BA LLB Paper Code: 118

Subject: Economics-II
(Macroeconomic Analysis) L4 C4

Unit – I: Overview of Macroeconomics (Lectures:10)

a. Interdependence of micro and macro economics

b. Development of macroeconomics-Schools of Thought-Classical, Keynesian and
Post-Keynesian
c. Goals of macroeconomic policy
d. Basic concepts-Stocks and Flows, National Product and Domestic Product,
Aggregate Consumption, circular Flow of Income
e. Alternative measures of National Output, Real and Nominal GNP
f. The Principle of Effective Demand-Aggregate Demand and Aggregate Supply

Unit – II: Theory of Money and Banking (Lectures: 12)

a. Functions for money, classification, supply and demand for money

b. Effects of money on output and prices
c. Inflation and deflation
d. Monetary policy
e. Money markets and capital markets
f. Commercial Banking-functions organization and operations
g. Central Banking- functions and credit control
h. Non-Banking Financial Institutions-meaning, role; distinction between banks and
NBFI

Unit – III: Principles of Public Finance (Lectures: 10)

a. Tax system- its meaning and classification

b. Public Finance vs. Private Finance
c. Fiscal Policy- concept, objectives and instruments
d. Central Budget
e. Burden of deficits and debts

Unit – IV: Poverty, Business Cycles and Unemployment (Lectures: 10)

a. Concept, causes and policy measures of poverty

b. Features of business cycles
c. Economic interpretation of unemployment
 Unit-1

Interdependence of micro and macro economics:

Micro and macro economics are the two sides of the same coin. There is close interdependence
between the two. We cannot analyses the individual behavior without the assuming to aggregate
and likewise aggregate cannot be effective unless individual variables are kept under
consideration.
Micro economics contributes towards macro economics in a number of ways as:-
1.Study of economic fluctuations:-Business cycles which are universal in every sector, are
influenced by both individuals and aggregate factors. Unless we review both micro and aggregate
variables, we cannot provide an appropriate solution to business cycles. Therefore to study trade
cycle’s micro and macro economics contribute significantly.

2.Basis of economic laws:-Micro economics acts as a basis macro economics because macro is an
aggregate of individual units. The success and accuracy of aggregates depends on the individual
units. Similarly, macro theories are used by micro economists.

3.Role in international trade:-In international trade both the approaches are used. Economists have
developed their theories on the basis of micro economics presuming full employment of resources
and mobility of factors move production. However, modern economists looked on the economy as
a whole and recognized the role of aggregates. So general equilibrium is nothing but an extension
of equilibrium of micro economics.

4.Balance of payments and interdependence:-Balance of payments problem is also a burning

problem for economy. An individual sector may have favorable balance of payments whereas
other sectors, unfavorable balance of payments. On theother hand. The overall position of an
economy is to be assessed from aggregate position of all sectors.

5.Theory of tariffs:-Many economists have propounded that modern macro approaches of imposing
tariffs with the intension of correcting balance of payments position is virtually based on the theory
of monopoly. So micro economics has influenced the modern macro economics theory.

Keynesian economics:

Keynesian economics ( or Keynesianism) is the view that in the short run, especially during
recessions, economic output is strongly influenced by aggregate demand (total spending in the
economy). In the Keynesian view, aggregate demand does not necessarily equal the productive
capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves
erratically, affecting production, employment, and inflation
 The theories forming the basis of Keynesian economics were first presented by the British
economist John Maynard Keynes in his book, The General Theory of Employment, Interest and
Money, published in 1936, during the Great Depression. Keynes contrasted his approach to the
'classical' economics that preceded his book. The interpretations of Keynes that followed are
contentious and several schools of economic thought claim his legacy.

Keynesian economists often argue that private sector decisions sometimes lead to inefficient
macroeconomic outcomes which require active policy responses by the public sector, in
particular, monetary policy actions by the central bank and fiscal policy actions by the
government, in order to stabilize output over the business cycle. Keynesian economics advocates
a mixed economy – predominantly private sector, but with a role for government intervention
during recessions.

Keynesian economics served as the standard economic model in the developed nations during
the later part of the Great Depression, World War II, and the post-war economic expansion
(1945–1973), though it lost some influence following the oil shock and resulting stagflation of
the 1970s.The advent of the global financial crisis in 2008 has caused a resurgence in Keynesian
thought.

Classical economics:
Classical economics is widely regarded as the first modern school of economic thought. Its
major developers include Adam Smith, Jean-Baptist Say, David Ricardo, Thomas Malthus and
John Stuart Mill.

Adam Smith's The Wealth of Nations in 1776 is usually considered to mark the beginning of
classical economics. The school was active into the mid 19th century and was followed by
neoclassical economics in Britain beginning around 1870, or, in Marx's definition by "vulgar
political economy" from the 1830s. The definition of classical economics is debated, particularly
the period 1830–70 and the connection to neoclassical economics. The term "classical
economics" was coined by Karl Marx to refer to Ricardian economics – the economics of David
Ricardo and James Mill and their predecessors – but usage was subsequently extended to include
the followers of Ricardo.

Classical economists claimed that free markets regulate themselves, when free of any
intervention. Adam Smith referred to a so-called invisible hand, which will move markets
towards their natural equilibrium, without requiring any outside intervention.

As opposed to Keynesian economics, classical economics assumes flexible prices both in the
case of goods and wages. Another main assumption is based on Say's Law: supply creates its
own demand - that is, aggregate production will generate an income enough to purchase all the
output produced; this implicitly assumes, in contrast to Keynes, that there will be net saving or
spending of cash or financial instruments. Another postulate of classical economics is the
equality of savings and investment, assuming that flexible interest rates will always maintain
equilibrium.
Differences Between Classical & Keynesian Economics:

Economics is the quantitative and qualitative study on the allocation, distribution and production
of economic resources. Economics often studies the monetary policy of a government and other
information using mathematical or statistical calculations. Qualitative analysis is made by
making judgments and inferences from fiscal information. Two economic schools of thought are
classical and Keynesian. Each school takes a different approach to the economic study of
monetary policy, consumer behavior and government spending. A few basic distinctions separate
these two schools.

Basic Theory:

Classical economic theory is rooted in the concept of a laissez-faire economic market. A laissez-
faire--also known as free--market requires little to no government intervention. It also allows
individuals to act according to their own self interest regarding economic decisions. This ensures
economic resources are allocated according to the desires of individuals and businesses in the
marketplace. Classical economics uses the value theory to determine prices in the economic
market. An item’s value is determined based on production output, technology and
wages paid to produce the item. Keynesian economic theory relies on spending and aggregate
demand to define the economic marketplace. Keynesian economists believe the aggregate
demand is often influenced by public and private decisions. Public decisions represent
government agencies and municipalities. Private decisions include individuals and businesses in
the economic marketplace. Keynesian economic theory relies heavily on the fact that a
nation’s monetary policy can affect a company’s economy.

Government Spending:

Government spending is not a major force in a classical economic theory. Classical economists
believe that consumer spending and business investment represents the more important parts of a
nation& economic growth. Too much government spending takes away valuable economic
resources needed by individuals and businesses. To classical economists, government spending
and involvement can retard a nation’s economic growth by increasing the public
sector and decreasing the private sector. Keynesian economics relies on government spending to
jumpstart a nation’s economic growth during sluggish economic downturns. Similar
to classical economists, Keynesians believe the nation’s economy is made up of
consumer spending, business investment and government spending. However, Keynesian theory
dictates that government spending can improve or take the place of economic growth in the
absence of consumer spending or business investment.

Short vs. Long-term Affects

Classical economics focuses on creating long-term solutions for economic problems. The effects
of inflation, government regulation and taxes can all play an important part in developing
classical economic theories. Classical economists also take into account the effects of other
current policies and how new economic theory will improve or distort the free market
environment. Keynesian economics often focuses on immediate results in economic theories.
Policies focus on the short-term needs and how economic policies can make instant corrections
to a nation& rsquo; s economy. This is why government spending is such a key cog of
Keynesian economics. During economic recessions and depressions, individuals and businesses
do not usually have the resources for creating immediate results through consumer spending or
business investment. The government is seen as the only force to end these downturns through
monetary or fiscal policies providing instant economic results.

Goals of macroeconomic policy:

The three primary macroeconomic policy goals are economic growth, low unemployment and
low inflation.

The three primary macroeconomic policy goals are economic growth, low unemployment, and
low inflation. Economic growth is an increase in a country’s standard of living. Unemployment
is the condition of wanting, but not having, a paid job. Inflation is a general increase in the price
level, which is the general level of prices for goods and services in an economy. A price index is
used to measure the price level. All three goals are important because of their influence on the
standard of living. Economic growth is the primary determinant of the standard of living,
however, and is thus the ultimate macroeconomic goal.

Stocks and Flows:

Economics, business, accounting, and related fields often distinguish between quantities that are
stocks and those that are flows. These differ in their units of measurement. A stock variable is
measured at one specific time, and represents a quantity existing at that point in time (say,
December 31, 2004), which may have accumulated in the past. A flow variable is measured over
an interval of time. Therefore a flow would be measured per unit of time (say a year). Flow is
roughly analogous to rate or speed in this sense.

For example, U.S. nominal gross domestic product refers to a total number of dollars spent over
a time period, such as a year. Therefore it is a flow variable, and has units of dollars/year. In
contrast, the U.S. nominal capital stock is the total value, in dollars, of equipment, buildings,
inventories, and other real assets in the U.S. economy, and has units of dollars. The diagram
provides an intuitive illustration of how the stock of capital currently available is increased by
the flow of new investment and depleted by the flow of depreciation.

Stocks and flows in accounting:

Thus, a stock refers to the value of an asset at a balance date (or point in time), while a flow
refers to the total value of transactions (sales or purchases, incomes or expenditures) during an
accounting period. If the flow value of an economic activity is divided by the average stock
value during an accounting period, we obtain a measure of the number of turnovers (or rotations)
of a stock in that accounting period. Some accounting entries are normally always represented as
a flow (e.g. profit or income), while others may be represented both as a stock or as a flow (e.g.
capital).

A person or country might have stocks of money, financial assets, liabilities, wealth,
wealth real means
of production, capital, inventories
inventories, and human capital (or labor power).
). Flow magnitudes include
income, spending, saving,, debt repayment, fixed investment, inventory investment,
investment and labor
utilization.

Comparing stocks and flows:

Stocks and flows have different units and are thus not commensurable – they cannot be
meaningfully compared, equated, added, oor subtracted. However, one may meaningfully take
ratios of stocks and flows, or multiply or divide them. This is a point of some confusion for some
economics students, as some confuse taking ratios (valid) with comparing (invalid).

The ratio of a stock overr a flow has units of (units)/(units/time) = time. For example, the debt to
GDP ratio has units of years (as GDP is measured in, for example, dollars per year whereas debt
is measured in dollars), which yields the interpretation of the debt to GDP ratio as "number of
years to pay off all debt, assuming all GDP devoted to debt repayment".

The ratio of a flow to a stock has units 1/time. For example, the velocity of money is defined as
nominal GDP / nominal money supply
supply;; it has units of (dollars / year) / dollars = 1/year.

In discrete time,, the change in a stock variable from one point in time to another point in time
one time unit later is equal to the corresponding flow variable per unit of time. For example, if a
country's stock of physical capital on January 1, 2010
10 is 20 machines and on January 1, 2011 is
23 machines, then the flow of net investment during 2010 was 3 machines per year. If it then has
27 machines on January 1, 2012, the fflow
low of net investment during 2010 and 2011 averaged
machines per year.

National Product and Domestic Product:

Gross national product (GNP)) is the market value of all the products and services produced in
one year by labor and property supplied by the residents of a country. Unlike Gross Domestic
Product (GDP), which defines production based on the geographical location of production, GNP
allocates production based on ownership.

GNP does not distinguish between qualitative improvements in the state of the technical arts
(e.g., increasing computer processing
cessing speeds), and quantitative increases in goods (e.g., number
of computers produced), and considers both to be forms of "economic growth".
Basically, GNP is the total value of all final goods and services produced within a nation in a
particular year, plus income earned by its citizens (including income of those located abroad),
minus income of non-residents located in that country. GNP measures the value of goods and
services that the country's citizens produced regardless of their location. GNP is one measure of
the economic condition of a country, under the assumption that a higher GNP leads to a higher
quality of living, all other things being equal.

