cent annual
rate of growth reported in the Indian luxury market, according to
retail consulting firm Technopak's The India Luxury Outlook
2011- 12.
"The number of 18,359 for those reporting income of Rs. 1 crore
plus looks like an understatement because it does not link well
with other data such as the sales of only luxury cars. Similarly,
even if you look at business-class airline travel, or hotel
occupancy, the number of 1 crore-plus income seems to have been
understated 10 times, if not more," said Arvind Singhal, Chairman
of Technopak.
180 faT
”P"'H" V ipul’s Business Economics - II (SCF)

India's luxury market he said, is valued at around $75 billion,

with about $10 billion spending in premium jewellery segment,
around $3-$4 billion in handbags, footwear, apparel, skincare and
around $5-$6 billion in the luxury furniture segment.
Apart from the DLF Emporio in Delhi, there are at least three
other exclusively luxury malls, the Palladium in Mumbai, The
Collection-UB City in Bengaluru and New Bergamo Mall in
Chennai, which cater entirely to luxury brands such as Armani,
Louis Vuitton, Estee Lauder and Versace.
"Clearly these malls would not be operationally viable if the
clientele is limited to just 20,000 people," an executive with
another consulting firm said.
This is further corroborated by a 2012 survey conducted by
MasterCard, which reported that more consumers in India were
planning to buy luxury goods over the next year than in any other
country in the Asia Pacific region, apart from Singapore — where
the per-capita income is more than 10 times higher.
Factfile:
S 18,359 individuals report annual earnings of Rs. 1 crore or
higher in FY '12.
■S 25,645 luxury cars sold in India in FY '12, average price tag of
Rs. 40 lakh.
S 1,880 apartment units in Mumbai up for sale in FY '12 in price
range of Rs. 10-100 cr.
S 81,000 ultra-HNHs reported in FY '12 by Kotak-CRISIL, each
with a net worth of Rs. 25 cr.
Source: Indian Express 3rd May, 2016.
Questions:
(1) The above article indicates the existence of huge black money in
circulation in India. List down the facts from the article which
indicate the same.
(2) The underestimation of crorepatis in India shows the failure of
monetary and fiscal policy to curb black money. Do you agree?
Justify your answer.
(3) Suggest measures to control black money in India.
Fiscal Policy a™Brgr 181

QUESTIONS
(1) D efine th e fo llo w in g :
(a) Inflation. '
(b) Fiscal policy.
(c) Deflation.
(d) Deficit financing.
F ill in th e b la n ks:
(a) Public debt is mobilised during___________.
(b) ___________system of taxation helps to reduce inflation.
- [A ns.: (a) inflation (b) progressive]
S tate w h e th e r th e fo llo w in g s ta te m e n ts are tru e o r fa lse :
(a) During recession government increases its expenditure.
(b) Fiscal policy is formulated by the central bank.
[A ns.: (a) True (b) False]
M atch th e fo llo w in g :________________________________________
(A) (B)
(1) Progressive taxation (a) Fiscal policy
(2) Surplus budget (b) Recession
(3) Repayment of public debt (c) Inflation
(4) Deficit financing (d) Equality
A ns.: (1 - d; 2 - c; 3 - b, 4 - a)
(2) What are the objectives of fiscal policy?
(3) Explain any two instruments of fiscal policy.
(4) Explain how fiscal policy should be used during inflation and deflation.
(5) W rite s h o rt n o te s on:
(a) Fiscal policy.
(b) Limitations of Fiscal Policy.

□□n
182 Ergror V Ip Business Economics - II (SCF)

15

Instruments of Fiscal
Policy-Taxation

TAX REVENUE

NON-TAX REVENUE

CANONS OF TAXATION

TYPES OF TAXES - DIRECT AND INDIRECT

TAX BASE AND RATES OF TAXATION

IMPACT AND INCIDENCE OF TAXATION

FACTORS INFLUENCING INCIDENCE OF TAXATION

ECONOMIC EFFECTS OF TAXATION

FACTORS INFLUENCING INCIDENCE OF TAXATION

QUESTIONS
Instruments of Fiscal Policy-Taxation 183

Modem governments undertake a variety of functions to

accelerate economic growth and promote social welfare. In order
to incur expenditure, revenue has to be mobilised. There are
various sources of revenue to the government. The major ones are:
(1) TAX REVENUE:
This is one of the main sources of public revenue. Tax is
defined as a compulsory payment made by the people of a
country to the government to meet public expenditure without
any direct quid pro quo. This implies that payment of tax is
compulsory and it is collected by the government to incur
expenditure for the benefit of all. Moreover for payment of tax no
individual can demand a proportionate benefit from the
government. The tax proceeds are used by the government for
common benefit rather than individual benefit. Various taxes are
levied by the government. They are classified as direct and
indirect taxes. Direct taxes are those taxes which are paid by the
person on whom it is levied. The burden cannot be shifted. Eg.
Income tax. Indirect taxes are those in which the burden can be
shifted. Eg. Excise duty.
(2) NON-TAX REVENUE:
Apart from tax revenue the government gets revenue from
other sources which are grouped under non-tax revenue. It
consists of fees, fines, special assessments, profits from public
sector enterprises, gifts and grants. They can be briefly explained
as follows:
(1) Fees: Fees are charged by the government for providing
certain specific service to the people. It is paid by those
people who demand the service from the government.
Examples of fees are driving license fee, license to open a
liquor shop, fees paid to get passport, etc. They have to be
paid compulsorily by those who are in need of the service.
(2) Fines: Fines are imposed to maintain law and order. The
objective of levying fines is not to earn revenue but to enforce
discipline. It is not a major source of revenue for the
government.
 184 H'D"!- V ip u l ’*™ Business Economics - II (SCF)

(3) Special Assessment: It is a special levy charged on the people

by the government when they get special benefits due to
certain projects undertaken by the government. According to
Seligman "A special assessment is a compulsory contribution
levied in proportion to the social benefits derived to defray the cost
o f a specific improvement to property undertaken in the public
i n t e r e s t This implies that, due to the construction of roads,
drainage or better street lighting, the value of property in that
area may increase. The people in that area benefit due to the
projects undertaken by the government when the government
levies a tax on the property it is called special assessment. It is
a tax and not a tax at the same time. Like tax it is compulsory.
Unlike tax it confers direct benefit to the people on whom it is
levied. It is also known as betterment levy.
(4) Profits from Public Sector Enterprises: The Central and State
Governments own a number of enterprises. The profit earned
by them is an important source of revenue to the
governments. The profits earned by the public sector units
depends upon the pricing policy of the government. Many
goods and services are sold by the government on a no-profit-
no-loss basis e.g. Postal department. In certain cases the
services provided by the public sector enterprises are
subsidised e.g. water supply, power supply etc. If the public
sector enterprise is a monopoly, prices tend to be high which
lead to more profits.
(5) Gifts and Grants: Gifts are not regular source of public
revenue. During natural calamities, war etc. people contribute
to the government. Grants are provided by the Central
Government to the State Governments. Grants are also
provided by the government of one country to the other and
also by international institutions like IMF and World Bank.
CANONS OF TAXATION:
All modern governments depend upon taxation to mobilise
substantial revenue. While levying taxes the governments are
have to follow certain maxims or rules known as Canons of
Taxation given by Adam Smith. The four main Canons given by
Adam Smith are as follows:
Instruments of Fiscal Policy-Taxation IPITSg"' 185

(1) Canon of equity: It is also termed as Canon of equality. This

canon is based on the principle of ability to pay. According to
this canon taxes should be imposed according to the abilities
of the tax payers. Accordingly the richer people should pay
more while poor should pay less or exempted totally. To
achieve this canon, progressive taxation should be adopted.
(2) Canon of certainty: This canon suggests that the tax which
each individual has to pay should be certain and not
arbitrary. The tax payer should know how much to pay, how
to pay and when to pay. The government should also know
how much it is going to collect from different taxes.
(3) Canon of convenience: Taxes should be levied in such a
manner that it is convenient for the tax payers to pay. In other
words there should not be any hardship for the tax payers for
paying tax. In case of agriculture, taxes should be levied after
the harvest as it is convenient for the farmers to pay it.
(4) Canon of economy: This canon implies that the expenditure
involved in collecting tax should be the minimum. The tax
revenue should be more than the cost of collecting tax. To
ensure economy, the administration should be efficient and
there should not be any scope for tax evasion. Moreover the
canon also suggests that the adverse effects of taxation should
be minimum.
Apart from the above four canons of taxation modem
economists have added the following canons.
(1) Canon of productivity: This canon suggests that the taxes
should be such that they bring adequate revenue to the
government. The taxes should be selected in such a way that
they yield significant revenue to the government.
(2) Canon of elasticity: This implies that the taxes should be
flexible in nature. They should have built in flexibility. It
should be possible to adjust the tax rates according to the
requirements. The canon also suggests that the revenue from
the tax should increase with an increase in national income.
186 □'“□'‘ET VipuVs ™ Business Economics - II (SCF)

(3) Canon of Simplicity: The tax system should be as simple as

possible. The common man should be able to easily
understand the tax laws. This will ensure better compliance.
(4) Canon of diversity: the tax system should consist of a
number of taxes rather than few taxes. There should be a
proper combination of both direct and indirect taxes.
Taxes based on the above canons will ensure equity, efficiency
and productivity.
Direct and Indirect Taxes: A direct tax is one in which the
burden cannot be shifted. It is paid by the person on whom it is
levied. The impact and incidence are on the same person. In other
words, the tax payer and the tax bearer are one and the same.
Examples of direct tax are income tax, wealth tax, corporate tax,
gift tax and capital gains tax. Indirect taxes are those in which the
burden can be shifted. The impact and incidence are on different
persons and tax payer and tax bearer are different. Examples of
indirect taxes are excise duty, customs duty, etc. Indirect taxes are
also called as commodity taxes. Indirect taxes may be specific
duties or advalorem duties or a combination of both. If the tax is
levied on the basis of per unit then it is called specific tax. If the
commodity is taxed according to its value, then it is called
advalorem tax. For e.g. if a tax of Rs. 5 is imposed on commodity
X, then it is termed as specific tax. On the other hand if a 5% tax is
levied on the value of the commodity then it is called advalorem
tax. Sales tax are levied as advalorem taxes, while excise duties
may be specific or a combination of both.
TAX BASE AND RATES OF TAXATION:
Taxes can be proportional, progressive and regressive.
Progressive taxation is one in which the tax rate increases with the
increase in the tax base. If the tax rate remains the same, whatever
be the tax base then it is called as proportional taxation.
Regressive taxation is one in which the tax rate reduces with the
increase in the tax base. It affects the poor people and hence it is
considered as inequitable. The following table explains the above
concepts: •
 Instruments of Fiscal Policy-Taxation 187

Type o f Taxation
Tax Base Progressive Proportional Regressive
(Rs. in
Tax Tax Tax Tax Tax Tax
lakhs)
Rate Amount Rate Amount Rate Amount
(%) (Rs.) (%) (Rs.) (%) (Rs.)
10 10 1,00,000 10 1,00,000 20 2,00,000
20 15 3,00,000 10 2,00,000 15 3,00,000
30 20 6,00,000 10 3,00,000 10
3,00,000
Both direct and indirect taxes are required to have an equitable
and productive tax structure. They are complementary to each
other as demerits of one type of tax is compensated by the merits
of the other. Modern governments are incurring huge public
expenditure. To meet this expenditure, both direct and indirect
taxes have to be relied upon by the government.
Both direct and indirect taxes are levied by modem
governments to mobilise substantial revenue. Each has its own
merits and demerits. They can be listed as follows:
IMPACT AND INCIDENCE OF TAXATION:
4

When taxes are levied by the governments, three concepts are

studied to identify whether the tax burden is shifted or borne by
the person on whom it is levied. They are:
(1) Impact of a tax: It refers to the initial burden of a tax. It is on
the person on whom it is legally levied by the government.
(2) Incidence: Incidence refers to the final burden of a tax. It
cannot be shifted further. It is the ultimate resting place of a
tax.
For example, when commodity taxes are levied, the impact
i.e. initial burden is on the producers. The producers
eventually shift the burden to the consumers. Hence the
incidence is on the consumers. In the case of direct taxes like
income tax, the burden cannot be shifted. Both impact and
incidence are on the same person.
(3) Shifting: It refers to the process of shifting the burden of a
tax. Burden can be shifted through sale and purchase. Price is
the vehicle through which shifting takes place. There are two
188 CiTST V fp w l’s™ Business Economics - II (SCF)

types of shifting namely (a) Forward shifting and (b)

Backward shifting.
(a) Forward shifting: When taxes are levied on producers of
goods, they shift it to the consumers either partly or fully
to the consumers by including the tax amount in the
price of the commodity. This is known as forward
shifting.
(b) Backward shifting: In this case the burden of the tax is
shifted to the factors of production or suppliers of raw
materials, intermediary products by passing them less for
their supply. In the case of factors of production like
labour they will offer less wages. In backward shifting,
price of the commodity will not change and the final
consumers will not have any burden of tax.
Forward and backward shifting may be combined by the
producers at times. A part of the burden will be shifted to the
consumers and the other part of the burden will be shifted to
the factors of production in a combination of the two.
Sometimes there can be a single point shifting i.e. from the
producer to the consumer directly. Shifting can also be a
multiple one when it involves many layers like producer to
wholesaler to retailer and then finally to the consumer.
FACTORS DETERMINING SHIFTING AND INCIDENCE OF
TAXATION:
The burden of tax, whether it is shiftable or not and who
ultimately bears the burden depends upon a number of factors.
The main factors are as follows:
(1) Nature of taxes: Taxes are classified as direct and indirect
taxes. Indirect taxes are on production and sale. The burden
of such taxes can be easily shifted through price changes. The
burden of direct taxes like income tax, wealth tax cannot be
shifted.
(2) Elasticity of Demand: If demand for goods and services are
highly elastic, then it implies that buyers are very sensitive to
change in price. If the tax burden is shifted, then demand will
fall. Therefore the seller will not try to shift the burden or he
Instruments of Fiscal Policy-Taxation H? H H 189

may shift very less tax burden by increasing the price. Thus,
greater the elasticity of demand, the higher will be the burden
on the seller and vice versa if demand is inelastic.
(3) Elasticity of supply: The burden of a tax will be more on the
consumers if the supply is elastic. By adjusting the supply the
seller can influence the price and thereby he can shift the
burden. On the contrary if supply is inelastic, the burden has
to be borne by the seller.
(4) Market structure: Shifting the burden of a tax depends on the
market structure under which the commodity is produced. In
a monopoly market, shifting is relatively easier. The
monopolist has control over the price. Hence the burden can
be easily shifted under monopolistic competition, shifting is
possible due to product differentiation. Under perfect
competition, it is difficult as individual firms are not price
makers but only price takers. It also depends upon elasticity
of demand and supply.
(5) Cost conditions: When firms produce goods, costs may be
increasing or decreasing or remaining constant. When the
firms produce under increasing costs it implies that they are
experiencing diminishing returns to scale. In this case a part
of the burden will be shifted to the consumers. If costs are
decreasing it implies increasing returns to scale. The burden
on the buyers will be more than the tax amount. In the case of
constant costs, the entire burden of the tax will be shifted to
the consumer.
(6) Nature of goods: If the goods are necessities it is easy to shift
the burden as demand is inelastic. In the case of comforts and
luxuries, demand being elastic, shifting is difficult.
(7) Time period: Shifting is difficult during the short run as
supply cannot be adjusted easily and increasing the price is
not easy. In the long run supply becomes elastic and hence it
is easy to shift the burden.
While formulating the tax policy, due importance is given by
the government to shifting and incidence of a tax and also the
190 □'“□'"cr VipuVs™ Business Economics - II (SCF)

factors which influence both to ensure the formulation of a sound

tax policy.
ECONOMIC EFFECTS OF TAXATION:
Taxes are an important source of revenue to the government.
The incidence and shifting of taxes have profound influence on
production, distribution, savings, investment etc. The various
effects of taxation can be analysed as follows:
(1) Effects of taxation on income and wealth: Taxes are
compulsory payments to the government by the people.
When direct taxes like income tax, wealth tax etc. are levied
their net income declines. When indirect taxes are imposed,
they have to pay more. Either way the income of the people is
affected. Elasticity of demand for income is one of the
important factors which will determine the effects of taxation
on income and wealth. If the demand for income is relatively
inelastic, then people will work hard to earn more and they
will also try to save more. Generally people tend to have
relatively inelastic demand for money due to the following
reasons:
(a) desire to have a high standard of living;
(b) need to support a large family;

(c) to maintain a high social status;

(d) to earn a reasonable amount of income and provide for
old age;
(e) to imitate the lifestyle of rich people i.e. influence of
demonstration effect and;
(f) to leave a fortune for their children.
If demand for money is relatively elastic, then imposition
of taxes will affect willingness to work. Hence people may
work less and save less. Wealth accumulation will take place
when demand for money is inelastic, savings are more and
investments are done prudently. If demand for money is
elastic, then wealth accumulation will be affected.
Instruments of Fiscal Policy - Taxation 191

(2) Effects of taxation on consumption: Taxes affect the

consumption level of the people. Direct taxes like income tax
reduce the net income of the people and hence reduce
consumption. Generally poor people are exempted from
direct taxation. If they are taxed then the consumption of
necessities will decline. In the case of the rich people demand
for comforts and luxuries would be affected. Indirect taxes
also affect consumption of goods and services. Indirect taxes
on necessities will affect their consumption. However the
impact of indirect taxes on luxuries and comforts would be
significant as demand is relatively elastic. Taxes on harmful
goods like cigarettes, liquor, etc. are always welcome as a
reduction in consumption will promote the health and
wellbeing of the people.
(3) Effects of taxation on savings and investments: Taxes reduce
the income of the people and thereby affect savings and
investments. Direct taxes like income tax corporate tax etc.
reduce the savings and investments of the rich people and
private enterprises. If the tax rates are very high, it will
severely affect saving and investment. If indirect tax rates are
increased then prices will go up affecting consumption
saving and demand. The reduction of these will result in fall
in investment.
The government takes measures to avoid the adverse
effects of taxation on savings and investments. Exemption
limits, incentives to encourage savings and increase in public
expenditure are adopted by modern governments. For the
productive sectors of the economy, the tax rates are kept at a
reasonable rate or exempted from taxation for some years.
During inflation, the tax rates may be raised to curb
consumption and encourage savings. During recession time,
the tax rates may be lowered to encourage spending and
thereby create an environment for more investments.
(4) Effects of taxation on production: The effects of taxation on
production can be analysed by examining the effects on
(a) ability to work, save and invest and willingness to work,
save and invest and (b) allocation of resources between
 a^ETET V ipu l’s™ Business Economics - II (SCF)

different industries and regions. These effects can be

explained as follows:
(a) Effects of taxes on ability to work, save and invest and
willingness to work:
(i) Ability to work: Ability to work depends upon the
level of consumption and income of the people.
Taxes on income reduce the net income and hence
affect the consumption expenditure. If the poor
people are exempted from taxation, then their ability
to work will not be affected. Similarly if necessities
or mass consumption goods are not taxed and the
luxury goods are taxed then the ability to work of
the masses will not decline as luxuries are demanded
mainly by the rich people. If mass consumption
goods are taxed then the consumption of the poor
people will decline affecting their ability to work.
(ii) Ability to save: Generally savings are done by the
richer section. Ability to save gets affected when
taxes are levied on the income and wealth of the rich
people. Similarly business firms' capacity to save
will also be affected due to the imposition of taxes.
(iii) Ability to invest: When ability to save is affected
due to taxation, ability to invest will also be affected.
Fall in savings of individuals and business firms will
result in a decline in investment. At the same time if
government increases its investment and public
expenditure then employment, income, saving and
investment will rise compensating the fall in private
investment.
(b) Effects of taxation on willingness to work, save and
invest: The effects of taxation on willingness to work,
save and invest depend upon the nature of taxes and the
reaction of the tax payers to those taxes. When taxes are
levied, generally the willingness to work, save and invest
would be affected. People generally feel that their hard
earned money is taken away by the government in the
Instruments of Fiscal Policy-Taxation 193

form of taxes. However it is not necessary that all taxes

will adversely affect the willingness to work, save and
invest. It depends upon the nature of taxes.
(i) If taxes on income and wealth are highly progressive
then willingness to work, save and invest will be
affected. Similar will be the case with corporates, if
the corporate tax rates are steep.
(ii) Taxes on windfall gains like winning a lottery, on
inherited wealth etc. will not affect willingness to
work, save and invest.
(iii) Taxes imposed on monopolists, high import duties
to protect domestic producers and low export duties
will rise the willingness to work, save and invest.
(iv) Similarly if commodity taxes are not very high and
people spend a small percentage of their income on
the taxed goods, then willingness will not be
affected. If the rates are high and people demand
such goods on a large scale, then willingness will be
adversely affected.
The reaction of the tax payers to the taxes imposed
also influences the willingness to work, save and invest.
If people have a strong desire to have a high level of
income, then willingness will not be affected even after
taxation. In other words if demand for income is
relatively inelastic, then willingness will not be affected.
On the contrary if demand for income is elastic, then
people would like to work less to pay less taxes.
Generally people have relatively inelastic income
demand. This is because of the desire to have a good
standard of living, to maintain the social status, to save
enough for future and for children etc. Like individuals
business firms are also affected by taxation. However if
the rates are reasonable then their investment and
production will not be affected.
(c) Allocation of resources: Imposition of taxes lead to
diversion of resources from one industry to the other and
194 a’“a'"Q'" V i p i i l ’s™ Business Economics - II (SCF)

also from one region to the other. Taxation also

influences the composition of output. When goods are
taxed, their prices will rise resulting in a decline in
demand. Hence the producers will shift the resources to
the production of those goods which are exempted from
taxation or which attract law tax rates;. If demand for the
taxed goods is highly elastic then more and more
resources will be transferred to the production of other
goods.
Taxes are imposed on variety of goods. If taxes on
luxuries and harmful goods lead to diversion of
resources to the essential sectors it is beneficial for the
economy. On the contrary if essentials are taxed and
liquor, cigarettes, etc. are taxed lightly, then resources
will move to these products which are harmful for the
people.
When import duties are levied by the government, the
domestic industries especially the infant ones will get
protection. This will lead to diversion of resources to
these industries which will lead to more production. If
the domestic goods are taxed then producers will try to
divert the goods to the export sector if such goods are in
demand. If taxes are levied to protect the inefficient ones,
then the effects will be unfavourable. Taxes levied on
more competitive industries will lead to transfer of
resources to the less competitive ones. If the tax levied on
a monopolist is low, he may produce more and sell more.
Taxes on gold, land and speculative investment may
divert resources to the industrial and service sector
which is beneficial for the economy.
Taxation leads to transfer of resources from one region
to the other. Modem governments give lot of tax
concession is backward region. This will induce transfer
of resources from the well-developed to the backward
regions. Resources always get diverted from high taxed
regions to low taxed regions.
Instruments of Fiscal Policy-Taxation □ ,195

Taxes produce beneficial and adverse effects. Along

with taxes the effects of public expenditure have to be
considered for a proper analysis of effects of taxation.

