MONEY, BANKING,

INTERNATIONAL TRADE
AND
PUBLIC FINANCE
 MONEY, BANKING,
INTERNATIONAL TRADE
AND
PUBLIC FINANCE
D.M. MITHANI
M.A., Ph.D.,
Professor Emeritus,
L.J. Institute of Business Management (MBA),
Ahmedabad, India.
Adjunct Professor,
Oriental Institute of Management,
Vashi, Navi Mumbai.
Former Professor, OYA Graduate School of Business,
Universiti Utara Malaysia (UUM), Malaysia.
Former Reader,
Department of Commerce, University of Mumbai,
Mumbai, India.
Former Head of Economics Department,
Maharashtra College of Arts, Science and Commerce,
Mumbai.

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© D.M. MITHANI, 2018
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 PREFACE TO THE TWENTIETH REVISED EDITION: 2018-19

Dealing with money, banking, international trade and public finance in one book all at the same time is
more exciting and challenging to the writer as well as to the reader, as it provides a new dimension to one’s
understanding of the macroeconomic world.
There is no dearth of books and literature on these fascinating subjects, yet most of them do not adequately
meet the specific requirements of the student community at large. Too often, students are required t o consult a
large number of books and journals to obtain the information they seek. The few good books available have
become out of date as the syllabii in the various universities and modes of analysis have changed considerably
in recent years. Besides, economics of money, banking, trade and finance has undergone a dynamic evo lution.
New ideas and new institutions have emerged with far-reaching effects on the relevant issues and problems and
their solution.
In such a situation, a study cannot become complete and illuminating unless the students are kept ab reast
of the prevalent trends. Most of the books available are, however, inadequate in this respect, to gr eater or lesser
degree. I have purposely designed this book so as to meet the felt need. Distinct features of the pr esent book:
1. It is comprehensive.
2. It has an integrated approach with an Indian perspective.
3. It lucidly discusses the subject matter in a style that draws the student into the depth of the study,
facilitating sound knowledge, understanding and appreciation of the subject.
4. It reviews the essential core topics of each field of money, banking, international trade and financ e in a
clear, precise and sequentially integrated manner so that the student can acquire an understanding o f
the subject.
5. It synthesises the materials scattered in numerous foreign authors’ books and journals. The subject matter
has been presented in a logical order, in a lucid and narrative style, using numerous illustrations, charts
and diagrams. It also gives a simple formulist presentation wherever needed.
6. It aims at giving a thorough grounding on the subject.
7. It contains discussions on the subject matter developed right from an introductory to an advanced level,
suitably arranged section-wise so that the students can pick up the sections of his requirements, omitting
the rest.
8. Most of the chapters in the book are written in a fairly self-contained manner. As such, the student can
read the text in the order which suits best his interest and the requirements of his own syllabus or
preference.
9. It incorporates numerous questions at the end of each chapter. These have been designed: (a) to test the
student’s understanding of the subject matter discussed in the text; (b) to encourage the student himself
to absorb the ideas expounded; and (c) to enable him to review definitions and important concepts
during the course of his study. In the objective test section, multiple choice questions are set to provide
practice in answering this form of questions, usually set in many professional examinations such as I.A.S.,
I.E.S., etc.
10. The book is designed to meet the varying needs of the graduate and postgraduate students and others
interested in economics.
 As a whole, this bookshould be of value to at least three categories of students:
(i) undergraduates in economics and commerce reading for B.A. and B.Com. degree at the various
Indian Universities; (ii) post-graduate students at M.A. and M.Com. levels; and (iii) those preparing for
professional examinations such as I.E.S., I.A.S., C.A., M.B.A., C.A.I.I.B., C.W.A., etc.
Finger Points to Exam Preparation:
 Never ever be nervous.
 Read, Read, Read and be prepared.
 Have focus of your reading on core topic of the subject/syllabus.
 While writing your answers, rely on your memory of what you have read.
 Choose the answer, the questions first which you feel you can give best answers.
 Give answers to all the questions with your rational choice in priority.
 Your first answer would be the best as examiners usually start reading the beginning with more atte ntion
in forming an opinion. Remember: First Impression is the Best Impression.
 Whenever possible, try to quote two relevant popular personalities' golden view or sentence in your answer
by underlining.
 Underline important/key sentence in your answer.
 Always begin a new answer to a new question on a new page at the top.
 Underline the number of the question, then
 Answer to Q. 4
 Answer to Q. 6
 Whenever supplementary answer book is added to the main answer book, at the end on the page, give an
indication, such as Sir Please see to Answer to Question further continued on next supplement tied.
 Relax once exam paper is handed over to the Supervisor.
 Do not worry about the result for the given paper and start preparing for the next.
For the sake of convenience, the book has been divided into four parts in a logical sequence. Part I contains
the subject-matter of money and banking, including Indian banking and the Reserve Bank’s monetary policy.
Part II provides an exhaustive treatment of the theory of income and employment, including an analys is of trade
cycles and measures of economic stabilisation. Part III deals with international trade: theory, policy and finance.
Part IV elucidates the principles of public finance and fiscal policy, including a discussion on India’s Finance
Commissions. A brief review of supply side economics has also been incorporated to keep the reader a breast of
the latest economic trends in the West. Within this, it is hoped that the book will serve as a comprehensive
textbook for the students of B.A. and B.Com. degree courses and a basic reference book for the M.A. and
M.Com. degree courses at all the Indian universities in general.
Money, Banking, Finance and Trade are the dynamics of macro studies in Economics and Management
field. The subject is fascinating and fast changing in scope and application. In view of this, the a uthor has taken
the opportunity this time to recast, and thoroughly revise, rewrite, and update the discussion on the subject-
matter. It is hoped the present new edition will have enhanced utility to the reader.
In writing a textbook of this kind, one incurs a mounting indebtedness to several writers on the subject. It
is, therefore, very difficult for me to state how greatly I am indebted to each of them. As I have drawn upon and
assimilated a great amount of materials from the standard works of these well-known authorities, I a cknowledge
with gratitude my debt to these authors and their publishers whose work I have referred to with ment ion or
without mention in the course of writing this volume.
 The author has taken this opportunity to update the information/data analysis included in this book. Several
new points and sub-topics have been incorporated, in the light of new development in the subject and new
official reports and publications of the Reserve Bank of India, International Monetary Fund, World Bank and the
Government of India. New concepts and topics, such as new monetary aggregates, Indian capital market , WTO,
etc. have been added. It is hoped that this volume will have an enhanced utility to the students and researchers
in India and other developing economies. Suggestions for further improvement of the book will be gra tefully
acknowledged.
The author is grateful to the student community and teaching fraternity alike for the warm welcome they
have accorded to this book so that it has seen the light of the Twentieth edition by now.
The author expresses his special gratitude to Prof. B.M. Peerzada, President, L.J. Institute of Mana gement
for his constant inspiration and encouragement. Besides, the author is grateful to Ex-Principal, A.A . Munshi and
present principal Dr. Sirasuddin H. Chougle, Maharashtra College of Arts, Science and Commerce for their encourgement
to the Author in this academic writing, then and now.
Comments and suggestions from the reviewers of the earlier editions, other adopters and friends like
Dr. Rajkumar Sen, Ex-President, Indian Economic Association, Dr. B.N. Ghosh (Universiti Sains Malaysia),
Dr. B.M. Jani (Saurashtra University), Prof. Devendra Awasthi (St. Andrew’s College Gorakhpur), Prof . P.S.
Trivedi (Mahila College, Bhavnagar), Dr. Himanshu Desai (Nav Gujarat College, Ahmedabad), Muzafarshah Mohd.
Mustafa and Lim Hock, Lecturers in Economics, College of Arts, Universiti Utara Malaysia (UUM) and my students
especially, Mohd. Husain Navloor, Ex-lecturer, Maharashtra College, Mumbai. Somchai and Jirapone of Thailand
(DBA), Prof. Shahzad of Pakistan and Mathi of Malaysia (MBA) and Sally (Ph.D. student) at UUM have been
most beneficial in preparing this volume. My thanks to all.

