1

Module 1
Introduction
Unit Structure :
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8

Objectives
Distinction between Microeconomics and Macroeconomics
Circular flow of Economic activities
Gross National Product (GNP)
Net National Product (NNP)
Personal Income
Disposable Income
Summary
Questions

1.0 OBJECTIVES
1. To study the distinction between Microeconomics and
Macroeconomics
2. To study the Circular Flow of Economic Activities
3. To understand the concept of Gross National Product (GNP)
4. To understand the concept of Net National Product (NNP)
5. To understand the concept of Personal Income
6. To understand the concept of Disposable income

1.1 DISTINCTION BETWEEN

AND MACROECONOMICS

MICROECONOMICS

1.1.1 Meaning :Microeconomics studies economic behaviour of individual economic

entities and individual economic variables. The economic entities
may be individuals or small group of individuals. It is the study of
individual economic units such as individual firms and households,
individual prices, wages, income, individual industries and individual
commodities.
Macroeconomics is concerned with the nature, relationships and
behaviour of such aggregate quantities and averages as national
income, total consumption, savings and investment, total
employment, general price level, aggregate expenditure and
aggregate supply of goods and services. As macroeconomics deals
with aggregate quantities of the economy as a whole, it is also
called as aggregative economics.
1.1.2 Subject matter :Microeconomics seeks to explain how an individual consumer

2
distributes his disposable income among various goods and
services. How he attains the level of maximum satisfaction and how
he reaches the point of equilibrium. Microeconomics is also
concerned with how individual firms decide `what to produce, `how
to produce, and `at what cost to produce to minimise the cost of
production. To be specific, theory of consumers behaviour, theory
of firms or theory of production, theory of product pricing, theory of
factor pricing ( or distribution theory )and the theory of economic
welfare constitute the body of microeconomics.
Theories of National Income, consumption, saving and investment,
theory of employment, theories of economic growth, business
cycles and stabilization policies, theories of money supply and
demand and theory of foreign trade broadly constitute the subject
matter of macroeconomics. Macroeconomic theories seek to
answer questions such as how is the level of National Income of a
country determined? What determines the levels of overall
economic activities in a country? What determines the level of total
employment? How is the general level of price determined? etc.
1.1.3 Uses :Microeconomic theory explain the behaviour of various individual
elements and bring out the nature of interrelationship and
interdependence between them. Microeconomic theories contribute
a great deal in formulating the economic policies and can also be
applied to examine the appropriateness of economic policies. One
of the most important uses of microeconomic theories is to provide
basis for formulating propositions that maximise social welfare. It
also suggests ways and means to correct mal-allocation of
resources and to eliminate efficiency.
The main justification for macroeconomics lies in the need for
generalising the behaviour of and relationships between economic
aggregates. To study the system as a whole and to explain the
behaviour of aggregate quantities and the relationship between
them is extremely difficult. Macroeconomic approach has made it
possible. It ignores the details pertaining to the individual economic
agents and quantities and compresses the unmanageable
economic facts to a manageable size and makes them capable of
interpretation. Macroeconomic theories are used in formulating
public policies. They provide clarity to the macroeconomic concepts
and quantities and bring out the relationship between macro
variables of the economy in the form of models or equations.
1.1.4 Limitations :Microeconomic theories assume a given level of National Income,
employment, saving and investment. In reality, these factors are
subject to change with the change in their determinants. Secondly,
microeconomic theories assume the existence of a free enterprise
economy i.e. absence of any government intervention. However

3
government controls and regulations of economic activities are the
rules of the day. Thirdly, another limitation of microeconomics that it
is concerned with the behaviour of individual elements of the
economic organism and not with the organism as a whole.
Microeconomic theories, therefore, cannot be applied to study the
complex economic system treated as one unit.
Study of macroeconomics is limited to only aggregates. It cannot be
applied to explain the behaviour of individual components of the
economic system and the individual quantities. Secondly, it ignores
the structural changes in constituent elements of the aggregate.
Hence conclusions drawn from the analysis of aggregates may
involve error of judgement and may be misleading.

1.2

CIRCULAR FLOW OF ECONOMIC ACTIVITIES

An economy can be defined as an integrated system of production,

exchange and consumption. In carrying out these economic
activities, people are involved in making transactions- they buy and
sell goods and services. Economic transactions generate two kinds
of flows :
i)
ii)

Real flow i.e. the flow of goods and services, and

Money flow.

Real and Money flows go in opposite direction in a circular fashion.

The goods flow consists of (a) factor flow, i.e., flow of factor
services, and (b) product flow, i.e., flow of goods and services. In a
monetized economy, the flow of factor services generates money
flows in the form of factor payments which take the form of income
flows. The factor payments and expenditure on consumer goods
and services take the form of expenditure flows. Both income and
expenditure flow in a circular fashion in opposite direction. The
magnitude of these flows determines the size of national income.
To present the flows of income and expenditure, the economy is
divided into four sectors i.e. household sector, business sector, the
firms, government sector and foreign sector. These are combined
to make the following three models for the purpose of showing the
circular flows.
i)
ii)
iii)

Two sector model including the household and business

sectors;
Three sector model including the household, business and
government sectors
Four sector model including the household, business,
government and the foreign sectors.

1.2.1 Circular flows of income and expenditure in a two sector

model :The two sector model consists of only household and firm sectors

4
representing a private closed economy in which there is no
government and no foreign trade. It is therefore unrealistic but
provides a starting point to analyze the circular flows.
The households are assumed to possess certain specific features :
- the households are the owners of all factors of production
- their total income consists of wages, rent, interest and profits
-they are the consumer of all the consumer goods and services
-they save a part of their income and supply finance to the firms.
The business firms are assumed to have the following features and
functions :
-they own no resources of their own
-they hire and use the factors of production from the households
-they produce and sell goods and services to the households
-they do not save, i.e. there is no corporate saving.
The working of a Two sector economy and the circular flows of
incomes and expenditure are illustrated in the following figure.

The Circular flows in a Two sector model

Figure 1.1
There are two sectors i.e. households and firms. They divide the
diagram in two parts. The upper half represents the factor market
and the lower half represents the commodity market. Both the
markets generate two kinds of flows- real and money flows.
In the factor market, factors of production flows from households to
firms. This makes the real flow shown by a continuous arrow. There
is another real flow of factor incomes (wages, interest, rent and
profits) which flows from firms to households.
In the commodity market (lower half) the goods and services
produced by the firms flow from the firms to the households. The

5
payment made by the households for the goods and services
creates money flow.
By combining the goods and money flows we get a circular flow.
In reality, there are leakages from and additions to the circular flows
of income and expenditure. They are also called as withdrawals
and injections. A withdrawal is the amount that is set aside by the
households and firms and is not spent on the domestically
produced goods and services over a period of time. On the other
hand, an injection is the amount that is spent by households and
firms in addition to their incomes generated within the regular
economy.
The Two sector model with savings :Household do save a part of their income for investment. The
financial sector is constituted of a large variety of institutions
involved in collecting household savings and passing it on to the
business sector. The financial sector includes only banks and
financial intermediaries like insurance companies, industrial finance
corporations, which accept deposits from the households and invest
it in the business sector in the form of loans and advances. It is
explained in the following figure.

The Circular flows in a Two sector model with the Financial sector

Figure 1.2
With the inclusion of the financial sector, the households incomes
(Y) is divided into two parts : consumption expenditure and savings
(S). As shown in the following figure, C and S take different routes
to reach the business sector. The consumption expenditure (C)
flows directly to the firms, whereas savings (S) are routed through
the financial sector as the banks and FIs use the deposits to buy
shares and debentures of the firms which is investment (I). In the
final analysis the entire money income generated by the firms flows
back to the firms which flows back again to the households as
factor payments.

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1.2.2 Circular flows of income and expenditure
government : A Three sector model :-

with

It depicts a more realistic economy. It includes the government

which plays an important role in the economy. The economic role of
the government has increased tremendously during the post War II
period. Here we will include only three fiscal variables to the circular
flows, viz. direct taxes, government spending on goods and
services and transfer payments. These variables have different
kinds of effects on the income and expenditure flows.
As seen in the figure below, a part of the household income is
claimed by the government in the form of direct taxes. Similarly, a
part of the firms income is taxed away in the form of corporate
income tax. The firms pass on to the government the indirect taxes
also which is collected from the households. The government
spends a part of its tax revenue on wages, salaries and transfer
payments to the households and a part of it on purchases from the
firms and payments of subsidies. Thus, the money that flows from
the households and the firms to the government in the form of
taxes, flows back to these sectors in the form of government
expenditure.

The Circular flows of income in a Three sector model

Figure 1.3
1.2.3 Circular flows in a Four sector model : Model with the
foreign sector :The Four sector model is formed by adding foreign sector to the
three sector model. It consists of two kinds of international
transactions : foreign trade i.e. exports and imports of goods and
services and inflow and outflow of capital. For simplicity we make
following assumptions :
-the external sector consists only of exports and imports of goods
and services
-the export and import of goods and non-labour services are made

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only by the firms
-the households export only labour
The circular flow is explained in the following figure

The Circular flows of income in a Three sector model

Figure 1.4
The lower part is the circular flows of money in respect of foreign
trade.
Exports (X) make goods and services flow out of the country and
make money (foreign exchange) flow into the country in the form of
receipts from export. This is in fact, flow of foreign incomes into the
economy. Exports (X) represent injections into the economy.
Similarly, imports (M) make inflow of goods and services and flow
of money (foreign exchange) out of the country. This is flow of
expenditure out of the economy. Imports (M) represent withdrawals
from the circular flows.
So far as the effect of foreign trade on the magnitude of the overall
circular flows is concerned, it depends on the trade balance i.e. XM. If X > M, it means inflow of foreign income is greater than the
outflow of income, or there is a net gain from foreign trade. The net
gain increases the magnitude of circular flows of income and
expenditure. If X < M it decreases the magnitude of circular flows.
Check Your Progress :
1. State whether the following statements are True or false :
a)
Microeconomics deals with aggregates.
b)
Macroeconomics is a study of whole economic system.
c)
In reality Two sector model is use to explain the circular
flow of economic activities.
d)
Foreign trade is included to represent a Four sector
model.

---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Introduction of the concepts of National Income Aggregates :

1.3 GROSS NATIONAL PRODUCT (GNP):

GNP is the total market value of all final goods and services
produced in a year plus net income from abroad. This is the basic
social accounting measure of the total output or aggregate supply
of goods and services. GNP includes four type of final goods and
services. First, consumers goods and services to satisfy, the
immediate needs and wants of the people Second, gross private
domestic investment. Third, goods and services produced by
government and four, net income from abroad i.e. net export of
goods and services GNP is the total amount of current production
of final goods and services
There are two things which have to be noted in regard to gross
national product Firstly, it measures the market value of annual
output or it is a monetary measure This enables the process of
adding up the different types of goods and services produced in a
year. However, for accuracy, the figure for GNP is adjusted for price
changes Secondly, for calculating gross national product
accurately, all goods and services produced in any given year must
be counted only once. GNP includes only the market value of final
goods and ignores transactions involving intermediate goods. Final
goods are those goods, which are being purchased for final use
and not for further processing. The inclusion of intermediate goods
will involve double counting. This will give us an inflated figure of
the national product.
In national income accounting, GNP is calculated both at
market prices and factor cost. In order to calculate GNP at market
prices, the outputs of all final goods and services are valued at
market price and the values thus obtained are added. The market
price of a good includes indirect taxes such as the sales tax and
excise tax. Thus it is greater than the price received by the seller.
Sometimes, the government may grant subsidy on a product. In this
case, the market price would be less than the price received by the
seller GNP at factor cost eliminates the influences of indirect taxes
and subsidies. It provides an estimate of the total value of the final
goods and services produced during a year at cost of production.

9
GNP at factor cost is obtained by subtracting net indirect taxes from
GNP at market prices. GNP at Factor cost = GNP at market price Net indirect taxes = GNP at market prices - (Total indirect taxes Subsidies)
National income is usually calculated by 3 methods
(a)
The product method.
(b)
The income method
(c) The expenditure method .
In the product method, GNP is the value added by the various
industries and activities of the economy in a particular year. In the
income method, we add up the income earned by the owners of
factors of products in a particular year. This gives the gross national
income (GNI). In the expenditure method; we add up the final
expenditure of all residents in a country. All the three different ways
of looking at one and the same thing.

1.4 GROSS DOMESTIC PRODUCT (GDP):

GDP refers to the value of final goods and services produced
within the country in a, particular year. GDP is different from GNP.
A part of GNP may be produced outside the country For example
the money earned by the lndians working in USA is a part of India's
GNP But it is not a part of GDP since they are earned abroad.
Therefore the boundaries of GNP are determined by the citizens of
a country whereas the boundaries of GDP are determined by the
geographical limits of a country. It is also clear that the difference
between GDP and GNP is due to the "net revenue from abroad." If
the citizens of a country are earning more from abroad than
foreigners are earning in that country, GNP exceeds GDP If the
foreigners in the country are earning more than its citizens are
earning abroad, GNP is less than GDP
1.4.1 Net National Product :This is a very important concept of national income. In the
production of gross national product, during a year, some capital is
used up or consumed i.e. equipment, machinery etc. the capital
goods wear out or undergo depreciation. Capital goods fall in value
due to its use in production process. By deducting the charges for
depreciation from the gross national product, we get the net
national product. It means the market value of all the final goods
and services after providing for depreciation. It is called national
income at market prices. In other words, net national product is the
total value of final goods and services produced in the country
during a year after deducting the depreciation, plus net income from
abroad.
1.4.2 Net Domestic Products:NDP is obtained by subtracting the depreciation from the GDP.
NDP differs from MNP due to the net income from abroad. If the net

10
income from abroad is positive, NDP will be less than NNP If the
net income from abroad is negative, NDP will be greater than NNP
NDP is also calculated either at market price or at factor cost.
National Income at Factor Cost:- means sum total of all
income earned by resource suppliers for their contribution of land,
labour, capital and entrepreneurial ability which go into the years
net production. National income at factor cost shows how much it
costs society In terms of economic resources to produce the net
output. We use the term national income for the national income at
factor prices.
National Income at factor cost = Net national product ( National
Income at market prices) - (indirect taxes +Subsidies)

1.5 PERSONAL INCOME

Personal income is the sum of the income actually received by
individuals or households during a given year. Personal incomes
earned are different from national income. Some incomes which are
earned such as social security contributions corporate income taxes
and undistributed corporate profits are not actually received by
households In the same manner, some incomes which are received
like transfer payments are not currently earned ex Old age pension,
unemployment compensation, relief payments interest payments
etc. To get personal income from national we must subtract from
National income the three types of incomes which are earned but
not received and add incomes that are not currently earned ,
Personal income = N.I - Social Security - contributions - corporate
income taxes -undistributed corporate profit + Transfer Payments

1.6 DISPOSABLE INCOME

The personal income which remains after payment of taxes to
the government in the form of income tax, personal property tax
etc., is called disposable income. Disposable income = Personal
Income - Personal Taxes. An individual can decide to consume or
save the disposable income as he wishes.
Check Your Progress :
1. Generally three methods are use to calculate national
Income-Explain.
2. Distinction Between : NNP and NDP
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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1.7
1.

2.

3.

4.

5.

6.

SUMMARY
Microeconomics studies economic behaviour of individual
economic entities and individual economic variables.
Macroeconomics deals with aggregate quantities of the
economy as a whole, it is also called as aggregative
economics.
There are three models which explain the circular flows.
a) Two sector model including the household and business
sectors;
b) Three sector model including the household, business and
government sectors
c) Four sector model including the household, business,
government and the foreign sectors.
GNP is the total market value of all final goods and services
produced in a year plus the net income from abroad. GNP at
factor cost = GNP at market Prices - Net indirect taxes subsidy.
Net National Product:- is the total value of final goods and
services produced in the country "during a year after deducting
the depreciation, plus net income from abroad.
National Income at Factor Cost:- means the sum total of all
incomes earned by the resource suppliers for their contribution
of land, labour, capital and entrepreneurial ability which go into
the years net production.
National income at factor prices = [Net National Product
(National Income at market
prices) - Indirect taxes + subsidies]
Personal Income .- is the sum of all income actually received by
individuals or households during a given year.
Personal Income = National Income - Social Securities
Contributions - corporate income taxes - undistributed
corporate profit + Transfer Payment

1.7 QUESTIONS
1. Discuss in detail the difference between Microeconomics
and Macroeconomics.
2. Explain the Circular Flow of various economic activities.
3. Explain the concepts of a) GNP b) NNP c) GDP
d) Disposable income.

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2
NATIONAL INCOME and PRICE INDICES
Unit
2.0
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
2.11
2.12
2.13

2.0

Structure :
Objectives
Methods of measurement of National Income
Net output or Value Added Method
Factor-income method
Expenditure method
Measurement of national income in India
Price Indices
Stages in the construction of Index numbers
Laspeyres price Index or Base Weighted Price Index
Paashes current weighted price index
Difficulties in construction of Index number
Use of index numbers
Summary
Questions

OBJECTIVES

1.