QUESTIONS
(1) Define the following:
(a) Public revenue.
(b) Tax.
(c) Direct tax.
(d) Indirect tax.
(e) Special assessment.
(f) Progressive system of taxation.
(g) Specific duty.
(h) Regressive system of taxation.
(i) Advalorem duty.
(j) Proportional system of taxation.
(k) Impact.
(I) Incidence.
(m) Shifting.
(n) Forward shifting.
(o) Backward shifting.
Fill in the blanks:
4a) Income tax is an example o f___________ tax.
^ (b) In the caseof indirect tax, the burden can be _
^ (c) Service tax is an example o f___________
(d) Special assessment is also known a s .
[Ans.: (a) direct (b) Shifted (c) indirect tax (d) betterment levy]
State whether the following statements are true or false:
(a) The burden of a direct tax cannot be shifted.
(b) The government of India always has a surplus budget.
' (c) Service tax is an indirect tax.
' (d) Progressive taxation helps to reduce inequality. .
~"(e) Indirect taxes are inequitable.
~ J fii' Direct taxes can be evaded easily.
(g) At present, direct tax revenue is more than indirect tax revenue in
. India.
XW Progressive and regressive system of taxation are one and the same.
[Ans.: (a) True (b) False (c) True (d) True (e) True (f) True (g) True
(h) False]
196 S s H V ip M l’s™ Business Economics- II (SCF)

(2) Examine the various sources of public revenue.

(3) Examine the effects of taxation on production.
(4) Explain the effects of taxation on income and wealth and consumption.
(5) Write short note on:
(a) Canons of taxation
(b) Direct taxes
(c) Indirect taxes
(d) Sources of non-tax revenue
(e) Tax base and rates of taxation
(f) Types of shifting
(9) Factors influencing incidence
(h) Impact, incidence and shifting
 g p g rg r 197
Public Expenditure

16

Public Expenditure

INTRODUCTION
CAUSES FOR THE INCREASING TREND IN PUBLIC
EXPENDITURE
CANONS OF PUBLIC EXPENDITURE

SIGNIFICANCE OF PUBLIC EXPENDITURE

QUESTIONS
 198 grnrig" V ipul’s™ Business Economics - II (SFC)

INTRODUCTION:
Public expenditure refers to the expenditure incurred by the
government to maintain the economy and maintain itself, it is
incurred to satisfy collective social wants. In the nineteenth
century, most of the economies followed the policy of laissez-faire
that is the policy of non-intervention. The role of government was
nominal and hence public expenditure was not given much
importance. However, in the twentieth century the role of state
had changed from that of a police state to that of a welfare state.
Due to this public expenditure has been increasing rapidly in all
modem states.
Public expenditure is an important socio-economic tool in the
hands of the government. It helps the government to achieve a
variety of objectives like promotion of social welfare, control of
depression, accelerating growth and development etc. Public
expenditure in modem times is very much essential to develop
infrastructure, to generate employment and for providing public
services to ensure social equity. It influences the economy in a
number of ways by influencing production and distribution of
goods and services. Public expenditure has increased
tremendously in all countries in recent times. A number of factors
are responsible for this increasing trend. They can be analysed as
follows:

CAUSES FOR THE INCREASING TREND IN PUBLIC

EXPENDITURE:
Public expenditure has increased significantly in all modern
economies. The main causes attributed this increasing trend are
(1) The Concept of Welfare State: The concept of police state
. was replaced by the concept of welfare state in the 20th
century. Modem states are providing various services to the
people to improve general welfare. Public expenditure as a
result continues to increase.
(2) Rapid Growth of Population: In many countries like India
population is growing at a faster rate. For e.g. in India in 1951
the population was 36 crores. By 2001 it has increased to 102
crores. This increase in population necessitates a higher level
Public Expenditure 199

of public expenditure. More expenditure has to be incurred

on education, health services, housing etc.
(3) Rise in National Income and Per Capita Income: Both
national income and per capita income have been increasing
in many countries. Increased income leads to increased
expenditure.
(4) Wagner's Law of Expenditure: Adolf Wagner, a German
economist proposed this law of expenditure. According to
him modem states while performing old functions, undertake
new functions. The state aims at promoting social welfare by
providing education, health facilities, transport,
communication etc. This leads to increase in public
expenditure. This reason given by Wagner came to be known
as Wagner's law of expenditure.
(5) Defence Expenditure: Defence expenditure of all countries
has increased over a period of time. War and threats of war
force the governments to increase their defence expenditure
year after year. The fear of foreign aggression is aggravated
by the possession of nuclear weapons by some countries. This
has made increased defence expenditure a necessary evil.
(6) Inflation: The continuous rise in the price level forces the
government to spend more and more while providing goods
and services to the people. In order to protect the real income
of the people, the government has to provide more
allowances to its employees which increases the expenditure
incurred by the government.
(7) Urbanisation: The urban population is increasing in the case
of developing countries like India. More population in the
urban areas necessitates the provision of various facilities like
transport, communication, housing etc. For all this the
government has to spend more.
(8) Development Projects: Many countries adopt economic
planning to accelerate economic growth under the planning
process, many developmental projects like infrastructural
development, development of basic and heavy industries etc.
 200 VipuVs™ Business Economics - II (SFC)

have been undertaken. These projects generally developed by

the public sector and hence the rise in public expenditure.
(9) Other Reasons: Modern governments incur huge public
debts. Servicing of public debt is of the main reasons for ever-
rising public expenditure in countries like India. Various
types of subsidies are provided by the modem governments
to promote the consumption of certain goods and services
and to help poorer sections of the society. For e.g. food
subsidy, fertilizer subsidy etc. Subsidies, at present constitute
a major item of expenditure of the government. Some
countries like India have a democratic system. Under this
system elections have to be held regularly for the Parliament,
State legislatures, local bodies etc. Election is a costly affair
and it requires a huge administrative machinery. All these
factors add to government expenditure.
CANONS OF PUBLIC EXPENDITURE:
While incurring public expenditure the government should
follow certain fundamental rules or principles which are called as
canons of public expenditure. Some of the important canons are:
(1) Canon of Benefit: According to this canon public
expenditure should always aim at general welfare of the
people. It should not be incurred for the benefit of a particular
section or community.
(2 ) Canon of Economy: This canon suggests that public
expenditure has to be incurred very carefully and
economically. This implies that wasteful public expenditure
should be avoided. It should be incurred productively and
efficiently so that social welfare can be maximised.
(3) Canon of Sanction: This canon implies that public
expenditure should be incurred after getting the prior
permission from the authority concerned. This is required to
ensure proper use of the funds and also to ensure economy.
(4) Canon of Surplus: According to this canon the government
should avoid a deficit budget. The budget of the government
will be an ideal one when the revenue is more than its
Public Expenditure srsT ® ’ 201

expenditure. Hence this canon suggests that there should be

reasonable saving on the part of the government.
Apart from the above four main canons, other canons have also
been suggested by economists. For e.g. canon of elasticity implies
that public expenditure should be flexible to suit the needs of the
economy. Canon of productivity states that public expenditure
should be incurred in such a way that it can promote production
of goods and services and accelerate economic growth. Thus
canons of public expenditure provide the necessary guidelines for
the government.
SIGNIFICANCE OF PUBLIC EXPENDITURE:
Public expenditure is an important component of public
finance. It helps the government to achieve many socio-economic
objectives. It is very valuable for the governments of both
developed and developing countries. Its significance is as follows:
(1) Economic growth and development can be accelerated
through proper resource allocation and utilization.
(2) Infrastructure development can be improved.
(3) Balanced regional development becomes possible.
(4) Poverty reduction, employment generation and reduction
of income inequalities can be targeted.
(5) Promotion of educational and health facilities contribute to
improvement of labour productivity and hence more
production.
The role of public expenditure in developed countries is
different from its role in developing countries. In the case of
developed nations, public expenditure aims at controlling trade
cycles, maintaining stability and full employment. In capitalist
countries like USA, UK etc. governments spend a huge amount on
social security system to promote the welfare of the people. In
developing countries like India the role of public expenditure is to
accelerate economic growth and development. The size of
population is huge in India whereas the resources are limited.
Hence the government has to use the resources optimally. Many
problems like poverty, unemployment, inequality, etc. need to be
202 ErETH™ V ip w l’s™ Business Economics - II (SFC)

addressed. To protect the weaker sections the following measures

are adopted in India:
(1) Social security measures: This includes old age pension,
unemployment allowance and sickness benefits. This
helps the poor to get the basic things in life.
(2) Support to low income group: The low income groups are
supported through the public distribution system,
subsidized housing, health and educational facilities.
Provision of scholarships and free ships, reservation of
seats in educational institutions and government
organisations enable the weaker section to get equal rights.
(3) Social insurance programmes: Various insurance
programmes like Universal Health Insurance Scheme,
Aam Admi Bima Yojana etc. provide insurance cover for
life, accidents, etc. at a low premium or free.
Thus public expenditure through these measures aims at
reducing inequality and achieve various objectives of fiscal policy.

QUESTIONS
(1) Define the following:
(a) Public expenditure.
(b) Revenue expenditure.
(c) Capital expenditure.
(d) Transfer expenditure.
(e) Non-transfer expenditure.
Fill in the blanks:
(a) Public expenditure refers to th e ___________ expenditure.
(b) Revenue expenditure is ___________ in nature.
(c) Expenditure on infrastructure is an example of ______
expenditure.
(d) Old age pension is an example o f___________ expenditure.
[Ans.: (a) government (b) recurring (c) capital (d) transfer]
State whether the following statements are true or false:
(a) Capital expenditure adds to the assets of the country.
(b) War expenditure is productive in nature.
(c) Revenue expenditure should be greater than capital expenditure.
(d) Public expenditure is ever increasing in all countries.
Public Expenditure 203

(e) Expenditure incurred on education is productive in nature.

(f) All modern states are welfare states.
[Ans.: (a) True (b) False (c) False (d) True (e) True (f) True]
Match the following:__________ ~
(A) (B)
(1) Payment of interest (a) Transfer expenditure —
(2) Unemployment allowances (b) Productive expenditure
(3) Expenditure on education (c) Rise in public expenditure ’—
(4) Urbanisation (d) Revenue expenditure -__
Ans.: (1 - d; 2 - a; 3 - b, 4 - c)
(2) Define public expenditure. What are the causes for the rapid growth of
public expenditure?
(3) Explain the different types of public expenditure.
(4) What is the significance of public expenditure?
(5) Write short notes on:
(a) Canons of public expenditure.
(b) Types of public expenditure.
(c) Significance of public expenditure
204 S 'S T i" V ip t t l ’s™ Business Economics - II (SFC)

17

Public Debt

INTRODUCTION

TYPES OF PUBLIC DEBT

PUBLIC DEBT AND FISCAN SOLVENCY

BURDEN OF PUBLIC DEBT

QUESTIONS
Public Debt 205

INTRODUCTION:
Public debt refers to the borrowings of the government when
public expenditure is more than its revenue, the government
resorts to borrowings. Public debt has emerged as an important
instrument of fiscal policy in recent times. The main instruments
of public debt are bonds, securities small savings, treasury bills
and long term capital bonds. Public debt may be from internal
sources or external sources. In modem times public debt is
considered as one of the important sources of resource
mobilisation as it has certain merits namely (1) It is the quickest
method to mobilise funds. (2) It helps to absorb the surplus funds
in the economy during inflation. (3) By using the funds
productively economic growth can be accelerated. The advantages
induce the modem governments to resort to public debt often.
While mobilising funds through public debt the government
should take case to avoid use of it for unproductive purposes and
the governments should be able to maintain a stable rate of
interest. Moreover, public debt involves the repayment of
principal amount and interest. Hence it involves financial burden
and should be kept within limits.
TYPES OF PUBLIC DEBT:
Public debt is of various types. The major ones are as follows:
(1) Internal Debt and External Debt: Public debt which is
mobilised within the country is called internal debt. It is in
terms of the local currency. It is flexible and can be adjusted
according to the requirements of the economy. It can be
voluntary or compulsory. External debt on the other hand
refers to the loans raised from outside sources. It can be from
foreign governments or international institutions. It has to be
paid in terms of foreign currency. Often external loans are
conditional, while internal loans are certain, external loans
are uncertain. Hence it is very difficult to estimate the
precisely. In the case of internal loans there is diversion of
resources from one section to the other while in the case of
external loans, there will be addition to the foreign exchange
resources at the time of borrowing and there will be depletion
206 g~Bj™n” V ip M l’S™ Business Economics - II (SFC)

of resources at the time of repayment as the principal amount

has to be repaid along with interest.
(2 ) Productive and Unproductive Debt: Loans which are
mobilised by the government for productive purposes like
development of industry, agriculture, infrastructure etc. are
called as productive debt. Such projects will yield substantial
revenue to the government and hence repayment of debt will
not be burdensome. Such loans are self financing or self
liquidating in nature. It is not necessary for the government
to levy additional taxes to repay such public debt. Debts
which do not result in the creation of additional assets to the
economy are termed as unproductive debt. For instance loans
raised for the purpose of waging a war or for incurring
regular administrative expenditure are said to be
unproductive. Such loans are not self financing in nature.
Hence additional taxes have to be levied for repayment of
such loans.
(3) Compulsory and Voluntary Debt: Those debts which are
raised by the government through coercion are known as
compulsory debts and those which are voluntarily
contributed by the people are termed as voluntary debt.
(4) Funded and Unfunded Debt: Funded debts consist of
securities which can be marketed in the stock exchange. It is a
long term debt while the payment of interest is certain,
repayment of principal amount is left to the discretion of the
government. In the case of unfunded debt, the loan has to be
paid back along with interest at the time of maturity. It is
short term debt mobilised by the government to meet its
temporary deficit.
(5) Short Term, Medium Term and Long Term Debt: On the
basis of the time period, public debts are classified into short
term, medium term and long term debt. While short term
debts are for a period of less than a year, a medium term
loans are for period of one to five years. Long term debts are
for a longer period of time. While the rate of interest for short
term loan is less, for long term loans it is high. Long term
Public Debt g|,’§l"Dr 207

loans are generally mobilised by the government for

developmental purposes.
(6 ) Redeemable and Irredeemable Debt: On the basis of the
repayment criterion loans are classified as redeemable and
irredeemable. Redeemable loans are those in which date of
repayment is specified. Irredeemable loans are those in which
the date of maturity is not specified. While the government
specifies the payment of interest here, it does not indicate the
repayment of the principal amount. Redeemable loans are
preferable to irredeemable loans as they involve certainty and
conveniences.
PUBLIC DEBT AND FISCAL SOLVENCY:
Modem governments are welfare governments. They perform
a variety of functions to promote general welfare. To discharge
their functions effectively, the government needs substantial
resources. Public debt is one of the important sources for the
government. Over a period of time, public borrowing has
increased considerably. Along with the volume of public
borrowing, servicing of public debt has also increased
significantly. It is necessary for the government to have an
effective public debt management mechanism. The government
should repay its public debt at regular intervals to reduce its
burden. Fiscal solvency refers to the ability of the government to
repay its debt on maturity. If the government is solvent,
repayment of debt is not burdensome. Fiscal solvency enables the
government to mobilise funds easily. Securing loans at low rate of
interest, early redemption, using the loans for productive
purposes so that they become self-liquidating in nature etc. are
sound policies of public debt management. By redeeming public
debt on time, the government can retain the confidence of the
lenders and public which will help the government to tap this
source more effectively in future. The various methods of debt
redemption are as follows:
M ETHODS OF DEBT REDEMPTION:
(1) Refunding: It refers to the method of repaying the old debt
through new loans. Generally, long term securities are issued
208 V tpul’s™ Business Economics - II (SFC)

in the place of short term securities. Simply it implies

extending the date of maturity. This method does not ensure
reduction in the burden of public debt. On the contrary, there
is a possibility of an increase in public debt burden.
(2) Sinking Fund: Creation of a sinking fund is said to be the
most systematic and scientific way of redeeming public debt.
It implies the creation of a fund for repayment of public debt.
Under this method, a part of the current revenue will be set
aside every year and will be accumulated to repay public
debt over a period of time. Once such a fund is created by the
government, it is not necessary to impose new taxes for
redemption of public debt. Sometimes, this fund may be used
by the government to meet emergencies. Modem
governments do not accumulate a certain amount every year
for redemption of public debt. They set aside a part of the
current revenue for repayment of debt in the same year.
Though this method is a slow process of debt redemption,
economists consider this as the best method.
(3) Conversion: This method is adopted by the government at
the time of maturity of a loan or just before maturity. Under
this, the government converts the existing loans into new
loans. It resorts to this method whenever the government
faces the problem of shortage of funds and when the rate of
interest fluctuates. The government might have borrowed at a
time when the interest rates were high. When the interest
rates fall, the government will convert the old loans into new
ones. Such conversion help the government to reduce the
interest burden. In real sense conversion is not redemption. It
is simply exchange of one loan for the other.
(4) Additional Taxation: Modem governments impose
additional taxes to redeem public debt. It imposes an
additional burden on tax payers. Moreover, resources will be
transferred from the tax payers to bond-holders end the
burden on the tax payers may be more.
(5) Surplus Budget: Surplus budget is also used to redeem
public debt. Surplus budget refers to the budget in which the
income of the country is more than its expenditure. To have a
Public Debt 209

surplus budget, government may impose heavy taxes which

involves additional burden on the people. In recent times,
governments rarely have surplus budgets. The ever
increasing public expenditure always results in a deficit
budget. Hence surplus budget is rarely used for debt
redemption.
(6 ) Capital Levy: Capital levy is a very heavy tax on wealth. It is
a one-time tax imposed on capital assets. It can be imposed by
governments in the immediate post war period or during
emergencies. Capital levy is justified by economists on the
following grounds:
(a) Public debt mobilised by the government to finance a
war is unproductive and is said to be a debt weight
burden on the community. It is better to repay it once
and for all by imposing a capital levy.
(b) During war time, generally the economy suffers from
inflation. Capital levy can be used as an effective anti
inflationary weapon. During inflation, the flexible
income group like traders, businessmen, speculators etc.
make huge profits. Hence, tax levied on such group of
people is not unjustified.
(c) Capital levy satisfies the canon of equity. It is based on
the principle of ability to pay. Hence, it can help to
reduce income inequalities.
(d) Savings and capital formation by the richer section will
not be affected by this tax. What they lose in terms of tax,
they may be able to gain as interest as they are generally
the bondholders.
(e) During war time in the immediate post war period,
people are vefy patriotic and ready to sacrifice assets for
the sake of the economy. The government cgn exploit
such sentiments to impose a capital levy and redeem
public debt.
(f) Capital levy is a one time tax. Through this, if the
government redeems unproductive public debt, it will
send the right signal to the public and investors. The fear
210 H™Enf“ V ip ul’s™ Business Economics - II (SFC)

of additional taxation will not be there. A sense of

optimism will arise leading to better investment and
revival of the economy.
Though capital levy has many advantages it has its own
drawbacks.
(1) It may create uncertainty in the capital market which will
affect investment. This may lead to a recessionary
condition.
(2) Flow of foreign capital to the economy may slow down
affecting economic development.
BURDEN OF PUBLIC DEBT:
The term burden of public debt refers to the sacrifice imposed
on the community by imposing a new tax or increasing the
existing rates at the time of repayment. It is classified as direct and
indirect money burden and direct and indirect real burden. Direct
money burden refers to the additional payment made due to the
imposition of tax while the indirect money burden implies the
effects of public debt on production and allocation of resources.
Direct real burden refers to the loss of welfare due to taxation and
indirect real burden refers to the adverse effects of taxation on
willingness to work, save and invest. The burden of public debt is
often debated in terms of whether it is borne by the present
generation or posterity. According to some economists the present
generation bears the burden in terms of reduced consumption as
they forego their present liquidity. Some economists argue that it
is the future generation which bears the burden as they have to
pay additional taxes. It has also been argued by economists that
public debt leads to fall in savings leading to low capital
formation. This will result in less capital stock affecting the future
generation. If the government raises new loans to pay old debts
then the burden is borne by the young and active generation.
The burden of public debt is also discussed with reference to
internal and external debt and also productive and unproductive
public debt. Internal debt is preferable to external debt as there is
no transfer of resources to other countries and internal debts are
not conditional. In the case of external debt at the time of
Public Debt gTBTg' 211

receiving the debt from other countries, there is an addition to the

resources of the economy. But at the time of repayment there will
be a drain on the resources of the economy as the debt has to be
paid back along with interest. If the debt is active, it will result in
the creation of assets and will be self liquidating in nature. Hence
the burden will be less. On the contrary if it is unproductive or
dead weight public debt like war finance then the burden will be
too severe. The time of raising public debt and. its time of
repayment also determines the burden. If the debt is raised during
normal times and the repayment is done when there is inflation in
the economy, then the burden will be high as the value of money
will be less. In conclusion it can be stated that if the public debt is
used for productive purposes then the burden will be less and
vice versa.

