FUNDAMENTALS OF ECONOMICS Public Economics Module II - Public Economics State vs Market - Public Revenue - Public Expenditure - Tax and Non-tax Revenue - Direct and Indirect tax - Goods and Service Tax in India - Budget - Types - Fiscal Deficit - Revenue Deficit - Public Debt - Trade Cycle and Its Phases - Fiscal and Monetary Policy as Tools for Combating Inflation and Deflation (2.1) STATE vs MARKET The word state stands for the government or the public sector, the term market represents the private sector characterised by the market forces of demand and supply and profits. Role of Government Economists from time immemorial used to raise the question - ‘What should be the role of the government in an economy"? While Adam Smith and others wanted to restrict the role of the government to defence, justice and public works, some socialist thinkers suggest very active and dynamic roles to the government in an economy. Today there are three different answers to the above questions, They are:- 1, Permit Government Actions if Private Individuals are not Attracted According to Otto Eckstein, “permit government action only when the private sector cannot do the job”. There are certain activities to which private individuals are not generally attracted. Such activities, if they are highly essential for the society, must be taken up by the government, Some such possible situations are given below. a, Welfare activities Will any rational individual be interested in starting and running a free hospital for the poor? Since private individuals are not normally attracted to this, such free services must be rendered to the poor by the government. b. Collective goods and services There are certain collective goods and services which are provided to the people in a country as a whole or to a group of people and not on an individual basis. Such services cannot be withheld from those who refuse to pay for them. For instance the national defence. The national security, provided by the defence forces in a country is for all. Some other collective services are flood control, services of the police, fire protection ete. €. Cases of Social costs In certain cases of social costs, the harm done to the society by each individual cannot be exactly calculated, Therefore he is not individually charged for it, We know that motor vehicle users pollute the air.FUNDAMENTALS OF ECONOMICS Public Economics Since the pollution done by each one cannot be separately assessed, he is not charged for it. Therefore the measures for cleaning the air are taken up by the government. d. Expensive and risky activities There are certain activities which are so expensive and risky that private individuals are not attracted to those fields. Bg. research on atomic energy etc. Then the government will have to come forward to take up such activities. e. Public utility services Public utility services like water supply, supply of electricity, postal services ete. can be supplied at lower rates to the society only if they are undertaken by the government. 2. A More Active Role for the Government Modern American economists recommend three additional functions for the government. © The government must give necessary incentives and encouragements to the managers in the public sector in order to get better services from them to the society. © The government, through its tax policy, should influence the consumption habits of the people in a country. It must encourage the consumption of essential and useful goods by removing the existing taxes or subsidising them. At the same time the government must discourage the consumption of harmful things like drugs, liquor, tobacco, etc. by imposing heavy taxes on them, © Another function of the government is to minimise the glaring inequality of income and wealth in the society. The instruments recommended for this purpose are progressive taxation on the one hand and welfare activities like social security, unemployment insurance, public works etc. on the other. 3. The Socialist Approach The socialist thinkers give an extreme view as regards the scope of government activity in a country, They argue that the private ownership of the means of production leads to the exploitation of the working class. Therefore all industries should be owned and run by the workers and their government, In short they want the total abolition of the private sector PUBLIC REVENUE AND PUBLIC EXPENDITURE As mentioned earlier, Public Economies deals with the role of the government in a country and the problems of Public Finance. Thus Public Finance is only a part of Public Economics, the latter is a wider term. According to Dalton "public finance is concemed with the income andFUNDAMENTALS OF ECONOMICS Public Economics expenditure of public authorities and with the adjustment of one to the other". Naturally the two major branches of Public Finance are Public Revenue and Public Expenditure. (2.2) PUBLIC REVENUE The very existence and functioning of the government require revenue. In modern times the functions of the govemmments in both developed countries and developing countries are on the increase, Therefore they require increasing revenues. A government obtains its revenue from various sources which may be classified into two, tax revenues and non tax revenues. x and Non-Tax Revenue 1. Tax Revenue A tax may be defined as a compulsory contribution collected from the people for the general services performed by the state. It is paid not for any particular service. According to Taussig "the absence of any direct quid-pro-quo between the taxpayer and the public authority is the essence of a tax", Taxes may be broadly classified into two, direct and indirect taxes. In the case of the former the taxpayer makes the tax payment directly to the government. eg. income tax, corporate tax, wealth tax ete. In the case of the latter the government collects the tax from the people indirectly through some agencies eg. sales tax, excise duties, customs duties, service tax ete. Direct and Indirect Taxes There are two terms used by promise to analyse the burden of a tax. They are impact and incidence. The