To study various measures of measurement of national

income
2. To study Net output method
3. To study Factor income method
4. To study Expenditure method
5. To understand the measurement of national income in India
6. To study the concept of price indices
7. To study the various stages in the construction of index
numbers
8. To study Laspeyers price index
9. To study Paashes current weighted price index
10. To understand the difficulties in construction of index numbers
11. To understand the uses of index numbers

2.1 METHODS OF MEASUREMENT OF NATIONAL

INCOME
For measuring national income, the economy through which people
participate in economic activities, earn their livelihood, produce
goods and services and share the national products is viewed from
three different angles :
1. The national economy is considered as an aggregate of
producing units combining different sectors such as
agriculture, mining, manufacturing, trade and commerce, etc.

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2. The whole national economy is viewed as a combination of
individuals and households owing different kinds of factors of
production which they use themselves or sell factor services
to make their livelihood.
3. The national economy may also be viewed as a collection of
consuming, saving and investing units (individuals,
households and government).
National income may be measured by three different corresponding
methods :
A) Net product method
B) Factor-income method
C) Expenditure method

2.2

NET OUTPUT OR VALUE ADDED METHOD :

It is also called the Value Added Method. It consists of three stages

: i) estimating the gross value of domestic output in the various
branches of production; ii) determining the cost of material and
services used and also the depreciation of physical assets; iii)
deducting these costs and depreciation from gross value to obtain
the net value of domestic output.
Measuring gross value : For measuring the gross value of
domestic product, output is classified under various categories and
it is computed in two alternative ways : i) by multiplying the output
of each category of sector by their respective market price and
adding them together, or ii) by collective data about the gross sales
and changes in inventories from the account of the manufacturing
enterprises and computing the value of GDP on the basis thereof. If
there are gaps in data, some estimates are made thereof and gaps
are filled.
Estimating cost of production : is, however a relatively more
complicated and difficult task because of non-availability of
adequate and requisite data. Countries adopting net-product
method find some ways and means to calculate the deductible cost.
The costs are estimated either in absolute terms or as an overall
ratio of input to the total output. The general practice in estimating
depreciation is to follow the usual business practice of depreciation
accounting.
Following a suitable method, deductible costs including
depreciation are estimated for each sector. The cost estimates are
then deducted from the sectoral gross output to obtain the net
sectoral products. The net sectoral products are then added
together. The total thus obtained is taken to be the measure of net
national products or national income by net product method.

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2.3 FACTOR - INCOME METHOD :

This method is also known as income method and factor-income
method. Under this method, the national income is calculated by
adding up all the incomes accruing to the basic factors of
production used in producing the national product. The total factorincomes are grouped under three categories :
i)
Labour incomes : included in the national income have three
components : a) wages and salaries paid to the residents of the
country including bonus and commission and social security
payments; b) supplementary labour incomes including employers
contribution to social security and employers welfare funds and
direct pension payments to retired employees; c) supplementary
labour incomes in kind, e.g. free health and education, food and
clothing, and accommodation, etc. Compensations in kind in the
form of domestic servants and other free-of-cost services provided
to the employees are included in labour income. War bonuses,
pensions, service grants, are not included in labour income as they
are regarded as transfer payments. Certain other categories of
income, e.g., incomes from incidental jobs, gratuities, tips etc., are
ignored for lack of data.
ii)

Capital incomes : According to Studenski, capital incomes

include the following capital earnings
a) Dividends excluding inter-corporate dividends;
b) Undistributed before-tax profits of corporations;
c) Interest on bonds, mortgages, and savings deposits
(excluding interests on war bonds, and on consumer-credit)
d) Interest earned by insurance companies and credited to the
insurance policy reserves;
e) Net interest paid out by commercial banks;
f) Net rents from land, building, etc., including imputed net rents
on owner-occupied dwellings;
g) Royalties;
h) Profits of government enterprises.

iii)

Mixed income : include earnings from

a) Farming enterprises;
b) Sole proprietorship (not included under profit or capital
income)
c) Other professions, e.g., legal and medical practices,
consultancy services, trading and transporting etc. This
category also includes the incomes of those who earn their
living through various sources as wages, rent on own
property, interest on own capital, etc.

All these three kinds of incomes added together give the measure
of national income by factor income method.

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2.4 EXPENDITURE METHOD

Also known as final product method, measures national income at
the final expenditure stages. In estimating the total national
expenditure, any of the two following methods are followed ;
First, all the money expenditures at market price are computed and
added up together, and Second, the value of all the products finally
disposed of are computed and added up, to arrive at the total
national expenditure.
The items of expenditure which are taken into account under the
first method are
a) Private consumption expenditure;
b) Direct tax payments;
c) Payments to the non-profit making institutions and
charitable organizations like schools, hospitals, orphanages,
etc.
d) Private savings.
Under the second method, the following items are considered
a) Private consumer goods and services;
b) Private investment goods;
c) Public goods and services;
d) Net investment abroad.
The second method is more extensively used because the data
required in this method can be collected with greater ease and
accuracy.
Treatment of Net Income from Abroad :
Nowadays, most economies are open in the sense that they carry
out foreign trade in goods and services and financial transactions
with the rest of the world. In the process, some nations get net
income through foreign trade while some lose their income to
foreigners. The net earnings or loss in foreign trade affects the
national income. In measuring the national income, therefore, the
net result of external transactions are adjusted to the total. Net
incomes from abroad are added to, and net losses to the foreigners
are deducted from the total national income arrived at through any
of the above three methods.
Briefly speaking, all exports of merchandise and of services like
shipping, insurance, banking, tourism and gifts are added to the
national income. And all the imports of the corresponding items are
deducted from the value of national output to arrive at the
approximate measure of national income. To this is added the net
income from foreign investment. These adjustments for
international transactions are based on the international balance of
payments of the nations.

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2.5

MEASUREMENT OF NATIONAL INCOME IN

INDIA :

In India, a systematic measurement of national income was first

attempted in 1949. Earlier, many attempts were made by some
individuals and institutions. The earliest estimate of Indias national
income was made by Dadabhai Naoroji in 1867-68. Since then
many attempts were made, mostly by economists and the
government authorities, to estimate Indias national income. These
estimates differ in coverage, concepts and methodology and are
not comparable. Besides, earlier estimates were mostly for one
year, only some estimates covered a period of 3 to 4 years. It was
therefore not possible to construct a consistent series of national
income and assess the performance of the economy over a period
of time.
In 1949, a National Income Committee (NIC) was appointed with
P.C.Mahalnobis as its Chairman, and Dr. D.R. Gadgil and V.K.R.V.
Rao as members. The NIC not only highlighted the limitations of the
statistical system of that time but also suggested ways and means
to improve data collection systems. On the recommendation of the
Committee, the Directorate of National Sample Survey was set up
to collect additional data required for estimating national income.
Besides, the NIC estimated the countrys national income for the
period from 1948-49 to 1950-52. In its estimates, the NIC also
provided the methodology for estimating national income, which
was followed till 1967.
In 1967, the task of estimating national income was given to the
Central statistical Organization (CSO). Till 1967, the CSO had
followed the methodology laid down by the NIC. Thereafter, the
CSO adopted a relatively improved methodology and procedure
which had become possible due to increased availability of data.
The improvements pertain mainly to the industrial classification of
the activities. The CSO publishes its estimates in its publication,
Estimates of National Income.
Methodology :- Currently, output and income methods are used by
the CSO to estimate the national income of the country. The output
method is used for agriculture and manufacturing sectors, i.e., the
commodity producing sectors. For these sectors, the value added
method is adopted. Income method is used for the service sectors
including trade, commerce, transport and government services. In
its conventional series of national income statistics from 1950-51to
1966-67, the CSO had categorized the income in 13 sectors. But, in
the revised series, it had adopted the following 15 break ups of the
national economy for estimating the national income;
i)

Agriculture;

17
ii)
iii)
iv)
v)
vi)
vii)
viii)
ix)
x)
xi)
xii)
xiii)

Forestry and logging;

Fishing;
Mining and quarrying;
Large-scale manufacturing;
Small-scale manufacturing;
Construction;
Electricity, gas and water supply;
Transport and communication;
Real estate and dwellings;
Public administration and Defense;
Other services;
External transactions.

National Income is estimated at both constant and current prices.

Check Your Progress :
1. Write notes on the following :
a) Net output method
b) Factor income method
c) Expenditure method
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

2.6 PRICE INDICES

Macro economic analysis deals with the study and comparison
of aggregate economic variables A mathematical or statistical
device which helps us to determine the average changes of these
economic changes is needed Economists are interested in knowing
the changes taking place in the value of money over a period of
time. The value of money depends on the level of prices. There is
an inverse relationship between the two. In business economics we
have to study the comparative changes in the price. The quantity
consumed and the expenditure concerning a commodity or group of
commodities over a period of time Statistics provide us a tool to
Measure these changes known as index numbers Index numbers
are a specialized averages designed to measure change in a group
of related variables over a period of time. Suppose the index of
prices in 2000 is 150, compared to 1998, it means that the prices
have risen by 50 over the period under consideration. Here 1998 is
the base year and 2000 is the current year. Index numbers help us
to measure the changes in the wholesale prices and cost of living.

18
Index numbers are also used to measure the changes in industrial
production, agricultural production etc.

2.7 STAGES IN THE CONSTRUCTION OF INDEX

NUMBER
1

The first step is to decide the purpose" for which the index
number is to be constructed. Suppose we want to construct
the Cost of Living Index Number.

We have to choose the commodity for this purpose. Those

commodities, which enter into day-to-day consumption, must
be selected.

3.

The next step is to consider the prices of these commodities.

The selected price must represent a large volume of
transaction and variation.

The selection of the base year should be done carefully. It

should be a normal year without fluctuations and should be
close to the current year as far as possible.

The next step is the tabulation of the commodities and their

respective prices in the base year and current year express
them as a percentage and calculate their average.

6.

The difference between the average base year price and the
current year price will show the change in prices and hence
the value of money.
There are broadly 2 types of index numbers 1
Simple Index Numbers
2
Weighted Index Numbers

Table 2.1 Simple Index Number

Commodities
Prices in the Index in the Prices the
Base year
base year Current year
a
b
c
d
e
f
9
h
!
]

Rs. 30/quintal
Rs. 50/quintal
Rs.
4/Kg
Rs
2/Kg
Rs
100
Rs.
10
Rs.
4
Rs.
6
Rs.
8
Rs.
5

100
100
100
100
100
100
100
100
100
100
1000

Rs. 150
Rs. 200
Rs 10
Rs.
8
Rs. 200
Rs. 50
Rs.
4
Rs.
2
Rs. 16
Rs. 20

Index in the
Current year
500
400
250
400
200
500
100
300
200
400
~3200

19
Total no
Items = 10

of

1000
100
10

3200
329
10
It is clear from the above simple index number that the prices
between the two years have increased by 3 X 2/10 times. The value
of money has decreased to the same extent. To get a reliable
picture of the changes in the value of money, simple index number
is not sufficient. Weight to different commodities should be
assigned on the basis of their importance in the consumption
pattern.
Let us take two commodities, rice and cigarettes. Let us
assume that rice is 10 times more important than cigarettes. By
attaching weight one (1) to cigarettes, and 10 to rice, we will
multiply the price of rice by 10 and that of cigarettes by 1.
Table 2.2

Weighted Index Numbers

Commodites

Prices in the Weight

Base Year

Index with
Weight

Weight

Index with
Weight

900

Prices in
Current
year
175

Rice

100

1700

Cigarettes 100

100

100

100

10000
-------- = 100
10

1800
------- = 180
10

We get a more realistic picture of the change of cost of living and

the value of money

2.8 LASPEYRE'S PRICE INDEX OR BASE WEIGHTED

PRICE INDEX
This compares the current and base year cost of a basket of
goods of fixed composition Suppose the base year quantities of
various goods are denoted by qc' and the base year prices by
PO q 0 the cost of the basket of goods in the base year is PO q 0
The cost of the current basket of the same quantity at current prices
P,' will be PO q 0 The ratio of current cost to base years cost gives
the consumer price index.
PO q 0
Consumers price Index = ---x100
PO q 0
This is known as Laspeyre's price index.

2.9 PAASHE'S CURRENT-'WEIGHTED PRICE INDEX:

In this the weights of the current period are used. Formula is given
as :-

20
P1 q1
x 100
P0 q 0

P0

2.10 DIFFICULTIES IN THE CONSTRUCTION OF

INDEX NUMBERS:1

Changes in the general level of prices form the basis for

measuring the changes in the value of money. The concept of
the general price level is not very clear.

2.

Change in the general price level does not reflect the price of
each and every commodity. All prices do* not change at the
same rate. ,

3.

It is difficult to select commodities since the pattern of

consumption is not uniform.

There are practical difficulties in assessing weights on the

basis of their importance in consumption.

Base year is selected arbitrarily.

2.11

USE OF INDEX NUMBERS

index numbers help in measuring the changes in the value of

money over a period of time

The Cost of living Index Number helps in studying and

comparing the changes in the real wages of the workers.

The index number enables us to compare the living conditions

of different people at different times and helps in comparison.

Index numbers help to measure the purchasing power of

currency of different countries and helps the government to
determine the rate of exchange between the different
countries.

Index numbers help in formulating suitable monetary policy

The government can devise monetary policy on the basis of
changes in the price level of commodities.

Check Your Progress :

1. What do you mean by Index Numbers?
2. Distinguish between Simple index numbers and Weighted
index numbers.
3. What are the difficulties in the construction of Index
numbers?

21
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

2.12 SUMMARY
1.

2.

3.

4.

5.

National income may be measured by three different

corresponding methods : Net product method, Factor-income
method and Expenditure method.
Measurement of National Income in India : The earliest
estimate of Indias national income was made by Dadabhai
Naoroji in 1867-68.
In 1949, A National Income Committee (NIC) was appointed.
In 1967, the task of estimating national income was given to
the Central statistical Organization (CSO).
Price indices:- Index numbers are useful and convenient to get
a complete picture of the economic situation in a country. It
helps us to compare the price change over a period of time.
Weighted index numbers are useful to show the relative
importance of commodities in question. The weights reflect the
purpose for which the index is constructed.
Retail price index is an index of the prices of goods purchased
by a typical householder. It is used to measure the changes in
the cost of living.

2.13
1.
2.
3.
4.
5.
6.
7.

QUESTIONS

Describe the various methods of measuring national income.

Distinguish between net-product method and factor-income
method.
How is foreign income treated in national income estimates?
What is value-added? Explain the value-added method of
estimating national income.
What are price indices? Explain the construction of an index
number with the help of examples.
What are weighted index numbers?
What is a retail price index? Explain its importance.

22

3
Module 2

CLASSICAL THEORY OF INCOME AND

EMPLOYMENT
Unit structure :
3.0
Objectives
3.1
Introduction of the Classical Theory of Income and
Employment
3.2
Says Law of market
3.3
Introduction of the Keynesian Theory of Income and
Employment
3.4
Keynes Principle of Effective Demand
3.5
Consumption Function
3.6
Summary
3.7
Questions

3.0
1.
2.
3.
4.
5.
6.

OBJECTIVES
To study the Classical theory of Income and Employment
To study the Says Law of market
To study the Keynesian Theory of Income and employment
To study the Keynesian Principle of Effective Demand
To study the concept of Consumption function
To study the Multiplier Theory

3.1 INTRODUCTION OF THE CLASSICAL THEORY OF

INCOME AND EMPLOYMENT :
The study of classical theory of income and employment is
essential because some of the aspects of classical theory are more
relevant to the conditions prevailing in the developing countries.
Classical theory highlights those factors, which govern income and
employment in these countries. In fact Keynesian macro economic
model is not able to explain the conditions of unemployment and
underemployment in less developed countries. Hence it cannot
explain the determination of income and employment in such
countries.
Hence it is necessary to study the classical theory

23
The classical theory of employment is a supply-oriented
theory. It is the product of an accumulation and refinement of ideas
developed by the 18lh and 19'" century economists. The classical
economists were basically concerned with the long run problem of
growth of the economy's production capacity and efficient allocation
of the given resources at full employment. The classical economists
focused their attention more on the supply side and demand side
was neglected while discussing the growth process. According to
Adam Smith, Ricardo, Say, Mill and followers of classical thought,
except Malthus believed that there is no problem on the demand
side as the aggregate demand would always take care of itself.
Hence the main problem is that of supply rather than demand.
According to the classical economists if prices and wage rates
were flexible, there would be a built in tendency for the economy to
operate at full employment. As a result they ignored the problems of
unemployment. The classical economists focused on the
following problems:1

The different types of goods and services that would be

produced in the economy

2.

The allocation of productive resources among the competing

firms and industries. The classical economists tried to find out
the conditions leading to the most efficient use and optimum
allocation of the given resources.

