qi AN TS eee PE INDIAN MONEY MARKET Meaning The Money Market is a market for lending and borrowing of short-term funds. It deals in funds and financial instruments having a maturity period of one day to one year. It covers money and financial assets that are close substitutes for money. The instruments in the money market are of short term nature and highly liquid. Discuss the structure (OR) components of Indian money market. The Indian money market consists of two segments, namely organized sector and unorganized sector. The RBI is the most important constituents of Indian money market. The organized sector is within the direct purview of RBI regulation, The unorganized sector comprises of indigenous bankers, money lenders and unregulated non-banking financial institutions. The structure or components of Indian money market is depicted in the chart 5.1. Svar NU IS) cr Calll and Notice Money Market Treasury Bills Market Commercial Bills Market Unregulated Non-Bank Financia Market for Certificates of Deposits (CDs) Intermediaries (Chit Funds, Nidhis and Market for Commercial Papers (CPs) Loan Companies) Repos Market * Finance Brokers Money Market Mutual Funds (MMMFs) Discount & Finance House of India (DFHI) Indigenous Bankers Money Lenders awww ewes (A) Organized Money Market Instruments and Features. 1. Call and Notice Money Market: Under call money market, funds are transacted on overnight basis. Under notice money market funds are transacted for the period between 2 days and 14 days. The funds lent in the notice money market do not have a specified repayment date when the deal is made. The lender issues a notice to the borrower 2-3 days before the funds are to be paid. On receipt of this notice, the borrower will have to repay the funds within the given time. Generally, banks rely on the call money market where they raise funds for a single day The main participants in the call money market are commercial banks (excluding RRBs), co- ‘operative banks and primary dealers. Discount and Finance House of India (DFHI), Non-banking financial institutions such as LIC, GIC, UTI, NABARD etc. are allowed to participate in the call money market as lenders,2. Treasury Bills (T-Bills): Treasury bills are short-term securities issued by RBI on behalf of Government of India. They are the main instruments of short term borrowing by the Government. They are useful in managing short-term liquidity, At present, the Government of India issues three types of treasury bills through auctions, namely - 91 days, 182-day and 364-day treasury bills. There are no treasury bills issued by state governments. With the introduction of the auction system, interest rates on all types of TBs are being determined by the market forces. 3. Commercial Bills: Commercial bill is a short-term, negotiable, and self-liquidating instrument with low risk, They are negotiable instruments drawn by a seller on the buyer for the value of goods delivered by him. Such bills are called trade bills. When trade bills are accepted by commercial banks, they are called commercial bills. f the seller gives some time for payment, the bill is payable at future date (i.e. usance bill). Generally the maturity period is upto 90 days. During the usance period, if the seller is in need of funds, he may approach his bank for discounting the bill Commercial banks can provide credit to customers by discounting commercial bills. The banks can rediscount the commercial bills any number of times during the usance period of bill and get money. 4. Certificates of Deposits (CDs): CDs are unsecured, negotiable promissory notes issued at a discount to the face value. They are issued by commercial banks and development financial institutions. CDs are marketable receipts of funds deposited in a bank for a fixed period at a specified rate of interest CDs were introduced in India in June 1989, The main purpose of the scheme was to enable commercial banks to raise funds from the market through CDs. According to the original scheme, CDs were issued in multiples of Rs.25 lakh subject to minimum size of an issue being Rs.1 crore. They had the maturity period of 3 months to one year. They are freely transferable but only after the lock in period of 45 days after the date of issue. 5. Commercial Papers (CPs): Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note with fixed maturity. They indicate the short-term obligation of an issuer. They are quite safe and highly liquid. They are generally issued by the leading, nationally reputed, highly rates and credit worthy large manufacturing and finance companies is the public as well as private sector. CPs were introduced in India January 1990. CPs were launched in India with a view to enable highly rated corporate borrowers to diversify their sources of short-term borrowings and also to provide an additional instrument to investors. RBI has modified its original scheme in order to widen the market for CPs. Corporates and primary dealers (PDs) and the all India financial institutions can issue CPs. A corporate can issue CPs provided they fulfil the following conditions: (a) The tangible net worth of the company is not less than Rs.4 crore. (b) The company has been sanctioned working capital limit by banks or all India financial institutions, and (©) The borrowed account of the company is classified as a standard asset by the financing institution or bank 6. Repos: A repo or reverse repo is a transaction in which two parties agree to sell and repurchase the same security. Under repo, the seller gets immediate funds by selling specified securities with an agreement to repurchase the same at a mutually decided future date and price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller at an agreed date and price. The repos in government securities were first introduced in India since December 1992 Since November 1996, RBI has introduced "Reverse Repos", ie. to sell government securities through auction 7. Discount and Finance House of India (DFH)): It was set up by RBI in April 1988 with the objective of deepening and activating money market. It is jointly owned by RBI, public sector banks and all India financial institutions which have contributed to its paid up capital. The DFHI deals in treasury bills, commercial bills, CDs, CPs, short-term deposits, call money market and government securities. The presence of DFHI as an intermediary in the money market has helped the corporate entities, banks, and financial institutions to invest their short-term surpluses in money market instruments,Q2 8 Money Market Mutual Funds (MMMFs): RBI introduced MMMFs in April 1992 to enable small investors to participate in the money market. MMMFs mobilizes savings from small investors and invest them in short-term debt instruments or money market instruments such as call money, repos, treasury bills, CDs and CPs. These instruments are forms of debt that mature in less than a year. (8) UNORGANIZED SECTOR OF INDIAN MONEY MARKET The unorganized Indian money market is largely made up of indigenous bankers, money lenders and unregulated non-bank financial intermediaries. They do operate in urban centers but their activities are largely confined to the rural sector. This market is unorganized because it's activities are not systematically coordinated by the RBI The main components of unorganized money market are: 1. Indigenous Bankers: They are financial intermediaries which operate as banks, receive deposits and give loans and deals in hundies. The hundi is a short term credit instrument. It is the indigenous bill of exchange. The rate of interest differs from one market to another and from one bank to another. They do not depend on deposits entirely, they may use their own funds, 2. Money Lenders: They are those whose primary business is money lending. Money lenders predominate in villages. However, they are also found in urban areas, interest rates are generally high. Large amount of loans are given for unproductive purposes. The borrowers are generally agricultural labourers, marginal and small farmers, artisans, factory workers, small traders, etc. 3. Unregulated non-bank Financial Intermediaries: Theconsist of Chit Funds, Nithis, Loan companies and others. (@) Chit Funds: They are saving institutions. The members make regular contribution to the fund, The collected funds is given to some member based on previously agreed criterion (by bids or by draws). Chit Fund is more famous in Kerala and Tamilnadu. (©) Nidhis: They deal with members and act as mutual benefit funds. The deposits from the members are the major source of funds and they make loans to members at reasonable rate of interest for the purposes like house construction or repairs. They are highly localized and peculiar to South India. Both chit funds and Nidhis are unregulated. 4. Finance Brokers: They are found in all major urban markets specially in cloth markets, grain markets and commodity markets. They are middlemen between lenders and borrowers. What are the features of Indian Money Market? oR Examine the defects of Money Market in Indi Several steps were taken in the 1980s and 1990s to reform and develop the Indian money market. Despite these efforts, Indian money market continues to remain lopsided, thin and extremely volatile. Indian money market is relatively underdeveloped when compared to advanced markets like London and New York money markets. ts main defects are explained below: 1. Existence of Unorganized Money Market:This is one of the major defects of Indian money market. It does not distinguish between short term and long term finance, and also between the purposes of finance. Since it is outside the control and supervision of RBI, it limits the RBI's control of over money market.‘sjoyew AQUOW #0, MON PUE LOPUCT Se YaNs sJOYeW Rouow padojanap ywa paseduios 2q youues y! ‘snyy “inpim pue yydap yuaroyjns ounboe oy yA sey pue padojanap ssa Ajaanejas si y jeu) aye21pur Ayea|s yaysew Aauow ueipul jo sjzajap eroge ayy “EIpU] Ul a1e1S pedojenapsopun ave sOWN|SU! SAY ‘Sd PUR SCD ‘SiIIq Kinsean Aep-p9¢ ‘siliq Ainsean Kep-zgi se yons sjuawingsul 1p: aU P2oNpoMU! 