person from whom a tax is collected is said to bear its impact. The person who ultimately pays the money is said to bear its incidence. The impact and the incidence are on the person in the case of a direct tax. Eg: income tax. On the other hand, the impact and the incidence are on different persons in the case of an indirect tax. Eg: sales tax. The impact is on the selle and the incidence on the buyers. (a) Direct Taxes A direct tax is one whose impact and incidence are on the same person. Merits of Direct Taxes 1. A direct tax is economical: It is paid by the taxpayer himself to the state. As such the cost of collection is less, 2. Direct taxes are certain: The taxpayer knows what exactly he has to pay and the state authorities know what they have actually to receive.FUNDAMENTALS OF ECONOMICS Public Economics 3. They are elastic: Direct taxes can be easily increased to meet the emergent demand on the state ‘purse’. Moreover the proceeds automatically increase as wealth and population increase. 4. Dir ct taxes are equitable because it is based on the principle of ability. They can be made progressive also, 5. Direct taxes promote civil and political consciousness because taxpayers take keen interest to observe and criticise the way in which their contributions are spent by the government. 6. The system of direct taxes enables the government to collect taxes from those people who live abroad while they derive their income from their home country. Defects of Direct Taxes 1, The burden of the direct taxes is keenly felt by the taxpayer compared with that of an indirect tax. 2. Direct taxes are sometimes very inconvenient, For instance, an income tax payer has to keep detailed accounts of income certificates, which causes considerable inconvenience to him, 3. Direct taxes are tried to be evaded. An income tax payer, in order to escape taxation, tries to give wrong statements, 4 In the case of direct taxes, it is not so ea 5/20 a just basis of assessment for all classes of people. 5. Direct taxes discourage the people. The ability of the people to work and save is adversely affected. 6. The system of direct taxes applies only to a small section of the society. (b.) Indirect Taxes An indirect tax is one whose impact and incidence are on different persons. According to Hicks an indirect tax is the one which is collected by the state through an unofficial agent like a merchant. Bg. sales tax. Merits of Indirect Taxes © Indirect taxes are more convenient than direct taxes, They are added to the price of commodities so that the buyers do not feel that they are paying any tax. Moreover, tax is paid little by little as purchases are made. © Itcan be collected from all classes of people © Indirect taxes cannot be easily evaded since they are included in the prices of the articles. © Taxes levied on intoxicating liquors and other harmful things do a distinct social and moral service of discouraging their consumption.FUNDAMENTALS OF ECONOMICS Public Economics © Certain indirect taxes such as those imposed on goods with inelastic demand are elastic from the point of view of revenue. © Some of the indirect taxes are highly productive. Eg. sales tax. They yield good revenue. © Indirect taxes can be easily made equitable by imposing them on luxuries and removing them from necessaries. Defects of Indirect Taxes © The payment of an indirect tax is not felt by the taxpayer. As such, it does not stimulate his civic consciousness. © These taxes are uncertain. The actual extent of consumption and the ultimate yield of revenue cannot be definitely anticipated. © Indirect taxes are inequitable. They are not based on the canon of ability, The rich or the poor, whoever purchases a thing, has to pay the same tax. © Indirect taxes are not economical since the expenses of collecting them are very high. © Indirect taxes are not productive. The yield is often low. Taxes on goods with elastic demand yield low revenue. 2. Non-Tax Revenues The non-tax revenues of the government include the following. 1. Fee Fee is a compulsory payment made by those citizens who receive special benefits from the services rendered by the government. For example, the licence fee is charged from those citizens who are given licences by the government. Registration fees for legal documents, court fees, stamp fees etc. are all examples of fees. There is "quid pro quo” in the payment of a fee 2. Fines and penalties Fine is levied on those who violate the law. Eg. Those who violate traffic laws are fined by the magistrate. Penalties are imposed upon those people who fail to fulfil certain undertakings. Income of the government is not the only objective of fines and penalties. These are also to discourage people from doing something forbidden by law. 3. Income from public property The governments receive income from their properties in land, buildings, mines, forests et. 4. Income from public enterprises Another source of income of the government is revenue from public enterprises like railways, post and telegraph, electricity ete,FUNDAMENTALS OF ECONOMICS Public Economics 5. Profits from industries In certain countries the govemments own and run industries. For example, in India there are iron and steel industries, watches and machine tool industries etc. in the public sector. The profits from. these industries are a source of income. 6. Special assessment It is a "compulsory contribution levied in proportion to the special benefit derived to defray the cost of a specific improvement to property undertaken in the public interest". For example, when the government constructs a road, all the property in the neighbourhood will appreciate in value. This is some sort of an unearned benefit to the people concemed. As such the state has a right to appropriate a part of this unearned benefit. 7. Gifts and grants Gifts are voluntary contributions made by the people to the government for some specific purpose. Rich people voluntarily give some donations to the s te for humanitarian purposes. Grants are the payments made by one government to the other for the performance of specified functions in a specified manner, Foreign assistance also may be included in this category. 