The relative price structure of different goods and factors

The distribution of real income among the productive factors.

The main postulates of the classical theory of employment are
the following.
1.
Long term analysis
2
Full employment
3.
Say's law of markets
4
interest Rate and Flexibility
5.
Wage rate and Flexibility

3.1.1

The Assumption of Full Employment:The classical economists believed in the prevalence of a

stable equilibrium at full employment as the normal characteristic in
the long run. Any deviation from this is abnormal under perfect
competition in a free capitalist economy, forces operate in the
economic system which tend to maintain full employment without
inflation. As a result, the level of output is always at full employment
with the optimum use of resources in the long run. Full employment
is a condition where there is absence of involuntary unemployment
to restore full employment again.

24
The classical theory believed m full employment as a normal
condition. This was on certain basic assumptions.
1.

Says law of market- .Supply creates its own demand

according lo Say's law. Hence there can never be any
deficiency of demand.

2.

Any unemployment that in the process of a competitive system

is automatically eliminated by the free market price system

3.2 SAY'S LAW OF MARKET

The belief of classical theory regarding the existence of full
employment in the economy is based on Say's Law put forward by
a French economist J B. Say. According to J. B. Say's law. "Supply
creates its own demand". This implies that any increase in
production made possible by the increase in the productive capacity
or the stock of fixed capital will be sold in the market. There will be
no problem of lack of demand. This appears to be a simple
proposition. But it has a number of implications.
Say's law contends that the production of output in itself
generates purchasing power, equal to the value of that output,
supply creates its own demand. Production increases not only the
supply of goods but by virtue of the requisite cost payment to the
factor of production, also creates the demand to purchase these
goods. Any production process has two effects:
1

As factors are employed in production process, income is

generated in the economy on account of the payment of
remuneration to the factors of production.

It results in the production of a certain level of output, which is

supplied in the market. According to Say's law additional
output creates additional incomes which creates an equal
amount of extra expenditure.
A new production process, by paying out income to its
employed factors generates demand at the same time, as it
adds to supply. Thus any increase in production is followed by
a matching increase in demand.

In the original form Say's law was applicable to a barter

economy. In a barter economy, people produce goods either to
consume or to exchange them for other products. In the process
the aggregate demand for goods equals the aggregate supply of
goods. Hence there is no possibility of over production. Introduction
of money also does not change the basic law. Money is used only
as a medium of exchange. The classical theorists believed that
money is neutral and does not influence the real process of

25
production and distribution. There is a circular flow of money from
the firm to house holds and from households to firms. The firm
purchases inputs for production. They pay in the form of wages,
rent, interest and profits. This becomes the income of households.
The households spend their income on goods and services
produced by firms. In this circular flow there is no saving and
hoarding. All income received is spent. In case the household
saves a part of the income, the circular flow can still be maintained
if savings are equal to investment.
If there is a divergence between saving and investment, the
equality is maintained through the flexibility of money interest.
Interest is a reward for saving. Higher the interest, more are the
savings and vice-versa. At the same time, lower the interest rate,
higher the demand for investment and vice-versa. If I > S rate of
interest will rise. Savings will also increase and investment will fall
till the two become equal.
3.2.1 Assumptions of the Law
The following assumption forms the backbone of Say s law.
1.

Optimum Allocation of Resources:- The resources are

optimally allocated in different channels of production on the
basis of equality of marginal products and proportionality.

2.

Perfect Equilibrium:- Demand and supply equilibrium leads

to the fixing of commodity price and factor prices.

3.

Perfect Competition:- The commodity and the factor markets

have perfect competition as the market conditions.

4.

There is a free enterprise or free market economy.

5.

Laissez-faire policy of the government:- There is no

government intervention in the economic field. Laissez-fair
policy leads to automatic adjustment and smooth working of
the market mechanism in the capitalist system.

6.

Elastic Market:- The market is very wide and spread out

without limits. Therefore as the output product increases,
markets also expand.

7.

Market Automatism:- A free market economy stimulates

capital formation. In an expanding economy, new workers and
firms will be automatically absorbed into the production
channels. There is no displacement of workers or firm.

26
8.

Circular Flow:- There is no break in the circular flow of

income and expenditure Income is automatically spent through
consumption expenditure, and investment expenditure.

9.

Saving Investment Equality:- All the savings are

automatically invested. Therefore, savings is always equal to
investment. Savings investment equality is the basic condition
of equality. Interest flexibility ensures this.

10. Long term :- The economy's equilibrium

considered from the long term point of view.

process is

Thus according to Say's law, when savings will be offset by an

equivalent investment and since hoarding is zero, aggregate
demand will always be equal to aggregate supply. Hence there will
be no general over production in the long run. Therefore,
equilibrium can be maintained automatically at full employment
level. Since over-saving is not possible ;Say s Law implied that
underemployment equilibrium is not possible.
Interest rate flexibility and wage flexibility are the 2 factors
which ensures this equilibrium between be discussed.
1.
Interest Rate Flexibility :- According to Say's law, all
incomes are spent i.e. income = expenditure. However, there may
be "leakages" in the circular flow of income & expenditure.
Whatever is saved is invested in production activities. Savings and
investments tor saving. If savings exceed investment, the rate of
interest will fall. Hence investment will rise and level of savings will
fall till they are in equilibrium. Therefore, in classical theory of
employment, the rate of interest is a strategic variable, which brings
about equality between savings and investment Interest rate
maintains the equilibrium between savings and investment.
2. Wage Rate Flexibility and Employment :- According to
the classical economist, money wage cut policy can solve the
problem Involuntary employment is due to a rigid wage structure. If
the wages can be lowered, involuntary unemployment will
disappear. A self-adjusting system of wage will push the economy
towards full employment stage.

27

Figure 3.1
3.2.2Implications of Says Law:1.

Automatic Adjustment of Full Employment- A free enterprise

economy automatically reaches a stage of full employment
level. There are no obstacles to full employment General
employment and over production are impossible.

2.

Self-adjusting Mechanism:- Increase in supply will ensure an

increase in demand in the process of the functioning of a free
capitalist economy There is no need for government
intervention.

3.

Resource adjustment and utilisation of resources take place

automatically in an expanding capitalist economy. When new
workers and firms start operating, they also help to produce
additional output and income. The entire economy becomes
richer with the increased National Income. The unused and
new resources are also productively employed in such a way
as to benefit the whole society.

Money plays a passive role. It is only a medium of exchange to

facilitate transactions. Behind the flow of money, there is a real
flow of goods and services, which is important. As a result,
changes in the supply of money has no effect on the
economys process of equilibrium at full employment level.

A free enterprise economy under Laissez-faire policy has built

in flexibility. Market mechanism helps in optimum adjustments
in the economy.

Rate of interest is an equilibrating factor in classical theory.

Flexible interest rates lead to equilibrium between savings and
investment.

7.

Wage flexibility ensures full employment in the economy.

28
3.2.3 Criticism:J.M. Keynes vehemently criticized the classical theory. The
assumptions on which the classical theory is based can be
criticized The Great Depression of 1930's has revealed the
weaknesses of the classical theory. The classical theory could not
suggest a solution to the problem of a depressed economy facing
large scale unemployment.
1.

Unrealistic Assumptions at Full Employment:- According to

Keynes. The basic assumption of full employment itself is
unrealistic. An economy can be in a state of equilibrium. In
under employment situation also full employment equilibrium is
just one possible equilibrium condition according to Keynes.

2.

Too much emphasis on Long Run:- Keynes gave

importance to the short run According to him. In the long run,
we are all dead.

3.

Keynes refuted Say's Law of Markets:- According to

Keynes, the classical economists failed to examine the level of
aggregate demand. Supply may not create demand. Over
production is a possibility and reality according to Keynes.
Supply can exceed demand. Hence automatic self adjusting
mechanism will not work.

4.

Interest is not an equilibrating factor:- Keynes attacked the

classical theory in regard to savings and investment. Flexible
interest rates will not lead to equilibrium savings and
investment. Changes in income bring about the equilibrium
between savings and investment according to Keynes.

5.

Role of money is neglected:- The classical economists

considered money as a veil. It's role is neutral. Keynes
recognized the importance of precautionary measures and
speculative demand for money He also recognized the effect
of money on output, incomes, employment.

6.

Keynes attacked the Laissez faire policy of classical

economists. In the conditions -of the modern world, state
intervention is necessary to solve the problem of
unemployment. Government spending, taxation and borrowing
are important instruments to increase employment and income
in an economy.

7.

Wage cut policy is not practical. Due to the strong trade

unionism it is not possible to cut wage rates as suggested by
the classical economists as a remedy to employ more workers.
A wage cut may in fact lead to reduced purchasing power with
workers which will lead to reduced effective demand for

29
products. This will adversely affect the levels of employment.
Hence a general wage cut will lead to reduced volume of
employment. The workers will revolt if the money wages are
cut. This is due to money illusion.
8.

The classical system will work only if there is perfect

competition. In such a case there should not be trade
unionism, wage legislation etc. But in. reality, all these factors
exist. Hence classical theory will not become applicable.

Check Your Progress :

1. Examine the statement : The classical theory was a supply
oriented theory.
2. What are the main postulates of classical theory of
employment?
3. State the assumptions of Says Law of Markets.
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

3.3 INTRODUCTION OF THE KEYNESIAN THEORY

OF INCOME AND EMPLOYMENT :
J.M. Keynes in his book "The General Theory of Employment,
Interest and Money, popularly known as the General Theory,
published in 1936 rejected the classical theory of full employment
equilibrium. He brought out the real determinants of income and
employment in a modern economy. His theory is called General
theory since he studied all the cases of employment i.e. full
employment, less than full employment, and more than full
employment. According to Keynes, the economy can be in
equilibrium at any level of employment. Full employment is just one
possible situation in an economy. Underemployment situations are
more common. Another reason why Keynes theory is called the
General Theory is that it explains inflation as well as
unemployment. Inflation is due to excess demand, whereas
unemployment is due to lack of demand. Thus Keyne's theory is
demand oriented. It stresses effective demand as a crucial factor in
determining the levels of income and employment. Yet another
reason for Keynes theory being called a genera Theory is that it
integrates theories of money and value. Keynes in contrast to the
classical economists gave importance to the short run equilibrium.
Keynes assumed that the amount of capital, ' population,
technology etc, do not change in titer short run. Therefore, in the

30
short run, the income and the output depend on the volume of
employment. The levels of employment in turn depend on the
effective demand, which depends on aggregate spending. Hence it
is necessary to know what is effective demand.

3.4 THE PRINCIPLE OF EFFECTIVE DEMAND

The principle of effective demand occupies a strategic position
in Keynes theory of employment. Effective demand manifests itself
in the total spending of the commodity on consumption and
investment goods. Total employment depends upon effective
demand Therefore unemployment results from lack of effective
demand. Higher the level of effective demand, the more the level of
employment in the economy.
Effective demand depends upon 2 factors - Aggregate
demand function, and aggregate supply function.
3.4.1 Aggregate Demand Price and Function: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 labor is employed. In other words, the aggregate demand price is
the amount of money, which the entrepreneurs expect to receive
from the sale of output produced at a particular level of
employment. The aggregate demand curve or function is a
schedule of the proceeds expected from the sale of the output at
different levels of employment. The aggregate demand curve
slopes upwards from left to right. It means that as the level of
employment and income increase aggregate demand price also
increases With increase in income, people tend to spend a small
amount of income on consumption goods, Hence with increase in
output and employment, aggregate demand price increases at a
diminishing rate The slope of the curve diminishes will increase in
employment. The figure below depicts an aggregate demand
function.

Figure 3.2
3.4.2

Aggregate Supply Price :

31
The main aim of an entrepreneur in a capitalist society is to
earn profits. The producer will employ workers in such a way as to
maximise profits. Employment of labour means that some costs
have to be incurred. A certain minimum amount of proceeds will be
necessary to induce employers to provide any given amount of
employment. The supply price for any given quantity of commodity
refers to that price at which the seller is willing or is induced to
supply that amount in the market. If the seller does not get the
minimum receipts, he will reduce output and employment. The
aggregate supply curve or function is a schedule of the minimum
amount of proceeds required to induce entrepreneurs to provide
varying amount of employment. It shows the cost of producing a
certain level of output or the minimum receipts which must be
obtained if that level of output is to be maintained. The aggregate
supply function slopes upwards. The shape of aggregate supply
function depends entirely on technical conditions of production. It is
decided by the manner in which cost rises in response to expansion
of employment. The figure below shows the aggregate supply
function.

Figure 3.3
3.4.3

Equilibrium Level of Employment:The intersection of the aggregate demand function with

aggregate supply function determines the level of income and
employment. The aggregate supply schedule represents costs
involved at each possible level of employment. The aggregate
demand schedule represents the expectation of maximum receipts
of the entrepreneur at each possible level of employment. As long
as receipts exceed costs, the level of employment will go on
increasing. The process will continue till receipts become equal to
cost. At the point of equilibrium, the amount of sales proceeds
which the entrepreneurs expect to receive is equal to what they
must receive in order to just appropriate their total costs.

32

Figure 3.4
The point E, where the aggregate demand curve intersects the
aggregate supply curve is called the point of effective demand. The
equilibrium level of employment is ONF. This is not necessarily full
employment. If the level of employment is more or less than ON,
the profits will be less than maximum. ONF level of employment is
the full employment level in the diagram since at this level of
employment the aggregate supply curve AS is vertical in shape.
Hence ON level of employment is less than full employment. This
happens because investment demand is insufficient to fill the gap
between income and consumption.

Figure 3.5
For reaching full employment, employment level has to be
increased. For this either the aggregate supply curve should be
lowered or aggregate demand should be increased. Increasing the
aggregate supply curve will necessitate increase in the productivity.
This is a long run problem. Keynesian theory is concerned with
short run analysis. Hence raising the aggregate demand is
possible. This shifts the equilibrium point to 1. This is the full
employment equilibrium. Any expansion of demand beyond E1 will
lead to inflation.
The-chart below gives us the gist of Keynesian theory of
employment.

33
Table 3.1
INCOME

EMPLOYMENT

EFFECTIVE DEMAND

Aggregate Demand Function

Consumption
Expenditure

Aggregate Supply Function

Investment Government
Expenditure Expenditure

Check Your Progress :

1. Examine that Keynesian theory is demand oriented theory.
2. Explain the two factors which determine effective demand.
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

3.5 CONSUMPTION FUNCTION

In Keynes theory of income and employment, we have already
seen that the volume of employment in a society depends on the
level of effective demand which in turn is determined by the
aggregate demand function. The aggregate demand is made up of
2 components i.e. consumption expenditure and investment
expenditure. Consumption expenditure is a major component of
aggregate demand in a economy. The consumption expenditure
depends on the size of income and propensity to consume, which is
called consumption function. The marginal efficiency of capital and
the rate of interest determine investment. The Investment multiplier
expresses the relationship between the increases in investment and
increases in consumption. We will be studying the consumption
function and the investment rnultiplier in this unit.
In macro economic theory, Keynes singled out income as the
main determinant-Of consumption. The relationship is expressed in
the form of a function. The consumption function is the assumed

34
direct relationship between the national income level and the
planned or desired consumption expenditure. Keynes called it the
propensity to consume. Algebraically the basic relationship between
consumption spending and national income is shown as
C = f(Y)
'C' stands for consumption function, 'Y' stands for national
income, 'f. stands for functional relationship.
The simplest form of relationship between income and
consumption can be expressed as follows .
C = cY
This means that the consumption (C) is a constant proportion
(c) of income (Y)
According to Keynes, at various income levels, a schedule of
the propensity to consume is a statement showing the functional
relationship between the level of consumption at each level of
income.
TABLE: 3.2
CONSUMPTION FUNCTION
INCOME Y
200
300
400
500
600
700

CONSUMPTION (C)
(In crores of rupees)
220
300
380
540
620

The schedule relating to the various amounts of consumption

at different levels of income is called the consumption function, it is
clear from the above table that consumption is an increasing
function of income since both the variables Y and C move in the
same direction. Consumption function can be represented
diagramatically as below.

35

Figure 3.6
In the above diagram, Y-axis measures consumption, and X axis
measures the real income. The curve 'C' represents the
consumption function (Propensity to consume). It moves upwards
to the right implying that consumption increases as income
increases However the increase in consumption C1C2 is less than
the increase in income Y1Y2 That part of the income, which is not
consumed is saved, SS' is the saving. Hence the consumption
function measures the amount saved also.
3.5.1 Technical Attributes of Consumption Function:
Keynes considered two technical attributes:
1
The average propensity to consume
2.
The MPC
The APC is defined as the rate of aggregate or total
consumption to aggregate income in a given period of time
Symbolically, APC = C/Y
Table 3.3

36

It can be seen that APC declines as income increases

because the proportion of income spent on consumption
decreases.