Gross National Product (GNP) is often contrasted with Gross Domestic Product (GDP). While
GNP measures the output generated by a country's enterprises (whether physically located
domestically or abroad) GDP measures the total output produced within a country's borders -
whether produced by that country's own local firms or by foreign firms.

When a country's capital or labour resources are employed outside its borders, or when a foreign
firm is operating in its territory, GDP and GNP can produce different measures of total output. In
2009 for instance, the United States estimated its GDP at $14.119 trillion, and its GNP at
$14.265 trillion.

GDP vs GNP:

circular Flow of Income:

In economics, the terms circular flow of income or circular flow refer to a simple economic
model which describes the reciprocal circulation of income between producers and consumers.[In
the circular flow model, the inter-dependent entities of producer and consumer are referred to as
"firms" and "households" respectively and provide each other with factors in order to facilitate
the flow of income.Firms provide consumers with goods and services in exchange for consumer
expenditure and "factors of production" from households. More complete and realistic circular
flow models are more complex. They would explicitly include the roles of government and
financial markets, along with imports and exports.

Human wants are unlimited and are of recurring nature therefore, production process remains a
continuous and demanding process. In this process, household sector provides various factors of
production such as land, labor, capital and enterprise to producers who produce by goods and
services by coordinating them. Producers or business sector in return makes payments in the
form of rent, wages, interest and profits to the household sector. Again household sector spends
this income to fulfill its wants in the form of consumption expenditure. Business sector supplies
them goods and services produced and gets income in return of it. Thus expenditure of one sector
becomes the income of the other and supply of goods and services by one section of the
community becomes demand for the other. This process is unending and forms the circular flow
of income, expenditure and production.

A continuous flow of production, income and expenditure is known as circular flow of income. It
is circular because it has neither any beginning nor an end. The circular flow of income involves
two basic assumptions:- 1.In any exchange process, the seller or producer receives the same
amount what buyer or consumer spends. 2.Goods and services flow in one direction and money
payment to get these flow in return direction, causes a circular flow.

Circular flows are classified as: Real Flow and Money Flow. Real Flow- In a simple economy,
the flow of factor services from households to firms and corresponding flow of goods and
services from firms to households is known to be as real flow.

Assume a simple two sector economy- household and firm sectors, in which the households
provides factor services to firms, which in return provides goods and services to them as a
reward. Since there will be an exchange of goods and services between the two sectors in
physical form without involving money, therefore, it is known as real flow.

Money Flow- In a modern two sector economy, money acts as a medium of exchange between
goods and factor services. Money flow of income refers to a monetary payment from firms to
households for their factor services and in return monetary payments from households to firms
against their goods and services. Household sector gets monetary reward for their services in the
form of rent, wages, interest, and profit form firm sector and spends it for obtaining various types
of goods to satisfy their wants. Money acts as a helping agent in such an exchange.

Assumptions:

The basic circular flow of income model consists of seven assumptions:

1. The economy consists of two sectors: households and firms.

2. Households spend all of their income (Y) on goods and services or consumption (C).
There is no saving (S).
3. All output (O) produced by firms is purchased by households through their expenditure
(E).
4. There is no financial sector.
5. There is no government sector.
6. There is no overseas sector.
7. It is a closed economy with no exports or imports.

Effective Demand-Aggregate Demand and Aggregate Supply:

Principle of Effective Demand: Aggregate Demand and Aggregate Supply

Introduction:

The logical starting point of Keynes’s theory of employment is the principle of effective
demand. In a entrepreneurial economy, the level of employment is based on effective demand.
Thus employment results from a deficiency of effective demand and the level of employment can
be raised by increasing the level of effective demand.

Aggregate Demand Price:

“The aggregate demand price for the output of any given amount of employment is the total
sum of money or proceeds which is expected from the sale of the output produced when that
amount of labour is employed.” Thus the aggregate demand price is the amount of money which
the entrepreneurs expect to get by selling the output produced by the number of men employed.
In other words it refers to the expected revenue from the sale of output produced at a particular
level of employment. Different aggregate demand prices relate to different levels of employment
in the economy.

A statement showing the various aggregate demand prices at different levels of employment
is called the aggregate demand price schedule or aggregate demand function. “The aggregate
demand function.” according to Keynes, “relates any given level of employment to the expected
proceeds from that level of employment.”

The below tablet represents the aggregate demand schedule where it reveals that, with the
increase in the level of employment proceeds, expected rise and at lower levels of employment
decline. When 900 thousand people are provided employment the aggregate demand price is
$560 million and when 250 thousand people are provided jobs, it is $480 million.

According to Keynes the aggregate demand function is an increasing function of the level of
employment and is expressed as D = F (N), where D is the proceeds which entrepreneurs expect
from the employment of N men.

In macroeconomics, aggregate demand (AD) is the total demand for final goods and services in
the economy (Y) at a given time and price level. It is the amount of goods and services in the
economy that will be purchased at all possible price levels. This is the demand for the gross
domestic product of a country when inventory levels are static. It is often called effective
demand, though at other times this term is distinguished.

It is often cited that the aggregate demand curve is downward sloping because at lower price
levels a greater quantity is demanded. While this is correct at the microeconomic, single good
level, at the aggregate level this is incorrect. The aggregate demand curve is in fact downward
sloping as a result of three distinct effects: Pigou's wealth effect, the Keynes' interest rate effect
and the Mendel-Fleming exchange-rate effect.
 Unit-2

Functions for money, classification, supply and demand for money:

Monetary theory develops the link between money supply and other macroeconomic variables,
including the price level and output (GDP). In this chapter we begin with competing theories of
money demand and some empirical evidence about the behavior of money demand.

I. The Quantity Theory of Money

This theory, developed by the classical economists over 100 years ago, related the amount of
money in the economy to nominal income. Economist Irving Fisher is given credit for the
development of this theory. It begins with an identity known as the equation of exchange:

MV = PY

Where M is the quantity of money, P is the price level, and Y is aggregate output (and aggregate
income). V is velocity, which serves as the link between money and output. Velocity is the number
of times in a year that a dollar is used to purchased goods and services.

The equation of exchange is an identity because it must be true that the quantity of money, times
how many times it is used to buy goods equals the amount of goods times their price.

To move towards the quantity theory of money, Fisher makes two key assumptions:

1. Fisher viewed velocity as constant in the short run. This is because he felt that velocity is affected
by institutions and technology that change slowly over time.
2. Fisher, like all classical economists, believed that flexible wages and prices guaranteed output, Y,
to be at its full-employment level, so it was also constant in the short run.

Putting these two assumptions together lets look again at the equation of exchange:

MV = PY

If both V and Y are constant, then changes in M must cause changes in P to preserve the equality
between MV and PY. This is the quantity theory of money: a change in the money supply, M,
results in an equal percentage change in the price level P.

We can further modify this relationship by dividing both sides by V:

M = (1/V) x PY

Since V is constant we can replace (1/V) with some constant, k, and when the money market is in
equilibrium, Md = M. So our equation becomes

Md = k x PY
 So under the quantity theory of money, money demand is a function of income and does not
depend on interest rates.

Is Velocity Constant?

A constant V is key to the quantity theory of money. For Fisher, the assumption was a leap of faith
since data on GDP and the money supply did not exist in 1911. However, looking at that data in
Figure 1, page 542, we see very clearly that velocity is not constant, even in the short run. In
particular, velocity drops significantly during recessions.

With the problems of the Great Depression, economists began to look for factors other than
income that influence money demand.

II. Keynes Liquidity Preference Theory

In 1936, economist John M. Keynes wrote a very famous and influential book, The General
Theory of Employment, Interest Rates, and Money. In this book he developed his theory of money
demand, known at the liquidity preference theory. His ideas formed the basis for the liquidity
preference framework discussed in chapter 5.

Keynes believed there were 3 motives to holding money:

• Transactions motive. Money is a medium of exchange, and people hold money to buy stuff. So as
income rises, people have more transactions and people will hold more money

• Precautionary motive. People hold money for emergencies (cash for a tow truck, savings for
unexpected job loss). Since this also depends on the amount of transactions people expect to make,
money demand is again expected to rise with income.

• Speculative motive. Money is also a way for people to store wealth. Keynes assumed that people
stored wealth with either money or bonds. When interest rates are high, rate would then be
expected to fall and bond prices would be expected to rise. So bonds are more attractive than
money when interest rates are high. When interest rates are low, they then would be expected to
rise in the future and thus bond prices would be expected to fall. So money is more attractive than
bonds when interest rates are low. So under the speculative motive, money demand is
negatively related to the interest rate. (We have seen this already in chapter 5).

Keynes also modeled money demand as the demand for the REAL quantity of money (real
balances) or M/P. In other words, if prices double, you must hold twice the amount of M to buy the
same amount of stuff, but your real balances stay the same. So people chose a certain amount of
real balances based on the interest rate, and income:

M/P = f(i, Y) The importance of interest rates in the Keynesian approach is the big difference
between Keynes and Fisher. With this difference also come different implications about the
behavior of velocity. Consider the two equations:
MV = PY
M/P = f (i, Y)

so M = PY/V in the first equation. Substituting in the second equation:

Y/V = f(i, Y) or V = Y/(f(i,Y)).

This means that under Keynes' theory, velocity fluctuates with the interest rate. Since interest rates
fluctuate quite a bit, then velocity must too. In fact, velocity and interest rates will move in the
same direction. Both are procyclical, rising with expansions and falling during recessions.

Further Developments to the Keynesian Approach:

After World War II, Keynes economic theories became very influential and other economists
further refined his motives for holding money. One of these economists, James Tobin, later won a
Nobel Prize for his contributions.

Tobin (and another economist Baume) both developed theories and how the transactions demand
for money is also related to the interest rate. As interest rates rise, the opportunity cost of holding
cash for transactions will also rise, so the transactions part of money demand is also negatively
related to the interest rate. Similarly, people will hold fewer precautionary balances when interest
rates are high.

One problem with Keynes' speculative demand is that his theory predicted that people would hold
wealth as either money or bonds, but not both at once. That is not realistic. Tobin avoided this
problem by observing that the return to money is much less risky than the return to bonds, so that
people will still hold some money as a store of wealth even when interest rates are high. This
diversification is attractive because is reduces risk.

Still one problem with money demand remains. There are other low risk interest bearing assets:
money market mutual funds, U.S. Treasury Bills, and others. So why would anyone hold money
(M1) as a store of wealth? Economist today still tries to develop models of investor behavior to
solve this "rate of return dominance" puzzle.

III. Friedman’s Modern Quantity Theory of Money

Milton Friedman (another Nobel Prize winner) developed a model for money demand based on the
general theory of asset demand. Money demand, like the demand for any other asset, should be a
function of wealth and the returns of other assets relative to money. His money demand function is
as follows:

Where Yp = permanent income (the expected long-run average of current and future income)
rb = the expected return on bonds
 rm = the expected return on money
re = the expected return on stocks
pi(e) = the expected inflation rate (the expected return on goods, since inflation is the increase in
the price (value) of goods)

Money demand is positively related to permanent income. However, permanent income, since it is
a long-run average, is more stable than current income, so this will not be the source of a lot of
fluctuation in money demand

The other terms in Friedman's money demand function are the expected returns on bonds, stocks
and goods RELATIVE the expected return on money. These items are negatively related to money
demand: the higher the returns of bonds, equity and goods relative the return on money, the lower
the quantity of money demanded. Friedman did not assume the return on money to be zero. The
return on money depended on the services provided on bank deposits (check cashing, bill paying,
etc) and the interest on some checkable deposits.

Friedman vs. Keynes :

When comparing the money demand frameworks of Friedman and Keynes, several differences
arise

• Friedman considers multiple rates of return and considers the RELATIVE returns to be important
• Friedman viewed money and goods and substitutes.
• Friedman viewed permanent income as more important than current income in determining money
demand

Friedman's money demand function is much more stable than Keynes'. Why? Consider the terms
in Friedman's money demand function:

• permanent income is very stable, and

• the spread between returns will also be stable since returns would tend to rise or fall all at once,
causing the spreads to stay the same. So in Friedman's model changes in interest rates have little or
no impact on money demand. This is not true in Keynes' model.

