Definition of Economics by Adam Smith | Criticism on Adam Smith

Definition of Economics by Adam Smith

Definition of Economics by Adam smith (1723 – 1790) a Scottish Philosopher and founder of
Economics wrote a book “An Inquiry into the Nature and Causes of the Wealth of Nations” was
published in 1776. In the book Adam Smith defined economics as a Science of Wealth. Some
other economists like J.B Say, F.A Walker, J.S Mills and other also declared economics as a
science of wealth. According to J.B Say Economics is the science which treats
wealth. F.A Walker made it clear that economics is that body of knowledge which relates to
wealth. This view of Economics narrating economics as a science of wealth was criticized by
Carlyle, Ruskin and other economists of the 19th Century.
They were on the view the economics teaches selfishness and greediness. Furthermore, it degrades
human personality by ignoring human virtues and spiritual values and makes wealth the center of
human life. Adam smith classified his books “An Inquiry into the Nature and Causes of the Wealth
of Nations”into four divisions i.e. consumption, distribution, production and exchange of wealth.
Criticism on Adam Smith Definition of Economics
As Adam Smith declared economics as a Science of Wealth. Some economists of 19th Century
criticized this definition. Firstly Carlyle and Ruskin declared it a “dismal and a pig science” which
teaches selfishness. The main criticisms on the definition of Adam Smith are given in brief as
under.
1. Too Much Importance to Wealth
Definition of Economics by Adam Smith gives primary importance to wealth and secondary to
human being.

This emphasis has now shifted from wealth to human being. Man occupies primary place and
wealth a secondary one. The real fact is that man is more important than study of wealth.

2. Narrow Meaning of Wealth

In the definition the word “Wealth” means only material goods such as vehicles, industries, raw
material, Banks etc. it does not include immaterial goods like services of doctor, lawyer and
teachers. In modern economics definition the word “Wealth” includes both material and
immaterial goods.
3. Concept of Economic Man
According to this main objective of human activities is only to earn more and more wealth. in
others words he earns only for his self interest and social interest is completely ignored. But Alfred
Marshall and his followers pointed out that economics does not study a man who works only for
his own interest, but a common man.

4. Man Welfare is Missing

The other objection by Marshall is that man’s welfare has not been mentioned in Adam’s definition
of economics. He has stressed much on wealth. Wealth is a means to an end, the end being the
human welfare.

5. It Does Not Study Means

The definition lays emphasis on the earning of wealth as an end in itself. It ignores the means for
the earning of wealth.

6. Narrow and Controversial View

Since the word “wealth” did not have a clear meaning of economics by Adam Smith, therefore,
the definition became controversial. Alfred Marshall neoclassical economist gave his own
definition of economics and therein he laid emphasis on man and his welfare.

Criticism of Smith’s Definition

1. The wealth-centric definition of economics limited its scope as a subject and was seen as
narrow and inaccurate. Smith’s definition forced the subject to ignore all non-wealth
aspects of human existence.
2. The Smithian definition over-emphasized the material aspects of well-being and ignored
the non-material aspects. It was assumed that human beings acted as rational economic
agents who mindlessly strived to maximize their own well-being.
3. The Smithian definition prevents the subject from exploring the concept of
resource scarcity. The allocation and use of scarce resources are seen as a central topic of
analysis in modern economics.

Alfred Marshall’s Definition of Economics

British economist Alfred Marshall defined economics as the study of man in the ordinary business
of life. Marshall argued that the subject was both the study of wealth and the study of mankind.
He believed it was not a natural science such as physics or chemistry, but rather a social science.

Criticism of Marshall’s Definition

1. The Marshallian definition, like the Smithian definition, ignored the problem of scarce
resources, which possess unlimited potential uses.
2. Marshall’s definition restricted economics as a subject to only analyze the material aspects
of human welfare. Non-material aspects of welfare were ignored. Critics of the Marshallian
definition asserted that it was difficult to separate material and non-material aspects of
welfare.
3. The Marshallian definition does not provide a clear link between the acquisition of wealth
and welfare. Marshall’s critics claimed that it left the subject in a state of perpetual
confusion. For instance, there are plenty of activities that might generate wealth but that
can reduce human welfare.

Lionel Robbin’s Definition of Economics

Lionel Robbin, another British economist, defined economics as the subject that studies the
allocation of scarce resources with countless possible uses. In his 1932 text, “An Essay on the
Nature and Significance of Economic Science,” Robbins said the following about the subject:
“Economics is the science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses.”

Criticism of Robbin’s Definition

1. Robbin’s definition of economics transformed the subject from a normative social science
into a positive science with an undue emphasis on individual choice. His definition
prevented the subject from analyzing topics such as social choice and social interaction
theory, which are important topics within the modern microeconomic theory.
 2. Robbin’s definition prevented it from analyzing macroeconomic concepts such as national
income and aggregate supply and demand. Instead, economics was merely used to analyze
the action of individuals, using stylized mathematical models.

Modern Definition of Economics

The modern definition, attributed to the 20th-century economist, Paul Samuelson, builds upon the
definitions of the past and defines the subject as a social science. According to Samuelson,
“Economics is the study of how people and society choose, with or without the use of money, to
employ scarce productive resources which could have alternative uses, to produce various
commodities over time and distribute them for consumption now and in the future among various
persons and groups of society.”

Equations and identities

An equation is a statement with an equals sign, stating that two expressions are equal in value, for
example 3�+5=11
Solving an equation means finding the value or values for which the two expressions are equal.
This means equations are not always true. In the example above, 3�+5=11, the only correct
solution for � is 2.
An identity is an equation which is always true, no matter what values are
substituted. 2�+3�=5� is an identity because 2�+3� will always equal 5� regardless of the
value of �. Identities can be written with the sign ≡, so the example could be written
as 2�+3�≡5�.
Example
Show that �=2 is the solution of the equation 3�+5=11
BIDMAS means the multiplication is carried out before the addition:
Say whether each of the following is an identity or an equation

 5�+10=3�+8
 5�+10≡5(�+2)
 5�+10=5�+2
 Hide answer

 This is an equation because the expression on the left of the equals sign cannot be rearranged to
give the equation on the right. The solution to the equation is �=−1.
 This is an identity because when you expand the bracket on the right of the identity sign, it gives
the same expression as on the left of the identity sign.
 This is an equation because the expression on the left of the equals sign cannot be rearranged to
give the equation on the right. There is no solution for this equation – no matter what value of � is
substituted into the equation, the expression on the left will never have the same value as the
expression on the right.

Law of Supply: Meaning, Assumptions, Reason and Exceptions

What is Law of Supply?
Economists have studied the behaviour of both buyers and sellers. They have discovered the law
of supply as a result of their findings. The law of supply describes the relationship between price
and amount supplied when all other variables remain constant (ceteris paribus).

Price is a dominant factor in the determination of the supply of a commodity. As the price of a
commodity increases, the supply of that commodity in the market also increases and vice-versa.
This behaviour of the producers is studied through the law of supply.

Assumptions of Law of Supply

The phrase “keeping other factors constant or ceteris paribus” is used when describing the law
of supply. This expression refers to the following presumptions that the law is based on:
1. The price of other commodities is constant.
2. The state of technology has not changed.
3. The price of factors of production is constant.
4. The taxation laws remain the same.
5. The producer’s objectives are constant.
The Law of Supply can be better understood with the help of the following table and graph.
The above table indicates that when the price of the commodity rises, an increasing number of
units are offered for sale.
In the above graph, the rising slope of the supply curve (SS) indicates a clear relationship
between price and quantity supplied.
Important points about Law of Supply:
 The law of supply states the positive relationship between price and quantity supplied of a
commodity after assuming that the other factors remain constant.
 As the law of supply indicates the direction of the changes in quantity supplied of a
commodity and not the magnitude of the change. it is considered as a quantitative
statement.
 The law of supply does not establish any proportional relationship between the change in
price and the respective change in quantity supplied of the commodity.
 The law of supply is one sided. It is because the law explains only the effect of change in
price on the supply of the commodity and not the effect of change in supply on the price of
the commodity.
Reason for Law of Supply
The main reasons behind the law of supply are as follows:
1. Profit Motive:
Maximising profits is the primary goal of producers when they supply a good or service. Their
profits grow when the price of a commodity rises without a change in costs. Therefore, by
increasing production, manufacturers increase the commodity’s supply. On the other hand, as
price fall, supply also declines since low price result in lower profit margins.
2. Change in Number of Firms:
When the price of a specific commodity increases, potential producers are encouraged to enter
the market and produce the good to make money. The market supply rises as the number of
businesses increases. However, once the price begins to decline, some businesses that do not
anticipate making any money at a low price may stop production or cut it back. As the number
of businesses in the market declines, it decreases the supply of the given commodity.
3. Change in Stock:
When the price of an item rises, sellers are eager to supply additional things from their stocks.
However, the producers do not release significant amounts from their stock at a significantly
cheaper price. They work on building up their inventory in anticipation of potential price
increases in the future.
Exceptions to the Law of Supply

Generally, the slope of the supply curve is upwards, showing that with the rise in the price of a
commodity, its quantity supplied also rises. However, there may be some cases when there is no
positive relationship between the supply and price of a commodity. These cases are as follows:
1. Future Expectations:
The law of supply is not valid if sellers expect a fall in the price in the future. The sellers will be
willing to sell more in this situation, even at a cheaper price. However, if sellers expect an
increase in the future price, they will reduce supply to deliver the item later at a higher price.
2. Agricultural Goods:
Agricultural products are exempted from the rule of supply as they are produced in response to
climatic circumstances. If the production of agricultural goods is low because of unexpected
weather changes, supply cannot be expanded, even at higher prices.
3. Perishable Goods:
Sellers are willing to offer more perishable commodities, such as fruits, vegetables, and other
foods, even if prices are dropping. This occurs because sellers cannot keep such things for an
extended period.
4. Rare Articles:
The law of supply does not apply to precious, rare, or artistic items. For example, even if the
price increases, the number of rare items like the Mona Lisa artwork cannot be increased.
5. Backward Countries:
Due to the scarcity of resources, output and supply cannot be enhanced in economically
underdeveloped countries.

What Is Land? Definition in Business, Valuation, and Main Uses

What Is Land?

Land, in the business sense, can refer to real estate or property, minus buildings and equipment,
which is designated by fixed spatial boundaries. Land ownership might offer the titleholder the
right to any natural resources that exist within the boundaries of their land.

Traditional economics says that land is a factor of production, along with capital and labor. The
sale of land results in a capital gain or loss. Under Internal Revenue Service (IRS) tax laws, land
is not a depreciable asset and qualifies as a fixed asset instead of a current asset.

KEY TAKEAWAYS

 Land can refer to real estate or property, minus buildings and equipment, which is
designated by fixed spatial boundaries.
 In economics, land is a primary factor of production, along with capital and labor.
 Land itself is a valuable resource, but if it comes with other natural resources, like oil and
gas, its value increases.
 Investing in land for development can be costly and may come with certain risks but can
also be a source of profits and appreciation.
  The associated risks of developing land can stem from taxation, regulatory usage
restrictions, leasing and selling a property, and even natural disasters.

Understanding Land

In Terms of Production

The basic concept of land is that it is a specific piece of earth, a property with clearly delineated
boundaries, that has an owner. You can view the concept of land in different ways, depending on
its context, and the circumstances under which it's being analyzed.

In Economics

Legally and economically, a piece of land is a factor in some form of production, and although
the land is not consumed during this production, no other production—food, for example—would
be possible without it. Therefore, we may consider land as a resource with no cost of production.
Despite the fact that people can always change the land use to be less or more profitable, we
cannot increase its supply.

Characteristics of Land and Land Ownership

Land as a Natural Asset

Land can include anything that's on the ground, which means that buildings, trees, and water that
are a part of land are an asset. The term land encompasses all physical elements, bestowed by
nature, to a specific area or piece of property—the environment, fields, forests, minerals, climate,
animals, and bodies or sources of water.

A landowner may be entitled to a wealth of natural resources on their property, including plants,
human and animal life, soil, minerals, geographical location, electromagnetic features, and
geophysical occurrences.

Because natural gas and oil in the United States are being depleted, the land that contains these
resources is of great value. In many cases, drilling and oil companies pay landowners substantial
sums of money for the right to use their land to access such natural resources, particularly if the
land is rich in a specific resource.

Economic characteristics of land include: Scarcity, meaning there's a limit to its

supply. Improvements, which include the economic development of the land; and
finally. Location, which is also known as situs, and is simply where it is. Land is considered the
primary factor of production. Land is rich in coal, water and petroleum, which are used for
generating power. Land is required to construct factories and industries to carry out the production
process.

Notes on Land:
The term ‘land’ generally refers to the surface of the earth. But in economics, it includes all
that, which is available free of cost from ‘nature’ as a gift to human beings. Land stands for
all nature, living and non-living which are used by man in production.

Even though land is passive factor and it does not possess any ability to produce on its own,
it is an important agent of production. Modern economists consider land as a specific factor
of production, which can be put, not only to a specific purpose but to several other uses.

Land has been defined by various scholars,

“By land is meant not merely land in the strict sense of the word, but whole of the materials
and forces which nature gives freely for man’s aid in land, water, in air and light and heat.”

—PROF. MARSHALL

“Land is a specific factor or that it is the specific element in a factor or again that it is the
specific aspect of a thing.” —PROF. f. K. MEHTA

Thus, we can say, land includes

i. Surface of the earth like plains, plateaus, mountains, etc.

ii. Sea, rivers, ponds, etc.

iii. Air, light, etc.

iv. Oil, coal, natural gas, etc.

v. Silver, gold and other metals and minerals.

Characteristics of Land:
‘Land’ has specific characteristics, which distinguish it from other factors of production.

The main characteristics of land are:

1. Free Gift of Nature:

Basically, land is available free of cost from the nature. In the initial stages, man paid no price
for the land acquired by him. However, to improve the usefulness or fertility of land or to
make some improvements over land, some expenditure is to be incurred, but as such, it is
available at no cost from nature. Man has to make efforts in order to acquire other factors of
production.

But to acquire land no human efforts are needed. Land is not the outcome of human labor.
Rather, it existed even long before the evolution of man.

2. Supply of Land is Fixed:

Supply of land is fixed in quantity. It means supply of land cannot be increased or decreased
like other factors of production. Although for an individual, supply of land may be flexible,
but at macro level, the overall supply of land is fixed. However, only effective supply of land
can be increased by making an intensive use of land.

3. Difference in Fertility

All lands are not equally fertile. Different patches of land have different degrees of fertility.
Some locations are very fertile and have very good agricultural productivity, whereas some
patches are totally barren and nothing can be grown there. Similarly, the degree of richness
of mineral wealth varies from place to place, making the land more useful or less useful from
economic point of view.

4. Indestructibility of Land:

Land is an indestructible factor of production. Man can change only the shape of a particular
location and composition of its elements, but as such land cannot be destroyed. It can either
be converted into a garden or to a forest or to an artificial lake. However, some parts of land
get eroded due to natural factors, but that is immaterial because overall availability of land
does not change.

5. Immobility:

Unlike other factors, land is not physically mobile. It is an immobile factor of production, as
it cannot be shifted from one place to another. It lacks geographical mobility. Some
economists, however, describe land as a mobile factor on the argument that it can be put to
several uses.

6. Land is a Primary Factor of Production:

In any kind of production process, we have to start with land. For example, in industries it
helps to provide raw materials, and in agriculture, crops are produced on land.

7. Passive Factor of Production:

Land is a passive factor of production, because it cannot produce anything on its own. Human
element and capital inputs are required to be combined in an appropriate manner with land in
order to obtain yields from it.

8. Effect of Laws of Returns:

Since land is a fixed factor of production, the laws of returns are more effectively applicable
on it. Increased use of capital and labor on a particular plot of land leads to an increase in
crop production at a diminishing rate.
9. Alternative Uses of Land:

Land is used for alternative purposes like cultivation, dairy or poultry farms, sheep rearing,
building, etc. The use of land for any particular purpose depends not only on the return from
that particular use, but also the returns from alternative uses.

10. Land is Heterogeneous:

Land like other factors of production differs from another in respect of location, fertility,
nature and productivity. Two pieces of land are not exactly the same.

Functions of Land:
The primary occupations are agriculture, dairying, animal husbandry and poultry farming.
These essential activities are not possible without land. Manufacturing industries depend
totally on land for raw materials. Land provides minerals, metals and many raw materials like
cotton, jute and sugarcane which are used to create other essential products.

1. Primary Occupation:

All primary occupations like agriculture, animal husbandry, poultry farming, fisheries,
dairying, forestry, etc. are land oriented and are also known as primary activities.

2. Basis of Industries:

Manufacturing industries get diverse type of raw materials from land, namely, raw cotton,
sugarcane, raw jute, coal, minerals and metals, etc.

3. Basis of Power:

All sources of power, i.e. hydro-electricity, thermal power, diesel, coal, oil, etc., emanate
from land.

4. Basis of Employment:
In underdeveloped countries nearly two-third of population is engaged in agriculture and other
primary activities. Agriculture, forests, mines, etc., provide lot of employment opportunities
to rising population.

5. Basis of Transport:

All the important modes of transport, i.e., road, railways, waterways and air-ways are mainly
based on surface of the land, rivers, oceans and air, which are all constituents of la nd.

6. Basis of Trade:

Products of land are traded within the country and also form part of foreign trade. Products
like food grains, minerals, metals, timber, leather, hides and skins, wool, tea, jute, petroleum,
milk, butter, etc., are tradable products of land.

7. Basis of Economic Growth:

A natural resource, that is land, play an important role in the economic development of a
country. Prosperity of gulf countries lies in the oil-wells found there. Economic development
of South Africa is mainly due to its fertile land, irrigation and power facilities. All these are
different facets of land.

8. Basis of Life:

We depend on land for our subsistence, residence and other necessities of life. Land provides
food, raw materials and shelter.

Importance of Land:
Land is considered the primary factor of production. Land is rich in coal, water and petroleum,
which are used for generating power. Land is required to construct factories and industries to
carry out the production process. Land is of great importance to mankind. A nation’s
economic wealth is directly related to the richness of its natural resources.
In spite of rich natural resources, a country may remain economically backward due to some
unfavorable factors on account of which the natural sources are either underutilized or not
utilized. On the other hand, if a country does not have rich natural resources, it is
comparatively much more difficult to make it prosperous.

The quality and the quantity of agricultural wealth of a country depend on the type of s oil,
climate, rainfall and water resources. The industrial progress and prosperity of a nation
depends on mineral resources. The presence of rich coal mines, waterfalls or petroleum wells
directly help in the generation of electric power, which is a key factor for industrial
development.

The localization of industries invariably depends on proximity of power and raw materials.
All these basic elements are provided by nature.

An example can emphasize the importance of land. In recent past, in spite of having enough
capital, labor and efficient organization, TATA Motors were unable to start their Nano car
project at Singur, West Bengal, due to the dispute over land possession.

In short, the importance of land is evident from the following points:

1. Land determines agricultural production.

2. The industrial progress and prosperity of a country depends on availability of mineral

resources, i.e., land.

3. Land determines total production of a country.

4. Land influences the economic growth of a country.

5. Land maintains ecological balance.

6. Land directly or indirectly fulfills the basic needs of the people.

7. Trade is influenced by land.

Therefore, all economic aspects, i.e., agriculture, industry and trade are influenced by natural
resources, referred by economists as ‘Land’.

Productivity of Land:
Productivity of land refers to extent of efficiency. The productivity of land can be
expressed by following measures:

1. Average Productivity of Land:

Average productivity of land is defined as the output obtained from land divided by area of
that piece of land.

2. Marginal Productivity of Land:

Marginal productivity means the increase in output obtained from land due to increase in one
unit of land, but the other inputs are kept constant.

Factors Affecting Productivity of Land:

The factors affecting the productivity of land are discussed below:

1. Fertility of Land:

The productivity of land is determined by its natural qualities and its fertility. A flat and
leveled land is comparatively more productive than an undulating one. The rich soil is more
fertile and productive. However, the agricultural productivity can be improved by proper and
extensive use of manure and fertilizers along with adoption of mechanized methods.

2. Proper Use of Land:

The productivity of ‘land’ is directly related to its proper utilization. For example, a piece of
land situated in the heart of city is more suitable for construction of a house or a market place.
If this piece of land is put for farming or agricultural use, its productivity wil l almost be
negligible.

3. Location of Land:

The location of ‘land’ affects its productivity to a great extent. For example, the location of
land near the market or bus station will result in economy of transportation charges and overall
productivity from this point of view will naturally be higher. Similarly, for better agricultural
productivity, its location near water resources is desirable.

4. Improvements done on Land by Increasing Irrigation Potential:

Permanent improvements done on land by generating artificial means of irrigation, i.e., wells,
tube wells, canals, tank, etc., help to keep the water supply regular and have a positive effect
on the productivity of land.

5. Ability of Organizer:

Land is a passive factor of production and so it is essential to combine it with other active
factors, in correct proportion, to achieve the optimum productivity. In order to accomplish it,
an able organizer is a must, who can successfully handle and combine the passive and the
active factors in right proportion so as to achieve greater productivity. The competence and
ability of an organizer directly affect the productivity of land.

6. Land Ownership Laws:

The ‘land ownership laws’ prevailing in a country have a significant influence on the
productivity of land’. When a full ownership is conferred, the owner takes more interest in its
development. For example, a cultivator possessing full ownership rights on land does more
hard work and the productivity automatically improves.

But, poor farmers work as tenants on the lands of large farmers. Insecurity of tenancy rights
may cause eviction of poor tenancy farmers which make them uninterested to improve land
productivity.
7. Availability of Efficient Labor:

The productivity of land depends on the availability of efficient labor as land alone cannot
produce anything without the efficient labor. If the labor is efficient, trained and capable to
adopt modern techniques; only then he can make the proper use of land.

8. Improved Techniques of Production:

New inventions, modern and scientific methods of production like using high yielding
varieties of seeds, manure, etc., have increased the productivity of land. Uses of modern
machines in mining have also increased the production of various minerals in India.

9. Availability of Capital:

Capital is the fundamental factor that affects the productivity of land. The productivity of land
can be maximized with the help of improved seeds, chemical fertilizers and machines. To
fulfill all these requirements, sufficient capital should be available.

10. Government Policy:

The productivity of land is affected by the government policy regarding agriculture.

Agricultural productivity starts increasing when the government adopts a proper agricultural
policy and provides required assistance to farmers. On the other hand, the state’s negligence
towards agriculture is regarded as one of the main causes of agricultural backwardness. This
results in low agricultural productivity.

BUSINESS & FINANCE

Key highlights of the Pakistan Economic Survey 2022-23

 Business Recorder takes a look at important points during a year of flood devastation,
uncertain IMF programme and massive political turmoil

 Pakistan’s gross domestic product (GDP) grew by 0.29% to Rs84.7 trillion

 Agriculture sector posted growth of 1.55% in FY23, led mainly by improvement in wheat,
sugarcane and maize and livestock

 Industrial growth contracted to 2.94% in fiscal year 2022-23 against growth of 6.83% in
2021-22

 Services sector witnessed meagre growth of 0.86% in the ongoing fiscal year compared to
6.59% in last fiscal year

 Headline inflation averaged 29.2% during July-May FY23 (average of 28.2% during July-
April) against 11.3% in the same period last year

 Per capita income fell from $1,765 in fiscal year 2021-22 to $1,568 in 2022-23

 Investment-to-GDP ratio stood declined to 13.6% in FY23 from 15.6% in FY22 mainly

 Cotton production declined by 41% to 4.91 million bales

 Rice production declined to 7.32 million tonnes from 9.32 million tonnes

 Wheat production was recorded at 27.63 million tonnes compared to 26.21 million tonnes
last year

 Fiscal deficit reduced to 4.6% of GDP (Rs3,929.3 billion) during July-April 2022-23
against 4.9% (Rs3,275.2 billion) in same period of last year

 Total revenues increased by 18.1% to Rs6,938.2 billion (8.2% of GDP) in July-March

2022-23

 Tax revenues grew by 16.5% on the back of a significant rise in FBR tax collection

 Non-tax revenues grew by 25.5% to Rs1.32 trillion during July-March FY23

  Total expenditures grew by 18.7% to Rs10 trillion in Jul-Mar FY2023

 Current expenditures grew by 25.3% to Rs9.24 trillion during July-March FY23

 Bank deposits increased by Rs683 billion during from July 1, 2022 to May 12, 2023

 Current account narrowed down by 76.1% and recorded deficit of $3.3 billion during Jul-
Apr FY23

 Workers’ remittances registered a decrease of 13% at $22.7 billion during July-April 2022-
23

 SBP’s foreign exchange reserves declined to $4.5 billion by end of April 2023 mainly on
account of amortization of official loans and liabilities during this fiscal year

 Total public debt stood at Rs59.25 trillion by end-March 2023

Capital as a Factor of Production

When economists refer to capital, they are referring to the assets—physical tools, plants, and
equipment—that allow for increased work productivity. Capital comprises one of the four
major factors of production, the others being land, labor, and entrepreneurship. Common
examples of capital include hammers, tractors, assembly belts, computers, trucks, and railroads.
Economic capital is distinguished from financial capital, which includes the debt and equity
accumulated by businesses to operate and expand.