QUESTIONS
(1) Define the following:
(a) Public debt.
(b) Productive public debt.
(c) Redeemable public debt.
(d) Funded public debt.
(e) Capital levy.
(f) Unfunded public debt.
(g) Sinking fund.
(h) Fiscal Solvency
Fill in the blanks:
(a) Debt mobilised from external sources is called debt.
(b) Loans in which repayment of principal amount is not fixed is called

(c) is a one-time tax levied for debt redemption.

(d) budaet is used for reDavment of debt.
[Ans.: (a) external (b) irredeemable (c) Capital levy (d) Surplus]
State whether the following statements are true or false:
(a) Productive debts are self-liquidating.
(b) External public debt by and large is conditional.
(c) All public debts are compulsory and burdensome.
(d) Sinking fund creation helps in effective debt repayment.
(e) Public debt is redeemed during inflation.
[Ans.: (a) True (b) True (c) False (d) True (e) False]
212 n’“ETEr VipuVs™ Business Economics - II (SFC)

(2 ) D e f i n e p u b lic d e b t . E x p la in t h e d if fe r e n t t y p e s o f p u b lic d e b t .
(3 ) E x p la in t h e m e t h o d s o f d e b t r e d e m p t io n .
(4) D i s c u s s t h e b u r d e n o f in t e r n a l a n d e x t e r n a l p u b lic d e b t.
(5 ) W r ite s h o r t n o t e s o n :
(a ) In te r n a l a n d e x t e r n a l d e b t .
(b ) B u r d e n o f p u b lic d e b t .

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Union Budget ^TEjrp'" 213

18

Union Budget

MEANING AND OBJECTIVES OF BUDGET

TYPES OF BUDGETS
STRUCTURE OF UNION BUDGET

DEFICIT CONCEPTS

FRBM ACT, 2003

QUESTIONS
214 n™n™ET V ipul’s™ Business Economics - II (SFC)

MEANING OF BUDGET:
The term budget is derived from the French word 'Budgette'
which means a bag or a wallet. It is a statement of the financial
plan of the government. It shows the income and expenditure of
the government during a financial year. It indicates the financial
performance of the government in the preceding year. It consists
of three accounts namely (1 ) revenue earned and expenditure
incurred in the preceding year (2 ) revenue and expenditure
estimated for the current year and (3) anticipated revenue and
proposed expenditure for the next financial year. By analyzing the
budget, resource allocation to the various sectors of the economy
can be known. It indicates the basic character of the fiscal policy
of the government. In short it is the focal point of fiscal policy.
OBJECTIVES OF BUDGET:
Budget preparation is a meaningful and purposeful exercise.
The various objectives are as follows:
(1) The trends in national income and sectorial contributions can
be analysed and measures can be identified to accelerate the
growth process.
(2 ) Resource mobilization and allocation can be done effectively.
(3) Allocation to priority sectors is done through the budget.
(4) Budget enables the government to bring about changes "in
taxation and expenditure according to the needs of the
economy.
(5) Socio-economic problems can be addressed through the
budget.
(6 ) Financial soundness of the economy and financial
management is also indicated by the budget. This helps the
government in formulating other policies.
Thus budget is an annual exercise which gives direction to the
economy to achieve economic development.
STRUCTURE OF UNION BUDGET:
The budget is broadly classified into two parts namely
(1 ) revenue budget and (2 ) capital budget.
Union Budget IT lT i' 215

(1) Revenue Budget:

Revenue budget consists of revenue receipts and revenue
expenditure. Revenue receipts are those items of revenue which
do not involve any corresponding liability or cause any reduction
in the assets of the government. For example, tax revenue is a
revenue receipt. The government has no obligation to repay
anything when taxes are received. Revenue receipts are broadly
classified into two types namely (a) tax revenue and (b) non-tax
revenue.
(a) Tax revenue: One of the important sources of revenue for
the government is the tax revenue. A tax is a compulsory payment
made by the citizens of a country to the government without any
direct quid-pro-quo. It implies that a tax has to be paid by all the
people and it does not involve any corresponding obligation on
the part of the government i.e. the government need not repay
anything. Taxes are broadly classified into direct and indirect
taxes.
A direct tax is one in which the burden cannot be shifted to any
other person. The person on whom the tax is levied has to pay the
tax. Examples of direct tax are income tax, wealth tax, corporate
tax etc. An indirect tax is one in which the burden of the tax can
be shifted to another person. Examples of indirect tax are excise
duty, custom duty, sales tax, etc. Both the taxes are levied by
modem governments to mobilize revenue. While developed
countries get more revenue through direct taxes, developing
countries like India get more revenue through indirect taxes.
(b) Non-tax revenue: Apart from taxes, governments receive
revenue from other sources. They are as follows:
(i) Fees: The government provides variety of services for which
fees have to be paid e.g. fees paid for registration of property,
births, deaths, etc.
(ii) Fines: Fines are imposed by the government for not
following the rules and regulations.
(iii) Profits from public sector enterprises: Many enterprises
are owned and managed by the government. The profits received
from them is an important source of non-tax revenue. For example
216 VipuVs™ Business Economics - II (SFC)

in India, the Indian Railways, Oil and Natural Gas Commission,

Air India, Indian Airlines, etc. are owned by the Government of
India. The profit generated by them is a source of revenue to the
government.
(iv) Gifts and grants: Gifts and grants are received by the
government when there are natural calamities like earthquake,,
floods, famines, etc. Citizens of the country, foreign governments
and international organisations like the UNICEF, UNESCO, etc.
donate during times of natural calamities. .
(v) Special assessment: It is a type of levy imposed by the
government on the people for getting some special benefit. For
example, in a particular locality, if roads are improved, property
prices will rise. The property owners in that locality will benefit
due to the appreciation in the value of property. Therefore the
government imposes a levy on them which is known as special
assessment.
(vi) Escheat: Escheat refers to that property which is not
claimed by anybody. It belongs to the government.
Thus revenue receipts consist of a variety of sources.
(2) Revenue Expenditure: Revenue expenditure refers to that
expenditure which is recurring in nature. It does not create any
asset to the government. Examples are old age pension, salaries to
government employees, interest payments, etc.
(2) Capital Budget:
It consists of (a) capital receipts and (b) capital expenditure.
(a) Capital receipts: Capital receipts are those which involve
an obligation for the government. For example borrowings are
considered as capital receipts. They have to be repaid along with
interest. Sometimes government sells its assets like shares in a
company owned by it. This revenue is also termed as capital
receipt. Thus capital receipts are those which involve an
obligation on the part of the government and those which lead to
a reduction in the assets owned by the government.
(b) Capital expenditure: Capital expenditure refers to all those
items of expenditure which reduce the liability of the government
Union Budget □'“ETBT 217

or those which cause an addition to the assets of the economy.

Examples of capital expenditure are loans given to the state
government, investment on land, machinery, etc.
Any prudent government will try to mobilize more revenue
through revenue receipts and will try to incur more capital
expenditure. This will ensure proper growth and development of
the economy. If any government incurs more revenue expenditure
and mobilizes more income through capital receipts will find it
difficult to sustain economic growth and development.
The components of the budget can be tabulated as given on the
next page:
Public expenditure i.e. expenditure of the government is also
classified as (a) development and (b) non-development
expenditure:
(a) Development expenditure: It refers to the expenditure
incurred on agricultural and industrial development, education,
transport, communication, etc.
(b) Non-development expenditure: It refers to the expenditure
incurred on administration, collection of tax, interest, payments,
etc.
Another way of classifying government expenditure is in terms
of (a) plan expenditure and (b) non-plan expenditure.
(a) Plan expenditure: Plan expenditure refers to developmental
expenditure like investment in transport, communication,
education, etc.
(b) Non-plan expenditure: Those items of expenditure which
are outside the scope of plan expenditure are known as non-plan
expenditure.
TYPES OF BUDGETS:
Budgets are broadly classified into two categories namely
(1) balanced budget and (2) Unbalanced budget.
(1) Balanced Budget:
A budget is said to be balanced when the revenue and
expenditure sides are equal. The classical economists were in
 N)

Merits:
(a) c 00
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It can ensure financial stability.

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Revenue Capital Revenue Capital (13
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Union Budget H^Era™
(b) Unproductive expenditure on the part of the government
would be reduced.
Demerits:
(a) It will not work during depression times.
(b) It is not suitable for less developed countries.
(2) Unbalanced Budget:
The budget in which income and expenditure are not equal to
each other is known as unbalanced budget. It is of two types:
(a) Surplus budget: A surplus budget is one in which revenue
of the government is more than its expenditure. The government
will impose high taxes and will reduce its expenditure if its aim is
a surplus budget. A surplus budget is advocated during inflation
to reduce the prices. The high taxes will reduce the income of the
people and this in turn will reduce the demand for goods and
services thereby bringing down the rise in the price level.
(b) D eficit budget: When the expenditure of the government is
more than its revenue, it is known as deficit budget. Deficit
budget is advocated by economists like J. M. Keynes during a
period of depression. The excess expenditure incurred by the
government will increase the level of employment in the
economy. Due to this, the demand for goods and services will
increase, bringing about a revival in the economy. However, a
deficit budget is not desirable during inflation.
TYPES O F D EFIC ITS:
Deficits in the finances of the government are classified into
four types. They are budgetary deficit, revenue deficit, fiscal
deficit and primary deficit.
(1) Budgetary deficit: The difference between total revenue and
total expenditure of the government is termed as budgetary
deficit. The revenue and expenditure in both revenue and
capital accounts are taken into account here.
(2) Revenue deficit: The difference between revenue receipts
and revenue expenditure is known as revenue deficit.
Revenue deficit has to be controlled effectively and should be
 220 ET'ErET V ipul’s Business Economics - II (SFC)

kept within limits. All efforts should be taken to eliminate

revenue deficit.
(3) Fiscal deficit: It measures the difference between total
expenditure, both revenue and capital and certain items of
revenue of the government. The items included under
revenue are revenue receipts, recovery of loans, grants and
income mobilized through disinvestment. This deficit shows
the extent of indebtedness of the government and the
resource gap.
(4) Primary deficit: It interest payments are deducted from fiscal
deficit, primary deficit can be obtained. Primary deficit is a
non-interest deficit.
The concept of budgetary deficit has lost its importance since
1997. The government discontinued the use of ad-hoc treasury
bills to monetize the budget deficit. Hence from 97-98 the concept
of fiscal deficit has acquired immense significance and is
considered as a key indicator at present.
In the earlier decades the deficits were high and that affected
the growth process. Over a period of time efforts have been taken
by the government to reduce the deficits. The FRBM Act guides
the government in monitoring the deficits and initiate necessary
action.
EMERGENCE OF FISCAL IMBALANCE:
The finances of the Central and State governments were in a
bad shape since 1980's. The revenue deficit which measures the
difference between revenue receipts and revenue expenditure
increased from 1 .1 % of GDP in 75-76 to 3.3% in 90-91. Gross fiscal
deficit increased from 4.1% to 6 .6 %. It measures the indebtedness
of the government. While revenue generation was less,
expenditure continued to rise. This fiscal imbalance resulted in a
serious economic crisis in 90-91.
The expenditure of the Central government especially non­
plan expenditure had increased significantly in the 80's. The main
items which showed significant increase were interest payments,
defence expenditure, loans to states, pensions and subsidies. Of
all the items the most notable one is interest payment. Nearly 70%
Union Budget a '“$ n g r 221

of the tax revenue in 2002 was used for interest payment. This also
has resulted in increased revenue deficit. If the borrowings of the
government were used for productive purposes, they would have
been self-liquidating in nature. In reality it is not so. Moreover
loans were raised by the government not at concessional rates but
at market rates. Hence debt servicing became costlier. Another
major item of expenditure was subsidies. The government
provided huge amount of subsidies on food, fertilizer and
petroleum products. While non-plan expenditure increased,
planned expenditure which is required to stimulate growth
started declining. This further aggravated the fiscal crisis.
During the 80's efforts were made by the government to rise
revenue from various sources. However, expenditure continued
to be higher than revenue. PSUs did not generate the expected
revenue. Some of them depended upon the government for
financial assistance. Direct tax revenue and non-tax revenue
sources did not show significant increase over a period of time.
The financial position of the State governments in the 80's was
equally alarming. Many State PSUs were incurring losses. They
could not get adequate resources from the Central government
also. The gross fiscal deficit of States as a % of GDP increased to
3.16 in 89-90.
Due to the mismatch between receipts and expenditure the
Indian economy was almost on the verge of a debt trap in 90-91.
Lack of resources forced the government to cut its capital
expenditure especially on infrastructure which affected economic
growth. The higher demand for funds pushed up the interest rate
which made the economy a high cost one. The government
mobilised substantial funds from the banking sector through high
CRR and SLR. This forced them to fix their lending rates at a
higher level. Excessive dependence of the government on the
funds of the financial sector prevented the government from
introducing reforms in the financial sector which again slowed
down economic growth.
The government took corrective measures from 1991.
Successive budgets in the 90's aimed at mobilising more tax
revenue through rationalisation and simplification of tax
 222 g-g-jg™ Vipul's™ Business Economics - II (SFC)

structure. PSUs have been exposed to competition to improve

efficiency. Disinvestment of PSUs has also been considered as an
option to mobilise more resources. Efforts were made to reduce
expenditure. The various ministries and departments were
advised to cut down unproductive expenditure and reduce
overstaffing. Reforms were introduced in the financial sector,
industrial sector and foreign trade to make them more
competitive and efficient. All these measures enabled the
government to reduce revenue deficit and fiscal deficit by 96-97.
However in the subsequent years both showed an increasing
trend. Revenue deficit as a % of GDP was 2.4% in 1996-97. It
increased to 3% in 1997-98, 3.8% in 1998-99 and in 1999-00 it
declined marginally to 3.5%. However, in 2000-01 it increased to
4.1% and in 2001-02 further increased to 4.4%. The fiscal deficit
showed an increased trend from 1996-97 to 2001-02. It was 4.1 in
1996-97 and by 2001-02 increased to 6.2%. On the whole fiscal
consolidation, an important element in the reform process
remained an unfinished task.
FISCAL RESPONSIBILITY AND BUDGET MANAGEMENT
(FRBM) ACT, 2003:
The Fiscal Responsibility and Budget Management Bill was
introduced in the Lok Sabha in December 2000. The aim of the bill
was to restore fiscal discipline at the level of the central
government. The fiscal situation was under severe pressure
during the 80's. The finances of both central and state
governments were in a very bad shape. While revenue generation
was less than the expected level, expenditure increased at an
unprecedented level. This led to enormous debt accumulation and
huge interest payments. Low returns from public sector units and
huge amount of subsidies given by the government aggravated
the problem of fiscal imbalance. All these factors resulted in low
economic growth. The FRBM bill attempted to fix responsibility
on the government and induce it to adopt a prudent fiscal policy.
The enactment of the FRBM (Act) in August 2003 and FRBM
Rules 2004 marked a turning point in the Fiscal policies of the
government. The Budget presentation process has been
streamlined by the FRBM Act 2003. The government revealed its
Union Budget ETfsrnr 223

commitment to a prudent fiscal policy by notifying the Act and

the Rules with effect from July 5,2004.
O B JE C T IV E S O F F R B M A C T 200 3 :
The main objectives of this Act are given below:
(1 ) To ensure transparency in the fiscal operations of the
government.
(2) To reduce fiscal and revenue deficits and follow a prudent
fiscal policy.
(3 ) To control public debt and reduce the burden of public debt
on future generations and achieve better debt management.
(4) To ensure long term macroeconomic stability by making the
government accountable for its fiscal operations.
F E A T U R E S O F F R B M A C T 2 0 0 3 A N D F R B M R U L E S 2004:

The main features are as follows:

(1) E lim in a tio n o f d e ficits:
♦ The focus of the act is to eliminate revenue deficit and
reduce, fiscal deficit and build up adequate revenue
surplus.
(2) R ev e n u e d eficit:
♦ Revenue deficit has to be reduced by 0.5% or more of the
GDP at the end of each financial year beginning from
2004-05.
♦ By March 2009, revenue deficit should become nil.
♦ A surplus has to be generated in the revenue account to
be used for discharging liabilities.
(3) F isca l D e ficit:
♦ Gross fiscal deficit should be reduced by 0.3% or more of
GDP at the end of each financial year beginning from
2004-05.
♦ The gross fiscal deficit should be brought down to 3% of
the GDP by March 2008.
 224 g-g-g™ V ipu l’s™ Business Economics - II (SFC)

(4) Guarantees:
♦ Guarantees given for any project should not exceed one-
half percent of the estimated GDP in any financial year
starting from 2004-05.
(5) M id -te rm fiscal p o licy sta te m e n t:

♦ Four fiscal indicators namely revenue deficit as a

percentage of GDP, fiscal deficit as a percentage of GDP,
tax revenue as a percentage of GDP and total outstanding
liabilities of the government as a percentage of GDP
should be projected by the government in its medium
term fiscal policy statement.
(6) D e v ia tio n s:

♦ Revenue deficit and gross fiscal deficit can deviate from

the limits only when there are natural calamities,
problems for national security, etc. Only exceptional
grounds should be considered for deviations.
(7) B o rro w in g s fro m C en tra l G o v e rn m e n t:

♦ The central government shall not borrow from RBI. Ways

and means advances can be used to meet temporary
deficits.
(8) T ra n s p a re n c y :

♦ Greater transparency will be ensured in the fiscal

operations of the government.
(9) Q u a rte rly R e v ie w s:

♦ The trends in revenue and expenditure will be reviewed

every quarter and outcome of such reviews will be placed
before the parliament. The Finance Minister must make a
statement if there are deviation from the targets and also
specify the remedial measures.
(10) A d d itio n a l lia b ilitie s:

♦ According to this Act, the additional liabilities of the

government should not exceed 9% of the GDP in 2004-05.
This limit should be reduced by one percentage point of
the GDP in each subsequent year.
Union Budget nT
“gT
"(5™ 225

CRITICAL EVALUATION OF THE ACT:

The FRBM Act attempts to ensure fiscal discipline on the part
of the government. While the bill has certain positive aspects,
economists have pointed out the following limitations.
(1) The state governments are left out of its scope though they
are also required to pursue fiscal discipline.
(2) Bringing down the revenue deficit to zero in a period of five
years has also been questioned. Revenue deficit is high due to
interest payments, subsidies etc. To reduce revenue deficit
government may cut down its expenditure on social sectors
and this will affect a larger section of our population. The
target of zero revenue deficit has not been achieved by 2008­
09. Instead of declining, it increased from 4.4% of GDP in
2008-09 to 5.1% in 2009-10. According to critics, the targets set
by the act are unrealistic.
(3) If fiscal deficit has to be reduced as per the limits of the bill,
government may have to reduce its capital expenditure and
this will have serious effect on the development process.
Private investments would be adversely affected.
(4) There is no time bound programme for the development of
infrastructure and human resource development in this bill.
(5 ) The bill gives more emphasis on cutting down public
expenditure. No concrete suggestions have been given for
raising tax-GDP ratio by improving tax administration and
collection. The revenue side has been ignored by this bill.
(6 ) It is based on various assumptions like lower fiscal deficit
lead to higher growth, large fiscal deficit lead to inflations,
etc. Economists have rejected these assumptions and
according to them if the deficit is due to productive capital
expenditure, higher growth rate is possible.
(7) According to Dr. Raja Chelliah while revenue deficit should
be phased out the fiscal deficit should be pegged at 6 % of
GDP and according to him fixing fiscal deficit at 2% of GDP is
not desirable from the point of view of productive
investment.
 226 V ipul’s™ Business Economics - II (SFC)

(8 ) To reduce fiscal deficit, government has a tendency to cut

down its expenditure on education, health, family welfare,
etc. All these are essential for human development.
Neglecting them will involve a huge social cost.
(9) This act has been opposed by many from the point of equity.
According to them to achieve the targets, the direct and
indirect subsidies given to the poor may be reduced making
them further poorer. Inequality is bound to get aggregated.
(10) While the government may reduce essential subsidies to
control the deficits, the unproductive subsidies may not be
reduced due to political pressure and the influence of vested
interests. This will result in wasteful resource allocation.
(11) The FRBM Act deals only with the budgetary operations of
the government. The government provides financial
assistance and subsidies to the enterprises and institutions
owned by it. Such support is not reflected in the budget of the
government. Such hidden support and subsidies given by the
government are called Quasi-deficits. FRBM Act is not
concerned with these deficits. This exclusion limits the
efficacy of this Act.
The FRBM act became operational from July 2004 and as per
the notification, the government had to place a quarterly review
before the parliament. In December 2004, the mid-year review for
2004-05 was presented by the government. The review indicated
that the fiscal performance of the government was not according
to the targets fixed by the FRBM act. While the benchmark for
revenue deficit is 45% in the FRBM act, the revenue deficit stood
at 78.7% of the budget estimate. It was mainly due to shortfall in
tax revenue. Fiscal deficit in the first half of 2004-05 was 38.7% of
budget estimate, which was within the 40% target fixed bv the
FRBM act. 7

The government has constituted a Task Force under the

chairmanship of Dr. Vijay Kelkar to make recommendations to
the government to achieve the FRBM targets. It submitted a report
to the government wherein it outlined measures to increase
revenue, reduce revenue expenditure and accelerate capital
Union Budget groTEr 227

expenditure to induce growth. Some of the suggestions are (1)