If the terms affecting money demand are stable, then money demand itself will be stable. Also,
velocity will be fairly predictable.
IV. Empirical Evidence on Money Demand

So who is right? Well, the chief differences between Keynes and Friedman lie in the sensitivity of
money demand to interest rates and the stability of the money demand function over time. Looking
at the data on these two features will yield some answers about the best theory of money demand.

Tobin did some of the earliest research on the relationship between interest rates and money
demand and concluded that money demand IS sensitive to interest rates. Later research in the
1950s and 1960s backed up his findings. Furthermore, the sensitivity did not change over time.
Many researchers looked at this question and their findings are remarkably consistent (which in
economics is somewhat miraculous :)).

Now for the stability of the money demand function. Up until the mid-1970s, researchers found the
money demand function to be remarkably stable. In other words, money demand functions
estimated in the 1930s, worked just as well predicting money demand in the 1950s or 1960s. The
relationship between money demand, income and interest rates did not change over time.

However, starting in 1974, the stability of the money demand function (M1) began to breakdown.
Existing money demand functions were overpredicting money demand (i.e. actual money demand
was lower than what old money demand functions were predicting). This case of the "missing
money" was a problem for policy makers that relied on these functions to predict the effects of
monetary policy. What caused this breakdown? It is likely that financial innovations in the 1970s
(money market accounts, NOW accounts, electronic funds transfers) changed the working
definitions of money even though our official definitions did not change. This problem grew worse
in the 1980s.

With the problems in the M1 money demand functions, policy makers turned to M2 money
demand. However, the stability of M2 money demand functions also broke down in the 1990s.
This cause the Federal Reserve to stop setting targets for M2 in 1992 after abandoning M1 targets
in 1987.

Inflation and deflation:

In economics inflation means, a rise in general level of prices of goods and services in a economy
over a period of time. When the general price level rises, each unit of currency buys fewer goods
and services. Thus, inflation results in loss of value of money. Another popular way of looking at
inflation is "too much money chasing too few goods". The last definition attributes the cause of
inflation to monetary growth relative to the output / availability of goods and services in the
economy.

In case the price of say only one commodity rise sharply but prices of other commodities falls, it
will not be termed as inflation. Similarly, in case due to rumors if the price of a commodity rises
during the day itself, it will not be termed as inflation.
What are different types of inflation:

(a) DEMAND - PULL INFLATION: In this type of inflation prices increase results from an
excess of demand over supply for the economy as a whole. Demand inflation occurs when
supply cannot expand any more to meet demand; that is, when critical production factors are
being fully utilized, also called Demand inflation.

(b) COST - PUSH INFLATION: This type of inflation occurs when general price levels rise
owing to rising input costs. In general, there are three factors that could contribute to Cost-Push
inflation: rising wages, increases in corporate taxes, and imported inflation. [imported raw or
partly-finished goods may become expensive due to rise in international costs or as a result of
depreciation of local currency

Types of inflation such as:

(1) currency inflation whereby prices rise NOT because of an increase in money supply, but a
decline in value of the currency on world markets (i.e. G5 manipulation of dollar 40% lower in
1985 led to 1987 Crash & capital flight back to Japan creating bubble there);

(2) capital concentration into one sector causing bubble which can be purely domestic or inspired
internationally with rising currency as was the case in Japan 1989 or USA into 1929;

(3) the classroom plain vanilla idea of a rise in prices with an increase in in money supply such as
sudden discovery of gold in California, Australia and Alaska during 19th century, and the import
of gold and silver from America into Europe by Spain that created wholesale systemic inflation in
all European economies, and

(4) Commodity inflation that is caused by a drop in supply such as food due to weather or
exhaustion of resources.

(5) Money supply remains unchanged, but the VELOCITY increases from leverage (i.e. lending).

Deflation:

Deflation is the opposite of inflation. Deflation refers to situation, where there is decline in
general price levels. Thus, deflation occurs when the inflation rate falls below 0% (or it is
negative inflation rate). Deflation increases the real value of money and allows one to buy more
goods with the same amount of money over time. Deflation can occur owing to reduction in the
supply of money or credit. Deflation can also occur due to direct contractions in spending,
either in the form of a reduction in government spending, personal spending or investment
spending. Deflation has often had the side effect of increasing unemployment in an economy,
since the process often leads to a lower level of demand in the economy. In economics, deflation
is a decrease in the general price level of goods and services.[1] Deflation occurs when the
 inflation rate falls below 0% (a negative inflation rate). This should not be confused with
disinflation, a slow-down in the inflation rate (i.e., when inflation declines to lower levels).[2]
Inflation reduces the real value of money over time; conversely, deflation increases the real value
of money – the currency of a national or regional economy. This allows one to buy more goods
with the same amount of money over time.

Economists generally believe that deflation is a problem in a modern economy because it increases
the real value of debt, and may aggravate recessions and lead to a deflationary spiral.[3] Historically
not all episodes of deflation correspond with periods of poor economic growth.[4] Deflation
occurred in the U.S. during most of the 19th century (the most important exception was during the
Civil War). This deflation was caused by technological progress that created significant economic
growth.[5][6][7] This deflationary period of considerable economic progress preceded the
establishment of the U.S. Federal Reserve System and its active management of monetary matters.

Deflation is likewise multidimensional

(1) the classroom version of a decrease in money supply;

(2) Failure of money supply expansion to match increase in demand for money

(a) as in deleveraging during economic decline as VELOCITY collapses and thus even QE1, QE2,
QE3 failed to produce inflation because they were less than the destruction of capital from
deleveraging

(b) the classic contraction in money supply during economic declines relative to the shift in
demand from assets to liquidity

(c) rise in the demand for money outpaces the available supply as in flight to quality

money supply growth falls below economic expansion

money supply growth falls below population expansion (more people making due with the same
amount of money)

(3) contraction in available capital due to rising costs private or public

(a) from sudden price sock as in OPEC during 1970s creating STAGFLATION

(b) sudden rise in taxation causing decline in VELOCITY of money

(c) confiscation of assets by regulation

(d) historical forced loans,

(e) criminalization of normal human activity to confiscate assets as penalty under pretense of law

(4) in a precious metal money supply the debasement of new currency causes Gresham’s Law
whereby the the older money supply is then hoarded thereby shrinking the TOTAL supply of
money
(a) this causes prices to rise in terms of the debased new currency ONLY creating an admixture of
inflation (rising prices systemically) coinciding with a deflation caused by the contraction in the
TOTAL available money supply

(5) collapse in government / rule of law causes wealth to shift and concentrate in tangible assets
(flight to quality) that survives the transition to a new government and monetary system

(a) this is normally associated with a collapse in the legal tender status of money whereby
government no longer accepts its own currency in payment for taxes

(i) as was the case in Rome

(ii) Japan constantly demonetized previous currency or devalued it by a factor of 10 causing wealth
to hoard in tangible assets and barter to emerge as rice displaced coins for 600 years because of
devaluation by government

Monetary policy:
Many economists have given various definitions of monetary policy. Some prominent definitions
are as follows.

According to Prof. Harry Johnson,

"A policy employing the central banks control of the supply of money as an instrument for
achieving the objectives of general economic policy is a monetary policy."

According to A.G. Hart,

"A policy which influences the public stock of money substitute of public demand for such assets
of both that is policy which influences public liquidity position is known as a monetary policy."

From both these definitions, it is clear that a monetary policy is related to the availability and
cost of money supply in the economy in order to attain certain broad objectives. The Central
Bank of a nation keeps control on the supply of money to attain the objectives of its monetary
policy.
 Objectives of Monetary Policy:

The objectives of a monetary policy in India are similar to the objectives of its five year plans. In a
nutshell planning in India aims at growth, stability and social justice. After the Keynesian
revolution in economics, many people accepted significance of monetary policy in attaining
following objectives.

1. Rapid Economic Growth

2. Price Stability
3. Exchange Rate Stability
4. Balance of Payments (BOP) Equilibrium
5. Full Employment
6. Neutrality of Money
7. Equal Income Distribution

These are the general objectives which every central bank of a nation tries to attain by employing
certain tools (Instruments) of a monetary policy. In India, the RBI has always aimed at the
controlled expansion of bank credit and money supply, with special attention to the seasonal needs
of a credit.

Let us now see objectives of monetary policy in detail:-

1. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary
policy can influence economic growth by controlling real interest rate and its resultant impact on
the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the
investment level in the economy can be encouraged. This increased investment can speed up
economic growth. Faster economic growth is possible if the monetary policy succeeds in
maintaining income and price stability.
2. Price Stability: All the economics suffer from inflation and deflation. It can also be called as Price
Instability. Both inflation are harmful to the economy. Thus, the monetary policy having an
objective of price stability tries to keep the value of money stable. It helps in reducing the income
and wealth inequalities. When the economy suffers from recession the monetary policy should be
an 'easy money policy' but when there is inflationary situation there should be a 'dear money
policy'.
3. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any
foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the
exchange rate, the international community might lose confidence in our economy. The monetary
policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the
foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain
the exchange rate stability.
4. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffers from the
Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to
maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus'
and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while
the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary
equilibrium, then the BOP equilibrium can be achieved.
5. Full Employment: The concept of full employment was much discussed after Keynes's publication
of the "General Theory" in 1936. It refers to absence of involuntary unemployment. In simple
words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs.
However it does not mean that there is a Zero unemployment. In that senses the full employment is
never full. Monetary policy can be used for achieving full employment. If the monetary policy is
expansionary then credit supply can be encouraged. It could help in creating more jobs in different
sector of the economy.
6. Neutrality of Money : Economist such as Picketed, Robertson have always considered money as a
passive factor. According to them, money should play only a role of medium of exchange and not
more than that. Therefore, the monetary policy should regulate the supply of money. The change in
money supply creates monetary disequilibrium. Thus monetary policy has to regulate the supply of
money and neutralize the effect of money expansion. However this objective of a monetary policy
is always criticized on the ground that if money supply is kept constant then it would be difficult to
attain price stability.
7. Equal Income Distribution: Many economists used to justify the role of the fiscal policy is
maintaining economic equality. However in recent years economists have given the opinion that
the monetary policy can help and play a supplementary role in attainting an economic equality.
Monetary policy can make special provisions for the neglect supply such as agriculture, small-
scale industries, village industries, etc. and provide them with cheaper credit for longer term. This
can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in
reducing economic inequalities among different sections of society.

Instruments of Monetary Policy - Quantitative & Qualitative Tools:

The instruments of monetary policy are tools or devise which are used by the monetary authority
in order to attain some predetermined objectives. There are two types of instruments of the
monetary policy as shown below.

(A) Quantitative Instruments or General Tools:

The Quantitative Instruments are also known as the General Tools of monetary policy. These
tools are related to the Quantity or Volume of the money. The Quantitative Tools of credit
control are also called as General Tools for credit control. They are designed to regulate or
control the total volume of bank credit in the economy. These tools are indirect in nature and are
employed for influencing the quantity of credit in the country. The general tool of credit control
comprises of following instruments.

1. Bank Rate Policy (BRP):

The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for
influencing the volume or the quantity of the credit in a country. The bank rate refers to rate at
which the central bank (i.e RBI) rediscounts bills and prepares of commercial banks or provides
advance to commercial banks against approved securities. It is "the standard rate at which the
bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for
purchase under the RBI Act". The Bank Rate affects the actual availability and the cost of the
 credit. Any change in the bank rate necessarily brings out a resultant change in the cost of credit
available to commercial banks. If the RBI increases the bank rate than it reduce the volume of
commercial banks borrowing from the RBI. It deters banks from further credit expansion as it
becomes a more costly affair. Even with increased bank rate the actual interest rates for a short
term lending go up checking the credit expansion. On the other hand, if the RBI reduces the bank
rate, borrowing for commercial banks will be easy and cheaper. This will boost the credit
creation. Thus any change in the bank rate is normally associated with the resulting changes in
the lending rate and in the market rate of interest. However, the efficiency of the bank rate as a
tool of monetary policy depends on existing banking network, interest elasticity of investment
demand, size and strength of the money market, international flow of funds, etc.