KEY TAKEAWAYS

 In economics, capital refers to the assets—physical tools, plants, and equipment—that

allow for increased work productivity.
  By increasing productivity through improved capital equipment, more goods can be
produced and the standard of living can rise.
 The four major factors of production are capital, land, labor, and entrepreneurship.

The Economic Role of Capital

Capital is unlike land or labor in that it is artificial; it must be created by human hands and
designed for human purposes. This means time must be invested before capital can become
economically useful. For example, the fisher who fashions themself a rod must first divert time
from other activities to do so.

In this sense, capital goods are the foundation of human civilization. Buildings need to be built,
tools crafted, and processes improved. By increasing productivity through improved capital
equipment, more goods can be produced and the standard of living can rise. Capital goods are
also sometimes referred to as the means of production because these physical and non-financial
inputs create objects that can eventually be bestowed with economic value. The economist Adam
Smith defines capital as, "that part of man's stock which he expects to afford him revenue."

Goods vs. Money

Ever-improving capital is important because of what follows its production: cheaper and more
bounteous goods. Note that money is not included among the factors of production. While money
facilitates trade and is an effective measure of a good's value, individuals cannot eat, wear, or be
sheltered by money itself. The ultimate aim of economic activity, work, and trade is to acquire
goods, not money. Money is a means to afford goods. Better capital goods allow people to travel
farther, communicate faster, eat better foods, and save enough time from labor to enjoy leisure.
Many countries have printed and inflated their way into poverty by losing focus on savings,
investment, and capital equipment in favor of increasing their money supply by printing more of
their currency.

Capital Goods Production Process

Before a factory can be built or a car can be manufactured, someone must have saved enough
resources to be able to survive the production process. This involves forgoing present
consumption in favor of greater future consumption.

Every capital production process starts with savings. Savings help by generating investments.
Investments eventually lead to finished goods and services. Traditionally, it is the role of the
capitalist to first save and then assume risk by employing people in production processes before
revenue is generated from the finished goods. All of the factors of production interact with one
another. Natural resources are transformed into capital goods by human labor and subjected to
market risk through entrepreneurial activity.

Each factor of production is able to contribute to production processes and earn an income based
on its use. The income for land is usually called rent. Labor receives wages. Employed capital
goods and equipment receive interest, normally through their investment. Successful
entrepreneurs receive profits.

Why Are the Factors of Production Important to Economic Growth?

Economic growth is the increase in the production of goods and services from one period to the
next. As such, the value of these goods and services increases, resulting in larger corporate profits.

But how does economic growth work and what factors affect it? It only comes by increasing the
quality and quantity of the factors of production, which are the resources used in creating or
manufacturing a good or service. Keep reading to learn more about these four factors—land,
labor, capital, and entrepreneurship—and what makes them so important.

KEY TAKEAWAYS

 Economic growth is the increase in the production of goods and services over a period of
time and is dependent on the four factors of production.
 Land is defined as agricultural land, commercial real estate, and natural resources, such
as oil, gas, and other commodities.
  Labor is made up of the individuals who are responsible for the development of goods and
services.
 Capital goods, such as tools, equipment, and machinery, are part of the capital category.
 The final factor of production is entrepreneurship, which includes the visionaries and
innovators who are behind the production process.

Understanding the Factors of Production

The factors of production are inputs that companies need to develop goods and services. This
enables them to earn profits. The concept of these factors dates back to neoclassical economics,
combining historic economic theories with other ideas, such as the idea of labor. As noted above,
the four factors of production are land, labor, capital, and entrepreneurship. As the Federal
Reserve Bank of St. Louis puts it:

"Factors of production are resources that are the building blocks of the economy; they are what
people use to produce goods and services."1

We highlight what each of these means below.

Land

When most people think of land, they automatically assume it means agricultural land. While
that's true, it isn't the only thing that makes up this factor. Land doesn't just refer to natural
resources, but it can also include commercial real estate and renewable resources like forests.
Producers also use natural resources that come from the earth, which also fit into this category.
These resources include:

 Oil and gas

 Coal
 Silver, copper, and other metals
 Other commodities

Land is generally considered one of the most important factors of production. Certain industries
rely on land more than others. For instance, a real estate developer needs it to make good on its
investments. But technology companies and those that rely on automation tend to rely less on
land, making it a less significant factor of production.

Labor

Labor consists of the people who are responsible for the creation of goods and services (from
beginning to end) and the effort they put forth. These individuals include factory workers,
managers, salespeople, and engineers who design the machinery used in production. As such, it
can take on many forms. For instance, the effort of construction workers who work on a building
site and quality control workers who ensure products are ready to go to market make up this
category.

Individuals are compensated for their time and effort, and the amount they are paid depends on
the skills they bring to the table. People with fewer skills and training tend to earn lower wages
while people who are educated and highly skilled often get paid more.

Innovation, though, is changing the labor force. Automation, increased technology, and
equipment are putting a dent into the need for workers. Companies that continue to innovate their
production processes rely less on human labor. For instance, the invention and availability of
equipment cut the need for physical laborers on farms.

As an investor, you can identify investment opportunities in companies that are improving their
factors of production.

Capital

Although most people think capital is cash, the term here actually describes a number of other
assets. Capital goods are also considered capital, which includes manufacturing plants,
machinery, tools, or any equipment used in the production process. Capital may also refer to a
fleet of trucks or forklifts as well as heavy machinery.
When the economy is flourishing and expands, corporations are able to access capital so they can
spend and make investments and continue making profits. During times of economic contraction,
though, they must cut costs to preserve capital to ensure they are still profitable. All of this is
necessary in order to ensure that they can continue bringing new products and services to market.

Keep in mind, though, that capital only refers to assets used for business purposes and for the
production of goods and services. As such, it doesn't apply to anything that is meant for personal
use.

Entrepreneurship

Entrepreneurship is the fourth factor and includes the visionaries and innovators behind the entire
production process. The entrepreneurs combine all the other factors of production to
conceptualize, create, and produce the product or service. They are the drivers behind any
technical change in the economic system which has been shown to be a major source of economic
growth.

Economists believe that entrepreneurship is one of the most integral parts of the production
process. That's because it uses all three of the other factors in the manufacturing of goods and
services.

The success of entrepreneurs depends entirely on the development of a business plan. This is a
document that business owners use to describe how their company operates, its objectives, and
its short- and long-term goals. Once the business plan is developed, entrepreneurs should look for
resources, hire personnel, and get access to financing.

The Solow residual is the residual growth rate of output that cannot be attributed to this growth
in inputs. Also known as total factor productivity, this residual includes things such as the state
of technological progress and innovation.

The Importance of the Factors of Production

Economic growth has a snowball effect, which often leads to higher stock prices and a rise in
employment. Companies have more capital to invest in new ventures and consumers are able to
spend more. As such, economic growth is one of the most-watched indicators, if not the most
important. Economists measure it in real terms, which factors in inflation, or in nominal terms,
which doesn't.

Aggregate growth is commonly measured as a nation's gross national product (GNP) or gross
domestic product (GDP). If businesses can improve the efficiency of the factors of production, it
stands to reason that they can increase production and create higher quality goods at lower prices.
Any increase in production leads to economic growth as measured by GDP. This metric merely
represents the total production of all goods and services in an economy. Improved economic
growth raises the standard of living by lowering costs and raising wages.

Capital goods include technological advances, from iPhones to cloud computing to electric cars.
For example, in the last several years, the technology of fracking, or horizontal drilling, has led
to improved extraction of oil, making the U.S. one of the world's largest oil producers.2 The
innovation couldn't be done without the labor behind the process, from conceptualization to the
finished product.

However, as technology helps to increase the efficiency of the factors of production, it can also
replace labor to reduce costs as we highlighted above. For example, artificial intelligence and
robotic machines are used in manufacturing boosting productivity, reducing costly errors from
human beings, and ultimately reducing labor costs.

Of course, nothing gets started without the entrepreneurs who create a vision and the action steps
needed to design the production process. Entrepreneurs combine all the factors of production,
including buying the land or raw materials, hiring the labor, and investing in the capital goods
necessary to bring a finished product to market.

What Determines Labor Productivity?

Labor productivity is the measure of an economy's hourly output of goods and services. Along
with unemployment, the jobs data, and the consumer price index, economists track labor
productivity to determine the relative strength of an economy. Any change in labor productivity
helps economists understand both recent and historical changes in the economy.
KEY TAKEAWAYS

 For any period of time, the level of labor productivity is determined by two broad factors:
capital equipment and applied technical efficiency.
 Labor productivity refers to how efficient workers are in generating products and profits
for s firm.
 It is typically measured in terms of output per hour.
 Technology can help increase a worker's output and productivity.
 Skills training and capital improvements are additional ways to increase labor
productivity.

Labor Productivity and Applied Technical Efficiency

Technical efficiency is the effectiveness with which a given set of inputs is used to produce an
output. A worker is said to be technically efficient if they produce the maximum output from the
minimum quantity of inputs, such as labor, capital, and technology.

To see how this works, consider a laborer who is painting three identical walls. For the first two
walls, they only have a 4-inch paintbrush, but in between painting the first and the second, they
learn a more efficient brush technique. This allows them to paint the second wall more quickly,
which increases their productivity. Their capital equipment did not change; they used the same
paintbrush, but their technical efficiency improved.

To calculate labor productivity, divide the total output by the total number of labor hours.

Increasing Technical Efficiency

There are many factors that can influence technical efficiency. Improved muscle memory or
learning new techniques can improve productivity; economists call this specialization. A laborer
might raise their productivity by receiving better education or training.

Some factors, such as motivation, are more difficult to control and predict.
Labor Productivity and Capital Goods

In between painting the second and third walls, the laborer replaces the paintbrush with a paint
sprayer. They can still use the same technique, but the sprayer distributes the paint faster. In
economic terms, they have better capital equipment.

Improving Capital Equipment

Tools are incredibly important determinants of productivity. It is easier to dig a ditch with a
hydraulic-powered tractor than with a small shovel. Unfortunately, no capital goods can be built
or improved without delaying present consumption because capital tools do not directly
produce revenue and cannot immediately be consumed. This is why businesses rely on savings,
investment, and loans while researching and improving their capital infrastructure.

What Factors Increase Labor Productivity?

Improvements in a worker's skills and relevant training can lead to increased productivity.
Technological progress can also help boost a worker's output per hour.

What Factors Decrease Labor Productivity?

Labor productivity can arise from a decline in workers' skills and education. An uneducated or
unmotivated labor force is, therefore, a big concern for corporations. Additionally, being unable
to catch up with technological progress elsewhere can leave productivity behind.

What Is Multifactor Productivity (MFP)?

Also known as total factor productivity (TFP), multifactor productivity (MFP) measures the
excess value embodied in the output of an economy after accounting for all of the inputs
(including labor, capital, services, etc.). This was identified by the economist Robert Solow as a
key measure of efficiency in an economy, and it's sometimes called the Solow Residual, as a
result.

How Does the Division of Labor Impact Productivity?

The division of labor (DOL) describes the process of specialization by the labor force. Due to this
process, each individual worker focuses more specifically on a narrow set of skills or tasks,
making them more efficient at this one facet of production. This increases productivity, versus
having to switch tasks or learn new and different skills across the various steps in producing a
product.

How Do You Calculate Labor Productivity?

Labor productivity is calculated as the quantity produced divided by hours worked. This can be
computed for an individual worker, a company, or in aggregate for an entire economy.

Internal vs. External Economies of Scale: What’s the Difference?

internal and External Economies of Scale: An Overview

An economy of scale is a microeconomic term that refers to factors driving production costs down
while increasing the volume of output. There are two types of economies of scale: internal and
external economies of scale.

Internal economies of scale are firm-specific—or caused internally—while external economies

of scale occur based on larger changes outside the firm. Both result in declining marginal costs
of production, yet the net effect is the same.

Economist Alfred Marshall first differentiated between internal and external economies of scale.
He suggested broad declines in the factors of production—such as land, labor, and effective
capital—represented a positive externality for all firms. These externality arguments are offered
in defense of public infrastructure projects or government research.1

KEY TAKEAWAYS

 Internal economies of scale measure a company's efficiency of production and occur

because of factors controlled by its management team.
 External economies of scale happen because of larger changes within the industry, so
when the industry grows, the average costs of business drop.
  Internal economies of scale offer greater competitive advantages because an external
economy of scale is shared among competitors.

Internal Economies of Scale

An internal economy of scale measures a company's efficiency of production. That efficiency is

attained as the company improves output when the average cost per product drops. This type of
economy of scale is a consequence of a company's size and is controlled by its management teams
such as workforce, production measures, and machinery. The factors, therefore, are independent
of the entire industry.

There are several different kinds of internal economies of scale. Technical economies of scale are
achieved through the use of large-scale capital machines or production processes. The classic
example of a technical internal economy of scale is Henry Ford's assembly line.2

Another type occurs when firms purchase in bulk and receive discounts for their large
purchases or a lower cost per unit of input. Cuts in administrative costs can cause marginal
productivity to decline, resulting in economies of scale.

Diseconomies of scale happen when a business' economy of scale stops functioning, which leads
to a rise in marginal costs—instead of a decrease—when output increases.

External Economies of Scale

External economies of scale are generally described as having an effect on the whole industry. So
when the industry grows, the average costs of business drop. External economies of scale can
happen because of positive and negative externalities.

Positive externalities include a trained or specialized workforce, relationships between suppliers,

and/or more innovation. Negative ones happen at the industry levels and are often called external
diseconomies.
There are several contributing factors behind external economies of scale. When competing
companies set up shop in one area, specialized workers will seek employment. An example of
this would be the IT industry in Silicon Valley, which has attracted a special set of skilled workers.

Secondly, certain industries may become so important that they can develop bargaining power
with politicians and local governments. This, in turn, can lead to more favorable treatment in the
form of subsidies or other concessions. The oil industry has a long history of subsidies in the
United States, which were historically given to continue a steady flow of domestic supply.

Special Considerations

Internal economies of scale offer greater competitive advantages than external economies of
scale. This is because an external economy of scale tends to be shared among competitor firms.
The invention of the automobile or the Internet helped producers of all kinds.

If borrowing costs decline across the entire economy because the government is engaged
in expansionary monetary policy, the lower rates can be captured by multiple firms. This does not
mean any external economy of scale is a wash.

Companies can still take relatively greater or lesser advantage of external economies of scale.
Nevertheless, internal economies of scale embody a greater degree of exclusivity.

Long Run: Definition, How It Works, and Example

What Is the Long Run?

The long run is a situation in economics wherein all factors of production and costs are variable.
The long run allows firms to operate and adjust all costs. There are also a variable number of
producers in the market, which means firms are able to enter and leave the market during times
of profitability and loss. In the long run, profits are ordinary, so there are no economic profits.
While a firm may be a monopoly in the short term, it may expect competition in the long run.

KEY TAKEAWAYS
  The long run refers to a period of time where all factors of production and costs are
variable.
 Over the long run, a firm will search for the production technology that allows it to
produce the desired level of output at the lowest cost.
 The long run is associated with the LRAC curve along which a firm would minimize its
cost per unit for each respective long run quantity of output.
 When the LRAC curve is declining, internal economies of scale are being exploited—and
vice versa.

How the Long Run Works

The term long run is used to describe an economic situation in which a manufacturer or producer
is flexible in its production decisions. This situation is characterized by variable inputs,
including capital, labor, materials, and equipment, among others.

Businesses can either expand or reduce production capacity when there is a long run. There is
also the chance to enter or exit an industry based on expected profits. Firms understand that they
cannot change their levels of production in order to reach an equilibrium between supply and
demand.

In macroeconomics, the long run is the period when the general price level, contractual wage
rates, and expectations adjust fully to the state of the economy. This stands in contrast to the short
run, when these variables may not fully adjust. Long-run models may also shift away from short-
run equilibrium, in which supply and demand react to price levels with more flexibility.

Firms can change production levels in response to expected economic profits. For example, a firm
may implement change by increasing (or decreasing) the scale of production in response to profits
(or losses), which may entail building a new plant or adding a production line.

The long run doesn't refer to a specific period of time. Rather, it is specific to the firm, industry,
or economic factor studied.
Long Run and the Long-Run Average Cost (LRAC)

Over the long run, a firm will search for the production technology that allows it to produce the
desired level of output at the lowest cost. If a company is not producing at its lowest cost possible,
it may lose market share to competitors that are able to produce and sell at minimum cost.

The long run is associated with the long-run average cost (LRAC), the average cost of output
feasible when all factors of production are variable. The LRAC curve is the curve along which a
firm would minimize its cost per unit for each respective quantity of output in the long run.

The LRAC curve is comprised of a group of short-run average cost (SRAC) curves, each of which
represents one specific level of fixed costs. The LRAC curve will, therefore, be the least
expensive average cost curve for any level of output. As long as the LRAC curve is declining,
then internal economies of scale are being exploited.

The long-run average cost can also be called the long-run average total cost.

Economies of Scale

Economies of scale refer to the situation wherein, as the quantity of output goes up, the cost per
unit goes down. In effect, economies of scale are the cost advantages that are achieved when there
is an expansion of the size of production.

The cost advantages translate to improved efficiency in production, which can give a business a
competitive advantage in its industry of operations, which, in turn, could translate to lower costs
and higher profits for the business.

If LRAC is falling when output is increasing, then the firm is experiencing economies of scale.
When LRAC eventually starts to rise then the firm experiences diseconomies of scale, and if
LRAC is constant then the firm is experiencing constant returns to scale.

Long Run vs. Short Run

The long run is the opposite of the short run. This is an economic situation wherein firms want to
meet a goal or target within a short period of time when demand for a product or service increases.

Unlike the long run, the short run involves at least one factor of production that is fixed while all
the others are variable while the costs are fixed so there is no equilibrium between these factors.
This means there is no flexibility when it comes to the inputs or outputs since the costs are fixed.

While ordinary profits are typical of the long run, the short run allows firms to realize economic
or exceptional profits.

Differences Between Long-Run and Short-Run

Long Run Short Run

Firms Variable Fixed

Labor Variable Fixed or variable

Capital/Costs Variable Fixed or variable

Flexibility Time to adjust No time to adjust

Profits Ordinary profits Exceptional profits

Example of a Long Run

Here's a hypothetical example to show how the long run works. Suppose a business has a one-
year lease. This firm's long run is defined as any period longer than a year since it’s not bound by
the lease agreement after that period of time. In the long run, the amount of labor, size of the
factory, and production processes can be altered if needed to suit the needs of the business or
lease issuer.

Why Is the Long Run Important in Economics?

The long run is an economic situation where all factors of production and costs are variable. It
demonstrates how well-run and efficient firms can be when all of these factors change.
What Eliminates Economic Profits in the Long Run?

There is perfect competition in the long run. This means that firms can easily enter the market.
Since there is the possibility of having an infinite number of competing firms in the same space,
profits can easily be eliminated. Keep in mind, though, that companies can also easily leave the
market, wiping out losses, too.

What Are Some of the Benefits of the Long Run?

Since the costs are variable in the long run, firms have the option to make adjustments to the way
it operates. So when the need arises, it can increase or decrease operations. Furthermore, they can
decide how best to shape their factors of production in order to reduce costs.

The Bottom Line

The long run is a situation where companies can operate under variable production factors.
Because these inputs aren't fixed, costs are also variable. This allows a greater degree of flexibility
because companies can make adjustments to their production levels and how they operate to keep
costs down. But there is a downfall. There is usually perfect competition, which means there is
no chance for exceptional profits.

4 Factors of Production Explained with Examples

What Are Factors of Production?

Factors of production are the inputs needed for creating a good or service, and the factors of
production include land, labor, entrepreneurship, and capital.

Those who control the factors of production often enjoy the greatest wealth in a society. In
capitalism, the factors of production are most often controlled by business owners and investors.
In socialist systems, the government (or community) often exerts greater control over the factors
of production.

KEY TAKEAWAYS
  Factors of production is an economic term that describes the inputs used in the
production of goods or services to make an economic profit.
 These include any resource needed for the creation of a good or service.
 The factors of production are land, labor, capital, and entrepreneurship.
 The state of technological progress can influence the total factors of production and
account for any efficiencies not related to the four typical factors.
 Land as a factor of production can mean agriculture and farming to the use of natural
resources.

How Factors of Production Work

The modern definition of factors of production is primarily derived from a neoclassical view of
economics. It amalgamates past approaches to economic theory, such as the concept of labor as a
factor of production from socialism, into a single definition.

Land, labor, and capital as factors of production were originally identified by early political
economists such as Adam Smith, David Ricardo, and Karl Marx. Today, capital and labor remain
the two primary inputs for processes and profits. Production, such as manufacturing, can be
tracked by certain indexes, including the ISM manufacturing index.

The 4 Factors of Production

There are four factors of production—land, labor, capital, and entrepreneurship.

Image by Sabrina Jiang © Investopedia 2020

Land As a Factor

Land has a broad definition as a factor of production and can take on various forms, from
agricultural land to commercial real estate to the resources available from a particular piece of
land. Natural resources, such as oil and gold, can be extracted and refined for human consumption
from the land.

Cultivation of crops on land by farmers increases its value and utility. For a group of early French
economists called “the physiocrats,” who predated the classical political economists, land was
responsible for generating economic value.

While land is an essential component of most ventures, its importance can diminish or increase
based on industry. For example, a technology company can easily begin operations with zero
investment in land. On the other hand, land is the most significant investment for a real estate
venture.

Labor As a Factor

Labor refers to the effort expended by an individual to bring a product or service to the market.
Again, it can take on various forms. For example, the construction worker at a hotel site is part of
labor, as is the waiter who serves guests or the receptionist who enrolls them into the hotel.

Within the software industry, labor refers to the work done by project managers and developers
in building the final product. Even an artist involved in making art, whether it is a painting or a
symphony, is considered labor. For the early political economists, labor was the primary driver
of economic value. Production workers are paid for their time and effort in wages that depend on
their skill and training. Labor by an uneducated and untrained worker is typically paid at low
prices. Skilled and trained workers are called “human capital” and are paid higher wages because
they bring more than their physical capacity to the task.

For example, an accountant’s job requires the analysis of financial data for a company. Countries
that are rich in human capital experience increased productivity and efficiency. The difference in
skill levels and terminology also helps companies and entrepreneurs create corresponding
disparities in pay scales. This can result in a transformation of factors of production for entire
industries. An example of this is the change in production processes in the information technology
(IT) industry after jobs were outsourced to countries with lower salaries.

Capital As a Factor

In economics, capital typically refers to money. However, money is not a factor of production
because it is not directly involved in producing a good or service. Instead, it facilitates the
processes used in production by enabling entrepreneurs and company owners to purchase capital
goods or land or to pay wages. For modern mainstream (neoclassical) economists, capital is the
primary driver of value.

It is important to distinguish personal and private capital in factors of production. A personal

vehicle used to transport family is not considered a capital good, but a commercial vehicle used
expressly for official purposes is. During an economic contraction or when they suffer losses,
companies cut back on capital expenditure to ensure profits. However, during periods of
economic expansion, they invest in new machinery and equipment to bring new products to
market.

An illustration of the above is the difference in markets for robots in China compared to the
United States after the 2008 financial crisis. After the crisis, China experienced a multi-year
growth cycle, and its manufacturers invested in robots to improve productivity at their facilities
and meet growing market demands.12 As a result, the country became the biggest market for
robots.3 Manufacturers within the United States, which had been in the throes of an economic
recession after the financial crisis, cut back on their investments related to production due to tepid
demand.4

As a factor of production, capital refers to the purchase of goods made with money in production.
For example, a tractor purchased for farming is capital. Along the same lines, desks and chairs
used in an office are also capital.

Entrepreneurship As a Factor
Entrepreneurship is the secret sauce that combines all the other factors of production into a
product or service for the consumer market. An example of entrepreneurship is the evolution of
the social media behemoth Meta (META), formerly Facebook.