8. Escheats Properties of people who die without legal heirs or wills belong to the state. They are known as escheats. 9. Issue of Currency The amount obtained from printing currency is yet another source of income for the government. 10. Public borrowing The borrowings of the government constitute another source of income for the temporary finance of government expenditure. (2.3) PUBLIC EXPENDITURE Public expenditure means the expenditure incurred by the government either in protecting the citizens or in promoting their economic and social welfare. It includes the expenditure of central, state and local governments. During the days of laissez-faire, the activities of the government were restricted to the maintenance of peace, law and order. Therefore, the government used to spend less in those days. The best government was the one which spent the least. But those days are gone, In modern times the functions performed by the government in every country have increased to a very extent. Therefore, the public expenditure also has increased considerably.FUNDAMENTALS OF ECONOMICS Public Economics Growth of Public Expenditure (How or why public expenditure increases?) The principal causes of increasing public expenditure are given below. 1, Welfare State The idea of 'police state’ is today an unwanted relic of the past. It is being replaced by the idea of a ‘welfare state' which stands for the uplift of the common masses. The governments, nowadays, take more interest in social security measures and other welfare activities. As such, public expenditure has increased by leaps and bounds. 2. Growth of democracy Democracy has become the order of the modern government. A democratic form of government is highly expensive. The growth of public expenditure is partly due to the spread of democracy. 3. Growth of population The growth of population in every country has resulted in an increase in public expenditure, 4, Inflationary tendency The ascending trend of public expenditure is accentuated by the rise in the general price level. 5. Defence expenditure The growth of defence expenditure in almost all countries has led to an increase in public expenditure 6. Expansion of public sector The expansion of public sectors in those countries which aim at a socialist pattem of society, has resulted in an increase in public expenditure. 7. The great depression The great depression of 1929-33 demonstrated the need for government intervention in economic activities in order to stabilise agriculture, industry, trade and commerce, Greater responsibilities of the governments led to greater public expenditure. 8. Growth of public debt There are various ways by which a government in modem times can raise public debt. This also has led to the growth of public expenditure CANONS OF PUBLIC EXPENDITURE Public expenditure is incurred in accordance ith certain general principles. They are known as the canons of public expenditure, which are explained below. 1. Maximum social advantage According to this principle, public expenditure is to be incurred in such a way as to attain maximum social advantage. The rich people are taxed by the government and the amount raised is,FUNDAMENTALS OF ECONOMICS Public Economics spent on the poor. Then the government must compare the addition to welfare obtained by spending a particular sum of money with the social and economic cost of raising it. The fiscal policy followed by the government will be the best if it enables us to secure the greatest possible net advantage. It means that the difference between the addition to welfare and the social cost involved in obtaining the money must be the maximum. 2. Canon of sanction No money should be spent unless the expenditure has been approved and sanctioned by a duty authorised person. This is to avoid unwise and reckless expenditure. 3. Canon of economy It does not mean miserliness in public expenditure. It only means that unnecessary and extravagant expenditure should be avoided. Careful planning and judicious spending will lead to the economy in public expenditure. 4. Canon of surplus According to this principle, there must be a surplus of income over expenditure. This canon has lost its significance in modern times. In times of a depression, when the country is faced with falling prices and growing unemployment, deficit budgeting is a virtue, 5. Canon of elasticity Public expenditure should not be constant in the sense that it should not be the same every year. It must be sufficiently elastic to meet the needs of the occasion. During an inflationary period, public expenditure must contract and during a deflationary period it must expand. Effects of Public Expenditure Adam Smith advocated that the government should restrict its activities to "justice, police and arms", According to him, public expenditure for any other purpose was a waste. "Money would fructify more in the hands of the people than in those of the state", It is the modem economists who recognised the importance of the growth of public expenditure in stabilising the economy. In this context, let us examine the various effects of public expenditure. (a) On Production Public expenditure on education, public health, housing facilities, recreational facilities, etc., will increase the efficiency of the people to work, Similarly, public expenditure in the forms of grants and bounties to industries enable the rapid economic development of a country. Defence expenditure is also productive because it is an insurance against external attack and internal disorder.FUNDAMENTALS OF ECONOMICS Public Economics Dalton points out that the desire to work and save is adversely affected by public expenditure in the forms of pension, social security measures, etc. Why should a person work and save if he will be looked after by the state during the rainy days? But the modern view is not in favour of this. (b) On Distribution ‘Taxing the rich people and spending on the poor are some sort of a levelling process. It enables the government to reduce the glaring inequalities