2. Open Market Operation (OMO):

The open market operation refers to the purchase and/or sale of short term and long term securities
by the RBI in the open market. This is very effective and popular instrument of the monetary
policy. The OMO is used to wipe out shortage of money in the money market, to influence the
term and structure of the interest rate and to stabilize the market for government securities, etc. It is
important to understand the working of the OMO. If the RBI sells securities in an open market,
commercial banks and private individuals buy it. This reduces the existing money supply as money
gets transferred from commercial banks to the RBI. Contrary to this when the RBI buys the
securities from commercial banks in the open market, commercial banks sell it and get back the
money they had invested in them. Obviously the stock of money in the economy increases. This
way when the RBI enters in the OMO transactions, the actual stock of money gets changed.
Normally during the inflation period in order to reduce the purchasing power, the RBI sells
securities and during the recession or depression phase she buys securities and makes more money
available in the economy through the banking system. Thus under OMO there is continuous
buying and selling of securities taking place leading to changes in the availability of credit in an
economy. However there are certain limitations that affect OMO via; underdeveloped securities
market, excess reserves with commercial banks, indebtedness of commercial banks, etc.

3. Variation in the Reserve Ratios (VRR):

The Commercial Banks have to keep a certain proportion of their total assets in the form of Cash
Reserves. Some part of these cash reserves are their total assets in the form of cash. Apart of these
cash reserves are also to be kept with the RBI for the purpose of maintaining liquidity and
controlling credit in an economy. These reserve ratios are named as Cash Reserve Ratio (CRR)
and a Statutory Liquidity Ratio (SLR). The CRR refers to some percentage of commercial bank's
net demand and time liabilities which commercial banks have to maintain with the central bank
and SLR refers to some percent of reserves to be maintained in the form of gold or foreign
securities. In India the CRR by law remains in between 3-15 percent while the SLR remains in
between 25-40 percent of bank reserves. Any change in the VRR (i.e. CRR + SLR) brings out a
change in commercial banks reserves positions. Thus by varying VRR commercial banks lending
capacity can be affected. Changes in the VRR helps in bringing changes in the cash reserves of
commercial banks and thus it can affect the banks credit creation multiplier. RBI increases VRR
during the inflation to reduce the purchasing power and credit creation. But during the recession or
depression it lowers the VRR making more cash reserves available for credit expansion.

(B) Qualitative Instruments or Selective Tools :

The Qualitative Instruments are also known as the Selective Tools of monetary policy. These
tools are not directed towards the quality of credit or the use of the credit. They are used for
discriminating between different uses of credit. It can be discrimination favoring export over
import or essential over non-essential credit supply. This method can have influence over the
lender and borrower of the credit. The Selective Tools of credit control comprises of following
instruments.

1. Fixing Margin Requirements:

The margin refers to the "proportion of the loan amount which is not financed by the bank". Or in
other words, it is that part of a loan which a borrower has to raise in order to get finance for his
purpose. A change in a margin implies a change in the loan size. This method is used to encourage
credit supply for the needy sector and discourage it for other non-necessary sectors. This can be
done by increasing margin for the non-necessary sectors and by reducing it for other needy sectors.
Example: - If the RBI feels that more credit supply should be allocated to agriculture sector, then it
will reduce the margin and even 85-90 percent loan can be given.

2. Consumer Credit Regulation:

Under this method, consumer credit supply is regulated through hire-purchase and installment sale
of consumer goods. Under this method the down payment, installment amount, loan duration, etc
is fixed in advance. This can help in checking the credit use and then inflation in a country.

3. Publicity:

This is yet another method of selective credit control. Through it Central Bank (RBI) publishes
various reports stating what is good and what is bad in the system. This published information can
help commercial banks to direct credit supply in the desired sectors. Through its weekly and
monthly bulletins, the information is made public and banks can use it for attaining goals of
monetary policy.

4. Credit Rationing:

Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount
available for each commercial bank. This method controls even bill rediscounting. For certain
purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help
in lowering banks credit expoursure to unwanted sectors.
5. Moral Suasion:

It implies to pressure exerted by the RBI on the indian banking system without any strict action for
compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary
periods. Commercial banks are informed about the expectations of the central bank through a
monetary policy. Under moral suasion central banks can issue directives, guidelines and
suggestions for commercial banks regarding reducing credit supply for speculative purposes.

6. Control Through Directives:

Under this method the central bank issue frequent directives to commercial banks. These directives
guide commercial banks in framing their lending policy. Through a directive the central bank can
influence credit structures, supply of credit to certain limit for a specific purpose. The RBI issues
directives to commercial banks for not lending loans to speculative sector such as securities, etc
beyond a certain limit.

7. Direct Action:

Under this method the RBI can impose an action against a bank. If certain banks are not adhering
to the RBI's directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI
may refuse credit supply to those banks whose borrowings are in excess to their capital. Central
bank can penalize a bank by changing some rates. At last it can even put a ban on a particular
bank if it does not follow its directives and work against the objectives of the monetary policy.
These are various selective instruments of the monetary policy. However the success of these
tools is limited by the availability of alternative sources of credit in economy, working of the
Non-Banking Financial Institutions (NBFIs), profit motive of commercial banks and
undemocratic nature off these tools. But a right mix of both the general and selective tools of
monetary policy can give the desired results.

Money markets and capital markets:

As money became a commodity, the money market became a component of the financial markets
for assets involved in short-term borrowing, lending, buying and selling with original maturities of
one year or less. Trading in the money markets is done over the counter and is wholesale. Various
instruments exist, such as Treasury bills, commercial paper, bankers' acceptances, deposits,
certificates of deposit, bills of exchange, repurchase agreements, federal funds, and short-lived
mortgage-, and asset-backed securities.[1] It provides liquidity funding for the global financial
system. Money markets and capital markets are parts of financial markets. The instruments bear
differing maturities, currencies, credit risks, and structure. Therefore they may be used to distribute
the exposure.
 Participants:

The money market consists of financial institutions and dealers in money or credit who wish to
either borrow or lend. Participants borrow and lend for short periods of time, typically up to
thirteen months. Money market trades in short-term financial instruments commonly called
"paper." This contrasts with the capital market for longer-term funding, which is supplied by bonds
and equity.

The core of the money market consists of interbank lending--banks borrowing and lending to each
other using commercial paper, repurchase agreements and similar instruments. These instruments
are often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate (LIBOR)
for the appropriate term and currency.

Finance companies typically fund themselves by issuing large amounts of asset-backed

commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit.
Examples of eligible assets include auto loans, credit card receivables, residential/commercial
mortgage loans, mortgage-backed securities and similar financial assets. Certain large corporations
with strong credit ratings, such as General Electric, issue commercial paper on their own credit.
Other large corporations arrange for banks to issue commercial paper on their behalf via
commercial paper lines.

In the United States, federal, state and local governments all issue paper to meet funding needs.
States and local governments issue municipal paper, while the US Treasury issues Treasury bills to
fund the US public debt:

• Trading companies often purchase bankers' acceptances to be tendered for payment to overseas
suppliers.
• Retail and institutional money market funds
• Banks
• Central banks
• Cash management programs
• Merchant banks

Functions of the money market:

• Transfer of large sums of money

• Transfer from parties with surplus funds to parties with a deficit
• Allow governments to raise funds
• Help to implement monetary policy
• Determine short-term interest rates
 Common money market instruments:
• Certificate of deposit - Time deposit, commonly offered to consumers by banks, thrift institutions,
and credit unions.
• Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for
one day—arranged by selling securities to an investor with an agreement to repurchase them at a
fixed price on a fixed date.
• Commercial paper - short term usanse promissory notes issued by company at discount to face
value and redeemed at face value
• Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the
United States.
• Federal agency short-term securities - (in the U.S.). Short-term securities issued by government
sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the
Federal National Mortgage Association.
• Federal funds - (in the U.S.). Interest-bearing deposits held by banks and other depository
institutions at the Federal Reserve; these are immediately available funds that institutions borrow
or lend, usually on an overnight basis. They are lent for the federal funds rate.
• Municipal notes - (in the U.S.). Short-term notes issued by municipalities in anticipation of tax
receipts or other revenues.
• Treasury bills - Short-term debt obligations of a national government that are issued to mature in
three to twelve months.
• Money funds - Pooled short maturity, high quality investments which buy money market securities
on behalf of retail or institutional investors.
• Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of the
exchange of currencies at a predetermined time in the future.

Capital market:

Capital markets are financial markets for the buying and selling of long-term debt- or equity-
backed securities. These markets channel the wealth of savers to those who can put it to long-term
productive use, such as companies or governments making long-term investments. Financial
regulators, such as the UK's Bank of England (BoE) or the U.S. Securities and Exchange
Commission (SEC), oversee the capital markets in their jurisdictions to protect investors against
fraud, among other duties.

Modern capital markets are almost invariably hosted on computer-based electronic trading
systems; most can be accessed only by entities within the financial sector or the treasury
departments of governments and corporations, but some can be accessed directly by the public.
There are many thousands of such systems, most only serving only small parts of the overall
capital markets. Entities hosting the systems include stock exchanges, investment banks, and
government departments. Physically the systems are hosted all over the world, though they tend to
be concentrated in financial centers like London, New York, and Hong Kong. Capital markets are
defined as markets in which money is provided for periods longer than a year.
A key division within the capital markets is between the primary markets and secondary markets.
In primary markets, new stock or bond issues are sold to investors, often via a mechanism known
as underwriting. The main entities seeking to raise long-term funds on the primary capital markets
are governments (which may be municipal, local or national) and business enterprises
(companies). Governments tend to issue only bonds, whereas companies often issue either equity
or bonds. The main entities purchasing the bonds or stock include pension funds, hedge funds,
sovereign wealth funds, and less commonly wealthy individuals and investment banks trading on
their own behalf. In the secondary markets, existing securities are sold and bought among investors
or traders, usually on a securities exchange, over-the-counter, or elsewhere. The existence of
secondary markets increases the willingness of investors in primary markets, as they know they are
likely to be able to swiftly cash out their investments if the need arises.

A second important division falls between the stock markets (for equity securities, also known as
shares, where investors acquire ownership of companies) and the bond markets (where investors
become creditors).

The money markets are used for the raising of short term finance, sometimes for loans that are
expected to be paid back as early as overnight. Whereas the capital markets are used for the raising
of long term finance, such as the purchase of shares, or for loans that are not expected to be fully
paid back for at least a year.

Funds borrowed from the money markets are typically used for general operating expenses, to
cover brief periods of illiquidity. For example a company may have inbound payments from
customers that have not yet cleared, but may wish to immediately pay out cash for its payroll.
When a company borrows from the primary capital markets, often the purpose is to invest in
additional physical capital goods, which will be used to help increase its income. It can take many
months or years before the investment generates sufficient return to pay back its cost, and hence
the finance is long term

Together, money markets and capital markets form the financial markets as the term is narrowly
understood. The capital market is concerned with long term finance. In the widest sense, it consist
of a series of channels through which the saving of the community are made available for
industrial and commercial enterprises and public authorities

Examples of capital market transactions:

A government raising money on the primary markets:
When a government wants to raise long term finance it will often sell bonds to the capital markets.
In the 20th and early 21st century, many governments would use investment banks to organize the
sale of their bonds. The leading bank would underwrite the bonds, and would often head up a
syndicate of brokers, some of whom might be based in other investment banks. The syndicate
would then sell to various investors. For developing countries, a multilateral development bank
would sometimes provide an additional layer of underwriting, resulting in risk being shared
between the investment bank(s), the multilateral organization, and the end investors. However,
since 1997 it has been increasingly common for governments of the larger nations to bypass
investment banks by making their bonds directly available for purchase over the Internet. Many
governments now sell most of their bonds by computerized auction. Typically large volumes are
put up for sale in one go; a government may only hold a small number of auctions each year. Some
governments will also sell a continuous stream of bonds through other channels. The biggest single
seller of debt is the US Government; there are usually several transactions for such sales every
second, which corresponds to the continuous updating of the US real time debt clock.

Commercial Banking-functions organization and operations:

Introduction to Banks:

Banks have developed around 200 years ago. The natures of banks have changed as the time has
changed. The term bank is related to financial transactions. It is a financial establishment which
uses, money deposited by customers for investment, pays it out when required, makes loans at
interest exchanges currency etc. however to understand the concept in detail we need to see some
of its definitions. Many economists have tried to give different meanings of the term bank.