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(@uNS 0) JaquIaAON) UOseas Asnq eu) Buunp ysavequl jo aye YBjy pue Aeuow jo AouaBul.ys |euoseas oy) :Aeuoy jo AouaBuins jeuosees * “sueaX 1U9984 Ol) Ul 1UAIXe BWOS 0} SPUN} Jo UONeZI|/GoW at peroudwut sey ‘uojsuedxa ysueig Apeynoed quauidojaaap Burjueq ayy ‘ianamoy ‘o1@ ‘Awouode jaijeled Jo aoue)sixe ‘syiqey Burjueg jo yor] ‘sBulnes Mo| ‘saniioey Burjueq ayenbapeu! ay|} Ssoyey snoUeA jo qunovoe uo YeyeW Aeuow uelpul Ul} spuny jo eBevoYs si eel Ayjeseued ispun4 aenbepeul * “suonmynsut jueseyIp £q qua] SUONeINP @WeS JO SPUN} JO} JEYIP Sered BY “JeYLOUB 0} JeyJeL KeuOW ey) JO UONDES BUD Woy puny Jo Ayyiqow Jo 49e| 0} aNp SI SIU ‘¥8 ‘sUOAMNSUI JeIUeUY Jo SaVe1 BuIpUD| ’syUeg JeIDJALWIOD pue arnessdoos jo sayes Guipue| pue sysodep ‘jwewuseaob jo ayes Buimoliog ay) se yons Joyrew Kovow uepul By) ul Saou! Jo sayes KueWH 00} SISIKO Bla :saeY ISezayU] UL Ayo! “saueuonouny Jo Ayoydnynu s| a4aua pue saonoeid un uy AyuOYUN OU Ss} 104 “Ie 's!puB] Kau ‘salueduIOD UEO} ‘sOYUEG snoUDBipul soIMNSUOD 41 JS) UI snoU@BOWOY jou si Jo}es paye|nBouun oy,1 ‘BuDoM siaun seyeInBes kpoq xade ue se Igy “SUOAMNSU! [eIOURLY PUe Syue erneiedood ‘syUeg JeIDFAUNUOD ‘eIPU] JO YUE aI ‘Iga Se Yons SuONMSUI JeFAANS SOyMNSUOD FR!eW poziueBI oY JOY!eU! pozueBioun oy) pue jxeW AOUCW paziueBio aip ‘sioias ony ow! papiaip Kipeoaq s| Yew KauowW UeIpUL ay, :YOResBAIU] Jo 49E7 ~Qi CAPITAL MARKET IN INDIA Capital market is the market for medium and long term funds. It refers to all the facilities and the institutional arrangements for borrowing and lending term funds (medium-term and long-term funds). ‘The demand for long-term funds comes mainly from industry, trade, agriculture and government. The central and state governments invest not only on economic overheads such as transport, irrigation, and power supply but also an basic and consumer goods industries and hence require large sums from capital market. The supply of funds comes largely from individual savers, corporate savings, banks, insurance companies, specialized financial institutions and government. Explain the role (OR) Significance of Capital Market in economic development. Capital market has a crucial significance to capital formation, Adequate capital formation is indispensable for a speedy economic development. The main function of capital market is the collection of savings and their distribution for industrial development, This stimulates capital formation and hence, accelerates the process of economic development. ‘A sound and efficient capital market facilitates the process of capital formation and thus contributes. to economic development. The significance of capital market in economic development is explained below. 1. Mobilisation of Savings: Capital market is an organized institutional network of financial organizations, which not only mobilizes savings through various instruments but also channelizes them into productive avenues. By making available various types of financial assets, the capital market encourages savings. By providing liquidity to these financial assets through the secondary markets capital market is able to mobilize large amount of savings from various sections of the people such as individuals, families, and associations. Thus, capital market mobilizes these savings and make the same available for meeting the large capital needs of industry, trade and business. 2. Channelization of Funds into Investments: Capital market plays a crucial role in the economic development by channelizing funds in accordance with development priorities. The financial intermediaries in the capital market are better placed than individuals to channel the funds into investments which are more favourable for economic development. 3. Industrial Development: Capital market contributes to industrial development in the following ways: (a) It provides adequate, cheap and diversified finance to the industrial sector for various purposes. (b) It provides funds for diversified purposes such as for expansion, modernization, upgradation of technology, establishment of new units etc. (©) It provides a variety of services to entrepreneurs such as provision of underwriting facilities, participating in equity capital, credit rating, consultancy services, etc. This helps to stimulate industrial entrepreneurship. 4. Modernization and Rehabilitation of Industries: Capital market can contribute towards modernization, rationalization and rehabilitation of industries. For example, the setting up of development financial institutions in India such as IFCI, ICICI, IDBI and so on has helped the existing industries in the country to adopt modernization and replacement of obsolete machinery by providing adequate finance. 5. Technical Assistance: An important bottleneck faced by entrepreneurs in developing countries is technical assistance. By offering advisory services relating to the preparation of feasibility reports, identifying growth potential and training entrepreneurs in project management, the financial intermediaries in the capital market play an important role in stimulating industrial entrepreneurship. This helps to stimulate industrial investment and thus promotes economic development. 6. Encourage Investors to invest in Industrial Securities: Secondary market in securities encourage investors to invest in industrial securities by making them liquid. It provides facilities for 6continuous, regular and ready buying and selling of securities. Thus, industries are able to raise substantial amount of funds from various segments of the economy. 7. Reliable Guide to Performance: The capital market serves as a reliable guide to the performance and financial position of corporate, and thereby promotes efficiency. It values companies accurately and toes up manager compensation to stock values. This gives incentives to managers to maximize the value of companies. This stimulates efficient resource allocation and growth. Q.2 What is capital market? Explain the structure (OR) composition of capital market in India. In the financial market all those institutions and organizations which provide medium term and long- term funds to business enterprises and public authorities, constitute the capital market. In simple words, the market which lends long-term funds is called the capital market. The capital market is composed of those who demand funds and those who supply funds. Thus, the borrowers and lenders in the financial market for medium-term and long-term funds constitute the capital market. The Indian Capital Market is broadly divided into two categories: 1). The securities market consisting of (a) The git-edged market and (b) The industrial securities market; and 2), The financial institutions (Development Financial Institutions) (DFs). Thus, the Indian capital market is composed of (@) The gilt-edged market or the market for government securities and industrial securities or corporate securities market. (b) Capital market includes Development Financial Institutions (DFls) such as IFCI, SFC, LIC, IDBI, UTI, ICICI, etc. They provide medium-term and long-term funds for business enterprises and public authorities. (©) Apart from the above, there are financial intermediaries in the capital market such as merchant bankers, mutual funds, leasing companies, venture capital companies etc. They help in mobilizing savings and supplying funds to investors. THE CAPITAL MARKET IN INDIA IS SHOWN BY CHART Chart 1 : Capital Market in India + + Government Industrial Securities Development Financial Financial Securities (gilt-edged market Institutions Intermediaries market) JN New le Market (A) @) Primary Secondary Market Market yoy oy eee IFC ICICl SFCs IDBI IRBI UTI Merchant Mutual Leasing =—-Venture. = Others Banks Funds Companies _ Capital Companies“Awouose uerpuy ety jo Yosb ayy buyjesipur paylssenip usaq sey Guluonouny sy ‘sapisag ‘Ajjenueisqns paseesou! sey suonsesuen joyew jeyded jo @WN|ON ayy ‘sapedep OM ySe] AY) Ul ‘1OB) U] UeWeroJdWW! ;eUeWOUeYd UMOYs eneY WeWUYSeAU! pue Burnes Jo awinjon ayy ynog ‘yymo.6 pides passaunim sey yayJew jeyded ‘suejq Jea,-anly ayy GuLing "LS6| Jaye yuewerosdu Apears umoys sey yee jeyded ueIpu| oy) :saueIpeeyuy eIoUeULY (py) poyeo ose suonnt uplyM suoNMysul je!ueuy jeIseds ose oxoY Jey) PaUONUOW oney oM:sUONMNSU] jeIoUeUTY (2) “senuinoas u! Buljeep pue Buljes “Burkng ut sseursng Gurjo.quoo pue Bune;nBes 40) yeysew peziuebio Ajybiy e si y ‘SenuNoas persi| JO payonb jo ajes pue aseysund ayy jo jeyJewW e si Jaye AJepuoses ayy JO jaye SHueYyoxe yOo\s oY) Heysew Asepuoes (g) “Kaun aup jo yymosB sCUODe UO yeduUI Sy Jo esneseq Wepodu!! si JeyseW anssI Mau Oty Je4) PayoU eq AE yj “ssauISNg Jie BuIpuedxe pue spuog ‘saJeys jo Woy au) ides mau jo Buises au) YM pauiJeou02 S| JexJeW aNssi MAU ey) Jeu Ksepuoras aL) payed “yeysew 490) Jo afueysxe yo0)s se umoUy AjuoWWUOD ‘JoxeW anss! pjo (q) pue yoyew Arewud ou pajles JoyJew anss! mau ay, neque; Arewiiid (v) 2sa0697e9 ony Oy! papiaip si Faye SITY) -fyo24y pls pue yyGnog aq uee YoIyM spuog pue SaMUAgap 'sexeYs Jo JEW e SII} y@xJEWW SaNLINdag JeLNSMPUl a4 (Z) “syuauunaysut gap pinby sow! ay) ese SenUNoes ueLUWeROB ‘sny | “suonesado jayew uado sy yBnoy yeyew pabpa-16 euy ul aos jueuIWop e sAeyd |gy “sumone pig pajeas panss! Apsow usaq aney saqunoes juaWienoB ‘266L auNr eoulg “seadns jo Sa10s9 paspuny ara 40 Salo! [elanas ow! uns Kew uonpesuen yeq ‘Abie Kian ase JayJEU SAnUNIAS TWOLULIAADB aup Ul SUONDeSUEH au “spuny uapjoud ayy pue ‘919 ‘Or ‘Sveq JeoJ9WWOD apNoUl SUoAMASUI esey) ‘SenUNZES esau) UI SpUNY JleLy Jo UOMOd UleYaD e JSeAUI 0) mej Aq pauinbas ase Keys “suonnyysu! Ajueuiwopeid ee yeysew pabpa-y6 ay) UI sioyseau! ey “sanlinoas Ayyjenb yseq aup ‘a’! pabpa-y6 se umouy ave Koy ‘soy YSU ae SeUNIGS ay] Sy JeYeW senUNIes JUaWUUeACD ay) Se UMOUY OS] SI JaxJeW pabpa-yID, ye veW pebpy“ssaooud quaLujo}|e au sasimadns jg¥4s jo aaneqasaides e ‘aseys Jo juauNOye aly ul aoejd sexe) eonoesdjew ou @INSUA OJ ’SJOISAAU! JO S]SaJaIU! Bt) Ja}O/d 0) SasNseaW SNOLeEA PednpoNu! Sey |gFS “SenuNdes ul SJOJSOAU! JO JSAZaYul UON}Ia}0Id 9) SI [GAS JO ajou JUeLOdUI UY :S10]SAAU] JO JSAJA}U] JO UONIO}OJd “syeysew Asepuoses pue Ayewiid 0} adsas ym suuiou ‘saujapin6 ‘saanoaup ‘suone;nBai ‘soins anssi 40 awey UeD |gAS ayL “eIpuy ul Syaysew Andes au jo uoNejnBas ayy si {g@3S Jo ajo1 JUeUOdW JeYJOUY :ajoy AsoyeinBay "S}oy JEU [eyded jo uawdojanep Ayyeay ayy Joy JUBA ase seinseaw Auojejnies sy ‘seonoeidjew Bulpey syueneid 3) ‘ssoyseaul jenpiipul ayy Ayersadse ‘SIOJSAAU! JO S\SosaqU pue SIYyBU ayy syajoud y “yeyJeW jeyded ayy Jo wawdojenap pue UONOWOd aul SI [GaS JO |JOl yueYOdWw! aL) jo suC:;eyIeW |eWdeg jo yUauUIdojaA|aq pue UOnOWOIg “Aysiuly @DuUeU!4 a4) Jo jo.NUOD Wes9A0 ayy JapUN Ss! |G3S eyL “eIpul UI YomaWeY A1oye;nBas jeIueUy aLy Jo jUaN|NSUOD yeLOdWUI Aiea e awi0deq MoU Sey yj “G66L Auenuer ul paseeJoul asem [gas Jo Siamod AuojejnBas ayy ‘smyeys Asoymeys papsooze sem }!'Z66L Arenuer pue gg6L u! pieog A10ynje}s-uou e se paysiiqeise sem |gaS ‘Waa Jo eouroyiu 7 80y ayy aulLUeXy vo“suoneaouu! BuiBesnooue pue uonjedwos Bunjejnuiys exe senyinses ey) YBnosyy sedounosed Jo uoNed0||e2 pue UONeZ|IIGoLW yo Ue Bunewioe ul ajos Jueyoduu! Ue sAejd |g34S eu, :seounosay jo UONe: “spuny Jenynw aySaWOp pue sj] 4 jo BuLoyuoWwW pue uoNeinBas ‘uonensibai rye syoo) osje y “(S||4) SiOySaAU] ;eEUOANMIASU] UBlel04 pue spuny jennwW InsSewWop 0) yadsas yum Aaijod yuaujsanu! jeuonMSU! Jaye yoo) [GIS ‘Aco yeuUNsanu] jeuoNNASU] “Bulpen 49) pue sjuawanow eoud jo Buyoyuow pue sabueyoxe yoors ay jo awos Jo uONeAsiuIWpe ‘sabueyoxe yooIs Jo SiequiaW jo Buyoyuow pue uojensibes 40) ajqisuodsai osje si y ‘s}onpoid queunsenu! mau puke jayJeW Asepuosas 10) sanss! Aioyejnfias pue Aayjod ye 10) ajqisuodsai si |gas :Aoog yeyxsey Asepuosas “S@URIPSWWAjU! payejes anssi jo Buoyuow pue uonejnBes ‘uonensibe: 40) ‘Aoyod yaxsew Asewid ayy ym Buneuipso-09 10) ‘senssi yybu pue dI\qGNnd Joj JaYJo Jo Sioa) pue sasmoadsoid sup |e jo Buman Joy ajqisuodsai si 3 “jeysew Auewid 0) Wadsau YM senss! AsoyejnBai pue syayew Aatjod at) Wye Jaye SyOo| |Gas :AdIoq yyey ewig ‘sajuedwios paysi jsuleBe |g4s 0) sjurejdwios aye 0} JUEM OYM SIO}SAAU! SjSISSe [GAS JO UOISIAIG a2UePIND pue jesselpay SaDUeAaLID 4JO}SAAU| OY “squrejdwos Jo}saau! YM jeap 0} wWaysKs Guypuey sjurejdwos payewoyne ue pesnpoqui sey |gaS “saouenali6 ssoysenu! aly Guissaupas Jo ajos seyjoue sAeid jQ3s ‘Jesseupay SaoueAeUD S,10}SaAU] “salpawias pue syyBu soup JO pue JayJewW Sanlinoas BU} 0} parejas SENSs! SNOUEA UO SJO\SAAU! ALN UAIYBI|US 0} Eun O} SU] WOY s|UeWesNeApe Senss! ¥ Jaye sanunsas ayy jnoge siojsaAu! ety BuNeonpa jo ajol e sey |G@AS :uOneINpy S,JO}SAAU]39 Module 2 MONETARY ECONOMICS Unit Structure 4.0 Objectives 4.1. Concept of Money Supply 42. Constituents of Money Supply 4.3. Determinants of Money Supply 4.4. Velocity of Circulation of Money 45 Summary 4.6 Questions 4.0 OBJECTIVES + To study the concept of money supply * To understand the constituents of money supply + To study various determinants of money supply ‘* To study the concept of velocity of circulation of money and its factor determinants 4.1 CONCEPT OF MONEY SUPPLY Money supply refers to the amount of money which is in circulation in an economy at any given time. It is the total stock of money held by the people consisting of individuals, firms, State and its constituent bodies except the State treasury, Central Bank and Commercial Banks. The cash balances held by the Federal and federating governments with the Central Bank and in treasuries are not considered as part of money supply because they are created through the administrative and non-commercial operations of the government. Further money supply refers to the disposable stock of money. Therefore money supply is stock of money in circulation. Money supply can be looked at from two points of views, namely, money supply as a stock and money supply as a flow. Thus at a given point of time, the total stock of money and the total supply of money is different.40 Money supply viewed at a point of point is the stock of money held by the people on a given day whereas money supply viewed overtime is viewed as a flow. Units of money are spent and re- spent several times during a given period. The average number of times a unit of money circulates amongst the people in a given year is known as Velocity of Circulation of Money, The flow of money is measured by multiplying the stock of money with the coefficient of velocity of circulation of money. 4.2__CONSTITUENTS OF MONEY SUPPLY There are two approaches to the constituents of money supply. They are the traditional and the modern approaches. 1. Traditional Approach: According to the traditional approach, the money supply consists of currency money consisting of coins and notes and bank money consisting of checkable demand deposits with commercial banks. The currency money is considered high powered money because of the legal backing of the State, The Central Bank of a country issues currency notes and coins because it has the monopoly of note and coin issue. The supply of money in a country depends upon the system of note issue adopted by the country. For instance, India adopted the Minimum Reserve System in 1957, Under this system, the Reserve Bank of India has to maintain a minimum reserve of *.200 Crores consisting of gold and foreign securities. Out of this, the value of gold should not be less than *.116 Crores. With this reserve, the Reserve Bank of India has the power to issue unlimited amount of currency in the country. Checkable demand deposits of commercial banks are used in the settlement of debt. Payments made through checks change the volume of demand deposits by creating derivative deposits. The creation of demand deposits is determined by the credit creation activities of the commercial banks. Bank money is considered as secondary money whereas cash money is known as high powered money. Thus according to the traditional approach, the total supply of money is the sum of high powered money and secondary money or currency and bank money. The ratio of bank money to currency money depends upon the extent of monetization, banking habits and banking development in a country. In advanced countries, ratio of bank money to currency money is high whereas in poor countries the ratio of currency money to bank money is high. 2, The Modern Approach: According to the modern approach, money supply includes currency money and near money. Money supply therefore consists of coins, currency notes,a demand deposits of commercial banks, time deposits of commercial banks, financial assets, treasury bills and commercial bills of exchange, bonds and equities. RESERVE BANK OF INDIA'S APPROACH TO THE MEASUEMENT OF MONEY SUPPLY: According to the Reserve Bank of India since its inception in 1935, money supply in the narrow sense of the term was the sum of currency with the people and demand deposits with the commercial banking system. Narrow money was denoted by the RBI by Mj, In 1964-65, the concept of broad money or aggregate monetary resources was introduced. Broad money was considered equal to Mi + Time deposits with commercial banks. In March, 1970 the RBI accepted the report of the Second Working Group on Money Supply. This report was published in the year 1977 and it gave a broad definition of money supply. Accordingly, four measures of money supply were brought into effect. These four measures are as follows: 1. My = Currency with the public + Demand deposits with the commercial Banks + Other deposits with the RBI. 2. Ma -M; + Post Office Savings Bank Deposits. 3. Ms -My, Time deposits with the commercial banks. 4, Mg -Ms + Total Post Office Deposits (excluding NSCs). The Reserve Bank of India gives importance to narrow money (M;) and broad money (M3). Narrow money excludes time deposits because they are not liquid and are income earning assets while broad money includes time deposits because some liquidity is involved in it as these assets earns interest income in future. Since time deposits have become convertible in recent times, they have become more liquid than what they were before. The Mz and My measures of money supply include post office savings and other deposits with the post offices. The third working group on money supply recommended the following measures of monetary aggregates through th report submitted in 1998: 1, Mo =Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI. (Mo is compiled on weekly basis). 2. M, =Currency with the public + Demand deposits with the bankingSystem + Other deposits with the RBI = Currency42 with the public + Current deposits with the banking system + Demand liabilities Portion of Savings Deposits with the banking system + other Deposits with the RBI 3, Mz = My + Time liabilities portion of saving deposits with the banking System + Certificates of deposits issued by the banks + Term Deposits [excluding FCNR (B) deposits] with a contractual maturity of up to and including one year with the banking system =Currency with the public + current deposits with the banking System + Savings deposits with the banking system + CertificatesOf Deposits issued by the banks + Term deposits [excluding FCNR (B) deposits] with a contractual maturity up to and Including ‘one year with the banking system + other deposits with the RBI. 4. M3 = Mz + Term deposits [excluding FCNR (B) deposits] with a Contractual maturity of over one year with the banking system +Call borrowings from Non-depository financial corporations by the — Banking system. (Ms, Mz & Mare compiled every fortnight). In addition to the monetary measures stated above, the following liquidity aggregates to be compiled on monthly basis were also recommended by the working group: 1. Ly =Ms + All deposits with the Post Office Savings Banks (excluding National Savings Certificates). 2. Le = Ly + Term deposits with Term lending institutions and refinancing Institutions (Fis) + Term borrowing by Fis + Certificates of Deposits issued by Fis. 3. Ls =L2+ Public deposits of Non-banking Financial Companies. (Lsis compiled on quarterly basis). 4.3 DETERMINANTS OF MONEY SUPPLY Currency in circulation and demand deposits are the main constituents of money supply. While the demand deposits are created by the commercial banks, currency is issued by the Central Bank and the Government. The supply of money is determined by the following factors: 1. Size of the Monetary Base: Money supply depends upon the size of the monetary base. The monetary base refers to the group of assets which empowers the monetary authorities to issue currency money. Money supply changes with changes in43 the monetary base. The monetary base of an economy consists of monetary gold stock, reserve assets such as government securities, bonds and bullion, foreign exchange reserve with the central bank and the amount of central bank's credit outstanding. In the present times, gold stock is not considered as part of the monetary base. . Community's Choice: The relative amount of cash and demand deposits held by the people also influences the supply of money. If the people prefer to make check payments much more than cash payments, the total money supply maintained by a given monetary base would be larger and vice versa Since money deposited in commercial banks generates derivative deposits and expand the supply of bank money through the credit multiplier, people's preference of bank money to cash would increase the supply of money. However, the choice of the community is determined by factors such as banking habits, per capita income, availability of banking facilities and the level of economic development. If these factors are developed, the money supply would be larger and vice versa . Extent of Monetization: Monetization refers to the use of |. Cash Reserve Rati money as a medium of exchange. The choice of the community for money as a liquid asset depends upon the extent of monetization of the economy. If monetization is high, demand for money would be high and vice versa The Cash Reserve Ratio refers to the ratio of a bank's cash holdings to its total deposit liabilities. It determines the coefficient of the credit multiplier. The CRR is determined by the Central Bank of a country. The credit multiplier (m) is determined as the reciprocal of the CRR (). Therefore m = 1/r. Excess funds with the commercial banks multiplied by the credit multiplier will give us the extent of credit creation by the commercial banks. Lower the CRR, greater will be value of the credit multiplier and therefore greater will be the ‘supply of bank money and vice versa. . Monetary Policy of the Central Bank: Monetary policy is defined as the policy of the Central Bank with regard to the cost and availability of credit in the economy, The monetary policy of the Central Bank of any country will be according to the macro- economic conditions. Thus under inflationary conditions, the Central Bank may follow restrictive monetary policy and thereby reduce the supply of bank money by pursuing both qualitative and quantitative measures of controlling money supply. Similarly under recessionary conditions the Central Bank may follow expansionary monetary policy and thereby raise the supply of money in the economy.44 6. Fiscal Policy of the Government: Fiscal Policy is defined as a Policy concerning the income and expenditure of the government. While the government raises revenue through various sources like different types of taxes, borrowing and through deficit financing, it spends the money raised for various developmental and non-developmental purposes. When the government raises revenue by imposing fresh taxes or by raising the existing level of taxes, it helps to reduce money supply. Similarly, market borrowing by the government reduces money supply and raises the market interest rates. This is known as the crowding out effect of government borrowing When the government spends the money so raised, money supply increases. However, when the government runs a deficit budget, it adds to the existing stock of money supply and thus raises the supply of money in the economy. The opposite will be the impact of a surplus budget but surplus budgets are a rarity in modern times. 