of income in the society. Reduction of inequality of income and wealth is the first step in the formation of a welfare state. (co) On Employment The effect of public expenditure on employment is quite encouraging. Keynes explains the relationship between public expenditure and employment as follows. An increase in public expenditure leads to an increase in income and effective demand. An increase in demand enables greater production and the promotion of employment, (2.4) BUDGET A budget may be defined as the financial statement of the estimated revenues and expenditures of the government in the coming financial year. It is regarded as the most important information document of the government. The budget has got two parts. The first part is something like an annual report, It gives an overall picture of the financial performance of the government during the period since its last budget. The second part presents the government's financial plans for the period up to its next budget in order to inform the country and get legislative approval. In mod- em times budgetary policies play an important role in the economic stabilisation of a country. Components of the Budget The budget of the government is split into two: © Revenue Budget © Capital Budget Revenue Budget Revenue budget includes the revenue receipts of the government and the expenditure met from such revenues, Revenue receipts include tax-revenue and non-tax revenue, Tax-revenue includes revenue from direct taxes like income tax, interest tax, wealth tax, corporation tax etc. and also the revenue from indirect taxes like sales tax, excise duties, customs duties ete. The non-tax revenues of the goverment include commercial revenues of the government (railways, post offices, tolls, interest on funds borrowed from the government, electricity, certain industries etc.)FUNDAMENTALS OF ECONOMICS Public Economics investment revenues of the government (interest and dividends) and administrative revenues (fees, fines, penalties, escheats etc). Then the other sources of revenue of the govemment are income from public properties, gifts by the people, grants by other governments ete. Revenue expenditure is for the normal running of the government departments, provision of various services, interest charges on debts incurred by the government, subsidies, grants in aid to the states ete. The speciality of revenue expenditure is that it does not result in the formation of assets. Capital Budget Capital budget consists of capital receipts and capital expenditure. The former include market loans, bor. rowings from the RBI, loans from international agencies, recoveries of loans granted to states and union territories ete. The latter includes expenditure for the acquisition of assets like land buildings, machinery, equipment ete, (2.5) TYPES OF BUDGET In economic planning, governments must manage their finances effectively to ensure stability and growth, Three critical concepts in public finance are the surplus budget, deficit budget, and balanced budget. Each of these budget types plays a significant role in shaping a country's economic landscape and influences various factors such as inflation, employment, and public investment, (mention components also) 1. Balanced Budget A balanced budget is one where the estimated expenditure is equal to the estimated revenue. For the purpose of simplicity let us assume that the only source of revenue of the government is @ lump sum tax. The budget being a balanced one, the tax amount equals the expenditure amount. A balanced budget can bring the economy which is at near full employment to a state of full employment. Expenditure = Revenue Advantages of a Balanced Budget: Fiscal Responsibility: A balanced budget reflects prudent financial management and reduces the risk of accumulating excessive debt. Predictability: It provides a stable economic environment, which can encourage investment and long-term planning. 10FUNDAMENTALS OF ECONOMICS Public Economics Inflation Control: By avoiding deficits, a balanced budget can help control inflation, as government spending does not outpace revenues. Disadvantages of a Balanced Budget: Rigidity: Rigid adherence to a balanced budget can limit a government's ability to respond to economic downtums or emergencies. Underinvestment: Maintaining a balanced budget might restrict necessary investments in public services and infrastructure, hindering long-term growth. Economic Cyeles: In times of recession, a balanced budget requirement can force governments to cut spending or raise taxes, exacerbating economic challenges. 2. Surplus Budget In the case of a surplus budget the estimated revenues are greater than the estimated expenditures. This situation allows the government to save money, pay down debt, or invest in future projects. A surplus can arise from increased tax revenues, often due to economic growth, or from reduced spending in certain areas. A surplus budget is never recommended in the case of deflation and recession as it worsens the situation. Expenditure < Revenue Advantages of a Surplus Budget: Debt Reductio Surpluses can be used to pay off existing national debt, which can lower interest payments and improve the country's eredit rating. Economic Stability: A surplus can provide a buffer during economic downtums, giving the government financial flexibility to respond to crises. Public Investment: Surpluses can fund essential public projects, such as infrastructure, education, and healthcare, leading to long-term economic benefits. Disadvantages of a Surplus Budget: Underinvestment: If a government consistently runs surpluses, it might underinvest in necessary services or infrastructure, "1FUNDAMENTALS OF ECONOMICS Public Economics Economic Contraction: Excessive surpluses may lead to a contraction in the economy, as high taxes or reduced government spending can decrease overall demand. 