Janmashtmi
2nd September 2018 D.M. MITHANI
 CONTENTS

PART I
MONEY AND BANKING 1 – 366

1. THE NATURE OF BARTER AND MONETARY ECONOMY 3 – 10

Barter Economy — Evolution of Money — Forms of Money in a Modern Economy — Nature of a Monetary
Economy — Circular Flow of Money — Monetisation — References — Questions for Discussion — Objective
Test.

2. FUNCTIONS AND SIGNIFICANCE OF MONEY 11 – 24

Definition of Money — Static Functions of Money — Dynamic Role of Money — Money as a Liquid Asset:
A Link with Future — Money and Near-money — Significance of Money in Modern Economic Life — Role
of Money in a Capitalist Economy — Classical and Modern Economists’ Views on Money — References
— Questions for Discussion — Objective Test.

3. MONETARY STANDARDS 25 – 29

The Concept of Monetary Standard — Metallic Standard — Monometallism — Bimetallism — Paper Standard
— Gresham’s Law — Reference — Questions for Discussion — Objective Test.

4. THE GOLD STANDARD 30 – 43

Meaning and Characteristics of Gold Standard — Functions of the Gold Standard — Forms of Gold Standa rd
— Domestic Gold Standard — International Gold Standard — Mechanism of International Gold Standard —
Rules of Gold Standard Game — Working and Collapse of the Gold Standard — References — Questions
for Discussion — Objective Test.

5. THE MONEY SUPPLY 44 – 58

The Concept of Money Supply — Components of Money Supply — The Modern Approach — Different
Approaches Regarding Measure of Money Supply — Reserve Bank of India’s Measure of Money Stock —
New Monetary Aggregates — Determinants of Money Supply — The Analysis of Changes in Money Supply:
Money Multiplier Theory — Money Supply Function — Velocity of Circulation of Money — Creation of Money:
Changes in Money Supply — Non-bank Financial Intermediaries and Money Supply — References — Questions
for Discussion — Objective Test.

6. THE DEMAND FOR MONEY 59 – 72

Introduction — The Classical Approach — The Keynesian Approach — Idle Cash Balances (The Speculative
Demand for Money) — The Liquidity Trap — Total Demand for Money — Portfolio Balance Approach to
Demand for Money — Wealth Theory of Demand for Money — The Money Illusion — A Note on Empirical
Studies of Demand for Money — References — Questions for Discussion —Objective Test.

7. VALUE OF MONEY 73 – 78

The Concept of Value of Money — Measurement of Changes in the Value of Money — Construction of
Price Index Number — Difficulties in Measuring the Changes in Value of Money — References — Questions
for Discussion — Objective Test.

8. QUANTITY THEORY OF MONEY 79 – 95

The Gist of the Quantity Theory of Money — The Cash Transactions Approach: Fisherian Version —
Criticisms against Fisher’s Quantity Theory of Money — The Cash-Balances Approach: The Cambridge
 Version — A Comparison between Fisherian and Cambridge Versions — Superiority of Cambridge Version
over Fisher’s Version — Shortcomings of Cash Balances Approach — General Evaluation of the Quantity
Theory of Money — Keynes’ Theory of Money and Prices (Keynes’ Reformulation of QTM) — The Chicago
Version of QTM — References — Questions for Discussion — Objective Test.

9. THE INCOME THEORY OF MONEY 96 – 102

Basic Theme of the Income Theory of Money (ITM) — Main Postulates of the ITM (Income Expenditure
Approach) — Saving and Investment Approach — An Appraisal of ITM — References — Questions for
Discussion — Objective Test.

10. INFLATION AND DEFLATION 103 – 136

Introduction — Meaning of Inflation — Inflation as a Pure Monetary Phenomenon — Inflation as a Post-full

Employment Phenomenon — Contemporary Views on Inflation — Features of Inflationary Economy — Types
of Inflation — Major Theories of Inflation — Demand-pull vs. Cost-push Inflation — The Keynesian Concept
of Inflationary Gap — Causes of Inflation — Effects of Inflation — Inflation in an Underdeveloped Ec onomy
— Inflation and Economic Development — The Control of Inflation — Deflation — Inflation Versus Deflation
(Inflation is Unjust, Deflation is Inexpedient) — Control of Deflation — Globalisation and Inflation — Global
Inflation Rates — Inflation in India: Current Scenario — References — Questions for Discussion — Objective
Test.

11. FINANCIAL MARKETS (Money and Capital Markets) 137 – 155

Nature and Functions of Financial Markets — Money Market – Its Meaning — Constituents of the Money
Market — Institutions of the Money Market — Characteristics of Developed and Underdeveloped Money
Markets — The Structure of the Indian Money Market — The Moneylenders — The Indigenous Bankers —
Deficiencies of the Indian Money Market — Measures for Improvement — A Note on the Report of the
Working Group (Vaghul Committee) on Money Market — Recent Innovations in the Money Market — Capital
Market — Structure of Interest Rates — Structure of Interest Rates in India — References — Questions for
Discussion — Objective Test.

12. THEORIES OF INTEREST 156 – 170

Concept of Interest — Classical Theory of Interest — Loanable Funds Theory of Interest — Keynes’ Liquidity
Preference Theory — Comparison between Classical and Keynesian Theories of Interest — The Modern
Theory of Interest (or Neo-Keynesian Theory) — References — Questions for Discussion — Objective Tes t.

13. COMMERCIAL BANKING 171 – 190

Evolution of Banking — What is a Bank? — Kinds of Banks — Functions of Commercial Banks — Structure
of Banking System: Unit Banking vs Branch Banking — Merits and Demerits of Unit and Branch Banking —
Functions and Services of Indian Banks — Bank’s Balance Sheet and Portfolio Management — Credit Creation
— Limits to Credit Creation — The Credit Expansion Multiplier: Revisited — Leaf-Cannon Criticism of the
Theory of Credit Creation — Role of Banks in a Developing Economy — Banks vs. Non-bank Financial
Intermediaries — References — Questions for Discussion — Objective Test.

14. BANKING IN INDIA 191 – 238

Introduction — Early Growth of Joint Stock Banks in India — Major Banking Developments/Reforms During
the Planning Era — Salient Features of Commercial Banking System in India — Growth of Commercial
Banking in India — Lead Bank Scheme — Action Plans — Mobilisation of Savings: Deposit Mobilisation —
Credit-Deposit Ratio of Scheduled Commercial Banks — Credit Deployment — Credit Deployment to Priority
Sectors — Analysis of Recent Credit Growth — Banks’ Participation in the IRDP — Other Aspects of
Credit Deployment — Innovative Banking — Novel Credit Schemes/Facilities — Merchant Banking — Indian
Banks Overseas — Customer Service in Banks — Agricultural Finance Corporation — The Problem of
Banks’ Overdues — Profitability of Commercial Banks — A Review of Current Banking Scenario — Technology
and Payment System — Virtual Banking — Report of the Working Group on Restructuring Weak Public
Sector Banks — Capital Adequacy — References — Questions for Discussion — Objective Test.

15. CO-OPERATIVE AND RURAL BANKING 239 – 269

Introduc tion — Differenc es between Co-operative Bank s and Commerc ial Banks — The Structure of
Co-operative Banking System in India — Primary Agricultural Credit Societies — Central Co-operative Banks
 — State Co-operativ e Bank s — Urban Co-operativ e Bank s — Land Dev elopment Banks — National
Co-operative Development Corporation — Scheduled Co-operative Banks — Rural Banks — The Scheme
of Regional Rural Banks — The Organisation and Functions of the Regional Rural Banks — Progress of
the Regional Rural Banks — The Major Problems Faced by RRBs — Suggestions for Reorganisation and
Improvement in the Working of RRBs — Dantwala Committee’s Report on RRBs — National Bank for Agricul ture
and Rural Development (NABARD) — Structural Reforms in Co-operative Banking — NABARD and its
Role in Rural Credit — Micro-finance — NABARD and the Co-operative Sector Revisited — References —
Questions for Discussion — Objective Test.