7. Velocity of Circulation of Money: Velocity of circulation of money refers to the average number of times a unit of money as a medium of exchange changes hands during a given year. Money supply is measured as total money in circulation multiplied by the velocity of circulation (MxV). Thus higher the velocity of circulation of money, higher will be the money supply and vice versa. 4.4 VELOCITY OF CIRCULATION OF MONEY The velocity of circulation of money determines the flow of money supply in an economy in a given period of time, normally such a period is one year. The average number of times a unit of money changes hands is known as the velocity of circulation of money. The supply of money in a given period is obtained by multiplying the money in circulation with the coefficient of velocity of circulation i.e., M x V where M refers to the total amount of money in circulation and V refer to the velocity of circulation of money in the given period. Factors Determining Velocity of Circulation of Money: The velocity of circulation of money is determined by the following factors: 1. Time Unit of Income Receipts: The more frequently people receive income, the shorter will be the average time period of holding money and greater will be the velocity of circulation of money. Thus if in a given society large number of people receive income on daily basis, the velocity of circulation of money would be higher than the one in which people receive income on weekly, fortnightly or monthly basis.45 Method and Habits of Payment: The velocity of circulation of money would be high if large number of people prefers to make payment on installment basis. As a result, the same unit of money will change hands more often than when payments are made in full Regularity of Income Receipts: If in a society people receive income on a regular basis, they will spend their current income without bothering about future and hence the velocity of circulation of money would be high. However, if future income receipts are uncertain, people will not spend more money in the present and hence the velocity will be less Saving Habits of the People: If the marginal propensity to save is high in a society, then the people will be spending less in the present and hence the velocity will be less. Similarly, if the marginal propensity to consume is high the people will spend more and the velocity of circulation of money will be high: Income Distribution: Income distribution may be more equal or more unequal in a society. If inequalities of income are high in a society with the top 20 % taking away a major portion of the national income, velocity of circulation of money would be low because the richer sections of the society will be holding more idle cash balances. However, if income distribution is more equal or less unequal, the bottom 40% of the people will receive more incomes and spend more thereby increasing the velocity of circulation of money. Development of Banking and Financial System: If the banking and financial institutions in a country are well developed, mobilization of savings can be effectively carried out and more credit made available to the needy. This not only prevents hoarding of cash balances but also increases the velocity of circulation of both currency and bank money. Business Cycle: During the prosperity phase of the business cycle, investment, output, income, employment and prices rise. Thus the velocity of circulation of money would be high during the prosperity phase. However, during the downturn of the business cycle, investment, output, income, employment and prices begin to decline thereby reducing the velocity of circulation of money. Liquidity Preference of the People: If the liquidity preference of the people is high ie., if they wish to hold a greater part of their income in the form of idle cash balances, the velocity of circulation of money would be low and vice versa46 9, Speedy Clearance of Checks and Transfer of Funds: A more advanced banking system would help speedy clearance of checks and transfer of funds from one account to another account, thereby increasing the velocity of circulation of money. SUMMARY 1. Money supply refers to the amount of money which is in circulation in an economy at any given time. It is the total stock of money held by the people consisting of individuals, firms, State and its constituent bodies except the State treasury, Central Bank and Commercial Banks. 2. There are two approaches to the constituents of money supply. They are the traditional and the modern approaches. 3. The supply of money is determined by the following factors: Size of monetary base, Community's choice, Extent of monetization, Cash Reserve Ratio, Monetary policy of the Central Bank, Fiscal policy of the Government, Velocity of circulation of money. 4, The velocity of circulation of money determines the flow of money supply in an economy in a given period of time, normally such a period is one year. 5. Factors determining velocity of circulation of money: Time unit of income receipts, Method and habits of payment, Regularity of income receipts, Saving habits of the people, Income distribution, Development of banking and financial system, Business cycle, Liquidity preference of the people, Speedy clearance of cheques and transfer of funds. 4.6 QUESTIONS 1. What is Money Supply? Explain the approaches to the constituents of money supply. Explain the determinants of money supply. What is Velocity of Circulation of Money and explain the determinants of velocity of circulation of money? RON POSSFISCAL POLICY ing to Arthur Smithies, the term ‘fiscal polic to ae which government uses its expenditine revenue programmes to produce desirable effects ang avoid undesirable effects on the national income, production a employment." Thus, fiscal policy may be defined as that part Ps government’s economic policy which deals with taxation expenditure, borrowing and the management of public debt in an economy for purposes of stabilization or development. The significance of fiscal policy as an instrument of ¢ control was first emphasised by Keynes. The Keynesian of fiscal policy is applicable to advanced economies. Thi fiscal policy in advanced economies is to stabilize the rate of growth. But, in the context of an under-developed economy, the role of fiscal policy is to accelerate the rate of capital formation, Fiscal policy as a means of providing economic development aims at achieving the following objectives : Conomic analysis role of Objectives of fiscal policy in under-developed countries @i) To increase the rate of investment.—Fiscal policy aims at the promotion and acceleration of the rate of investment in the private and public sectors of the economy. This can be achieved by checking actual and Potential consumption and by raising the saving ratio. (ii) To encourage socially optional investment.—fiscal policy should encourage the flow of investment into the channels which are considered socially desirable. This relates to the optimum pattern of investment and it 1s the responsibility of the State to promote investment in social and economic overheads to achieve economie development. Investment in transport, communicatien, Power development and soil conservation fall unde economic overheads. Investment in education, PU’ a : health and technical training facilities come ( 472 )social overheads, (ii) To increase employment opportunities.—Fiscal policy should aim at increasing employment opportunities and reducing unemployment and under-employment. For this, the State expenditure should be directed towards Providing social and economic overheads, Such expenditure creates more employment and increases the productive efficiency of the economy in the long-run. (iv) To promote economic stability in the face of international _instability—Fiscal policy should promote the maintenance of reasonable economic stability in the face of short-run international cyclical fluctuations. An under-developed country is prone to the effects of international cyclical fluctuations due to the very nature of its economy. (v) To counteract inflation.—Fiscal policy should aim at counteracting inflationary tendencies inherent in a developing economy. (vi) To increase and_ redistribute national income.—Fiscal policy should increase national income and redistribute it in such a manner that the extreme inequalities of income and wealth are reduced in the economy. (vii) To remove the regional imbalances in the economy.—Fiscal policy should-aim to develop all the regions equally in the economy. (viii) To estimate sectorial imbalances.—Fiscal policy should be to estimate, as far as possible, sectorial imbalances arising in the economy from time to time. The success of fiscal policy in achieving these objectives depends on taxation,. public spending, public borrowing and deficit financing.TAXATION axes are compulsory payments to the government without expectation of, definite return or benefit to the tax-payer. Dalton says; "A tax is a compulsory contribution imposed by a public authority, irrespective of the exact amount of service rendered to taxpayer in return and not imposed as a penalty for any offence." According to Prof. Seligman, "A tax is a compulsory contribution from the person to the government to defray the expenses incurred in the common interests of all, without reference to special benefits conferred." Bastable defines a tax as compulsory contribution of the wealth of a person or a body of persons for the service of public power. W. Taussig says that the essence of a tax, as distinguished from other charges by government, is the absence of a direct quid pro quo between the tax payer and the public authority. Thus, a tax is generally levied to augment the public revenue which is utilised for public benefit and it cannot be predicted as to what extent the amounts paid by an individual to the State. come back to him in the form of services rendered by the authority or State. Characteristics of taxes.