Removal of exemptions to widen the tax base (2) Reducing the
number of slabs and lowering the tax rate to increase the tax
revenue
(3) Making the compliance system more effective and efficient
(4) Rationalisation of custom duties and excise duties.
(5) Empowering local bodies through transfer of resources etc.
According to the Task Force, by strictly adhering to the
provisions of the Act, by implementing the suggestions the
government can bring about the much needed fiscal discipline
and fiscal consolidation.
To ensure fiscal consolidation, the government introduced
various measures like rationalizing the tax structure reduction of
exemptions, inducing better tax compliance through innovative
methods, increasing the productivity of public expenditure etc.
Considerable progress has been made in fiscal consolidation in
the post FRBM period. According to the Economic Survey 2007-
OS, fiscal deficit has declined from 6.2% of GDP in 2001-02 to 3.4%
in 2006-07. The revenue deficit has also shown a downward trend
from 4.4% in 2001-02 to 1.9% of GDP in 2006-07.
The financial position of the state governments too showed
improvement in recent times. 26 states passed the fiscal
responsibility legislations. The enactment of this legislation and a
strong support given by the central government in terms of
incentive-based fiscal transfers ensure the success of fiscal reforms
introduced by the central and state governments.
The financial meltdown in 2008-09 in USA and its impact on
the various economies affected the implementation of the FRBM
Act by the government. To revive the economy from the crisis and
the recession that followed the government of India has to inject a
huge fiscal stimulus. From that time onwards, meeting the targets
of FRBM Act has become a major challenge for the government.
With all the constraints, economists point out the targets can be
achieved by ensuring the required fiscal discipline and rational
allocation and utilization of resources.
 228 @™irs" V ipul’s™ Business Economics - II (SFC)

QUESTIONS
(1) Define the following:
(a) Revenue budget.
(b) Capital budget.
(c) Balanced budget.
(d) Unbalanced budget.
(e) Revenue deficit.
(f) Fiscal deficit.
(g) Primary deficit.
Fill in the blanks:
(a) The difference between revenue receipts and revenue expenditure is
known a s ___________deficit.
(b) The Union Budget is usually presented by th e____________ minister.
(c) When the revenue is more than the expenditure the budget is said to
be a ___________budget.
(d) ----------------- deficit shows the extent of indebtedness of the
government.
[A ns.: (a) Revenue (b) Finance (c) Surplus (d) Fiscal]
State whether the following statements are true or false:
The government of India always has a surplus budget.
(b) Primary deficit is the difference between fiscal deficit and interest
payments.
[A ns.: (a) False (b) True]
(2) Examine the structure of Union budget.
(3) Explain the various types of deficits.
(4) Discuss the various components of budget and deficits with reference to
India.
(5) Identify the extent of deficits in the Union Budget 2016-17 and 2017-18
Explain the factors which led to the changes in the deficits.
(6) Write short note on:
(a) Types of budget.
(b) Types of deficits.
(c) Various Components of budget.
(d) Objectives of budget.
Theories of International Trade □'"OTEr 229

M ODULE - IV:
Open Economy: Theory and Issues
of International Trade

19

Theories of
International Trade

RICARDO'S THEORY OF COMPARATIVE COST

ADVANTAGE

HECKSCHER-OHLIN THEORY OF INTERNATIONAL

TRADE

QUESTIONS
 230 sSESr. n!K£r ssar V ipul’s™ Business Economics - II (SFC)

RICARDO'S THEORY OF COMPARATIVE COST

ADVANTAGE:
The comparative cost advantage theory of international trade
was propounded by the famous classical economist David
Ricardo. According to Ricardo countries will specialise in the
production of those goods in which they have a cost advantage,
produce a surplus and export it to other countries. They will
import those goods in which they have a cost disadvantage.
Before Ricardo, Adam Smith the father of economics attributed
international trade to absolute cost differences. However,
according to Ricardo comparative costs advantage is the main
reason for the emergence of international trade.
This theory is based on the labour theory of value. The labour
theory of value states that the value of anything depends upon the
amount of labour used for producing it. The comparative cost
advantage theory is based on the following assumptions:
(1) Labour is the only factor of production and it is assumed to
be a homogeneous factor.
(2 ) The cost of production of all commodities are measured in
terms of labour cost.
(3) Production function in both the countries are assumed to be
linear and homogeneous.
(4) Labour is perfectly mobile within the country but immobile
between countries.
(5) The economy is a laissez-faire economy i.e. there is no
government intervention.
(6 ) Production is subject to constant returns to scale.
(7) Free trade exists which implies absence of tariffs, quotas, etc.
(8 ) Perfect competition prevails in both countries.
(9) Transport costs are ignored.
(1 0 ) There is full employment in both the countries.
Ricardo explained the theory by using two country-two
commodity and one factor of production model. Let us suppose
two countries Portugal and England and two commodities wine
Theories of International Trade WWW 231

and cloth. The number of labour hours to produce one unit of

both the goods in both the countries can be given as follows:
C o u n tries N o. o f h o u rs re q u ired to C om p arativ e D o m e stic
p ro d u ce on e u n it o f C ost R atio E xch an ge R ate

W in e C lo th

P ortu gal 80 0.66 < 0.9 1W =0.88C

90
England 120 100 1.1 < 1 .5 1W =1.20C

From the table it is quite clear that Portugal has absolute

advantage in producing both the goods and England has
disadvantage in producing both. Still Portugal has comparatively
greater advantage in producing wine rather than cloth. Hence it
will specialise in the production of wine which requires only 80
labour hours compared to 90 labour hours for cloth. Hence it will
produce wine on a large quantity and export it in exchange of
cloth from England. England on the other hand has less
comparative disadvantage in producing cloth rather than wine.
Hence it will specialise in the production of cloth and exchange it
with Portugal for wine.
The cost ratios of producing the goods in both the countries
can be calculated to show the advantages of trade. The cost of
ratio of producing wine is 80/120, which is better compared to
cost of ratio of producing cloth which is 90/100. That is 0.66 < 0.9
in Portugal. In the case of England the cost ratio works out to be
better for cloth compared to cost ratio of wine which is 100/90 <
120/80 i.e. 1.1. < 1.5. Thus it is beneficial for Portugal to produce
wine and England to specialise in cloth.
When the two countries do not have trade relations, then both
goods will be produced by each country and one good will be
exchanged for the other. This is known as domestic exchange rate.
From the above example if we calculate domestic exchange rate
for England then it is 1 unit of wine = 1.2. units of cloth. In the
case of Portugal it is 1 unit of wine = 0.88 units of cloth. When
trade takes place between the two countries the exchange ratio for
one unit of wine will range between 1 . 2 units of cloth to 0 . 8 8 units
of cloth. Portugal would like to get more than. 0.88 units of cloth
from England for every unit of wine it exchanges. On the other
 232 snrsr V ipul’s™ Business Economics - II (SFC)

hand England would like to give less than 1 . 2 units of cloth for
every unit of wine it imports from Portugal. Let us assume the
exchange ratio is 1 unit of wine = 1 unit of cloth. Then both the
countries will benefit. Portugal will get 0.12 extra units of cloth
while England will give 0.2 units less of cloth for every unit of
wine from Portugal.
When countries specialise like this the production of both the
goods will be more. In the absence of trade, Portugal will produce
1 unit of wine and 1 unit of cloth by using 170 labour hours (80 +

90). England will use 220 labour hours (120 + 100) to produce the
same. The total production in this case is 2 units of wine and 2
units of cloth. Suppose there is specialisation Portugal will use 170
hours to produce wine only. Therefore wine production will be
170/80 = 2.1 units of wine. In the case of England 220 labour
hours will be used to produce cloth only. Hence production will
be 220/100 = 2.2 units of cloth. Thus specialisation leads to a
larger volume of output.
The following table shows the level of production before and
after trade and indicates the increase in production due to
specialisation.
Before Trade
No. of hours required to produce 1 unit and output produced
Wine Cloth
Countries
Hours Output Hours Output
Portugal 80 IW 90 1C
England 120 IW 100 1C
Total Output 2W
. 2C
After Trade
Total no. of labour hours available, no. of hours required to
_________produce 1 unit and total output produced
Wine Cloth
Countries
Hours Output Hours Output
Portugal 170
170
80 =2A - -
Theories of International Trade n r g T”n T" 233

220
England - - 220 ----- - 2 2
100

Total Output 2.1W 2.2C

Thus according to this theory, the differences in comparative

cost advantage leads to international trade.
Critical Evaluation:
The Ricardian theory of international trade is considered as a
significant improvement over Adam Sm ith's theory. Later
theories have evolved on the basis of this theory. At the same
time, Ricardo's theory has been criticised on the following
grounds:
(1) The theory is based on two-country, two commodity and one
factor model. It is restrictive in nature.
(2) It is based on the labour theory of value which is based on
many unrealistic assumptions. Hence it is also an unrealistic
theory.
(3) Assumptions of full employment, perfect mobility of factors
within the country etc. are not tenable.
(4) Only one factor of production namely labour is considered.
Other factors are ignored. Hence it is not comprehensive.
(5) It is a partial theory as it ignores the demand side giving too
much emphasis to supply side.
(6 ) It does not explain the actual determination of the exchange
rate.
(7) Many unrealistic assumptions like constant returns to scale
homogeneous production function etc. are not practical.
(8 ) The theory does not explain the differences for comparative
cost advantage. It gives only immediate reason but not the
ultimate reason for international trade.
(9 ) It is based on partial equilibrium analysis while the modern
theory is based on general equilibrium analysis.
(10) This theory is said to be a static theory as it is based on
unrealistic assumptions like constant returns to scale, same
technology, etc. The modem world is a dynamic world where
things change constantly due to technological changes.
234 ET-m^a™ V fp w l’s™ Business Economics - II (SFC)

(1 1 ) This theory is not suitable for developing countries like India

where assumptions like perfect competition, full employment
etc. are not possible.
Despite all the limitations, the Ricardian theory is widely
accepted as the basic theory of international trade. All other
developments are based on this theory.
HECKSCHER-OHLIN THEORY OF INTERNATIONAL
TRADE: * J> A P .
The mode Dry of international trade given by Heckscher-
Ohlin explains the reasons for the emergence of international
trade. The classical economists attributed the cost differences as
the main reason for the emergence of international trade.
However they did not explain the reason for cost differences. The
modem theory addresses this issue. It is also known as factor-
endowment theory or general equilibrium theory or factor
proportions theory. This theory does not refute the classical
theory but supplements it. Hence it is said that the modem theory
begins where the comparative cost theory ends.
According to the modem theory the immediate cause for
international trade is comparative cost difference. The difference
in cost arises due to two reasons mainly:
(1 ) Different countries have different factor endowments.
(2) Factor proportions used for producing commodities are
different in different countries.
To explain the theory, the following assumptions are made
(1) The theory assumes a two-country, two-commodity and
two factors model.
(2 ) One country is endowed with abundance of labour and
the other with capital.
(3) There is free trade.
(4) Full employment exists in both countries.
(5) Perfect competition exists in both product and factor
markets.
Theories of International Trade STW Sr 235

(6 ) Factors of production are perfectly mobile within the

country but immobile between countries.
(7) Factors of production are homogenous in both the
countries. Hence production functions will be linear and
homogenous.
(8 ) There are no transport costs.
(9) Factor intensity is different for different goods.
(10) Factor intensity for a particular commodity will be the
same in both the countries. For example, if good 'A' is
capital intensive in one country, it will be the same in the
other country.
According to Heckscher-Ohlin countries will specialise in the
production of those commodities which uses the abundant factor.
This implies that a capital rich country will specialise in capital
intensive goods and export it while a labour abundant country
will produce labour intensive goods and exports same. This is
because the abundant factor is available at a cheaper rate and
enables the country to gain from international trade. The theory's
main arguments are:
(1) International trade arises due to differences in commodity
prices.
(2) Commodity prices are different because factor prices are
different.
(3) Factor prices tend to differ due to differences in factor
endowments.
The modem theory is explained in terms of 'Factor
Abundance' and 'Factor Intensity'.
Factor Abundance:
According to Heckscher and Ohlin differences in factor
endowments give rise to international trade. Some countries have
more labour while some others may have more capital. In some
countries, natural resources like minerals, forests, etc. may be
abundant. Factor abundance can be explained in terms of physical
criterion and price criterion.
 VipuVs™ Business Economics - II (SFC)
236 WWW
Physical Criterion: Let us suppose two countries country 1 and
2. Country 1 is capital abundant while country 2 is labour
abundant. The physical criterion is expressed as follows:
Ki Kz
Li > L2
Here Ki refers to capital and Li refers to labour in country 1
and K2 refers to capital and L2 refers to labour in country 2. It
implies the relative abundance of capital in country 1 and relative
abundance of labour in country 2. According to the physical
criterion, country 1 will specialise in capital intensive goods and
export the same, while country 2 will produce labour intensive
goods and exchange it with the other country.
In physical criterion, the ratio of capital to labour of one
country is compared with that of the other country and not the
Ki K2 .
absolute quantity of labour and capital. Thus ^ ^ implies
country 1 is capital abundant in relation to country 2 while
country 2 is labour abundant compared to country 1. Physical
criterion can be explained with the help of the following diagram:

Fig. 19.1
Theories of International Trade □''ETDr 237

In the above diagram PQ is the production possibility curve of

country 1 and RS is the production possibility curve of country 2.
AB and CD are the respective price lines of country 1 and 2.
Equilibrium is attained at points E and E' where the price lines are
tangent to the respective production possibility curves (PPCs).
The PPCs differ from each other due to differences in factor
endowments. In the above figure PQ is the PPC of country 1. It is
more inclined towards Y axis indicating it is a capital abundant
country. In the case of country 2 PPC is more inclined towards X
axis indicating abundance of labour. Thus country 1 will
specialise in capital intensive good and country 2 will specialise in
labour intensive good and this specialization will lead to
international trade.
Equilibrium is attained at points E and E'. The above figure
indicates that country 1 can produce good Y at a cheaper rate by
using the abundant factor capital. It can produce OP quantity of
Y, PR quantity more than country 2. On the other hand country 2
can produce OS quantity of good X, SQ quantity more than that of
country 1. Thus according to Heckscher and Ohlin, differences in
factor endowments lead to differences in factor prices and
product prices and this gives rise to international trade.
Price Criterion: Under this version, the prices of the two
factors of production are considered. Here also a two country two
commodity and two factor model is considered. The price
criterion of factor abundance is expressed as follows:
PKi PK2
PLi < PL2
Here PKi and PLi refer to price of capital and labour in country
1 and PK 2 and PL 2 refer to the price of capital and labour in
country 2. The price criterion implies that capital is relatively
cheaper in country 1 compared to country 2. Therefore country 1
will export capital intensive good while country 2 will export
labour intensive good.
Factory Intensity: In the modem theory of international trade,
differences in factor endowments lead to international trade.
238 nrH™p" Viput »s™ Business Economics - II (SFC)

Along with this, differences in factor proportions or factor

intensity are also responsible for giving rise to international trade.
Factor intensity shows the number of units of capital required
for one unit of labour to produce a commodity. Alternatively, it
also means the number of labour units required for one unit of
capital required to produce a commodity. In factor intensity, the
factor ratios are considered and not the absolute quantity of
factors to determine if the commodity is labour intensive or
capital intensive. This can be explained with the help of the
following example.
K
Commodity Capital Labour ^ Ratio

10
A 10 10
10 ~1
15
B 15 2 0
20 ~ 0-75

Here, ^ ratio for commodity A is higher than that of B.

Though for commodity B more of capital and labour is used, j -

ratio is less than that of A. Therefore, commodity A is capital
intensive while B is labour intensive.
Under factor intensity, the ratio of the two factors is considered
rather than their absolute quantity. According to Heckscher-
Ohlin, differences in factor proportions or factor intensities along
with different factor endowments give rise to international trade.
Factor Price Equalisation:^
According to the modem theory, international trade will
continue to take place till the factor prices are different in different
countries. Trade will cease to grow when factor prices are
equalised. International trade tends to equalise factor prices if
there are no tariffs, quotas, transport costs and if there is free
trade.
Let us consider 2 countries USA and China. USA is capital
abundant while China is labour abundant. Initially capital will be
Theories of International Trade g rg p g r 239

cheaper while labour will be expensive in USA. USA will

specialise in capital intensive goods. Hence demand for capital
will be more and its price will start rising. At the same time,
demand for labour will be less leading to a fall in wages. In China
labour will be cheaper while capital will be expensive.
Specialisation of labour intensive goods by China will lead to a
rise in demand for labour pushing up the wage rate. At the same
time import of capital goods from USA will reduce the demand
for capital in China resulting in a fall in the price of capital.
Hence, other things being equal, free trade will equalise the prices
of factors of production. The modern theory is therefore also
known as factor price equalisation theory.
Factor prices, however in reality do not get equalised as it is
not possible to realise all the assumptions and there are many
constraints to free trade.
Thus the modem theory emphasises on the differences in
factor endowments as the ultimate reason for the emergence of
international trade.
Criticisms of Heckscher-Ohlin Theory:
The following criticisms have been levelled against the
Heckscher-Ohlin theory:
(1) This theory is based on two countries, two commodities
and two factors of production model. In reality there are
multiple commodities, other factors and many countries.
Hence it is a restrictive model.
(2) Like Ricardian theory, this theory is also based on
unrealistic assumptions like perfect competition, free trade
etc.
(3) It is a static theory as it is based on constancy of
technology and constant scale of production which do not
exist in reality.
(4) It is a one sided theory as it considers the supply side and
ignores the demand side.
(5) Other factors of production like land, natural resources
which are required for production are not considered.
240 ETSSTD”
SS: SB JW V ip u l ’*™ Business Economics - II (SFC)

(6 ) According to Heckscher and Ohlin, factor prices determine

commodity prices. However, according to critics factor
prices depend upon commodity prices as demand for
factors is a derived demand depending on the demand for
final goods.
(7) An American economist by name W. E. Leontief verified
the theory in USA and his findings were contrary to the
theory. According to W. W. Leontief, USA, a capital
abundant country instead of exporting capital intensive
goods imports capital intensive goods and exports labour
intensive goods which is contrary to Heckscher-Ohlin
theory. This observation came to be known as 'Leontief
Paradox'.
Inspite of the above limitations, the Heckscher-Ohlin theory
occupies a significant place in the theory of international trade. It
is said to be superior to the classical theory on the following
grounds:
(1) According to Heckscher and Ohlin, there is no need for a
separate theory of international trade as it is nothing but
an extension of interregional trade At the most it can be
considered as a special case of internal trade.
(2 ) The modem theory has integrated commodity and factor
markets and has given a general equilibrium approach.
(3) The modem theory clearly explains that the differences in
factor endowments lead to differences in factor prices. The
differences in factor process and differences in factor
proportions lead to comparative cost advantage. This
explanation is widely accepted as the reason for the
emergence of international trade.
(4) The comparative cost advantage theory states that trade
would continue as long as there differences in the
efficiency of labour in the two countries. Once the
differences cease, there is no scope for international trade.
Heckscher-Ohiln on the other hand argues that
international trade can never cease as the differences in
factor endowments and factor prices will continue to exist.
Theories of International Trade 241

The modern theory on account of its superiority has secured

immense significance in international trade theories.

QUESTIONS
(1) Define the following:
(a) Domestic exchange rate.
(b) Terms of trade.
Fill in the blanks:
(a) The comDarative cost advantaae theorv was aiven bv
(b) Accordina to modern theorv. differences in
ultimate reason for international trade.
is the

(c) The Factor Endowment Theorv was developed bv .

[A ns.: (a) David Ricardo (b) factor endowments (c) Heckscher-Ohlin]
State whether the following statements are true or false:
Comparative cost advantage theory has no limitations.
Modern theory of international trade assumes a two country, two
commodity and two factors of production model.
--(c) Modem theory begins where the Ricardian theory ends.
Modern theory rejects the Ricardian theory of international trade.
(e) Modern theory of international trade rejects the comparative cost
theory completely.
Factor abundance and factor intensity are responsible for
international trade according to modern theory.
[A ns.: (a) False (b) True (c) True (d) False (e) False (f) True]
(2) Discuss the comparative cost advantage theory of David Ricardo.
(3) Explain in detail the modem theory of international trade.
(4) Compare the modern theory with the comparative cost advantage theory.
(5) Write short note on:
(a) Limitations of the comparative cost advantage theory.
(b) Criticisms of the modern theory of international trade.