Figure 3.7
The above diagram represents the APC. The APC is any one point
on the CC curve
It indicates the ratio of consumption to income. At point A,
OC1
APC
The curve becomes flat indicating that as income
OY1
increases, APC falls, and vice versa,
APS = S / Y = 1 - C / Y
The proportion of income saved increases as income
increases.
MPC refers to the proportion of each small addition to the level
of a country's national income that wit be devoted to additional
spending on consumer goods. If Y denotes a small change in

37
income, and C denotes a small change in the consumption due to
change in income. MPC can be symbolically written as C/Y.
In the above table, MPC is calculated at different levels of
income. It is clear that MPC is always positive but less than one.
This attribute of MPC arises from the Keynes fundamental
psychological law of consumption, that consumption increases less
proportionately than income, when income increases.
MPC = C / Y < 1
0 < C / Y < 1
From the MPC, we can derive the MPS,
C
MPS = 1-MPC
or -----Y
MPC is significant since it helps us to know the division of
extra income into consumption and investment. It facilitates the
planning of investment to maintain the desired level of income. It
has significance in the multiplier theory also.

Figure 3.8
When income increases from Y1 to Y2, the consumption increases
from C1 to C2. The change in income (Y) is Y1Y2 and change in
consumption is, C = C1 C2.
Hence MPC = C / Y
MPC refers to the slope of the consumption curve. As income
increases, the MPC level will fall at higher levels of income, there
will be more savings.
3.5.2
1.

Relationship Between APC And MPC

When the MPC is constant, the consumption function is linear
i.e. a straight line. APC will be constant only if the consumption

38

3
4.

function passes through the origin. If it does not pass through

the origin. APC will not be constant.
MPC refers to the marginal increase in consumption (C) due
to a marginal increase in income Y. APC refers to the ratio of
total consumption C to the total income Y.
As income increases, MPC also falls, but it falls to a greater
extent than the APC.
As income falls, MPC rises. APC also rises but at a slower
rate.

3.5.3 Factors affecting the Consumption Function :

According to Keynes, consumption function is affected by two
factors - subjective and objective. These factors normally do not
change in the short run. The subjective factors are endogenous or
internal. They refer to psychological characteristics of human
nature, social structure, social institutions and social practices. The
objective factors affecting the consumption function are
endogenous. These factors may change, which may lead to a shift
in the consumption function.
a) Subjective Factors;
The slope and position of the consumption function are
determined by the subjective factors Human behavior regarding
consumption function and savings depend on psychological
.motives. There are motives, which lead individuals to refrain from
spending out of their income. Keynes lists out eight such .motives
1.

Motive of Precaution: The desire to build up reserve against

unforeseen contingencies.

2.

The Motive of Foresight: The desire to provide for

anticipated future needs i.e. for education, old age etc.
The Motive of Calculation: Refers to the desire to enjoy a
larger income at a future date by way of interest and
appreciation

3.

4.

5.

The Motive of Improvement: The desire to enjoy a gradually

increasing expenditure, so that people can look forward to
gradually improving the standard of life.
The Motive of Independence: The desire to enjoy a sense of
independence and the power to do things.

6.

The Motive of Enterprise: The desire to be enterprising and

speculative or establish business deals

7.

The Motive of Pride: The desire to posses or to bequeath a

fortune

39
8.

The Motive of Avarice: The desire to satisfy miserliness and

abstain from expenditure. Subjective motivations are also
applicable to the behaviour patterns of business corporations
and governmental bodies. Keynes listed the following motives
for accumulation.
a) The Motive of Enterprise: It refers to the ambitious
plans to expand and secure resources for further
investments.
b) The Motive of Liquidity: The desire to face emergencies
and difficulties easily.
c) The Motive of Improvement: The desire to enhance
income levels and became successful.
d) The Motive of financial Prudence : The desire to
ensure adequate financial provision against depreciation
and obsolesce and discharge debts.
b) Objective Factors:

Objective factors are subjected to rapid changes and they

cause drastic shifts in the consumption function. They are as
follows:
1.

Windfall Gains or Losses : Consumption levels change due

to windfall gains or losses

2.

Fiscal Policy: Change in fiscal policy of the government leads

to change in the propensity to consume. For example
imposition of heavy taxes tends to reduce the disposable real
income of the community. Hence the level of consumption may
change adversely. Also abolishing of certain taxes may lead to
an upward shift of the consumption function.

3.

Change in expectation regarding the future leads to a change

in the propensity to consume. If people expect a war, they fear
a rise in prices in the future. People tend to hoard. This will
lead to a shift in the consumption function.

4.

The Rate of Interest changes in the rate of interest affects

consumption A rise in the rate of interest may induce people to
reduce consumption at each income level because people will
save more to take advantage of the high interest levels
Change in the net income: Net income rather than the total
income affects the consumption function. Changes in
accounting practices will affect the net income and therefore
influence the consumption function -

5.

Besides the above factors, Keynes and his followers had introduced
a number of factors such as financial policies of corporations,
holding of liquid assets, and distribution of income

40
3.5.4 Significance of Keynes Consumption Function
According to Hansen, Keynes analysis of consumption
function is a major landmark in the history of economic doctrines.
Keynes concept of consumption function has revolutionized the
entire economic thinking in modem times.
The important implications are the following.
1.

Importance of Investment: Since consumption is a stable

function, Keynes concluded that employment can increase
only if the investment increases. Investment therefore is
regarded as a crucial factor determining employment in the
short run investment has to De sufficient to fill in the gap
between income and consumption if output and employment
are to be maintained.

2.

Refutes the Say's Law of Market: Keynes was able to

invalidate the Say's law of market which was the basic
principle of the classical theory. Keynes showed the
consumption expenditure rises less than the rise in income.
Hence supply does not create its own demand. All that is
produced is not demanded

3.

Keynes Theory explains the Trade cycle Phenomenon:

Keynes consumption function provided a satisfactory
explanation of the upward and downward swings in the trade
cycle. When the MFC is less than usual, the economy is at the
upper turning point (down turn from propensity). As
consumption falls and savings become more, with increase in
income, will ultimately lead to a slump. The lower turning point
i.e. from depression to recovery is explained in terms of the
failure of people to cut down their consumption as the income
decreases.
3. MEC helps to study the nature of income propagation :A very important implication is the need for government
interference to remedy the problems of overproduction and
unemployment.

Check Your Progress :

1. What are the two technical attributes of Consumption
function?
2. State the subjective and objective factors of consumption
function.
-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

41
---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

3.6 SUMMARY
1.

The classical theory of employment deals with the

determinants of employment propounded by classical writers
like Adam Smith, Ricardo, Mill and others.

The classical theory was a supply oriented theory.

The classical economists were concerned with the long run

problems of growth of the economy, productive capacity and
efficient allocation of the given resources at full employment.

The main postulates of the classical theory of employment

were the following
a)
Long term analysis
b)
Full employment
c)
Says law of markets
d)
Interest rate flexibility
e)
Wage rate flexibility

The classical theory believed in full employment as a normal

condition arose from certain basic assumptions - Says Law of
Markets.

6.

The French economist J. B. Say believed that "supply creates

its own demand". This is the basic assumption in the classical
theory of employment. It implied that there will be no problem
of lack of demand. Every increase in production is followed by
a matching increase in demand.

7.

The following are the assumptions of Say's Laws:a)

Optimum allocation of resources
b)
Perfect equilibrium
c)
Perfect competition
d)
Laissez faire policy
e)
Elastic market
f)
Market automation
g)
Circular flow and Say's investment equality.
h)
Long term

Flexible interest rates bring about equilibrium between savings

and investment.

42
9.

Wage rate flexibility ensures that there is no unemployment. A

self adjusting system of wage rates will push the economy
towards full employment stage.

10. J M. Keynes criticizes Say's law of markets on a number of

grounds like unrealistic assumptions of full employment, long
run assumption. Say's law is also criticized since it is one
sided and neglects the demand side. It is also criticized that
interest does not equalize savings and investment. Classical
theory neglects the role of money. Keynes also criticized the
Lessaize faire policy of classical economists Wage cut policy
is not a practiced solution to solve unemployment problems.
Moreover the assumptions of perfect competition are
unrealistic.
11. Keynes consumption function is a very significant contribution
to modern macro economic theory. In order to explain the
concepts of consumption function and the multiplier theory, a
study of the fundamental Keynesian principles is important.
12. Keynes in his general theory, brings out the real determinants
of income and employment in a modern economy. According
to him, the economy can be in equilibrium at any level of
employment. Full employment is one of the different situations
in an economy. Under employment equilibrium situations are
more common.
13. Keynesian theory is demand oriented. It stresses effective
demand as a crucial factor in determining the levels of income
and employment.
14. Keynes gave importance to short run equilibrium. He assumed
that the amount of capital, population, technology etc. do not
change in the short run. Therefore, in the short run, the income
and output depends upon the volume of employment. The
levels of employment depend upon effective demand, which
depends upon aggregate spending.
15. Effective demand manifests itself in the total spending of the
community on the consumption and investment goods. Total
employment depends on effective demand unemployment is
due lo lack of effective demand.
16. Two Factors determine effective demand - Aggregate demand
function and aggregate supply function. The intersection of
aggregate demand function and aggregate supply function
determines the level of income and employment. This point is
known as the effective demand. The equilibrium reached thus
need not be the full employment equilibrium point. For
reaching full employment equilibrium aggregate demand
should increase.

43

17. The aggregate demand is made up of two components consumption expenditure and investment expenditure.
Consumption expenditure is an important component of the
total expenditure. Consumption expenditure depends on the
size of income and propensity to consume, which is called the
consumption function C = f(Y)
18. Keynes considered two technical attributes 1) APC 2) MPC
APC = C/ Y and MPC = C/ Y
19. A number of subjective and objective factors affect the
consumption function.

3.7 QUESTIONS
1

What are the main postulates of the classical theory of income

and employment?

What is the Say's law of markets? What are its assumptions?

3.

What are the main features of classical theory of employment

and income?

4.

Critically examine the classical theory.

5.

Discuss the Keynesian theory of employment.

6.

What is the Keynesian Consumption function? What are the

various factors affecting the consumption function?

7.

Explain the concepts of APC and MPC.

44

4
KEYNESIAN MULTIPLIER AND
INVESTMENT FUNCTION, INFLATION
Unit Structure :
4.0 Objectives
4.1 Keynesian Multiplier Theory
4.2 Keynesian Investment Function
4.3 Liquidity Preference Theory of Interest
4.4 Meaning and Definition of Inflation
4.5 Demand-pull inflation
4.6 Cost-push inflation
4.7 Summary
4.8 Questions

4.0
1.
2.
3.
4.
5.
6.

4.1

OBJECTIVES
To study the Keynesian Multiplier Theory
To study the Keynesian Investment function
To study the Liquidity Preference Theory of Interest
To study and understand the concept of inflation
To Study various types of inflation-Demand-pull inflation
To study Cost-push inflation

KEYNESIAN MULTIPLIER THEORY

The multiplier theory explains the effect of changes in the

investment upon the consumption expenditure and the resulting
generation of income. The theory of multiplier is an integral part of
the General theory of employment since it establishes a precise
relationship between aggregate employment and income and the
rate of investment, given the marginal propensity to consume
According to the multiplier theory, when there is an increment of
aggregate investment, income will increase by an amount, which is
K times the increase of investment. It explains the cumulative
effects of changes in investment on income through their effects on
consumption expenditures. It helps us to understand the dynamic
process of income generation.
4.1.1

The Concept of Multiplier:

R.F Kahn developed the concept of multiplier in 1931. This

was used to explain the effect of an increase in investment on
employment. Keynes used the idea to explain the effect of an

45
increase in investment on income Keynes multiplier is known as the
investment income multiplier.
Multiplier expresses a relationship between an initial increment
in investment and the resulting increase in aggregate income.
Multiplier is the numerical coefficient which indicates the increase in
income which will result in response to an increase in investment It
is expressed as the ratio of the realised change in aggregate
income to the given change in investment
K = Y / l where K = investment multiplier
Y = represents change in income
l = represents change in investment
Given the multiplier coefficient K we can measure the resulting
change in the level of income due to change in investment).
Y = K .I
If the investment increases by Rs. 1000, and income by
Rs.500, Multiplier = 5 According to Samuelson, multiplier means
"the number by which the change in investment must be multiplied
in order to present us with the resulting change in income
The most important factor in the multiplier effect is the
consumption function. When investment increases income
increases. As income increases, consumption also increases
Consumption expenditures become additional income to factors of
production, which produce consumers goods. Incomes further
increase due to induced consumption as so on. However, the whole
of the increased income is not consumed. The process will continue
until the increasing ratio of income to expenditure gradually works
itself out. MPC is less than unity. This is the reason why
consumption does not change in the same manner as the increase
in income. The value of the multiplier depends on the marginal
propensity to consume. The lower the value of the MPC, the greater
the value of the multiplier and vice-versa.
The formula for multiplier is given as
1
K = ;r Or 1 - MPC
C
1y
Where 'K' is the multiplier coefficient
C / Y = MPC
In other words
K=1/MPS

1 - MPC = MPS

46
i.e the reciprocal of the MPS
4.1.2 The Working of the Multiplier Process :
Sequence analysis helps us to understand the working of the
multiplier. For ex., during a given period, if the investment goes up
by Rs.10 crores income goes up by Rs. 10 crores. Suppose MPC is
0.5 or 50%, Rs.5 crores will be spent for consumption by the people
who receive this income. The amount spent on consumption means
a further amount of income received within the economy. Those
people who received Rs. 5 crores now will spend 50% of that
income in consumption i.e.Rs.2.5 crores in the second round. In the
third round, Rs.1.25 crores will be generated and so on. The
interval between consumption responses is the multiplier period".
As we move from one multiplier period to another, the addition to
the income gradually diminishes. The process will continue till the
total increment in income becomes so large that it results in
additional savings which is equal to the increase in investment. This
process can be explained with the help of a formula.
Y = I (I + C + C2 + C3 + ..+Cn)
Y = increase in income, l, initial increase in investment, c = MPC
Since the absolute value of C is less than 1, the sum of the infinite
geometrical progression is
1
1 + C + C2 + C3 + .. + Cn =
1 C
C = MPC, where C is less than one,
1
Change in income = - x change in investment
1 - MPC
Y

10x1
1
10 x
1 05
1/ 2

= 10 x 2 = Rs. 20 crores
Given the MPC to be 0 .5 an initial investment of Rs 10 crores
will lead to Rs. 20 increase in the income. In the above example,
Keynes ignores time lags. Modern economists on the other hand
feel that it takes time for the impact of the initial investment to make
itself felt throughout the entire economy.
The multiplier effects of investment on income can be
diagrammatically shown

47
Figure 4.1
The C curve is the consumption curve and it is drawn on the
assumption that MPC is constant at all levels of income i.e.. 0.5.
The level of effective demand is determined by consumption and
investment outlays i.e. consumption and investment. This is super
imposed on the C curve. The 45 degree line OY shows that Income
= Consumption + Savings. The original equilibrium is at E where
the consumption + Investment curve intersects the 45 degree line.
The equilibrium level of income is O. As new investment is injected,
the line shifts to C + I + I.
The new equilibrium point is at E1 and the new equilibrium
income is OY,. Taking the original example, an initial outlay of Rs.
10 leads to an increase in income to Rs. 20, where K = 2. Hence
the increase in income ( Y) is a multiplier of the increase in
investment ( l).
4.1.3 Assumptions of the Multiplier Theory :
The following are the assumptions of the multiplier theory :
1.
2
3
4

5
6
7

Constant Marginal Propensity to Consume.

Monetary and fiscal policies remain stable so that they do not
affect the propensity to consume.
The multiplier period is absent.
Excess capacity exists in the economic system. The
assumption is that the economy operates at less than full
employment.
Closed economy is another assumption.
The effect of
international economic transactions are ruled out.
There should be a net increase in investment.
Consumer goods are available in sufficient quantities.

4.1.4 Leakages of the Multiplier :

There are serious limitations in applying the concept of
multiplier in practice. Certain forces, which operate in an economy,
reduce the strength of the process of income propagation. Leakages reduce the income generated. They are
1.

Increase in the MPS: The higher the marginal propensity to

save, the greater the leakages of additional income out of the
income. In a dynamic economy, the MPC or MPS is not
constant. With increases in income MPS rises. As a result, the
multiplier value may fall.

2.

Debt Cancellation: Paying back of debts taken by people

reduces the value of the multiplier since consumption is
reduced.

48
3.

Hoarding Idle Cash Balances: If people prefer to hold liquid

cash than spend it on consumption goods, it will lead to a
leakage from the income stream and reduce the value of the
multiplier.

4.

Imports: the income spent on imports will not lead to income

generation within the domestic country, and hence leads to a
restriction of the value of the multiplier.

5.

Purchase of Old Shares and Securities: If the newly generated

income is used to buy old stocks, shares and securities,
consumption will be less and as a result, the value of the
multipliers will be low.