—From the above definitions, the following elements of taxes are visible :— (1) Taxes are imposed by the government only. (2) A tax is compulsory. contribution of the tax payer. (3) In the payment of a tax, the element of sacrifice is involved. (4) Payment of a tax is the personal obligation of the tax payer. (5) The aim of taxation is the welfare of the community as a whole. (6) A tax is a legal collection. (7) An element of force is there. ( 441)PRINCIPLES OF ECONOMICS FOR Law STUg NTS (8) A tax is not imposed to realise the cost of benef, (9 aes may be assed out of income.” Py 0) At a ey are actly eld by inde (1) The tax dows Oe public authority. between th e tax is raising public revenue, (12) The purpose of the ts (13) Tax is used for public purpose or common benefit of all. (14) Tax involves appropriati CANONS OF TAXATION dam Smith in his "An Inquiry into the Nat and Gecass 6 ee Wealth of Nations" (Book V, chapter (2), rat II) enunciated four famous maxims. They oe a (1) Canon of equality—'The subjects of every State ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue which they respectively enjoy under the protection of the State. In the observation or neglect of the maxim consists what is called the equality or inequality of taxation." In other words, every person will pay taxes to the government in proportion to his ‘ability to pay’. The richer a person is, the more is his ability to pay towards the running of the government. The ability to pay may be judged on the basis of wealth or income or expenditure. The maxim implies that the income which a person enjoys under the protection of the State, should be taxed on the proportional rate of taxation. Though, at another place, he pointed out that richer citizens should not pay in proportion to their wealth, but more than in proportion, he proposed here . proportional taxes for equality. a) —'The tax which each individual er to pay oughi\to be certain, and not arbitrary. e time of payment,\the manner of payment, the ceeded be paid oughtto be clear and plain to the ee fs ive faked 0 person." The canon 0 tax payer by the tax to prevent the exploitation of the ax collector or the State. Uncertainty ion of private property,AND FISCAL POLICY 443 yf in taxation encourages insolence or corruption. The annon of certainty demands that there should be no element of arbitrariness in a tax. The tax payer should be able to see for himself why he is called upon to pay a particular sum as taxation. Certainty is needed not only from the point of view of the tax-payer, but also from that of the State. The government should be able to estimate the proceeds of the various taxes and the time when they are expected to flow in. Canon of convenience.—'Every tax ought to be levied at the time or in the manner in which it is most likely to be convenient for the contributor to pay it." The canon of convenience says that the time of payment and the manner of payment should be convenient. It implies that taxes should be imposed in such a manner and at the time which is most convenient for the tax-payer. Adam Smith also pointed out the reasons and the taxes which can conveniently be collected, ie., taxes on articles of luxuries, "taxes upon such consumable goods as articles of luxury, are finally paid by the consumer and generally in a manner that is very convenient for him." The payment of these taxes is convenient to consumer because he pays them little by | little and whenever he likes as he has the freedom to | buy them at the most convenient time or not to buy them at all. Canon of economy.—"Every tax ought to be contrived as both to take out and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the State." This canon indicates that taxes should not be imposed unless the revenue from them is considerable and, at the same time, the collection charges should not be too much and too high a proportion of the total tax revenue. , Adam Smith pointed out the conditions under which, a tax 4y either take-out or keep-out of the pockets of the people more : 4 ings into treasury in the following four ways : @® The levying of it may require a great number of officers, whose salaries may eat up the greater part of the Produce of the tax, and whose pre-requisites may impose another additional tax upon the people. Hence, the administration cost should be minimum. 3 rr 4(ii) PRINCIPLES OF ECONOMICS FOR LAW STUDENTS It may obstruct the industry of the people, and | discourage them from applying to certain branches of business which might give maintenance and employment to great multitudes. Hence, the taxes should not be levied so heavily as to discourage production. (iii) The forfeitures and other penalties which these unfortunate individuals incur, who attempt unsuccessfully to evade the tax may frequently ruin them, and thereby put an end to the benefit which the community might have received from the employment of their capital. An injudicious tax offers a great temptation to smuggling. Hence, the tax should not be so heavy as to offer great temptation for evasion or smuggling and tax-payer may not be put under unnecessary extra cost. (iv) By subjecting to the frequent visits and the odious examination of the tax-getters it may expose them to much unnecessary trouble, vexation and oppression. The first canon of Adam Smith is ethical and the other three are administrative in character. (6) (6) Mm (8) Other Canons.—Some writers, like Bastable have added a few more canons of taxation to Adam Smith's four maxims. Canon of productivity or fiscal adequacy.— Bastable’s first canon of taxation is the canon of productivity. The productivity of a tax may be observed in two ways. In the first place, a tax should yield a satisfactory amount for the maintenance of a government. Secondly, the taxes should not obstruct and discourage production in the short as well as in the long run. Canon of elasticity—Bastable also laid stress on the principle of elasticity, ie, the yield of the taxes may be increased or decreased according to the needs of the government. Taxes on property and commodities are not 80 elastic as income tax. Canon of diversity—There should be all types of taxes, direct and indirect, so that every class of citizens may be called upon to contribute something towards the State revenue. The burden of taxation should be widely distributed on the entire economy withoutcausing much harm to anyone. (@) Conon oulsimplicity emacs tha oe Gul e : by the tax-payer, ie, its nature, its aim, time of payment, method and basis of i { —_ | estimation should all be easily followed by each tax \ BANKING AND FISCAL POLicy wy easily be understood payer. Obviously th, difficulties of the aeaeers may remove several interest of his couventere and therefore, it is in the | 40) Canon of neutrality,—: i t ¢ the sense that they sbecld ant nrc oe meal a production or distribution, (11) Canon of expediency.—tt implies that the possibilit of imposing a tax should be taken into acount from different angles, i.e., its reaction upon the tax payers. Sometimes, it is seen that a tax may be desirable and may have most of the characteristics of a good tax but the government may not find it expedient to impose it. For example, progressive agriculture income tax is very much desirable in India, but it has not been imposed so far in the manner it should have been imposed. Hence, this canon is of vital importance in democratic countries. (12) Canon of contribution to economic stabilization.—It may be interpreted as to promote full employment and if possible a stable financial level. The stabilization of the balance of payments may be a subsidiary objective of a well organised tax system. (13) Canon of co-ordination.—In democratic countries, taxes are imposed by federal and local governments. It is therefore very much desirable that there must be co-ordination between the different taxes that are imposed by different tax authorities. OBJECTIVES OF TAXATION Normally, there is only one objective for the imposition of tires, i.e, to collect revenue for the government. But in modern 8, social and economic justice is only the end in a Democratic Socialist State. Hence, the following are regarded as the broad “cial and economic objectives of taxation to achieve the above Boal, (1) Prevention of concentration of wealth.—Prof. Musgrave provided the following devices to prevent thePRINCIPLES OF ECONOMICS FOR LAW STUDENTS concentration of wealth : (i) A tax transfer scheme, combining progressive income taxation of high income households with a subsidy to low income households. (ii) A combination of taxes on goods purchased largely by high income consumers and subsidies to other goods which are used ee consumers. . (2) To secure economic stability—The tool of taxation may be used to secure economic stability or to remove economic fluctuations. The economic fluctuation a be due to changes in ployment, prices and aggregate demand. The measures are: (i) If involuntary unemployment taxation should be reduced. (ii) If inflation prevails, the level o! increased. ‘ — 7 (ii) If full employment and price stability prevails, then, there is no need to change the present level of taxation~ (3) To secure adjustment in allocation of resources.— All wants cannot be satisfied through the market. Public sector is used to make provision of social wants or collective wants, i.e., defence, justice, railways and roads, social and cultural welfare, etc. As social life became more complex and civil sense of the people developed, the State found it necessary and possible. to take upon itself some further obligations such as those of protection against internal disorders, regulation of trade and commerce, etc. To meet the expenditure. for these functions revenue is to be raised through taxes. (4) To accelerate economic growth.