Mark Zuckerberg assumed the risk for the success or failure of his social media network when he
began allocating time from his daily schedule toward that activity. When he coded the minimum
viable product himself, Zuckerberg’s labor was the only factor of production. After Facebook,
the social media site, became popular and spread across campuses, it realized it needed to recruit
additional employees. He hired two people, an engineer (Dustin Moskovitz) and a spokesperson
(Chris Hughes), who both allocated hours to the project, meaning that their invested time became
a factor of production.5

The continued popularity of the product meant that Zuckerberg also had to scale technology and
operations. He raised venture capital money to rent office space, hire more employees, and
purchase additional server space for development. At first, there was no need for land. However,
as business continued to grow, Meta built its own office space and data centers.6 Each of these
requires significant real estate and capital investments.

Connecting the Factors

Another example of entrepreneurship is Starbucks Corporation (SBUX). The retail coffee chain
needs land (prime real estate in big cities for its coffee chain), capital (large machinery to produce
and dispense coffee), and labor (employees at its retail outposts for service). Entrepreneur Howard
Schultz, the company’s founder, provided the fourth factor of production by being the first person
to realize that a market for such a chain existed and figuring out the connections among the other
three factors of production.7

While large companies make for excellent examples, a majority of companies within the United
States are small businesses started by entrepreneurs. Because entrepreneurs are vital for economic
growth, countries are creating the necessary framework and policies to make it easier for them to
start companies.

Ownership of Factors of Production

The definition of factors of production in economic systems presumes that ownership lies with
households, who lend or lease them to entrepreneurs and organizations. But that is a theoretical
construct and rarely the case in practice. Except for labor, ownership for factors of production
varies based on industry and economic system.

For example, a firm operating in the real estate industry typically owns significant parcels of land,
while retail corporations and shops lease land for extended periods of time. Capital also follows
a similar model in that it can be owned or leased from another party. Under no circumstances,
however, is labor owned by firms. Labor’s transaction with firms is based on wages.

Ownership of the factors of production also differs based on the economic system. For example,
private enterprises and individuals own most of the factors of production in capitalism. However,
collective good is the predominating principle in socialism. As such, factors of production, such
as land and capital, are owned and regulated by the community as a whole under socialism.

Ownership of the factors of production depends on the type of economic system and society

Factors of Production Capitalism Socialism Communism

Are owned by... Individuals Everyone Everyone (via the government)

Are valued for... Profitability Usefulness to people Usefulness to society

The Role of Technology

While not directly listed as a factor, technology plays a vital role in influencing production. In
this context, technology has a fairly broad definition and can refer to software, hardware, or a
combination of both used to streamline organizational or manufacturing processes.

Increasingly, technology is responsible for the difference in efficiency among firms. To that end,
technology—like money—is a facilitator of the factors of production. The introduction of
technology into a labor or capital process makes it more efficient. For example, the use of robots
in manufacturing has the potential to improve productivity and output. Similarly, the use of kiosks
in self-serve restaurants can help firms cut back on their labor costs.
The Solow residual, also known as "total factor productivity (TFP)," measures the residual output
that remains unaccounted for from the four factors of production and typically increases when
technological processes or equipment are applied to production. Economists consider TFP to be
the main factor driving economic growth for a country. The greater a firm's or country's TFP, the
greater its growth.

Discuss the importance of study of national income? which method of computing

national income do you prefer and why

To simply understand what National Income is, it can be represented as - National Income defines
a country's wealth. This income depicts the value of goods and services which are produced by an
economy. This gives effect to the net result of all the economic activities performed in the country.

Imagine how you would define a country’s wealth without any economic term? In that case, there
would be no accountability and responsibility linked with the production in the country. The
resources would go uncalculated and there would be a vague economic atmosphere. Thus, let us
indulge in this study which talks about National Income.
Understanding National Income
National income is the sum total of the value of all the goods and services manufactured by the
residents of the country, in a year., within its domestic boundaries or outside. It is the net amount
of income of the citizens by production in a year.
To be more precise, national income is the accumulated money value of all final goods and services
produced in a country during one financial year. Computation of National Income is very vital as
it indicates the overall health of our economy for that particular year.
The aggregate economic performance of a nation is calculated with the help of National income
data. The basic purpose of national income is to throw light on aggregate output and income and
provide a basis for the government to formulate its policy, programs, to maximize the national
welfare of the people. Central Statistical Organization calculates the national income in India.
Definition of National Income

The definition of National Income if of two types-

 Traditional Definition of National Income

 Modern Definition

Traditional Definition of National Income-

According to Marshall: “The labor and capital of a country acting on its natural resources produce
annually a certain net aggregate of commodities, material and immaterial including services of all
kinds. This is the true net annual income or revenue of the country or national dividend.”

Modern Definition

This definition has two subparts

 GDP

 GNP

Gross Domestic Product

Gross Domestic Product, abbreviated as GDP, is the aggregate value of goods and services
produced in a country. GDP is calculated over regular time intervals, such as a quarter or a year.
GDP as an economic indicator is used worldwide to measure the growth of countries economy.

Goods are valued at their market prices, so:

 All goods measured in the same units (e.g., dollars in the U.S.)

 Things without exact market value are excluded.

Constituents of GDP

 Wages and salaries

 Rent

 Interest

 Undistributed profits

 Mixed-income

 Direct taxes

 Dividend

 Depreciation

The Formula for Calculation of GDP

GDP = consumption + investment + government spending + exports - imports.
Gross National Product

Gross National Product (GNP) is an estimated value of all goods and services produced by a
country’s residents and businesses. GNP does not include the services used to produce
manufactured goods because its value is included in the price of the finished product. It also
includes net income arising in a country from abroad.
Components of GNP

 Consumer goods and services

 Gross private domestic income

 Goods produced or services rendered

 Income arising from abroad.

Formula to Calculate GNP
GNP = GDP + NR (Net income from assets abroad or Net Income Receipts) - NP (Net payment
outflow to foreign assets).
Importance of National Income

Setting Economic Policy

National Income indicates the status of the economy and can give a clear picture of the country’s
economic growth. National Income statistics can help economists in formulating economic
policies for economic development.
Inflation and Deflationary Gaps

For timely anti-inflationary and deflationary policies, we need aggregate data of national income.
If expenditure increases from the total output, it shows inflammatory gaps and vice versa.
Budget Preparation
The budget of the country is highly dependent on the net national income and its concepts. The
Government formulates the yearly budget with the help of national income statistics in order to
avoid any cynical policies.
Standard of Living

National income data assists the government in comparing the standard of living amongst countries
and people living in the same country at different times.
Defense and Development

National income estimates help us to bifurcate the national product between defense and
development purposes of the country. From such figures, we can easily know, how much can be
set aside for the defense budget.

Sets of methods for measuring National Income

There are four methods of measuring national income. The type of method to be used depends on
the availability of data in a country and the purpose which is attempted for.

Income Method

In this method, we add net income payments received by all citizens of a country in a particular
year. Net incomes that result in all the factors of production like net rents, wages, interest, and
profits are all added together, but income received in the form of transfer payments are omitted.

Product Method

According to this method, the aggregate value of final goods and services produced in a country
during a financial year is computed at market prices. To find out GNP, the data of all the productive
activities-agricultural products, Minerals, Industrial products, the contributions to production
made by transport, insurance, communication, lawyers, doctors, teachers. Etc are accumulated and
assessed.

Expenditure Method
The total expenditure by the society in a financial year is summed up together and includes
personal consumption expenditure, net domestic investment, government expenditure on goods
and services, and net foreign investment. This concept is backed by the assumption that national
income is equal to national expenditure.

Value Added Method

The distinction between the value of material outputs and material inputs at every stage of
production is Value added.
GDP Vs GNP

The Gross Domestic Product and the Gross National Product are the two most widely used
measures in a country’s calculation of aggregate economic unit.

GDP is the measure of the value of goods and services that are being produced within a country's
borders, by the citizens and the non-citizens. While GNP determines the value of goods and
services that are being produced by the country's citizens in the domestic and abroad spectrum.
GDP is popularly used by the global economies at large. While, the United States eliminated the
use of GNP in the year 1991, thereby adopting GDP as the measure to compare their economy
with other economies.

Difficulties in Measurement of National Income

Following are the difficulties in estimating the National Income

 Conceptual difficulties

 Statistical difficulties
A. Conceptual difficulties

1. It is difficult to calculate the value of some of the items such as services rendered for free and
goods that are to be sold but are used for self-consumption.

2. Sometimes, it becomes difficult to make a clear distinction between primary, intermediate and
final goods.

3. What price to choose to determine the monetary value of a National Product is always a
difficult question?
 4. Whether to include the income of the foreign companies in the National Income or not because
they emit a major part of their income outside India?
B. Statistical difficulties

1. In case of changes in the price level, we need to use the Index numbers which have their own
inherent limitations.

2. Statistical figures are not always accurate as they are based on the sample surveys. Also, all
the data are not often available.

3. All the countries have different methods of estimating National Income. Thus, it is not easily
comparable.

Questions on National Income

What is the usefulness of estimating the National Income?

Ans.

The usefulness of estimating National Income is as follows:

1. It depicts the change in the production to output and also the effects of the Government policies
on the economy.

2. The National Income studies the relation between the input of one industry and the output of
the other.

3. It shows the income distribution among different economic units.

4. It also shows the change in the tastes and preferences of the consumers and thus, helps the
producers to decide what to produce and for whom to produce.

5. The quantum of the National Income of a country indicates its ability to pay its share for
international purposes, such as membership of IMF, World Bank or SAARC.
What Is Economic Growth and How Is It Measured?

What Is Economic Growth?

Economic growth is an increase in the production of economic goods and services in one period
of time compared with a previous period. It can be measured in nominal or real (adjusted to
remove inflation) terms. Traditionally, aggregate economic growth is measured in terms of gross
national product (GNP) or gross domestic product (GDP), although alternative metrics are
sometimes used.

KEY TAKEAWAYS

 Economic growth is an increase in the production of goods and services in an economy.

 Increases in capital goods, labor force, technology, and human capital can all contribute
to economic growth.
 Economic growth is commonly measured in terms of the increase in aggregated market
value of additional goods and services produced, using estimates such as GDP.
 The four phases of economic growth are expansion, peak, contraction, and trough.
 Tax cuts are generally less effective in spurring economic growth than are increases in
government spending.
 If the rewards of economic growth go only to an elite group, then it is unlikely that the
growth will be sustainable.

Understanding Economic Growth

In simplest terms, economic growth refers to an increase in aggregate production in an economy,

which is generally manifested in a rise in national income.1 Often, but not necessarily, aggregate
gains in production correlate with increased average marginal productivity. That leads to an
increase in incomes, inspiring consumers to open up their wallets and buy more, which means a
higher material quality of life and standard of living.

In economics, growth is commonly modeled as a function of physical capital, human capital,

labor force, and technology. Simply put, increasing the quantity or quality of the working age
population, the tools that they have to work with, and the recipes that they have available to
combine labor, capital, and raw materials, will lead to increased economic output.2Phases of
Economic Growth

The economy moves through different periods of activity. This movement is called the “business
cycle.”

It consists of four phases:3

 Expansion – During this phase employment, income, industrial production, and sales all
increase, and there is a rising real GDP.
 Peak – This is when an economic expansion hits its ceiling. It is in effect a turning point.
 Contraction – During this phase the elements of an expansion all begin to decrease. It
becomes a recession when a significant decline in economic activity spreads across the
economy.
 Trough – This is when an economic contraction hits its nadir.

A single business cycle is dated from peak to peak or trough to trough. Such cycles generally are
not regular in length, and there can be a period of contraction during an expansion and vice versa.

Since World War II, the U.S. economy has experienced more expansions than contractions.
Between 1945 and 2019, the average expansion lasted about 65 months, while the average
contraction was only 11 months. However, the Great Recession, from December 2007 to June
2009, went on for 18 months. This was followed by the longest expansion on record, 128 months,
lasting until 2020 and the advent of the COVID-19 pandemic.3

Governments often try to stimulate economic growth by lowering interest rates, which makes
money cheaper to borrow. However, that can only last for so long. Eventually, as happened in
2022, rates need to be hiked to combat price inflation and keep the economy from boiling over.4

How To Measure Economic Growth

The most common measure of economic growth is the real GDP. This is the total value of
everything, both goods and services, produced in an economy, with that value adjusted to remove
the effects of inflation. There are three different methods for looking at real GDP.5

 Quarterly growth at an annual rate – This looks at the change in the GDP from quarter
to quarter, which is then compounded into an annual rate. For example, if one quarter’s
change is 0.3%, then the annual rate would be extrapolated to be 1.2%.
 Four-quarter or year-over-year growth rate – This compares a single quarter’s GDP
from two successive years as a percentage. It is often used by businesses to offset the
effects of seasonal variations.
 Annual average growth rate – This is the average of changes in each of the four quarters.
For example, if in 2022 there were four-quarter rates of 2%, 3%, 1.5%, and 1%, the annual
average growth rate for the year would be 7.5% ÷ 4 = 1.875%.

GDP, the most popular way to measure economic growth, is calculated by adding up all of the
money spent by consumers, businesses, and the government in a given period. The formula is:
GDP = consumer spending + business investment + government spending + net exports.

Of course, measuring the value of a commodity is tricky. Some goods and services are considered
to be worth more than others. For example, a smartphone is more valuable than a pair of socks.
Growth has to be measured in the value of goods and services, not just the quantity.

Another problem is that not all individuals place the same value on the same goods and services.
A heater is more valuable to a resident of Alaska, while an air conditioner is more valuable to a
resident of Florida. Some people value steak more than fish and vice versa. Because value is
subjective, measuring for all individuals is very tricky.

The common approximation is to use the current market value. In the United States, this is
measured in terms of U.S. dollars and added all together to produce aggregate measures of output
including GDP.
There are alternatives to GDP. For example, the World Bank uses gross national income per
capita, which includes income sent back by citizens working overseas, to measure economic
growth, classify countries for analytical purposes, and determine borrowing eligibility.6

How to Generate Economic Growth

Economic growth is dependent on the following four contributory areas:

Increase Physical Capital Goods

The first is an increase in the amount of physical capital goods in the economy. Adding capital to
the economy tends to increase productivity of labor. Newer, better, and more tools mean that
workers can produce more output per time period. For a simple example, a fisherman with a net
will catch more fish per hour than a fisherman with a pointy stick. However, two things are critical
to this process.

Someone in the economy must first engage in some form of saving (sacrificing their current
consumption) in order to free up the resources to create the new capital. In addition, the new
capital must be the right type, in the right place, and at the right time for workers to actually use
it productively.

Improve Technology

A second method of producing economic growth is technological improvement. An example of

this is the invention of gasoline fuel; prior to the discovery of the energy-generating power of
gasoline, the economic value of petroleum was relatively low. The use of gasoline became a better
and more productive method of transporting goods in process and distributing final goods more
efficiently.

Improved technology allows workers to produce more output with the same stock of capital goods
by combining them in novel ways that are more productive. Like capital growth, the rate of
technical growth is highly dependent on the rate of savings and investment, as they are necessary
to engage in research and development (R&D).
The four factors of production are land and natural resources, labor, capital equipment,
and entrepreneurship.

Grow the Labor Force

Another way to generate economic growth is to grow the labor force. All else being equal, more
workers generate more economic goods and services. During the 19th century, a portion of the
robust U.S. economic growth was due to a high influx of cheap, productive immigrant
labor.7 However, as with capital-driven growth, there are some key conditions to this process.

Increasing the labor force necessarily increases the amount of output that must be consumed in
order to provide for the basic subsistence of the new workers, so the new workers need to be at
least productive enough to offset this and not be net consumers. Also, just like additions to capital,
it is important for the right type of workers to flow to the right jobs in the right places in
combination with the right types of complementary capital goods in order to realize their
productive potential.

Increase Human Capital

The last method is to increase human capital. This means laborers become more accomplished at
their crafts, raising their productivity through skills training, trial and error, or simply more
practice. Savings, investment, and specialization are the most consistent and easily controlled
methods.

Human capital in this context can also refer to social and institutional capital. Behavioral
tendencies toward higher social trust and reciprocity, along with political or economic
innovations such as improved protections for property rights, are types of human capital that can
increase the productivity of the economy.

Why Does Economic Growth Matter?

In the simplest terms, economic growth means that more will be available to more people, which
is why governments try to generate it. However, it’s not just about money, goods, and services.
Politics also enter into the equation. How economic growth is used to fuel social progress matters.
According to 10 years of research conducted by the United Nations University World Institute
for Development Economics Research, “most countries that have shown success in reducing
poverty and increasing access to public goods have based that progress on strong economic
growth.” If the benefits flow only to an elite group, the growth will not be sustained.8

How Do Taxes Affect Economic Growth?

Taxes affect economic growth, at least in the short term, through their impact on demand. A tax
cut increases demand by raising personal disposable income and encouraging businesses to hire
and invest. However, the size of the effect is dependent on the strength of the economy. If it is
operating close to capacity, the effect is likely to be small. If it is operating significantly below
its potential, the impact will be more pronounced. The Congressional Budget Office (CBO)
estimates that the effect is three times larger in the latter case than in the former.9

The CBO also found that tax cuts are generally not as effective in stimulating economic growth
as government spending increases. That is because most of the spending boosts demand, while
tax cuts boost savings as well as demand. One way to mitigate this effect is to target tax cuts to
lower- and middle-income households, which are less likely to put the money into savings.9

What Is Another Word or Term for Economic Growth?

Other words and terms for economic growth include “boom,” “prosperity,” “economic
development,” “economic upswing,” “economic upsurge,” “industrial development,” and
“buoyancy of the economy.

What Are Ways Economic Growth Can Be Achieved?

Economic growth is measured by an increase in gross domestic product (GDP), which is defined
as the combined value of all goods and services produced within a country in a year. Many forces
contribute to economic growth. However, there is no single factor that consistently spurs the
perfect or ideal amount of growth needed for an economy. Unfortunately, recessions are a fact of
life and can be caused by external factors such as geopolitical and geofinancial events.
In the United States, economic growth often is driven by consumer spending and business
investment. If consumers are buying homes, for example, home builders, contractors, and
construction workers will experience economic growth. Businesses also drive the economy when
they hire workers, raise wages, and invest in growing their businesses. A company that buys a
new manufacturing plant or invests in new technologies creates jobs and spending, which leads
to growth in the economy.

Other factors help promote consumer and business spending and prosperity. Banks, for example,
lend money to companies and consumers. As businesses have access to credit, they might finance
a new production facility, buy a new fleet of trucks, or start a new product line or service. The
spending and business investments, in turn, have positive effects on the companies involved.
However, the growth also extends to those doing business with the companies, including in the
above example, the bank employees and the truck manufacturer.

KEY TAKEAWAYS

 Economic growth often is driven by consumer spending and business investment.

 Tax cuts and rebates are used to return money to consumers and boost spending.
 Deregulation relaxes the rules imposed on businesses and has been credited with creating
growth but can lead to excessive risk-taking.
 Infrastructure spending is designed to create construction jobs and increase productivity
by enabling businesses to operate more efficiently.

Tax Cuts and Tax Rebates

Tax cuts and tax rebates are designed to put more money back into the pockets of consumers.
Ideally, these consumers spend a portion of that money at various businesses, which increases the
businesses' revenues, cash flows, and profits. Having more cash means companies have the
resources to procure capital, improve technology, grow, and expand. All of these actions increase
productivity, which grows the economy. Tax cuts and rebates, proponents argue, allow consumers
to stimulate the economy themselves by imbuing it with more money.
In 2017, the Trump administration proposed, and Congress passed the Tax Cuts and Jobs
Act.1 The legislation lowered corporate taxes to 20%; the highest corporate income tax rate was
35% before the bill. Various personal income tax brackets were lowered as well. The bill cost
$1.5 trillion and was designed to increase economic growth for the next 10 years.23
As with any stimulus used to spur economic growth, it's often difficult to pinpoint how much
growth was created by the stimulus and how much was generated by other factors and market
forces.

Stimulating the Economy With Deregulation

Deregulation is the relaxing of rules and regulations imposed on an industry or business. It

became a centerpiece of economics in the United States under the Reagan administration in the
1980s, when the federal government deregulated several industries, most notably financial
institutions. Many economists credit Reagan's deregulation with the robust economic growth that
characterized the U.S. during most of the 1980s and 1990s.

Proponents of deregulation argue tight regulations constrain businesses and prevent them from
growing and operating to their full capabilities. This, in turn, slows production and hiring, which
inhibits GDP growth. However, economists who favor regulations blame deregulation and a lack
of government oversight for the numerous economic bubbles that expanded and subsequently
burst during the 1990s and early 2000s.

Many economists cite that there was a lack of regulatory oversight leading up to the financial
crisis of 2008. Subprime mortgages, which are high-risk mortgages to borrowers with less-than-
perfect credit, began to default in 2007. The mortgage industry collapsed, leading to a recession
and subsequent bailouts of several banks by the U.S. government. New regulations were
implemented in the years to follow that imposed increased capital requirements for banks,
meaning they need more cash on hand to cover potential losses from bad loans.

Using Infrastructure to Spur Economic Growth

Infrastructure spending occurs when a local, state, or federal government spends money to build
or repair the physical structures and facilities needed for commerce and society as a whole to
thrive. Infrastructure includes roads, bridges, ports, and sewer systems. Economists who favor
infrastructure spending as an economic catalyst argue that having top-notch infrastructure
increases productivity by enabling businesses to operate as efficiently as possible. For example,
when roads and bridges are abundant and in working order, trucks spend less time sitting in
traffic, and they don't have to take circuitous routes to traverse waterways.

During the Great Recession, the Obama administration, along with Congress, proposed and
passed The American Recovery and Reinvestment Act of 2009.4 The stimulus package was
designed to spur economic growth in the economy since business and private investment was
waning. The Obama stimulus as it's commonly referred to included federal government spending
exceeding $80 billion for highways, bridges, and roads. The stimulus was designed to help create
construction jobs that were hit hard due to the impact of the mortgage crisis on residential and
commercial construction.5
Additionally, infrastructure spending creates jobs as workers must be hired to complete the green-
lighted projects. It is also capable of spawning new economic growth. For example, the
construction of a new highway might lead to other investments such as gas stations and retail
stores opening to cater to motorists.

Methods of Credit Control used by Central Bank

The following points highlight the two categories of methods of credit control by central bank.

The two categories are: I. Quantitative or General Methods II. Qualitative or Selective
Methods.

Category # I. Quantitative or General Methods:

1. Bank Rate Policy:

The bank rate is the rate at which the Central Bank of a country is prepared to re-discount the
first class securities.

It means the bank is prepared to advance loans on approved securities to its member banks.
As the Central Bank is only the lender of the last resort the bank rate is normally higher than
the market rate.

For example:

If the Central Bank wants to control credit, it will raise the bank rate. As a result, the market
rate and other lending rates in the money-market will go up. Borrowing will be discouraged.
The raising of bank rate will lead to contraction of credit.

Similarly, a fall in bank rate mil lowers the lending rates in the money market which in turn
will stimulate commercial and industrial activity, for which more credit will be required from
the banks. Thus, there will be expansion of the volume of bank Credit.

2. Open Market Operations:

This method of credit control is used in two senses:

(i) In the narrow sense, and

(ii) In broad sense.

In narrow sense—the Central Bank starts the purchase and sale of Government securities in
the money market. But in the Broad Sense—the Central Bank purchases and sale not only
Government securities but also of other proper and eligible securities like bills and securities
of private concerns. When the banks and the private individuals purchase these securities they
have to make payments for these securities to the Central Bank.

This gives result in the fall in the cash reserves of the Commercial Banks, which in turn
reduces the ability of create credit. Through this way of working the Central Bank is able to
exercise a check on the expansion of credit.

Further, if there is deflationary situation and the Commercial Banks are not creating as much
credit as is desirable in the interest of the economy. Then in such situation the Central Bank
will start purchasing securities in the open market from Commercial Banks and private
individuals.
With this activity the cash will now move from the Central Bank to the Commercial Banks.
With this increased cash reserves the Commercial Banks will be in a position to create more
credit with the result that the volume of bank credit will expand in the economy.

3. Variable Cash Reserve Ratio:

Under this system the Central Bank controls credit by changing the Cash Reserves Ratio. For
example—If the Commercial Banks have excessive cash reserves on the basis of which they
are creating too much of credit which is harmful for the larger interest of the economy. So it
will raise the cash reserve ratio which the Commercial Banks are required to maintain with
the Central Bank.

This activity of the Central Bank will force the Commercial Banks to curtail the creation of
credit in the economy. In this way by raising the cash reserve ratio of the Commercial Banks
the Central Bank will be able to put an effective check on the inflationary expansion of credit
in the economy.

Similarly, when the Central Bank desires that the Commercial Banks should increase the
volume of credit in order to bring about an economic revival in the country. The Central Bank
will lower down the Cash Reserve ratio with a view to expand the cash reserves of the
Commercial Banks.