16. THE CENTRAL BANK AND INSTRUMENTS OF CREDIT CONTROL 270 – 288

Central Bank: An Apex Financial Authority — Functions of a Central Bank — Functions of Reserve Bank
of India — Central Bank and Monetary Management — Instruments of Credit Control — Bank Rate Policy
(BRP) — Open Market Operations — Variable Cash Reserve Ratio (VCRR) — A Review of the General
Instruments of Credit Control — Selective Credit Control (SCC) — Objectives of Selective Credit Cont rol
— Measures of Selective Credit Control — Limitations of Selective Credit Control — Selective Credit Control
in a Developing Economy — References — Questions for Discussion — Objective Test.

17. DEVELOPMENT BANKS AND OTHER TERM FINANCING INSTITUTIONS IN INDIA 289 – 295

The Concept of Development Banking — Development Banks in India — The Industrial Finance Corporation
of India (IFCI) — The Industrial Development Bank of India (IDBI) — The Industrial Reconstruction Ba nk of
India (IRBI) — The National Small Industries Corporation (NSIC) — The Industrial Credit and Investment
Corporation of India (ICICI) — State Financial Corporations (SFCs) — The State Industrial Developmen t
Corporations (SIDCs) and the State Industrial Investment Corporations (SIICs) — The Export-Import Ba nk
of India (EXIM) — Land Development Banks (LDBs) — The Life Insurance Corporation of India (LIC) — The
Unit Trust of India (UTI) — Questions for Discussion — Objective Test.

18. THE RESERVE BANK OF INDIA: ORGANISATION AND FUNCTIONS 296 – 316

Introduction — Organisational Structure and Management of the Bank — Departments of the Res erve
Bank — Objects and Functions of the RBI — The RBI as Currency Issuing Authority — The RBI as a
Banker to Government — The RBI as a Banker’s Bank and Supervisor — Exchange Management and
Control — Collection of Data and Publications — Miscellaneous Developmental and Promotional Functions
—The Bill Market Scheme — The RBI and Agricultural Finance — The RBI and Industrial Finance — The
RBI and Export Finance — The Deposit Insurance Corporation — National Housing Bank — References
— Questions for Discussion — Objective Test.

19. MONETARY POLICY 317 – 334

Introduction — Meaning and Content of Monetary Policy — Objectives of Monetary Policy — Neutrality of
Money — Exchange Rate Stability and Equilibrium in the Balance of Payments — Price Stability and Control
of Business Cycles — Full Employment — Economic Growth — Choosing between Conflicting Objectives —
Role of Monetary Policy in a Developing Economy — Efficacy of Monetary Policy — Limitations of Monetary
Policy — References — Questions for Discussion — Objective Test.

20. A REVIEW OF THE WORKING AND OPERATIONS OF THE RESERVE BANK OF INDIA 335 – 354

Monetary Regulation and Credit Management of the RBI: Introduction — Objectives of Monetary Policy in
India — Controlling Measures Adopted by the RBI — Major Issues of Indian Monetary Policy in Retrospe ct
and Prospect — Chakravarty Report on the Working of the Indian Monetary System — The Narasimham
Committee Report: A Review — Recent Monetary and Credit Policy Operations — Liquidity Management
by the Reserve Bank — Stance of Monetary Policy in India in 2005-06 — References — Questions for
Discussion — Objective Test.

21. INDIAN CAPITAL MARKET 355 – 364

Meaning and Functions of Capital Market — Structure of the Indian Capital Market — Capital Market fo r
Corporate Securities — Capital Market for Government Securities — Growth Prospects of Indian Capital
Market — Recent Developments in Indian Securities Markets — Review of Policy Development — References
— Questions for Discussion — Objective Test.
22. MERCHANT BANKING 365 – 366

Introduction — Merchant Banking in India — Functions of a Merchant Bank — Regulation of Merchant

Banking in India — Questions for Discussion — Objective Test.

PART II
THE THEORY OF INCOME AND EMPLOYMENT 367 – 481

23. NATIONAL INCOME 369 – 383

Concept of National Income — Concepts Associated with National Income Total — Other Related Concepts
and Relationships — Methods of Estimating National Income — Difficulties in National Income Estimate —
Method of Deflating National Income — Importance of National Income Data — Social Accounting Method
— Reference — Questions for Discussion — Objective Test.

24. EMPLOYMENT AND UNEMPLOYMENT 384 – 391

Concept of Unemployment — Full Employment — Types of Unemployment — Nature of Unemployment in

Underdeveloped Countries — References — Questions for Discussion — Objective Test.

25. THE CLASSICAL THEORY OF EMPLOYMENT 392 – 399

Introduction — Supply-oriented Classical Theory of Employment — Assumptions of Full Employment —

Say’s Law of Markets — Interest Rate Flexibility — Classical Model of Employment — Wage Rate Flexibility
and Employment — Keynes’ Criticisms against Classical Theory — References — Questions for Discussion
— Objective Test.

26. KEYNESIAN THEORY OF EMPLOYMENT 400 – 414

Introduction — The Principle of Effective Demand — Analysis of the Level of Effective Demand (Factor s
Determining Effective Demand) — How GNP is Determined? — Paradox of Poverty and Potential Plenty —
An Outline of the Keynesian Theory of Employment — Shortcomings of Keynesian Theory — References —
Questions for Discussion — Objective Test.

27. THE CONSUMPTION FUNCTION 415 – 423

Fundamental Psychological Law of Consumption — The Consumption Function — Saving Function — Technical
Attributes of Consumption Function — Factors Affecting the Consumption Function — Significance of the
Concept of Consumption Function — Measures to Increase Consumption Spending — References — Questions
for Discussion — Objective Test.

28. THE INVESTMENT FUNCTION 424 – 434

Introduction — Meaning of Investment Function — Marginal Efficiency of Capital — Marginal Efficiency of

Capital (MEC) and Rate of Interest — MEC Schedule — Investment Demand Schedule (Function) — Factors
Affecting MEC — The Role of Expectations — Criticisms of MEC — Measures to Stimulate Investment —
References — Questions for Discussion — Objective Test.

29. THEORY OF MULTIPLIER 435 – 440

Introduction — The Concept of Multiplier — Working of the Multiplier (The Process of Income Propagation)
— Graphical Representation of the Multiplier Effect — Assumptions of the Multiplier Theory — Leakages in
the Multiplier Process — Shortcomings of the Multiplier Theory — Income Fluctuations in a Less Developed
Economy — References — Question for Discussion — Objective Test.

30. THE ACCELERATOR PRINCIPLE 441 – 445

Meaning of Accelerator — Working of the Accelerator — Limitations of the Acceleration Principle — Significance
of the Acceleration Principle — Interaction of the Multiplier and the Accelerator — References — Questions
for Discussion — Objective Test.
31. SAVINGS AND INVESTMENT 446 – 456

The Concept of Savings — Determinants of Savings — Saving: A Virtue or a Vice? — Saving and Investme nt
Equality — Underemployment Equilibrium — References — Questions for Discussion — Objective Test.

32. KEYNES’ THEORY AND UNDERDEVELOPED COUNTRIES 457 – 459

Introduction — Distinctive Nature and Typical Causes of Unemployment in Underdeveloped Countries —

The Static Feature of the Keynesian Model — Failure of the Keynesian Multiplier in Underdeveloped Countries
— References — Questions for Discussion — Objective Test.

33. TRADE CYCLES AND MEASURES OF ECONOMIC STABILISATION 460 – 476

Introduction — Features of a Trade Cycle — Phases of a Trade Cycle — Important Trade Cycle Theories
— The Purely Monetary Theory — The Monetary Over-investment Theory — Non-monetary Over-investment
Theory — Under-consumption (Or Over-saving) Theory — The Psychological Theory — The Innovation Theory
— Keynes’ MEC Theory — Hicks’ Theory of Trade Cycles — General Conclusions on the Theories of Trade
Cycle — Measures of Economic Stabilisation — References — Questions for Discussion — Objective Test.