—For the purpose of promoting a country’s economic development, taxation may be used to achieve the following objectives : (i) to curtail consumption and thus transfer resources from consumption to investment; a ‘0 increase me incentives to save and invest; iii ransfer the resources from the hands of the public to the hands of the government in order to make public investment possible; (iv) to modify the pattern of investment into socially f taxation should be“‘Buyqured pue 3uny3eq ay} [oI}U09 04 yUSUNI}sUI UB se U0T}exXe} ay} es Ue JUEUTUJEAOS OY, “WWeAdTeIIT are yt [jedosd YoIyM saatjour 9y} yey} puE SMye[SIBa_ ayy. Jo 1amod ou? UF St UoHexe, oy ‘onueAel Butster Jo aoInos 8 Ajazaul jou pue Joryu0 eL0s Jo JueuINIysul peztudo00e1 BS UOHEXeL—Jo1;U09 [B}o0s Jo yuournzysut uy (9) '— ‘Aya08 ur yypeam JO WOLNQLYSIp atqeynbe aye 0} puB satzTenbout o1WoUOIa ey} aeonpar 0} (A) pus ‘1ouueur e[qeiisep a 13" in AQI10d THOSId NY ONIAN 4om Jo 8U0 UT pazer}Ua0U0D Suraq Jo peaysur Peytsrearp aq Pinoys we}sAs xe} OY, ‘sUI9z1 snotZeA UO Perse] ore sexe} YOTYM UI WezShs xB} ay} 07 Si9jer xeq efdiyinur y—me384s AISIOAIP 10 ute4shs uoMnexe,-yInW (g) ‘uoryexe} JO Ueping 4we18 B 1eaq Pinoys fay} pue sexe} exou Awd prnoys jo 7oyV0q ere CYM asoyy ‘sf JUL ‘SeOUBISUMOTD eyTTUN ur suosied jo quourzear4 aanefer a[qBrISep 94} St UoTyexey ut AyTeNba jo podse puoses oY, “UOHBxe} Jo Uepng oures oy} 1e9q P[noys seouBISUNOITD IBIAS UT padstd ere oym suosiad asoyy Iv ‘sfenbe jo yueury¥e13 [enba, st aseo ST} UT eyer oY, ‘seouBySUINOIID O¥YI] UI SsuOSsIed Jo yuourwe 1odoid eu} st 381g eUL AyTenbe Jo ura;qord 94} 03 sjoedse omy ore any —aopang XB}. Jo UOHNGLYySIp oy) Ur AyTENby (z) ‘requinu qseye03 84} Jo pooS 4soqver9 94} eJ0WoI1d prnoys wayshs xe} f10aq ‘aures ay} 8q plnoys sexe} yuereyIp 30 soytioes [eursreur ayy yey} Aem w& Yons ut etdoad # suotjses yuarayyIp uo PeTA9] 8q Plnoys sexe} ay} ‘sty3 Ssaampe Q], ‘adequeape [etoos unurxeur jo afdroutid ay} uo paseq st yorym 489q 94} SI UoTyexe} Jo uIeyshs yey} “eC IC 04 Surproosy—syxyaueq TeIo0s umunrxey] (1) : 5 ayeig Aue # waysks xe, punos JO SostopoBIEYO oy} ore ButmoT[oy ayy, WALSAS XV GOOD V JO SOLLSIUSLOVAVHO NOLLVXVL 40 Sa TdIONINdtaxes. At the same time, care should be taken to avoid oltiplicity of taxes, Arthur Young states, "If I were to define @ good system of taxation, it shou! ing light! of taxation, it should be that of bearing “igntly on an infinite number of points, heavily on none. 4) Productivity of the tax system—The term ‘productivity’ is interpreted in two senses. First, the taxation system should be such as to provide adequate income to the government to meet its expenditure. As the needs of the public authorities increase continually, the tax system should yield increased revenues. Secondly, the tax system should be such as to produce no adverse effect on the productive capacity of the country. In other words, the tax system should give the maximum possible encouragement to the productive capacity of the country. (5) Rights of tax-payers.—A sound tax system will have to safeguard the interests of the tax payers. In a democratic set-up, the rights of tax-payers have to be continuously kept in mind. Besides, the present level of taxation as well as the further prospects of taxation necessitate that the interest and rights of tax-payers should be given adequate recognition. The authority should : (i) make efforts to broaden their understanding of particular tax measures, (ii) provide for prompt and fair treatment of his complaints, and (iii) reduce the inconvenience to minimum. (6) Universal application of taxes.—Each individual should pay according to his ability to pay, and the individuals possessing the same ability to pay should contribute the same amount by way of taxes without any discrimination. In India, income tax is lacking this characteristic because income from agriculture is not taxed to the extent the incomes have been taxed in the non-agriculture sector. (1) Elasticity.—The taxation system should provide to the government increased income with the increase in the national income of the country. The taxation system should also yield more income when the government expenditure goes up. Two things are essential to bring about elasticity in the tax system. First, there should be proper blending of direct and indirect taxes. Secondly, certain sources of income should be(8) (9) PRINCIPLES OF ECONOMICS FOR LAW STUDENTS exclusively reserved for emergencies. Convenience.—The government should keep in view the convenience of the tax-payer while devising th, taxation system of the country. Since the tax-payers make sacrifices when they pay the taxes, it is essential for the government to see that they are not put to any avoidable inconvenience. Absence of tax evasion.—The tax system of the country should be so devised as to leave no scope for tax evasion on the part of the tax-payers. To achieve thié objective, there should be a proper blending of all sorts of commodity and personal taxes. This will reduce the scope for tax evasion to the minimum. (10) Conducive to economic growth.—The tax system must be so shaped as to accelerate economic development. It should generate a healthy investment climate and provide incentives to the entrepreneurial classes to come forward and set up new business and industrial enterprises in the country. (11) Optimum allocation of resources.—The tax system should be so framed. as to ensure that the productive resources of the economy are optimally allocated and utilised. For this purpose, it is essential that the tax system should be economically neutral. (12) Ensuring economic stability—The tax system should provide for in-built measures to fight the demon of inflation. Inflation not only erodes the real income of the masses, but also perpetuates glaring inequalities of income and wealth. From the point of view of ensuring economic stability, it is necessary that the tax system must be progressive in relation to changes in the national income.DIRECT AND INDIRECT TAXES Taxes have been broadly categorised into direct taxes and indirect taxes. Dalton made a distinction between direct and indirect taxes as "that a direct tax is really paid by a person on whom it is legally imposed, while an indirect tax is imposed on one person, but paid partly or wholly by another owing to a consequential charge in the terms of some contract or bargaining between them." J.S. Mill says," Direct tax is that which is demanded from the persons who (it is intended or desired) should pay it. Indirect taxes are those which are demanded from one person in the expectation and intention that he shall indemnify himself at the expense of another." Bastable defined direct taxes as those "which are levied on permanent and recurring occasions" and indirect taxes as “charges on occasional and particular events.” Prof. Shirras distinguished the direct and indirect taxes as "Those taxes levied immediately on property and income of Persons are called direct taxes, whereas those that are paid by the consumers to the State indirectly are called indirect taxes." ‘hus, income tax, wealth tax, and corporate taxes which are directly paid to the State may be called direct taxes, and customs and excise duties and sales tax may be called indirect taxes. The direct taxes involve a direct money burden and in the ‘ase of indirect taxes, the man who Pays the tax to the 8overnment is different from the person who bears it ultimately. Direct v, Indirect taxes : (1) Reverting to the contrast between direct and indirect taxes, it will be appreciated that it is not possible to introduce the principle of Progressive tax incidence in indirect taxes, whereas the Progressive tax incidence ig(2) Apart (3) PRINCIPLES OF ECONOMICS FOR LAW STUDENTs : aa ah taxes. It would be impracticable fo possible ae ‘0 enforce a system of central eecige fa guvel trol whereby & higher rate be charged if it ig on pet by av! i and lower rates from a Ie 7 a the poor. Hence, indirect taxes are sarily pro] ional. : neces: from peers there is another one, namely, ion of tax. There is possibility for evasion of income eroranarens it is not possible to evade the excise duties i customs duties. : aan oa ‘equity’ is the very life of direct taxes. The rinei le of equity is not observable in case of indirect Pires. Let us compare the merits and demerits of both direct and indirect taxes. of Direct Taxes :— ee inistrative cost of collecting these qa) Economy.—The admi (2) (3) (4) (5) ©) taxes is low because the same officers who assess small income or properties can assess larger incomes ‘and properties. Moreover, the tax payers make the payment to the State and therefore, every of these taxes direct ise that is taken out of the pockets of the tax payer paise : is deposited in the State treasury. Certainty.—These taxes also satisfy the canon of certainty. The tax payer is certain as to how much he is expected to pay, and similarly, the State is certain as to how it has to receive income from direct taxes. Equity.—Direct taxes are considered to be just and equitable because they are generally based on the principle of progression. Therefore, they fall more heavily on the rich than on the poor. Reduction in inequalities.—As the direct taxes are Progressive, rich people are subjected to higher rates of taxation. These taxes help to reduce inequalities in incomes. Elasticity—The taxes also satisfy f ee atisfy the canon 0! Sean as the government revenue may be increas in ply e raising the rate of taxation. Moreover, the income from direct taxes will also increase with the couse in income of the people. consciousness.—It is said that direct taxes create civil consciousness among the tax-payers. Theoft BANKING AND FISCAL Poxigy tax-payer May take j, “ : +, intelligent interest i oaibed ia soenditure and observe whether ie arenes | country, this Ci coed sae ny ®, democratic the public expenditure, "e8® checks the wastage in erits of Direct Taxes ; (1) Unpopular.—The direct A taxes shifted, and thereft _ are generally not Hence, such taxes re) they are painful to the tax payer. are unpopular j generally opposed by the faa cave in nature and are ; ers. (2) Inconvenience.—These taxes which | it. is derived, which is generally subject to complications. Moreover, the payment of these taxes in lump sum is not as convenient to the tax payer as the frequent payment of small amounts of indirect taxes. Possibility of injustice.—In practice it is difficult to assess the income of all cases accurately. Hence, the direct taxes may not fall with equal weight on all classes. Moreover, the rates of direct taxes are arbitrarily fixed by the government and they may not be on the basis of ability to pay. . Possibility of evasion.—A direct tax is said to be a tax on honesty, it is not evaded only when the tax payer is honest, otherwise it can be evaded through fraudulent practices. The progressiveness of direct taxes induces the tax payer to evade the payment of taxes. (5) Exemption of low income group.—If only direct taxation is resorted, the low income group people cannot be approached by direct taxes, as they are normally exempted from such taxes on the basis of ability or equality. Merits of Indirect Taxes :— (1) Convenient.—They are imposed at the time of purchase of a commodity or the enjoyment of a service so that the tax-payer does not feel the burden of the tax as it is hidden in the price of the commodity bought. They are also convenient because they are paid in small amounts and in intervals and not in one lump sum. (3) 4» (2) (3) (4) (6) ) @ (8) PRINCIPLES OF BUNS FOR LAW STUbeis Difficult to evade—Indirect taxes are genera included in the price of commodities purchased. Eva,’ of an indirect tax will mean giving up the satisfac” of a given want. .. Elastic.—Taxes imposed on commodities with ing] demand are elastic. A le.—Indirect taxes enable everyone, even ae, vations to contribute something towards - expenses of the State. Since direct taxes leave lower income groups from their scope, indirect taxes Take them share in the financial burden of the State, Can be progressive.—Indirect taxes can be Made progressive by imposing heavy taxes on luxuries ang exempting articles of common consumption. Productive.—The income from indirect taxes can be made highly productive by imposing few taxes each yielding a substantial amount of revenue. . Wide coverage.