With this, the Commercial Banks will now be in a position to create more credit th an what
they were doing before. Thus, by varying the cash reserve ratio, the Central Bank can
influence the creation of credit.

Which is Superior?

Either variable cash reserve ratio or open market operations:

From the analysis and discussions made above of these two methods of credit, it can be said
that the variable cash reserve ratio method is superior to open market operations on the
following grounds:
(1) Open market operations is time consuming procedure while cash reserves ratio produc es
immediate effect in the economy.

(2) Open market operations can work successfully only where securities market in a country
are well organised and well developed.

While Cash Reserve Ratio does not require such type of securities market for the successful
implementation.

(3) Open market operations will be successful where marginal adjustments in cash reserve are
required.

But the variable cash reserve ratio method is more effective when the commercial banks
happen to have excessive cash reserves with them.

These two methods are not rival, but they are complementary to each other.

Category # II. Qualitative or Selective Method of Credit Control:

The qualitative or the selective methods are directed towards the diversion of cr edit into
particular uses or channels in the economy. Their objective is mainly to control and regulate
the flow of credit into particular industries or businesses.

The following are the important methods of credit control under selective method:

1. Rationing of Credit.

2. Direct Action.

3. Moral Persuasion.

4. Method of Publicity.

5. Regulation of Consumer’s Credit.

6. Regulating the Marginal Requirements on Security Loans.

1. Rationing of Credit:
Under this method the credit is rationed by limiting the amount available to each applicant.
The Central Bank puts restrictions on demands for accommodations made upon it during times
of monetary stringency.

In this the Central Bank discourages the granting of loans to stock exchanges by refusing t o
re-discount the papers of the bank which have extended liberal loans to the speculators. This
is an important method of credit control and this policy has been adopted by a number of
countries like Russia and Germany.

2. Direct Action:
Under this method if the Commercial Banks do not follow the policy of the Central Bank,
then the Central Bank has the only recourse to direct action. This method can be used to
enforce both quantitatively and qualitatively credit controls by the Central Banks. This
method is not used in isolation; it is used as a supplement to other methods of credit control.

Direct action may take the form either of a refusal on the part of the Central Bank to re -
discount for banks whose credit policy is regarded as being inconsistent with the maintenance
of sound credit conditions. Even then the Commercial Banks do not fall in line, the Central
Bank has the constitutional power to order for their closure.

This method can be successful only when the Central Bank is powerful enough and has cordial
relations with the Commercial Banks. Mostly such circumstances are rare when the Central
Bank is forced to resist to such measures.

3. Moral Persuasion:
This method is frequently adopted by the Central Bank to exercise control over th e
Commercial Banks. Under this method Central Bank gives advice, then request and
persuasion to the Commercial Banks to co-operate with the Central Bank is implementing its
credit policies.
If the Commercial Banks do not follow or do not abide by the advice or request of the Central
Bank no gross action is taken against them. The Central Bank merely was its moral influence
and pressure with the Commercial Banks to prevail upon them to accept and follow the
policies.

4. Method of Publicity:
In modern times, Central Bank in order to make their policies successful, take the course of
the medium of publicity. A policy can be effectively successful only when an effective public
opinion is created in its favour.

Its officials through news-papers, journals, conferences and seminar’s present a correct
picture of the economic conditions of the country before the public and give a prospective
economic policies. In developed countries Commercial Banks automatically change their
credit creation policy. But in developing countries Commercial Banks being lured by regional
gains. Even the Reserve Bank of India follows this policy.

5. Regulation of Consumer’s Credit:

Under this method consumers are given credit in a little quantity and this period is fixed for
18 months; consequently credit creation expanded within the limit. This method was
originally adopted by the U.S.A. as a protective and defensive measure, there after it has been
used and adopted by various other countries.

6. Changes in the Marginal Requirements on Security Loans:

This system is mostly followed in U.S.A. Under this system, the Board of Governors of the
Federal Reserve System has been given the power to prescribe margin requirements for the
purpose of preventing an excessive use of credit for stock exchange speculation.

This system is specially intended to help the Central Bank in controlling the volume of credit
used for speculation in securities under the Securities Exchange Act, 1934

How the Banking Sector Impacts Our Economy?

Banks help keep the economy running smoothly—and can also send it crashing
What Is the Banking Sector?

The banking sector is a major segment of the U.S. and world economies. While some might define
it more broadly, the U.S. Department of Commerce considers it a subsector of the larger financial
services industry, which also includes subsectors focusing on asset management, insurance,
venture capital, and private equity.

The U.S. banking system alone had $23.60 trillion in assets and a net income of $263 billion at
the end of 2022.123

The principal economic functions of the banking sector are to take deposits and make loans.4

KEY TAKEAWAYS

 The banking sector is vital to the U.S. and world economies.

 Its primary function is to safeguard depositors’ assets and make loans to individuals and
businesses.
 Banks are regulated by the federal government, and sometimes state governments, to try
to keep them from taking on too much risk and imperiling the economy.

How Banking Works

Holding financial assets is at the core of all banking, and where it began in ancient times—though
it has expanded far beyond the days of storing gold coins for wealthy patrons.

At the most basic level, a bank takes deposits from individuals or businesses, with the promise
that the money can be withdrawn when the depositor wants it (though sometimes with a penalty
for early withdrawal). Depending on the type of account, the bank also may pay interest on the
depositor’s money.

The bank then lends the money it has on deposit to other individuals and businesses and receives
interest payments from the borrower in return. Banks make a profit on the difference between the
interest rate that they pay depositors for the use of their money and the higher interest rate that
they charge borrowers.
By law, banks cannot lend out all of the money in their possession, but are required by regulators
to keep a certain amount of capital in reserve to cover withdrawals and other needs. The rules
change from time to time and vary by the size of the bank, but many large U.S. banks recently
were required to keep 8% of their capital in reserve.5

In addition to making loans, banks can invest their own money in other kinds of assets, such as
government securities.

How Do Banks Drive the Economy?

The banking sector is crucial to the modern economy. As the primary supplier of credit, it provides
money for people to buy cars and homes and for businesses to buy equipment, expand their
operations, and meet their payrolls.

Banks also provide depositors with a safe place to keep their money (particularly since the advent
of the Federal Deposit Insurance Corp. (FDIC), which insures many accounts up to certain limits)
as well as to earn some interest on it.

The credit cards, debit cards, and checking accounts that banks make available facilitate all kinds
of everyday transactions. They also help drive ecommerce, where cash is of little use.

The banking sector is also a major employer. In 2022, for example, FDIC-insured commercial
banks alone employed nearly 2 million people in the United States.6

On the negative side, the banking sector also has the capability of doing enormous harm to the
economy. In the subprime mortgage meltdown that began in 2007, for example, reckless lending
on the part of some banks sent the economy into a tailspin and triggered the Great Recession of
2007–2009. Regulatory reforms enacted since that time may help avert a similar crisis in the
future.

How Banks Are Regulated

Because of the vital role that banks play in the economy, governments around the world have
laws in place to try to prevent them from engaging in excessively risky behavior. In the United
States, for example, banks are regulated by an assortment of federal and state agencies, depending
on the type of bank. The sector also self-regulates through actions of organizations such as
the Financial Services Forum and the Financial Services Roundtable.

The federal regulators include the Federal Reserve System, the Office of the Comptroller of the
Currency, and the FDIC. Credit unions, which also may be considered part of the banking sector,
are regulated by the National Credit Union Administration.7

State-chartered banks fall under the jurisdiction of state banking regulators and supervisors. Some
banks are regulated on both state and federal levels

The banking sector is crucial to the modern economy. As the primary supplier of credit, it provides
money for people to buy cars and homes and for businesses to buy equipment, expand their
operations, and meet their payrolls.

11 characteristics/features of a bank are;

Dealing in Money

Individual/Firm/Company

Acceptance of Deposit

Giving Advances

Payment and Withdrawal

Agency and Utility Services

Profit and Service Orientation

Ever-increasing

Connecting Link
Banking Business

Name Identity

The main characteristics/ features of a bank are discussed below:-

1. Dealing with Money

The bank is a financial institution that deals with other people’s money, i.e., the money giv en
by depositors.

2. Individual/Firm/Company

A bank may be a person, firm, or company. A banking company is a company that is in the
business of banking.

3. Acceptance of Deposit

A bank accepts money from people in deposits that are usually repayable on demand or after
a fixed period expires. It gives safety to the deposits of its customers. It also acts as a custodian
of funds of its customers.

4. Giving Advances

A bank lends out money in loans to those who require it for different purposes.
5. Payment and Withdrawal

A bank provides its customers with an easy payment and withdrawal facility in checks and
drafts. It also brings bank money into circulation. This money is in the form of checks, drafts,
etc.

6. Agency and Utility Services

A bank provides various banking facilities to its customers. They include general utility
services and agency services.

7. Profit and Service Orientation

A bank is a profit-seeking institution with having service-oriented approach.

8. Ever-increasing

Functions Banking is an evolutionary concept. There is continuous expansion and

diversification regarding a bank’s functions, services, and activities.

9. Connecting Link

A bank acts as a connecting link between borrowers and lenders of money. Banks collect
money from those who have surplus money and give the same to those who require money.

10. Banking Business

A bank’s main activity should be to do banking business that should not be a subsidiary of
any other business.

11. Name Identity

A bank should always add the word “bank” to its name to let people know that it is a bank
that deals in money.

Functions of Banks

The functions of banks are briefly highlighted in the following diagram or chart.

Primary Functions of Banks.

Accepting Deposits.

Saving Deposits.

Fixed Deposits.

Current Deposits.

Recurring Deposits.

Granting of Loans and Advances.

Overdraft

Cash Credits
Loans

Discounting of Bill of Exchange

Secondary Functions of Banks.

Agency Functions.

Transfer of Funds.

Collection of checks.

Periodic Payments.

Portfolio Management.

Periodic Collections.

Other Agency Functions.

General Utility Functions.

Issue of Drafts, Letters of Credit, etc.

Locker Facility.

Underwriting of Shares.

Dealing in Foreign Exchange.

Project Reports.

Social Welfare Programs.

Other Utility Functions.

A. Primary Functions of Banks

The primary functions of a bank are also known as banking functions. They are the main
functions of a bank. These primary functions of banks are explained below.

1. Accepting Deposits

The bank collects deposits from the public. These deposits can be of different types, such as

Saving Deposits: This type of deposit encourages saving habits among the public. The rate of
interest is low. At present, it is about 4% p.a.

Fixed Deposits: The lump sum amount is deposited at one time for a specific period. A higher
rate of interest is paid.

Current Deposits: This type of account is operated by businessmen. Withdrawals are freely
allowed. No interest is paid.

Recurring Deposits: This type of account is operated by salaried persons and petty traders.
Withdrawals are permitted only after the expiry of a certain period. A higher rate of interest
is paid.

2. Granting of Loans and Advances

The bank advances loans to the business community and other members of the public. The
rate charged is higher than what it pays on deposits. The types of bank loans and advances
are:

Overdraft: This type of advance is given to current account holders. It is sanctioned to

business people and firms. An overdraft facility is granted against collateral se curity.
Cash Credits: The client is allowed cash credit up to a specific limit fixed in advance. The
cash credit is given against the security of tangible assets and or guarantees. The advance is
given for a longer period, and a larger loan amount is sanctioned than that of an overdraft.

Loans: It is normal for the short term, say a period of one year, or medium-term, says a period
of five years. Nowadays, banks do lend money for the long term. Loans are normally secured
against the tangible assets of the company.

Discounting of the bill of exchange: The bank can advance money by discounting or
purchasing bills of exchange, both domestic and foreign. The bill is presented to the drawee
or acceptor of the bill on maturity, and the amount is collected.

B. Secondary Functions of Banks

The bank performs some secondary functions, also called non-banking functions. These
important secondary’ functions of banks are explained below.

1. Agency Functions

The bank acts as an agent of its customers. The bank performs several agency functions, which
include:-

Transfer of Funds: The bank transfers funds from one branch or place to another.

Collection of checks: The bank collects the checks’ money through its customers’ clearing
section. The bank also collects money from the bills of exchange.

Periodic Payments: On standing instructions of the client, the bank makes periodic payments
regarding electricity bills, rent, etc.
Portfolio Management: The banks also undertake to purchase and sell the shares and
debentures on behalf of the clients and accordingly debit or credit the account. This facility
is called portfolio management.

Periodic Collections: The bank collects salary, pension, dividend, and other periodic
collections on behalf of the client.

Other Agency Functions: They act as trustees, executors, advisers, and administrators on
behalf of their clients. They act as representatives of clients to deal with other banks and
institutions.

2. General Utility Functions

The bank also performs general utility functions, such as,

Issue of Drafts and Letter of Credits: Banks issue drafts for transferring money from one place
to another. It also issues letters of credit, especially in the case of import trade. It also issues
travelers’ checks.

Locker Facility: The bank provides a locker facility to safely store valuable documents, gold
ornaments, and other valuables.

Underwriting of Shares: The bank underwrites shares and debentures through its merchant
banking division.

Dealing in Foreign Exchange: Commercial banks are allowed by.RBI to deal in foreign
exchange.

Project Reports: The bank may also undertake to prepare project reports on behalf of its
clients.

Social Welfare Programs: It undertakes social welfare programs, such as adult literacy
programs, public welfare campaigns, etc.
Other Utility Functions: It acts as a referee to customers’ financial standing. It collects
creditworthiness information about clients of its customers. It provides market information to
its customers, etc. It provides travelers’ check facilities.

Importance of Banks

Banking plays an important role in financial life, and the importance of banks can be seen
from the fact that they are considered the lifeblood of the modem economy.

Although bank creates no wealth, their essential activities facilitate we alth production,
exchange, and distribution. In this way, banks become effective partners in the process of
economic development and growth.

Advantages and Disadvantages of Indirect Taxes

Advantages of Indirect Taxes:

Indirect taxes have advantages of their own.

Briefly speaking, they are as under:

(i) The Poor Can Control;

They are the only means of reaching the poor. It is a sound principle that every, individual
should pay something, however little, to the State. The poor are always exempted from paying
direct taxes. They can be reached only through indirect taxation.

(ii) Convenient:

They are convenient to both the tax-prayer and the State. I he tax-payers do not feel the burden
much partly because an indirect tax is paid in small amounts and partly because it is paid only
when making purchases. But the convenience is even greater due to the fact that the tax is
“price-coated”.

It is wrapped in price. It is like a sugar-coated quinine pill. Thus, a tobacco tax is not felt
when it is included in the price of every cigarette bought. It is convenient to the State as well
which can collect the tax at the ports or at the factory.

(iii) Broad-based:

Indirect taxes can be spread over a wide range. Very heavy direct taxation at just one point
may produce harmful effects on social and economic life. As indirect taxes can be spread
widely, they are more beneficial and suitable.

(iv) Easy Collection:

Collection takes place automatically when goods are bought and sold. A dealer collects the
tax when he charges a price. He is an honorary tax collector.

(v) Non-evadable:

They cannot be evaded, as they are a part of the price. They can be evaded only when the
taxed article is not consumed, and ‘his may not always be possible’

(v) Elastic:

They are very elastic in yield, imposed on necessaries of life which have an inelastic demand.
Indirect taxes on necessaries yield a large revenue, because people must buy these things.

(vi) Equitable:

When imposed on luxury or goods consumed by the rich, they are equitable. In such cases,
only the .Veil-to-do will pay the tax.

(vii) Check Harmful Consumption: .

By being imposed on harmful products, they can check consumption of harmful commodities.
That is why tobacco, wine and other intoxicants are taxed.

Disadvantages:

Indirect taxes have some disadvantages too, which are as follows:

ADVERTISEMENTS:

(i) Regressive:

Indirect taxes are not equitable. For instance, salt tax in India fell more heavily on the poor
than on the rich, as it had to be paid at the same rate by all. Whether a rich man buys a
commodity or a poor man, the price in the market is the same for all. The tax is wrapped in
the price. Hence, rich and poor pay the same amount, which is obviously unfair. They are
thus; regressive.

(ii) Uncertain:

Unless indirect taxes are imposed on necessaries, we cannot be sure of the revenue yield. In
the case of goods, with an elastic demand, the tax might not bring in much revenue. The tax
will raise the price and contract the demand. When the thing is not purchased, the question of
the tax payment does not arise.

(iii) Raising Prices Unduly:

They cause the price of an article to rise b; more than the tax. A fraction of the money unit
cannot be calculated, so ever middleman tends to charge more than the tax. This process is
cumulative.

(iv) Uneconomical:

The cost of collection is quite heavy. Every source o production has to be guarded. Large
administrative staff is required to administer such taxes. This turns out to be a costly affair.
(v) No Civic Consciousness:

These taxes do not develop civic consciousness, because many times the tax -payer does not
even know that he is paying tax. The tax is concealed in the price.

(vi) Harmful to Industries:

They discourage industries if raw materials are taxed. This will raise the cost of production
and impair their competitive capacity.

Direct Vs. Indirect Taxes:

In answer to the question whether direct or indirect taxes are better, much can be said on both
sides. But it is safe to conclude that no country can do with one type only. Both types have to
be mixed in a good system of taxation.

The rich can be taxed best directly, but pockets of the poor have also to be tapped through
indirect taxes. Nowadays, when the state functions are multiplying, substantial amounts are
required for the discharge of its multifarious activities. Neither the direct nor the indirect taxes
alone can raise adequate revenue. Both are necessary.

Their relative importance depends on a number of factors, such as distribution of income,

nature of the economic system, the stage of economic development, etc. Thus, the discussion
of the relative merits and demerits of direct and indirect taxes is only academic. It has no
practical importance.

What Is an Indirect Tax?

It is a tax levied upon goods or services by the Indian government on the end consumer. Typically,
the market price of the goods or services includes this tax. Indirect taxes in India are not well
defined by any Act. However, our government brings out notifications and circulars to impose
indirect taxes on tangible and intangible products.

What Are the Types of Indirect Taxes?

There are various types of indirect taxes in India. Though all these taxes came under one group
after the introduction of GST, the pre-existing types are as follows -
1. Service Tax

A consumer pays service tax to purchase a service from any entity. The Indian government collects
service tax on certain transactions that a service provider performs to sell a service.
2. Value Added Tax

State governments collect this tax on a good or service at each point of purchase where a value has
been added. This tax is applicable from the point of a raw material purchase to the sale of a finished
product.
3. Custom Duty

The Union government collects this indirect tax on an import of a product in India. Timely, it is
applicable on products exported from India.
4. Excise Duty

Our government collects excise duty from the manufacturers of goods manufactured in an Indian
company. The manufacturers collect it from their buyers through the price of the goods.
5. Sales Tax

Central government imposes this tax on an Inter-state sale and the State government on an Intra-
state sale of a good.
6. Entertainment Tax

State government charges this tax on the purchase of any entertainment-related goods and services.
This can be purchasing goods like video games or services like movies, theatres, sports,
amusement parks
7. Securities-Transaction-Tax

Securities-Transaction-Tax or STT is levied during purchase of securities via Stock Exchanges of

India. These are inclusive of F&O transactions, mutual funds, shares etc.
8. Stamp Duty
This type of indirect tax is levied by the State Governments upon immovable property transfer of
respective states. Furthermore, the State Government levies tax on legal documents. The rate of
stamp duty varies from one state to another.

What Are the Features of Indirect Tax?

Below are some salient features of indirect tax -

 Initially, its nature was regressive. This is because it formerly imposed a significant
burden on a taxpayer's income, whether high or low. However, it turned progressive
after the introduction of the Goods and Services Tax.

 The liability of tax payment can be transferable. This means retailers, service
providers or manufacturers pay the tax first. Then they accrue it from their customer.

 The taxpayer is always the end consumer, and the taxable product is a finished good
and service.

 Indirect tax encourages an individual to save and invest and boost growth.

 It is impossible to escape this tax as it comes under the market price of a product.

Advantages of Indirect Taxes

Below are some benefits of this tax -

1. Easy to Fetch

It is relatively easier to collect than direct tax. Retailers or service providers add this tax to a
product's market price and collect it only upon purchase. Therefore, the initial taxpayer (retailer or
service provider) need not worry about recollecting it from their customers.
2. Convenient and Time-Saving

One of the merits of indirect tax is that it is transferable from one person to another. Since the
taxpayer is the end buyer, retailers or service providers can collect it directly at their stores. This
makes the collection of this tax time-saving and convenient.
3. Mitigation of Stress of Tax Payment
The taxpayers do not need to pay this tax directly from their salary. Our government implements
it through the market value of a product and collects it at a point of purchase. Hence, it does not
feel like a burden to the taxpayers.
4. Fair Distribution of Tax

This tax is inversely related to the necessity of any commodity. Therefore, items that serve our
essentials and basic needs have a lower tax. Conversely, luxurious and valuable commodities will
hold higher taxes.
5. Inevitable to Escape

It is not easy to escape indirect tax as it comes included in a good and service price tag. Therefore,
you pay this tax automatically whenever you make a purchase.
6. Equal Collection from All

An income of less than ₹2.5 lakhs annually does not fall under any income tax slab. People having
this earning do not need to pay direct tax. However, they pay our government indirect tax and
contribute to the development of our country.

Disadvantages of Indirect Taxes

Along with the bright sides, this tax comes with some drawbacks. Below are some
1. Regressive Nature

This tax remains regressive to some extent even after the introduction of the Goods and Services
Tax. The tax on a commodity or service is the same for all, disregarding the poor or rich. This
makes commodities expensive for a poor person and affects his net operating income.
2. Cumulative Nature

Charging this tax sometimes works cumulatively. Intermediaries tend to charge high tax at every
point of transactions, from raw material to the finished product. This increases the price of a
commodity.
3. Unfavourable for Industries

One of the demerits of indirect tax is it is not favourable for rising industries. As discussed in the
previous pointer, intermediaries charge high on the raw material. This leads to a cost of production
that discourages industries from expanding.
What Are Some Examples of Indirect Taxes?

Some examples of indirect tax are service tax, sales tax, central sales tax, state excise duty,
countervailing duty, octroi and entry tax, purchase tax.

Hopefully, the above discourse on indirect taxes' types, features, and pros and cons has helped you
gain a clear idea. Keep the above pointers in mind when dealing with payment of any of these tax
types.
Causes Producing Disequilibrium in the Balance of Payments of a Country

Causes producing disequilibrium in the balance of payments of a country are: 1. Trade Cycles 2.
Huge Developmental and Investment Programmes 3. Changing Export Demand 4. Population
Growth 5. Huge External Borrowings 6. Inflation 7. Demonstration Effect 8. Reciprocal Demands!

Disequilibrium in a country’s balance of payments position may arise either for a short period or
for a long period.

Any disequilibrium in the balance of payments arises owing to a large number of causes or factors
operating simultaneously. Types of disequilibrium differ from country to country, while the
different kinds of disequilibrium and their causes in the same country will differ at different times.

However, following are the important causes producing disequilibrium in the balance of
payments of a country:
1. Trade Cycles:
Cyclical fluctuations, their phases and amplitudes, differences in different countries, generally
produce cyclical disequilibrium.

2. Huge Developmental and Investment Programmes:

Huge development and investment programmes in the developing economies are the root causes
of the disequilibrium in the balance of payments of these countries. Their propensity to import
goes on increasing for want of capital for rapid industrialisation; while exports may not be boosted
up to that extent as these is the primary producing countries.
Moreover, their exports quantum of primary commodities may decline as newly-created domestic
industries may require them. Thus, there will be structural changes in the balance of payments and
structural disequilibrium will result.

3. Changing Export Demand:

A vast increase in the domestic production of foodstuffs, raw materials, substitute goods, etc. in
advanced countries has decreased their need for import from the agrarian underdeveloped
countries. Thus, export demand has considerably changed, resulting in structural disequilibrium in
these countries.

Similarly, advanced countries also will suffer in their exports as a result of loss of their markets in
developing countries owing to the tendency of the poor nations for self-reliance and their ways
and means of curtailing their imports. But disequilibrium (deficit) in balance of payments seems
to be more persistent in the underdeveloped or developing nations than in the advanced rich
nations.

4. Population Growth:
High population growth in poor countries also had adversely affected their balance of payments
position. It is easy to see that an increase in population increases the needs of these countries for
imports and decreases the capacity to export.

5. Huge External Borrowings:

Another reason for a surplus or deficit in the balance of payments arises out of international
borrowing and investment. A country may tend to have an adverse balance of payments when it
borrows heavily from another country, while the lending country will tend to have a favourable
balance and the receiving country will have a deficit balance of payments.

6. Inflation:
Owing to rapid economic development, the resulting income and price effects will adversely affect
the balance of payments position of a developing country. With an income, the marginal propensity
to import being high in these countries, their demand for imported articles will rise.
Since marginal propensity to consume is also high in these countries, people’s demand for
domestic goods also will rise, and hence less may be spared for export. Moreover, a huge
investment in heavy industries in the developing countries may have an inflationary impact, as the
output of these industries will not be forthcoming immediately, whereas money income will have
been already expanded.