3. Deficit Budget A det it budget is one where the estimated revenue is less than the estimated expenditure. It means that the expenditure exceeds the tax. This situation requires borrowing to cover the shortfall, often leading to an increase in national debt. While running a deficit is sometimes viewed negatively, it can be a strategic tool for stimulating economic growth. A policy of deficit budget is recommended during the times of recession and unemployment. Expenditure > Revenue Advantages of a Deficit Budge Economic Stimulus: During periods of economic recession, running a deficit can stimulate demand through increased government spending, helping to revive the economy, Investment in Growth: Deficits can finance vital public services and infrastructure projects that promote long-term economic growth. Flexibility in Crisis: In times of emergency, such as natural disasters or pandemics, a deficit can provide necessary funds for rapid response. Disadvantages of a Deficit Budget: Increased Debt: Persistent deficits lead to rising national debt, which can burden future generations with repayment. Higher Interest Rates: Increased borrowing can lead to higher interest rates, potentially crowding out private investment. Inflation Risks: If financed through excessive money printing, deficits can contribute to inflationary pressures in the economy. (2.6) FISCAL DEFICIT Fiscal deficit is the difference between the total expenditure of the government (revenue expenditure + capital expenditure + loans net of repayments) on the one hand, and the sum 12FUNDAMENTALS OF ECONOMIES Public Economics revenue receipts, capital receipts which are not in the nature of borrowing but which finally accrue to the government on the other. The amount of fiscal deficit indicates the amount of borrowing required by the government, Large borrowings create the problem of heavy interest payment in the future. Large fiscal deficits may also fuel inflation. (2.7) REVENUE DEFICIT Revenue deficit is the excess of government's expenditure over the revenue receipts. It is considered as a good reflection of the government's extravagance and wrong fiscal policy. A deficit on the revenue account basically implies that the government is borrowing to maintain even its consumption expenditure. In India, the revenue deficit was continuously rising during the past decade. In 1990-91 it was 3.3% of the GDP. It rose to 3.6% of the GDP in 2000-01, In 2017-18 the revenue deficit was at 3.5%. (2.8) PUBLIC DEBT Borrowing made by the public authorities form the public debt. The government may borrow from banks and other financial institutions, business houses, and individuals. It may also borrow from foreign countries. The government loan is generally in the form of bonds which are promises of the government to pay to the holders of these bonds the principal sum along with interest at the agreed rate. Such loans are raised by the government to meet the gap between its revenue and expenditure. Need for Public Debt A balanced budget had been the accepted concept of public finance till recent times. The government must confine its expenditure within the limits of its tax revenue. But this idea has been relegated to the background in recent times. The modem view is to resort to public borrowings if necessary. The following facts justify a public debt. © Sometimes the actual revenue of the government may fall short of the expected or planned revenue owing to miscalculations and defective planning. This may lead to a temporary lag between revenue and expenditure, If the economy is to go on efficiently, the government has to take short term loans on such occasions. © Public borrowings become inevitable when unforeseen national emergencies like war, devastation by drought, floods, fire, ete. occur. Usually no government is able to face such situations with the funds from current revenue. 13FUNDAMENTALS OF ECONOMIES Public Economics © In order to achieve rapid economic development and full employment, the government has to resort to public borrowings. Ambitious development projects cannot be financed without borrowings. © During times of inflation the government may borrow from the public and thus withdraw the surplus money from circulation even if the revenue does not lag behind the expenditure will be effective anti-inflationary measures. Thus public borrowings are conducive and sometimes highly essential for economic stability and growth, But reckless borrowings by the government are not advisable Classification of Public Debts Productive and unproductive Public debt is said to be productive when the investment yields an income which will meet the yearly interest payments of the debt and the repayment of the principal sum in the long run. Eg. Loans taken for financing railways, irrigation works, etc, Unproductive debts are those which do not create any asset. Eg, loans raised by the government to finance a war. Voluntary and compulsory Usually government loans are voluntary in the sense that individuals and institutions are invited to take up government bonds. There is no force from above. The loans become compulsory when certain people are compelled to buy government bonds. Internal and external A loan raised by the government from sources within the country is called internal debt. Borrowings from foreigners are called external debt. Funded and unfunded or floating While funded debt is the one which is repayable only after a long time, unfunded or floating debts are short term loans like treasury bills. Redeemable and irredeemable Redeemable loans are those for which a definite date of repayment has been fixed. On the other hand irredeemable debts are those without a mention of the date of repayment, Sometimes they may not be redeemed at all but the government promises to pay interest regularly. Redemption of public debt Like a private individual, the government also has to repay the principal together with the agreed rate of interest. Repayment of debt in time is an honourable deed and it strengthens the 14FUNDAMENTALS OF ECONOMICS Public Economics confidence of the public in the government. The following methods are generally used for the redemption of public debt. 1, Surplus revenue ‘According to this method if a budget surplus arises in any year, it may be used for the repayment of th. public debt. But modern governments usually do not favour this method, 2. Sinking fund This is supposed to be the most systematic method of redeeming public debt. It refers to the creation and accumulation of a fund which will be sufficient to pay off public debt. A certain amount may be set apart every year for this purpose from the current revenue. Terminal annuity The government pays off its debt in equal annual instalments which include interest and principal. ‘The main advantage of this method is that the burden of the debt decreases every year. 4. Conversion It refers to the conversion of an old loan into a new loan, When the market rate of interest falls, the government raises fresh loans at lower rates to pay off the high interest bearing old debts provided the bond holders are not willing to accept the current rate of interest. 