34. MONETARISM AND KEYNESIANISM 477 – 481

Introduction — Monetarism — Genesis of Monetarism — Other Aspects of Friedman’s Contribution in Monetarist

Doctrine — Major Monetarist Propositions — Keynesian vs. Monetarist — Reference — Questions for
Discussion — Objective Test.

PART III
INTERNATIONAL TRADE: 483 – 605
THEORY, POLICY AND FINANCE

35. THE NATURE OF INTERNATIONAL TRADE 485 – 488

Internal and International Trade — Salient Features of International Trade — Differences between Internal
Trade and International Trade — Advantages of International Trade — Disadvantages of Foreign Trade —
References — Questions for Discussion — Objective Test.

36. THE THEORY OF COMPARATIVE ADVANTAGE 489 – 496

The Theory of Comparative Advantages (The Classical Theory of International Trade) — Comparative
Costs Measured in Terms of Money (Taussig’s Restatement of Comparative Costs Doctrine) — A Critical
Appraisal of the Theory of Comparative Costs — Doctrine of Comparative Costs and Underdeveloped
Countries — Revealed Comparative Advantage — References — Questions for Discussion — Objective
Tes t.

37. MODERN THEORY OF INTERNATIONAL TRADE:

GENERAL EQUILIBRIUM APPROACH 497 – 509

Introduction — Heckscher-Ohlin Theorem — Factor-Price Equalisation Theorem — An Appraisal and Comparison

between Classical and Modern Theory of International Trade — Shortcomings of Ohlin’s Theory — Empirical
Tests of the Factor Endowment Theory — Reference — Questions for Discussion — Objective Test.

38. GAINS FROM TRADE AND TERMS OF TRADE 510 – 518

Gains from Trade — Distribution of Gains — Meaning and Types of Terms of Trade — Equilibrium Terms
of Trade (Theory of Reciprocal Demand) — Factors Influencing Terms of Trade — Reasons for the Unfavourable
Terms of Trade of Less Developed Countries (LDCs) — Effects of Tariff on the Terms of Trade — Effects
of Devaluation on the Terms of Trade — Effects of Economic Development/Growth on the Terms of Trade
— References — Questions for Discussion — Objective Test.
39. MECHANISM OF INTERNATIONAL PAYMENTS 519 – 535

Instruments of External Payments — Foreign Exchange Market and its Functions — Rate of Exchange —
Determination of the Rate of Exchange — Equilibrium Rate of Exchange — Mint Parity Theory — Purchasi ng
Power Parity (PPP) Theory — Criticisms against the PPP Theory — Balance of Payments Theory — Causes
of Fluctuations in Exchange Rates — Fixed and Flexible Exchange Rates — Case for Fixed Exchange Rate
System — Case for Flexible Exchange Rates — Managed Flexibility — References — Questions for Discuss ion
— Objective Test.

40. THE BALANCE OF PAYMENTS 536 – 547

Introduction — Structure of Balance of Payments — Balance of Trade and Balance of Payments — Balance
of Payments Always Balances — Equilibrium in the Balance of Payments — Types of Disequilibrium in the
Balance of Payments — Fundamental Disequilibrium — Causes of Disequilibrium — Measures for Correcting
Disequilibrium — Deflation — Exchange Depreciation — Devaluation — Exchange Control — Non-monetary
Measures — Reference — Questions for Discussion — Objective Test.

41. TRADE POLICY: FREE TRADE VS. PROTECTION 548 – 554

Free Trade Policy — Protection — Advantages of Protectionism — Role of Protection in Underdeveloped

Countries — References — Questions for Discussion — Objective Test.

42. PROTECTIVE TRADE DEVICES: TARIFFS AND QUOTAS 555 – 562

Tariffs — Effects of Tariffs — Import Quotas — Types of Import Quotas — The Effects of Quotas —
Quotas vs Tariffs — References — Questions for Discussion — Objective Test.

43. EXCHANGE CONTROL 563 – 567

Meaning of Exchange Control — Objectives of Exchange Control (Merits of Exchange Control) — Techniqu es
of Exchange Control — Methods of Exchange Control — Indirect Methods of Exchange Regulation — Demeri ts
of Exchange Control — References — Questions for Discussion — Objective Test.

44. THE IMF AND THE PROBLEM OF INTERNATIONAL LIQUIDITY 568 – 576

Introduction — Achievements of the IMF — The Problem of International Liquidity — IMF and International
Liquidity — Special Drawing Rights — Features of SDR Scheme — A Critical Appraisal of the SDR Scheme
— The SDRs in Operation — Questions for Discussion — Objective Test.

45. INTERNATIONAL FINANCIAL INSTITUTIONS 577 – 580

The World Bank — International Finance Corporation (IFC) — International Development Association (ID A)
— Questions for Discussion — Objective Test.

46. EURO-DOLLAR MARKET 581 – 583

Prelude — The Meaning of Euro-dollar — Euro-dollar Market — Benefits of the Euro-dollar Market — Effects
of Euro-dollar Market on International Financial System — Shortcomings of the Euro-dollar Market — Reference
— Questions for Discussion — Objective Test.

47. EUROPEAN ECONOMIC COMMUNITY (EEC) 584 – 586

The Nature and Objective of the EEC — The Organisation of EEC — The Impact of EEC — European Free
Trade Association (EFTA) — Questions for Discussion — Objective Test.

48. GENERAL AGREEMENT ON TARIFFS AND TRADE 587 – 589

Origin of GATT — Objectives of GATT — Most Favoured Nations Clause — Tariff Negotiations — The
Kennedy Round — Questions for Discussion — Objective Test.
49. UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT 590 – 597

Introduction — Organisation of the UNCTAD — Functions of UNCTAD — UNCTAD and GATT — Appraisal
of Recommendations of UNCTAD-I — UNCTAD-II — UNCTAD-III — UNCTAD-IV — UNCTAD-V — UNCTAD-
VI — New International Economic Order (NIEO) — Questions for Discussion — Objective Test.

50. THE WORLD TRADE ORGANISATION (WTO) 598 – 603

Introduction — Objectives and Functions of the WTO — The WTO Code/Agreements — The WTO in Action
— Singapore Issues — WTO and India — Sinagapore Issues, Doha Declaration and Cancun Fiasco —
WTO: What it is and What it Does? — Questions for Discussion.

51. FOREIGN DIRECT INVESTMENT AND ITS DETERMINANTS 604 – 605

References — Questions for Discussion.

PART IV
PRINCIPLES OF PUBLIC FINANCE 607 – 734

52. NATURE AND NORMS OF MODERN PUBLIC FINANCE 609 – 616

Meaning and Scope of Public Finance — Functions of Public Finance — Importance and Objects of Modern
Public Finance — Public Finance vs. Private Finance — The Principle of Maximum Social Advantage —
Limitations of the Principle — Limitations of the Principle — Dalton’s Objective Tests of Social Adv antage
— Circular Flow of Income and Taxes — References — Questions for Discussion — Objective Test.

53. PUBLIC REVENUE 617 – 620

Meaning of Public Revenue — Tax Revenue — Non-tax Revenue — Classification of Public Revenue —
References — Questions for Discussion — Objective Test.

54. CANONS OF TAXATION AND PRINCIPLES OF EQUITY 621 – 626

Canons of Taxation — Equity in Taxation — Cost of Service Principle — Benefit Principle — Objective
Approach of Ability to Pay Principle — Taxable Capacity — References — Questions for Discussion —
Objective Test.

55. CHARACTERISTICS OF A GOOD TAX SYSTEM AND THE INDIAN TAX STRUCTURE 627 – 631

Characteristics of a Good Tax System — The Indian Tax Structure — References — Questions for Discuss ion
— Objective Test.

56. TYPES OF TAXATION 632 – 642

Proportional, Progressive, Regressive and Digressive Taxes — Specific and Ad Valorem Taxes — Direct
and Indirect Taxes — Merits of Direct Taxation — Demerits of Direct Taxation — Merits of Indirect Taxation
— Demerits of Indirect Taxes — Comparison between Direct and Indirect Taxes — Role of Direct and Ind irect
Taxes in Developing Countries — Complementarity Aspect of Direct and Indirect Taxes — References —
Questions for Discussion — Objective Test.