Thus, there will be an excess of monetary demand for goods and services in general which will
push up the price levels. A rise in the comparative price level certainly encourages imports and
discourages exports, resulting in a deficit balance of payments.

7. Demonstration Effect:
Demonstration effect is another most important factor causing deficit in the balance of payments
of a country — especially of an underdeveloped country. When people of underdeveloped nations
come into contact with those of advanced countries through economic, political or social relations,
there will be a demonstration effect on the consumption pattern of these people and they will desire
to have western style goods and pattern of consumption so that their propensity to import increases,
whereas their export quantum may remain the same or may even decline with the increase i in
income, thus causing an adverse balance of payments for the country.

8. Reciprocal Demands:
Since intensity of reciprocal demand for products of different countries differs, terms of trade of a
country may be set differently with different countries under multi-trade transactions which may
lead to disequilibrium in a way.

How Is Disequilibrium Resolved?

Disequilibrium is a result of a mismatch between the market forces of supply and demand. The
mismatch is generally resolved through market forces or government intervention.

In the example of the labor market shortage above, the excess labor supply situation can be
corrected either through policy proposals that address unemployed workers or through a process
of investment in training workers to make them fit for new jobs. Within a market, innovations in
manufacturing or supply chain, or technology can help address imbalances between supply and
demand.

For example, suppose the demand for a company's product has receded due to its expensive price.
The company can regain its share of the market by innovating its manufacturing or supply chain
processes for a lower product price. The new equilibrium, however, might be one where the
company has a greater supply of its product in the market at a lower price.

Measures to correct disequilibrium in BOP:

Sustained or prolonged deficit has to be settled by short term loans or depletion of capital
reserve of foreign exchange and gold.

Following remedial measures are recommended:

(i) Export promotion:

Exports should be encouraged by granting various bounties to manufacturers and exporters.

At the same time, imports should be discouraged by undertaking import substitution and
imposing reasonable tariffs.

(ii) Import:

Restrictions and Import Substitution are other measures of correcting disequilibrium.

(iii) Reducing inflation:

Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore,
government should check inflation and lower the prices in the country.

(iv) Exchange control:

Government should control foreign exchange by ordering all exporters to surrender their
foreign exchange to the central bank and then ration out among licensed importers.

(v) Devaluation of domestic currency:

It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign
exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a
government order when a country has adopted a fixed exchange rate system. Care should be
taken that devaluation should not cause rise in internal price level.

(vi) Depreciation:

Like devaluation, depreciation leads to fall in external purchasing power of home currency.
Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds
the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation
is done in fixed exchange rate system.)

The economics of zakat

How zakat can redistribute wealth in society and alleviate poverty, hunger and other social
ailments

Zakat is one of the five pillars of Islam. It is a compulsory procedure for Muslims earning above a
certain threshold and should not be confused with Sadaqah, the act of voluntarily giving charitable
gifts out of kindness or generosity, and with Awqaf, the permanent dedication by a person
professing Islam of any movable or immovable property for any purpose recognized by Muslim
Law as pious, religious or charitable.

Zakat is said to purify yearly earnings that are over and above what is required to provide for the
essential needs of a person or family. zakat is based on income and the value of possessions.

The common minimum amount for those who qualify is 2.5% or 1/40 of a Muslim's total savings
and wealth. If personal wealth is below the nisab during one lunar year, no zakat is owed for that
period.

One of the most profound aspects of Islam is that it takes human dignity very seriously.
Distributing zakat is not handing out charity to the poor. Instead, it is essentially a due for the poor
from the rich ( the have –nots have a rightful share of the wealth of the rich – Al Quran)
In this way, zakat is a powerful tool to help re-circulate wealth to those most vulnerable, many of
whom are experiencing poverty at no fault of their own, but due to their unfortunate circumstances,
such as lack of access to resources because of poverty, war and other adverse circumstances.

Accordingly, zakat may be regarded as a social security system in Islam. Further, zakat means
purification and growth as it washes away the greed and the acquisitive orientation of the rich.
According to the Quran:

Indeed, [prescribed] charitable offerings are only [to be given] to the poor and the indigent, and
to those who work on [administering] it, and to those whose hearts are to be reconciled, and to
[free] those in bondage, and to the debt-ridden, and for the cause of God, and to the wayfarer.
[This is] an obligation from God. And God is all-knowing, all-wise. - Al-Tawbah, 9:60.

According to the above testament of the Quran following eight are the categories of recipients of
zakat

1. The poor (al-fuqarâ'), meaning low-income or indigent.

2. The needy (al-masâkîn), meaning someone who is in difficulty.
3. zakat administrators.
4. Those whose hearts are to be reconciled, meaning new Muslims and friends of the Muslim
community.
5. Those in bondage (slaves and captives).
6. The debt-ridden.
7. In the cause of God.
8. The wayfarer, meaning those who are stranded or travelling with few resources.

So, zakat can be an effective mechanism to achieve sustainable development by reducing social
problems and boosting economic activities. Some of the social and economic benefits of zakat are
as follows.

(1) It gives hope to those who may feel hopeless;

(2) It ensures redistribution of wealth;

(3) Zakat restores and establishes human dignity;

(4) Zakat reduces poverty;

(5) Zakat provides financial help by way of food, shelter and clothes;

(6) It provides assistance and support for those in severe debt;

(7) It prevents the poor from resorting to unlawful or illegal means to earn a living;

(8) It helps bridge the gap between the rich and poor;

(9) It discourages hoarding of wealth;

(10) Eliminates social conflicts;

(11) Establishes collective ownership;

(12) Establishes social security

With a focus on alleviating poverty, zakat can be a solution, locally, nationally and globally. It is
a powerful institution for contributing to sustainable development in communities worldwide. An
estimated $200 Billion to $2 Trillion of zakat is generated each year and circulates the world. In
this way, zakat has the potential to alleviate hunger, thirst, and poverty.

The key takeaway from the above discussion is that wealth distribution can solve very real
problems. This is precisely what zakat achieves. It's a small percentage of 2.5% that may be small
to you but put together it is extremely powerful.

The modern approach to zakat institution is a significant economic and social instrument for the
poverty alleviation and stability of the Muslim ummah. In this context, the zakat institution is to
serve as a pool of resources for the economic and social development of the ummah beginning
with those who are most needy.
In this regard, zakat funds can be utilised for the development of resources especially concentrated
in the area of human capital development for the long-term rather than short-term relief for those
in need and at the same time, prevent the zakat revenues from diversion to undesired. zakat
management institutions should aim at using zakat funds as a means of providing assistance that
will have a long-lasting effect. zakat institutions should have long-term programmes to teach the
poor and needy know how to catch fish rather than every year they merely provide them with fish
to eat.

Question

Find the mean and variance for the data 6,7,10,12,13,4,8,12

Solution

Verified by Toppr

Given date is, 6,7,10,12,13,4,8,12

Mean ¯x=∑8i=1xin=6+7+10+12+13+4+8+128=728=9
Now,

xi (xi−¯x) (xi−¯x)2

6 -3 9

7 -2 4

10 -1 1

12 3 9

13 4 16

4 -5 25
8 -1 1

12 3 9

74

∴ Variance (σ2)=1n8∑i=l(xi−¯x)2=18×74=9.25
Measurement of Economic Development

Generally, economic development is a process of change over a long period of time.

Though there are several criteria or principles to measure the economic development, yet none
provides a satisfactory and universally acceptable index of economic development.

Hence, it is a complex problem to answer about the measuring of economic development.

R.G. Lipsey maintains that there are many possible measures of a country’s degree of
development, income per head, the percentage of resources unexploited, capital per head,
saving per head and amount of social capital. But more commonly used criteria of economic
development are increase in national income, per capita real income, comparative concept,
standard of living and economic welfare of the community etc.

Let us make a detailed study of these measurements for better understanding:

1. National Income as an Index of Development:

There is a group of certain economists which maintains the growth of national income should
be considered most suitable index of economic development. They are Simon Kuznets, Meier
and Baldwin, Hicks D. Samuelson, Pigon and Kuznets who favored this method as a basis for
measuring economic development. For this purpose, net national product (NNP) is preferred
to gross national product (GNP) as it gives a better idea about the progress of a nation.

According to Prof. Meier and Baldwin, “If an increase in per capita income is taken as the
measure of economic development, we would be in the awkward position of having to say
that a country had not developed if its real national income, had risen but population had also
risen at the same rate.”

Similarly, Prof. Me de maintains that, “Total income is a more appropriate concept to measure
welfare than income per capita.” Therefore, in measurable economic development, the most
appropriate measure will be to include final goods and services produced but we must allow
for the wastage of machinery and other capital goods during the process of production.

Arguments in Favour of National Income:

There are certain arguments for stressing real national income as a measurement of economic
development.

They are:

(i) A larger real national income is normally a pre-requisite for an increase in real per capita
income and hence, a rising national income can be taken as a token of economic development.

(ii) If per capita income is used for measuring economic development, the population problem
may be concealed, since population has already been divided out. In this context, Prof. Simon
Kuznets writes, “The choice of per capita, per unit or any similar measure to gauge the rate
of economic growth carried with it danger of neglecting the denominator of the ratio.”

(iii) If an increase in per capita income is taken as the measure of economic de velopment, we
are likely to be put in an awkward situation of saying that a country has not developed if its
real national income has increased but its population has also increased at the same rate.

Arguments against National Income:

Despite the favorable arguments, national income as a measure of economic development

suffers from certain shortcomings:

(i) It cannot definitely be said that economic welfare has increased if the national and even
the per capita income may be rising unless the distribution of income is equitable.
(ii) Expansion of national and per capita income cannot be identified with enrichment because
the composition of the total output is also important. For example, an expansion of total output
could be accompanied by a depletion of natural resources or it could compose of only
armaments or could consist of merely a greater output of capital goods.

(iii) It must not only consider what is produced but also how it is produced. It is possible that
when real national output grows, the real costs i.e., ‘pain and sacrifice’ of the society may
also grow.

(iv)It is difficult to determine proper deflators to eliminate the effects of price changes in an
underdeveloped country.

(v) It is also complicated when average income is rising but unemployment exists due to the
rapid growth of population, thus, such a situation is not consistent with the development.

2. Per Capita Real Income:

Some economists believe that economic growth is meaningless if it does not improve the
standard of living of the common masses. Thus, they say that the meaning of economic
development is to increase aggregate output. Such a view holds that economic development
be defined as a process by which the real per capita income increases over a long period time.
Harvey Leibenstein, Rostow, Baran, Buchanan and many others favour the use of per capita
output as an index of economic development.

The UNO experts in their report on ‘Measures of Economic Development of Under-developed

Countries’ have also accepted this measurement of development. Charles P. Kindleberger also
suggested the same method with proper precautions in computing the national income data.

Arguments in favour of per Capita Real Income:

The aim of economic development is to raise the living standard of the people and through
this to raise consumption level. This can be, estimated through per capita income rather than
national income. If national income of a country goes up but the per capita income is not
increasing, that will not raise the living standard of the people. That way, per capita income
is a better measure of economic development than the national income.

The increase in per capita income is a good measure of economic development. In the
advanced countries, per capita income has been on continuous increases because the growth
rate of national income is greater than the growth rate of population. This has raised the
economic lot of the people. In underdeveloped countries, there is very less capacity to produce
per head. So, as the capacity to produce goes up these economies proceed towards economic
development.

Increase in per capita income can be better index of an increase in the welfare of the people.
In advanced countries, national income has increased much faster than the growth rate of
population. It means the per capita real income has been constantly increasing and this has
led to the increase in welfare of the people. That way, per capita income can be considered a
better index of the welfare of the people.

Arguments against Per Capita Real Income:

The real per capita income, a measure of economic development has been severely criticized
by Jacob Viner, Kuznet etc.

(a) According to Meier and Baldwin, “If an increase in per capita income were taken as the
measure of development, we would be in the awkward position of having to say that a country
had not developed if its real national income had risen, but population has also risen at the
same time.”

If in a country an increase in national income is offset by the increase in population, then we

would be bound to say that no economic development has taken place. Similarly, if national
income in a country has not gone up but population has reduced due to epidemic or war, in
that case we would be bound to conclude that economic development is taking place.

(b) When we divide national income by population, the problem of population in that case is
ignored. It confines the scope of the study.
(c) In this measure, distributive aspect has been ignored. If national income goes up but there
is unequal distribution of income among different sections of the society, in that case rise in
national income will be meaningless.

(d) In the underdeveloped countries where per capita income is regarded as a measur e of
economic development, with the increase in per capita income of these countries, there is also
increase in unemployment, poverty and income inequalities. This cannot be regarded as
development.

(e) Economic growth is multi-dimensional concept which involves not only increase in money
income but also improvement in social activities like education, public health, greater leisure
etc. Such improvements cannot be measured by changes in per capita real income.

(f) The data of per capita national income are often inaccurate misleading and unreliable
because of imperfections in national income data, and its computation. That way, per capita
real income cannot be free from weaknesses. Despite these drawbacks in the measure of real
per capita income, many countries have adopted this measure as an indicator of economic
development.

3. Economic Welfare as an Index of Economic Development:

Keeping in view the drawbacks of real national income and real per capita measures of
economic development, some economists like Coline Clark, Kindleberger, D. Bright Singh,
Hersick etc. suggested economic welfare as the measure of economic development.

The term economic welfare can be understood in two ways:

(a) When there is equal distribution of national income among all the sections of the society.
It raises economic welfare.

(b) When the purchasing power of money goes up, even then there is an increase in the level
of economic welfare. The purchasing power of money can go up when with the increase in
national income there is also increase in the prices of goods. That means economic welfare
can increase if price stability is ensured.

Thus economic welfare can boost with equal distribution of income and price stability. Higher
the level of economic welfare, higher will be extent of economic development and vice-versa.

Arguments against Welfare Index:

In order to assess economic welfare, it is essential to know the nature of national income and
the social cost of production. We face lot a practical difficulty while estimating these
economic factors. It is on account of this reason that many economists do not consider
economic welfare as a good measure of economic development. Also the concept of welfare
is subjective in nature which cannot be measured. Also welfare is a relative term which differs
from person to person.

4. Comparative Concept:

Economic development is a comparative concept and it can easily be understood and

measured. In a simple way, from comparative concept, we can ascertain how much the
economic development has been attained in a country.

The comparison can be made by two methods over time period:

(а) Comparison within the country.

(b) Comparison with other countries.

(a) Comparison within the Country:

To compare the economic development of a country over time, we will have to consider the
long period and divide it into different phases. For instance, national income in 1990 is Rs.
1,000 crores which rose to Rs, 1,200 crores in 1995 and Rs. 1,800 crores in 2000.
In 2000, it has been registered of amounting Rs. 2,250 crores. Therefore, within the period of
five years i.e., from 1990 to 1995 national income increases to the extent of 20 percent
(200×100/1000=20%). Form 1995-2000, it rose to 50 percent (600×100/1200) and from 1995-
2000, it rose 25 percent (450×100/1800=25%). This can also be drawn with the help of
diagram.

The above stated figure exhibits that national income in 1990 was Rs. 1,000 which rose to Rs.
1,200 crores in 1995 and Rs. 1,800 crores in 2000: Therefore, rise in national income over
five years period is 20 percent, 50 percent and 25 percent respectively.

(b) Comparison with Other Countries. In this Figures 2 time, is shown on the horizontal axis
and national income on vertical axis OY. The curve PP’ depicts the path of development
(showing slow rise in income) of country MM’ curve shows the path of development of
country B.
In the beginning of the time periods, country B is at a much higher level of national income
than country A.But in the meanwhile, the rate of development of country A becomes higher
than rate of development of country B. At point E i.e., time period 5, national incomes of both
the countries are equal.

In the long run or after time interval, national income of country A becomes higher than of
country B. In this way, we can say that country A is more developing economy and country
B is a comparatively decaying economy.

5. Measurement through Occupational Pattern:

The distribution of working population in different occupations is also regarded as a c riteria

for the measurement of economic development. Some economists regard the changes in the
occupational structure as a source for measuring the nature of economic development.
According to Colin Clark there is deep relation between the occupational structure and
economic development. He has divided the occupational structure in three sectors.

(1) Primary Sector:

It includes agriculture, fisheries, forestry, mining etc.

(2) Secondary Sector:

It consists of manufacturing, trade, construction etc.

(3) Tertiary Sector:

It includes services, banking, transport, etc. In under-developed countries, majority of the

working population in engaged in primary sector. On the contrary, in developed countries the
majority of the working population works in tertiary sector.

A shift in occupational distribution of population from primary sector to secondary and

territory sectors shows the movement towards economic development when a country makes
economic progress, its working population begins to shift from primary sector to secondary
and tertiary sectors. Thus, with economic development the percentage of population engaged
in primary sector declines, while the percentage of population working in secondary and
tertiary sectors increases.

Here we should note that the measurement of economic development through

occupational patterns is not considered as satisfactory on following grounds:

(i) It is not possible to clearly classify the occupations in an underdeveloped economy in three
distinct categories

(ii) Secondly, in the early stages of development, the activities of tertiary sector like transport,
communications, trade etc. are inadequate and insufficient. Consequently the chances of
employment in these activities are very restricted.

6. Standard of Living Criterion:

Another method to measure economic development is the standard of living. According to

this view, standard of living and not rise in per capita income or national income should be
considered an indicator of economic development. The very objective of developmen t is to
provide better life to its people through improvement or upliftment of the standard of living.
In other words, it refers to increase in average consumption level of the individual. But, this
criteria is not practicably true.

Let us suppose, national income and per capita both increase but the government mops up this
income with the way of heavy dose of taxation or compulsory deposit scheme or any other
method, in such a situation, there is no possibility to raise to average consumption level i.e.,
standard of living.

Moreover, in poor countries, propensity to consume is already high and stern efforts are made
to reduce superfluous consumption in order to encourage savings and capital formation. Again
‘standard of living’ is also subjective which cannot be determined with objective criterion.

Which is the Best Measure of Economic Development?

After studying all the above methods of measurement of economic development we are likely
to be confused and the question might arise as to which of the above measures of economic
development is the best. Answer depends on the objective of measuring economic
development. However, after considering form different point of view it may be concluded
that GNP or per capita is the best method of measuring economic development.

In the words of Prof. R.G. Lipsey, “Whatsoever changes there may be in future in the
measurement of economic development they cannot fully replace gross national product
(GNP).” Economists and U.N. Organisations use GNP per capita as the measurement of
economic development.

The vicious circle of poverty leads to underdevelopment. how can a country get rid of this
circle?

Vicious circle of poverty implies that poverty is the cause of poverty.

A poor person, in order to repay his existing debt, will borrow some more, thereby adding to his
debt. Further, he will also incur interest payment obligations. This will only increase his total
amount of debt. He is also likely to pass on this debt to his children, who will remain caught in
this poverty trap. Poor people tend to remain poor and pass on the poverty situation to the future
generations.

Poverty is a great curse in the world for which our beloved Prophet Hazrat MUHAMMAD
(SAW) also asked ALLAH to save him. It is the major barrier in the way of economic
development. Poverty cannot be described, it can only be felt. Ranger Nurkse in his “Problems of
Capital Formation in Underdeveloped Countries” states that: “Vicious circle of poverty is the
basic cause of under-development of poor countries.”

Definitions:

According to R. Nurkse:

“The less developed countries remain poor due to domestic obstacles. These obstacles act and react
upon one another in such a way that they form a vicious circle. They keep the country in a perpetual
low level of development.”

According to Meier and Baldwin:

“A country is poor and remains poor because its human and natural resources remain unutilized.
People in less developed countries are mostly technologically backward. They are illiterate, lack
initiative and entrepreneurial ability. The absence of skilled and trained labour leads to under-
utilization and even mis-utilization of natural resources. A country is poor because it is caught up
in under-development trap.”

Explanation:

Now we can say a country is poor because it is poor. Vicious circle of poverty can be
explained with the help of a simple example to prove that a country is poor because it is poor.

Simple Example:

A poor man may not have enough to eat, being under-fed, his health may be weak, being
physically weak, his working capacity is low, this will give him less return which means that he is
poor, all this means that he will not have enough to eat and so on.

How is Vicious Circle of Poverty Created?

Accordingly, a country is poor because it is poor. Being poor, a country has little ability to
save. The low level of saving leads to low level of investment and to deficiency of capital. When
the productivity is low, the income will be low and so there is poverty and the vicious circle is
complete.

MEASURES TO REMOVE VICIOUS CIRCLE OF POVERTY

A. ECONOMIC MEASURES

1- Raising the Stock of Capital and Foreign Exchange

There is deficiency of saving, investment and foreign exchange reserves in Pakistan. To

increase the saving and investment, various steps of government are required. Increase in saving,
investment and foreign exchange reserves will lead to capital formation; it results in removal to
vicious circle of poverty. Domestic saving is 9.9 % of GDP; total investment is 16.6 % of GDP
and foreign exchange reserves are $ 15.0 billion in Pakistan.
2- Control on rapidly growing Population

Pakistan is facing a serious problem of backward over population. Control on rapidly

growing population is another measure to break the vicious circle of poverty. Total population of
Pakistan is 169.94 million, its fast growth rate is 2.05 % and Pakistan is at 6th number at the chart
of most populous nations.

3- Use the Advanced Technology

Most of the developing countries use backward techniques of production. To make rapid
economic development, it is necessary to adopt advanced technology. To break the vicious circle
of poverty, we should use the modern methods of production in all the sectors of economy.

4- Check the Inflation

Due to inflation, the purchasing power of people decreases, it leads to increase in the
consumption proportion and decrease the saving. This whole situation causes to create vicious
circle of poverty. In developing countries like Pakistan, the purchasing power of the people is low
due to high rate of inflation. Rate of inflation is 13.3 % in Pakistan. To break the vicious circle of
poverty, there should be price stability in the country.

5- Optimum Use of Natural Resources

No doubt, natural resources are available in developing countries. But it is not possible for
them to use these resources in the best way. The best possible use of natural resources is necessary
to remove the vicious circle of poverty. Contribution of natural resources to GDP is just 0.8 % and
forest area in Pakistan is 4.21 % of the total area in Pakistan.

6- Reduce the Burden of Internal and External Debts

Government has to pay a huge amount for services charges on internal and external debts
in developing nations. Due to external debts, the development plans and polices are under the
influence of external forces. Accordingly, self-reliance policy should be adopted and we should
reduce the dependence on debts. Today, the burden of total internal debts on Pakistani economy is
Rs. 8160 billion and external debts are $ 53.9 billion.

7- Balanced Growth Strategy

 Balanced growth strategy refers to the growth of the various sectors at the same time.
Vicious circle of poverty operates over all the sectors of an economy. Development of any one
sector cannot remove the vicious circle of poverty. Balanced growth strategy is compulsory to
remove the vicious circle of poverty. There is inter-relationship between agriculture and industrial
sector. So, growth and development of both is necessary to check the vicious circle of poverty.

8- Enhance the Economic Growth Rates

Vicious circle of poverty can be checked through increasing the economic growth rates.
Increase in economic growth rate refers to the growth and development of economy. Economic
growth and development will cause progress and prosperity in the country. All this results in
removal of vicious circle of poverty. At present, real GDP growth rate of Pakistan is just 4.1 %.

9- Surplus in Balance of Payment

Since partition, Pakistan is facing the deficit in its balance of payment (but only in five
years) that is also caused in creation of vicious circle of poverty. To break the vicious circle of
poverty, surplus in balance of payment is needed. By increasing exports and decreasing imports
we can achieve surplus in balance of payment. During July-March 2010, exports are $ 14.162
billion and imports are $ 25.107 billion in Pakistan. Accordingly, deficit in balance of payment is
$ 10.945 billion.

10- Reduction in Unemployment

The major reason of poverty is unemployment. Government should start those projects and
install those industries, which are labour intensive. Maximum job opportunities will be provided
to population to remove the vicious circle of poverty. Rate of unemployment in Pakistan is 5.5 %,
under-employment is 16 % and disguised unemployment is 20 %.

11- Denationalization

It is the common observation that in developing countries like Pakistan, the state owned
enterprises are facing the problem of continuous loss. These losses are due to some internal
problems. Those institutions, which are facing loss, should be denationalized to increase the
efficiency and to reduce the burden on economy. Nationalization policy was adopted according to
Nationalization Act of 1974.
B. SOCIAL MEASURES

12- Islamic Economic System

Islamic economic system is the best economic system all over the world. Vicious circle of
poverty easily can be removed by adopting the Islamic economic system. This system is very
useful to reduce consumption, to increase investment, to remove corruption and unequal
distribution of income and wealth.