—Through indirect taxes every member of the community can be taxed, so that everyone may provide something to the government to finance the services of public utilities. Social welfare.—Heavy taxation on articles which are lastic * injurious to the health and efficiency of the people may restrict their consumption. Demerits of Indirect Taxes :— qd) (2) (8) (4) (5) Regressive.—The indirect taxes are generally regressive in nature as they fall more heavily upon the Poor than upon the rich. Administrative cost——The administrative cost of collecting such taxes is generally heavy because they have to be collected from millions of individuals in small amounts. Hence, they are uneconomical. Reduction in savings.—Indirect taxes discourage haves oar they are included in price and people mor i iti are ise Vesat nes © on essential commodities and pncertainty.—The income from indirect taxes is said aecesatencertain, because the taxing authority cannot = y-estimate the total revenue from. indirect No civil consciousness.— Indirect taxes are collectedje RING AND FISCAL PoUcy 451 acted wemen like traders and hence they have Generally speaking, the burden of indirect taxes tends to pal more foe on the Poorer sections of the community and pat of direct taxes mainly on the richer sections of the unity. They both are not competitive but are complementary. at is why Gladstone, the great Victorian statesman, remarked the direct and indirect taxes should be viewed as equally attractive sisters, neither of whom. should be pursued too ardently. PROPORTIONAL AND PROGRESSIVE TAXATION Taxes may be divided into Proportional and progressive, | pased on the burden of taxation. Proportional taxation :— PE. Taylor says, "A schedule of Proportional tax rates is one in which the rates of taxation remains constant as the tax base changes." The amount of tax payable is calculated by multiplying the tax base with the fixed rate. Thus, in proportional tax system the multiplier, i.e., the rate remains constant with the change in multiplicant (income). Case for or Merits of the proportional taxation :— (1) Proportional tax does not affect the relative position of the tax payer. (2) Proportional tax is simple to estimate and calculate and the imposition is uniform. The willingness to work more and save more of the tax Payer is not adversely affected by the proportional taxation. (4) The principle of equality of justice is being followed in Proportional taxation. (5) Equality of sacrifice’ as between the rich and the poor can be achieved by it. Mc Culloch, a well-known supporter of proportional taxes ‘ys, "When you abandon the plain principle (of proportion) you are at sea without rudder and compass and there is no amount injustice you may not commit.” against proportional taxation : (1) A system of proportional taxation would not lead to equitable and just distribution of the burden of taxation as it falls more heavily on the small incomes than on (3)PRINCIPLES OF ECONOMICS FOR LAW STUDENTs igh i es because the marginal utility of mone, amano reas rapidly as the income increases, a (2) A system of proportional taxation means the tax Tates (3) i d the poor are the same. Hence, th. oats ea eobtadn from the richer sections of the community as much as they can give. The proportional tax system, however, cannot be elastic as the financial needs of a government may chai from time to time and it is often required to have more funds. Progressive Taxation :— . PE. Taylor says, "A schedule of progressive tax rate is one in which the rate of taxation increases as the tax base increases," In the case of progressive tax, the multiplier (ie., the Tate) increases as the multiplicant (income) increases. Case for progressive taxation :— @ (2) (3) (4) (5) (6) It is argued that as income increases, the marginal utility of each addition to the income decreases. Hence, the payment of the tax by the rich entails much less sacrifice than by the poor. The ‘rich people should, therefore, pay tax at high rate. . Progressive taxation has been justified on the ground that it serves as a powerful instrument for reducing the inequalities of income. Progressive taxes have been justified on the ground that they are economical as the cost of collection does not raise with increase in the rate of taxes. Progressive taxes develop ‘tax consciousness’ inasmuch as the payer of such tax is definitely conscious of m a contribution to the welfare resources of the State, and can be expected also to take interest in removing governmental waste and inefficiency. Progressive taxes hi justi und atta ave been justified_on the gro y are elastic, the need of increased. public revenue can easil fi ‘ . rates of taxes. ly be fulfilled by increasing the Progressive taxes have been justified because the public cevenue automatically increases with the increase i? economic. activities and income, as the rise in income 2 _futomatically taxed at higher rates under this system./ BANKING AND FISCAL PouIcy boa (7) Progressive taxation may be helpful in curbing the inflationary trends, as it reduces consumption demand and the resources, thus, mobilised may be directed towards productive investment which may increase the supply of commodities, Hence, inflationary trend may be curbed, growth and economic stability may be achieved. (8) Progressive taxes may increase the desire to work, save and invest on the part of the rich because they are keen to have the same sum after the tax as before the tax. (9) Finally, the loss of Satisfaction for the community as a whole will be minimum only under conditions of Progressive tax systém, as the principle of least sacrifice states that the sacrifice imposed upon the community as a whole will be the Teast, if the richer sections are taxed at higher rates and the poorer sections are either exempted from taxation or are taxed at low rates. Prof. Pigou pointed out that the basis of satisfaction of many tich people is not the amount of their wealth; but because they are relatively richer than others, Hence, if the income of all the tich people is reduced by way of progressive taxation and their relative position does not change, the loss of satisfaction for them will not be very great. Arguments against the progressive taxation : (1) It has been argued that progressive taxation may adversely affect production and discourage capital formation. (2) It has been Pointed out that Progressive taxation is entirely arbitrary. There. is no guiding Principle according to which tax rates are determined. (8) It is said that Progressive taxation punishes prudence and virtue and rewards extravagence and idleness, (4) There is the danger of evasion of taxes, There would be very great efforts to evade a steeply graduated tax than to a proportional tax. (5) It is pointed out that the Principle of rogressio; be advocated on the ground of Bromoting eae because welfare is subjective and cannot f be me: E (6) Investments which are risky but which yield high sors*xe} [euorjs0doid e sauoseq FI FUT] yey} puoteq ynq “FIUTT] UTEz100 & OF dn oatssaisoid Aypitur st XB} earssoidep ey], ‘SUOT}es JoYSTI oY} Tey} S07}er reystq ye paxe} oe suorjves 10100d 904} pus Surysturmip uo seod xe} ay} JO ayer oY} ‘SOSBaIOUT [eNPLATpUl Ue Jo eUIOOUT ay} SB ‘UOTJExXe} aAtsseiZa1 Iepuy, ‘sureysAs xB} aatsseiZo1d pue yeuorsodoid sapiseq stieysXs U0T}BxB} OAISSeidep PUB aAIssaidal ore a19U,L, *suiajsAs xe} [[e q sey ofdriourid sty} yng “WorBosyUOS spremo} doqs @ St UOTJExe} aatsseigoid ‘wry 0} SuTprooy S£1aqqor peyenpers wv ‘joey ul ‘pus uolexe}, Jo epour ysnfun Aje.iyue ue sem xey-ouloour peyenpels y, ‘skes THN SL ‘aouepL ‘Aryunoo ay} ut yueuLXojdura pue oulooUT Jo [aAeT 94} eONper [Ila yuewyseaut Jo uoTjoNpey ‘euTooU! UT SsBerTDUT 94} WjUa sasvaroul 9781 xe} oY} SB paseinoosip ore syyoid jo SLNIONLS MV1 HOI SOINONODZ 40 SITAIONIUd ur peydope AT[esieatun use‘Shortcomings of the Tax System in 1880s Direct taxes High degree of progressiveness. Adverse effect on efficiency uring the 1960s and the 1970s Large number of exemptions! Eroded the already narrow tax basa Concessions Income tax Large number of rates and ad-hoc | Made it difficult for the economic ‘and frequent changes in the ‘agents to keep a track adding to tax rates uncertainty ont Poor enforcement and high Tax evasion pa compliance cost Discrimination between different | Discouraged investment and ‘| Corporate taxes | types of companies ‘encouraged devious routes a Double taxation of the dividends | Discouraged investment in equity = Indirect taxes High rates of excise/cusioms duties | Adverse effect on industrial competitiveness Customs and Wide dispersal of rates across ‘Ambiguities leading to litigation and Central Excise | the commodities poor compliance and comuption Numerous exemptions Vested interests/obbying for lax | erergon VAT Absence of VAT Cascading of taxes and distortion of prices Services Services sector outside the Major growth sector outside the Le tax net tax base 9.2.3 Reforms of the Tax system ‘The efforts at reforming the taxation system and the tax structure prior to the economic reforms of the 1990s, on the basis of the recommendations of successive expert commit- tees, have been documented by scholars (Thimmaiah, 2002)."' Notable among these efforts was the announcement of the Long-term Fiscal Policy in 1985, which recognized that the deteriorating fiscal position was a major challenge that needed taking a long-term view. The policy provided a direction for changing the taxation system, for increasing its elasticity and for securing bercer tax compliance. The non-integrated and complex nature of the indirect tax structure, and che problem of multiplicity of levies and its cascading effects, also received attention in the mid-1980s. A technical group was appointed by the government in 1985, to review and rationalize che central excise tariff, which led to the introduction of the Modified System of Value-Added Tax (MODVAT) in 1986. The reforms in the customs dury focused on an increased reliance on the tariff system, rather than on quantitative restrictions to regulate imports and a general reduction in the tariffs. A harmonized system (HS) of the classification of goods was also introduced.Tax reforms received a further boost im the carly 1990s, under the structural adjust- ment programme initiated in the wake of the economic crisis of 1991. The reforms in the tax structure, both direct and indirect, have since been an ongoing process."? In 1991, the Government of India appointed the Tax Reforms Committee (TRC), under the chair manship of Prof Raja Chelliah, to lay out an agenda for reforming the tax system and the tax structure. The basic approach adopted in the reports of the TRC (1991, 1992 and 1993) was different from the carlicr ones. The emphasis was on adopting a small number of simple and broad-based taxes, with moderate and a limited number of rates, and very few exemptions and deductions. Secondly, the measures suggested were comprehensive as they covered both the direct and the indirect taxes. Thirdly, the recommendations included measures for improving the tax administration. In brief, the recommendations of the TRC emphasized the following: 1, Reforming the personal taxation system by reducing the marginal tax rates. Reduction in the corporate tax rates. . Reducing the cost of imported inputs by lowering the customs duties. Reduction in the number of Customs tariff rates and its rationalization. Simplifying the excise duties and its integration with a Value-Added Tax (VAT) system. ». Bringing the services sector in the tax net within a VAT system. . Broadening of the tax base. . Building a tax information and computerization. 