Nature of Commercial Banks:

Commercial banks are an organization which normally performs certain financial transactions. It
performs the twin task of accepting deposits from members of public and make advances to needy
and worthy people from the society. When banks accept deposits its liabilities increase and it
becomes a debtor, but when it makes advances its assets increases and it becomes a creditor.
Banking transactions are socially and legally approved. It is responsible in maintaining the
deposits of its account holders.

Definitions of Commercial Banks:

While defining the term banks it is taken into account that what type of task is performed by the
banks. Some of the famous definitions are given below:

According to Prof. Sayers, "A bank is an institution whose debts are widely accepted in settlement
of other people's debts to each other." In this definition Sayers has emphasized the transactions
from debts which are raised by a financial institution.

According to the Indian Banking Company Act 1949, "A banking company means any company
which transacts the business of banking. Banking means accepting for the purpose of lending of
investment of deposits of money from the public, payable on demand or other wise and withdraw
able by cheque, draft or otherwise."
 Functions of Commercial Banks:

Commercial bank being the financial institution performs diverse types of functions. It satisfies the
financial needs of the sectors such as agriculture, industry, trade, communication, etc. That means
they play very significant role in a process of economic social needs. The functions performed by
banks are changing according to change in time and recently they are becoming customer centric
and widening their functions. Generally the functions of commercial banks are divided into two
categories viz. primary functions and the secondary functions. The following chart simplifies the
functions of banks.

Primary Functions of Commercial Banks:

Commercial Banks performs various primary functions some of them are given below :

1. Accepting Deposits : Commercial bank accepts various types of deposits from public especially
from its clients. It includes saving account deposits, recurring account deposits, fixed deposits, etc.
These deposits are payable after a certain time period.
2. Making Advances : The commercial banks provide loans and advances of various forms. It
includes an over draft facility, cash credit, bill discounting, etc. They also give demand and
demand and term loans to all types of clients against proper security.
3. Credit creation : It is most significant function of the commercial banks. While sanctioning a loan
to a customer, a bank does not provide cash to the borrower Instead it opens a deposit account
from where the borrower can withdraw. In other words while sanctioning a loan a bank
automatically creates deposits. This is known as a credit creation from commercial bank.

Secondary Functions of Commercial Banks:

 Along with the primary functions each commercial bank has to perform several secondary
functions too. It includes many agency functions or general utility functions. The secondary
functions of commercial banks can be divided into agency functions and utility functions.

Agency Functions : Various agency functions of commercial banks are

1. To collect and clear cheque, dividends and interest warrant.

2. To make payment of rent, insurance premium, etc.
3. To deal in foreign exchange transactions.
4. To purchase and sell securities.
5. To act as trusty, attorney, correspondent and executor.
6. To accept tax proceeds and tax returns.

General Utility Functions: The general utility functions of the commercial banks include

1. To provide safety locker facility to customers.

2. To provide money transfer facility.
3. To issue traveler’s cheque.
4. To act as referees.
5. To accept various bills for payment e.g. phone bills, gas bills, water bills, etc.
6. To provide merchant banking facility.
7. To provide various cards such as credit cards, debit cards, Smart cards, etc.

Central Banking- functions and credit control:

A Central Bank is defined in terms of its functions and as per Vera Smith, “The primary definition
of Central Banking is a banking system in which a single bank has either complete control or a
residuary monopoly of note issue.”

As per Sayers, the Central Bank “Is the organ of Government that undertakes the major financial
operations of the government and by its conduct of these operations and by other means,
influences the behavior of financial institutions so as to support the economic policy of the
government.”

The broadest definition has been given by Economist De Knock and as per him a Central Bank is
“A Bank which constitutes the apex of the monetary and banking structure of its country and
which performs as best as it can in the national economic interest, the following functions:

1. The regulation of currency in accordance with the requirements of business and the
general public for which purpose it is granted either the sole right of note issue or at least
a partial monopoly thereof.
2. The performance of general banking and agency of the state.
3. The custody of the Cash Reserves of the Commercial Banks.

4. The granting of accommodation in the form of re-discounts and collateral advances to

commercial banks, bill brokers and dealers or other financial institutions and the general
acceptance of the responsibility of lender of the last resort.
 5. The custody and management of the nation’s reserves of international currency. The
settlement of clearance balances between the banks.
6. The control of credit in accordance with the needs of business and with a view to carrying
out the broad monetary policy adopted by the state.”

Functions of a Central Bank:

Majority of Economists has accepted the following functions to be performed by a Central Bank
and it is been framed by the economist De Knock.

1. Regulator of Currency:
• The central bank is the issue bank and it has a monopoly note issue. Notes issued by it flows as
legal tender money.
• The issue department issues notes and coins to commercial banks and coins are manufactured in
the government mint but are placed into flow through the central bank.
• Various Central banks had been adopting varied modes of note issue in various nations. The
central bank is obligatory by statute to hold a specified volume of gold and foreign securities
versus the notes issue.
• In few nations, the quantity of gold and foreign securities abides a fixed proportion amidst 30 to 45
percent of the total notes issued.
• In few other nations, a minimum specified quantity of gold and foreign currencies is obligatory to
be kept against note issue by the Central Bank.

2. Banker, Fiscal Agent and Adviser to the Administration:

• In general, Central Bank performs as bankers, fiscal agents and advisers to their corresponding law
of administration. As a banker to the law of administration, the central bank holds the deposit
investment of the central and state governments and makes spending on behalf of the law of
administration. And hence, however, it denies paying interest on government deposit investments.
• It purchases and sells foreign currencies on behalf of the law of administration.
• It holds the inventories of gold of the law of administration and thus it is the guardian of
administration’s finance and affluence.
• As a fiscal agent, the central bank makes short term loans to law of administration for a term not
more than 90 days.
• As an adviser, the central bank advises government on fiscal and money matters as protecting,
devaluation and revaluation, inflation or deflation of the currency, balance of payments, deficit
financing etc.

3. Guarding of Cash Reserves of Commercial Banks:

• Commercial banks are necessitated by law to keep reserves equal to a certain percentage of both
time and demand deposits liabilities with the central bank.
• It is on the origin of these reserves that the central bank shifts funds from one bank to another to
make possible the clearing of cheques.
• Thus the central bank performs as the guardian of the cash reserves of commercial banks and
facilitates in making feasible their transactions.

Function of Central Bank:

In the monetary and banking setup of a country, central bank occupies central position and
perhaps, it is because of this fact that this called as the central bank. In this way, this bank works as
an institution whose main objective is to control and regulate money supply keeping in view the
welfare of the people. Central bank is an institution that fulfills the credit needs of banks and other
credit institution, which woks as banker to the banks and the government and which work for the
economic interest of the country.
1. Monopoly of note issue:
Note issue primarily is the main function of a central bank in every country. These days, in all the
countries where there is a central bank generally it has got the monopoly of the sole right of note
issue. In the beginning this was not the function of central bank, but gradually all the central bank
gas acquires this function.

There are many advantages of the note issue by central banks some important ones are as follow:
1. Central bank controls the credit creating power of commercial bank. By controlling the
amount of currency in circulation, the volume of credit can be controlled to quite a large extent.
2. People have more confidence in the currency issued by the control bank because it has the
protection and recognition of the government.

3. In the event of monopoly of note issue of central bank, there will be uniformity in the currency
system in the country.

4. The currency of the country will be flexible if the central bank of the country has the
monopoly of note issue because central bank can bring about changes very early in the volume of
paper money according to the needs of business, industry and messes.

5. The system of note issue has some advantages. If the central bank of the country has the
monopoly of note issue, all such advantages will accrue to the government.

2. Bankers, Agent and Adviser to the Government:

As banker to the government, central bank provides all those service and facilities to the
government which public gets from the ordinary banks. It operates the account of the public
enterprise. It mangers government departmental undertaking and government funds and where
there is a need gives loan to the government. From time to time, central bank advice the
government on monetary, banking and financial matters.

3. Custodian of Cash Reserve of Commercial Bank:

Central bank is the bank of banks. This signifies that it has the same relationship with the
commercial banks in the country that they gave with their customers. It provides security to their
cash reserves, give them loan at the time of need, gives them advice on financial and economic
matter and work as clearing house among various members bank.

4. Custodian of Nation’s Reserve of International:

Central bank is the custodian of the foreign currency obtained from various countries. This has
become an important function of central bank. These days, because with its help it can stabilize the
external value of the currency.

5. Lender of The Last Resort:

Central bank works as lender of the last resort for commercial banks because in the time of need it
provides them financial assistance and accommodation. Whenever a commercial bank faces
financial crisis, central bank as lender of the last resort comes to its rescue by advancing loans and
the bank is saved from being failed.

6. Clearing House Function:

All commercial bank have their accounts with the central bank. Therefore, central bank settles the
mutual transactions of banks and thus saves all banks controlling each other individually for
setting their individual transaction.
7. Credit Control:
These days, the most important function of a central bank is to control the volume of credit for
bringing about stability in the general price level and accomplishing various other socio economic
objectives. The significance of this function has increased so much that for property understanding
it. The central bank has acquired the rights and powers of controlling the entire banking.
A central bank can adopt various quantitative and qualitative methods for credit control such as
bank rate, open market operation, changes in reserve ratio selective controls, moral situation etc.
Other Functions:

Besides the 7 functions explained above, central banks perform many other functions that are as
follows:
8. Collection of Data
Central banks in almost all the countries collects statistical data regularly relating to economic
aspects of money, credit, foreign exchange, banking etc. from time to time, committees and
commission are appointed for studying various aspects relating to the aforesaid problem.

9. Central Banking in Developing Countries

The basic problem of underdeveloped countries is the problem of lack of capital formation whose
main causes are lack of saving and investment. Therefore, central bank can play an important role
by promoting capital formation through mobilizing saving s and encouraging investment

Non-Banking Financial Institutions-meaning, role; distinction between banks

and NBFI:
A non-bank financial institution (NBFI) is a financial institution that does not have a full banking
license or is not supervised by a national or international banking regulatory agency. NBFIs
facilitate bank-related financial services, such as investment, risk pooling, contractual savings, and
brokering. Examples of these include insurance firms, pawn shops, cashier's check issuers, check
cashing locations, payday lending, currency exchanges, and microloan organizations. Alan
Greenspan has identified the role of NBFIs in strengthening an economy, as they provide "multiple
alternatives to transform an economy's savings into capital investment [which] act as backup
facilities should the primary form of intermediation fail."

Role in Financial System:

NBFIs supplement banks by providing the infrastructure to allocate surplus resources to

individuals and companies with deficits. Additionally, NBFIs also introduces competition in the
provision of financial services. While banks may offer a set of financial services as a packaged
deal, NBFIs unbundle and tailor these service to meet the needs of specific clients. Additionally,
individual NBFIs may specialize in one particular sector and develop an informational advantage.
Through the process of unbundling, targeting, and specializing, NBFIs enhances competition
within the financial services industry.

Growth:

Some research suggests a high correlation between a financial development and economic growth.
Generally, a market-based financial system has better-developed NBFIs than a bank-based system,
which is conducive for economic growth.

Stability:

A multi-faceted financial system that includes non-bank financial institutions can protect
economies from financial shocks and enable speedy recovery when these shocks happen. NBFIs
provide “multiple alternatives to transform an economy's savings into capital investment, [which]
serve as backup facilities should the primary form of intermediation fail.”

However, in the absence of effective financial regulations, non-bank financial institutions can
actually exacerbate the fragility of the financial system.

Since not all NBFIs are heavily regulated, the shadow banking system constituted by these
institutions could wreak potential instability. In particular, CIVs, hedge funds, and structured
investment vehicles, up until the 2007-2012 global financial crisis, were entities that focused NBFI
supervision on pension funds and insurance companies, but were largely overlooked by regulators.