13- Remove the Illiteracy

Literacy rate in Pakistan is only 57 %, which is almost 100 % in developed countries. Due
to illiteracy, we have shortage of skilled and trained people. To remove the vicious circle of
poverty, we have to increase the literacy rate.

14- Discourage the Joint Family and Caste System

Most of the population is connected with the joint family and caste system in developing
countries like Pakistan. Due to joint family system, people sometimes, do not take interest in their
separate business activities. People prefer only those jobs, which are according to their caste in
caste system.

15- Reduction in Unproductive Expenditure

Unproductive expenditure is a social evil. In Pakistan, people not only spend more on
customs and traditions but also sometime they have to borrow to perform the customs and
traditions. People spend a large portion of their income on litigations, marriage, birth and death
occasion which reduces their savings.

16- Reduction in Consumption

Due to international demonstration effect, our population wants to copy the life styles of
the rich nations. In this way, they allocate the huge portion of their income to adopt the life styles
of rich nations. In this way the consumption of population is very high and saving is very low. To
remove the vicious circle of poverty, it is necessary to reduce the consumption.
17- Provision of Infrastructure

Basic infrastructure is necessary for economic development. Provision of roads, transports,

communications etc. will encourage the economic development. In this way vicious circle of
poverty can be broken. Government has allocated an amount of Rs. 133 billion to improve the
infrastructure.

18- Fair Distribution of Wealth

To remove the vicious circle of poverty, suitable income and wealth distribution is compulsory.
In developing countries, the gap between haves and haves not is increasing day by day. Due to
unequal distribution of wealth, poor population remains away from economic activities and it
results in creation of vicious circle of poverty. In Pakistan, 50 % national resources are in the
possession of 20 % population. On the other hand 20% poor population has only 6.37 % national
resources.

C. CULTURAL AND POLITICAL MEASURES

19- Save the Resources from Litigations

Most of the population especially in rural areas is facing the problem of litigations in
developing countries like Pakistan. They are wasting resources in litigations. It is unproductive
use of income and reduction in saving and investment. Saved resources from litigations can be
utilized to break vicious circle of poverty.

20- Check on Out-flow of the Best Brain

To remove the vicious circle of poverty, expert staff, trained labour and efficient
management is required. But in developing countries, there is an out-flow of the best and talented
brain. A country has to check on out-flow of the intelligent people to break the vicious circle of
poverty.

21- Increase in the Efficiency of Entrepreneur

 Spreading education and training institutions can improve efficiency of entrepreneur.
Efficient entrepreneur is helpful to break the vicious circle of poverty.

22- Political Stability

Political stability is essential for the development of any country. In developing countries
like Pakistan, there is political instability and the policy instability of the stable government. To
get free from the vicious circle of poverty, political stability is needed.

23- Stable Fiscal Policy

To remove the vicious circle of poverty, stability of fiscal policy is essential. Due to change
in tax structure, consumption pattern of people is affected. If government reduces the taxes, it will
cause to increase in real income, more saving and investment. It will cause to remove the vicious
circle of poverty.

Conclusion:

VCP is the major obstacle in way of economic development. Without its removal,
economic development is impossible. It can be removed through adopting self-sufficient policy.
Government should adopt labour intensive technologies to remove unemployment and poverty.

1. The solution to the supply side of the vicious circle: An increase in savings and investments should
be done. A solution to the demand-side vicious circle: The extent of the market should be widened
so that people invest more. Proper Use of Natural Resources :- The developing countries can
achieve rapid economic. ...

How to Break these Circles?

As it is stated that “a country is poor due to its poor policies”, to break these circles of poverty and
don’t let them severe, LDCs can adopt following measures:

1. Savings:
The root cause of vicious circle of poverty is low savings level in LDCs. Vicious circles can be
broken by making efforts to increase the volume of saving both at individual and government level.

Strong monetary and fiscal measures can be helpful to raise the level of domestic and foreign
saving to meet the capital requirements for investment.

2. Role of State:

It is also the responsibility of Govt. to break these circles. Government should make serious effort
to break these circles by providing employment opportunities to their citizens. Government should
plan and takes certain steps to uplift the employment level to enhance the income level.

3. Utilization of Natural Resources:

LDCs are not getting the full benefit from their available natural resources. These resources either
are not being fully utilize or misused in LDCs due to number of obstacles. To prevent economy
from the problems of V.C.P., optimum utilization of available natural resources should be ensured.

4. Human Resources:

In LDCs shortage of human resources such as doctor, engineers, teachers. writers etc. is one of the
primary cause of poverty. Due to poor education of health facilities and shortage of training
institutions, LDCs are facing problems of human capital shortage.

Effective measures are required lo bridge up the deficiency of human capital to raise their income
and living standards. Raising income level will increase the per capita income and saving level in
the country that will be helpful in breaking circles of poverty.

5. Rode of Technology:

Technology plays vital role in the way of economic progress of a country. Government should
make affective arrangements to provide facilities of modern technology for mass production to
break these circles of poverty.

6. Role of Advanced Nations:

Advanced nations can help the LDCs to break these circles by providing them economic assistance
in the form of soft loan, and aid for social sector. Foreign aid should be used very carefully to
create employment for the nations to raise their income, spending and saving levels. This process
will provide greater help to break these circles.

7. Reducing Population Growth Rate:

High population growth rate is also one of the main features of developing countries. High
population growth rate reduces the per-capita income and creates many economic and non-
economic problems in the society.

Government should take appropriate measures to retard the rapid growth rate in population to rise
the per capital income and to prevent society from many other non-economic problems which is
necessary to break these circles.

8. Awareness:

Financial institutions should properly propagate their schemes to develop awareness among
people. Majority of our population lives in rural areas. People in rural as hoard money and make
it stagnant, saving schemes should be started in these areas to mobilize these resources for
investment.

9. Political and Social Contribution:

Most important to break vicious circle of poverty are political stability, constant Policies, honest
and efficient administration etc. Planners should make effective economic plans. Government
should perform its duties purely for the best of nation to achieves the targets of growth and
development.

Conclusion:

V.C.P. is the major obstacle in way of economic development. Without its removal, economic
development is impossible. It can be removed through adopting self-sufficient policy. Government
should adopt labour intensive technologies to remove unemployment and poverty.
write a note on different sources of capital formation

Capital formation refers to the process of increasing the stock of real capital in an economy. It is
essential for economic growth and development. The main sources of capital formation are:

1. Savings: Savings are the most important source of capital formation. When people save a
portion of their income, it is invested in productive assets, which leads to capital formation.
2. Investment: Investment refers to the purchase of new capital goods, such as machinery,
equipment, and buildings. Investment increases the stock of capital in an economy, leading
to economic growth.
3. Public borrowing: Governments can borrow money from the public to finance capital
projects, such as infrastructure development. This form of capital formation is known as
public borrowing.
4. Foreign investment: Foreign investors can invest in a country's economy, providing a
source of capital formation. This can be in the form of direct investment or portfolio
investment.
5. Retained earnings: When companies retain a portion of their profits instead of distributing
them as dividends, it can be used to finance capital projects and lead to capital formation.
6. Depreciation: When existing capital assets wear out or become obsolete, they need to be
replaced with new capital goods. The process of replacing these assets is known as
depreciation, and it contributes to capital formation.

Overall, the sources of capital formation are diverse and can be classified into two categories:
internal sources (such as savings, retained earnings, and depreciation) and external sources (such
as foreign investment and public borrowing).

The main sources of capital formation are:

Savings: Personal and corporate savings can be used to fund capital formation. When individuals
or businesses save a portion of their income, they can use that money to invest in capital goods or
to lend it to others who need it for their own capital formation projects.

Investments: Investments can take many forms, including stocks, bonds, mutual funds, and real
estate. When investors purchase these assets, they are providing capital to the companies or entities
that issue them, which can be used for capital formation.

Government Expenditures: Governments can contribute to capital formation through infrastructure

spending, such as building roads, bridges, and other public works. This spending can stimulate
economic growth by providing better transportation and communication systems, which can attract
businesses and encourage investment.

Foreign Investment: Foreign investors can contribute to capital formation in a country by investing
in local businesses or purchasing local assets. This can bring new capital into the country and help
fund new projects.

Bank Loans: Banks provide loans to individuals and businesses that need capital for investment or
expansion. This can be an important source of capital formation, as it allows borrowers to access
funds that they may not have otherwise.

Retained Earnings: When companies earn profits, they can reinvest those earnings into the
business for capital formation. This can include purchasing new equipment, expanding facilities,
or hiring more employees.
Overall, these sources of capital formation are essential for economic growth and development, as
they allow individuals, businesses, and governments to invest in the future and create new oppo

rtunities.

What Is Capital Formation?

Capital formation is the net capital accumulation during an accounting period for a particular
country. The term refers to additions of capital goods, such as equipment, tools, transportation
assets, and electricity.

KEY TAKEAWAYS

 Capital formation is the net accumulation of capital goods, such as equipment, tools,
transportation assets, and electricity, during an accounting period for a particular country.
 Generally, the higher the capital formation of an economy, the faster an economy can
grow its aggregate income.
 To accumulate additional capital, a country needs to generate savings and investments
from household savings or based on government policy.
 When investors purchase stocks and bonds issued by corporations, the firms can put the
capital at risk to increase production and create new innovations for consumers.
 The World Bank tracks gross capital formation, which it defines as outlays on additions
to fixed assets, plus the net change in inventories.

Understanding Capital Formation

Countries need capital goods to replace the older ones that are used to produce goods and services.
If a country cannot replace capital goods as they reach the end of their useful lives, production
declines. Generally, the higher the capital formation of an economy, the faster an economy can
grow its aggregate income.
Producing more goods and services can lead to an increase in national income levels. To
accumulate additional capital, a country needs to generate savings and investments from
household savings or based on government policy. Countries with a high rate of household
savings can accumulate funds to produce capital goods faster, and a government that runs
a surplus can invest the surplus in capital goods.

The higher the capital formation, the faster an economy can grow its aggregate income.

Example of Capital Formation

Caterpillar is one of the largest producers of construction equipment in the world. It produces
equipment that other companies use to create goods and services.

Caterpillar (CAT) is a publicly traded company and raises funds by issuing stock and debt. If
household savers choose to purchase a new issue of Caterpillar common stock, the firm can use
the proceeds to increase production and develop new products for the firm’s customers.

When investors purchase stocks and bonds issued by corporations, the firms can put the capital
at risk to increase production and create new innovations for consumers. These activities add to
the country’s overall capital formation.

Explaining Pakistan’s balance of payments crisis: A comparative analysis

A look at some of Pakistan's trade metrics in comparison with its regional peers.

Pakistan is in the midst of another economic crisis, negotiating yet another bailout package from
the International Monetary Fund (IMF).

Bailout packages come with a large price tag as they increase the financial burden on the
population through various measures. The government also attaches a promise of redemption on
the tough road to recovery, terming the reforms a necessity to stabilise a tailspinning economy.

While some may point to the unending political crisis that has surely exacerbated our economic
meltdown, the rot goes much deeper.
As we begin to understand why Pakistan has ended up in such a dire situation, while its regional
peers are doing well, it is essential to study the country’s relationship with international trade.

The roots of the crisis

Foreign exchange reserves held by the State Bank of Pakistan dipped to $2.9 billion on 3rd
February 2023 from a peak of $20.1 billion in August 2021. Such low levels of foreign exchange
reserves raise alarm bells as investors and currency speculators fear imminent risk of an economic
default. This has major implications on the currency exchange rate, which continues to depreciate.

The economic crisis in Pakistan takes its roots from the inability of the government to meet its
external debt obligations, a problem that is directly linked to the country’s trade disequilibrium.
Pakistan’s current account, which reflects the country’s net trade in goods and service and is an
important component of the balance of payments, has consistently recorded large deficits over the
years.

Considering data from the SBP, the current account deficit was at $17.4 billion in FY22. Imports
outpaced exports by approximately $45 billion, with remittances, valued at $31.3 billion, softening
the blow.

Clearly, one of the major reasons behind our economic crisis is this trade deficit as exports are
worth only 45 per cent of imports.

There are several factors that can be listed for this imbalance, primary among which is a lack of
efficiency across different markets, such as labor and capital markets. These inefficiencies mean
Pakistani producers are unable to productively compete with foreign producers, particularly those
located in the neighbouring Asian region.

Lack of industrialisation

A recently published report by the World Bank, “From Swimming in Sand to High and Sustainable
Growth: A Roadmap to Reduce Distortions in the Allocation of Resources and Talent in the
Pakistani Economy” highlights the lack of productivity in non-agricultural sectors.
This not only fuels our economic crisis but also discourages productivity-enhancing investments
in the country. For instance, the capacity to generate exports has not increased in Pakistan relative
to its peers, which reduces the ability of exporters to take advantage of a depreciating currency
that should otherwise boost exports.

This lack of productivity, in turn, impacts the level of industrialisation and consequently the ability
of Pakistani producers to compete in the world market.

Manufacturing value added (MVA) measures the contribution of the manufacturing sector to the
GDP. United Nations Industrial Development Organisation (UNIDO) generally uses MVA per
capita as a measure to determine the level of industrialisation in a country. Metrics such as MVA
per capita and the exports of merchandise goods per capita gauge a country’s capacity to produce
and export manufactured goods.

Given that manufactured goods constitute a large percentage of merchandise goods exported by
several countries in the Asian region, the aforementioned indicators can be useful to determine
industrial competitiveness. More productive producers located across countries, often a result of
the combination of efficient markets and higher levels of industrialisation, are more likely to
participate in international trading activities than their less productive counterparts.

The following analysis compares the level of industrial competitiveness between Pakistan and its
major Asian counterparts. The countries included in the analysis are India and Bangladesh, the two
largest economies in South Asia, and Vietnam and Cambodia.

The success story of Vietnam is widely known. However, Cambodia also has reported significant
export growth in the previous decade. The analysis uses data on MVA, population, merchandise
exports and imports from the World Development Indicators (WDI) and data on tariffs imposed
on imports and exports, compiled by the World Bank’s World Integrated Trade Solution (WITS).

The manufacturing value added per capita for the selected countries is reported in Figure 1.
Pakistan reported higher values than both Bangladesh and Cambodia in 2000 but lower values than
India and Vietnam. However, it reported the lowest value amongst the five countries in 2021.
Hence, the level of industrialization in Pakistan has reduced relative to that in Bangladesh and
Cambodia.

While Pakistan has only managed to double the value between 2000 and 2021, India has almost
tripled it. Bangladesh, Cambodia and Vietnam have more than quadrupled it.

The lack of improvement in the level of industrialisation in Pakistan has its implications on the
economy, particularly as the country faces a regular balance of payments crisis.

The trade perspective

Exports per capita of the selected countries are presented in Figure 3. While Bangladesh,
Cambodia and India all reported a value of more than $260 in 2021, Pakistan reported a value of
$122.

As the figure shows, Pakistan’s exports per capita in 2000 were higher than that of Bangladesh
and India. The numbers for Vietnam have not been reported to keep the scale concise as Vietnam
had surpassed $3000 in 2021.

While Vietnam saw a whopping 1,800 per cent increase in the last two decades, the growth rate
for Pakistan is negligible in comparison, rising by 100 percent in the same period.

The other three countries have reported a minimum of 400 per cent growth in their exports per
capita.

The percentage growth in exports per capita between 2000 and 2021 for selected regions is
presented in Figure 5. Pakistan performed below the regional average for sub-Saharan Africa,
Latin America and the Caribbean. These regions have faced their own challenges that have limited
their ability to improve their level of industrialisation, which has lagged other the Asian
economies.

On the flip side, Pakistan also reports relatively low levels of imports per capita in comparison to
its Asian counterparts. In essence, Pakistan’s exports per capita and imports per capita are low in
comparison, indicating a lack of trade participation by Pakistani firms. This speaks volumes about
their productive capacity and the ability of Pakistani businesses to compete in regional and global
markets.

Import tariff rates

A major reason for Pakistan performing below its peers is the inability of Pakistani businesses to
tap into the trade potential offered by its partners.

While the cost of doing business as well as barriers to trade are high in Pakistan due to
inefficiencies in the various markets, the higher levels of tariffs imposed on Pakistani goods as
well as the tariffs imposed by Pakistan on imports limit participation of Pakistani firms in
international trading activities.

The weighted average tariff rates on the import of goods into the selected countries is presented in
Figure 7.

While all the selected countries lowered average tariff rates in the last two decades, Vietnam,
Cambodia and India lowered them to a greater extent than Pakistan and Bangladesh. Vietnam has
almost eliminated tariff rates on its imports, helping it integrate into global value chains.

Furthermore, Pakistan not only imposes prohibitively high tariff rates, exceeding 1,000 per cent
on the import of certain products, it also has the highest number of tariff lines above 15 per cent.
Bangladesh, on the other hand, follows a more uniform tariff policy across products with a
maximum rate of 25 per cent in 2021. It consequently does not report any tariff lines for which the
rate is three times above the simple average tariff rate.

The weighted average import tariffs faced by these countries on their exports is presented in Figure
8.

Pakistan reported one of the highest weighted average tariffs in 2000 and 2021. This is likely to
add to the cost of trade from Pakistan, particularly as Pakistan exports low value-added goods that
are sensitive to changes in their cost of production. Higher tariff rates are likely to discourage
exporters.
Vietnam, which reported similar rates in 2000, was able to negotiate several agreements and lower
the average tariff rates on its exports. ASEAN has proved to be a major game changer for Southeast
Asian countries, helping boost their regional integration. Vietnam has 15 regional trade agreements
(RTAs) in force, while India has 18. Pakistan, on the other hand, has 10 RTAs in force.

One of the biggest impediments of high import tariff rates, as well the lack of trade agreements, is
that it discourages participation of producers in global value chains.

Southeast Asian countries have benefitted significantly from their participation in regional and
global value chains as they have created well-established backward linkages with their trading
partners. Imports are more efficiently converted into exports, contributing to value addition in the
manufacturing sector. Low tariffs on imports and exports aid such linkages between trading
partners.

Unfortunately, Pakistan continues to face challenges as policymakers have not been able to make
strides in negotiating regional trade agreements in recent years. India, for instance, has recently
negotiated a free trade agreement with the United Arab Emirates, while Vietnam has done so with
the United Kingdom and the European Union.

What should be done

The government’s recent administrative controls on imports have hurt the capacity of the industry.
The Business Confidence Index published by the SBP in collaboration with the Institute of
Business Administration (IBA), Karachi, reports not only a fall in business confidence in the
industrial sector but also a decline in capacity utilisation.

High tariffs and taxes coupled with import restrictions have decreased production capabilities. The
delay in reaching the Staff Level Agreement (SLA) with the IMF is creating further challenges for
the manufacturing sector, damaging its technical capabilities. The longer the import restrictions
last, the bigger the impact on the already weakened trading relationships will be.
Tariffs act as a burden on both exports and imports and reduce the ability to participate in regional
and global value chains. They make Pakistani producers inward looking and reduce their desire to
improve their level of competitiveness as they remain protected from competition.

Initiatives such as Pakistan Single Window that reduce trade costs are crucial. In addition,
policymakers must not only address the lack of trade agreements, which have locked out domestic
producers from foreign markets, but also improve the quality of trade missions abroad.

The decline in industrial competitiveness in the last two decades is alarming.

It is imperative that steps are taken to reverse this trend. The lack of industrialisation and the lack
of trade participation by Pakistan has implications for the overall economic health of the country.

Transport and Communication

A modern transport and communication facilities play an important role for integrated economic
development. It plays a major role in the economic uplift of a country as it promotes internal and
external trade, economic use of natural resources, mobility of skilled labour-force, diversification
of markets, provision of fuel, reduction in employment, increase in agricultural and industrial
production etc. Pakistan is taking benefits of its strategic location and has focused on to develop
efficient and well integrated transport and communication system by connecting remote regions
of the country into one road one Asia chain. With the help of China Pakistan Economic Corridor,
roads and railways infrastructure will integrate Pakistan with the regional countries which will
result in generating economic boom by integrating Pakistani markets with Central Asia, Middle
East and other parts of the world. The Corridor will be a strategic game changer in the region and
would go a long way in making Pakistan a richer and stronger entity. The investment on the
corridor will transform Pakistan into a regional economic hub and it will be confidence booster for
investors and attract investment not only from China but also from other parts of the world. Other
than transportation infrastructure, the economic corridor will provide Pakistan with modern
telecommunication and energy infrastructure, also.

Pakistan is blessed with a very unique geo-strategic location posing strength and challenges for its
endurance. The opportunities and potential can be realized by exploring its critical connectivity of
land routes, coastal lines and pass through air routes which are endowed by the favourable climate.
The country offers the most effective, economical and viable transit routes throughout the seasons
to the land locked Central Asian Countries and other neighbouring countries providing a very
convenient trade corridor. World Bank estimates that poor performance of the transport sector is
costing Pakistan about five percent of its GDP. Furthermore thirty percent of agriculture output is
currently wasted due to its inefficient farm to market channels, lack of cold storage facilities and
an obsolete underpowered trucking fleet. Government of Pakistan is committed to develop and
enhance a modernize transport and logistics sector. Vision 2025 also seeks to establish an efficient
and integrated transport system that will facilitate the development of our economy. The targets
set forth are to ensure reduction in transport cost, safety, effective connectivity between rural areas
and urban areas markets interprovincial high speed connectivity, integrated roads network and
transportation corridor connectivity with major regional trade partner countries.

How transport and communication is important for development?

Both transport and communication play an essential role in developing our country. Transportation
helps us travel and move goods from one place to another. The use of transportation depends upon
our need to move things from the place of their availability to the place of their use.

Why is planning essential for development?

Why is planning important? It helps us to identify our goals clearly. It makes us decide clearly and
concretely what we need to do to have the effect on society that we want. It helps us make sure
that we all understand our goal and what we need to do to reach it by involving everyone in the
planning process.
Importance of Development Planning

The importance of planning is not always obvious to everyone. In fact there is a view that suggests
that only developing countries have development plans. In fact developed countries will tell you
that they do not do development planning; they tell you that they just somehow do what they need
to do without a plan. However, they all have development plans except that they might be referring
to them by different names.
When you have a plan – and if it is a good plan – your objectives and goals are much clearer for
all to see and appreciate. This is especially important for those that are required to implement the
plan. It provides them with a clear direction for all of them to direct their efforts towards the same
objectives. Planning also reduces the risks of uncertainty. We are now living in a world that is
more uncertain than before; a world where the environment in which we operate keep changing
around us. Having a good plan will therefore be helpful in anticipating future risks.
Without a plan that serves as a compass, we are likely to be all over the place and in the process
creating unnecessary overlaps and wasting scarce resources. A good plan will guide us to answer
questions such as what is to be done; why must it be done; where will it be done; when will it be
done; and who will do it. These are important questions to be decided upon in the plan to avoid
overlapping and wastage of resources.
It is also the case that development planning provides certainty and improves the quality of
decision-making process for all parts of government – from national, regional to local governments
– and for the private sector.

Good Governance and Accountability

There is another important factor that impacts development planning. I am here referring to the
importance of effective governance when it comes to development planning. Without effective
governance, our development agenda will be less successful. Effective governance is the bedrock
of sustainable development.
How we decide on how best to utilise our resources, or what to prioritise with the limited resources,
or the order in which to implement our priorities is a function of effective governance. Effective
governance is therefore part of the necessary infrastructure needed to achieve the goals and
objectives contained in any development plan.
The World Bank defines good governance as the “manner in which power is exercised in the
management of a country’s economic and social resources for development”. In our context, the
concept of good governance should go further to include the improvement in the processes of
decision-making and implementation to transform the lives of the people.

Development in its simplest form is about improving for the people’s standard of living. We
should, however, also be careful not to only think about development as a tool for improving the
physical and material conditions of the citizens, but also as means to ensuring people’s freedoms
– the freedom to choose and lead the lives that people have reason to value. There exist thus a clear
relationship between good governance and development.

Effcetive Implementation

It is said that a good plan is only as good as its implementation – and without plan implementation
it is just as good as not having a plan at all. Evidence-based monitoring and evaluation is therefore
a cornerstone of our development planning and implementation. It is imperative that we
continuously track our progress, including identifying unexpected circumstances and problems
that might hinder our progress.
In order for us to ensure effective implementation of our plans, I again want to emphasize the
importance of a comprehensive ownership of the plan. The plan can only be fully implemented
when it enjoys the support from all the stakeholders that will be impacted by the plan
implementation.