9. Improving the quality of tax administration. Subsequently, the government appointed two task forces—the task force on the direct taxes and the task force on the indirect taxes, both under the chairmanship of Dr Vijay Kelkar. The reports of these wo task forces provided a further direction to the tax reform process after 2003-04. Tables 9.4 and 9.5 summarize some of the important changes in the direct and the indirect taxes, respectively. The personal and corporate income tax rates were progressively brought down and a large number of rates on the personal income were simplified co just three in 1992-1993, with a reduction in che rates at the upper end. In 1997-98 the three slab rates were further modified to 10-20-30 per cent, Although in the subsequent years the need for additional revenue led to the imposition of a surcharge and a2 per cent primary education cess on all taxes, the tax rates have remained stable with the modifications made mainly to the level of income at which the tax rates are applicable." Another important reform has been the expansion of the Tax Deduction at Source (TDS), which has had the effect of reaching the "hard to tax’ categories. In the case of corporate taxes, there was a reduction in the tax rates in a phased manner for domestic companies from 50 per cent (in 1990) to 30 per cent by 2005-06. The 1994 budget removed the difference in the corporate tax rates applicable to the widely held and the dlosely held domestic companies. The wide difference in the corporate tax rate on the foreign companics camming income in India vis--vis the Indian companies was narrowed down. “Though the reduction in the corporate tax was also followed up with efforts to mop out taxes from the ‘zero tax’ companies, through the introduction of Minimum Altemnare Tax (MAT) in 1996-97, in general, the tax regime for the companies has become more moderate. SPrADYVAYN“2195 QR IaA0 apnput o2 seak Surpaszons ayy ut papurdxe uaaq sey ast] Sy] “suopEsTUNUTWODI]>1 pur aFesayoig 4202s “3TUTIMSUT JFT]-WOU “ZEA ‘s9>1AI95 J9IY ALM CGF GGT “] PA!A9] 9q 07 ueaq pas] euu22 ayp re saotsas uo xe? yy “poxer Suraq woyy aseq xe1 Sy Jo JUsUISas Sse awoou ue Surpnpxa Aqazayp tuonexe) yo que ay) Wouy s2914Ja5 yo UOMdumsuOD ay) INO SULARZ] UT Prinsay STYY 4, “S9ICIS IYI 07 JO aNUAD ay 1 JeUpIa paudisse Ayeayrsads 10u OM SAMAIIS UO SOXTI ai ary SEM. Tipu ur qswWUsISsE XE} JO waists ay jo aTIEay Vv "BO-Z00Z I % 0) 01 PaSeaOU SEM ae) BY "%/ Fe paxey “siEaA Oye, eqUAD “A "EO SENN BSOKS wWasoyer-pe solew [4 Jo LORONPaY | esfoxe jeNUED | Z 5. 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DWNeD (L§H) XBL SOdIAISg puB spoon’ souspusdapuI souls ULIOJQI xe} 1S99SIq 5,zIPU] INIOTY XVL AAISSIYOOUd ‘XVL SFOIANAS CNY SGOOD RyPUBLIC EXPENDITURE, PUBLIC DEBT AND BUDGETING Public Expenditure The expenditure incurred by the public authorities-Central State and Local Governments—either for protecting the citizen. or for promoting their economic and social welfare is called ‘public expenditure.’ Mrs. Ursula Hicks has classified public expenditure on the lines of the duties of the sovereign suggested by Adam Smith as - (i) defence expenditure; (ii) civil expenditure, (iii) economic expenditure; and (iv) social expenditure. _ Hugh Dalton classified public expenditure as follows . (i) The maintenance of the ceremonial head of the State including diplomatic representatives abroad: (ii) The maintenance of the machinery of civil government which includes expenses of the executive and the legislature; . (iii) The maintenance of the army and the police to protect the country from foreign aggression and to maintain law and order within the country; (iv) The administration of justice; (v) The expenditure on the development of agriculture. industry and commerce, transportation a communication, ports, currency and mint, and so ay (vi) Social expenditure on education, public health, social security schemes, etc. and (vii) Public debt charges including payment of interest repayment of principal. Trend or Growth of public expenditure Adolf Wagner, a German economist, in his ‘Law Increase of State Activities’ states, "Comprehensive comP ( 466 ) of the ar'sionswoney, BANKING AND FISCAL Poucy “7 of different countries and different times show that among ive People, with which alone we are concerned, an increase regularly takes place in the activity in both the central and local governments. ‘This increase is both extensive and intensive, the central and local governments constantly undertake new functions, while they perform both old and new functions more efficiently and completely." Wagner's theory provides that the extension of government activities in both extensive and intensive ways, paved the way for the increase of public expenditure in both old and new functions. The study of FS. Nitti showed the increase of public expenditure of all types of governments from the earliest times. The causes responsible for the increasing tendency of public expenditure are : (i) taking up of welfare activities; Gi) war and preparation of war; Gii) growth of population and urbanisation; (iv) use of democratic institutions; (v) rise in price level and national income; (vi) the great depression and extension of government functions; (vii) accepting of socialistic pattern of society; (viii) for economic development __ establishing public undertakings. Theories or Principles or Canons of Public Expenditure @) Principle of Maximum Social Advantage or Benefit.—Dalton says, "Public expenditure in every direction must be carried just so far that advantage of the community of a further small increase in any direction is just balanced by the disadvantage of a corresponding small increase in taxation and in receipts from any other source of public income. This gives the ideal of public expenditure and of public income." Pigou states that "Expenditure should be pushed in all directions up to the point, at which satisfaction obtained from the last shilling expended is equal to the satisfaction lost in respect of the last shilling called up on Government." (ii) Principle of Economy.—Economical’ expenditure means that wasteful and extravagant expenditure should be avoided and utilisation of the public resources on best and most urgent needs with the greatest care463 PRINCIPLES OF ECONOMICS FOR LAW STUDENTS and prudence. (ii) Principle of Surplus.—The public authorities should aim at a surplus of income over their expenditure and that they should avoid deficits. (iv) Principle of Sanction.—No money should be spent unless the expenditure has been approved and sanctioned by a duly authorised person to safeguard against the possibility of unwise and reckless expenditure. (v) The Principle of Elasticity—Public expenditure should vary according to needs and circumstances. (vi) The Principle of Neutrality—Public expenditure should have no adverse effect on production and distribution. Government expenditure has important effects on the entire economy of a country. Public expenditure has influence on such aspects as the level of employment, production, stability of prices, the creation and maintenance of full employment and a better distribution of income and wealth in the country. Public expenditure can increase the efficiency of a person to work and will promote production and national income. It also influences the willingness to work and save. Public expenditure can bring about a better allocation of economic resources as between the present and the future. Public expenditure can be used as a tool to bring economic stability and control the business cycles. In under-developed countries, public expenditure achieves economic development. Public Debt Public debt is the borrowing by the government of a country: from individuals, institutions and nations with the obligation of paying the money back with interest. In modern times, borrowing by the State has become a normal method of government finance along with other sources such as taxes. The government may borrow from banks, business houses, other organisations ane - individuals. It can borrow within the country or from outside. The government loan is generally in the form of bonds (or treasury bills if the loan is required for short period). The public debt may be classified as : (i) internal and external debt; (i) productive or unproductive debt, (iii) redeemable an Predeemable debt; (iv) funded and unfunded debt; and w compulsory and voluntary debt.vr The public debt is made to meet important situations, such 1s to meet budget deficits, (i) to meot war expenditure; (ii) remedy ® depression; (iv) to develop the economy, etc. Public borrowing has its effects on consumption, investment, wd distribution of income. In the case of an internal debt, there jg no direct monetary burden on the community as a whole, since ws pe tranater ofp ae taxation to meet the same involve i urchasing power from one of persons Smgnother, to the extent, that the bondholders and taxpayers the same, there may not be any net burden at all on the community. The total money burden of an external debt is more on society because the interest is paid to foreigners. With the mounting public debt, people assert that the nation became bankrupt. If the borrowed money is utilised in productive investment, the returns from them may be used for repayment of debt and there will be no burden on public in general. If the borrowed money is used for unproductive activities, then arises the problem of bankruptcy. Redemption of Public Debt Different methods are used by a government to redeem its debts. They are : (1) Repudiation of debt.—Repudiation of debt means simply that the government does not recognise its obligations and refuses to pay the interest as well as the principle. Normally, a government does not repudiate its debt, for this will shake the confidence of the general public in the government. Conversion of loans.—The government converts an old loan into a new loan. Conversion is not the repayment of loan, but a method of postponing the payment. (8) Serial Bond Redemption.—The government may decide to pay every year a certain portion of the bonds issued previously. This system enables a portion of the debt to be paid off every year. (4) Buying up loans.—The government may redeem its debts through buying up loans from the market. Whenever the government has surplus income, it may spend the amount to buy off government bonds from the market where they are bought and sold. (5) Sinking Fund.—The government creates the sinking (2