5, Repudiation According to this method the present government refuses to recognise the debts incurred by the former government. This is an unusual and revolutionary method. In fact repudiation is not paying off a loan but destroying it, Usually it happens after a revolution. For eg. The Communist government in the U.S.S.R repudiated all loans taken by the Czarist government. 6. Capital levy Capital levy is a tax on privately owned special levy imposed on all capital at a progressive rate so as to raise sufficient amounts to pay off the entire public debt. Capital levy was not a success ‘though it was tried in some European countries after the First World War. Burden of Public Debt A public debt taken for productive purpose will not have any burden as there are income yielding assets against the liability. If the debt is for an unproductive purpose it will impose a burden on the community. In the case of an internal debt, the government imposes taxes on the people in order to clear off the liabilities. The bond holders receive what the tax payers pay. While bond holders are rich, the community of taxpayers consists of rich and poor. Ifthe taxes are direct, the burden felt by the community will be little. If the taxes are indirect the burden will be really felt by the community. 15FUNDAMENTALS OF ECONOMICS Public Economics Tn the case of an external debt the amount paid by the debtor country towards interest and. the principal is the measure of the direct money burden on the community. The direct real burden of an external debt is equal to the value of goods drained from the debtor country towards its. payment and the resulting loss of economic welfare. Trade cycle or business cycle refers to the phenomenon of cyclical booms and depressions. Ina business cycle, there are wave-like fluctuations in aggregate employment, income, output and price level. The term business cycle has been defined in various ways by different economists. Prof. Haberler "The business cycle in the general sense may be defined as an alteration of periods of prosperity and depression of good and bad trade.” Estey: "Cyclical fluctuations are characterised by alternating waves of expansion and contraction. They do not have a fixed rhythm, but they are cycles in that phase of contraction and expansion recur frequently and in fairly similar patterns." Characteristics of Business Cycles © Cyclical fluctuations are wave-like movements, © Fluctuations are recurrent in nature. They are non-periodic or irregular. © These variables move at about the same time in the same direction but at different rates. © Business cycles are not seasonal fluctuations such as upswings in retail trade during Diwali or Christmas. © They are not secular trends such as long-run growth or decline in economic activity. TYPES OF BUSINESS CYCLES. Business cycles are usually classified as under: The Short Kitchin Cycle: It is also known as the minor cycle which is of approximately 40 months duration. It is famous after the name of the British economist Joseph Kitchin. The Long Jugler Cyele: This cycle is also known as the major cycle, In 1862 Clement Jugler, French economist, showed that periods of prosperity, crisis and liquidation followed each other always in the same order. A Jugler cycle's duration is on the average nine and a half years, 16FUNDAMENTALS OF ECONOMIES Public Economics The Very Long Kondratieff Cycle: In 1925, N.D Kondratieff, the Russian economist, came to the conclusion that there are longer waves of cycles of more than 50 years duration. A very long cycle has come to be known as the Kondratieff wave. Building Cycles: Another type of cycle relates to the construction of buildings which is of fairly regular duration. Such cycles are associated with the names of Warren and Pearson. Kuznets Cyel non Kuznets, propounded a new type of cycle, the secular swing of 16-22 years which is so pronounced that it dwarfs the 7 to 11 years eycle into relative insignificance. This has come to be known as the Kuznets Cycle. (2.10) PHASES OF A BUSINESS CYCLE A typical cycle is generally divided into four phases: 1. Boom or prosperity or the upswing, 2. Recession or upper-tumning point. 3. Contraction or depression or downswing 4. Revival or recovery or lower-turning point, Peak Recession , Expansion Real | Expansion *P GDP Time Boom/Prosperity Boom is a period of expansion. Almost all macroeconomic variables such as output, employment, prices and business profit tend to rise. The economy reaches full employment equilibrium and the 7FUNDAMENTALS OF ECONOMICS Public Economics actual and potential GNP become equal. Thus, there is no underutilization of resources. The maximum GNP during a boom is called peak. Recession or upper-turning point Recession is a mild down-turn of economic activities. The economy shrinks in its activities. Prices fall, business profit declines and investment slides down. Thus, output and employment decline. Contraction or depression or downswing. Depression is the acute form of recession. Unsold inventories accumulate and business profit, investment and output further fall. Involuntary unemployment appears. The rock bottom level of GNP during depression is called trough. Recovery Depression does not go indefinitely. Technological progress takes place in some industries. In this Way, net investment turns out to be positive. Thus, production rises and the economy recovers from the deep depression and it gradually moves to boom/prosperity. (2.11) FISCAL POLICY Fiscal policy refers to the use of government spending and taxation to influence a nation’s, economy, It is a critical tool for managing economic activity, addressing unemployment, controlling inflation, and promoting sustainable growth. Policymakers, typically through legislative bodies, enact fiscal policies to respond to changing economic conditions and to achieve specific economic objectives. Components of Fiscal Policy 1. Government Spending: This includes all government expenditures on goods and services, such as infrastructure, education, healthcare, and defense. Increased government spending can stimulate economic activity, especially during a recession, by creating jobs and boosting demand. 