Because these NBFIs operate without a banking license, in some countries their activities are
largely unsupervised, both by government regulators and credit reporting agencies. Thus, a large
NBFI market share of total financial assets can easily destabilize the entire financial system. A
prime example would be the 1997 Asian financial crisis, where a lack of NBFI regulation fueled a
credit bubble and asset overheating. When the asset prices collapsed and loan defaults skyrocketed,
the resulting credit crunch led to the 1997 Asian financial crisis that left most of Southeast Asia
and Japan with devalued currencies and a rise in private debt.
Due to increased competition, established lenders are often reluctant to include NBFIs into existing
credit-information sharing arrangements. Additionally, NBFIs often lack the technological
capabilities necessary to participate in information sharing networks. In general, NBFIs also
contribute less information to credit-reporting agencies than do banks

Types of Non-Bank Financial Institutions:

Risk Pooling Institutions:
Insurance companies underwrite economic risks associated with illness, death, damage and other
risks of loss. In return to collecting an insurance premium, insurance companies provide a
contingent promise of economic protection in the case of loss. There are two main types of
insurance companies: general insurance and life insurance. General insurance tends to be short-
term, while life insurance is a longer-term contract, which terminates at the death of the insured.
Both types of insurance, life and general, are available to all sectors of the community.

Although insurance companies don't have banking licenses, in most countries insurance has a
separate form of regulation specific to the insurance business and may well be covered by the same
financial regulator that also covers banks. There have also been a number of instances where
insurance companies and banks have merged thus creating insurance companies that do have
banking licenses.

Contractual Savings Institutions:

Contractual savings institutions (also called institutional investors) give individuals the opportunity
to invest in collective investment vehicles (CIV) as a fiduciary rather than a principal role.
Collective investment vehicles pool resources from individuals and firms into various financial
instruments including equity, debt, and derivatives. Note that the individual holds equity in the
CIV itself rather what the CIV invests in specifically. The two most popular examples of
contractual savings institutions are pension funds and mutual funds.The two main types of mutual
funds are open-end and closed-end funds. Open-end funds generate new investments by allowing
the public to purchase new shares at any time, and shareholders can liquidate their holding by
selling the shares back to the open-end fund at the net asset value. Closed-end funds issue a fixed
number of shares in an IPO. In this case the shareholders capitalize on the value of their assets by
selling their shares in a stock exchange.

Mutual funds are usually distinguished by the nature of their investments. For example, some
funds specialize in high risk, high return investments, while others focus on tax-exempt securities.
There are also mutual funds specializing in speculative trading (i.e. hedge funds), a specific sector,
or cross-border investments.

Pension funds are mutual funds that limit the investor’s ability to access their investments until a
certain date. In return, pension funds are granted large tax breaks in order to incentivize the
working population to set aside a portion of their current income for a later date after they exit the
labor force (retirement income).
Market Makers:

Market makers are broker-dealer institutions that quote a buy and sell price and facilitate
transactions for financial assets. Such assets include equities, government and corporate debt,
derivatives, and foreign currencies. After receiving an order, the market maker immediately sells
from its inventory or makes a purchase to offset the loss in inventory. The differential between the
buying and selling quotes, or the bid-offer spread, is how the market-maker makes profit. A major
contribution of the market makers is improving the liquidity of financial assets in the market.

Difference between bank and nonbanking financial institution:

A Bank is an organization that accepts customer cash deposits and then provides financial services
like bank accounts, loans, share trading account, mutual funds, etc.

A NBFC (Non Banking Financial Company) is an organization that does not accept customer cash
deposits but provides all financial services except bank accounts.

a) A bank interacts directly with customers while an NBFI interacts with banks and governments.

(b) A bank indulges in a number of activities relating to finance with a range of customers, while
an NBFI is mainly concerned with the term loan needs of large enterprises.
(c) A bank deals with both internal and international customers while an NBFI is mainly concerned
with the finances of foreign companies.
(d) A bank's man interest is to help in business transactions and savings/ investment activities
while an NBFI's main interest is in the stabilization of the currency
 Unit-3

Tax system- its meaning and classification:

A tax (from the Latin taxo; "rate") is a financial charge or other levy imposed upon a taxpayer (an
individual or legal entity) by a state or the functional equivalent of a state such that failure to pay is
punishable by law. Taxes are also imposed by many administrative divisions. Taxes consist of
direct or indirect taxes and may be paid in money or as its labor equivalent.

According to Black's Law Dictionary, a tax is a "pecuniary burden laid upon individuals or
property owners to support the government [...] a payment exacted by legislative authority." It "is
not a voluntary payment or donation, but an enforced contribution, exacted pursuant to legislative
authority" and is "any contribution imposed by government [...] whether under the name of toll,
tribute, tall age, gable, impost, duty, custom, excise, subsidy, aid, supply, or other name."

Classification of Taxes:

Modern Tax systems comprise of many types of taxes. Proper classification of the sundry taxes is
essential to understand the nature and significance of different taxes. Usually, taxes are classified
on the basis of form, nature, aim and methods of taxation. The following classifications are
common in all modern tax systems:

• Direct and Indirect taxes:

Direct tax and Indirect tax are defined by different economists and experts on public finance in
different ways, based on different criteria like based on ‘shifting of tax, based on ‘the intention of
the legislature or government’, based on the relation between the tax payer and the revenue
authorities and based on the timing of appraising or striking the income of the tax payer. The most
practical and convenient way to distinguish between direct and indirect taxes which are in
conformity with “generally accepted view” of direct and indirect taxes. Corporation tax which is
directly paid to the state may be called as direct taxes. On the other hand, taxes which affect the
income and property of persons through their consumptions may be called as direct taxes. Thus,
customs and excise duties, sales tax fall under the category of indirect taxes.

• Specific duties and Ad-valorem duties: Specific duties are based on specific characteristics or
measures or qualities of goods. Advalorem duties are base on the value of goods. Specific duties
are levied on the basis of physical attributes like length, weight, volume, etc., of the commodities.
Specific duties are simple, easy to estimate and administer. As a result, most of the goods were
taxed on the basis of specific duties till recently.

The Latin word ‘Advalorem’ means ‘according to value’. Advalorem duty is a duty expressed as
percentage of the value of the commodity. It is levied on the value of the goods. Advalorem
duties result in higher tax revenue with increase in volume as well as price of goods.

• Proportional, Progressive, Regressive and regressive taxes:

• Proportional Taxation: It is a tax system in which the tax rate remains constant
irrespective changed in the ‘Tax Base’. Here tax is at a uniform rate and Ta payable is
 steady. So, in this method the rate of tax increases with increase in the income. The
applicable rate depends upon the income level of individuals.
• Regressive Taxation: It is one where the rate of tax decreases as the tax base increases.
So, the rate of tax decreases for higher incomes.
• Digressive Taxation: It is one where the rate of tax increases up to a certain limit and
after that the rate of tax is constant for further increases in income. This system may be
called as a mixture of proportional and progressive tax systems.

Single and Multiple Tax Systems:

• Single tax System: 'Single Tax' means only one kind of tax. It implies tax on only one
thing or one class of things or one class of people. The tax may be collected regularly at
periodic intervals.
• Multiple Tax system: Multiple tax system means a tax system comprising several types
of tax. They may include both direct and indirect taxes. In such a system, every class of
citizen may be called upon to “contribute his mite” towards State revenues

Public Finance vs. Private Finance:

For years, we have been told that privatization of everything is best and government is
Good for little, if not nothing. The recent seizing of the credit market is clear evidence that
Private finance has failed. After $236 trillion of production in the United States since 1945,
Total credit market debt is larger than ever, $50 trillion. To maintain the pattern of debt growth
In 2008, another $4 trillion of debt is needed. If more debt brings recovery, which has always
Been the case, more than $4 trillion of additional debt will be needed in 2009. Meanwhile
Hundreds of thousands of homes have been foreclosed and major investment firms and banks
Have collapsed.
The cause of the current crisis is debtor exhaustion. Sub‐prime mortgages are but one
Example of efforts by persons working for creditors to find more debtors. Given that creditworthy
debtors were already overburdened and unwilling to take on yet more debt, the
Purveyors of debt dug into the “less‐than‐credit‐worthy” population. It is not creditors that
Need relief; it is debtors! That relief can be provided through public finance.
 Fiscal Policy- concept, objectives and instruments:

Definitions

“By fiscal policy we denote to government actions afflicting its receipts and outlays which
are ordinarily taken as measured by the government’s receipts, its surplus or deficit.”

“A policy under which the government uses its outlay and revenue programmes to produce
desirable effects and avoid undesirable effects on the national earnings, manufacturing and
employment.”

Otto Eckstein defines fiscal policy as “changes in taxes and expenditures which aim at short run
goals of full employment and price level stability.”

Objectives of Fiscal Policy

The following are the objectives –

1. To uphold and accomplish full employment.

2. To alleviate the price level.

3. To soothe the development rate of financial system.

4. To sustain symmetry in the balance of payment.

5. To endorse the monetary development of under developed nations.

 Instruments of Monetary Policy

Monetary policy through variations in government outlays and taxation profoundly afflicts
national earnings, employment, productivity and prices. An enhancement in public outlay during
depression adds to the total demand for merchandise and services and leads to a large enhancement
in earnings thus enhancing consumption and investment outlays of the people. Alternatively, a
decrease of public expenditure during inflation decreases total demand, national earnings,
employment, productivity and prices, whilst an enhancement in taxes is likely to decrease
disposable earnings thus decreases consumption and investment outlays. Therefore government
can manage depression and inflationary pressures in the fiscal system by a judicious combination
of outlay and taxation programmers.

Central Budget:

Government has several policies to implement in the overall task of performing its functions to
meet the objectives of social & economic growth. For implementing these policies, it has to spend
huge amount of funds on defence, administration, and development, welfare projects & various
other relief operations. It is therefore necessary to find out all possible sources of getting funds so
that sufficient revenue can be generated to meet the mounting expenditure.The term budget is
derived from the French word "Budgette" which means a "leather bag" or a "wallet". It is a
statement of the financial plan of the government. It shows the income & expenditure of the
government during a financial year, which runs generally from 1stApril to 31st March. Budget is
most important information document of the government. One part of the government's budget is
similar to company's annual report. This part presents the overall picture of the financial
performance of the government. The second part of the budget presents government's financial
plans for the period upto its next budget.

So, every citizen of a nation from the common man to the politician is eager to know about the
budget as they would like to get an idea of the :-

1. Financial performance of the government over the past one year.

2. To know about the financial programmes & policies of the government for the next one year.
3. To know how their standard of living will be affected by the financial policies of the government
in the next one year.

Definitions of Budget

According to Tayler, "Budget is a financial plan of government for a definite period". According to
Rene Stourm, "A budget is a document containing a preliminary approved plan of public revenues
and expenditure".
Components of Government Budget

The main components or parts of government budget are explained below.

1. Revenue Budget

This financial statement includes the revenue receipts of the government i.e. revenue collected by
way of taxes & other receipts. It also contains the items of expenditure met from such revenue.

(a) Revenue Receipts

These are the incomes which are received by the government from all sources in its ordinary
course of governance. These receipts do not create a liability or lead to a reduction in assets.

Revenue receipts are further classified as tax revenue and non-tax revenue.

i. Tax Revenue :-

Tax revenue consists of the income received from different taxes and other duties levied by the
government. It is a major source of public revenue. Every citizen, by law is bound to pay them and
non-payment is punishable. Taxes are of two types, viz., Direct Taxes and Indirect Taxes. Direct
taxes are those taxes which have to be paid by the person on whom they are levied. Its burden can
not be shifted to someone else. E.g. Income tax, property tax, corporation tax, estate duty, etc. are
direct taxes. There is no direct benefit to the tax payer.

Indirect taxes are those taxes which are levied on commodities and services and affect the income
of a person through their consumption expenditure. Here the burden can be shifted to some other
person. E.g. Custom duties, sales tax, services tax, excise duties, etc. are indirect taxes.
 ii. Non-Tax Revenue :-

Apart from taxes, governments also receive revenue from other non-tax sources.