57. INCIDENCE OF TAXATION 643 – 649

Meaning of Incidence — Impact, Shifting and Incidence — Tax Evasion and Tax Shifting — The Process
of Tax Shifting — Tax Capitalisation — Dalton’s Theory of Incidence (Demand-Supply Analysis of Tax
Shifting) — Incidence of Customs Duties, Income Tax and Corporate Income Tax — Reference — Questions
for Discussion — Objective Test.
58. EFFECTS OF TAXATION 650 – 656

Introduction — Effects of Taxation on Production — Effects of Taxation on the Allocation of Resources —

Effects of Taxation on Distribution — Other Macroeconomic Impacts of Taxation — References — Questio ns
for Discussion — Objective Test.

59. PUBLIC EXPENDITURE 657 – 665

Introduction — Importance and Objects of Public Expenditure — Increasing Trend of Public Expenditure —
Causes of Public Expenditure Growth — Canons of Public Expenditure — Effects of Public Expenditure —
Reference — Questions for Discussion — Objective Test.

60. PUBLIC DEBT 666 – 676

Introduction — Necessity of Public Borrowing — Forms of Public Debt — Burden of External Debt — Burd en
of Internal Debt — The Question of Shifting of the Burden of Public Debt — Redemption of Public Debt —
Reference — Questions for Discussion — Objective Test.

61. FISCAL POLICY 677 – 685

Introduction — The Concept of Sound Finance (Balanced Budget Approach) — The Concept of Functional
Finance (Unbalanced Budget Approach) — Objectives of Fiscal Policy — Fiscal Policy in Depression —
Role of Fiscal Policy in Developing Countries — Instruments of Fiscal Policy — Limitations of Fiscal Policy
— References — Questions for Discussion — Objective Test.

62. DEFICIT FINANCING 686 – 689

The Concept of Deficit Financing — Deficit Financing and Price Level — Limits of Deficit Financing —
Questions for Discussion — Objective Test.

63. MOBILISATION OF RESOURCES FOR DEVELOPMENT 690 – 692

Introduction — Taxation and Development — Public Borrowings for Development — Profits of Public Sect or
and Development — Deficit Financing for Development — Foreign Capital and Economic Development —
Questions for Discussion — Objective Test.

64. FEDERAL FINANCE 693 – 703

Introduction — Principles of Federal Finance — The Problem of Distribution and Adjustment of Financial
Resources — Methods of Adjustments — Inter-governmental Financial Relations in India — Finance Commissions
— References — Questions for Discussion — Objective Test.

65. SUPPLY-SIDE ECONOMICS: AN OUTLINE 704 – 706

Introduction — Keynes vs. Classicists — The Gist of SSE (The Laffer Curve) — Tenets of SSE — References
— Questions for Discussion — Objective Test.