2. Taxation: Tax policy encompasses how much individuals and businesses are taxed and the structure of these taxes (¢.g., income tax, corporate tax, sales tax). Changes in tax rates ean influence consumer spending and investment decisions. Lower taxes typically increase 18FUNDAMENTALS OF ECONOMICS Public Economics disposable income, leading to higher consumption, while higher taxes can help control inflation but may dampen spending. FISCAL POLICY DURING INFLATION Inflation, characterised by rising prices and reduced purchasing power, poses significant challenges for economies. To combat inflation, governments often employ fiscal policy measures to stabilise prices and ensure economic growth. Reduction in Government Spending: Cutting public expenditure can directly reduce aggregate demand. By scaling back on projects and services, the government can help alleviate inflationary pressures, This measure, however, must be balanced to avoid harming essential services or economic growth, Increase in Taxes: Raising taxes, particularly on high-income eamers or luxury goods, can reduce disposable income and consumer spending. This can help lower demand and cool inflation However, higher taxes can also have negative effects on consumption and investment, so they must be carefully designed. ‘Targeted Subsidies: While broad subsidies can contribute to inflation, targeted assistance (e.g., food or energy subsidies) can alleviate the burden on low-income households without overly stimulating demand Investment in Supply-Side Policies: Increasing government investment in infrastructure, technology, and workforce development can help enhance productivity. By improving supply capacity, these measures can address the underlying causes of inflation, particularly when supply chain constraints contribute to price increases. Automatic Stabilizers: These are fiscal mechanisms that automatically adjust based on economic conditions, such as unemployment benefits and progressive tax systems. During inflation, these stabilisers can help moderate demand without requiring new legislation, FISCAL POLICY DURING DEFLATION If the economy is passing through a period of deflation, the fiscal policy should aim at raising the aggregate demand including consumption expenditure and investment expenditure. The fiscal measures to be adopted for the achievement of the above goal are the following, 19FUNDAMENTALS OF ECONOMICS Public Economics a. Public Expenditure During deflation, effective demand declines sharply, making increased public expenditure a crucial fiscal measure. This can be achieved through two approaches: pump priming and compensatory spending. Pump priming involves initial public expenditure aimed at reviving economic activity and stimulating private investment by injecting purchasing power into the ‘onomy. Compensatory spending seeks to offset the decline in private investment during a depression, continuing until private investments retumn to normal levels. Typically implemented through public works and social security measures, this spending leverages the multiplier and accelerator effects to boost income, output, and employment, Together, these strategies can effectively enhance effective demand and combat the impacts of deflation, b. Taxation Policy In times of deflation and depression, the government should adopt a tax policy that boosts both consumption and investment expenditures by reducing the tax burden on individuals and businesses. This can be achieved by lowering commodity taxes, such as sales and excise duties, to encourage consumer spending, and by cutting business and corporation taxes to stimulate private investment. Additionally, a policy of "redistributive taxation” should be implemented, imposing progressive income taxes on wealthier individuals with a low propensity to consume. The revenue generated should be used to subsidise the consumption of poorer segments of society, ultimately raising overall consumption and countering the effects of depression. c. Budget Keynesians recommend a deficit budget in order to fight out deflation and depression because it will inject more money income into the income stream. The main feature of a deficit budget is that, the expenditure exceeds the revenue and the deficit is usually met by printing new curreney. The injection of fresh money income into circulation will work against depression. Prof. Gunnar Myrdal says, “under-balaneing the budget during a depression is not primarily a deliberate policy but a practical necessity". 20FUNDAMENTALS OF ECONOMICS Public Economics 4, Public Borrowing The amount raised through public borrowings can be utilized for the execution of public works and social security programmes. But the government will have to consider two things while borrowing from the public during a period of depression. 