6.

Inflation: Rise in the prices adversely affects the real

consumption of people. Hence consumption will not increase
during inflation. This also affects the value of the multiplier.

4.1.5

Criticism :

1.

It is a static phenomenon: it does not explain the dynamic

change. It explains the process of income propagation from
one point of equilibrium to another under static assumptions.
The actual sequence of events is not explained.

2.

It is a timeless phenomenon: Keynes assumed an

instantaneous relationship between income, consumption, and
investment. However, there are time lags between
consumption and income. Hence according to modern
economists, multiplier effect takes time to make an impact.

3.

No Empirical Evidence: There is no empirical evidence to

prove the operation of multiplier effect. It does not tell us
anything about the real world.

4.

It gives too much importance to Consumption: The

emphasis is exclusively on consumption.

5.

The theory has neglected the derived demand phenomenon of

investment in capital goods sectors. It fails to establish a
relationship between the demand for capital goods and
consumption goods.

4.

Some economists like Prof. Hazhtt hold that the multiplier

concept is only a myth There cannot be a precise mechanical
relationship between investment and income

Check Your Progress :

1. Examine the working of the multiplier process.
2. Explain the factors which reduces the strength of the process

49
of income generation.
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

4.2 INTRODUCTION OF THE INVESTMENT FUNCTION

In modern macroeconomic analysis, the term investment
refers to real investment.
A firm invests when it uses steel or other material to build plant
or when new machines are purchased. This is real investment.
When a person buys shares or deposits money in the money in the
bank, it tends to be financial investment.
Investment leads to the production of new capital goods - plant
and equipment. Capital formation takes place if the newly produced
capital goods leads to a net addition to the given stocks of capital
assets over and above their replacement requirement
(depreciation).
Investment may be either gross investment or net investment.
Gross investment is defined as a flow of expenditure or new fixed
capita! assets or an addition to inventories over a given period of
time. Since we are not considering inventories, gross investment
means the investment expenditure on fixed capital. A part of the
new capital will be needed simply to replace the depreciated capital
stock This must be deducted to find out the net addition to the
existing capital stock Therefore, Net investment = Gross investment
Depreciation of Fixed Capital investment can also be classified into
autonomous investment and induced investment. Autonomous
investment does not change with the changes in income i.e. it is
independent of income. It takes place in construction of roads,
building etc.
Autonomous investment depends on population growth and
technical progress than on the level of income. Most of the
investment activity of the government is autonomous in nature
Induced investment changes with changes in income,
4.2.1 Determinants of Investment :
Investment function refers to inducement to invest or investment
demand. According to the classical economists, investment
demand is a decreasing function of the rate of interest.

50

FORMULA
I = f (i) where I = Investment
(i) = rate of interest
According to Keynes, the volume of investment depends upon
two factors, 1) The marginal efficiency of capital and 2) The rate of
interest. The marginal efficiency of capital is called the expected
rate of profit.
Prospective investors
Prospective investors will compare the marginal efficiency of
capital with the rate of interest Inducement to investment depends
on these two factors. If investment is to be profitable, the expected
rate of profit must not be less than the current rate of interest in the
market. New investment will take place if the expected rate of profit
is greater than the rate of interest. The rate of interest does not
change in the short run. Hence inducement to invest basically
depends on the marginal efficiency of capital.
4.2.2

Marginal Efficiency of Capital:

To examine the profitability of ventures, Keynes introduced the

concept of marginal efficiency of capital. Marginal efficiency of a
given capital asset is the highest rate of return over the cost
expected from an additional or marginal unit of that capital asset
According to Kurihara, marginal efficiency of capital is the ratio
between the prospective yields of additional capital assets and their
supply price, expressed as
e=Q/P
Where e = marginal efficiency of capital
Q = the expected yield of return
P = The supply price of this asset.
Hence the marginal efficiency of capital depends upon two
factors - 1) The prospective yield from the capital asset, 2)the
supply price of this asset. "Prospective yield" means the amount of
annual income an investor expects to obtain from selling the output
of his investment or capital assets after deducting the running
expenses In other words, the prospective yield of a capital asset is
the aggregate net return expected from it during its life time The
total expected life of a capital asset can be divided into a series of
periods i.e. years. The annual returns or annuities can be
represented by Q1, Q2, Q3, Q4 . The series of annuities or returns is
called prospective yield of investment. An investor has to consider
the supply price of an asset. The supply price of a particular type of
asset is the cost of producing a totally new-asset of that kind
Combining the two concepts. Keynes defines marginal efficiency of
capital as "being equal to that rate of discount which would make

51
the present value of the series of annuities given by the return
expected from the capital asset during its life just equal to its supply
price In other words, the marginal efficiency of a capital asset is the
rate at which the prospective yield expected from one additional
unit of the asset must be discounted if it is just equal to the cost i.e.
the supply price of the asset The following equation signifies the
concept of MEC.
FORMULA
R
R2
C= 1
1 r
(1 r ) 2

R3
(1 r ) 3

......

Rn
(1 r ) n

C = Supply price of capital assets

R1, R2, R3 ......... Rn are the annual prospective yields from the
capital asset, 'r' is the rate of discount or the marginal efficiency of
capital, 'r' is the internal rate of return on R that asset. The term
R1
represents the current value of the annuity or yield
(1 r )1
receivable at the end of the first year, discounted at the rate 'r'. If
the rate of discount is assumed to be 10%. each rupee which we
expect to get after a year is worth 90.91 paise now i.e. 90.91 paise
currently invested at 10% will become one rupee within a year. In
the same way, (1 + e)2 represents the current value of annuity or
return expected at the end of the second year discounted af the
rate of r.
An example can be taken to explain how the marginal
efficiency of capital is calculated If we suppose that the supply price
cost of a machine is Rs, 1600 and its economic life is two years, the
prospective yield on this machine in each year is Rs. 1440 and its
disposal value is also Rs.1440. The marginal efficiency of capital
can also be obtained.
1600 =

1440
(1 r )

1440
(1 r ) 2

1600 (1 + r)2 = 1440 (1 + r) + 1440

1600 (1 + 2r + r2) = 1440 + 1440r + 1440
1600 + 3200r + 1600r2 + 1440 + 1440r + 1440
1600r2 = 1760 - 1280 = 0
By using the formula for the root of anabatic equation
ax2 + bx + c = 0
x=

b2
2a

4ac

52

r=

1760

(1760) 2 4(1600) ( 1280)

2 (1600)

r = - 1.6 or r = 0.5
Since 'r' cannot be negative r = 0.5 or r = 50%
If this is the rate of return, investment in the machine will be
profitable, if the cost of borrowing funds (rate of interest) is less
than 50% i.e. given the cost of capital asset at Rs. 1600, MEC was
calculated at 50%. Suppose the ratio of interest is 18%. investment
will be profitable. .
MEC Schedule (curve)
MEC falls as investment increases due to fall in the prospective
yield and increase in the supply price of the capital assets. The
marginal efficiencies of all types of capital assets which may be
made during a given period of time represents the schedule of MEC
or the investment demand schedule.
MEC Schedule
Investment Rs.
20000
50000
75000

MEC %
15
12
10

It is clear from the above table that as investment increases

MEC goes on falling. The downward slope of the curve shows the
inverse relationship between investment and MEC i.e. an increase
in investment will lead, to a fall in MEC.

VOLUME OF INVESTMENT
Figure 4.2
The more elastic the MEC curve, the greater the investment given a
fall in the interest rate. Usually the MEC curve tends to be inelastic.
MEC curve shifts if the profit expectations change or the technology
improves. Keynes believed that investment responds to changes in
expectation and shifts in MEC rather than the rate of interest.

53

MEC and The Rate of Interest:

MEC is expressed as a ratio and compared to the rate of
interest. There is a comparison between the expected rate of profit
and the rate of interest. In effect it is a comparison between the
supply price of an asset and its demand price. Keynes makes a
distinction between the demand price and the supply price of a
capital asset. The demand price of an asset is defined as the sum
of the expected future yields discounted at the current rate of
interest. We have already seen that supply price = the sum of
prospective yields discounted by the MEC.
In symbolic terms, demand price of an asset can be put as
follows.
Q3
Qn
Q1
Q2
DP
.....
2
3
(1 i )
(1 i )
(1 i)
(1 i ) n
DP = demand price, Q1, Q2, Q3,... Qn = the prospective yield
or annuities, i = current rate of interest.
For Example, the market value of an asset., which promises to
yield Rs. 1600 at the end of one year and Rs. 1210 at the end of 2
years will be estimated at higher than Rs 2000, when the interest
rate is less than 10%. If the market rate of interest is 5% the
present value of capital asset will be
Demand
Price

1100
1.05

1210
(1 (0.05) 2

= 1047.62 + 1097
= 2144.62

This is the demand price of a capital asset.

The effect of the relative positions of demand and supply on the

behaviour of investor in taking decisions will be as follows
1)
When MEC = interest rate, SP = DP - neutral
2)
If MEC > DP > SP - favourable
3)
When MEC < DP < SP unfavourable
The two strategic variables in investment decisions are the MEC
and the rate of interest. MEC of an asset falls as I in that asset
increases. The reasons are,
1

The prospective yield of that asset will fall as more units are
produced. More production will lead to the units competing
with each other to meet the demand for the product.

54
2

The supply price of the asset will rise as more of the assets
are produced. Investment will be in equilibrium when MEC
becomes equal to the given current rate of interest. This is
given by the following diagram

Figure 4.3
At i1 rate of interest investment is OM1 . At this level of investment,
MEC = i1 . If the rate of interest falls to i2, investment will rise to
OM2. However change in profit expectation can shift the MEC curve
also.

Figure 4.4
This is shown by the above diagram. Due to rise in profit
expectation, MEC curve shifts to MEC1. As a result investment also
increases to i2. MEC is the prime factor in determining investment,
since rate of interest is rather rigid during the short period.
Factors Affecting MEC :
A number of short run and long run factors affect the marginal
efficiency of capital.
Short run Factors:
1.

Expectation about demand, price and cost of Production: It

there is an expectation of demand to increase and hence

55
prices to rise, a high MEC leads to increased investment and
vice versa
2.

Business Optimism and Pessimism: If the atmosphere is one

of optimism , entrepreneurs will estimate MEC to be high.

3.

Changes in Income: Unexpected windfall gains suddenly

increases income levels. This will induce an increase in MEC.

4.

An increase in the propensity to consume will raise the MEC

and vice-versa: Increased demand for consumption goods will
induce the demand for capital goods

Long Run Factors :

1.
Population Growth: Increase in population leads to increase in
demand. MEC will increase as a result.
2. Technological Advancement: Improvement and growth of new
technology leads to new products, new markets etc This will
have a favourable impact on the MEC.
3. Development of Infrastructure : Developing the infrastructure
also has a positive-impact on the MEC in the long run.
Check Your Progress :
1. State which two factors determine the investment demand.
2. Examine the factors which affect MEC.
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

4.3 LIQUIDITY PREFERENCE THEORY OF INTEREST

According to Keynes interest is a monetary phenomenon Rate
of interest is determined by the interaction of the demand for and
supply of money Keynes showed that the demand tor money is
inversely related to the rate of interest Keynes looked at the
demand for money not just as a medium of exchange but as an
asset.
According to Keynes, the rate of interest is determined by the
intersection of the supply schedule of money (total quantity of
money) and the demand schedule for money (the liquidity
preference). According to Keynes rate of interest is a reward paid
for parting with liquidity. The demand for money is a demand for
liquidity. Liquidity preference means that people prefer to hold
wealth in the form of liquid cash rather than the other non-liquid

56
assets like bonds, securities, bills of exchange etc.
4.3.1 There are three motives which lead to liquidity preference;
1.
The transaction motive .
2
The speculative motive
3
The precautionary motive ,
According to Keynes. the demand for money is positively
correlated with income i.e. an increase in the levels of income
implies a rise in the demand for money and vice-versa There is a
negative correlation between the demand for money and the rate of
interest. A rise in the rate of interest reduces the demand for
money.
In symbolic terms, L1 is expressed as the demand for money
for transactions and precautionary motives L1 depends on income
mainly. It is not influenced by the changes in the rate of interest L 2
is the speculative motive of demand for money which is influenced
by the changes in the rate of interest. 'L' stands for total demand for
money.
L= L1 +L2
This remaps fixed in Keynes theory. The money supply at any
time is determined by the action of monetary authority. If M is the
total supply of money and M, the total quantity of money held by
people for transactions and precautionary motives and M2 the
quantity of money held for speculative purposes: 'V is the total level
of income and r is rate of interest, then
M1 =L1 (Y)...................... (2) Money for Transaction
M2 =L2 (r) .... Money supply related to speculative demand
Liquidity function
M = M1 + M2 = L1 (Y).+ L2(r)
M = L(r, y)
This M = L(r, y) implies that the quantity of money held depends of
the rate of interest and the level of income.
4.3.2

Liquidity Preference Schedule:

The demand for money can be explained with the help of a

diagram. The liquidity preference schedule shows the functional
relationship between the amount of money demanded for all
motives and the rate of interest.

57

Figure 4.5 (a)

Figure 4.5 (b)

Figure 4.5

The diagram 4.5 (a) shows a liquidity function. It slopes downwards.

It shows an inverse relationship between the amount of money
demanded and the rate of interest. At low rates of interest, people
prefer to hold money
Figure 4.5 (b) shows the shifts in the liquidity function. Liquidity
preferences also change with the changes in liquidity function i.e. it
increases or decreases as the liquidity function changes Rate of
Interest determination:

58

Figure 4.6 (a)

Figure 4.6 (b)

The interaction between the liquidity preference function and the

supply of money leads to the equilibrium rate of interest. In the
diagram 4.5 OR is the equilibrium rate of interest
Rate of interest can change either due to change in demand or
supply of money. This is depicted in the diagram 4.6 (a) and 4.6 (b).

4.3.4 Shortcomings of the Liquidity Preference Theory :

The liquidity preference theory of interest has been vigorously
criticised by Hansen and others.
1.

Indeterminateness : according to Prof Hansen. Keynes

interest theory is also indeterminate like the classical theory.
To know L1, we should know the income level and to know the
income level, we must know the rate of interest. Hence
Keynesian theory suffers from the same problem as the
classical theory.

2.

One Sided: Real factors which determine the rate of interest

are neglected. Interest is a purely monetary phenomenon in
Keynes theory. Real factors like productivity time preferences
are neglected.

3.

Ignored Saving: The impacts of saving on the rate of interest

are ignored. According to Jacob Viner, there is an exaggerated
importance of expectation in Keynes theory. A complete theory
of interest must recognize the fact that "without savings there
can be no liquidity to surrender."

4.

Empirical Contradiction: The theory does not have the

empirical validity. According to 'he theory, the rate of interest
should be the highest during depression due to failing prices or
rising value of money But it is found that the rate of interest is

59

lowest during depression,

The theory suffers from vagueness and is narrow in scope.
Moreover it is unrealistic also The existence of different rates of
interests cannot be explained with the help of the liquidity
preference theory Since the theory is a short term theory it fails
to explain long term interest rate determination

Check Your Progress :

1. Explain the three motives which lead to liquidity preference.
---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Types of Inflation : Demand pull and Cost push inflation

4.4

MEANING AND DEFINITION OF INFLATION :

A continuous rise in the general price level over a long period time
has been the most common feature of both developed and
developing economies. Some authors consider inflation as the
dominant economic problem in modern times. In a broad sense of
the term, inflation means a considerable and persistent rise in the
general level of prices over a long period of time. However, there is
no universally acceptable definition of inflation.
According to Pigou, Inflation exists when money income is
expanding more than in proportion to increase in earning activity.
Crowther defined inflation as, a state in which the value of money
is falling, that is, prices are rising.
Some recent definitions of inflation are as follows :
According to Ackley, Inflation is a persistent and appreciable rise
in the general level or average of prices.
According to Samuelson, Inflation denotes a rise in the general
level of prices.
Harry G. Johnson defines inflation as a sustained rise in prices.
Types of inflation :
There are two important causes of Inflation i.e. Demand-pull and
Cost-push.

4.5

DEMAND-PULL INFLATION :

It may be defined as a situation where the total monetary demand

60
persistently exceeds total supply of real goods and services at
current prices, so that prices are pulled upwards by the continuous
upward shift of the aggregate demand function.
The demand-pull theorists point out that inflation might be caused
by an increase in the quantity of money, when the economy is
operating at full employment level. As the quantity of money
increases, the rate of interest will fall and consequently, investment
will increase. This increased investment expenditure will soon
increase the income of the various factors of production. As a
result, aggregate consumption expenditure will increase leading to
an effective increase in the effective demand. With the economy
already operating at the level of full employment, this will
immediately raise prices, and inflationary forces may emerge. Thus,
when the general monetary demand rises faster than the general
supply, it pulls up prices.