□ □ □
viwh. yi»yi »tpw.
242 ETErn™ Vipul's™ Business Economics - II (SFC)

20

Terms of Trade and Gains

from Trade

TERM S OF TRADE

GAINS FROM TRADE

GAINS FROM TRADE WITH OFFER CURVES

FACTORS DETERMINING TERM S OF TRADE

QUESTIONS
 Terms of Trade and Gains from Trade ir s " ,s r 243

TE&MS OF TRADE:
' Meaning and Types:
Terms of trade is an important concept in international trade. It
is very useful to determine the gains from international trade. It
refers to ratio at which a country's export^ are exchanged for
imports. It is also defined as the ratio of export price to import
price. The various types of terms of trade are as follows:
jjS Gross Barter Terms of Trade (GBTT): It refers to the ratio
dr physical quantity of imports to physical quantity of exports. It
is expressed as:

Here, Qm = volume /quantity of imports

Qx = volume/quantity of exports
A rise in GBTT implies more quantity of imports for a given
quantity of exports indicating a favourable change for the
importing country.
J2)<Net Barter Terms of Trade (NBTT): NBTT is also known as
commodity terms of trade. It is expressed as the ratio of export
price to import price. It is denoted as:
Px
NBTT = 5 -
1m
Where, Px refers to price of exports
Pm refers to price of imports
An increase in this terms of trade implies that more imports
can be obtained for a certain amount of exports based on price
relations and vice versa.
(3) Income terms of trade: A nation's capacity to import is
indicated by income terms of trade. It is expressed as:
Px x Qx
244 E rE T g '” V lp w l’s™ Business Economics - II (SFC)

Px '
= NBTT x Qx. (— = net barter terms of trade).
1 m

When T improves, it indicates that the country can import

more for exports. Here, T indicates the capacity of the country to
imports based on export capacity alone and not on the total
capacity to import. The total capacity to import depends on many
factors like flow of foreign capital, remittances, etc.
J&) Single factoral terms of trade: Net barter terms of trade
was modified by Jacob Viner to include productivity. Single
factoral terms of trade refers to net barter terms of trade adjusted
to changes in productivity of factors of production in the export
industries. Symbolically it is expressed as:
Single factoral TOT = N x Zx where N refers to net barter terms
of trade and Zx refers to productivity index in the export
industries.
45) Double factoral terms of trade: Double factoral terms of
trade considers changes in productivity in both export and import
industries. It is expressed as:
, Zx ,
Double factoral TOT = N x ^ where Zmrefers to productivity
index in the import industries.
Real cost terms of trade: Here, terms of trade is measured
in ierms of utility and this concept was given by Jacob Viner.
According to him, exports deprive availability of resources to the
domestic country. Hence, it involves disutility. Imports on the
other hand add utility. Both have to be compared to find out the
gains from trade. This terms of trade is expressed as:
Real Cost TOT = N x Fx x Rx
Where,
N refers to net barter terms of trade
Fx refers to index of productivity in exports industries
Rx refers to index of disutility in exports industries
Jf7) Utility terms of trade: This concept is an improvement over
real cost terms of trade. Here, the relative utility of imports is
Terms of Trade and Gains from Trade gT
“E rn '“ 245

compared with the utility of the commodities which could have

been produced with the resources which are used for exports at
present. It is denoted as:
Utility terms of trade = N x Fx x Rx x Um
Where, Um refers to the index of relative utility of imports
compared to goods that can be produced by using resources
which are diverted for production of exports now.
Thus, various types of terms of trade are used to measure gains
from international trade.
GAJNS FROM TRADE: ^ g# C 50 . ^
"^International trade leads to various gains for the participating
countries. The notable gains are:
jl) Comparative cost advantage: (According to the comparative
cost advantage theory of David Ricardo, a country will
specialise in the production of a commodity which has a
comparative cost advantage^ It will produce a surplus and
export it to the other country. It will import that commodity
which if produced at home has a cost disadvantage. Hence,
international trade enables countries to specialise in a product
and exchange it with the other country. It is a win-win
situation for both the countries.
( ? f Specialisation:jjntem ational trade encourages specialisation
which leads to production on a large scale. Hence, economies
of scale can be derived and this helps to reduce co stan d jark e
and compete effectively
(3V Optimum use^oT'resources: Resources are put to optimum
use under international trade. Every country specialises in
that product in which there is a cost advantage. To get the
cost advantage resources are used optimally.
Benefits to consumers: Consumers are able to get variety of
goods at reasonable rates due to international trade. Real
consumption increases due to the availability of goods.
Increase in production, employment and national income:
International trade enables countries to produce on a large
scale. This offers ample employment opportunities to people.
 246 E T E rg ,u V ip ul’s™ Business Economics - II (SFC)

Hence, there is expansion of economic activities leading to

higher national income and maximisation of social welfare.
(&' Availability of goods and services: Goods and services
which cannot be produced internally can be produced from
outside. The question of non-availability of goods does not
arise once foreign trade takes place.
Conservation of scarce resources: When certain resources of
a country are scarce, the goods which need these resources
can be imported and the scarce resources can be preserved.
(8 ) Promotion of inter-dependence and co-operation: Under
international trade, relations between countries improve and
this ensures better cooperation amongst the trading partners.
In the present globalised era, this has become very important
factor for the smooth conduct of foreign trade.
GAINS FROM TRADE WITH OFFER CURVES:
International trade confers many gains. How the gains are
distributed among the trading partners is a major issue. It is often
believed that advanced countries get a larger share of the gains
from trade compared to under developed and developing
countries. Many factors determine the distribution of gains from
international trade. The most important factor is the terms of
trade. Terms of trade refers to the rate at which a country's
exports are exchanged for imports. If the terms of trade is closer to
the domestic exchange ratio of a country, gains will be lesser for
that country, while it will be more for the other country. Let us,
take the example given in the comparative cost advantage theory
given by David Ricardo. It is a two country - two commodity and
one factor of production model. The model can be"explained with ~
theTielp of the following table:
No. of hours of labour required
Countries to produce 1 unit of Domestic exchange ratio
Wine Cloth
Portugal 80 90 1 W = 0.88 C
England 120 100 1 W = 1.20 C
Terms of Trade and Gains from Trade g “E r E r 247

Domestic exchange ratio is the ratio at which goods are

exchanged within the country in the absence of external trade. If
the terms of trade at which trade takes place is closer to the
domestic ratio of Portugal, gains will be more for England and
vice versa. Suppose, the international exchange ratio is 1 unit of
wine = 0.7 unit of cloth, then it is closer to the domestic exchange
ratio of Portugal. For Portugal, the benefit is less whereas for
England, the benefit is more as it will get 1 unit of wine by giving
only 0.7 unit of cloth rather than the domestic exchange ratio of 1
W = 1.2 C. On the contrary, if the international exchange ratio
moves closer to the domestic exchange ratio of England, Portugal
will benefit more than that of England. Thus, terms of trade is a
major factor influencing the distribution of gains from trade. Offer
curves are used to explain the distribution of gains from
international trade. This can be explained with the help of the
following diagram:

Fig. 20.1

Offer curves represent reciprocal demand. Reciprocal demand

refers to the strength and elasticity of demand of one country for
the commodity of the other country. The exchange of goods take
place according to terms of trade. Reciprocal demand is one of the
important factors in determining the gains from trade.
248 □ i“ia,“E r VipuVit™ Business Economics - II (SFC)

An offer curve indicates the various quantities of exports of a

country in exchange for the various quantities of imports from the
other country at different price ratios of exports and imports.
In the above diagram, OA is the offer curve of USA and OC is
the offer curve of China. The two offer curves intersect at point E,
which is the equilibrium point. International terms of trade is
determined at this point. USA offers OM of commodity X to get
ME of commodity Y from China or China offers EM of Y to get
OM of X from USA.
In the absence of international trade, USA and China have to
produce and exchange the two goods within the country. The rate
at which the two goods are exchanged within the country is called
domestic exchange rate. The line OQ shows the domestic
exchange rate for USA and line OP shows the domestic exchange
rate for China. Within the country USA has to offer OM of X to get
MS of Y. When trade takes place between USA and China, for OM
unit of X, USA will get EM unit of Y. Thus, USA gets more of Y
than what it gets within the country. Its gain is equal to ES units
of Y. In the case of China, within the country, it has to offer RM
units of Y to get OM units of X. After trade takes place, China has
to offer less i.e., it has to give ME of Y to get OM of X. Thus, it is
able to save RE units of Y. Thus, international trade helps both the
countries to gain.
Thus, gains from international trade depends upon terms of
trade and reciprocal demand. Other factors like cost ratio, stage of
development of an economy and its income also influence gains
from trade. In the modern times, technological revolutions play a
significant role in enhancing the gains from international trade.
FACTORS DETERMINING TERM S OF TRADE:
Terms of trade are influenced by a variety of factors.They are
(1) Size of population: If the population of a country is huge and
it has the resources and need to import, then its imports will
be more leading to adverse terms of trade.
(2) Size of the country: If one of the trading partners is a small
country and produces a commodity required by a big
Terms of Trade and Gains from Trade o rg r^ r 249

country, then terms of trade will be favourable to the small

country.
(3) Demand and supply: Demand for a product of a country and
its capacity to produce determines terms of trade. If the
demand from another country is high and the supply can be
managed, then terms of trade will be favourable.
(4) Elasticity of demand and supply: If the goods demanded by
the people of India from USA is inelastic then India will have
unfavourable terms of trade and vice versa. Similarly if
supply is inelastic then terms of trade will be unfavourable.
(5) Nature of exports and imports: When a country exports
agricultural goods and imports manufactured goods then
terms of trade will be unfavourable and vice versa.
(6 ) Nature of goods: If mass consumption goods are exported
then terms of trade will be favourable.On the contrary if
goods consumed by a small section is exported then exports
will be less and terms of trade will be unfavourable.
(7) Exchange rate: If the value of a currency in terms of another
currency increases, then terms of trade will be favourable and
vice versa.
(8 ) Trade policy: If the policy of protectionism is followed by a
government, tariffs and quotas will be imposed to ]3 rqtect ih^
domestic producers. If the other country retaliates/ then
exports will be affected leading to unfavourable terms of

(9 ) ______ try has to make unilateral

payments to another country, then demand for the other
country's currency will be more leading to unfavourable
terms of trade.
(10) Tastes and preferences: When people of a country like
imported items and they prefer imports over domestic goods
then the importing country will experience unfavourable
terms of trade.
250 n™n™Q™ V ipu l’s™ Business Economics - II (SFC)

QUESTIONS
(1) Define the following:
(a) Gross barter terms of trade.
(b) Net barter terms of trade.
(c) Income terms of trade.
(d) Single factoral terms of trade.
(e) Double factoral terms of trade.
(f) Real cost terms of trade.
(g) Utility terms of trade.
(h) Offer curve.
(i) Gains from trade.
Fill in the blanks:
(a) ___________ is the ratio of export price to import price.
(b) Offer curves represent______________ demand.
[A ns.: (a) Net barter terms o f trade (b) reciprocal]
State whether the following statements are true or false:
(a) Income terms of trade indicates a country’s capacity to import.
(b) Terms of trade influences the distribution of gains from international
trade.
[A ns.: (a) True (b) True]
(2) Define terms of trade. Explain the various types of terms of trade.
(3) Explain the various gains from international trade.
(4) Discuss the gains from international trade with the help of offer curves.
(5) Define terms of trade. What factors determine it?
(6) Write short note on:
(a) Types of terms of trade.
(b) Gains from trade.
(c) Factors determining terms of trade.
Free Trade v/s Protection gpgrET 251

21

Free Trade v/s Protection

INTRODUCTION

POLICY OF FREE TRADE

PROTECTIONISM

QUESTIONS
 252 jg“ErEr V ip u l ’s™ Business Economics - II (SFC)

INTRODUCTION:
Trade policy refers to the policy of the government regarding
export and import of goods and services and flow of capital. It
consists of the rules and regulations to be followed while
indulging in external trade. It also indicates tax laws, subsidies,
incentives offered and restrictions imposed by the government.
Trade policy gives a direction to the foreign trade sector.
Trade policy is mainly classified into two namely: (1) Free
Trade Policy and (2) Policy of Protectionism. Each policy has its
own merits and demerits.
POLICY OF FREE TRADE:
As the name suggests free trade policy is one in which there
are no restrictions on trade. Restrictions are in terms of tariffs,
quotas, exchange controls, etc. Various arguments have been
proposed for the policy of free trade. Some of them are:
Arguments in favour of free trade:
(1) Free trade ensures comparative cost advantage for the
countries involved. Each country would specialise in that
commodity in which it has a cost advantage, produce a
surplus and export it. It will import the commodity which
involves a higher cost if produced domestically. Thus, it is a
win-win situation for both the countries.
(2) Optimum utilisation of resources is possible due to free trade.
(3) Due to specialisation, countries would be able to produce on
a large scale and get economies of scale. This will result in
low cost of production.
(4) Competition will increase resulting in improved efficiency.
(5) Consumers will benefit significantly in terms of availability of
variety of goods and services, better quality goods and
reasonable prices.
(6) Growth of monopolies and exploitation by them are not
possible under free trade.
(7) As there are no tariffs, quotas, etc. there is no scope for
corruption and red tape.
' . \rr"l3'-y
Free Trade v/s Protection 1? 0 |5j 253

While free trade offer these benefits, many economists are very
critical of it and argue in favour of protectionism. These
arguments also indicateJhe disadvantages of free.t.rfldg-_
PR O T EC T IO N ISM :
Protectionism involves the use of tariffs, quotas, exchange
control and other instruments to direct foreign trade. All these are
used to protect the domestic industry from competition. The main
arguments in favour of protection are as follows:
Arguments in favour of protectionism:
(1) New industries termed as infant industries by the economist
Frederick List, require protection initially to grow and
compete with the established ones. According to him "nurse
the baby, protect the child and free the adult."
(2) To improve terms of trade, protectionism can be used.
(3) Developing countries like India, need this policy to improve
their balance of payments situation. By imposing tariffs and
quotas, imports can be controlled.
(4) To protect the domestic industries from the practice of
Humping by foreign countries, protectionism is useful. Under
dumping, foreign countries sell goods at a lower price in the
other country while selling the same goods at a higher price
in the domestic market.
This practice ruins the industries of the importing country.
By imposing anti-dumping duties, protection can be provided
to the domestic industries.
(5) Every country requires a well diversified industrial sector to
avoid risks and to ensure stability. For diversification, policy
of protectionism is necessary.
(6) To generate employment, domestic industries need to be
encouraged and protected against competition. Import
substituting industries can be given protection which lead to
employment generation.
(7) Strategic industries like defence need the support of
protectionist policy. It is not advisable to depend on the other
 254 S V ipul’s™ Business Economics - II (SFC)

countries for defence requirements. These industries require

protection due to strategic reasons.
(8) Other arguments like expansion of the domestic market,
maintaining the high wages of labour against cheap labour of
the other country etc. are also put forth by economists in
favour of protection.
The policy has been vehemently criticised by economists. The
arguments against it are as follows: D ' ’
(1) It encourages the growth of domestic monopolies. ^ ? 0 -fo u_
(2) Problems like corruption, red tapism and bureaucracy are
rampant. —"
(3) Domestic industries become inefficient and produce sub­
standard products.
(4) Consumers are deprived of choice and quality goods at
reasonable prices.
(5) Optimum use of resources is not possible.
(6) Due to retaliation by countries, world trade will shrink in
size.
Thus, policy of free trade and protectionism has theirimvn
merits and demerits. At present, under the WTO regime, all
member nations of WTO are trying to liberalise trade through
negotiations and consensus. IP C ^ fO i rfio q jL - C

c .Jw CASE STUDIE

CASE STUDY 1:
Better nutrition and better schools will help alleviate
poverty, but there is another target that promises to be even
more effective: lowering barriers to international trade.
The most important, over-arching problem facing the world is
poverty, which still afflicts billions of people. Poverty is the
ultimate source of many other problems. The immediate result is
high rates of infant mortality, as well as poor cognitive skills and
reduced productive capacity among surviving children. The
ultimate result is a cycle of poverty.
Free Trade v/s Protection P"WW 255

Better nutrition and better schools will help alleviate poverty,

but there is another target that promises to be even more effective:
lowering barriers to international trade. The historical evidence on
this point is compelling. In China, South Korea, India, Chile and
many other countries, reducing trade restrictions has lifted
incomes and reduced poverty, and triggered decades of rapid
income growth.
Poverty reduction was the first item in UN's list of Millennium
Development Goals, and the numerical target was achieved.
Why? Income growth in China was a big part of the story. And
how did the Chinese achieve that remarkable feat? Most evidence
suggests that international trade was a key ingredient. Trade
produces immediate benefits by opening up markets, but it also
facilitates the flow of ideas and technologies, producing even
greater benefits over a longer horizon. A successful Doha free
trade agreement could lift 160 million people out of extreme
poverty.
Source: The Times of India dated 24th April, 2015.

Questions:
(1) What are the advantages of removing barriers to trade?
(2) Analyse the pros and cons of removing trade barriers.
Explain with reference to the Indian Economy.
CASE STUDY 2:
Visa Walls W ill Hurt US Firms More
In early April, the US Citizenship and Immigration Services
announced that the agency received more than 236,000 petitions
for H-1B visas during the annual filing period. This means, that
once again the demand for high-skilled temporary foreign
workers in the US is nearly three times higher than the 85,000 cap
on H-1B visas mandated by the US Congress. The fact, that
demand for visas continues to be so high despite the reinstated
and increased visa fees unfairly imposed by Congress in
December 2015 certainly proves that a shortage of information
technology specialists in the US persists.
 256 srisrw VipuVs™ Business Economics - II (SFC)

In fact, the shortage is getting worse as businesses and other

organisations across all sectors of the American economy seek
digital strategies to gain efficiencies, improve customer service
and open new markets. According to US government data, there
could be 2.4-million unfilled STEM (science, technology ,
engineering, maths-related) jobs in the US by 2018, with more
than half of these vacancies in computer and IT-related s k i l l s
So why do certain US "experts" and the journalists who follow
them continue to claim that employees of India's IT sector
operating in the US are stealing jobs from Americans? In part,
such claims reflect an election year climate in the US, when
complicated issues are boiled down to simplistic slogans to attract
votes. But they also reflect myths that we at Nasscom are working
hard to correct.
One such myth is the mistaken notion that American workers
are losing jobs to less than fully qualified foreign workers on
temporary visas and are required to "train" these workers before
departing. In reality, the IT professionals coming to the US from
India on temporary H-1B visas are well educated and highly
trained in technical knowledge.
Another myth is that temporary high-skilled workers earn far
less than their American counterparts. This has been disproven by
credible US institutions such as the Brookings Institution, whose
studies have found that H-1B visa holders are paid salaries
comparable to or even higher than American workers with
bachelor's degrees.
Also a myth is the notion that building a virtual wall of policies
and even higher costs to keep Indian IT companies from
operating, investing and recruiting in the US would somehow
benefit the job prospects and quality of life of Americans Most
certainly the opposite is true. If American businesses cannot
obtain skilled IT support in the US, they will have no choice but to
curtail operations and cut jobs, or to move operations to overseas
locations.

Besides making their US customers more efficient and

competitive, Nasscom member companies also invest nearly $1
Free Trade v/s Protection g? s |l 257

billion annually in the US, support the employment of more than

411,000 Americans and pay $6 billion in federal, state and local
taxes a year.
Yet another "idea" that seems to be growing in this US election
year is that foreign trade hurts Americans. Certainly the opposite
is true when it comes to India, which the World Bank expects to
overtake China in real GDP growth this year. A long-standing US
trade deficit with India is beginning to turn around, based on 2015
data. When increased US defence sales to India are added to the
equation, that deficit is further reduced. US military sales to India
have increased dramatically along with remarkable strides in
military cooperation since the New Framework for Defence
Cooperation in 2005.
Rather than building walls, we should remove impediments to
strategic collaboration, trade, and the free exchange of intellectual
talent. A strong commercial and strategic partnership between
India and the US is in the interests of both of our nations. Unfairly
focusing blame on India's IT sector is not.
Source: Article by R. Chandrashekar, President - Nasscom,
The Times of India dated 5th May, 2016.

Questions:
(1) Do H-1B Visa restrictions indicate protectionism? If so, what
for?
(2) What are the benefits of free flow of skilled labour and capital
for both the trading partners.
(3) List down myths of competition from Indian labour to
American labour.

QUESTIONS
(1) Define the following:
(a) T r a d e P o lic y
(b) F r e e T r a d e
(c) P r o t e c t io n i s m
Fill in the blanks:
(a) F r e e t r a d e e n c o u r a g e s
258 QrErEn VipuVs™ Business Economics - II (SFC)

(b) At present, free trade is encouraged b y _________.

(c) E c o n o m i s t ____________ a r g u e d in fa v o u r o f p r o t e c t i o n i s m
(d) _________benefit more under free trade
[Ans.: (a) Competition (b) WTO (c) Fredrick List (d) Consumers]
State whether the following statements are true or false:
(a) Protectionism is adopted only by developing countries.
(b) Tariffs and quotas are popular tools under protectionism.
(c) Terms of trade can be improved through protectionism.
(d) Infant industries need free trade to flourish.
[Ans.: (a) False (b) True (c) True (d) False]
(2) What are the arguments for and against free trade?
(3) Explain the pros and cons of protectionism.
(4) Differentiate between free trade and protectionism
(5) At present WTO promotes free trade. Is it good for developing countries'?
Explain.
(6) Analyse whether free trade is good for India.
(7) Write Short notes on:
(a) Arguments in favour of free trade.
(b) D is a d v a n ta g e s o f p ro te c tio n is m

□ □ H
VWUL W Ul VIWl
Foreign Direct Investment STff’S ” 259

22

Foreign Investment

FOREIGN DIRECT INVESTM ENT AND FOREIGN

PORTFOLIO INVESTMENT:

DISTINCTION BETWEEN PORTFOLIO INVESTM ENT AND

FOREIGN DIRECT INVESTM ENT

ROLE OF MNCS

QUESTIONS
 260 nr'ETH’ VipuVs™ Business Economics - II (SFC)

FOREIGN DIRECT INVESTM ENT AND FOREIGN

PORTFOLIO INVESTMENT: .’ ^ ..... ?
Foreign capital plays an important role in the development of
the economy especially that of developing economies. Countries
like India are in need of huge amount of capital to accelerate the
growth process. Foreign capital flows both from private as well as
government sources. The role of foreign capital in a developing
country like India can be enumerated as follows:
(1) Foreign capital promotes capital formation by supplementing
domestic capital.
(2) It enables to import technical know how, capital goods etc. to
accelerate economic growth.
(3) Adverse balance of payment can be corrected with the help of
foreign capital.
(4) Industrial development can be achieved with the aid of
foreign capital.
(5) Foreign capital also helps modernization of the various
sectors of the economy.
Foreign capital is broadly classified as loans, aid, grants
foreign direct investment and portfolio investments. Foreign'
capital is mobilized through official and non-official sources.
Loans from foreign governments and financial institutions take
the form of foreign aid. Foreign aid is a concessional loan given to
developing countries by the developed ones and international
institutions like IMF, World Bank etc. The rate of interest for such
loan is less than that of the market rate and the term of the loan is
longer. Such loans are sanctioned to the government by and large,
n rare cases they are also given to private parties. Sometimes a
part of foreign aid is given as grants which are not refundable and
are non-interest bearing.
Foreign capital in the form of loans is also mobilized through
commercial borrowings from the international capital market.
Here the rate of interest is market related and the term is also
shorter Public sector undertakings, private companies and
mutual funds mobilize such capital.
Foreign Direct Investment WW W 261

Equity capital is another route through which foreign capital

flows into a country. There is no obligation to repay the capital as
well as interest payments. The investments made in the shares of
new companies as well as old companies is , known as equity
capital or portfolio investment. Portfolio investments are short
term investments. They are made mainly to make profits. They
are highly volatile and unreliable., j ^ r
Another form of foreign capital is foreign direct investment,
popularly called as FDI, Under FDI, funds are used for the
establishment of factories and companies which act as
subsidiaries to the parent company. They establish production
facilities and there by add to the capital resources of the economy.
Further through FDI, foreign companies transfer their technology,
marketing strategies, management practices and environmental
protection methods to the domestic economy. They employ local
labour, export goods and provide substantial tax revenue to the
government. Such capital investments are made with long term
interests and they are far more dependable than that of portfolio
investment.
The distinction between portfolio investment and foreign
direct investment can be summarized as follows:________________
Portfolio investment FDI

(1) It refers to the flow of (1) It refers to the flow of

foreign capital in the form foreign capital for the
of equity capital. establishment of
production facilities.