1) The government should borrow at a low rate of interest so as to keep the burden of the borrowing low. 2) The government should see that the borrowings are made from those people with whom. funds are lying idle. (2.12) MONETARY POLICY Monetary Policy may be defined as the conscious management of money supply in a country for the purpose of attaining a specific objective or a set of objectives. It takes various measures to regulate the flow of currency, credit and other money substitutes so as to make the supply equal to demand. In short, monetary policy aims at regulating the economy by regulating the money supply. It is in consultation with the central bank that the government of a country formulates the monetary policy. The main objectives of monetary policy are stability of prices, stability of exchange rate, avoidance of trade cycles, neutrality of money, full employment and economic growth. The importance of any particular objective varies from country to country depending upon the pressing economic problems of the country concerned. Instruments of Monetary Policy Usually the monetary policy of a country is formulated and carried out by the central bank. The important instruments used by the monetary authority are the following. 1. Bank Rate Bank rate is the rate at which the central bank rediscounts first class bills. The interest rate usually follows the bank rate. That is, the interest rate goes up when the bank rate is raised and vice versa. During a period of inflation the central bank raises the bank rate. This is followed by a rise in the interest rate. This will discourage borrowings and encourage savings. During a period of deflation and depression the central bank lowers the bank rate, The consequent fall in the interest rate encourages borrowings 2FUNDAMENTALS OF ECONOMICS Public Economics 2, Open Market Operations They are the purchase and sale of eligible securities by the central bank. During inflation and boom, the central bank sells securities in the open market and withdraws the surplus money from circulation. The central bank buys securities and injects additional money into circulation during deflation and depression 3. Changes in the Reserve Ratio Every commercial bank is required to keep with the central bank a certain percentage of its deposits. This is known as the reserve ratio, When the reserve ratio is raised, the commercial banks. are forced to send more cash to the central bank, Then the cash resources of the commercial banks become less and their lending capacity is automatically reduced. When the reserve ratio is lowered, the cash resources of banks increase and they lend more, 4, Selective Credit Control According to this principle, the central bank directs the commercial banks to advance loans only for productive purposes. Loans for unproductive purposes are discouraged. The principle of selective credit control has become important in recent times. 5. Credit Rationing It means the restriction placed by the central bank on demands for accommodiation made upon it by commercial banks during times of monetary stringency. The credit is rationed by limiting the amount available to each applicant. MONETARY POLICY DURING INFLATION When there is inflation in a country, the excessive money in circulation must be withdrawn, A dear money policy is recommended during a period of inflation. A dear money policy entails raising interest rates and tightening the money supply to curb excessive spending and control inflation. Objectives © Stabilise prices and prevent inflation from rising uncontrollably. © Discourage excessive borrowing and speculative investments. © Promote savings by offering higher returns on deposits. 22FUNDAMENTALS OF ECONOMICS Public Economics The following measures are applied for this purpose. 1. When the bank rate is raised, the interest rate will follow it. This will withdraw the surplus money from circulation in the forms of deposits. Besides, at a higher rate of interest the expenditure by the business community will decrease 2. Sale of securities to the public by the government will help to withdraw the surplus money from circulation, Raising the reserve ratio of the commercial banks will control the lending activities of the banks. 4. Commercial banks must be directed to advance loans only for productive purposes. Effects: © Reduced consumer spending and business investment. © Slower economic growth, which can lead to higher unemployment if applied too aggressively. © Helps maintain price stability and confidence in the currency. MONETARY POLICY DURING DEFLATION Generally a cheap money policy is followed in order to mitigate the problems of deflation. By cheap money policy we mean a low rate of interest. A cheap money policy involves lowering interest rates and increasing the money supply to encourage borrowing and spending. Objectives. © Stimulate economic growth during periods of recession or slow economic activity. © Increase consumption and investment by making credit more accessible. © Encourage businesses to expand and consumers to spend. The following measures are applied for this purpose. © The rate of interest can be brought down by lowering the bank rate. © Purchasing of securities by the central bank, and printing of additional curreney will increase the supply of money in circulation, © Increased supply of money will lead to a low rate of interest. © Ata lower rate of interest investments will go up promoting the level of employment and national income, 23FUNDAMENTALS OF ECONOMICS Public Economics Effeets: # Increased consumer spending and business investment. * Potential for inflation if the money supply grows too quickly. © Can help reduce unemployment by s imulating job creation. Neutral Money Policy The neutral money policy is associated with the name of Prof. F.A. Hayek, one of the Nobel Prize winners in Economics. He is of the opinion that economic instability is mainly due to monetary instability. So economic instability can be avoided if the money supply can be properly regulated and brought under control in such a way that the effect of money should not be felt at all. Money should be neither cheap nor dear. It must be neutral. Thus neutrality of money means zero mark of inflation and deflation in the economy. Does neutral money policy stand for a constant money supply? Hayek gives a negative reply. Ina dynamic economy where total output, total population, the technique of production ete. are going on changing, the money supply should not be constant. 24