APPENDIX 707 – 734

PART
I

MONEY AND BANKING

True happiness comes when money is

shared than acquired

1
Money matters much
in modern times
 1 THE NATURE OF
BARTER AND
MONETARY
ECONOMY
Money confers inestimable benefits to our commercial
life in a modern society. We can appreciate the significance
and role of money in a modern economy straightaway
when we look at the difficulties and inconveniences
experienced in a primitive society’s moneyless economy
called “Barter Economy.”
1. BARTER ECONOMY
Barter system was prevalent in the earliest stages
of man as a commercial animal. Even today, in some
of the interior parts of African countries and even in
backward regions of India, especially in the non-monetised
subsistence sector of some rural and Adivasi areas,
barter exchange in some degree is in operation.
There is no use of money or any medium of exchange
in a barter economy. “Barter” means direct exchange
of goods — goods exchanged against goods. Corn may
be exchanged for ox hides, house for horses, pigs for
poultry, lemons for oranges, baskets for bananas, shoes
for shirts and so on. In the barter system, thus, one
has to give some kind of goods to get some other kind
of goods.
The barter system is not as simple and smooth a
system of exchange as its meaning shows. Many difficulties
and inconveniences are inherent in a simple barter.
As a society becomes more civilised and the complexities
of economic organisation begin to multiply, exchange
through barter tends to become more difficult and
complicated.
 Difficulties of Barter System
A few major difficulties of the barter system may
be traced below:
1. Want of Coincidence. The first difficulty in
the barter system of exchange is that there has to be
3
a double coincidence of wants. Two persons can have
barter exchange only if their disposable possessions
mutually suit each other’s needs. In barter trading,
thus, two parties must agree on their mutual exchange,
which is possible only if there exists a double coincidence
of wants. That is, one party must be wanting a commodity
which the other party wants to dispose of and the former
must have disposable possession of the commodity that
is desired in exchange by the latter. In a barter, therefore,
a person who wants to exchange his goods for some
other goods has not only to find another person who
possesses what he needs but who, at the same time,
has a desire for what he has to offer. In practice, it is
difficult always to have such double coincidence of
wants and, therefore, there are delays in transactions,
and a considerable amount of time and effort is wasted
in effectuating the exchanges. Clearly, trade and business
cannot develop rapidly in a barter economy for want
of coincidence. Barter as such is a high barrier to economic
progress.
2. Lack of a Common Measure of Value. Another
serious difficulty of the barter is that it lacks any common
measures of value or unit of account. In the absence
of a well-defined unit of account, in a barter, the values
of goods are measured in a relative sense; hence there
is no absolute measurement of value. Since the value
of each commodity can be expressed in terms of every
other commodity, one has to remember a large number
of cross relations of values in exchange for different
goods which is physically impossible to do when there
are an infinite number of commodities. Under such
conditions, no meaningful accounting system can be
evolved.
3. Want of a Means of Subdivision. Barter
exchange also suffers from a severe inconvenience on
account of indivisibility of many kinds of goods. One
can easily portion out a bag of foodgrains, a basket
4  MONEY, BANKING, INTERNATIONAL TRADE AND PUBLIC FINANCE
of fruits, etc. which are divisible goods and can give
more or less in exchange for what is wanted. But, the
real difficulty arises in the process of exchange between
indivisible and divisible goods.
For instance, a horse is not divisible and cannot
be exchanged in parts against different divisible goods
like rice, sugar, potatoes, etc. Thus, barter trade between
divisible and indivisible goods in small values cannot
be carried on without a loss of value.
In a barter system, smooth exchange operations
are impossible for want of a means of subdividing
and distributing values according to people’s varying
requirements. 1
4. Lack of Standard of Deferred Payments.
Another drawback of barter is that it lacks a standard
of deferred payments, so that contracts involving future
payments or loan transactions cannot take place with
ease in such a system. Credit transactions cannot be
promoted smoothly under barter trading. Chance of
controversy about the quality of goods or services to
be repaid can arise. There will be no easy agreement
on the mode of repayment. Credit transactions would
also involve high risks to both parties as the real value
of a commodity to be repaid may drastically increase
or decrease in future.
5. Lack of Efficient Store of Value. Perhaps,
a major inconvenience of barter is the lack of facility
to store value or the lack of existence of a generalised
purchasing power. Under barter, people can store value
for future use by storing wealth, but the difficulty arises
when wealth consists of perishable goods. Moreover,
the store of value in terms of real wealth involves cost
and further, the problem of storing the goods arises.
In addition, bulky goods cannot be easily exchanged
for other goods as and when required. A quick exchange
sometimes involves a heavy loss, too.
Chart 1 pinpoints the shortcomings of a barter economy
as have been discussed above.
CHART 1
SHORTCOMINGS OF BARTER ECONOMY
WANT OF COINCIDENCE
WANT OF A MEANS OF SUBDIVISION
LACK OF EFFICIENT STORE OF VALUE
To recapitulate, the main difficulties experienced
in a barter economy are:
l requirement of double coincidence of wants;
l absence of a unit of account;
l indivisibility of bulky goods and lack of a means
of subdivision;
l lack of a standard of deferred payments; and
l lack of generalised purchasing power as a store
of value.
It follows that the barter economy is a highly inefficient
economy of exchange. With the progress of civilisation
and economic expansion, these difficulties and inconveniences
of the barter system becomes more pronounced. To
overcome these drawbacks, some kind of money was
invented and evolved in every society.
2. EVOLUTION OF MONEY
Growing inconvenience of barter in the complex
economic societies necessitated the invention of money.
Writers like Spalding, however, opine that money seems
to have been discovered rather than invented in the
progress of economic civilisation of mankind. 2 According
to Crowther, money was undoubtedly an invention;
“it needed the conscious reasoning power of man to
take the step from simple barter to money accounting.” 3
Whatever it may be, the fact remains that with the
increased volume of trade and growing process of division
of labour and specialisation, barter became more and
more difficult in its direct exchange phenomenon. Hence,
to overcome the basic difficulties of barter such as
want of double coincidence, want of means of subdivision,
etc., it was thought that exchange of goods should be
made indirect by using some medium in between. Thus,
money came into the picture as a medium of exchange.
Crowther 4 observes that, in the beginning, in a
simple exchange of goods for goods, the terms of exchange
LACK OF UNIT OF ACCOUNT
LACK OF STANDARD OF DEFERRED PAYMENTS
 THE NATURE OF BARTER AND MONETARY ECONOMY
were fixed with reference to one standard commodity.
Values of different goods being measured in terms of
this standard commodity, in the exchange process, it
came to be accepted as a medium of exchange. This
standard commodity used as a medium of exchange
was known as money.
Etymologically, the term “money” is derived from
the Latin word Moneta, the name of the Roman goddess
Juno, in whose temple coins were being minted. Use
of money as a medium of exchange and a unit of account
is, however, much older than coinage. Numerous things
like shells and sheep, grains and stones, tea and tobacco,
ivory and iron, gold and silver have been used as money
at different times and different places before the invention
of modern-day’s metallic and paper money. The origin
of money as such is difficult to trace for want of record.
Lord Keynes puts it as the origin of money is deep-
rooted in antiquity, and it is a far more ancient institution.
“Its origins are lost in the mists when the ice was melting,
and may well stretch back into the paradisical intervals
in human history of the inter-glacial periods, when the
weather was delightful and the mind free to be fertile
of new ideas — in the islands of the Hesperides or
Atlantis or some Eden of Central Asia.” 5 Indeed, money
is the epitome of the history of human civilisation.
No doubt, the evolution of money has been a
secular process. Like several other economic institutions,
money, in its present form, has passed through several
phases and developed through the centuries.
 Development of Money in Different Stages
The development of money has passed through
various stages in accordance with time, place and
circumstances with the progress of economic civilsation
of mankind. Economists have recognised five such stages
in the evolution of money:
I. Animal Money
II. Commodity Money
III. Metallic Money
IV. Paper Money
V. Credit Money
I. Animal Money. Animals were being used as
a common medium of exchange in the primitive hunting
stage. History records that cattle occupied a place of
pride as money in the earliest period of human civilisation.
In temperate regions of Europe, Asia and Africa, cattle
was regarded as the most standard unit of barter for
quite a long time in the primitive era. In the ancient
Indian civilisation, the concept of Go-Dhan (cattle wealth)
as a form of money is also referred to in Arth-Veda.
In the fourth century B.C., the Roman State had officially
recognised crows and sheep as money to collect fines
and taxes.
 5
II. Commodity Money. In certain communities,
early primitive money, in its crudest sense, also took
the form of commodity money. A large number of
commodities from axes to yarn have been adopted
as money. The particular commodity chosen to serve
as money depended upon various factors like location
of the community, climatic environment of the region,
cultural and economic standard of society, etc. For
example, people living by the seashore adopted shells
and dried fish as money. People of the cold regions
in Alaska and Siberia preferred skins and furs as a
medium of exchange. African people used ivory and
tiger jaws as money. Besides, commodities such as
precious stones, rice, tea, tobacco, etc. also served
as money during the primitive days of human civilisation.
Professor Paul Einzig6 has recorded some 172 commodities
in the list of primitive money.
Animal and commodity money, however, suffered
from such drawbacks as:
1. Lack of uniformity and standardisation;
2. Inefficient store of value due to the problem
of storing and loss of value with the lapse of
time;
3. Lack of easy transferability due to difficulties
of portability; and
4. Indivisibility.
III. Metallic Money. Commodity money gradually
transformed into metallic money when precious metals
like gold, silver, copper, bronze, etc. were discovered
and used as a medium of exchange with the growth
of economic civilisation from the pastoral to the commercial
stage of society. Use of metals as money in the course
of time paved the way for the development of coinage
system in the economy.
As historian Toynbee narrates, the coin age began
around 700 B.C. in Lylia, a Greek city state. Imperfections
of the metallic money in size, shape and weight, etc.
have been removed with the minting of coins by states.
Metallic money had, however, the following drawbacks:
1. On account of its bulkiness, a large sum of
money in terms of coins was not easily portable.
2. It was unsafe to carry and could be easily lost
or stolen.
3. Rapid transactions were not feasible by using
coins as a mode of payment.
The coin era, however, lasted till the 17th century.
IV. Paper Money. In the 17th and 18th centuries,
paper currency emerged as “token money.” In modern
era, paper money has become popular. It originally
came as paper receipts against metallic money which
was found unsafe to carry by itinerant merchants. Then
with the shortage of metals, state authorities thought
6  MONEY, BANKING, INTERNATIONAL TRADE AND PUBLIC FINANCE
of introducing paper currency — a representative paper
money — which was convertible. In the later stages,
however, it became “fiat money”, i.e., inconvertible
legal tender. Being a representative money, paper currencies,
thus, economise the use of standard coins or metals.
V. Bank Money. In the final stage, along with
paper money, another form of convertible money developed
in the form of credit money or bank money, owing to
the growth of banking institutions and credit creation
activities and cheque system of payments in modern
era. In modern commerce, large transactions are carried
on through cheques and only small transactions are
managed through currency money.
In modern economy, coins, paper notes and bank
money, i.e., cheques issued against demand deposit,
all serve as money. But even today, sometimes other
things have also served as money. In Germany, for
example, in the post-war period (1945-46), cigarettes
and cognac were used as money when its financial
and economic condition had greatly deteriorated. Sometime