(2) The main consideration is (2) Here the motive is to make

short term profits. long term profits.

(3) This type of capital js j ; 0 ^ (3) This type of capital is

highly volatileJ-unstable / relatively stable.
and hence risky. '
(4) It does not involve transfer (4) It involves transfer of
of technology, managerial technology, managerial and
practices, etc. organisational practices,
etc.
 262 E rm ar V ipul’s™ Business Economics - II (SFC)

(5) The main benefit is the flow (5) It confers a no. of benefits
of capital to the primary like employment
and secondary markets. opportunities, technical
know-how, export
promotion, etc.
(6) It is very risky and hence (6) Preference for FDI is more
less preferred. due to the variety of
benefits.
Due to the various advantages, foreign capital has acquired
immense significance in recent times in developing countries like
India. The flow of capital in terms of foreign equity capital and
FDI have been increasing due to liberalization and globalisation.
Moreover developing countries offer good opportunities for
investments and a good rate of return. Developing countries are
able to undertake a number of development projects with the help
of foreign capital.
While attracting foreign capital certain safeguards have to be
provided to minimise the risk and harmful effects. Foreign loans
are by and large conditional. Loans should not be obtained
against the interests of the country. Foreign capital should be
allowed in certain areas which require high technology skills a n d "
high priority areas. Unrestricted flow of capital would destabilize
the economy and retard the growth process. Proper rules and
regulations are essential to regulate the flow of capital. Finally, the
cost of foreign capital should be duly considered before
mobilizing capital in the form of borrowings.
Foreign capital, thus has its own merits and demerits. By
having a right policy and proper implementation of rules and
regulations, the effective use of foreign capital can be ensured.
Role of MNCs:
A multinational Corporation (MNC) is defined as a corporation
which operates in other countries apart from its home country.
MNCs have their head office in their home country while having
offices or factories in other countries. They are also called
transnational corporations. Some examples of MNCs are
Microsoft, Google, General Electric, Toyota, Pepsico, Sony
Foreign Direct Investment g™gro" 263

Corporation, Phillips Electronics etc. MNCs play an important

role in the development of their home country as well as the
development of countries where they operate. At the same time
their role in the case of developing countries has been debated
often. While there are many arguments in support of their role,
opposition to them is also very vehement. According to the
supporters of MNCs, the following benefits can be reaped by
encouraging MNCs:
(1) They enhance capital formation and help in accelerating
economic growth.
(2) As they are profit oriented, resources will be utilised
optimally.
(3) Along with capital, MNCs bring in their own advanced
technology and better management practices.
(4) Employment generation, training of labour and improving
their skills are direct benefits from MNCs.
(5) They encourage ancillary industries and contribute to
industrial development.
(6) Consumers benefit substantially due to the introduction of
new and variety of products. Competition also ensures that
products are available at lower prices.
(7) Relationship between countries become better due to the
operation of MNCs and they help in the integration of world
economy.
While the above arguments are correct, there are certain
apprehensions about MNCs. Some of the major lim itations are:
(1) MNCs have superior staying power and financial powers.
Domestic producers cannot withstand this competition.
(2) They generally bring in capital intensive technology which is
not suitable for a labour abundant country like India.
(3) They are mainly interested in maximisation of profits and
will not be interested in serving national interests.
(4) According to the critics, the MNCs have a tendency to
influence the people with their own culture and encourage
wasteful consumption.
 264 E
as:r rrt
c r sas»
VipuVs™ Business Economics - II (SFC)

(5) Generally they are not very keen to transfer their technology
and skills and many a times they have a tendency to dump
those technologies which have become outdated in their own
country.
(6) Finally MNCs may become monopolies and there may be
unfair trade practices. By and large MNCs are interested in
exploiting the huge domestic market rather than developing
India as an export base.
Despite the above limitations, FDI and MNCs are essential in
these days of globalisation. While allowing MNCs and attracting
.foreign capital, the government can be selective in its approach.
While attracting foreign investment and MNCs, the policy should
be designed in such a way that the national interests are protected
effectively.

QUESTIONS
(1) Define the following concepts:
(a) Foreign direct investment.
(b) Portfolio investment.
(c) Multinational Company.
Fill in the blanks:
(a) FDI stands fo r___________
(b) Portfolio investments are concerned with________ .
(c ) ------------------ is preferable to portfolio investments.
[A ns.: (a) foreign direct investment (b) Short term profits (c) FDI]
State whether the following statements are true or false.
(a) Foreign capital promotes economic development.
^ ( b ) Portfolio investments are risky and not reliable.
(c) FDI involves transfer of technology.
_ (d) Portfolio investments are for a long period of time.
[A ns.: (a) True (b) True (c) True (d) False]
(2) Explain the various sources of foreign capital.
(3) Distinguish between FDI and portfolio investment.
(4) FDI is preferable to portfolio investment’. —Justify.
Balance of Payments c r ^ r a ’" 265

23

Balance of Payments

BALANCE OF TRADE AND BALANCE OF PAYMENTS

STRUCTURE OF BALANCE OF PAYMENTS

DISEQUILIBRIUM IN BALANCE OF PAYMENTS:

CAUSES OF DISEQUILIBRIUM *

TYPES OF DISEQUILIBRIUM

METHODS TO CORRECT DISEQUILIBRIUM IN THE

BALANCE OF PAYMENTS POSITION

QUESTIONS
266 , Vipul’i[™ Business Economics - II (SFC)
t \ V V■ ' !
BALANCE OF TRADE AND BALANCE OF PAYMENTS:
Balance of trade and balance of payments are concepts related
to international trade. Balance of trade is a record of transactions
of goods or merchandise. In other words it is a record of visible
items only. It does not include invisible items or services as well
as capital transactions. Balance of payments is a comprehensive
record of all the transactions of a country with the rest of the
world during a given period of time. It includes both visible and
invisible items. It is a record of export and import of goods,
services and capital transactions. Balance of trade is a part of
balance of payment. Balance of trade may be a surplus or a deficit
one. But balance of payments always balances.
Balance of payments is an important concept in international
economicslltxefers to a systematic record of all the transactions of
a country with the rest of the world during a given period of time.
It is the record of all the exports and imports of a country with
other countries during a year. Export of goods and services gives
rise to receipts while imports give rise to payments. A complete
record of all receipts and payments is given by the balance of
payments statement. It is defined by Prof. Kindleberger as: "the
systematic record of all economic transactions between the
residents of the reporting country and residents of foreign
countries." Here economic transactions refer? to the sale and
purchase of goods and services, transfer of assets and liabilities,
receipts and payments. Residents refer to individuals, business
firms and public authorities. .
Balance of payment is a financial statement. It gives a
comprehensive idea about the various transactions of a country
with other countries. Different countries adopt different methods
to prepare the balance of payments statement. The figures are
expressed in terms of the currency of the domestic country. If
necessary it is also expressed in terms of U.S. dollars. It is a very
useful statement to the government, business firms and the banks
to formulate various policies.
STRUCTURE OF BALANCE OF PAYMENTS: 4
Balance of payments consists of transactions which give
income to a country and also those transactions which involve
Balance of Payments □'"ETET 267

payments. Hence it consists of two sides namely receipts and

payments. A model of balance of payments can be shown as
follows:
Receipts/Credits Payments/Debits

(D Export of goods Import of goods

(2) Export of services Import of services
(3) Receipt of interest, profit and Payment of interest, profit and
dividend dividend
(4) Unilateral receipts (gifts, Unilateral payments (payments
remittances, donations, etc.) to foreign countries, gifts to
others etc.)

(5) Foreign investments Investments abroad

(6) Borrowings of short term, Lending of short term, medium

medium term and long term term and long term capital
capital
(7) Changes in reserve Changes in reserve

The above model of balance of payments can be analysed

under two broad categories namely current account and capital
account. The first four items refer to current account. Current
account is that account which records imports and exports of
goods and services and unilateral transfers. The balance of export
and import of visible items is called balance of trade. It is also
called as merchandise account. Unilateral transfers refer to those
items which have no quid-pro-quo i.e. no corresponding receipts
and payments. Donations given and received, remittances
received and sent etc. are examples of unilateral transfers.
Capital account consists of item numbers 5 and 6 in the table.
Capital account refers to that account consisting of items which
lead to a change in the assets or liabilities of the people or the
government of a country. It includes direct investment, portfolio
investment, transactions of the government and private
institutions.
The reserves maintained by the Central bank are included in
item no. 7. The reserves are held in the form of gold, foreign
268 g '“g T"H™ VipuVs™ Business Economics - II (SFC)

currencies etc. These reserves are used to cover deficits in other

accounts.
Thus current account consists of all real transactions while
capital account consists of all capital transactions. Balance of
payments of a country is based on double entry booking-keeping
system. It implies that for every debit entry, there will be a credit
entry. At any given point of time the total credit of a country must
be equal to its total debit. In case if there is a difference between
debit and credit it is adjusted by including an item "Errors and
Omissions". A surplus or deficit in the current account will be
corrected by a deficit or surplus in the capital account. Hence in
the accounting sense, it is said that "Balance of payments always
balances". While this is true in the accounting sense, in reality
there can be disequilibrium in the balance of payments. When
total credit is more than total debit it is termed as surplus balance
of payment or favourable balance of payments. On the other hand
when payments are more than receipts, it is called as
unfavourable or adverse balance of payments position. By
analysing the balance of payments position of a country, its
position in international trade can be ascertained.
Differences between balance of trade and balance of payments:
Balance of Trade Balance of Payments
(1) It consists of export and import It consists of export and import
of visible items. of visible and invisible items.
(2) It's scope is narrow. It has a wider scope.
(3) It can show a deficit or a surplus. It is always balanced.
(4) It gives a partial picture of the It gives a comprehensive picture
economy. of the economy.
(5) It has limited practical It is widely used by governments
applications. \ and institutions while
formulating various polices.
Balance of payment is said to be in balance when receipts are
equal to payments. If receipts are more than payments, there is
said to be a surplus in the balance of payments position. While a
surplus in balance of payments is favourable, a continuous
surplus will lead to inflation in the economy. Compared to
Balance of Payments ^ n rg ™ 269

surplus, deficit in balance of payments has far reaching effects on

the economy. Huge deficits may lead to borrowings from foreign
governments and international institutions leading to
indebtedness. In due course of time, the credibility of the country
in the international market will become low which will affect its
further borrowings. Adverse balance of payments position will
lead to severe political, social and economic effects. Hence all
efforts should be taken to ensure equilibrium in the balance of
payments position. Both monetary and fiscal measures are used
by modem governments to correct disequilibrium in the balance
of payments position.
D ISEQUILIBRIUM IN BALANCE OF PAYMENTS:
Balance of payments (BOP) is a systematic record of all
economic transactions of a country with the rest of the world
during a given period of time. In the accounting sense balance of
payments always balances as it is based on the double - entry
book keeping system. In reality however, balance of payments
rarely balances. Often disequilibrium is experienced in the
balance of payments. It can be of two types namely surplus in the
balance of payments and deficit in the balance of payments. BOP
is said to be a deficit one if payments are more than the receipts
and vice versa BOP is said to be a balanced one if receipts from
exports and payments for imports are equal to each other.
Disequilibrium in balance of payments is explained in terms of
Autonomous and Accommodative Transactions. Autonomous
transactions are those which are undertaken for their own sake
and it is independent of other items. Such transactions take place
in the normal course of foreign trade. It includes all transactions
like export and import of goods and services, movement of capital
etc. All these transactions are profit motivated. Accommodating
transactions are not profit oriented. They are undertaken to
correct disequilibrium in the balance of payments. It consists of
transactions like short term loans, monetary gold movement etc.
to bring about equilibrium in balance of payments. These
transactions occur due to imbalances in other items. The
autonomous items are termed as "Above the line Items" while
accommodating items are known as "Below the line Items."
270 □ T“g™g™ Vipul's™ Business Economics - li (SFC)

The disequilibrium in the balance of payments position is

caused by autonomous transactions. If autonomous receipts are
more than autonomous payments then the balance of payments of
payments is said to be a surplus one. On the other hand if
autonomous payments are more than the receipts, then the
balance of payments is said to be in deficit. Accommodating
transactions are carried out to correct the disequilibrium in the
balance of payments positions. Generally long-term capital
transactions, export of goods and services are considered as
autonomous items while drawing down foreign exchange
reserves, short term capital transactions and monetary gold
movement are regarded as accommodating transactions. In reality
it is difficult to clearly demarcate the items into these two types. It
depends upon the motive with which the transactions are carried
out. The balance of payments is said to be in balance when a
surplus or deficit in autonomous transactions is corrected by a
deficit or surplus in the accommodating transactions.
CAUSES OF DISEQUILIBRIUM : \\r'^
A surplus or deficit in balance of payments causes
disequilibrium. While both affect the economy, a deficit in the
balance of payments adversely affects the economy. When the
payments are more than receipts, then there is said to be a deficit
in the balance of payments. A number of factors cause
disequilibrium in the balance of payments position. They are as
follows:
(1) Development projects: Developing countries like India
undertake a variety of development projects to accelerate
economic growth. They require raw materials, machines,
equipments and technology to bring about rapid
industrialization. As the domestic supply of these
requirements is not enough, they have to resort to massive
imports. Another important item of import for developing
countries is the petroleum products. While imports are
increasing at rapid rate, exports do not keep pace. Developing
countries generally export primary products and face adverse
terms of trade. In recent times many developing countries are

I
Balance of Payments STWW 271

able to increase their exports. Even then imports continue to

be more than exports causing balance of payments problems.
(2) Trade cycles: Trade cycles refer to ups and downs in
business. When the economy experiences a period of boom,
then exports will increase leading to a surplus in the balance
of payments position of the exporting country. On the
contrary when there is depression, the demand for goods will
be less leading to a deficit.
(3) Rapid growth of population: When population increases at a
rapid rate, the demand for goods and services will be high
leading to more imports. At the same time their capacity to
export is les§ leading to a deficit in the balance of payments.
(4) Demonstration effect: It refers to the tendency on the part of
the poor people in less developed countries to imitate the life
style of the people in rich countries. Due to this effect they
tend to demand more foreign goods. This leads to more
imports resulting in deficit in balance of payments.
(5) Trade barriers: When tariff and non-tariff barriers are
imposed on trade, exports will be affected leading to
disequilibrium, Though under WTO, a number of restrictions
have been removed or liberalized, advanced countries still
impose a number of non-tariff barriers. This affects the export
prospects of developing countries.
(6) Capital transactions: When countries borrow and lend
money, balance of payments would be affected. If a country
borrows from IMF, World Bank or foreign governments, it
will have adverse balance of payments at the time of
repayment. On the contrary if a country lends capital, it will
result in surplus in balance of payments position.
(7) Technological advancement: Development of new
technologies lead to new type of goods and substitutes. This
affects the demand for existing goods affecting the balance of
payments position.
(8) Inflation: Developing countries undertake various
development projects. Many of these projects are long-
gestation projects. They generate income for the people
Iua" iv - y - .w
 272 g™ETjg,“ V ipul’s™ Business Economics - II (SFC)

employed and for those who supply the components.

However the output may not be generated at the required
pace.
(9) Political instability: When an economy experiences political
instability, capital flight will take place. Inflow of foreign
capital will also decline. This will adversely affect the balance
of payments position.
(10) Lack of cooperation: Lack of cooperation amongst countries
^ ^adversely affects international trade. If there is a cross-border
1 prejudice, then neighbouring countries may not have smooth
flow of goods and services, e.g. India and Pakistan. Due to
lack of cooperation, they may have to resort to expensive
imports or lose a good market for exports. This leads to
adverse balance of payments situation.
In the recent times, liberalization, privatization and
globalization are influencing the income, taste and preferences
and the demand for goods and services. Many economies have
introduced structural reforms to face the challenges of
globalisation. The WTO regime has introduced a new world
order. International Trade is becoming more liberalised. All these
factors influence exports and imports leading to disequilibrium in
the balance of payments position.
TYPES OF DISEQUILIBRIUM :
Disequilibrium in the balance of payments is classified as
follows:
(1) Cyclical disequilibrium.
(2) Structural disequilibrium.
(3) Short run disequilibrium.
(4) Long run disequilibrium.
(1) Cyclical disequilibrium: Disequilibrium caused by business
cycles is known as Cyclical Disequilibrium. A business cycle
has four phases namely prosperity, recession, depression and
recovery. During prosperity, the demand for goods and
services willjbe more leading to more imports. On the other
hand during depression, the income of the people will be low
Balance of Payments ir ir i? 273

resulting in less demand for imports. In the present

globalised era business cycles in one country affect the other
countries without any lapse of time. If one country has
depression demand for imports will decline leading to a
decline in the exports of other countries. During business
cycles, employment, income, price level etc. change leading to
disequilibrium in the balance of payments position. The
nature and duration of trade cycles differ from country to
country. Hence there is no uniformity in the measures
adopted by the countries to correct cyclical disequilibrium.
(2) Structural disequilibrium: When structural changes take
place in the economy, the demand for goods and services will
be affected leading to structural disequilibrium. This type of
disequilibrium lasts for a longs period of time. It arises due to
a variety of structural changes. Some of them are
(a) Due to changes in tastes and preferences of the people
demand for certain goods may decline resulting in less
exports. Hence the resources have to be diverted to the
production of other goods.
(b) Due to technological advancements, new methods of
production may be initiated. The demand for traditional
raw materials may decline. The quantity required may be
less. Discovery of new substitutes will reduce the
demand for the existing product.
(c) When countries suffer from serious problems like war,
natural calamities etc., production of goods and services
will be affected leading to disequilibrium.
(d) Changes in factor prices and their availability affect
production of goods and services and their prices. For
e.g. Of supply of skilled labour is available at cheaper
rates, labour intensive exports of the country can be
increased. On the contrary if labour is scarce and
becomes expensive, prices of the final product will
increase, leading to less demand for exports.
(e) Underdeveloped and developing Countries need huge
resources to achieve rapid development. When they rely
274 S ” S ” S " VipuVss™ Business Economics - II (SFC)

upon import of technology, raw materials, petroleum

products etc. their balance of payments will become
adverse.
(f) When the flow of foreign capital to a country declines
structural disequilibrium will arise as production
employment, income etc. will be affected.
(g) During the 90's many countries have introduced reforms.
Many sectors have been opened up to ensure
competition. Under the WTO regime, rules and
regulations of international trade are changed. All these
result in structural disequilibrium.
(3) Short run disequilibrium: When the disequilibrium persists
for a short period of one year or more it is known as short-run
equilibrium. It may be because of unexpected factors like
failure of monsoon, political instability, high rate of inflation
etc. For e.g. Of the monsoon is adequate and normal, a
country may enjoy a bumper crop leading to reduction in
import of foodgrains and exports may be possible. This will
result in a surplus in the balance of payments situation. If
there are industrial strikes and lock outs in a particular year,
exports would be affected leading to disequilibrium. Since the
short run disequilibrium is temporary, it can be corrected
easily by resorting to short term loans. However if the short
run disequilibrium persists for a long period of time then
long-run disequilibrium will set in.
(4) Long-run disequilibrium: This is also termed as fundamental
disequilibrium. When the disequilibrium persists for a long
period of time it is termed as long run disequilibrium. Factors
like changes in demand and supply, growth of population,
hike in oil prices, rapid and continuous increase in imports
etc. lead to fundamental disequilibrium. The best solution to
correct long-run disequilibrium is to export more and import
less. Countries suffering from long-run disequilibrium are
often advised by the IMF on the policies and measures to be
taken to address this problem.
Balance of Payments g^ETET 275