The non-tax sources of public revenue are as follows :-

1. Fees : The government provides variety of services for which fees have to be paid. E.g. fees paid
for registration of property, births, deaths, etc.
2. Fines and penalties : Fines and penalties are imposed by the government for not following
(violating) the rules and regulations.
3. Profits from public sector enterprises : Many enterprises are owned and managed by the
government. The profits receives from them is an important source of non-tax revenue. For
example in India, the Indian Railways, Oil and Natural Gas Commission, Air India, Indian
Airlines, etc. are owned by the Government of India. The profit generated by them is a source of
revenue to the government.
4. Gifts and grants : Gifts and grants are received by the government when there are natural
calamities like earthquake, floods, famines, etc. Citizens of the country, foreign governments and
international organisations like the UNICEF, UNESCO, etc. donate during times of natural
calamities.
5. Special assessment duty : It is a type of levy imposed by the government on the people for getting
some special benefit. For example, in a particular locality, if roads are improved, property prices
will rise. The Property owners in that locality will benefit due to the appreciation in the value of
property. Therefore the government imposes a levy on them which is known as special assessment
duties.

iii. India's Revenue Receipts :-

The tax revenue provides major share of revenue receipts to the central government of India. In
2006-07 tax revenue (direct + indirect taxes) of central government was Rs. 3,27,205 crores while
non-tax revenue was Rs. 76,260 crores.

(b) Revenue Expenditure :

Revenue expenditure is the expenditure incurred for the routine, usual and normal day to day
running of government departments and provision of various services to citizens. It includes both
development and non-development expenditure of the Central government. Usually expenditures
that do not result in the creations of assets are considered revenue expenditure.
 Expenses included in Revenue Expenditure:-

1. Expenditure by the government on consumption of goods and services.

2. Expenditure on agricultural and industrial development, scientific research, education, health and
social services.
3. Expenditure on defence and civil administration.
4. Expenditure on exports and external affairs.
5. Grants given to State governments even if some of them may be used for creation of assets.
6. Payment of interest on loans taken in the previous year.
7. Expenditure on subsidies.

iii. India's Defense Expenditure :-

In 2006-07, Defense expenditure of the central government of India was Rs. 51,542 crores.

2. Capital Budget

This part of the budget includes receipts & expenditure on capital account projected for the next
financial year. Capital budget consists of capital receipts & Capital expenditure.

(a) Capital Receipts

Receipts which create a liability or result in a reduction in assets are called capital receipts. They
are obtained by the government by raising funds through borrowings, recovery of loans and
disposing of assets.

Items included in Capital Receipts :-

1. Loans raised by the government from the public through the sale of bonds and securities. They are
called market loans.
2. Borrowings by government from RBI and other financial institutions through the sale of Treasury
bills.
3. Loans and aids received from foreign countries and other international Organizations like
International Monetary Fund (IMF), World Bank, etc.
4. Receipts from small saving schemes like the National saving scheme, Provident fund, etc.
5. Recoveries of loans granted to state and union territory governments and other parties.

(b) Capital Expenditure:

Any projected expenditure which is incurred for creating asset with a long life is capital
expenditure. Thus, expenditure on land, machines, equipment, irrigation projects, oil exploration
and expenditure by way of investment in long term physical or financial assets are capital
expenditure.
Burden of deficits and debts:

Government debt is the stock of outstanding IOUs issued by the government at any time in the past
and not yet repaid. Governments issue debt whenever they borrow from the public; the magnitude
of the outstanding debt equals the cumulative amount of net borrowing that the government has
done. The deficit is the addition in the current period (year, quarter, month, etc.) to the outstanding
debt. The deficit is negative whenever the value of outstanding debt falls; a negative deficit is
called a surplus....

While robust growth in the quarter century after WWII allowed a fairly rapid reduction of
debt/GDP ratios, this is not likely to happen now. The current high public debt levels in the United
States and Europe are not going to disappear soon thanks to vigorous growth. In addition, the
aging of the population is going to significantly add to the current fiscal problems induced by the
Great Recession. Major discretionary policy intervention will be needed on both sides of the
Atlantic in the next several years. The paper by Hubbard identifies
clearly the costs of deficits. Together with the work by Reinhart and Roofs (2009), observations
about the costs of debt burden on growth, Hubbard reminds us of the seriousness of the situation.
Ben Friedman himself, in his Day of Reckoning volume (Friedman 1988),
warned about the evils of excessive debt of the eighties.

Interest Rates:

One of the costs of excessive deficits is their effects on interest rates. We can classify the latter into
two such effects. One occurs even when there is no default risk, and it has simply to do with the
increase in quantity of Treasury bonds offered in the market. Currently interest rates on “safe”
public debt are low, but they can only increase. The second source of problems comes from default
risk. For the first time in decades, some forms of default or restructuring have been openly
discussed for several OECD countries—Greece, Ireland, Italy, Portugal, and Spain. Even the
United States has lost its triple-A status. Default risk can trigger a dangerous spiral. The more the
markets fear a default, the higher the interest rate premium they ask; the
latter makes the solvency of the government in question even more problematic, inducing markets
to require even higher interest rate premiums.
This problem has been aggravated by a very late awakening of markets in Europe. For the first
decade of the euro, the interest rates on public debts in Europe converged almost fully to those of
Germany. Greece, Portugal, and Spain were borrowing large quantities of funds at very low rates,
contributing to creating large imbalances. Suddenly, after the financial crisis, markets woke up to
the idea that Greek debt was not German debt! Currently the interest differentials
Between countries in Europe are large.

The Tax Burden:

Large public debt implies a large interest rate burden. To the extent that the interest rate burden is
financed by tax revenues, the distortionary costs of taxation induced by large public debts become
relevant. European countries and (to a lesser extent) the United States have high tax rates, and the
top of the Lifer curve may be appearing on the not too distant horizon. For countries with debt
levels approaching 100 percent of GDP, even relatively small increases in rates, holding primary
spending constant, would lead to a significant increase in distortionary tax rates.

Rigidity of Fiscal Responses:

When a country has accumulated a high debt, it loses the necessary flexibility for responding
aggressively with deficits if a recession occurs. Even allowing automatic stabilizers to “do their
job” may become overly costly because of a dangerous debt dynamic. Thus, high-debt countries
may have to contain deficits even during recessions, leading to dangerous vicious circles: the
deeper the recession, the larger the deficits; the larger the latter, the more stringent the budget
constraint for highly indebted countries and the higher the pressure to reduce deficits, aggravating
the recession.

How to Reduce Deficits:

We are currently witnessing a lively debate on the issue of how and when to reduce deficits. Two
critical questions are as follows:
(i) What are the short-run costs of a fiscal tightening?
(ii) How does one minimize the costs of fiscal adjustments?

On both questions we, as economists, do not know as much as we would like or perhaps we
should. The issues are complicated, because of very difficult “identification” problems. Suppose
we observe that the ratio of spending of GDP goes down while GDP goes up. What causes what?
How do we disentangle the issue? Also, fiscal policy experiments—in particular, large fiscal
adjustments—are accompanied by a host of other policies, such as more or less loose monetary
policy, exchange rate devolutions, and structural reforms. Therefore
it is often difficult to isolate the effects of fiscal policy from everything else.

A lively debate is alive today in the profession. This is not the place for a full review of the recent
literature on fiscal policy, but the following points represent my readings of the results.
• Spending multipliers (i.e., the effect of one dollar of discretionary
spending on GDP) are estimated between roughly 0.8 and 1.5. Some estimates fall outside of that
range, but most fall within it.

• The effect of government spending on employment has weakened in the latest recessions.
• Tax multipliers are (much) larger than spending multipliers.
• Spending multipliers are slightly larger in recessions.
Overall these results should give pause to those who hold a textbook Keynesian view of public
finance. According to the latter, spending multipliers should be larger than tax multipliers, and
spending multipliers should be (much) larger than one. The wide range of estimates
Does not allow us to draw firm conclusions on how much one should use discretionary
government spending as a countercyclical tool, but they certainly are not an endorsement of a very
proactive stand. In addition, those estimates do not deal with two additional
Issues. One is the “long and variable lags” and the effect on deficits. That is, by the time an
expansionary fiscal package is designed, approved, implemented, and spent, it may take so long
that it may reach the wheels of the economy when it is too late, i.e., in the wrong
part of the cycle. In addition, deficit spending (including the effect of automatic stabilizers) should
be compensated by surplus during expansions. But often, for political reasons, it is not, and deficit
spending during recessions accumulates in large debts, because they
are never compensated. Therefore my reading of this evidence is that one should be careful in
using discretionary spending as a countercyclical fiscal policy tool, above and beyond automatic
stabilizers Let’s now turn to the second issue, namely how costly it’s going to be to reduce deficits.
Virtually everyone would agree that in the medium run, having a solid fiscal position facilitates
public policies and growth. The most hotly debated issue is what are the short-run costs of the kind
of large deficit-reduction policies that are needed both in several European countries and in the
United States. Once again, this is not the place for a survey of the rather vast literature on these
issues. Much of this literature, starting in the early nineties, has studied
Several examples of large fiscal adjustments that have occurred in OECD countries. My reading of
the results is as follows:
• Spending based on adjustments is less costly in terms of short run recessions than tax-based
adjustments.
• Only spending-based adjustments are likely to lead to a long lasting stabilization and reduction of
the debt/GDP ratio. This is because without putting a break on programs which automatically
grow, tax revenues cannot keep up with spending increases, especially with an aging population.
Which program are better candidates for cuts vary across countries but typically include pensions,
health spending, and various other types of subsidies. In many European countries, government
employment is overextended and public-sector wages have grown more than private-sector ones.
• In some cases, spending-based adjustments have been much less costly than a standard
Keynesian model would predict, and in fact they have been accompanied by expansionary effects
on the economy.
• In these cases, a swift response of private-sector investment (in addition to private consumption)
has “crowded in” aggregate private demand.
• These “expansionary” fiscal contractions are helped when they are accompanied by a structural
reform package that indicates a “regime change.”
• In small open economies, exchange rate devaluations helped in the short run.
These results are sometimes labeled as “non-Keynesian effects” of fiscal policy, Namely the
possibility that a fiscal adjustment does not bring about a deep recession even in the short run.
Several non-Keynesian channels that could counteract the standard effects of spending cuts on
aggregate demand have been discussed in the literature.
 Unit-4

Poverty is the state of one who lacks a certain amount of material possessions or money.[1]
Absolute poverty or destitution refers to the deprivation of basic human needs, which commonly
includes food, water, sanitation, clothing, shelter, health care and education. Relative poverty is
defined contextually as economic inequality in the location or society in which people live.

For much of history, poverty was considered largely unavoidable as traditional modes of
production were insufficient to give an entire population a comfortable standard of living. After the
industrial revolution, mass production in factories made wealth increasingly more inexpensive and
accessible. Of more importance is the modernization of agriculture, such as fertilizers, to provide
enough yield to feed the population. The supply of basic needs can be restricted by constraints on
government services such as corruption, tax avoidance, debt and loan conditionality’s and by the
brain drain of health care and educational professionals. Strategies of increasing income to make
basic needs more affordable typically include welfare, economic freedoms, and providing financial
services.

Definitions:

Poverty reduction is a major goal and issue for many international organizations such as the United
Nations and the World Bank. The World Bank estimated 1.29 billion people were living in
absolute poverty in 2008. Of these, about 400 million people in absolute poverty lived in India and
173 million people in China. In USA 1 in 5 children lives in poverty. In terms of percentage of
regional populations, sub-Saharan Africa at 47% had the highest incidence rate of absolute poverty
in 2008. Between 1990 and 2010, about 663 million people moved above the absolute poverty
level. Still, extreme poverty is a global challenge; it is observed in all parts of the world, including
the developed economies.

United Nations: Fundamentally, poverty is a denial of choices and opportunities, a violation of

human dignity. It means lack of basic capacity to participate effectively in society. It means not
having enough to feed and clothe a family, not having a school or clinic to go to, not having the
land on which to grow one’s food or a job to earn one’s living, not having access to credit. It
means insecurity, powerlessness and exclusion of individuals, households and communities. It
means susceptibility to violence, and it often implies living in marginal or fragile environments,
without access to clean water or sanitation.

World Bank: Poverty is pronounced deprivation in well-being, and comprises many dimensions. It
includes low incomes and the inability to acquire the basic goods and services necessary for
survival with dignity. Poverty also encompasses low levels of health and education, poor access to
clean water and sanitation, inadequate physical security, lack of voice, and insufficient capacity
and opportunity to better one’s life.