ago, due to shortage of token coins in India, coupons
and stamps were used as money.
In short, anything and everything can serve and
has served as money provided it is generally recognised
and accepted as means of payment. But all things cannot
serve as a good money. Good money should possess
the attributes of general acceptability, cognisability,
portability, divisibility, maleability, durability, uniformity,
adequacy and stability of value.
3. FORMS OF MONEY IN A
MODERN ECONOMY
In the modern monetary systems, there are three
forms of money in actual use: (i) Metallic Money,
(ii) Paper Money, and (iii) Credit Money.
The first two kinds of money are in the form of
currency money and the last one is credit or bank money.
 Metallic Money
Metallic money refers to coins made out of various
metals like gold, silver, bronze, nickel, etc. A coin is
a piece of metal of a given size, shape, weight and
fineness whose value is certified by the State. The right
of minting coins is the monopoly of the State. The
department of government minting coins is called the
Mint.
Coins are of two types: (i) Standard or full-bodied
coins and (ii) Token Coins.
A coin is regarded as a standard coin or full-bodied
coin if its “face value” (i.e., the exchange value fixed
by the issuing authority and embossed on it) is equal
to its “intrinsic value”, i.e., the worth of the metallic
content of the coin. In the past, coins made from precious
metals like gold and silver were regarded as standard
coins and the monetary systems adopting them were
referred to as “gold and silver standards.”
On the other hand, a token coin refers to a coin
having the face value of more than its intrinsic value.
Token coins are usually made of cheap metals like
nickel, copper or bronze. They are generally of lower
denominations. Token coins are issued primarily as a
form of subsidiary money which is to be used for small
change only. They are useful as a convenient means
for the payment of small sums.
Since all types of coins are issued by the State
authorities — either the Treasury or the Central Bank
of the country — they are regarded as legal tender.
Legal tender money’s acceptability is sanctioned or backed
up by law; hence, a refusal to accept it is a punishable
offence. Standard coins are, however, unlimited legal
tender in the sense that they are acceptable as a means
of payment of up to any amount, while token coins
are limited legal tender as payments can be made up
to a small sum only.
 Paper Money
Paper money consists of currency notes issued by
the State Treasury or the Central Bank of the country.
In India, one rupee notes are issued by the Ministry
of Finance of the Government of India, while all other
currency notes of higher denominations are issued by
the Reserve Bank of India.
In modern era, the use of paper money is widespread
owing to its following advantages:
1. Paper money is economical. Obviously, paper
is much cheaper than any metal.
2. Paper money economises the use of precious
and scarce metals by serving as representative
money.
3. It is very convenient to carry paper money
from place to place.
4. It is also easy to store paper notes. Currency
notes of lakhs of rupees can be stored in a
small vault.
5. It is easier to count paper notes than metallic
coins.
6. Supply of paper money is easily adjustable as
per the need of the economy. Thus, paper money
is of great monetary and fiscal advantages to
the government.
However, paper money has also some disadvantages
such as:
 THE NATURE OF BARTER AND MONETARY ECONOMY
1. There is the danger of overissue of notes as
they can be easily printed and their supply depends
upon the whim of the government. An excessive
money supply may lead to rising prices or inflation
thereby reducing the value (purchasing power)
of money.
2. Paper money lacks general acceptability if the
people lose confidence in the government for
one reason or the other.
3. Durability of paper money is much less than
metallic money.
4. Paper money can circulate within the domestic
economy only. For making foreign exchange
payments, paper money is not acceptable unless
it is a key currency like the dollar.
But these disadvantages are surmountable and
controllable by a proper check. Therefore, paper money
is in wide circulation.
 Credit Money
In modern economic societies, with the development
of banking activity, along with paper money, another
form of convertible money has developed in the form
of credit money or bank money. Bank demand deposits,
withdrawable by issuing cheques, have started functioning
as money, and cheques are now conventionally accepted
as a mode of payment by the business community in
general. It must be noted that a cheque by itself is
just a credit instrument. Actually, it is the bank deposit
behind the cheque that serves as money.
Bank money today constitutes a major part of
money supply in advanced countries. In many countries
such as America, it amounts to nearly 90 per cent of
the total money supply. In poor countries, the proportion
of currency money widely exceeds that of bank money.
Indeed, in a modern economy, currency money
and bank money together constitute the total stock of
money or money supply. Currency money is a legal
tender and has general acceptability, whereas bank
deposits are conventional money and lack general
acceptability.
In fact, though the use of money has become all-
pervasive throughout the world, certain backward areas
are still non-monetised. Barter is, therefore, not completely
obsolete. In India, for instance, some Adivasi areas
are still unfamiliar to the use of money.
4. NATURE OF A MONETARY
ECONOMY
A monetary economy is one in which money is
widely used and accepted as a medium of exchange.
It is a monetised economy.
 7
Unlike in barter economy, in an organised market
of a monetary economy, money buys goods and goods
buy money — but goods do not buy goods directly. In
short, in a money economy, goods are exchanged indirectly
— goods are sold for money and money purchases goods.
In a monetary economy, money serves as a means
of payment. It is the general and permanent abode
of purchasing power. Thus, all transactions are measured
and recorded in terms of money. Money serves as a
unit of account in a monetary economy. Money being
a common denominator of value, the price system has
emerged as a distinct characteristic of monetary economy.
As compared to the barter system, exchange process
is more efficiently organised in a monetary economy
when money is used as a medium of exchange. The
use of money in the process of exchange has far-reaching
consequences when it reduces the amount of information
required in concluding a transaction. All the inconveniences
of barter like want of double coincidence, want of a
means of subdivision, want of efficient store of wealth
etc., are automatically eliminated in a monetary economy,
cost and time involved in searching for a double coincidence
is saved. Further, the use of money and consequent
emergence of the price mechanism simplifies the process
of transactions by condensing the complex signalling
mechanism of prices into simple assimilable forms of
information. 7
Money serves as an indispensable factor of production
in a monetary economy for enabling its output to increase
and diversify.8 A higher level of output and more varieties
of goods and services are enjoyable by the people in
a monetary economy as compared to a barter economy.
Indeed, the flow of money and credit enables and encourages
entrepreneurs to innovate and accelerate the process
of growth.
The institution of money is a valuable social
resource of a monetary economy. Money serves
as a pivot around which all economic activities
move. It is the key to all the wealth. People
work for the sake of money, since money is regarded
as a prominent means to buy formal happiness
in a modern money economy.
Monetary economy has a greater degree of liquidity
than a barter economy. Money being the most liquid
asset, it serves as a link between the present and the
future in a monetary economy. There is an absence
of any such link in a barter economy. Further, unlike
the barter system, a monetary economy contains banking
institutions. There are commercial banks and the Central
Bank as the apex financial institution. There exists a
capital market too for long-term credit activities. Credit
is the edifice of modern commerce which rests on the
institution of money, especially bank money.
8  MONEY, BANKING, INTERNATIONAL TRADE AND PUBLIC FINANCE
A distinguished feature of a monetary economy is
that it is covered with a veil of money. There is a circular
flow of money side by side and corresponding to the
real flow of economic transactions. In fact, there is a
continuous flow of money payments and spendings among
households and the government sector of a modern monetary
economy.
Money matters much in a modern capitalist economy.
It is the embodiment of Adam Smith’s “Invisible Hands”.
Money is the bloodstream of the organic composition
of a modern monetary economy. It serves as a great
wheel of circulation and a great instrument of commerce.9
Every fabrication of the modern economic society in
its present complex form may be attributed to money
that has served as a means of valuing, distributing
and contracting for commodities of various kinds. 10
No doubt, money has conferred inestimable benefits
to modern man’s living and progress.
5. CIRCULAR FLOW OF MONEY
A money economy is basically characterised by
the circular flow of money. It involves a continuous
flow of money payments in its economic activities. Modern
economic life is interdependent. Thus, in the want-
satisfying activity, goods produced by one are exchanged
for the consumption of the other. There are, thus, two
major classes in the economic process. These are: producers
(or firms) and consumers (or households). The portion
of money income, which the consumers spend on the
purchases of goods and services in a economy, passes
through the hands of many people — the retailers,
wholesalers and manufacturers, i.e., the producer class.
These producers then again use money in investments
and it thus passes to the consumers in the form of
wages, salaries, interest, rent, profit, etc. In short, there
is a circular flow of money between firms and households
(in a closed economy).
A simple model of such type of circular flow is
illustrated in Fig. 1.
CULAR FLOW OF M
CIR ON
EY
CTION E XPE
O DU ND
ITU
PR RE
R PAYMENT
C TO S)
(FA
FIRMS HOUSE-
HOLDS
CO RE
NSU TU
MPTION EXPENDI
Fig. 1. The Circular Flow of Money — A Simple Model
As a matter of fact, there are real flows and monetary
counter-flows. In a simple two-sector (firms and households)
closed economy model, thus, the real flows constitute
the movement of productive factor resources from the
households sector to firms, while real output (finished
products) of the firms move to the household. In a
barter economy, money being used as a medium of
exchange, there are monetary payments involved behind
real transactions. Thus, there are “monetary counter-
flows” to the “real flows”, which being circular in movement
constitute the “circular flow of money”. Thus, money
flows from firms to households, when firms purchase
factor services and, to that extent, firms’ spendings
determine the income of the owners of factors of production
comprising the household sector. To state in elaborate
terms, the firm pays the prices to the factors of production
while employing them into the productive channels.
This constitutes the cost of production which in turn
becomes the income of households. Thus, in an aggregate
sense, the value of national income can be viewed in
terms of factor cost or factors’ earnings in total. Similarly,
when households spend on real output produced by
firms, real goods and services flow from firms to households
while money flows from households to firms. What households
spend on firms’ products is equivalent to the prices
of products which indicate the value of real output
turned out by the firms. Thus, the value of national
product can be measured by aggregating their market
prices.
Continuous or unchanged real flows and money
flows in an economy would imply that the same amount
of goods and services are produced at constant prices
over a period of time. Thus, the main condition of
constant prices is that the flow of goods and services
should remain intact and there should be no leakage
of money in its circular flows, i.e., whatever has been
paid out to households by the firms should come back
through their consumption expenditure.
In the above given very simple model of circular
flow, we may now incorporate a saving element (which
implies a sort of leakage from the flow of income-expenditure).
Saving is the unconsumed part of income or unspent
money left with households. If the savings of households
are not hoarded but made available to the loanable
funds market, i.e., capital market, the businessmen (firms)
can borrow them for investment purposes. When saving
tends to be equal to investment or vice versa and the
circular flow of money remaining undisturbed, economic
activity and the price level would remain constant in
the economy. Fig. 2 illustrates such a circular flow.
It is obvious that the circular flow of money would
remain undisturbed if the flow of funds into the capital
market (i.e., savings) and the flow of funds out of the
capital market (i.e., investments) are equal. Any disequilibrium
 THE NATURE OF BARTER AND MONETARY ECONOMY  9