Discuss the factors hindering Effective Planning in Pakistan

Introduction
Pakistan, like other less developed countries, is caught up in the vicious circle of poverty. Since
Partition, the Government of Pakistan is anxious to raise the standard of living of the people hut it
has not yet been able to come out of the boggy of poverty. On the other side, the developed
countries are growing at a fast speed as they have a set of favourable conditions for growth. The
gap between the developed and the developing countries is widening instead of narrowing. In order
to overcome the shortcomings of market mechanism and to push up the tempo of development,
the Government of Pakistan has drawn up eight five years plans. Some of the plans did succeed in
raising industrial and agriculture production but the overall performance of the plans is
discouraging. The main factors which have inhibited partially or wholly effective planning in
Pakistan are as follows:
1. Lack of Basic Data
In order to draw a comprehensive and realistic plan, the accurate statistical information about the
existing conditions of the economy should be available to the planners. In Pakistan, the date on
natural, human and financial resources provided to the planning machinery are mostly inaccurate
and unreliable. If the date are obsolete or continue wide margins or error, the objectives of the
plans would not be achieved and the plan ends in failure.
2. Appointment of Non-Technical Persons
Another important factor standing in the way of effective planning in Pakistan is the appointment
of non-technical persons in drawing up and execution of the plans. In the entire history of the
Planning Commission, (except for ten years) of Pakistan, the Planning Commission has been
headed by a senior member of the civil service, rather than by a professional economist.
3. Lack of Public Co-operation
Lack of co-operation and mistrust of the Government has remained an important hurdle to effective
planning in Pakistan. The Planning Machinery has not been able to enlist the co-operation, support
and enthusiasm of the people for the implementation of the plans.
4. Political Instability
Another major bottleneck to effective planning is the political instability in Pakistan. The rapid
change over of the government set up, has led to unplanned, haphazard economic growth. The
uncertainties of the election results have hindered, and slowed down the rate of economic
development in the country and have made the plans mostly ineffective.
5. Role of Foreign Assistance
Pakistan has been relying on foreign aid for quickening the tempo of economic development since
the first day of economic planning in Pakistan. The loan giving countries do not finance the project
of the developing countries for philantrophic motive. They have their political and economic
interests. So long the interest between the aid giving countries and the aid receiving countries do
not conflict, the aid is given. As and when the interests of the two clashes, the aid is immediately
stopped or reduced Pakistan aid has been curtailed many a times in the past and the achievement
of the plans fell short of expectations.
6. Natural Calamities
Agriculture is the backbone of our country. It now contributes 25% of GDP accounts for 45% of
foreign exchange earning and engages 50% of the labour force. If in any year or years, the rain is
untimely, weather unfavourable or locust storm attacks the standing crop, the agricultural
productions falls short of the target. Export of raw material and manufactured goods decline.
Expenditure on the import of food-grain increases. The sectorial allocations in the plan then have
to be revised which upsets the whole programme of planning.
7. Dualism
Dualism is another important constraint on the effective planning in Pakistan. The difference in
social customs, difference of technology and a gap in the level of per capital income between the
four provinces of the country, have stood in the way of effective planning in Pakistan.
8. Ambitious Plan
If we look at the objectives of all the Eight Five Year Plans, we will find them too ambitious but
they are not properly fetched in time. When the objectives of plans are partially achieved , it create
discontentment among the people and reduce the usefulness of the development plans.

A country is poor because she is poor discuss

Why are Poor Countries Poor?

Have you ever wondered why some countries seem so incredibly poor and dirty, while others
don’t? Maybe you’ve wondered: “Are ‘poor countries’ poor because they don’t have natural
resources?”

If Not A Lack of Natural Resources, Why Are Developing Countries Poor?

So, we need to keep asking questions: “Why?” and “Are poor countries poor because of
corruption with those natural resources?”

Now we’re on to something.

A pattern that’s been termed the “resource curse” has been used when countries have found that,
sadly, natural resources actually have a negative effect on their society, economy and politics—
and that these countries don’t live up to their development potential.

Corruption can be a major factor—like when the governing officials at the top keep the wealth
to themselves instead of investing it in infrastructure, supporting mothers, meeting the needs of its
citizens and letting the wealth trickle down to the people.

They may use the profits to fund their political groups, keep themselves in power, build up their
armies and weapons, or do other underhanded things with it.
Some experts say that’s the fundamental difference between rich countries and poor countries: to
what degree does the country have institutions in place to prevent a small group of the elite from
hoarding the wealth?

If those in power are fueled by greed or corruption, or aren’t committed to helping their people
and ending poverty, having gas and oil resources can heighten the risk of violent conflict. If rebel
groups are getting the profits, they can strengthen their factions.

There is a long list of violent civil conflicts that have at least in part been over who had control of
oil and gas resources—Nigeria, Angola, Chad and Sudan, just to name some in Africa. And, sadly,
studies show that if a country depends on the export of fossil fuels in particular, that the risk of
civil war increases greatly.

Why are poor countries poor? A wide ranging number of answers have been offered to this
question. Within the Solow framework, three usual suspects have been rounded up: physical
capital, human capital, and total factor productivity. Scarcity of physical capital, first, has been
rapidly disregarded as a cause of poverty because no externalities seem to exist and capital mobility
worldwide would meet capital shortage (see, among others, Easterly, 1999). Human capital has
also been progressively discarded: again, externalities seem to be very low or inexistent (see
Heckman and Klenow, 1997, or Krueger and Lindahl, 2001) and the contribution of human capital
to growth appears to be too small to explain the gap between rich and poor nations (see, among
others, Bils and Klenow, 2000). One could also add that migrant workers earn much more in rich
countries than in their home countries, so that human capital cannot be, in isolation, the reason
why poor countries are poor. Eventually, only one suspect appears to survive: total factor
productivity, which lends itself to the analysis of other kinds of explanatory variables such as
institutions or “social infrastructure” as they are called in Hall and Jones (1999).

The entire argument is summed up in Nurkse's words: “A country is poor, because it is poor.”
Explanation: They (the under- developed countries) cannot get their heads above water because
their production is so low that they can spare nothing for capital formation by which their standard
of living can be raised.
Growth drives human development Economic growth is not just associated with reducing poverty.
There is also clear evidence for a positive link between economic growth and broader measures of
human development. Economic growth is not fundamentally about materialism. Nobel laureate
Amartya Sen has described economic growth as a crucial means for expanding the substantive
freedoms that people value. These freedoms are strongly associated with improvements in general
living standards, such as greater opportunities for people to become healthier, eat better and live
longer.17 Growth generates virtuous circles of prosperity and opportunity (see Figure 2). Strong
growth and employment opportunities improve incentives for families to invest in education by
sending their children to school. This may lead to the emergence of a strong and growing group of
entrepreneurs, which will generate pressure for improved governance. Strong economic growth
therefore advances human development, which, in turn, promotes economic growth. Equally, weak
economic growth implies vicious circles in which poor human development contributes to
economic decline, leading to further deterioration in human development. For many countries,
achieving the Millennium Development Goals will require breaking out of vicious circles to enter
virtuous circles. The link between economic growth and human development operates through two
channels. First, there is the ‘macro’ link whereby growth increases a country’s tax base and
therefore makes it possible for the government to spend more on the key public services of health
and education. Growth is essential if governments are going to be able to continue to provide
public services, which directly benefit the poor. Although aid may provide initial support,
increasing public expenditure in developing countries must ultimately be financed by collecting
greater tax revenues. Given the generally low levels of tax revenue collection (often still below 20
per cent of GDP in African countries), this can only be achieved in the long-run by strong and
sustained growth. Botswana and Kenya provide contrasting examples of this macro link. In 1960,
the two countries had similar levels of per capita income and spent approximately nine per cent of
their GDP on health and education over the next three decades. But by 1990, because Botswana
had grown by 6.5 per cent a year while Kenya had only grown by 1.6 per cent a year, Botswana
was spending five times as much as Kenya on these sectors.

Inflation & Deflation – Definition, Causes, Effects, Basics

nflation happens when the price of goods and services increase, while deflation takes place when
the price of the goods and services decrease in the country. Inflation and deflation are the opposite
sides of the same coin.

Maintaining the balance between these two economic conditions, i.e. inflation and deflation is
essential as the economy can quickly swing from one condition to the other as a result of these two
conditions. The Reserve Bank of India keeps an eye on the levels of price changes and controls
deflation or inflation by conducting monetary policy,

Inflation

Inflation is the rate at which the prices for goods and services increase. Inflation often affects the
buying capacity of consumers. Most Central banks try to limit inflation in order to keep their
respective economies functioning efficiently. There are certain advantages as well as
disadvantages to inflation.

Inflation refers to the increase in the prices of the goods and services of daily use, such as food,
housing, clothing, transport, recreation, consumer staples, etc. Inflation is measured by taking into
consideration the average price change in a basket of commodities and services over a period of
time.
Inflation is calculated in India by the Ministry of Statistics and Programme Implementation.

A simple example would be, suppose a kg of apple cost Rs.100 in 2019 and it cost Rs.110 in 2020,
then there would be a 10% increase in the cost of a kg of apple. In the same way, many
commodities and services whose prices have raised over time are put in a group and the percentage
is calculated by keeping a year as the base year. The percentage of increase in prices of the group
of commodities is the rate of inflation.

 Inflation is the rate at which prices for goods and services rise.
 Inflation is sometimes classified into three types: demand-pull inflation, cost-push
inflation, and built-in inflation.
  The most commonly used inflation indexes are the Consumer Price Index and the
Wholesale Price Index.
 Inflation can be viewed positively or negatively depending on the individual viewpoint
and rate of change.
 Those with tangible assets, like property or stocked commodities, may like to see some
inflation as that raises the value of their assets.

Causes of Inflation

Inflation is caused by multiple factors, here are a few:

Money Supply

Excess currency (money) supply in an economy is one of the primary cause of inflation. This
happens when the money supply/circulation in a nation grows above the economic growth,
therefore reducing the value of the currency.

In the modern era, countries have shifted from the traditional methods of valuing money with the
amount of gold they possessed. Modern methods of money valuation are determined by the amount
of currency that is in circulation which is then followed by the public’s perception of the value of
that currency.

National Debt

There are a number of factors that influence national debt, which include the nations borrowing
and spending. In a situation where a country’s debt increases, the respective country is left with
two options:

 Taxes can be raised internally.

 Additional money can be printed to pay off the debt.

Demand-Pull Effect

The demand-pull effect states that in a growing economy as wages increase within an economy,
people will have more money to spend on goods and services. The increase in demand for goods
and services will result in companies raising prices that the consumers will bear in order to balance
supply and demand.

Cost-Push Effect

This theory states that when companies face increased input cost on raw materials and wages for
manufacturing consumer goods, they will preserve their profitability by passing the increased
production cost to the end consumer in the form of increased prices.

An increase in the supply of money is the root of inflation, though this can play out through
different mechanisms in the economy. A country's money supply can be increased by the
monetary authorities by:

 Printing and giving away more money to citizens

 Legally devaluing (reducing the value of) the legal tender currency
 Loaning new money into existence as reserve account credits through the banking system
by purchasing government bonds from banks on the secondary market (the most common
method)

In all of these cases, the money ends up losing its purchasing power. The mechanisms of how this
drives inflation can be classified into three types: demand-pull inflation, cost-push inflation, and
built-in inflation.
Exchange Rates

An economy with exposure to foreign markets mostly functions on the basis of the dollar value.
In a trading global economy, exchange rates play an important factor in determining the rate of
inflation.

Effects of Inflation

When there is inflation in the country, the purchasing power of the people decreases as the prices
of commodities and services are high. The value of currency unit decreases which impacts the cost
of living in the country. When the rate of inflation is high, the cost of living also increases, which
leads to a deceleration in economic growth.

However, a healthy inflation rate (2-3%) is considered positive because it directly results in
increasing wages and corporate profitability and maintains capital flowing in a growing economy.

Steps to offset Inflation and its effects on Your Retirement

Factoring for inflation is an essential process for financial planning. The question is how much
will you actually need when you retire? Here are a few ways you can retire financially sound
keeping inflation in mind.

Invest in long-term investments.

When it comes to long-term investments, spending money now for investments can allow you to
benefit from inflation in the future.
Save More

Retirement requires more money than one might imagine. The two ways to meet retirement goals
are to save more or invest aggressively.

Make balanced investments

Though investing in bonds alone feel safer, invest in multiple portfolios. Do not put all your eggs
in one basket to outpace inflation.

Controlling Inflation

A country’s financial regulator shoulders the important responsibility of keeping inflation in

check. It is done by implementing measures through monetary policy, which refers to the actions
of a central bank or other committees that determine the size and rate of growth of the money
supply.

In the U.S., the Fed's monetary policy goals include moderate long-term interest rates, price
stability, and maximum employment. Each of these goals is intended to promote a stable financial
environment. The Federal Reserve clearly communicates long-term inflation goals in order to
keep a steady long-term rate of inflation, which is thought to be beneficial to the economy.

Price stability or a relatively constant level of inflation allows businesses to plan for the future
since they know what to expect. The Fed believes that this will promote maximum employment,
which is determined by non-monetary factors that fluctuate over time and are therefore subject to
change.

For this reason, the Fed doesn't set a specific goal for maximum employment, and it is largely
determined by employers' assessments. Maximum employment does not mean zero
unemployment, as at any given time there is a certain level of volatility as people vacate and start
new jobs.1415
 Hyperinflation is often described as a period of inflation of 50% or more per month.16
Monetary authorities also take exceptional measures in extreme conditions of the economy. For
instance, following the 2008 financial crisis, the U.S. Fed kept the interest rates near zero and
pursued a bond-buying program called quantitative easing (QE).17

Some critics of the program alleged it would cause a spike in inflation in the U.S. dollar, but
inflation peaked in 2007 and declined steadily over the next eight years. There are many complex
reasons why QE didn't lead to inflation or hyperinflation, though the simplest explanation is that
the recession itself was a very prominent deflationary environment, and quantitative easing
supported its effects.1819

Consequently, U.S. policymakers have attempted to keep inflation steady at around 2% per year.
The European Central Bank (ECB) has also pursued aggressive quantitative easing to counter
deflation in the eurozone, and some places have experienced negative interest rates. That's due to
fears that deflation could take hold in the eurozone and lead to economic stagnation.2021

Moreover, countries that experience higher rates of growth can absorb higher rates of inflation.
India's target is around 4% (with an upper tolerance of 6% and a lower tolerance of 2%),
while Brazil aims for 3.25% (with an upper tolerance of 4.75% and a lower tolerance of 1.75%)

Public Expenditure | Meaning, Classification, Principles, Effects

Table of Contents
 1 What is Public Expenditure?
o 1.1 a. The New Concept of Welfare State
o 1.2 b. War and War Programmes
o 1.3 c. Growth of population and rise of towns
o 1.4 d. The Great Depression [1929-33] and Extension of Government function
 2 Classification of Public Expenditure
 3 Principles / Canons of Public Expenditures
o 3.1 1. Principle of Maximum Social Advantage
o 3.2 2. Canon of Economy
o 3.3 3. Canon of Sanction
 o 3.4 4. Canon of Elasticity
o 3.5 5. Canon of Surplus
 4 Effects of Public Expenditure
o 4.1 1. Effects on production
o 4.2 2. Effects on distribution
o 4.3 3. Effects on income and employment
 5 Infographic on Public Expenditure – Meaning, Classification, Principles, Effects
What is Public Expenditure?

Public expenditure refers to expenditure of the government. In the past, the subject of public
expenditure was neglected because the expenditure of the government was very small. There has
been a persistent and continuous increase in public expenditures in countries all over the world.
This tendency was observed in the 19th century itself but it has become clear and definite in the
20th century.

Public Expendiure – Meaning, Classification, Principles, Effects

Adolf Wagner, a noted German fiscal theorist of the 19th century, presented his famous hypothesis
“law of the increase of state activities” which has led to increase in public expenditure. He
hypothesized as follows:

a. The New Concept of Welfare State

The 19th century State was mainly and basically a police State, but the 20th Century State is a
Welfare State whose main objective is to promote the economic, political and social well being of
citizens. Government spend money to create and maintain full employment, development
programmes, education [free] and on social security measures.

b. War and War Programmes

Expenditure on national defence generally accounts for half of the total expenditure. Larger the
country, greater the percentage of revenue allotted to national defence.

c. Growth of population and rise of towns

The continuous process of urbanization brings an expansion in expenditure on the protection of
life and prosperity, and on public health, educations and other functions like hospitals,
playgrounds, organized recreations, water, sewerage growth of network of roads, railways and
provision of welfare and assistance.

d. The Great Depression [1929-33] and Extension of Government function

The great depression demonstrated the need for government to interfere and participate in
economic activity and new functions. The government took various measures for the active
encouragement of industry, agriculture, labour full employment, promoting public welfare, and
control over all sectors of the economy.

The other causes for the growth of public expenditure includes, rise of democracy, rise in price
levels, increase in public debt followed by increased interest rates, growth of the spirit of economic
nationalism and desire for self sufficiency, etc.

Buchler, in his book “Public Finance”, says that, “to some persons any increase in public
expenditure seems a calamity, to others it is a cause of rejoicing and to still others, it is a matter of
indifference”. But public expenditure is growing at the rate of 15 to 20 percent per annum.

Classification of Public Expenditure

Different economists have classified Public Expenditure into different forms. Prof. Adam Smith
has classified public expenditure on the basis of functions performed by the government. They are
defence expenditure, commercial expenditure and development expenditure. Prof. Dalton
classified public expenditure into grants and purchase price. When the government transfers its
resource without any quid pro quo, it is grant. Expenditure incurred to provide services is grant.

When the government transfers revenue to individuals or community in return for specific services,
it is called purchase price. Normally, public expenditure is classified into:

1. Revenue expenditure: This means expenditure on civil administration, defence and welfare
schemes, etc.
2. Capital expenditure: This is incurred once and all. It is non-recurring expenditure. Expenditure
on multipurpose projects, big factories like steel and cement, money spent on machinery, building
and land are all capital expenditure.

3. Development expenditure: This is made on irrigational development, industrial development,

education and health etc.

4. Non-development expenditure: This is the money spent on civil administration, police force,
defence forces, judiciary, etc.

Principles / Canons of Public Expenditures

The principles of public expenditure are certain guidelines for the public authorities in spending
government money. They are also known as canons of expenditure. These canons are:

1. Principle of Maximum Social Advantage

The objective behind this principle is that public money should be spent for general cause and
must promote social welfare. It should not be spent for the benefit of a particular group of society.
Public expenditure should result in increased production, elimination of inequality and promotion
of welfare of all. It should secure internal peace and also protection from external aggression.

2. Canon of Economy

The authorities are expected to follow utmost economy in its expenditure. Public money should
not be misused and not result in any wastage. Whenever money is raised by taxation, public
expenditure in return should bring maximum benefit. It should not produce unfavorable effect on
production. Canon of economy does not mean niggardliness or miserliness. It simply means the
prevention of extravagance and waste of all kinds.

3. Canon of Sanction

Without the sanction of the public authority, no money should be spent. At the same time, the
amount of money must be spent for the purpose for which it was sanctioned.

This will ensure that:

  waste and extravagance are avoided,
 there is proper audit done compulsorily,
 there is control and legislative supervision over public expenditure,
 It is seen whether the expenditure has fulfilled the objective.

In the absence of proper sanction, there may be misuse and misappropriation of public funds. The
Public Accounts Committee established by every legislature sees that these objectives are
achieved.

4. Canon of Elasticity

This implies that there should be scope for varying the expenditure according to need or
circumstances. There should not be any rigidity in public expenditure.

5. Canon of Surplus

To greater extent, the government expenditure should lead to increased production, employment
and income. The expenditure should be with in the revenue of the State. Deficit is permitted only
for a short duration. In times of crisis, government is allowed to have deficit budget. The deficit
must be made good after the normalcy returns.

Finally, public expenditure should promote economic growth, stability and social justice. Public
expenditure should be directed to achieve economic and social objectives of the country.

Effects of Public Expenditure

Public expenditure is beneficial since it influences the economy in many directions. The effects of
public expenditure are always beneficial. It increases the capacity of the people to produce output
efficiently. It influences the production not only directly but also indirectly. It increases the
community’s productive power. It promotes social and economic equality and finally increases
income, employment and welfare.

1. Effects on production
Expenditure on defence becomes productive and it becomes a protective expenditure.
Development of infrastructures facilitates production and thereby helps to increase national
income and in turn per capita income. Expenditures on social services like free education, health
and medical aid, which increase the capacity of the people to work and save and productive power.

2. Effects on distribution

Public expenditure is an ideal medium to remove economic inequalities in society. The

government should tax more the rich. The amount so collected should be spent on free education,
medical aid, cheap food, subsidized houses, old age pension, etc. This process of public
expenditure will bring about redistribution of national income in favour of the poor.

3. Effects on income and employment

Public expenditure affects the level of income and employment in the country by removing the
widespread unemployment. Investing more on public works like roads, hydro-electric generating
works, etc. will create a multiplier effect on the economy and thereby increases the income and
employment. This results in increased consumption and in turn develops the consumption goods
industries and capital goods industries.

Thus, public expenditure plays a vital role in the economic development of a country. It also creates
necessary environment for the expansion of private enterprise and initiative.

Effects on Production ▪ A. Effect of Public expenditure on production ▪ The public expenditure

has some effects on the pattern and amount of production in a country. Public expenditure
influences the productive activity in a number of ways. ▪ However, the effect of public expenditure
depends upon three facts; 1. Ability to work, save and invest; 2. Willingness by people to work
save and invest; 3. Allocation of economic resources as between different use and localities.

1. Ability to Work, Save and Invest ▪ Ability to work, save and invest is generally
affected with the increase in public expenditure. Increase in public expenditure on
education, medical facilities, cheap housing facilities, means of transports and
communication and recreational facilities will increase the efficiency of person to
work. This will in turn affect production and national income. At the same time,
 public expenditure can push up the saving and the efficiency of the workers. The
purchasing power of the people will also be the increased by such type of public
expenditure on free education facilities, unemployment benefits, sickness benefits,
cheap housing facilities etc. in addition to this. Expenditure for maintaining law
and order creates confidence and faith in the minds of the common people which
helps to encourage the investment into productive channels.
2. Public expenditure improves the mental standard of people results in better
utilization of the ability of the people, therefore, the public expenditure should not
be weighed in favour of luxury because I twill decrease the ability of the people to
work and it will lead to harmful effect on production. But public expenditure should
be incurred on public utility services such as construction of roads, banks, dams,
education and medical facilities.
3. Willingness by People to Work Save and Invest ▪ Public expenditure also affects
the willingness to work, save ad also invest. It not only affects the present but also
the future generation. The Public expenditure should be in that way so that it must
be more fruitful to the worker while working than when he is out of job. The
negative side of public expenditure is that why a person should would put hard
work and save when he finds his future safe and secure. ▪ The desire to work and
save will increase if the common masses are such that their present savings and
investments are secured and will yield good dividend to them in the years to come.
Public expenditure should be incurred system activity and in a planned manner in
order to provide social security to the maximum extent
4. Allocation of Economic Resources as Between Different Use and Localities. ▪
Public expenditure refers diversion of economic resources between different areas
and uses can significantly influence the pattern of production. Government has to
select the particular region or industry for incurring the public expenditure so that
the maximum national production and maximum social advantage be attained. The
provisions of roads, railways, and irrigation etc, infrastructure all increases the
opportunities and make it possible for people to carry on and extend productive
activity.
How does permanent income hypothesis relate to the concept of marginal propensity to
consume?

The permanent income hypothesis is a theory of consumer spending stating that people will spend
money at a level consistent with their expected long-term average income. The level of expected
long-term income then becomes thought of as the level of “permanent” income that can be safely
spent. A worker will save only if their current income is higher than the anticipated level of
permanent income, in order to guard against future declines in income.

KEY TAKEAWAYS

 The permanent income hypothesis states that individuals will spend money at a level that
is consistent with their expected long-term average income.
 Milton Friedman developed the permanent income hypothesis, believing that consumer
spending is a result of estimated future income as opposed to consumption that is based
on current after-tax income.
 Under the theory, if economic policies result in increased income, it will not necessarily
translate into increased consumer spending.
 An individual's liquidity is a factor in their management of income and spending.

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What is MPC?

What is PIH?

How does MPC relate to PIH?

4

How does PIH affect aggregate demand?

How does PIH explain consumption patterns?

How can you apply PIH to your personal finance?

Here’s what else to consider

You may have heard of the term marginal propensity to consume (MPC) in macroeconomics, but
do you know how it relates to the permanent income hypothesis (PIH)? In this article, you will
learn about the basic concepts of MPC and PIH, and how they affect your consumption behavior
and the aggregate demand in the economy.
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1What is MPC?

MPC is the ratio of the change in consumption to the change in income. It measures how much of
your additional income you spend on goods and services, rather than saving or investing. For
example, if your income increases by $100 and you spend $80 of it, your MPC is 0.8. MPC can
vary depending on your income level, preferences, expectations, and other factors.