Price level

By using the aggregate demand and aggregate supply curves, the

demand-pull process be shown diagrammatically as follows ;

Figure 4.7
Demandpull inflation
In the above figure, the X-axis measures real output and Y-axis
measures the price level. Aggregate demand curves are
D,D1,and D2 whereas S curve represents Aggregate supply
function , which slopes upward from left to right and at point F it
becomes a vertical straight line. At this point the economy
reaches at full employment level. Hence real output remains
same or inelastic at this point. D curve intersect S curve at point
F, where real output or income is at full employment and OP is
the price level. When aggregate demand increases from D to D 1
and D2, the real output or income will remain same but the price
level tends to increase from OP to OP1 and further to OP2.

61
In short the inflationary process can be described as follows :
Increasing demand increasing prices increasing costs
increasing income increasing demand increasing prices
and so on.
Causes of Demand-pull inflation :
1. Increase in public expenditure There may be an increase in
the public expenditure (G) in excess of public revenue. This
might have been possible through public borrowings from
banks or through deficit financing, which implies an increase
in the money supply.
2. Increase in Investment - There may be an increase in the
autonomous investment (I) in firms, which is in excess of the
current savings in the economy. Hence, the flow of total
expenditure tends to rise, causing an excess monetary
demand, leading to an upward pressure on prices.
3. Increase in MPC There may be an increase in the marginal
propensity to consume (MPC), causing an excess monetary
demand. This could be due to the operation of demonstration
effect and such other reasons.
4. Increasing export and surplus Balance of Payments In an
open economy, increasing demand for exports leading to
increasing money income in the home economy. Whereas in
the domestic market there is reduction in the domestic supply
of goods because products are exported. If an export surplus
is not balanced by increased savings, or through taxation,
domestic spending will be in excess of the value of domestic
output.
5. Diversification Resources A diversification of resources from
consumption goods sector either to the capital good sector or
the military sector will lead to an inflationary pressure
because the current flow of real output decreases on account
of high gestation period involved in these sectors. The
opportunity cost of war goods is quite high in terms of
consumption goods meant for the civilian sector. This leads to
an excessive monetary demand for the goods and services
against their real supply, causing the increase in prices.
A) Cost-push inflation : Some economists holds the view that
inflation is initiated not by an increase in demand but by an
increase in costs, as factors of production try to increase
their share of the total product by raising their prices. Such a
price rise is termed as cost-push inflation as prices are being
pushed up by the rising factor costs.

4.6 COST-PUSH INFLATION

It is sometimes also called as wage inflation as wages constitute
nearly seventy percent of the total cost of production. When wages
rises it will lead to rise in cost of production and a consequent rise
in the price level.

62

Price level

Cost-push inflation can be diagrammatically explained as follows.

Real Output
Figure 4.8 Cost push inflation
In the above figure, demand curve D represent the aggregate
demand function and SS represents aggregate supply function. The
full employment level of income is OY. At this F is the point of
intersection between aggregate demand and aggregate supply
function. When aggregate supply function shifts upward to S 1 it will
become a vertical straight line at point G at full employment level.
The new equilibrium point A is determined at OY1 level of output,
which is less than full employment level at P1 level of prices. This
means that with a rise in the price level unemployment increases. A
further shift in the aggregate supply curve to S2 due to further
increase in wages lead to further increase in price to P 2 and fall in
income level to OY2.
Cost-push inflation may occur either due to wage-push or profitpush. When there are monopolistic labour organizations, prices
may rise due to wage-push. When there are monopolies in the
product market, the monopolists may be induced to raise the prices
in order to fetch high profits. Then there is profit-push in raising the
prices.
Check Your Progress :
1. Define Inflation.
2. What are the various causes of demand-pull inflation?
3. Explain the causes of cost-push inflation.
-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

63

4.7

SUMMARY

1.

Keynes consumption function is a very significant contribution

to modern macro economic theory. In order to explain the
concepts of consumption function and the multiplier theory, a
study of the fundamental Keynesian principles is important.

2.

Keynes in his general theory, brings out the real determinants

of income and employment in a modern economy. According
to him, the economy can be in equilibrium at any level of
employment. Full employment is one of the different situations
in an economy. Under employment equilibrium situations are
more common.

3.

Keynesian theory is demand oriented It stresses effective

demand as a crucial factor in determining the levels of income
and employment

4.

Keynes gave importance to short run equilibrium. He assumed

that the amount of capital, population, technology etc. do not
change in the short run
Therefore, in the short run, the
income and output depends upon the volume of employment.
The levels of employment depend upon effective demand,
which depends upon aggregate spending

5.

Effective demand manifests itself in the total spending of the

community on the consumption and investment goods. Total
employment depends on effective demand unemployment is
due lo lack of effective demand.

6.

Two Factors determine effective demand - Aggregate demand

function and aggregate supply function. The intersection of
aggregate demand function and aggregate supply function
determines the level of income and employment. This point is
known as the effective demand. The equilibrium reached thus
need not be the full employment equilibrium point. For
reaching full employment equilibrium aggregate demand
should increase.

The aggregate demand is made up of two components consumption expenditure and investment expenditure.
Consumption expenditure is an important component , of the
total expenditure. Consumption expenditure depends on the
size of income and propensity to consume, which is called the
consumption function. C = f(Y)

Keynes considered two technical attributes 1) APC 2) MPC

APC = C/ Y
' MPC = C/ Y

A number of subjective and objective factors affect the

64
consumption function.
10

The multiplier theory explains the effect of changes in the

investment upon the consumption and the resulting generation
of income. The theory of multiplier is a very important part of
the General theory of employment.

11

Multiplier is the numerical coefficient which indicates the

increase in income due to an increase in the investment. K =
Y/ l.

13

Sequence analysis is used to understand the working of the

multiplier.

14

However there can be certain leakages from the multiplier

which undermine the value of the multiplier..

15. The unit ends with a criticism of the multiplier principle.

16. investment plays a crucial role in macro economic theories.
Fluctuation m employment and income occur due to changes
in inducement to invest.
17. The factors which determines the investment demand are 1)
MEC, 2) Rate of interest. Marginal Efficiency of a given capital
asset is the highest rate of return over the cost expected from
an additional or marginal unit of the capital asset MEC
depends on 1) the prospective yield of capital asset 2) the
supply price of this asset
18. A comparison of the expected rate of profit and rate of interest
is important in investment decision. This leads to a comparison
between the supply price of one asset and its demand price.
Where. MEC = interest rate, SP = DP....... neutral
MEC < i, DP > SP Favorable for investment
MEC < i, DP < SP Unfavorable for investment
.Investment will be in equilibrium when MEC becomes equal to
the given rate to interest .
19. Short run and Long run factors affect MEC
20. The unit concludes with a discussion of Keynes liquidity
preference theory of interest. Interest, according to Keynes is
a purely monetary phenomenon. Rate of interest is determined
by the intersection of the supply schedule of money and the
demand schedule of money. Money is demanded for three
purposes - transaction purposes, precautionary and
speculative purposes. The first two depend on the levels of
income, whereas the speculative demand depends on the rate
of interest. 'M' the total supply of money is given by the

65
monetary authority.
M = L (r y) i.e. the quantity of money held depends on the rate
of interest and the level of income. The interaction of the
liquidity preference function and the supply of money leads to
equilibrium rate of interest. The rate of interest may change
either due to shifts in the liquidity function or due to charges in
the supply of money.
21. Keynes liquidity preference theory also suffers from a number
of drawbacks.

4.8 QUESTIONS
1
2

Discuss the Keynesian theory of employment.

What is the Keynesian Consumption function? What are the
various factors affecting the consumption function?
3
Explain the concepts of ARC and MPC.
4. What is multiplier? Explain the working of the multiplier.
5. Give a critical evaluation of the Keynesian multiplier theory.
6. Explain the objective and subjective factors affecting
consumption.
7. Write notes on
a.
Leakages in the working of the multiplier.
b.
ARC and MPC.
8. What is investment function?
9. Explain the factors which determine investment
10. a) What is MEC?
b) What are the factors which affect MEC in the short run and
long run?
11. How does MEC and the rate of interest determine the volume
of investment?
12.

Explain the role of MEC and interest rate in Keynesian theory

of employment.
13. Critically explain the liquidity preference theory of interest .
Write notes on 1) Motives of demand for money 2) MEC

66

5
Module 3:

MONEY SUPPLY
Unit structure :
5.0 Objectives
5.1 Introduction and Definition of Money
5.2 Functions of Money
5.3 Meaning and Definition of Money Supply
5.4 The Constituents of money supply
5.5 Reserve Bank of Indias Measures of money supply
5.6 Determinants of money supply
5.7 Velocity of circulation of money
5.8 Summary
5.9 Questions

5.0
1.
2.
3.
4.
5.
6.
7.

5.1

OBJECTIVES
To study the meaning and definition of money
To understand the various functions of money
To study the meaning and definition of money supply
To study the constitution of money supply
To Know the RBIs measures of money supply
To study the determinants of money supply
To study the velocity of circulation of money supply

INTRODUCTION OF MONEY

Due to the difficulties of the barter system, money came into

existence. Initially, we use metallic money, which was replaced by
the paper money over a period of time. Today there are a wide
variety of assets, which are used as money or near money. Before
explaining what constitutes money, we will try to understand some
of the important definitions, of money and then functions of money
Definition of money :
Different economists have defined money differently. Some of
them focus on the exchange function of money while some others
consider the general acceptability of money as a medium of
exchange. Following are some of the important definitions of money
Crowther Money can be anything that is generally acceptable
as a means of exchange and that at the same time act a measure
and store of Value.

67
Marshall Money constitutes ail those things, which are at any
time and space generally accepted without doubt or special enquiry
as a means of purchasing commodities and services and of
defraying expenses.
Robertson Money is anything, which is widely accepted in
payments for goods or in discharge of other kinds of business
obligations
Walker

Money is what money does.

From the above definitions, we may enlist following features of

money:
1
Money must have a general acceptability.
2. Money should act as a medium of exchange in buying and
selling operations
3. Money should be capable of storing the value for the future

5.2 FUNCTIONS OF MONEY

MONEY IS A MATTER OF FUNCTIONS FOUR,
A MEDIUM, A MEASURE, A STANDARD, A STORE.
Money performs following important functions: 1.

Medium of Exchange: Perhaps the most important function of

money is to serve as a medium of exchange in buying and
selling goods. Under barter system, exchange required finding
of two people wanting each other's goods, (double
coincidence of wants) The existence of money has eliminated
such requirement and the exchange transactions have
become very simple. A man having wheat can sell it for money
and buy anything that he wants with that money. He does not
have to find a man having the commodity of his need.

2.

Measure of Value: Money serves as a common measure of

value for all the commodities and service's. The value of every
commodity can be expressed in terms of money. This
simplifies the exchange transactions of all the commodities on
one hand, and helps to compare the values of different
commodities, on the other hand. For example, it is very easy
to compare the values of say Radio and a Cassette player
once we express them it terms of money. We can easily
conclude that the cassette player of Rs 4500 is more valuable
than a Radio of Rs.2300.

Store of Value: In the absence of money, it would be difficult to

store the value for the future Money makes it very convenient
to store the value for the future Money does not require more

68
space, it is durable and is readily exchangeable with the other
commodities and services whenever required.
4

Standard of Deferred Payments: Money also performs one

more important function of the modem times. With the
invention of money, it is possible to express future payments in
terms of money. A borrower borrows some amount of money
today and assures to repay the same with some interest in
future. All the credit transactions related to trade and
commerce of modem economy are based on this function of
money.

5.

Other functions: Apart from the above-mentioned important

functions of money, there are some other ways in which
money helps the modem economies. It facilitates the
distribution of National income among different factors of
production in the form of the rewards for the services rendered
by them. Thus, the labour class gets wages, the capitalists get
interest, the landowners get rent and the entrepreneurs get
profits in the form of money.

Check Your Progress :

1. Define money.
2. State the four functions of money supply.
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

5.3 MEANING AND DEFINITION OF MONEY SUPPLY

Money supply refers to the stock of money available for the
spending purpose which is held by the people of a country. The
money may be available in the various forms.
1

Coins and notes which are issued by the government and the
central bank of the country and which are in circulation. This
portion of money supply is known as legal tender.

2.

Demand deposits with the commercial banks, which are

withdrawable at any time. To withdraw the demand deposits
the customers need not give a prior notice to the bank.

3.

Time deposits and other kinds of less liquid assets also may
be included in the concepts of the money supply. These

69
concepts will be analyzed in the latter part of the study
material.
From the concept of money supply, some types of financial
assets are excluded These are.
1

That part of currency notes and coins which lies with the
commercial banks and with the central bank as reserves. This
is because this part of money is not included m circulation.

The monetary gold held by the central bank of the country

does not get circulated in the economy It becomes a part of
international money So it is excluded from the concept of
money supply.

All those cash balances held either by the banks or by the

government of which are in the treasury of a country are also
excluded from the concept of money supply. This is because,
they are kept for the administrative and non-commercial
activities and are not circulated in the economy.

In short, m its very narrow sense, money supply is defined as

the money available with the public in the form of currency (notes
and coins) and the demand deposits with the banks.
Two dimensions of the Concept of money supply :

a
b

The concept of money supply should be analysed in two ways:

Stock concept
Flow concept

The stock concept of money supply refers to the money

available in circulation for spending purposes. The stock concept
includes the money held by the public alone. The money in terms of
currency notes, coins and demand deposits held by the public at
any given point of time is called the stock of money.
The flow concept refers to the money supply over a period of
time. Here the velocity or the speed of money in circulation is taken
into consideration The velocity of money is defined as the number
of times money changes hands from one person to another. In an
economy, over a period of time, money changes hands. That
means it is spent and re-spent same units of money are used again
and again in a year. For example, Rs. 100 crores of currency notes
may get circulated in the economy, on an average for five times,
making the total money supply to be 500 crores-within a year. Here
the velocity of money is five. The flow concept of money supply is
calculated as follows: -

70
Money supply by the flow concept = MV where, M stands for
stock of money and V stands for the velocity of money i.e. the
number of times money changes hands.

5.4

THE CONSTITUENTS OF MONEY SUPPLY

There are two views about the constituents or the components

of money supply A group of economists has defined money supply
in a very narrow sense and the other group has defined money
supply in a very broad sense. Following is a brief analysis of the
various views on the constituents of money supply.
i)
ii)

Traditional View
Modem view.

i)

Traditional View
According to this view, the concept of money supply includes
only two things
A

Currency notes and coins issued either by the government of a

country or a central hank of a country.'- The currency notes
and coins have an important feature of general acceptability.
Generally the central bank of a country has a monopoly of
note issue. In some countries the government also issues
notes In India, one rupee note and coins are issued by the
government of India. The issuing of notes is possible under
various systems.
*

Under the gold reserve or silver reserve system, the

issue of paper currency notes is backed by 100% gold or
silver deposits. That means the central banks keep the
reserves equal to the amount of notes issued by them in
terms of gold or silver. If the notes worth 20 crores are
issued, gold or silver worth 20 crores is kept as reserves.

Under the system of fixed Fiduciary Issue, the amount of

paper currency notes to be issued is fixed by law and the
reserves are kept in the form of government securities.

Under the maximum fiduciary issue system, the

maximum limit for the note-issue is fixed legally and it is
covered by the security of government securities

Some countries follow the system of proportional gold

reserve under which a certain % of gold reserves are
kept against the note issue and the rest of the reserves
are kept in the form of treasury bills, Government
securities, etc.

71
*

b)

India follows a system of what is called as the minimum

percentage gold reserves. Under this system, a minimum
% of gold reserves are kept against the note issue and
the rest of the reserves are kept in the form of different
assets of the central bank.

Demand deposits of the commercial banks can be withdrawn

by a cheque whenever demanded. They constitute another
important part of money supply according to the traditional
view. The share of demand deposits of the banks in the total
money supply depends upon the level of development of the
country. In the developed countries like the U.S.A., 80% of the
total money supply is in the form of demand deposits. This is
because, a large number of transactions take place in the form
of cheque payments in such countries. Actual handling of cash
is much less.

Thus, the traditional approach to the money supply is highly

narrow and includes strictly those assets which are highly liquid in
nature like the legal tender money and the demand deposits of the
commercial banks. This approach considers money only as a
medium of exchange. So only those constituents of money which
have a general acceptability as a medium of exchange are included
in the traditional aspect of supply, of money.
ii)

Modern View :
A modem view to money supply is much wider and it includes
in the concept of money supply different types of money and near
money assets. Apart from the medium of exchange function of
money, the store of value function of money is also considered
important by the followers of this approach. The constituents of
money supply according to the modern approach include.
a
b
c

d
e
f
g
h.
i

Currency notes and coins

Demand deposits of the commercial banks
Fixed deposits :- The modern approach to supply to supply of
money includes the saving and time deposits of the
commercial banks. The-time deposits are those deposits
which are withdrawable only at the expiry of the time for which
the deposits are kept
Treasury bills and the other bills held by the commercial
banks.
Post office saving deposits
National saving certificates
Equity shares
Government securities and bonds
Many other assets which are near money assets.