FLOW OF MON
CIRCULAR EY

EXPENDITURE (FACTOR P
TION AYM
ODUC ENT
PR S)

BORROWINGS CAPITAL SAVINGS HOUSE-

FIRMS
(INVESTMENT) MARKET HOLDS

CONS
UMPTION EXPENDITURE

Fig. 2. The Circular Flow of Money — An Extended Model

in the savings and investments, of course, will reflect
itself either in the decrease or increase in the circular
flow of money.
6. MONETISATION
A well organised system of exchange in an economy
based on the use of money is described as monetisation.
Under monetisation, money is introduced as a medium
for the smooth operation of transactions of goods and
services for the mutual satisfaction of wants.
A barter economy is non-monetised. Monetisation
is a process under which the barter and subsistence
sectors of an economy are brought and tied up with
its monetary exchange sector. Monetisation process
implies extension of monetary exchange to the barter
system. Monetisation, in essence, means conversion
of barter into the monetary economy.
Existence of non-monetisation in a modern economy
reflects the stage of its economic backwardness. The
degree of monetisation is, thus, an index of a country’s
monetary development and general economic advancement.
In a backward economy, usually, a large part is non-
monetised. The non-monetised sector is subsistence
and stagnant. This sector is, by and large, self-sufficient
— where production is just meant for self-consumption.
There is little marketable surplus. And, a very limited
exchange, if any, takes place on a barter basis. Use
of money is unfamiliar to the people in the sector. As
per an estimate made by Dr. Madalgi, during the mid-
seventies, about 15 per cent of Indian economy’s output
in rural hinterland and Adivasi areas was non-monetised.11
This non-monetised output includes: (i) partly barter
transactions, (ii) partly output for self-consumption, and
(iii) payment of wages to workers in kind.
Expansion of money supply in such successive
stage of economic development spreads the process
of monetisation in the economy. With economic progress,
when exchange complexities tend to multiply, when agriculture
becomes more and more commercialised with an increasing
amount of marketable surplus, diversified consumption
pattern and varied production pattern, the need for
intermediation of money to effectuate smooth and rapid
transactions becomes more and more intense which paves
the way for the expansion of the monetised sector by
bringing the barter sections under its purview.
 Factors Affecting Monetisation
The pace of monetisation in an economy is affected
by a multitude of factors:
1. Difficulties of Barter. The difficulties and
inconveniences of the barter system tend to be more
pronounced and intense with the growth of trade and
increased overdependence of a progressive economic
community which work as a propelling force to introduce
and use money as a medium of exchange.
2. Extent of Divis ion of Labour and
Specialisation. With the increased application of complex
division of labour in the process of production and
more diversified output through growing specialisation
and integrated system of production, the need for increased
monetisation is felt in the economy.
3. Transition of Subsistence Economy into
Exchange Economy. When a self-sufficient village
economy is lifted up from its subsistence level through
rural industrialisation process and commercialisation
of agriculture, monetisation automatically occurs.
4. Development of Banking. Extension of banking
activities and other financial institutions in unbanked
areas and backward regions obviously lead to an increased
availability and use of money which helps rapid monetisation
of the economy.
5. Development of Trade, Transport and
Communication. Size of market, volume of trade and
commerce and consequent growth of exchange transactions
10  MONEY, BANKING, INTERNATIONAL TRADE AND PUBLIC FINANCE

are facilitated and encouraged by the increased network 9. Chandler, L.V.: The Economics of Money and Banking,
of transport, infrastructure and development of communication p. 5.
system in the country which goes a long way in accelerating 10. Jevons, W.S.: Money and Mechanism of Exchange,
the process of monetisation. p. 2.
6. I ndus tr ialis ation. With the growth of 11. Madalgi, S.S.: “Trends in Monetisation in the Indian
industrialisation and capital formation, the pace of economic Economy,” Reserve Bank Staff Occasional Papers, June,
1976.
development increases which leads to a rapid growth
of the secondary and tertiary sectors of the economy
I. QUESTIONS FOR DISCUSSION
with diversified occupational structure and rapidity of
transactions calling for a greater degree of monetisation 1. (a) What is a barter?
in the economy as a whole. (b) What are the inconveniences of barter exchange?
7. Demonstration Effect: With the increased 2. Trace the evolution of money, in brief.
contacts between urban and rural population, when
3. What are the forms of money in a modern economy?
the latter is impressed by the consumption pattern of
4. Describe briefly the nature of a monetary economy.
the former and when due to this demonstration effect,
the rural folk is induced to produce more marketable 5. Write a note on: Circular Flow of Money.
surplus of their goods for selling it to the urban areas 6. (a) What is monetisation?
and earning money to buy urban goods, monetisation (b) Enumerate the factors determining the extent of
is automatically accelerated. monetisation in an economy.
8. Government Sector. With the extension and
II. OBJECTIVE TEST
intensification of the functions of the government in
a welfare state, the budget is enlarged and more and 1. Which of the following is an essential characteristic of
more tax revenues are collected and increased public barter economy?
expenditure is incurred. This necessitates increased use (a) Goods exchanged against goods.
of money. Further, under the technique of deficit financing, (b) Simple and a smooth system.
the government resorts to the injection of more and (c) Lack of civilisation.
more money into the supply stream which is also absorbed (d) Inconvenience.
by the non-monetised sector to some extent and the 2. Barter exchange is not possible when:
pace of monetisation is accelerated as a result. (a) a standard commodity is used in intermediation.
9. Degree of Development. In general, degrees (b) two persons have no mutual agreement on their
of development and monetisation are interconnected. wants.
Monetisation is the cause of, as well as the consequence (c) there is no money.
of, economic advancement. Monetisation facilitates more (d) there is no common measure of value.
specialisation and rapid economic transactions and 3. Invention of money is the outcome of:
enlargement of the size of market and consequently (a) people’s reasoning power.
rapid and smooth economic development. So also, economic (b) the banking system.
development needs more and more use of money as (c) difficulties of barter.
a more sophisticated instrument of exchange and creates (d) none of the above.
scope for monetisation. 4. The Metallic Money contains:
(a) token coins only.
REFERENCES (b) all money.
(c) standard coins plus token coins.
1. Jevons, W.S.: Money and the Mechanism of Exchange,
(d) gold and silver only.
p. 5.
5. Token coin means:
2. Spalding, W.F.: A Key to Money and Banking, p. 13.
(a) coin having face value more than its intrinsic value.
3. Crowther, G.: An Outline of Money, p. 3. (b) coin having face value the same as intrinsic value.
4. Ibid., p. 3. (c) coin given as bank’s token against cheque.
5. Keynes, J.M.: A Treatise on Money, Vol. I, p. 3. (d) none of the above.
6. Einzig, Paul: Primitive Money, pp. 507-509. 6. Standard coin means:
7. Walters, A.A. (ed.): Money and Banking, p. 9. (a) a full-bodied coin.
8. Ibid., p. 9. (b) silver standard.
(c) legal tender.
(d) RBI coin.

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