M ETHODS TO CORRECT DISEQUILIBRIUM IN THE

BALANCE OF PAYMENTS POSITION:
Balance of payments in said to be in disequilibrium, when
there is a surplus or a deficit. Both will have their effects on
internal and international trade. However the effects of a deficit in
balance of payments is much more severe than that caused by a
surplus. Hence more emphasis is given to the measures required
to correct a deficit in the balance of payment position. There are
broadly two methods to correct deficits in the balance of
payments. They are (1) Monetary methods and (2) Non-monetary
methods. They can be elaborated as follows:
Monetary Methods:
The measures included in the monetary method are: (1) Defla­
tion (2) Exchange Depreciation (3) Devaluation (4) Exchange
Control and (5) Attracting foreign capital. The monetary methods
induce exports and reduce imports indirectly. The various
measures operate as follows:
(1) Deflation: Deflation refers to a situation when a dear money
policy is adopted to reduce cost and prices. This is done by
using various monetary tools like bank rate, open market
operation, cash reserve ratio etc. For example the bank rate
may be increased by the central bank to reduce the supply of
credit in the economy. A rise in bank rate leads to a rise in the
lending rate of commercial banks. This will result in less
demand for credit and less investment. Less production and
reduction in cost of production will eventually bring down
the prices of goods and services. As a result exports would
become relatively cheaper and the demand for exports will
start increasing. Other monetary measures also affect the
liquidity in the system and thereby they control the price
level.
While export increase on the one hand, imports will start
declining on the other hand. This is because the income of the
people in a deflationary situation would be less and imports
would be relatively costlier than the domestic goods. Along
with monetary tools, fiscal tools are also used to create a
276 ST Ernr V lp w l’s™ Business Economics - II (SFC)

deflationary condition. For e.g. budget may be used to control

prices or the government may resort to a reduction in
unproductive expenditure etc.
Deflation controls disequilibrium is the balance of
payments through domestic changes and it does not
influence the exchange rate. To be successful and effective the
following conditions are required:
(a) The Demand for exports and imports should be elastic.
(b) Various economic variables like investment, production
prices etc. should be flexible.
(c) Other countries should cooperate and they should not
retaliate by following a deflationary policy.
Deflation can correct disequilibrium by influencing the
availability of credit and prices. However economists criticize
the use of this measures as it may lead to unemployment, low
income and depression. It may affect the stability of the
economy and is not suitable for developing countries.
(2) Exchange Depreciation: If refer to a reduction in the external
value of a domestic currency in terms of a foreign currency.
The change is effected through the market forces. Suppose 1$
= Rs. 50 and if exchange rate depreciates then 1$ will be
equivalent to Rs. 60. Depreciation will make exports cheaper
and imports costlier. In the above example for the same $1,
more goods can be purchased from India. Hence demand for
goods from India will increase. At the same time Indians
have to pay more for the same $1. Hence demand for goods
from USA will decline. Thus reduction in imports and
expansion in exports will take place simultaneously
correcting the disequilibrium in the balance of payments
situation.
The success of depreciation depends on the following
conditions:
(a) There should be a flexible exchange rate system.
Balance of Payments gpgTQ’ 277

(b) There should be cooperation from other countries. If they

also experience exchange depreciation, then
disequilibrium will worsen.
(c) The demand for export and should be elastic.
(d) Depreciation may lead to inflation due to increased
prices of imports and also due to more money supply
because of increased exports. If it is not controlled,
. depreciation will not succeed.
(3) Devaluation: Devaluation refers to an official reduction in the
external value of the domestic currency in terms of a foreign
currency. It is also known as expenditure switching policy.
While exchange depreciation is automatic induced by market
forces, devaluation is deliberately done by the government. If
the exchange rate is 1$ = Rs. 40 and if the government
devalues the currency by 25%, then the exchange rate would
be 1$ = Rs. 50. When devaluation takes place, exports become
cheaper while imports become costlier. Devaluation is
adopted by countries when there is a persistent deficit in the
balance of payments position.
Exchange depreciation and devaluation correct
disequilibrium in the same way. The main difference between
the two is that exchange depreciation is market induced
while devaluation is done officially. The extent of devaluation
depends upon the severity of the disequilibrium. Both correct
disequilibrium by increasing exports and reducing imports.
Contrary to devaluation, revaluation refers to making the
domestic currency costlier in terms of a foreign currency. This
is done to make imports cheaper and exports costlier. Like
exchange depreciation, exchange appreciation is market
induced and indicates the strengthening of the domestic
currency^ -
Devaluation will succeed only if the following conditions
prevail. -
(a) Demand for exports and imports should be elastic in
nature. If the elasticity of demand is more than one, then
exports and imports would change according to the
change in the exchange rate.
 n™ETEr V ipul’s™ Business Economics - II (SFC)

(b) The domestic price level should remain stable. If along

with devaluation, prices increase, then demand for
exports will not increase. Suitable monetary and fiscal
measures should be used to control inflation.
(c) Due to structural changes, if disequilibrium occurs, then
devaluation will not work. For e.g. If a new substitute is
found for a commodity like jute than export of jute
products will not increase despite - devaluation.
(d) Cooperation from other trading partners is very essential
for devaluation to succeed. If they provide subsidies to
their exporters or impose high tariffs on imports, than
devaluation will not succeed. In other words, other
countries should not retaliate when one country devalues
its currency.
(e) The success of devaluation also depends upon the nature
of exports and imports. If a country exports primary
goods and imports capital goods or manufactured goods
then devaluation will not be effective. This is because the
demand for primary goods is relatively inelastic while
the demand for manufactured goods is relatively elastic.
This will result in unfavourable terms of trade worsening
the balance of payments position.
(f) Devaluation will be effective only where the prices of
competitive goods from other countries do not decline
after devaluation.
Devaluation, no doubt an effective measure to control
disequilibrium in the balance of payments. However its
success depends on many conditions. Moreover it should be
used sparingly. Frequent devaluation would create
uncertainty and indicate the limitations of the economic
system. It should be used only as a temporary device to
correct disequilibrium in the balance of payments position.
Exchange control: Another monetary measure to control
disequilibrium is to control the use foreign exchange. The
central bank of the country will start imposing restrictions on
the use of foreign exchange. All exporters have to surrender
Balance of Payments 279
ir ir w

their export earnings to the government against domestic

currency. The foreign exchange thus mobilized by the
government would be allotted for importing essential items
and import of luxuries would be restricted. This method
directly influences imports. Here the Central bank sets
priorities for the use of foreign exchange and accordingly
allocates it.
Exchange Control is a temporary measure. It cannot solve long
run disequilibrium. It definitely affects the flow of exports and
imports and reduces the volume of external trade. Moreover,
distortions may creep in the allocation of foreign exchange and
there can be misuse of the same. Trade relations with other
countries may be affected as exchange control involves an element
of discrimination between countries and goods. This in the long
run will be detrimental to the growth of international trade.
Non-Monetary Methods:
The measures used under the non-monetary method are:
(1) Tariffs (2) Quotas (3) Export Promotion and (4) Import
substitution. They either increase exports or reduce imports and
thereby correct the disequilibrium.
(1) Tariffs: Tariffs are duties levied on imports. Due to this the
prices of imported goods will increase leading to a reduction
in the demand for imports. It will encourage the consumers to
buy domestic goods rather than the imported ones and will
also induce the producers to produce substitutes. High tariffs
can be used to curtail the consumption of non-essential
imports.
While tariffs can control imports and generate income for the
government, it has certain limitations. They are
(a) If the demand for imports is inelastic then imports will
not decline despite imposing tariffs.
(b) If other countries retaliate by imposing tariffs, then
exports will suffer.
280 g jr g s r g g r V ip w l’s™ Business Economics - II (SFC)

(c) A very efficient and honest administration is a pre­

requisite for tariffs to be effective. A corrupt system will
render it useless.
(d) Tariffs provide only temporary solution. Tariffs tend to
correct disequilibrium without addressing the basic
causes. Hence it cannot provide a long lasting solution.
(e) Imposition of tariffs leads to reduction in exports
resulting in shrinkage of external trade.
Since the establishment of WTO in 1995, members of WTO
have to reduce tariffs on a number of items to promote
international trade. Hence it is not possible to use tariffs as a
permanent corrective measure.
(2) Quotas: Quotas refer to restrictions imposed on the quantity
of imports or the value of imports. Quotas are said to be very
effective compared to tariffs, as they directly reduce imports,
Quota score over tariffs on the following grounds.
(a) They are certain
(b) They are flexible in nature. They can be adapted to the
requirements of the economy.
(c) While impositions of tariffs require the permission of the
legislature, quotas depends on the decision of the
government.
(d) If demand for imports is inelastic, quotas can be used
effectively to control it, while tariffs will not be
successful.
Quotas are no doubt effective in controlling imports. At
the same time they are said to be disadvantageous for the
following reasons.
(a) Quotas affect the volume of trade and often imposition of
quotas lead to conflict between countries.
(b) While tariffs generate revenue for the state, quotas do not
generate income.
(c) Quota system generally results in monopoly tendencies.
It also leads to corruption in the allocation of quota.
Balance of Payments 281

(d) In the post WTO era countries are advised to reduce

quotas and hence it is difficult to use them to correct
disequilibrium.
(3) Export Promotion: Export Promotion is considered as the
best solution to correct disequilibrium in the balance of
payments position. To promote exports the government can
provide tax concessions, subsidies, easy credit and marketing
facilities, grants, etc. It can help the exporters to advertise
their products by conducting trade fairs, exhibitions etc.
Along with the export promotion measures, the necessary
resources should be made available to increase the
production of exportable items.
(4) Import substitution: Dependence on imports can be reduced
by encouraging import substitutes. The government can
encourage the industries producing import substitutes by
extending monetary help, technical assistance, credit and
marketing facilities etc. Import substitution will enable the
country to achieve self-reliance and self-sufficiency.
(5) Foreign Capital: Efforts should be taken to attract foreign
capital especially foreign direct investment (FDI). FDI has
more benefits than portfolio investment. While portfolio
investment is profit oriented and short term in nature, FDI is
long term in nature and has advantages like employment
generation, technology transfer etc. By framing proper
policies and offering incentives, FDI can be attracted
significantly. By providing other services like health facilities
(medical tourism), education, business processing etc. flow of
foreign capital can be enhanced.
While import substitution helps to reduce imports, the
industries producing substitutes enjoy a certain degree of
protection and cannot compete effectively with others. The
protected industries will expect the government to continue the
concessions for ever. Corruption and red-tapism will prevail
while extending concessions. This will distort production and
allocation of resources. •
 282 n rg rn " V ip u l ’*™ Business Economics - II (SFC)

The non-monetary methods, on the whole are said to be better

than the monetary methods to correct disequilibrium in the
balance of payments position. Of all the measures export
promotion is the most effective method to correct disequilibrium
in the balance of payments position.

QUESTIONS
(1) Define the following:
(a) Balance of trade.
(b) Balance of payments.
(c) Devaluation.
(d) Tariff.
(e) Quota.
Fill in the blanks:
(a) An official reduction in the external value of currency is called

(b) Export and import of visible items is called___________ .

(c) Balance of payments always___________.
(d) If imports are more than exports, then balance of payment is

[A ns.: (a) devaluation (b) trade account (c) balances (d) adverse balance
o f payments]
State whether the following statements are true or false:
(a) Devaluation can be used often to correct adverse balance of
payments.
(b) Quotas are more effective than tariffs.
(c) Exchange depreciation is due to market forces.
(d) WTO advocates reduction in tariffs and removal of quotas.
[A ns.: (a) False (b) True (c) True (d) True]
Match the following:________
(A) (B)
(1) Export of goods (a) Capital account
(2) Deflation (b) Trade account
(3) Import substitution (c) Monetary measure
(4) Import of capital (d) Non-monetary measure
Ans.: (1 - b; 2 - c; 3 - d, 4 - a)
(2) What is meant by disequilibrium in the balance of payments position? What
are the causes for it?
(3) Explain the various types of disequilibrium in the balance of payments
position.
Balance of Payments = « » Z8;5

(4) What are the various measures used to correct a deficit in the balance of
payments?
(5) What are the differences between exchange depreciation and devaluation?
Explain how they are used to correct disequilibrium.
(6) Write short notes on the following:
(a) Non-monetary method.
(b) Devaluation.
(c) Exchange control.
(7) From the following data calculate trade balance, current account balance
and capital account balance for 2012-13 and 2013-14.
(US$ million)
Items 2 0 1 2 -1 3 2 0 1 3 -1 4
3 ,0 6 ,5 8 1 3 ,1 8 ,6 0 7
(1 ) E x p o rt o f g o o d s
5 ,0 2 ,2 3 7 4 , 6 6 ,2 1 6
(2 ) Im port of g o o d s
1 ,0 7 ,4 9 3 1 ,1 5 ,2 1 2
(3 ) In v isib les (net)
982 1 ,0 3 2
(4 ) E x tern al a s s is t a n c e
8 ,4 8 5 1 1 ,7 7 7
(5 ) E x tern al c o m m ercia l b orrow ings
2 1 ,6 5 7 - 5 ,0 4 4
(6) S h o rt term d eb t
4 6 ,7 1 0 2 6 ,3 8 6
(7 ) Fo reig n in v estm e n t
-5 ,1 0 5 - 1 0 ,8 1 3
(8) O th e r flow s
1 6 ,5 7 0 2 5 ,4 4 9
(9) B an k in g cap ital
Source: Economic Survey 2014-15.
284 crcm VipuVs™ Business Economics - II (SFC)

24

Foreign Exchange Market

FUNCTIONS OF FOREIGN EXCHANGE MARKET

DEALERS IN THE FOREIGN EXCHANGE MARKET

SPOT EXCHANGE RATE AND FORWARD EXCHANGE

RATE

HEADING, SPECULATION AND ARBITRAGE

TYPES OF FLOATING RATE SYSTEM

EXCHANGE RATE MECHANISM

M ERITS AND DEM ERITS OF FIXED EXCHANGE RATE

SYSTEM

MERITS AND DEM ERITS OF FLEXIBLE EXCHANGE RATE

SYSTEM

MANAGED FLEXIBILITY

QUESTIONS
Foreign Exchange Market 285

International trade involves the use of various currencies. The

different currencies are linked with each other through the foreign
exchange market. Foreign exchange market is the market where
various currencies are exchanged for each other or where the
foreign currencies are bought and sold. In the words of
Kindleburger, "The foreign exchange market is the market for a
national currency anywhere in the world." It is also known as
Forex market.
The foreign exchange market like any other market does not
refer to a particular place. On the contrary to refers to a link
between the buyers and sellers. The link can be established
through telephone, fax, internet, etc. This market is a twenty for
hour market operating throughout the year transacting billions
and billions of foreign currencies. Though it transacts all
currencies, some currencies like US Dollar, Pound Sterling, Euro,
Yen are transacted in huge volumes. Of all these currencies, US
Dollar is the most popular one as it is accepted worldwide for
various transactions. Hence, it is termed as a 'vehicle currency
which implies international acceptance.
Exchange rate is the rate at which one currency is exchanged
for the other. In some countries, the exchange rate is fully
determined by market forces indicating a flexible system. In some
other countries, the government fixes the exchange rate through
the central bank. Some others follow a combination of both.
Under this system, the exchange rate is determined by the market.
However, the central bank will interfere whenever it is necessary.
For example, in India, the government follows a 'managed float
systems' where the market decides the exchange rate and the
central bank interferes whenever necessary.
^"FUNCTIONS OF FOREIGN EXCHANGE MARKET:
The most important functions of a foreign exchange market
are:
(1) Transfer of purchasing power: It facilitates the conversion of
one currency into another for buying and selling of goods in
the international market. It helps to transfer purchasing
286 □'■jgHET VipuVs™ Business Economics - II (SFC)

power of people in different countries for exchange of goods

and services.
(2) Provision of credit: By providing credit, foreign exchange
market helps to promote international trade. Various
instruments like bank drafts, foreign bills of exchange and
telegraphic transfers are used to facilitate the supply of credit.
(3) Coverage of risks: It helps the exporters and importers to
cover the risks involved in foreign trade through the forward
exchange market. Forward exchange market is where the
buyers and the sellers enter into a contract to sell or buy
foreign exchange at a fixed rate in future. The rate and the
date are fixed at present while the actual delivery takes place
in future. Through this, the risks which arise due to
fluctuations in the market can be avoided.
DEALERS IN THE FOREIGN EXCHANGE MARKET:
Dealers refer to the players in the market who buy and sell
foreign exchange. Dealers include commercial banks, investment
firms, corporate houses and also individuals who are authorized
by the Central Bank to deal in foreign exchange reserves. The
main players in the market are:
(1) Central banks: Central banks play a very significant role in
the forex market. They are the custodian of the foreign
exchange reserves of the economy. The domestic exchange
market is regulated by the central bank. Central banks
intervene in the market by buying and selling in order to
control fluctuations in the market.
(2) Brokers: They act as a middlemen between the buyers and
sellers. They have full knowledge about the market condition
and their main job is to liaison with the buyers and sellers.
They do not transact on their own but enable the buyers and
the sellers to strike a deal. Their main source of profit is the
commission charged by them.
(3) Commercial banks: Commercial banks are another important
component of the exchange market. They buy and sell for
their own needs as well as on behalf of the customers. Daily
Foreign Exchange Market 287

quotes for buying and selling are given by the commercial

banks.
(4) Other players: Apart .from above, the forex market consists of
exporters, importers, tourists, business travelers and
immigrants. They demand foreign exchange on a continuous
basis. Their needs are satisfied by the commercial banks or
brokers.
Various currencies are traded in this market. The forex
market is the world's 'largest market working 24 x 7 x 365
days. Some of the centres like New York, London, Tokyo,
Singapore are very active markets.
Though various currencies are traded, US $ is the most
accepted currency internationally. Hence it is called as a vehicle
currency. The exchange rate mechanism differs from country to
country. While some countries have a flexible exchange rate
determined by the market forces, some countries have a fixed
exchange rate mechanism determined by the Central bank. Indian
government adopts a managed float system wherein the exchange
rate is determined by market forces and there is intervention by
the Central bank to stabilize the market as and when necessary.
SPOT EXCHANGE RATE AND FORWARD EXCHANGE
RATE:
Spot Exchange Rate: Spot exchange rate is the current
exchange rate prevailing in the market. It is determined by
demand for and supply of foreign exchange. Immediate delivery
of foreign exchange takes place at this rate. Though the foreign
exchange has to be delivered immediately, in reality it takes two
working days. Suppose a deal is struck on Monday actual
delivery will take place on Wednesday provided Tuesday and
Wednesday are working days. Tfte two days are meant for
processing and paperwork. The market segment where spot
transactions happen is called spot exchange market.
The dealers in this market quote a two way price. For example,
the quote will be INR / US $ 60.50 bid/60.75 ask. -
The above quote implies that when the dealer buys foreign
exchange, he would pay Rs. 60.50 for every $. When he sells $, the
 288 g ’-ETEr VipuVs^ Business Economics - II (SFC)

customer has to pay Rs. 60.75. The difference between the bid and
the ask rate denotes the profit earned by the dealer. Here the
profit earned is 0.25 $ per transaction.
In the spot exchange market, huge amount of transaction takes
place at lightning speed. The players in this market are connected
by telephone, fax and satellite communication network called the
Society for Worldwide International Financial
Telecommunications popularly called as the SWIFT. This
communication system based in Brussels, connects all the players
and enables vast transactions in foreign exchange. Spot
transactions account for a major part of the transactions in the
forex market.
Forward Exchange Rate: Forward exchange rate refers to the
rate at which the transaction takes place at a future date. The rate
and the date are fixed in the current period and the delivery takes
place after a certain period of time. The market where this kind of
transaction takes place is known as the Forward Exchange
Market. The forward exchange rate differs from the spot exchange
rate. While the spot exchange rate refers to the current market
rate, forward exchange rate can be at a premium or at a discount
of the spot exchange rate. For example, if the spot exchange rate is
1$ = Rs. 50, the forward exchange rate may be 1$ = Rs. 52 or 1$ =
Rs. 48. The contracts in this market usually have a maturity period
of 30 days, 60 days, 90 days. Sometimes the contract period
extends upto 180 days and 360 days.
The forward rates may be quoted in terms of the local
currency. Then the rate is known as outright rate. Sometimes they
are quoted in terms of points known as forward points. The points
may be added or subtracted to the current rate as the case may be.
For example, let us suppose the current rate is quoted as INR / US
$ 60.50 bid/60.75 ask. If the forward points are given as 25 - 30,
then these points should be added to the quote. Here the forward
exchange rate will be 60.75 bid/61.05 ask.
On the contrary if the forward points are given 30 - 25, then
these points have to be subtracted from the spot rate. The forward
quote here will be 60.20 bid/60.50 ask. This indicates the forward
rate is at a discount while the former rate is at a premium. Thus
Foreign Exchange Market sy g rg p 289

when the points are at an ascending order, the forward rate will
be at a premium and will be at a discount when the points are in
the descending order.
The forward exchange market helps the players to cover
uncertainty, fluctuations in the market and protect themselves
against loss. In this market swap arrangement also exits. Here a
dealer may enter into a contract to sell $ 1000 after 90 days. At the
same time he will enter into a contract to buy $ 1000 after 90 days
with another dealer. This again helps to cover the risks involved
and such swap arrangements give profit in the form of margins.
The forward exchange rate, whether it will be at a premium or
discount depends upon many factors like economic strength of
the nation, balance of payment situation, political stability etc.
Forward exchange market helps the buyers and the sellers to
minimise their loss in their transactions.
ARBITRAGE AND SPECULATION:
Arbitrage refers to the process of buying and selling a foreign
currency in two different markets at the same time. The price
difference enables them to earn profits. For example, in London,
the exchange rate is 1£ = Rs. 66 and in India it is 1£ = Rs. 65. Then
those who indulge in arbitrage will buy 1£ in India by giving Rs.
65 and sell it in London market and get Rs. 66. Thus this will give
a profit of Re. 1 for every 1£ sold. Those who are involved in
arbitrage are known as arbitrageurs. This practice eventually will
equalize the exchange rate. Development of Communication
facilitates enables arbitrage.
Speculators are those who buy and sell foreign exchange in the
market with the aim of making profit. They take advantage of the
changes in the exchange rate and enter into deals to earn profits.
Like others, they also enter into swap arrangement to protect
themselves against risks and minimise their loss.
Apart from the arbitrageurs and speculators another group
which exists in the market is the hedgers. They enter into forward
contracts to protect themselves against risk due to changes in the
exchange rate. It is adopted by those who enter into transactions
involving large amount of foreign currency. The interactions of
290 n™ETET VipuVs™ Business Economics - II (SFC)

the arbitrageurs, speculators and the hedgers influence the deals

in the forward market.
PURCHASING POWER PARITY (PPP) THEORY:
The purchasing power parity theory was developed by the
Swedish economist Gustave Casell. According to Gustav Casell,
identical goods sold in different markets will sell at the same price
when expressed in terms of a common currency. The theory
assumes that the market structure is competitive and there are no
transport costs. The theory states that under inconvertible paper
standard, the absolute exchange rate is determined by the
purchasing power of the currencies in their respective countries.
The theory has two versions namely:
(4) Absolute version, and
(5) Relative version,
ABSOLUTE VERSION OF PURCHASING POWER PARITY
(PPP) THEORY:
The Absolute Version of Purchasing Power Parity states that
the absolute rate of exchange is determined by the absolute prices
prevailing in the respective countries. For instance, in India, a
basket of goods cost Rs. 200 and the same goods cost $ 4 in USA
then the exchange rate will be:
Rs. 200 = $ 4
Rs. 50 = $ 1
Thus the exchange rate will be Rs. 50 = $ 1. The exchange rate
can be determined with the help of the following formula.
P
R p* where R refers to the exchange rate, P refers to the price
of basket of goods in the domestic currency, P* refers to the price
of identical basket of goods in the foreign currency.
By using this formula, exchange rate for the given data can be
calculated as follows:

R= . =50. Thus the exchange rate is 1$ - Rs. 50.