Add your perspective

2What is PIH?

PIH is a theory of consumption proposed by Nobel laureate Milton Friedman. It states that your
consumption depends on your permanent income, which is your expected average income over
your lifetime, rather than your current income, which may fluctuate due to temporary shocks. For
example, if you receive a bonus or a tax refund, you may not spend it all immediately, but save
some of it for the future, because it does not affect your permanent income. Similarly, if you face
a temporary loss of income, you may not cut your consumption drastically, but borrow or use your
savings, because you expect your income to recover.

Many models in both macro- and microeconomics rely on utility functions that relate risk
aversion/tolerance to intertemporal consumption preferences (which imply degrees of
consumption smoothing). The CRRA (constant relative risk aversion) sub-class of
preferences is an example of such models. Epstein-Zin models, alternative preference
models to the CRRA sub-class, separate financial risk aversion/tolerance from
intertemporal preferences, with the aim of making model outputs consistent with empirical
(observed) data.

1
3How does MPC relate to PIH?

According to PIH, your MPC is higher for permanent changes in income than for temporary
changes in income. This means that you are more likely to spend a larger proportion of your income
if you expect it to last for a long time, rather than a short time. For example, if you get a promotion
or a pay raise, you may increase your consumption more than if you get a one-time bonus or a gift.
Conversely, if you lose your job or face a pay cut, you may reduce your consumption less than if
you face a one-time expense or a fine.

In models of lifetime wealth, the permanent income hypothesis may materialize in the form
of average income growth over time, which by construction relates lifetime consumption
to lifetime wealth. Lifetime consumption in this model does not react to temporary
increases in income, unless they are large enough to increase the mean across a lifecycle.

4How does PIH affect aggregate demand?

Aggregate demand is the total demand for goods and services in the economy. It depends on the
consumption, investment, government spending, and net exports of the economy. Consumption is
the largest component of aggregate demand, so changes in consumption behavior due to PIH can
have significant effects on the overall economic activity. For example, if consumers expect a
permanent increase in income due to economic growth or policy changes, they may increase their
consumption and boost the aggregate demand. On the other hand, if consumers expect a permanent
decrease in income due to recession or policy changes, they may decrease their consumption and
reduce the aggregate demand.

5How does PIH explain consumption patterns?

PIH can help explain why consumption patterns may differ across countries, regions, and groups
of people. For example, PIH suggests that countries with more stable and predictable income
streams may have higher MPCs and higher consumption levels than countries with more volatile
and uncertain income streams. Similarly, regions or groups of people with more access to credit
markets, insurance, and social security may have higher MPCs and higher consumption levels than
regions or groups of people with less access to these mechanisms. PIH can also help explain why
consumption may not respond proportionally to changes in income, especially in the short run.

6How can you apply PIH to your personal finance?

PIH can help you make better decisions about your personal finance, especially when it comes to
budgeting, saving, and investing. PIH suggests that you should base your consumption on your
permanent income, which reflects your long-term earning potential and wealth, rather than your
current income, which may be affected by temporary factors. This means that you should avoid
overspending when your income is high, and avoid underspending when your income is low.
Instead, you should save and invest some of your income for the future, and use your savings and
credit wisely when you face income shocks. By doing so, you can smooth your consumption over
time and achieve a more stable and satisfying lifestyle.

Marginal Propensity to Invest (MPI): Definition and Calculation

What Is the Marginal Propensity to Invest (MPI)?

The marginal propensity to invest (MPI) is the ratio of change in investment to change in income.
It shows how much of one additional unit of income will be used for investment purposes.
Typically, people will only invest a portion of their income, and investment increases when
income increases and vice versa, meaning that the MPI is a positive ratio between 0 and 1. The
greater the MPI, the larger the proportion of additional income is invested rather than consumed.

KEY TAKEAWAYS

 The marginal propensity to invest (MPI) is the proportion of an additional increment of

income that is spent on investment.
 The MPI is one of a family of marginal rates devised and used by Keynesian economists
to model the effects of changes in income and spending in the economy.
 The larger the MPI, the more of an addition to income gets invested.
  Spending directed toward investment, by the MPI, may have a multiplier effect that boosts
the economy, but this effect might vary or possibly even be negative if crowding out
occurs.

Understanding the Marginal Propensity to Invest (MPI)

Although John Maynard Keynes never explicitly used the term, the MPI originates
from Keynesian economics. In Keynesian economics, a general principle states that whatever is
not consumed is saved. Increases (or decreases) in income levels encourage individuals and
businesses to do something with the amount of available money.

The MPI is one of several marginal rates that have been developed through Keynesian economics.
Others include the marginal propensity to consume (MPC), the marginal propensity to
save (MPS), and less well-known ones such as the marginal propensity for government purchases
(MPG).

The MPI is calculated as MPI = ΔI/ΔY, meaning the change in value of the investment function
(I) with respect to the change in value of the income function (Y). It is thus the slope of the
investment line. For example, if a $5 increase in income results in a $2 increase in investment,
the MPI is 0.4 ($2/$5). In practice, the MPI is much lower, especially in relation to the MPC.

MPI holds tremendous value when compared over time. For example, governments may see what
the MPI was before and after implementing a policy; therefore, it can see the economic impact
on MPI by comparing the difference.

How the Marginal Propensity to Invest (MPI) Impacts the Economy

Consumption tends to be impacted more by increases in income, although the MPI does have an
impact on the multiplier effect and also affects the slope of the aggregate expenditures function.
The larger the MPI, the larger the multiplier. For a business, increases in income can be the result
of reduced taxes, changes in costs, or changes in revenue.
According to Keynesian theory, an increase in investment spending will employ people
immediately in the investment goods industry and have a multiplied effect by employing some
multiple of additional people elsewhere in the economy. This is an obvious extension of the idea
that spending on investment will be re-spent. However, there's a limit to the effect. The real output
of the economy is limited to output at full employment, and spending multiplied past this point
will simply raise prices—especially in the case of capital goods or financial assets.

Keynesian theory, and its critics, also suggest that any given investment project (public or private)
may not always raise income and employment with the full force of the multiplier because that
decision to invest may take the place of investment that would have happened in its absence.

For example, funding a project might raise interest rates, discouraging other investments or
competing with other projects for labor. This is related to the phenomenon that economists refer
to as crowding out, where public investment spending or other policies meant to encourage
investment have diminished or even have a negative effect on economic growth to the extent that
they replace investment that would otherwise have occurred, rather than encouraging additional
investment.

Factors That Impact MPI

The MPI for individual firms or investors can be influenced by a variety of factors. Here are some
of the key implications that change how firms and and investors save:

 Prevailing Expected Rate of Return. The expected rate of return on investment is a

critical factor in MPI as it dictates the psychology of whether or not it is worth investing.
Firms and investors are more likely to invest when they anticipate higher returns on their
capital investments. This can be influenced by factors such as market conditions, demand
for their
products or services, and competition in any given investment space.
 Interest Rates. The prevailing interest rates in the financial markets can significantly
impact MPI. Lower interest rates can make borrowing more attractive for financing
investments, potentially increasing the MPI. Conversely, higher interest rates can
 discourage borrowing for investments. Alternatively, monetary policy that is striving to
slow or boost the economy may influence growth and market expansion.
 Access to Financing. The availability of financing options and capital resources is a key
determinant. Firms with easy access to financing, whether through bank loans, equity
markets, or internal funds, may have a higher MPI. This relates to the bullet above about
interest rates, as a lower cost of capital or greater ease of liquidity make make investing
more desirable.
 Tax Incentives and Policy. Government policies and tax incentives can influence MPI.
For example, tax credits for research and development or accelerated depreciation
schedules can encourage firms to invest
in these areas, effectively raising the MPI. Government policies (like monetary policy
mentioned above) also influence investment decisions.
 Technological Advancements. Technological innovations can drive MPI as firms seek
to invest in new technologies and equipment to improve productivity, reduce costs, or
enter new markets. Industries with rapid technological change often have higher MPI as
there stands greater cost efficiency opportunities and greater revenue growth
opportunities.
 Risk Appetite. A firm's or investor's willingness to take on risk can influence MPI. Those
with a higher risk appetite may be more inclined to invest in higher-yield but riskier
projects. This may also be the case when talking about general market conditions; though
expected rate of returns may be lower, more risk-seeking investors may still be okay
pursuing lower yield opportunities.

Users of MPI

Economists and policymakers frequently use MPI to assess and fine-tune fiscal and monetary
policies. For instance, central banks use it to gauge the impact of interest rate changes on
investment decisions.1 When MPI is high, lower interest rates can stimulate investment as
borrowing becomes cheaper. In contrast, when MPI is low, interest rate adjustments may have a
weaker effect on encouraging investment.
Investment decisions at both the micro and macro levels are influenced by the MPI. Businesses
use MPI to make capital allocation decisions and to anticipate the impact of changes in economic
conditions on their investments. Households consider MPI when deciding how much of their
disposable income to invest rather than consume. Policymakers use MPI to craft
effective economic policies, particularly during periods of economic uncertainty or recession,
where stimulating investment can be crucial to economic recovery.

MPI also plays a significant role in economic forecasting. Economists use it as a parameter in
macroeconomic models to predict how changes in investment spending will affect overall
economic activity, employment, and growth. Therefore, MPI is a tool that helps in understanding
the drivers of economic fluctuations and ultimately understanding its overall economic health and
stability.

MPI can be used in some many unique contexts. For example, MPI is cited in a U.S. government
research paper analyzing the economic impacts of the change in Puerto Rico's status back in the
1990's.2

MPI vs. MPC

The MPC represents the proportion of additional income that households or individuals will spend
on consumption. In many ways, an individual can either spend money or save it for future
consumption, so MPI and MPC somewhat contrasting in what they measure, at least regarding
the time horizon in which capital is spend.

The MPC is primarily used to understand and predict the overall level of consumer spending in
an economy. It is crucial for analyzing the impact of changes in income or government policies
like tax cuts or stimulus packages on consumption patterns. For example, governments may
analyze how implementing a reduction in taxes helped boost the economy by giving individuals
more capital to spend. Meanwhile, the MPI is used to analyze and predict the level of investment
in an economy meant for expanded production and contribution to longer-term economic growth.

The MPC focuses on the behavior of households and individuals, while the MPI focuses on the
behavior of firms and investors. Therefore, each have different economic implications. A high
MPC suggests that a significant portion of income is spent on consumption which can stimulate
current economic activity but may not contribute as much to long-term growth. A high MPI
suggests that a substantial part of income is channeled into productive investments, which can
lead to diminished shorter-term objectives but increased productivity and innovation over a longer
horizon.

What Is the Multiplier Effect? Formula and Example

What Is the Multiplier Effect?

The multiplier effect is an economic term, referring to the proportional amount of increase, or
decrease, in final income that results from an injection, or withdrawal, of capital. In effect,
Multipliers effects measure the impact that a change in economic activity—like investment or
spending—will have on the total economic output of something. This amplified effect is known
as the multiplier.

KEY TAKEAWAYS

 The multiplier effect is the proportional amount of increase or decrease in final income
that results from an injection or withdrawal of spending.
 The most basic multiplier used in gauging the multiplier effect is calculated as the change
in income divided by the change in spending and is used by companies to assess
investment efficiency.
 The money supply multiplier, or just the money multiplier, looks at a multiplier effect
from the perspective of banking and money supply.
 The money multiplier is a key concept in modern fractional reserve banking.
 Other multipliers include the deposit multiplier, fiscal multiplier, equity multiplier, and
earnings multiplier.

Understanding the Multiplier Effect

Generally, economists are most interested in how infusions of capital positively affect income or
growth. Many economists believe that capital investments of any kind—whether it be at the
governmental or corporate level—will have a broad snowball effect on various aspects of
economic activity.

As its name suggests, the multiplier effect provides a numerical value or estimate of a magnified
expected increase in income per dollar of investment. In general, the multiplier used in gauging
the multiplier effect is calculated as follows:

Multiplier=Change in IncomeChange in SpendingMultiplier=Change in SpendingChange in Inc

ome

The multiplier effect can be seen in several different types of scenarios and used by a variety of
different analysts when analyzing and estimating expectations for new capital investments.

Example of the Multiplier Effect

For example, assume a company makes a $100,000 investment of capital to expand its
manufacturing facilities in order to produce more and sell more. After a year of production with
the new facilities operating at maximum capacity, the company’s income increases by $200,000.
This means that the multiplier effect was 2 ($200,000 / $100,000). Simply put, every $1 of
investment produced an extra $2 of income.

The Keynesian Multiplier

Many economists believe that new investments can go far beyond just the effects of a single
company’s income. Thus, depending on the type of investment, it may have widespread effects
on the economy at large. A key tenet of Keynesian economic theory is that of the multiplier, the
notion that economic activity can be easily influenced by investments, causing more income for
companies, more income for workers, more supply, and ultimately greater aggregate demand.

Essentially, the Keynesian multiplier is a theory that states the economy will flourish the more
the government spends, and the net effect is greater than the exact dollar amount spent. Different
types of economic multipliers can be used to help measure the exact impact that changes in
investment have on the economy.
For example, when looking at a national economy overall, the multiplier would be the change
in real GDP divided by the change in investments, government spending, changes in income
brought about by changes in disposable income through tax policy, or changes in investment
spending resulting from monetary policy via changes in interest rates.

Some economists also like to factor in estimates for savings and consumption. This involves a
slightly different type of multiplier. When looking at savings and consumption, economists might
measure how much of the added income consumers are saving versus spending. If consumers
save 20% of new income and spend 80% of new income, then their marginal propensity to
consume (MPC) is 0.8. Using an MPC multiplier, the equation would be:

MPC Multiplier=11−MPC=11−0.8=5where:MPC=Marginal propensity to consume

MPC Multiplier=1−MPC1=1−0.81=5where:MPC=Marginal propensity to consume

Therefore, in this example, every new production dollar creates extra spending of $5.

Money Supply Multiplier Effect

Economists and bankers often look at a multiplier effect from the perspective of banking and a
nation's money supply. This multiplier is called the money supply multiplier or just the money
multiplier. The money multiplier involves the reserve requirement set by the Federal
Reserve, and it varies based on the total amount of liabilities held by a particular depository
institution.

In general, there are multiple levels of money supply across the entire U.S. economy. The most
familiar ones are:1

 The first level, dubbed M1, refers to all of the physical currency in circulation within an
economy.
 The next level, called M2, adds the balances of short-term deposit accounts for a
summation.

When a customer makes a deposit into a short-term deposit account, the banking institution can
lend one minus the reserve requirement to someone else. While the original depositor maintains
ownership of their initial deposit, the funds created through lending are generated based on those
funds. If a second borrower subsequently deposits funds received from the lending institution,
this raises the value of the money supply even though no additional physical currency actually
exists to support the new amount.

The money supply multiplier effect can be seen in a country's banking system. An increase in
bank lending should translate to an expansion of a country's money supply. The size of the
multiplier depends on the percentage of deposits that banks are required to hold as reserves. When
the reserve requirement decreases, the money supply reserve multiplier increases, and vice versa.

Back in 2020, prior to the COVID-19 pandemic, the Fed mandated that institutions with more
than $127.5 million have reserves of 10% of their total deposits. However, as the pandemic
sparked an economic crisis, the Fed took a dramatic step: On Mar. 26, 2020, it reduced the reserve
ratio to 0%—essentially, eliminating these requirements entirely to free up liquidity.2

Money Supply Reserve Multiplier

Most economists view the money multiplier in terms of reserve dollars and that is what the money
multiplier formula is based on. Theoretically, this leads to a money (supply) reserve multiplier
formula of:

MSRM=1RRRwhere:MSRM=Money supply reserve multiplierRRR=Reserve requirement ratio

MSRM=RRR1where:MSRM=Money supply reserve multiplierRRR=Reserve requirement ratio

For example, in the case of banks with the highest required reserve requirement ratio—10% prior
to COVID-19—their money supply reserve multiplier would be 10 (1 / 0.10). This means every
one dollar of reserves should have $10 in money supply deposits.

If the reserve requirement is 10%, then the money supply reserve multiplier is 10 and the money
supply should be 10 times reserves. When a reserve requirement is 10%, this also means that a
bank can lend 90% of its deposits.
Money Supply Reserve Multiplier Example

Looking at the money multiplier in terms of reserves helps one to understand the amount of
expected money supply. In this example, $651 equates to reserves of $65.13. If banks are
efficiently using all of their deposits, lending out 90%, then reserves of $65 should result in a
money supply of $651.

If banks are lending more than their reserve requirement allows, then their multiplier will be
higher, creating more money supply. If banks are lending less, then their multiplier will be lower
and the money supply will also be lower. Moreover, when 10 banks were involved in creating
total deposits of $651.32, these banks generated a new money supply of $586.19, for a money
supply increase of 90% of the deposits.

Types of Multipliers

A multiplier may occur in a variety of ways, impacting different instruments or balances. The
most common types of multipliers are below.

 The money multiplier demonstrates how central bank reserves are amplified by
commercial banks
 The deposit multiplier demonstrates how fractional reserve banking can amplify
deposits through new loans
 The fiscal multiplier measures the effect that increases in fiscal spending will have on a
nation's economic output, or gross domestic product (GDP).
 The investment multiplier quantifies the additional positive impact on aggregate income
and the general economy generated from investment spending.
 The earnings multiplier relates a company's current stock price to its per-share earnings.
 The equity multiplier calculates how much of a company’s assets are financed by stock
rather than debt.

Impact of Multiplier Effect

The multiplier effect as several implications on an economy. First, the multiplier effect often has
a positive impact on the economy and economic growth. Instead of being limited to the actual
quantity of funds in possession or in circulation, the multiplier effect can scale programs and
allow for more efficient use of capital.

Multiplier effects may also impact economies in different ways. First, economies experience
direct impacts when an economic factor is directly attributed to an entity. For example, when a
government awards a tax incentive to an individual, that individual is said to have received the
direct financial impact.

However, the multiplier effect incorporates two additional impacts: the indirect impact and the
induced impact. The indirect impact of the government benefit above is that the individual takes
their tax benefit and spends it. These funds do not sit idly by in one bank account; it may be spread
across a dozen different businesses potentially relating to grocery stores, restaurants, car
dealerships, or online purchases.

The last impact (induced impact) highlight the true benefit of multiple effects. Although a single
individual received a tax benefit, many companies and their employees benefited. For example,
imagine the individual dined at a restaurant and left a tip. That tip would now be the benefit of
the waitstaff who may buy a crafted item at a local market and increase the income of a local
artist. As currency flows through an economy, more than one individual or entity may residually
receive benefit from a financial instrument. Therefore, the single tax benefit is said to have a
multiplier effect on the economy.

What Is a Multiplier?

In economics, a multiplier broadly refers to an economic factor that, when changed, causes
changes in many other related economic variables. The term is usually used in reference to the
relationship between government spending and total national income. In terms of gross domestic
product, the multiplier effect causes changes in total output to be greater than the change in
spending that caused it.

Circular Flow Model Definition and Calculation

What Is the Circular Flow Model?

The circular flow model demonstrates how money moves through society. Money flows from
producers to workers as wages and flows back to producers as payment for products. In short, an
economy is an endless circular flow of money.

That is the basic form of the model, but actual money flows are more complicated. Economists
have added in more factors to better depict complex modern economies. These factors are the
components of a nation's gross domestic product (GDP) or national income. For that reason, the
model is also referred to as the circular flow of income model.

KEY TAKEAWAYS

 The circular flow model demonstrates how money moves from producers to households
and back again in an endless loop.
 In an economy, money moves from producers to workers as wages and then back from
workers to producers as workers spend money on products and services.
 The models can be made more complex to include additions to the money supply, like
exports, and leakages from the money supply, like imports.
 When all of these factors are totaled, the result is a nation's gross domestic product (GDP)
or the national income.
 Analyzing the circular flow model and its current impact on GDP can help governments
and central banks adjust monetary and fiscal policy to improve an economy.

Understanding the Circular Flow Model

The basic purpose of the circular flow model is to understand how money moves within an
economy. It breaks the economy down into two primary players: households and corporations. It
separates the markets that these participants operate in as markets for goods and services and the
markets for the factors of production. Other sectors can be added for more robust cash flow
tracking.
The circular flow model is used to measure a nation's income, as the circular flow model measures
both cash coming into and exiting a nation's economy. It is also used to gauge the
interconnectivity between sectors as a fully robust and strong economy will have interaction
between components. For instance, the relationship between a government's taxation policies and
a household's consumption spending will have a direct impact on a business's ability to sell goods.

The circular flow model is aptly named because funds tend to continuously flow between sectors.
As highlighted in the diagram below, money often flows from one sector to another, awarding
benefits along the way. No single sector should hoard or collect all resources; instead, a fully-
functioning circular model will continuously move funds so each sector can operate appropriately.
Note that this example below is a single type of model and does not represent all circular flow
models.

Sectors of a Circular Flow Model

There are different types of circular flow models, each with a different number of sectors it tracks.
Below are the potential sectors that could be included in a circular flow model. Each sector within
a circular flow model may be designated with a capital letter often used to describe how to
calculate GDP.

Household Sector

In a two-sector model, circular flow models start with the household sector that engages
in consumption spending (C). Households contribute to an economy by working (giving away
time and labor) and by buying products (giving away money). In return, households consume
products and utilize government programs.

Business Sector

In a two-sector model, circular flow models also include the business sector that produces the
goods. Businesses absorb a variety of production costs including labor, materials, and overhead.
As a result, many companies are able to manufacture products that benefit other parties.
Government Sector

In a three-sector model, government sector cash flows are included. The government injects
money into the circle through government spending (G) on programs such as Social Security and
the National Park Service. It also extracts money from households and businesses by way of taxes.

Foreign Sector

In a four-sector model, money also flows into the circle through exports (X), which bring in cash
from international buyers from the foreign sector. By extension, this indicates that the two-sector
or three-sector models are domestic activity only. The foreign sector is different from the
domestic sector as there may be administrative inefficiencies that result in lost cash flow due to
import taxes, duties, or fees.

Financial Sector

In a five-sector model, cash flow from the financial sector is added. This includes banks and
other institutes that provide cash flow via lending services. Some circular flow models also outline
investor activity, as cashflow from entrepreneurs and investors may represent an inflow to
businesses while net profits from the company represent an outflow.

A change in one sector may critically change the rest of the circular flow model. For example,
imagine if governments doubled individual tax rates. This change would likely have major
repercussions on business, individuals, and other sectors within the circular flow model.

Circular Flow Model: Injections and Leakages

Just as money is injected into the economy, money is withdrawn or leaked through various means
as well. Taxes (T) imposed by the government reduce the flow of income. Money paid to foreign
companies for imports (M) also constitutes a leakage. Savings (S) by businesses that otherwise
would have been put to use are a decrease in the circular flow of an economy’s income.
A government calculates its gross national income by tracking all of these injections into the
circular flow of income and the withdrawals from it. The circular flow of income for a nation is
said to be balanced when leakage equal injections. That is:

 The level of injections is the sum of government spending (G), exports (X), and
investments (I).
 The level of leakage or withdrawals is the sum of taxation (T), imports (M), and savings
(S).

When G + X + I is greater than T + M + S, the level of national income (GDP) will increase.
When the total leakage is greater than the total injected into the circular flow, national income
will decrease. As long as a country's injections is greater than its leakages, a country's economy
can theoretically remain sustaining forever. However, if there are cash flow shortages (i.e.
leakages), the country must find additional cash flow to compensate for the shortage.

Example of Circular Flow Model

Consider a circular flow model involving Apple employees and Apple product consumers. In this
example, we'll also include the government to form a three-sector circular flow model.

From the household/consumer perspective, there are several factors to consider. First, households
may spend money and in return, the households get new innovative technology products. Second,
households may be employed by Apple. Households may contribute labor hours and time to the
company resulting in Apple growing and becoming a more successful company. Households
receive income from Apple, though part of these funds is given to the government via taxes.
Households then benefit from government programs.

From the business perspective, the company exists to create products. From above, they sell
products and take money from households. They also take time for workers to make those
products. A certain portion of the cosmpany's profits is given to the government in the form of
taxes. In some cases, Apple may benefit from government programs or subsidies, so part of these
tax dollars may indirectly benefit Apple.
From the government's perspective, both households and business pay taxes. These dollars are
then used to deploy capital projects or public programming, both of which may benefit Apple, its
employees, or its customers.

In this example, additional sectors (or additional flows) could be added. For example, Apple is
an international company that sells goods around the world. Another example is how investors
may contribute money into Apple in return for a portion of the company. This example highlights
the complexity of the circular flow model as inputs and outputs are continually cycling throughout
a systematic economy.