The followers of the modern concept of money supply were

the economists like Milton Friedman, Gurley and Shaw, and the

72
Radcliff committee members. According to Milton Friedman, the
money supply concept should include time and savings deposits of
the commercial banks apart from the currency and demand
deposits Gurley and Shaw were of the opinion that even the assets
of the non-bank financial institutions and bonds and shares of
different kinds are also to be included in the concept of money
supply. The Central bank approach to the constituents of money
supply includes all the funds lent by a number of financial
institutions
Thus, the modern view regarding the money supply includes
all those assets which are highly liquid along with those assets
which have limited liquidity. But the economists like Gurley and
Shaw are of the opinion that the near money assets like those
mentioned above (C to i) are also important constituents of money
supply. As a result, this approach is a wider approach.

5.5 THE RESERVE BANK OF INDIAS MEASURES OF

MONEY SUPPLY :
The concept of money supply as adopted by the RBI has
changed since 1977 This is called the measures of money supply.
Under this concept, money supply is defined as follows
M1

C + DD + OD
C
Currency Notes
DO Demand deposits of commercial banks
OD Other deposits with the RBI

M2

M1 + SD
=C+DD + OD + SD
SO : Saving bank deposits

M1 + TD
.
= C + DD + OD.+ TD
TD : Time deposits with all the commercial and co-operative banks
M3

M4
A3

M3 + TDP

= C + DD + OD + TD + TDP
TDP : Total deposits with Post office
Thus, the RBI has taken all possible deposits in the concept of
money supply. Even by including post office saving deposits, RBI
has broadened the concept of money supply. Post office saving
deposits being less liquid, for all official matters, M3 is considered
to be the most relevant measure of supply in India.
The RBI working Group has made some changes in the
concept of money supply in India in the year 1998. According to the

73
recommendations of this group, the measure of money M is totally
abolished and now there are only three measures of money supply.
M1 = C + DD + OD (same as earlier)
M2 =
M1 + Saving deposits + CDs issued by the banks + term
deposits maturing within one year.
M3 =
M2 + term deposits over one year maturity + term
borrowings of banks
Check Your Progress :
1. Money supply is a stock as well as flow concept-Explain.
2. Examine the traditional view of money supply.
3. Explain the modern view of money supply.
4. What are the RBIs measures of money supply.
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

5.6 DETERMINANTS OF MONEY SUPPLY

The total money supply in the economy depends upon various
factors. They are called as the determinants of money supply.
Following is a brief analysis of the factors on which money supply
depends.
1)

Reserve or high powered money.

High powered or Reserve money (H) is a base of money
supply. It includes only the currency (C). cash reserves of the
banks (R) and other deposits with the RBI (OD)
H = C + R + OD High powered money is a major determinant
of money supply in the economy

2)

Money Multiplier:
The high powered money along with the money multiplier
determine the total supply of money. Money multiplier depends
upon the people's preference to hold cash If more cash is held
by the people, banks will have less cash, their credit creation
capacity will be low So availability of money in the economy
will also be low. The value of money multiplier will also depend
upon the reserve requirements. The commercial banks have to
keep certain % of their deposits with the Central bank. Their
credit creation capacity decreases due to this and hence the
supply of money, in the economy also gets reduced. Thus

74
higher the value of money multiplier, higher will be the money
supply and vice versa.

3)

Community's choice :
Total money supply also depends upon the choice of
community - whether to hold money in terms of cash or in
terms of deposits of commercial banks. If the community holds
larger part of money m cash, it that money does not enter into
the credit creation process. But if the community keeps their
money in the banks and make transactions by cheques more
money will be held by the banks which can be circulated in the
economy through of credit creation process.

4)

Velocity of circulation (v):

The number of times money changes hands or the velocity of
money is an important determinant of money supply. The
Higher the velocity of money, the more will be the supply of
money and vice versa.

5)

Fiscal and monetary policy :

Fiscal policy is the policy which influences economy through
taxation, public expenditure, public debt and deficit financing.
The decisions of the fiscal authorities also have an influence
on the supply of money. Increase in public expenditure or
reduction in the rates of taxes or deficit financing may increase
the supply of money. On the other hand, introduction of new
taxes, and fall in the government expenditure will reduce the
total money supply in the economy.
Monetary policy of the Central Bank is also an important
determinant of money supply A cheap money policy by the
central bank increases the availability of money in the
economy and a restrictive money policy reduces the total
money supply (discussed in detail in the next unit.)

6)

5.7

Liquidity Preference :
Liquidity preference is the desire of people, to hold money in
cash. More the liquidity preference, less is the money available
for circulation and less will be total money supply.

VELOCITY OF CIRCULATION OF MONEY

The velocity of money is the number of times money Changes

hands during a given period of time, generally one year The money
supply in the economy is greatly affected by the velocity of money
in circulation. The more the velocity of the money, more is the
money supply in the economy. The velocity or speed of money
depends upon many factors

75
(1)

Regularity of Income
In a Community, if people are receiving income quite regularly
and at a regular interval, the velocity of money is quite high.
The people would spend money frequently as they receive the
money regularly. In the community where people receive their
income irregularly, the velocity of money will be less because
the people will tend to hold more cash than spending it.

(2)

Liquidity preference
The liquidity preference means the desire of people to hold
cash. If people want to hold more money in cash or they have
more liquidity preference, less will be the velocity of money.

(3)

Savings
The more the savings or less the consumption's, the lower is
the velocity of money in circulation More money saved means
people hold more money in cash and do not spend. This
reduces the movement of money .in the circulation.

(4)

Development of banking and financial institutions

in a country with more banking and financial institutions,
money changes hands quite frequently. People's savings are
mobilised more quickly by the banking and financial institution.
This increases the velocity of money in circulation.

(5)

Trade Cycles
The velocity of money also Changes in accordance with the
phases of the trade Cycle. During prosperity, the volume of
transactions is more, money Changes hands more quickly.
This increases the degree of velocity of money. On the other
hand, during the depression situation or in deflation, the
volume of transactions is quite less. This reduces the degree
of velocity of money

(6)

Level of income
The velocity of money is quite high among the low income
groups people. This is because they have to spend most of
their incomes on the immediate' needs. This is not so with high
income groups. This group can withhold their consumption as
many of their wants are satisfied. As a result the velocity of
money in circulation may be low.

Check Your Progress :

1. What are the determinants of money supply?
2. Which factors affect the velocity of circulation of money?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

76
-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

5.8 SUMMARY
a.

Money is considered as a medium of exchange.

b.

Over the years money has performed many more functions

than just being an exchange medium.

c.

Money supply is the total stock of money circulated in the

economy. It is a stock as well as flow concept.

There are two different views regarding the constituents of

money supply- traditional or narrow and modern or broad.

e.

As per the recommendations of the RBIs Working Group

1998, the revised measures of money supply are M1, M2 and
M3.

f.

Total money supply in the economy depends upon many

factors which are called as the determinants of money supply.

g.

The velocity of circulation of money is the average number of

times money changes hands during a given period of time,
generally a year.

5.9
1)
2)
3)
4)

QUESTIONS
Define Money supply. Discuss its constituents.
What are the determinants of money supply?
How is the traditional approach to money supply different from
the modern approach?
Write short notes on :- .
a) Velocity of money .
b) Functions of money
c) Determinants of money supply
d) Constituents of money supply.

77

6
DEMAND FOR MONEY
Unit Structure :
6.0
Objectives
6.1
The Classical approach to demand for money
6.2
The Fishers Equation of Exchange
6.3
The Neo-classical approach to demand for money
6.4
The Keynesian approach to demand for money
6.5
The concept of Liquidity trap
6.6
The Friedmans Theory of demand for money
6.7
Summary
6.8
Questions

6.0
1.
2.
3.
4.
5.
6.

OBJECTIVES
To study the Classical approach to demand for money
To study the Fishers equation of exchange
To study the Neo-classical approach to demand for money
To study the Keynesian approach to demand for money
To understand the concept of liquidity trap
To study the Friedmans version of demand for money

6.1 THE CLASSICAL APPROACH TO DEMAND FOR

MONEY
The classical economists emphasized the medium of
exchange function of money According to the classical economists
like J.S. Mill. David Hume and Irving Fisher, the demand for money
arises since money facilitates the exchange of real goods and
services among individuals. Hence money is demanded for buying
and selling goods and services or for spending over a period of time
The classical economists believed that the demand for money
depends on objective factors like the volume of exchange
transactions of goods and services produced and supplied during a
given period of time, the amount of money needed to buy the goods
and services and by the velocity of circulation. Since the volume of
goods and services changes from time to time, the demand for
money also changes The classical approach to the demand for
money can be grouped into the Fishers cash -- Transactions
Approach and the Cambridge economists' cash-Balances approach

78

6.2 THE FISHERS APPROACH TO DEMAND FOR

MONEY
Irving Fisher's Equation of Exchange is one of the most
prominent explanations which analyse the demand for money.
According to Fisher, the demand for money means the amount of
money to be held to undertake a given volume of transactions over
a period of time. Fisher's equation of exchange is given as MV =
PT, where M is the money supply, V the transaction velocity, T
transactions and 'P the price level. 'PT' in the equation represents
the demand for money and MV stands for the supply of money. The
PT
demand for money (Md) is equal to
. It means that the demand
V
for money is equal to 'P' multiplied by 'T' over a period of time and
divided by V The demand for money depends on the amount of
money which people have to hold in order to carry on a volume of
transactions over a period of time. According to Fisher 'V and 'T' are
constant during the short period As a result, the demand for money
varies with changes in 'P'. According to Fisher the supply of money
PT
(Ms) is equal to
. Since the demand for money (Md) is equal
V
PT
it means that the demand for money is always equal to the
V
supply of money. Fishers version of demand for money stresses
the role of money in spending and not saving The demand for
money changes in proportion to the changes in the price level. V
also determines the demand for money.

6.3 THE NEO-CLASSICAL OR CAMBRIDGE

APPROACH TO DEMAND FOR MONEY :
The Cambridge approach or the cash balances approach was given
by Marshall, Pigou, Robertson and Keynes. These economists
stressed the store of value function of money. This approach
concentrates on what individual want to hold for satisfying the
transaction motive and precautionary motive. According to this
approach, the demand for money refers to the cash balances held
by all individuals in an economy. The following factors influence the
decisions of individuals in holding cash.
(i)
(ii)
(iii)

The prevailing prices of goods and services and the

expected changes.
The existing interest rates and expected changes in
future.
The wealth in the hands of the people.

These factors remain constant according to the Cambridge

79
economists. The total demand for money or cash balances is a
certain proportion of national income. The demand for money can
be expressed as,
Md = KPY, where MD is the demand for money, K is the
constant proportion of income Y. It is the proportion of national
income which people desire to keep in the form of cash balances
and Py is the nominal national Income. According to the Cambridge
economists the demand for money is the constant proportion (K) of
Y. Wherever there is a change in the price level or in the real
national income, the demand for money also changes in equal
proportion For example if MD is Rs. 2000 crores and the money
income is Rs 6000 crores per year K = 1/3 per year. This imples
that on an average the public likes to hold money amounting to 1/3
of the annual income.
Check Your Progress :
1. Distinguish between Cash transaction and Cash balance
approach to demand for money.
---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

6.4 THE KEYNESIAN APPROACH OF DEMAND FOR

MONEY :
J M Keynes introduces his theory on the demand for money
through his book titled, the "General Theory of Employment.
Interest and Money" in 1936. According to Keynes money was
demanded due to three main motives i.e. the transactions motive,
the precautionary motive and the speculative motive. The
speculative motive of demand for money is a special contribution of
Keynes.
(i)

The transaction motive :

It refers to the transaction demand for money as a medium of

exchange for carrying on current trade and business transactions.
Money is demanded for transaction purposes since it is received at
discrete intervals of time and expenditure goes on continuously.
Keynes classified the transactions motive into (a) income motive
and (b) business motive.
(a)

The income motive :

People hold cash to bridge the gap between the receipt of

80
income and expenditure. The income in the form of salary or wages
is recovered at a certain time like once in a week or once in a
month. But expenditure goes on throughout all the time. To meet
day-to-day expenditure a part of the income has to be held in the
form of liquid cash. The following factors decide the amount of
money held by people:
(i)

Level of Income
As the level of income increases, the
transaction demand for money of the individual will increase
and vice versa.

(ii)

Tune Interval: The longer the time interval between the

receipt of income and expenditure, the higher the amount of
money held by people for transaction purposes.

(iii) The standard of Living : The higher standard of living, the

larger the amount of money held and vice versa.
(b)

The business Motive :

The businessmen and the firms also hold cash balance in
order to bridge the interval between the time of incurring business
costs or expenses and the receipt of the sale proceeds. The larger
the volume of turnover or transactions for the business firms, the
greater will be the amount of money held for this purpose. The
amount of money held by the business firms depends on the size of
their income and their turnover. The aggregate demand for money
for satisfying the transaction motive is the sum total of the
individuals demand for cash as well as the individual firm's demand
for cash. This aggregate demand for money will depend upon total
size of national income, the level employment and the price level.
The transactions demand for money primarily depends on the level
of income. The transaction demand for money which is incomeelastic can be expressed in the following manner.
L = (fy) where Lt with transaction demand for money, T stands for
function of and y stands for the national income. The figure below
shows the transaction demand for money.

81
Figure 6.1
In the above figure, dd is rising indicating that, with the increase in
national income, the demand for money for transaction purposes
also rises,
(ii)

The Precautionary Motive :

Besides the money kept also for transaction purposes, people
hold additional amount of money to meet unexpected or unforeseen
contingencies, emergencies or unexpected events. Money held for
such precautions is known as precautionary motive. The
accessibility of individuals and firms to the credit market determines
the amount of money held for this purpose. If borrowing is easy or
the assets of the people can be easily connected into cash, the
amount of money held for this motive will be very low and vice
versa. Uncertainty regarding future will make individuals and firms
keep aside money for precaution purposes. The precautionary
motive of demand for money depends on the income level ie. L =
f(y), where 'Lp stands for precautionary motive, T a function of and
y, the level of income,
(iii) Speculative motive :
People hold money as a store of wealth or liquid asset for
investment and lending, with a view to make speculative gains.
People speculate about the future prices of bonds or securities or
future interest rates. People prefer to hold securities where prices
are expected to rise in future and vice-versa. People make capital
gains from speculative about the prices of bond or securities or
future interest rates. According to Keynes. the speculations motive
is the desire to earn profit by knowing better than the market what
the future will bring forth The individuals have to choose between
holding money or other assets Uncertainly regarding the behavior
of the future interests and price of bonds leads to speculation. If the
rate of interest is high and the prices of bonds are low, the lower will
be liquidity preference. In such a case money will be lent or bonds
will be purchased. There is an inverse relation between the prices
of bonds and interest rate.
If the interest rate is expected to rise, or the prices of bonds to
fall, people sell the bonds or assets and hold more cash. The
people will buy the bonds when their prices actually fall In the other
hand, if the people expect the rate of interest to fall, or prices of
bonds to rise, people will buy bonds whose prices are expected to
go up. This leads to a fall in liquidity preference. This shows that
speculative demand for money is interest elastic.
L = f(i) where. L2 is the demand for money for speculative purpose,
(i) the rate of interest

82

Liquidity preference (Speculative demand for money)

Figure 6.2
The above figure shows the inverse relation between the rate
of interest and the speculative demand for money. It slopes
downwards from left to right indicating that when the rate of interest
is high, the demand for money is low and vice versa.

6.5 THE LIQUIDITY TRAP

If the rate of interest goes below a certain acceptable minimum
people will not part with liquidity. The liquidity trap is defined as the
set of points on the liquidity preference curve, where the
M
percentage change in the demand for money
in response to a
M
i
percentage change in the rate of interest
approaches infinity. In
i
other words, the demand for money becomes perfectly elastic at
very low rates of interest. The figure below makes clear this
situation

Figure 6.3
This indicates that the rate of interest remains constant even when
there is an increase in the quantity of money. The actual rate of

83
interest cannot fall below Or.
The Total Demand for money : The total demand for money, or
the community demand for money can be put as.
L = L1 + L2 where 'L' refers to the overall demand for money,
'L1' the demand for money for satisfying the transaction motive and
the precautionary motive and L2 the total demand for satisfying the
speculation motive.