Copenhagen Declaration: Absolute poverty is a condition characterized by severe deprivation of

basic human needs, including food, safe drinking water, sanitation facilities, health, shelter,
education and information. It depends not only on income but also on access to social services.The
term 'absolute poverty' is sometimes synonymously referred to as 'extreme poverty.
Absolute poverty:

Poverty is usually measured as either absolute or relative (the latter being actually an index of
income inequality). Absolute poverty refers to a set standard which is consistent over time and
between countries.

First introduced in 1990, the dollar a day poverty line measured absolute poverty by the standards
of the world’s poorest countries. The World Bank defined the new international poverty line as
$1.25 a day for 2005 (equivalent to $1.00 a day in 1996 US prices). but have recently been updated
to be $1.25 and $2.50 per day. Absolute poverty, extreme poverty, or abject poverty is "a condition
characterized by severe deprivation of basic human needs, including food, safe drinking water,
sanitation facilities, health, shelter, education and information. It depends not only on income but
also on access to services." The term 'absolute poverty', when used in this fashion, is usually
synonymous with 'extreme poverty': Robert McNamara, the former President of the World Bank,
described absolute or extreme poverty as, "...a condition so limited by malnutrition, illiteracy,
disease, squalid surroundings, high infant mortality, and low life expectancy as to be beneath any
reasonable definition of human decency". Australia is one of the world's wealthier nations. In his
article published in Australian Policy Online, Robert Tinton notes that, "While this amount is
appropriate for third world countries, in Australia, the amount required to meet these basic needs
will naturally be much higher because prices of these basic necessities are higher."

However as the amount of wealth required for survival is not the same in all places and time
periods, particularly in highly developed countries where few people would fall below the World
Bank's poverty lines, countries often develop their own National poverty lines.

An absolute poverty line was calculated in Australia for the Henderson poverty inquiry in 1973. It
was $62.70 a week, which was the disposable income required to support the basic needs of a
family of two adults and two dependent children at the time. This poverty line has been updated
regularly by the Melbourne Institute according to increases in average incomes; for a single
employed person it was $391.85 per week (including housing costs) in March 2009. In Australia
the OECD poverty would equate to a "disposable income of less than $358 per week for a single
adult (higher for larger households to take account of their greater costs).

For a few years starting 1990, The World Bank anchored absolute poverty line as $1 per day. This
was revised in 1993, and through 2005, absolute poverty was $1.08 a day for all countries on a
purchasing power parity basis, after adjusting for inflation to the 1993 U.S. dollar. In 2005, after
extensive studies of cost of living across the world, The World Bank raised the measure for global
poverty line to reflect the observed higher cost of living.Now, the World Bank defines extreme
poverty as living on less than US$1.25 (PPP) per day, and moderate povertyas less than $2 or $5 a
day (but note that a person or family with access to subsistence resources, e.g. subsistence farmers,
may have a low cash income without a correspondingly low standard of living – they are not living
"on" their cash income but using it as a top up). It estimates that "in 2001, 1.1 billion people had
consumption levels below $1 a day and 2.7 billion lived on less than $2 a day."A dollar a day, in
nations that do not use the U.S. dollar as currency, does not translate to living a day on the
equivalent amount of local currency as determined by the exchange rate.Rather, it is determined by
the purchasing power parity rate, which would look at how much local currency is needed to buy
the same things that a dollar could buy in the United States.Usually, this would translate to less
local currency than the exchange rate in poorer countries as the United States is a relatively more
expensive country.

The poverty line threshold of $1.25 per day, as set by The World Bank, is controversial. Each
nation has its own threshold for absolute poverty line; in the United States, for example, the
absolute poverty line was US$15.15 per day in 2010 (US$22,000 per year for a family of four),[
while in India it was US$ 1.0 per day[ and in China the absolute poverty line was US$ 0.55 per
day, each on PPP basis in 2010. These different poverty lines make data comparison between each
nation's official reports qualitatively difficult. Some scholars argue that The World Bank method
sets the bar too high, others argue it is low. Still others suggest that poverty line misleads as it
measures everyone below the poverty line the same, when in reality someone living on $1.2 per
day is in a different state of poverty than someone living on $0.2 per day. In other words, the depth
and intensity of poverty varies across the world and in any regional populations, and $1.25 per day
poverty line and head counts are inadequate measures.

The proportion of the developing world's population living in extreme economic poverty fell from
28 percent in 1990 to 21 percent in 2001.Most of this improvement has occurred in East and South
Asia.In East Asia the World Bank reported that "The poverty headcount rate at the $2-a-day level
is estimated to have fallen to about 27 percent [in 2007], down from 29.5 percent in 2006 and 69
percent in 1990." In Sub-Saharan Africa extreme poverty went up from 41 percent in 1981 to 46
percent in 2001, which combined with growing population increased the number of people living
in extreme poverty from 231 million to 318 million.

In the early 1990s some of the transition economies of Central and Eastern Europe and Central
Asia experienced a sharp drop in income.The collapse of the Soviet Union resulted in large
declines in GDP per capita, of about 30 to 35% between 1990 and the trough year of 1998 (when it
was at its minimum). As a result poverty rates also increased although in subsequent years as per
capita incomes recovered the poverty rate dropped from 31.4% of the population to 19.6%

World Bank data shows that the percentage of the population living in households with
consumption or income per person below the poverty line has decreased in each region of the
world since 1990

Concept of relative poverty:

In 1776 Adam Smith in the Wealth of Nations argued that poverty is the inability to afford, "not
only the commodities which are indispensably necessary for the support of life, but whatever the
custom of the country renders it indecent for creditable people, even of the lowest order, to be
without."

In 1958 J. K. Galbraith argued that, "People are poverty stricken when their income, even if
adequate for survival, falls markedly behind that of their community."
In 1964 in a joint committee economic President's report in the United States, Republicans
endorsed the concept of relative poverty. ”No objective definition of poverty exists... The
definition varies from place to place and time to time. In America as our standard of living rises, so
does our idea of what is substandard."

In 1965 Rose Friedman argued for the use of relative poverty claiming that the definition of
poverty changes with general living standards. Those labeled as poor in 1995, would have had "a
higher standard of living than many labeled not poor" in 1965.

In 1979, British sociologist, Peter Townsend published his famous definition, "individuals [...] can
be said to be in poverty when they lack the resources to obtain the types of diet, participate in the
activities and have the living conditions and amenities which are customary, or are at least widely
encouraged or approved, in the societies to which they belong

Brian Nolan and Christopher T. Whelan of the Economic and Social Research Institute (ESRI) in
Ireland explained that, "poverty has to be seen in terms of the standard of living of the society in
question."

Relative poverty measures are used as official poverty rates by the European Union, UNICEF and
the OEDC. The main poverty line used in the OECD and the European Union is based on
"economic distance", a level of income set at 60% of the median household income.

Characteristics:
The effects of poverty may also be causes, as listed above, thus creating a "poverty cycle"
operating across multiple levels, individual, local, national and global

Health:

One third of deaths – some 18 million people a year or 50,000 per day – are due to poverty-related
causes: in total 270 million people, most of them women and children, have died as a result of
poverty since 1990. Those living in poverty suffer disproportionately from hunger or even
starvation and disease. Those living in poverty suffer lower life expectancy. According to the
World Health Organization, hunger and malnutrition are the single gravest threats to the world's
public health and malnutrition is by far the biggest contributor to child mortality, present in half of
all cases. Almost 90% of maternal deaths during childbirth occur in Asia and sub-Saharan Africa,
compared to less than 1% in the developed world.

Those who live in poverty have also been shown to have a far greater likelihood of having or
incurring a disability within their lifetime. Infectious such as malaria and tuberculosis can
perpetuate poverty by diverting health and economic resources from investment and productivity;
malaria decreases GDP growth by up to 1.3% in some developing nations and AIDS decreases
African growth by 0.3–1.5% annually.
Business Cycle and Characteristics of Business Cycle:

Business cycle is also called Trade Cycle. The business is never steady. There are always ups and
downs in economic activity. This cyclical movement both upwards and downwards is commonly
called Trade Cycle. This is a wave like movement in regular manner in business cycle. In business,
there are flourishing activities, which take economy to prosperity and growth whereas there are
periods when there is recession, which leads to decline in the employment, income and output.
When the economy goes into downswing then there is a stage of recovery to reach a new boom.
According to Keynes, “Trade Cycle is composed of periods of good trade characterized by rising
price and low unemployment percentage altering with periods of bad trade characterized by
falling price and high unemployment percentage.” In the simple words – Business Cycle is a
fluctuation of the economy characterized by periods of prosperity followed by periods of
depression.

Characteristics of Business Cycle:

The fluctuations are wave like movement and are recurrent in nature.
Business Cycle is characterized by waves of expansion and contraction. But these are not only
two phases of business cycle. There are four phase of business cycle – Expansion, Recession,
Contraction and Revival or Recovery.
The movement from peak to trough and again though to peak is not symmetrical. According to
Keynes, prosperity phase of business cycle comes to end fast but dip is gradual and slow.

Business Cycle is self generating. Every phase has germs of the next phase, that is, expansion
has the germs of the recession in it.

UNEMPLOYMENT AS A SOCIAL AND ECONOMIC INDICATOR:

The various mechanisms affecting the cyclical fluctuations of unemployment
as discussed above have implications for the interpretation of measured unemployment
as a social and economic indicator. The implications depend, however,
on what unemployment is meant to indicate. Three roles of unemployment are
Considered below, namely:
- a measure of under-utilization of labor;
- an indicator of social hardship;
- a determinant of wage pressure.

From the point of view of under-utilization of labor, both the cyclical employment responsiveness
and labor-force responsiveness have important implications. If expanding output leads to a strong
employment response while the labor Force remains unchanged, then unemployment falls strongly
with rising output.

However, to the extent an increase in production gives rise to rising productivity And rising
employment induces an increase in the labor-force, potential output Expands as a result of
increasing actual output.lG coming out of a downturn, Countries with responsive productivity and
labor force may thus be able to expand for longer, or more strongly, before inflationary pressures
 develop and Corrective policies are called for. In this sense, cyclical fluctuations of productivity
and cyclical labor-force variations - and not just measured unemployment – are relevant for
gauging the full extent of under-utilization of labor and the associated output loss during a
slowdown.

Some of the same factors which reduce the usefulness of unemployment as Measure of labor
utilization render it dubious as an indicator of social hardship. Given the flexible response of the
labor force to changes in employment, and given the flexibility of hours worked with respect to
output, changes in measured Unemployment under-represent changes in gainful employment and
earned Income. Unemployment, accordingly, does not fully reflect the amount of economic
hardship caused by cyclical downturns. On the other hand, unemployment compensation partly
cushions against economic hardship caused by job loss. To the extent that the status of “official”
unemployment confers the right of receiving income transfers exceeding those available to non-
participants of otherwise identical income and wealth characteristics, there is of course an obvious
difference between the unemployed and the non-participants. Preferential access to income support
may be one reason for individuals to remain “unemployed” rather than drop out of the labour force
once they lose their job.

Economic Interpretation of Unemployment:

Frictional Unemployment: the usual amount of unemployment resulting from

- people who have left jobs that did not work out
- people who are entering or reentering the labor force

Structural Unemployment: results from permanent shifts in the pattern of demand for goods and
services or from changes in technology. Therefore workers need to learn new skills or move to
other locations.
Cyclical Unemployment: occurs during periods of contraction or recession, or in any period when
the economy fails to operate at its potential.
Total amount of unemployment in any month
= frictional + structural + cyclical unemployment
where frictional and structural unemployment result from natural and unavoidable occurrence in
a dynamic economy, and the cyclical unemployment is the result of imbalances between
aggregate purchases and the aggregate production corresponding to full employment ( this is
controllable).
Text Books:
1. Dwivedi, D.N. Macroeconomics; Tata Mc Graw Hill; 2005
2. Shapiro, E. Macroeconomic Analysis; Tata Mc Graw Hill; 2003

3. Seth. M.L. Money, Banking, International Trade and Public Finance;

 Reference:
1. Dewett, K.K. Modern Economic Theory;
2. Myneni, S.R. Principles of Economics: Allahabad Law Agency; Faridabad
3. Bhatia, H.L. Public Finance;
4. Mishra, S.K. and V.K. Puri Modern Macroeconomic Theory; Himalaya Publishing
House; 2003

5. Jhingan, M.L. Macroeconomic Theory

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