Foreign Exchange Market Ejrgrnr 291

The PPP theory further states that if prices in India fall, that of
prices in USA remain the same then the exchange rate will
appreciate for the domestic economy against the foreign currency.
For e.g. in India prices fall to Rs. 100, in USA it remains the same
100 ^ ...
as $ 4, then the exchange rate will change to R = ^ = 25. Earlier
it was 1$ = Rs. 50. Now the exchange rate is 1$ = Rs. 25. If prices
rise in India, prices in USA remaining the same, then there will be
depreciation of the Indian rupee against dollar.
Limitations/Criticisms of the Absolute Version of Purchasing
Power Parity Theory:
The Absolute Version has the following limitations:
(1) This version is based on the assumption that there is no
transport cost. In reality transport costs bring about
differences in commodity prices. Assuming nil transport costs
is unrealistic.
(2) Many restrictions like tariffs, qtfotas are levied by countries
when they trade goods internationally. The absolute version
ignored these trade restrictions. Various subsidies provided
by government also distort the prices. This is also not
considered by this version.
(3) The assumption that goods are identical is not realistic.
Qualitative differences exist in products produced by
different countries.
(4) The absolute version considers only traded goods. Omission
of the prices of non-traded goods is a major limitation.
(5) An important component of balance of payments, namely
capital account has been ignored by this version. Flow of
capital has an important influence on domestic prices and
exchange rate. Similarly trade in services has also been
ignored.
(6) Domestic prices are influenced by non-economic factors like
customs, traditions, political stability etc. When these factors
change the exchange rate will not be equal to the purchasing
power of the currencies.
 292 E rE T H ” V ip w l’s™ Business Economics - II (SFC)

(7) In reality exchange rate changes whenever there is a change

in the elasticity of reciprocal demand for imports and exports.
This has been neglected by this version.
(8) Role of relative prices is given too much importance. Other
factors like flow of capital, availability of factors of
production etc. affect exchange rates which are not
considered. This is another important drawback of the
absolute version.
The drawbacks of the absolute version led to the development
of the relative version.
RELATIVE VERSION OF PURCHASING POWER PARITY
(PPP) THEORY:
This version considers the changes in prices in both the
countries and analyse its impact on the exchange rate. According
to this version, the relative change in exchange rate between two
country's currencies is proportional to the change in the relative
prices. The following formula is used to calculate the new
exchange rate.
Pi
Ri = Ro x Where

Ri = New Exchange Rate

Ro = Equilibrium exchange rate in the base year.
For e.g., let us assume the exchange rate in the base year = 50.
The price index in India has increased from 200 to 300 and in USA
from 100 to 150. In this case the new exchange rate will be

Ri = Ro x

™ 100
- 50 x so

= 100
Thus, the new exchange rate will be 1$ = Rs. 100.
Foreign Exchange Market STBTW 293

Limitations/Criticisms of the Relative Version of Purchasing

Power Parity Theory:
The Relative Version, though considered as an improvement
over absolute version has been criticized on the following
grounds:
(1) Selection of base year and price index: To calculate the new
exchange rate, a base year has to be selected. The base year
should be a normal year free from major fluctuations. Further
various price indices are available. A proper base year and
price index have to be selected which is not an easy one.
(2) Quality of goods: Like absolute version, here also quality of
goods in different countries is ignored. Differences in quality
lead to differences in exchange rate.
(3) Trade restrictions: Restrictions on trade like tariffs, quotas
affect exchange rate. This version has ignored this aspect.
(4) Transport costs and subsidies: The relative version has not
considered the effects of transport cost and subsidies on the
exchange rate, which is a major drawback.
(5) Services and capital transfers: The relative version considers
only the trade in goods. In international trade, services and
capital transfers play a major role in influencing the exchange
rate. The relative version, therefore has limited applicability.
(6) Change in prices: The relative version assumes that the
prices of goods rise or fall uniformly. But in reality it is not so.
Hence this version is too simplistic in nature.
(7) Price and exchange rate: The relative version states that
changes in the price level will lead to changes in the exchange
rate. In reality this may not happen. Similarly, sometimes
exchange rate may be changing without any change in the
price level. Moreover this relative version explains that
change in price level leads to change in exchange rate.
However, the vice versa is also true which is not analysed by
the relative version.
(8) Purchasing power: There are many factors which affect
exchange rate. However, only purchasing power is given
emphasis here. Hence it is an incomplete theory.
 <

294 VipuVif™ Business Economics - II (SFC)

(9) Applicability: The relative version is applicable to small

countries rather than big ones. Small countries depend on
foreign trade for growth and development and in those
countries price level and exchange rate are closely
interconnected. This is not so in the case of big countries.
Inspite of these limitations, the PPP theory highlights the
importance of purchasing power parity in influencing the
exchange rate.
TYPES OF FLOATING RATE SYSTEM:
The exchange rate mechanism followed by various countries
differs from each other. Till 1973, the IMF system of exchange rate
mechanism was adopted by the member nations. The fixed
exchange rate mechanism broke down and countries started
adopting a different system of exchange rate mechanism to bring
about stability. The different systems are as follows:
(1) Independent floating: Under this system some countries like
USA, UK, Japan etc exchange their domestic currency for a
certain amount of other currencies at a fixed rate and at the
same time retain their freedom to float their currency.
(2) Managed float system: This is adopted by India and certain
other countries wherein the exchange rate is determined by
market forces. At the same time the Central bank intervenes
as and when necessary to bring about stability in the market.
(3) Crawling bands: In this system, the exchange rate is allowed
to fluctuate within a wide margin. Here the exchange rate is
fixed by the government and also adjusts the rate whenever
required.
(4) Crawling Peg: Under this, the exchange rate is a fixed one
but allowed to change within a small margin.
(5) Conventional fixed pegging system: Here the exchange rate
is pegged to a particular currency or basket of currencies. The
exchange rate is allowed to fluctuate within a narrow margin.
(6) Currency board arrangements: In this system a group of
nations form a board which fixes the exchange rate.
Foreign Exchange Market
n r g T" g r 295

(7) Pegged exchange rate within horizontal band Peg: In this

system, the exchange rate is fixed. At the same time, the
upper and lower limits for fluctuation are also specified.
(8) Common legal tender: Some countries form a group and
accept one country's currency is considered as legal tender in
the other country leaving no scope for fixing exchange rate.
Thus in the present floating exchange rate mechanism,
different types are followed by nations. By and large they
follow a combination of fixed and flexible exchange rate
mechanism.
EXCHANGE RATE MECHANISM:
Exchange rate mechanism is broadly classified as Fixed
Exchange Rate Mechanism and Flexible Exchange Rate
Mechanism. While the fixed exchange rate mechanism was
prevalent before and after the establishment of IMF, the flexible
exchange rate mechanism is in vogue in many countries at present
in different forms.
Fixed Exchange Rate Mechanism:
Under the fixed exchange rate system, gold standard was
adopted as the system before the Brettonwoods System of IMF
came into existence. In the case of gold standard, the currency was
fully convertible to gold or the currency was in gold. When the
gold standard failed, IMF came out with a new system. Under this
system member countries of IMF fixed the rate par value of their
currency in terms of gold and this was linked to the US dollar. US
dollar was accepted as the vehicle currency and the US$ and gold
exchange rate was fixed at $35 = 1 ounce of gold. The exchange
rate was allowed to fluctuate upto 1%. This system popularly
called as the Brettonwoods System came to an end by 1973 due to
huge deficits in the balance of payments of USA. Since then
different forms of flexible exchange rate system have been
adopted by various countries.
Flexible Exchange Rate Mechanism:
Under the flexible exchange rate mechanism, the exchange rate
is determined by market forces. When there is no government
intervention in the determination of exchange rate, it is called as
 296 □ “E r a VipuVs™ Business Economics - II (SFC)

clean float. When the government interferes, it is called dirty float.

When the central bank intervenes as and when necessary in the
flexible exchange rate mechanism, it called 'managed float
system'. Each one of these system has its own merits and
demerits.
M ERITS AND DEM ERITS OF FIXED EXCHANGE RATE
SYSTEM:
Merits:
(1) Fixed exchange rate ensures certainty and hence facilitates
smooth flow of trade.
(2) Flow of capital between countries will be easier due to a
stable exchange rate.
(3) Though speculations is not totally absent in this system, the
harmful effects are less as compared to flexible system
wherein speculation tends to be irrational.
(4) International cooperation improves under the fixed system
than under flexible system.
(5) Monetary and fiscal policies remain stable as the system
requires stability in these policies. Fixed exchange rate system
discourages governments in following expansionary policies
leading to inflation or in devaluing their currency to boost
exports. Thus, fixed system forces governments to have
monetary and fiscal discipline.
(6) Inflation will be under control as the exchange rate remains
stable. Hence, stability in the domestic economy prevails
leading to better economic growth.
(7) Balance of payments fluctuations can be controlled by
following suitable trade policies. It is not true that only
flexible exchange rate system enables effective adjustment of
surplus or deficit in balance of payments.
Demerits:
(1) Element of certainty is no guarantee for promotion of world
trade. Supporters of flexible exchange rate point out that
 Foreign Exchange Market E r g r“E f 297

trade tends to grow under flexible system when foreign

exchange market is well developed.
(2) Fixed system requires huge foreign exchange reserves to be
maintained by the monetary authorities. This may not be
possible for many countries.
(3) According to the requirement of the economy, frequent
adjustments are not possible. Rigidity poses a problem to the
authorities.
(4) Internal stability may be sacrificed to maintain external
stability.
(5) Monetary and fiscal policies have to be framed keeping in
mind the exchange rate system. Thus the authorities lose their
freedom to formulate the policies according to domestic
needs.
^ M E R IT S AND DEM ERITS OF FLEXIBLE EXCHANGE RATE
SYSTEM:
Merits:
(1) Under the flexible exchange rate system, demand for and
supply of foreign exchange determines the exchange rate. It is
market determined and hence it is simple and easy to
determine.
(2) Adjustments in the rate are automatic according to situations.
(3) Deficit or surplus in the balance of payments gets corrected
automatically.
(4) There is no need to link the monetary policy with the
exchange rate mechanism. Monetary policy can be
independent.
(5) Automatic adjustments in the exchange rate directs the flow
of investments between countries and accelerate economic
development.
(6) Excessive speculations gets corrected due to market forces
and equilibrium rate gets restored.
298 n™ETEr VipuVs™ Business Economics - II (SFC)

(7) Unlike the fixed system, there is no need to maintain huge

foreign exchange reserves by the central bank. Monetary
authorities can retain their autonomy under flexible system.
(8) Stability of the domestic economy, attaining full employment,
better economic growth and development are possible under
this system due to the free play of market forces.
Demerits:
(1) This system can succeed only if there is full international
cooperation and coordination which is difficult to realise in
this competitive world.
(2) Exports and imports get affected due to uncertainty in the
exchange rate.
(3) Constant changes in the rate affects the flow of investments
between countries and slows down economic growth.
(4) Speculation in this system sometimes may be excessive
resulting in harmful effects.
(5) Though supporters of flexible system argue that monetary
and fiscal policies are independent, in reality changes are
required in these policies to ensure overall stability.
Thus, both the systems have their own merits and demerits.
Managed Float System:
In the present globalised world, many countries especially the
developing ones adopt the managed float system. Under this
system, the exchange rate is determined by the market forces.
However, the government or the central bank interferes to control
the fluctuations in the exchange rate and maintain stability in the
rate. The interventions of the central bank is by selling or buying
foreign currencies as per the requirements.
Developing countries are in favour of this system for the
following reasons:
(1) The exchange rate can be influenced by the central bank to
correct adverse balance of payments position.
(2) Overvaluation or undervaluation of a currency in terms of
other currencies create unfavourable effects like wrong
Foreign Exchange Market S"S"H" 299

allocation of resources, inflation, unemployment etc. Through

proper intervention by the central bank, these adverse effects
can be avoided.
(3) The government or the central bank has access to all vital
information. They are able to assess the market situation and
foresee changes in the near future. Hence they can formulate
suitable policies to prevent undue fluctuations in the market.
(4) This system is said to be better than protectionist policies
involving the use of tariffs, quotas, etc.
Many developing countries like India adopt the managed float
system to prevent volatility in the foreign exchange market.
RBI's Intervention in the Foreign Exchange Market:
The foreign exchange market is regulated by the RBI. After
independence, India like other countries adopted the IMF system,
wherein Indian rupee was pegged to US$ and UK£. When the
Brettonwoods system collapsed, Indian currency was pegged to a
basket of currencies rather than one currency. This continued till
the emergence of economic crisis in India in 1991. The Indian
rupee was devalued twice to overcome the balance of payments
crisis. In 1992, RBI introduced the Liberalised Exchange Rate
Management Systems (LERMS). Under this 60% of the export
receipts could be converted at the market rate and 40% at the
official rate. The same rule was extended to those who demanded
foreign exchange for travel, import of goods, etc. In 1993, full
convertibility of rupee was announced in the current account. In
the capital account, rupee is not yet fully convertible. The
government and the RBI are taking efforts and continuously
introducing reforms to pave the way for full convertibility of
rupee.
Under the managed float system, the Reserve Bank of India
buys foreign exchange when supply is more than demand to
prevent appreciation of the rupee and vice versa when demand is
more than supply. The intervention of RBI is categorised as
sterilised intervention and unsterilized intervention. Under
sterilised intervention, RBI uses monetary instruments like CRR,
open market operation etc. along with the intervention in the
 300 § ”i r s r V ipul’s™ Business Economics - II (SFC)

foreign exchange market. For instance when supply of foreign

exchange is excess of demand, RBI will buy foreign exchange.
This is result in more supply of rupee in the domestic economy
leading to inflation. To control this, RBI will sell securities in the
market or increase CRR. In the reverse case it will buy securities
and reduce CRR. Thus, sterilised intervention is accompanied by
the use of monetary tools to influence the exchange rate. Non­
sterilised intervention refers to buying and selling of foreign
exchange without the simultaneous buying and selling of
domestic currency.
Developing countries like India have a thin and narrow foreign
exchange market. To prevent fluctuations in the market the
central bank of the country intervenes and this intervention policy
is called Leaning against the Wind'. The Reserve Bank of India
regulates the commercial banks and Authorised Dealers in the
foreign exchange market to ensure stability. The Foreign
Exchange Management Act of 1999 (FEMA) is administered by
the RBI. Through its intervention the central bank aims at
regulating the exchange rate and preventing speculations and
volatility.

QUESTIONS
(1) Define the following terms.
(a) Foreign exchange market.
(b) Exchange rate.
(c) Spot exchange rate.
(d) Forward exchange rate.
(e) Arbitrage.
(f) Swap arrangement.
(g) Equilibrium exchange rate.
Fill in the blanks:
(a) ------------ -— refers to the current exchange rate.
(b) The foreign exchange market deals with spot and
transactions.
(c) US $ is said to be a ____________________ pcurrency.
(d) Demand for a n d of foreign exchange determines the
-

equilibrium exchange rate.

[A ns.: (a) spot rate (b) Forward (c) Vehicle (d) supply]
Foreign Exchange Market § '" § " 0 ” 301

State whether the following statements are true or false:

(a) Forward transactions help to minimize risk and loss.
(b) Foreign exchange market operates only on weekdays.
(c) Arbitrage helps to equalize the exchange rate.
(d) All countries adopt a flexible exchange rate mechanism at present.
[A ns.: (a) True (b) False (c) True (d) False]
(2) Define foreign exchange market. What are its main functions?
(3) Who are the main dealers in the exchange market?
(4) Explain the following:
(a) Spot exchange.
(b) Forward exchange rate.
(c) Arbitrage.
(d) Hedging.
(5) Explain the determination of equilibrium exchange rate.
(6) Explain the purchasing power parity theory.
(7) What is the difference between absolution version and relative version of
PPP theory?
(8 ) Explain the different types of floating rate system.
(9) Write short notes on:

(b)
(a) Functions of foreign exchange market.
Forward and spot transactions.
(c) Equilibrium exchange rate.
(d) Determination of exchange rate.
(10) Case Study:
Nothing To Panic About: 5 Reasons Rupee Fall Is Good For The
Economy:
The Indian currency’s sudden 3% fall in the new financial year to near
Rs. 64/dollar has raised concerns. However, with inflation under control,
this decline may actually give a nudge to the economy that’s struggling to
climb higher, although foreign debt-heavy companies will suffer.
The five advantages of the falling rupee against $ are:
(1) The fall will improve the competitiveness of the economy.
(2) The export sector will benefit significantly as demand for exports will
increase and this will give a boost to domestic industry.
(3) Remittances from non-resident Indians will increase strengthening the
external sector.
(4) Sectors like IT and Pharma with high export earnings will get a boost.
(5) Imports will become expensive giving a push to ‘Make in India’.
Source: The Economic Times dated 11th May, 2015.
Questions:
(1) List down the disadvantages of the falling rupee against $.
(2) Is India in a position to realise all the above advantages of the falling
rupee? Explain.

D D D
tflPUL Wlpyi VIWIL
302 g rg rn " V ip u l ’s™ Business Economics - II (SFC)

Model Question Paper

Time: 2Vt Hrs Marks: 75

Notes: (1) Attempt all questions. (2) All questions carry equal marks.

(1) Answer any tw o : (15)

(a) Explain circular flow o f income in a three sector model.

(b) Define effective demand. How is it determined?

(c) What are the features and phases of a trade cycle? Explain
with a suitable diagram.

(2) Answer any tw o : (15)

(a) Define money supply. What factors determine velocity o f

circulation o f money?

(b) Explain Fisher's equation o f exchange.

(c) Distinguish between demand pull inflation and cost push

inflation.

(3) Answer any tw o : (15)

(a) Define functional finance. Explain the role o f government in

providing public goods.

(b) What are the effects o f taxation on production and

distribution?

(c) Explain the main features o f FRBM Act 2003.

M odel Question Paper i 0 i 303

(4) Answer any tw o : (15)

(a) Explain the modern theory o f international trade.

(b) What are the merits and demerits o f foreign direct

investment?

(c) "Spot and forward exchange rates are different" Explain.

(5) (a) Explain the follow ing concepts. (Any four): (8)

(i) Green GNP

(ii) Monetary Policy

(iii) Capital expenditure

(iv) Fiscal deficit

(v) Balance o f payment

(vi) Arbitrage

(5) (b) M ultiple Choice Question: (Any 7) ( 1 x 7 = 7)

(1) Macro Economics is concerned w ith ___________ .

(i) individual firms (ii) industry (jji) whole economy

(2) Investment m ultiplier wasgiven b y ___________ .

(ij J. M. Keynes (ii) Marshall (iii) Robertson

(3) When income increases consumption will increase in a

proportion.

(i) greater (ii) lesser (iii) constant

(4) Inflation redistributes income in favour of the

people.

(i) rich (ii) poor (iii) middle income

304 ™ H V ip u l ’s™ Business Economics - II (■

(5) Inflation target fixed by RBI at present is ___________ .

(i) 4% (ii) 6% (iii) 2%

(6) According to Keynes, rate o f interest is purel\

phenomenon.

(i) fiscal (ii) monetary (iii) political

(7) During depression___________ budget is adopted by t.._

governm ent.

(i) surplus (ii) deficit (iii) balanced

(8) Sound finance was advocated b y ___________ .

(i) J. M. Keynes (ii) A. P. Lerner (iii) Adam Smith

(9) _______ ____ is the difference betw een revenue receipts

and revenue expenditure.

(i) Fiscal deficit (ii) Revenue deficit (iii) Primary deficit

(10) Comparative cost advantage theory was formulated by

(i) Ohlin (ii) Hecksher (iii) Ricardo

(11) The current exchange rate system in India is called

(i) fixed system (ii) flexible system (iii) managed flc .

system

(12) Balance o f paym ents___________ balance o f trade.

(i) excludes (ii) includes (iii) balances

□ H □ ! □ B
viww.;; m m :
viwr