6.6 FRIEDMANS THEORY OF DEMAND FOR MONEY

According to Milton Friedman who restated the quantity theory
of money and prices there are four determinants of demand for
money (i) the level of prices (ii) the level of real income and output
(iii) the rate of interest (iv) rate of change in general price level.
Friedman Classifies the holders of money into (a) ultimate wealth
holders (b) business enterprises His theory is relevant to the
ultimate wealth holders
Friedman has given a very broad concept of wealth which
includes all sources of income or services. According to Friedman,
the demand for money is a demand for capital asset since money
like capital assets provides services and returns. Bonds are
monetary assets in which the people can hold their wealth and
enjoy fixed interest income. The return on bonds is the sum of the
coupon rate of interest and the anticipated capital gains or losses
due to the expected change in the market rates of the interest
People can also hold their wealth in the form of equity shares and
enjoy returns in the form of dividend income and capital gains or
losses Milton Friedman gave his demand function in the following
manner
P
Md = f (w. h. rm rb , re , P.
, u)
P
This is the nominal money demand function. The demand for
real money balances can be derived by dividing the nominal money
demand by the price level
Md = f (w. h, rm, rb, re, P .

P
, u)
P

Md
= demand for real money balances.
P
w
=wealth of the individual
h
= the proportion of human wealth to the total wealth held by
the individuals
rm
= the rate of return on money or interest
rb
= the rate of interest on bonds
re
= the rate of return on equity shares
p
= the price level
Where. .

84

P
P
u

= change in the price level

= Institutional factors.

The simplified version of Friedrnan's demand function for money

can be written as,
Md
.
= f (r, Yp, u)
P
The demand-function of Friedman, though it looks similar to Keynes
equation is different from Keynes in some ways :(1)
(2)
(3)

Keynes gave importance to current income whereas Friedman

gave importance to wealth
Friedrnan's theory does not consider unstable elements like
the Keynes speculative demand for money
Friedman did not consider the possibility of a liquidity trap
situation.

Check Your Progress :

1. What is the Keynesian approach to demand for money?
2. Explain the concept of Liquidity trap.
3. What are the Friedmans determinants of demand for
money?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

6.7

SUMMARY

1.

The demand for money is a derived demand, since it is

demanded for the functions that it performs. Broadly speaking
the different approaches to the demand for money are (i) The
classical approach (ii)
The Neo-Classical approach (i)i)
The Keynesian approach (iv) The Modern Approach

2.

According to the classical view of demand for money or the

Fishers' version, money is demanded for transaction
purposes. Fisher explains the transaction demand for money
in the following form
MV = PT
Md = PT/V
It means that the demand for money is the product of the

85
volume of transaction (T) over a period of time multiplied by
the average price level (P) and divided by the velocity (V).
3.

Fisher assumes V and T1 to remain constant during the short

period. Hence, the demand for money varies with changes in
'P'. The Cambridge economists gave importance to the store
of value function of money. According to the neo-classical or
Cambridge economists, the demand for money is the amount
of money people desire to hold. The demand for money can
be expressed as Md = KPY. The demand for money is a
constant proportion (K) of y. Wherever there is a change in the
price level or in the real national income, the demand for
money also changes in equal proportion.

4.

According to Keynes' view on the demand for money there are

three motives of demanding income i.e. Transactionary,
precautionary and speculative motive. The transaction and
precautionary motives of demand for money depend on the
level of income whereas the speculative demand depends on
the rate of interest. The speculative motive is a negative
function of the rate of interest. When the price of bonds is low
or the rate of interest is high, people prefer bonds to liquidity
and as the prices of bonds rises, people prefer liquidity to
bonds.

5.

When the rate of interest is very low, i.e., below the acceptable
minimum people prefer to hold cash balances. This Situation is
known as the 'Liquidity Trap.' The total demand for money
according to Keynes is L = L (y) + L (r)

6.

According to Milton Friedman there are four determinants of

demand for money (i) the level of prices (ii) the level of real
income and output (iii) the rate of interest (iv) the rate of
change in general price level. Friedman presented a broad
picture of wealth which includes all sources of incomes or
services.

Milton. Friedman gave his demand function in the following

manner
P
Md = f (2, h, rm, rb, re, P .
, u)
P
^Dividing the nominal demand function by the price level, gives us
the real money balances.
P
Md = f (2, h, rm, rb, re, P .
, u)
P
The simplified version of the equation is as follows Md / P = f (r, Yp.
u)

86

6.8 QUESTIONS
1
2
3.
4
5

Explain the cash transaction approach to demand for money.

Explain the neo-classical or the cash balances approach to the
demand for money.
What are the three motives of demand for money according to
Keynes.
Write a note on Friedman's version of the demand for money.
Write notes on (a) The liquidity trap
(b) Speculative Motive
(c) Fisher's equation of exchange.

87

7
Module 4 :

BANKING AND FINANCIAL MARKETS

COMMERCIAL BANKS
Unit structure :
7.0
Objectives
7.1
Introduction of the commercial banks
7.2
Functions of the commercial banks
7.3
Liquidity Vs Profitability objectives of the commercial banks
7.4
Credit creation process of the commercial banks
7.5
Commercial banking development in India since 1969
7.6
Summary
7.7
Questions

7.0 OBJECTIVES
1.
2.
3.
4.
5.

7.1

To understand the concept of commercial banks

To study the functions i.e. banking and non banking of
commercial banks
To study the conflict between liquidity and profitability
objectives of the commercial banks
To study the credit creation process of the commercial banks
To study the commercial banking development in India since
1969 ( Nationalisation of commercial banks)

INTRODUCTION

There are various types of banks like the commercial banks,

co-operative banks, agricultural banks, industrial banks, etc. Each
of them are established with some specialized purpose For
example, the foreign exchange banks is specialized in the provision
of the foreign currency, the industrial banks deal with the supply of
credit to the industrial sector, etc
Commercial bank can be defined as a joint stock company
which deals with the money by accepting deposits from the people
and by lending money to the entrepreneurs for various activities.
The commercial banks act as a link between the savers and the
investors. The people having surplus money may not be interested
in the investment, while the people who wish to invest the money
may not have surplus funds. These two types of people have to be
brought together or at least the surplus funds of the people are to
made available to the investors The commercial banks are the

88
important institutions undertaking the task of encouraging the
people to save their surplus funds in the form of the bank deposits
by paying them interest on their savings and then to circulate' these
funds among the investors and charging interest rate from them In
the process, the commercial banks make profits.
The commercial banks can not print the notes. The printing of
money is an exclusive right to the central bank of the country. But
the commercial banks are the profit earning institutions. They play
an important role in the creation of credit in the economy by
reutilizing the existing deposits of their customers. Thus, the
commercial banks are not only the traders of money but they are
also the creators of credit. In the further discussion we will try to
understand how this is done.

7.2

FUNCTIONS OF THE COMMERCIAL BANKS

The functions of the commercial banks may be subdivided into two

categories
A)
B)
7.2.1

Banking Functions
Non-banking or Subsidiary functions
Banking functions of the commercial banks

i)

Accepting depositsThe commercial banks accept deposits from the people and
pay them the interest rate on their deposits. The rate of interest
vanes in accordance with the amount of deposits and the duration
for which the deposits are kept with the bank. There are various
kinds of deposits.
A

Demand deposits- These are withdrawals at any time or

whenever the depositor demands Either a very low interest
rate is paid on such deposits or no interest is-paid A depositor
can withdraw any number of times from his demand deposit
account There are generally no restrictions on the withdrawals

Saving bank deposits - These deposits are generally opened

by the salaried people An account can be opened with a small
sum of money. A very little interest rate is paid on these
accounts

Fixed or Time deposits - Under these deposits, money is

kept for a certain fixed period of time, say, a year, three
months, five years, etc. These deposits can earn more interest
rate and, the fixed deposits are the important way in which the
people keep their savings. There is a restriction in the number
of withdrawals from the time deposits and if these, deposits

89
are withdrawn before the expiry of the time, the depositor has
to pay a penalty.
D

Recurring deposits : Here a depositor is supposed to save a

certain amount in his recurring deposit account every month or
every year The purpose of these deposits is mainly to
inculcate the saving habits among the people. These deposits
also earn a reasonably high rate of interest.

ii)

Giving loans:
The commercial banks are the important financial institutions
So they mobilize the money from the saving agents and lend these
to the customers who want to borrow the money for productive
purposes. The commercial banks generally lend money for short or
medium term. They .lend money to various productive sectors like
industry, trade, commerce, tourism, export and import activities and
also to the agricultural sector While lending money to the
customers, the commercial banks have to follow the rules and
regulations fixed by the central bank of the country, they can lend
money in accordance with their deposits, they also have to keep
some amount of their deposits as reserves .This means that they
cannot lend 100% of their deposits but have to maintain a part of
their deposits in the liquid form. We will study more about the credit
creation capacity of the commercial banks later in the following
discussion. The commercial banks give loans in various forms
a.

Call loans - These are the loans which are given for a very
short period of time i.e. 24 hours. They are generally given to
the stock brokers and agents.

b.

Bill of Exchange - The bill of exchange is used in the

business payments. Here the person who is supposed to
make payments (debtor) gives a written promise to the person
to whom the money is to be paid (creditor) to make payment in
a particular. . time period say, between one month and three
months. The creditor can immediately discount these bills from
the commercial banks. That means the creditor can take -, this
written promise to the commercial bank, get cash in exchange
but pay some amount as a discounting rate. The creditor gets
the cash immediately but he has to accept a slightly less
amount than what the discount bill is meant for.

c.

Overdraft facility - The commercial banks also allow their

regular depositors to withdraw more money than what they
have in their account. Some interest rate is charged only on
the amount which is over and above the actual deposits of the
borrower in the bank.

d.

Loans - The commercial banks provide direct loans to the

customers who have a sound investment project and a

90
capacity to pay back the loans. The commercial banks even
cam money by, charging rate of interest on these loans
7.2.2

Non-banking Functions of the commercial banks

i)

Agency services - The commercial banks act as agents of

their customers and they perform various services for them.
They may collect cheques on behalf of them, they may sell
and purchase securities and other financial assets, they may
carry correspondence on behalf of their customers.

it)

Collection - The commercial banks also collect cheques,

drafts, dividends, bills and other type of receipts of their
customers The banks may charge some service charges for
providing these services but the customers get a lot of help
from the commercial banks in speedy provision of these
services.

iii)

Payments - With a request from the customers, the

commercial banks can also make certain payments on behalf
of the customers. They can pay the insurance premium, rents,
taxes, electricity bills, telephone bills, etc if they are instructed
to do so by their customers.

iv)

Utility services - The commercial banks provide many utility

services like underwriting facilities, locker facilities, draft
facility, foreign exchange dealings, guarantor, etc.

v}

Publication of data and other statistical information - The

commercial banks may also be engaged in the collection and
publication of statistical information regarding the important
financial indicators. ,

Thus we can summarize the functions of the commercial banks in

the following chart
CHART 7.1

7.3 LIQUIDITY
VS
PROFITABILITY
COMMERCIAL BANK :

OF

THE

91
The commercial banks are the profit earning institutions. They try to
maximise their profits by accepting the deposits and then lending
the money to those who need loans for the productive purpose. In
doing so they try to maximize the difference between the rate of
interest which they pay to the depositors and the rate of interest
they charge from the people who borrow from the banks. At the
same time they have to use maximum amount of their deposits for
lending the money. However, the commercial banks have to keep
certain amount of their deposits in cash or in the liquid form
because the depositors may demand, their money at any time. The
people will loose the confidence in the bank if they 00 not get their
money in cash whenever they want if, for example, a situation
arises in which the commercial bank tends, most of the deposits in
the form of industrial loans to maximise the profits and then fails to
give cash to its customer who has a current account in the bank,
and wants to withdraw a pan of deposits in his account. This would
go against the reputation of the bank and perhaps the bank would
have to close its business. So a proper and safe ratio between the
liquid cash and advances to the customers has to be kept by each
commercial bank.
Thus, the liquidity (maintaining cash balances in anticipation of
the demand from the deposit holders of the bank) and profitability
(lending money to the borrowers by charging rate of interest) are
the two principles on which the efficient working of the commercial
banks depends
Liquidity is the cash field by the commercial banks. The
lending and investments of the banks should be so planned that
there should be enough liquid assets in the hands of commercial
banks The liquid assets can be converted into cash without a loss
of much time.
Profitability is the rate of return that the commercial banks get
either by investing the money or the rate of interest which they can
charge on the loans and advances given by them to their
customers. The liquid assets do not get any rate of return
Therefore, there e a clash between the liquidity objective and the
profitability-objective of the commercial bank. More the liquidity,
less is the profitability. But as the commercial banks also have to
think about their depositors, it is mandatory for them to keep certain
amount as cash reserves.

7.4 CREDIT CREATION PROCESS OF COMMERCIAL

BANKS
The commercial banks, as we have seen earlier, are the profit
earning institutions. They have to utilize the deposits kept by the
people with them, convert these deposits into the advances and
then earn the rate of return on these loans. The process by which

92
the commercial banks turn their primary deposits into the secondary
or active deposits and earn profit is called a process of multiple
credit creation. In this part of the unit, we will first understand all the
concepts related to the credit creation process and then we will
actually learn how the banks can create money out of the existing
deposits.
The money accepted by the banks from its depositors in the
form of cheque or cash is called as the primary deposits. These
deposits, are passive in nature.
With the help of the primary deposits, the commercial banks
can advance loans of different types. These are called as the
secondary or derivative deposits. These deposits are active in
nature and it is these deposits that bring out the profitability to the
commercial bank.
The process of multiple credit creation can be explained with
the help of following assumptions :1
2
3
4.

There are many banks operating in the economy.

People deposit money with the bank
There is a sufficient demand for the bank loans
The banks keep a part of their deposits in terms of cash
reserves which are legally fixed by the central bank.

Suppose Bank A receives Rs. 20.000 as the primary deposits

(money deposited by a customer in the bank). Suppose the banks
are required to keep 20% as a reserve requirement prescribed by
the central bank The balance sheet of the bank A will look
something like this
Assets

Liabilities

Fresh deposits

20.000

Fresh cash

20.000

Total

20,000

Total

20,000

Now suppose that Bank A wants to advance loans, it has to

keep 20% of its deposits as a cash reserve requirement The
remaining amount can be given as loans. Now the balance sheet
will look as follows :
Assets

Liabilities

Reserves

4,000

Loans

16,000

Deposits

20.000

93
Total

20.000

Total

20.000

Now if Bank A gives loans worth Rs 16.000, the total money

supply in the economy also has increased by 16.000/- A person
who borrows Rs 16,000 may make his payments by cheque which
may be deposited in Bank B. The balance sheet of Bank B will look
something like this :Balance sheet of Bank B
Assets

Liabilities

Reserves

3.200

Loans

12,800

Total

16,000

Deposit

16,000

Total

16,000

So now Rs. 12,800 are added into the money supply. This
process continues and from the primary deposits of Rs. 20,000
many times more secondary deposits are created which is called as
the process of multiple credit creation.
Following table briefly explains the process of multiple credit
creation in a given period of time.
Table : 7.2
Primary
Deposits

Banks

A
B
C
D
E
F
G
H

Total of the banking system

20000
' 16000
12800
10240
8192
.
etc
100000

Loans

Reserves

.16000
12800
10240
8192
6553.60

4000
3200
2560
2048
16.38.40

etc
80000

etc
20000

Thus, at the end of the process of multiple credit creation, the

primary deposits increase by 5 time and become worth Rs.
1,00,000; the loans given to the investors are worth Rs. 80.000/and the reserves with the central bank are Rs. 20.000/- which is
20% of the total deposits.
The value of multiplier is 5 in the above example and hence
the secondary deposits are 5 time more than the primary deposits.

94
The value of multiplier (k) is found out with the help of following
formula.
1
K
R
Where
K-multiplier
R - reserve ratio
In the above example R = 20%.
1
1
100
K
20%
20 / 100
20
Value of multiplier is
K = 5.
7.4.1

Limitations to the credit creation process of commercial

banks

Though the commercial banks can create credit with the help of the
deposits, their capacity to create credit is limited by many factors.
They can not expand credit indiscriminately. Following are some of
the limitations on the credit expansion capacity of the commercial
banks
(1)

Cash Reserve Ratio

The commercial banks can expend the credit with the help of
cash in their hands. A part of cash with the commercial banks
has toe kept with the central bank. Higher this part (CRR),
lower is the capacity of commercial banks to expand credit.

(2)

Amount of Primary Deposits

The commercial banks can not print notes. They have to
depend totally on the deposits kept with them their customers.
These are the primary deposits. More the volume of these
deposits, grater is the credit expansion and vice versa.

(3)

Caution
The banks have to keep certain amount of deposits in cash to
meet the regular demand by customers. Sometimes, to gain
confidence of the public, the commercial banks may keep a
larger amount of deposits in terms of cash than legal
requirement. This limits their capacity to expand credit.

(4)

Policy of the Central bank

The central bank may influence the credit creation capacity of
the commercial banks. It may either follow cheap money policy
to enforce commercial banks to expand credit or it may follow
dear money policy to make commercial banks restrict their
credit creation capacity.

(5)

Banking habits of the people

95
In a community where the people make their transactions
more with the help of cheques than cash, the commercial
banks can expand credit more rapidly. This is because they do
not have to maintain more cash reserves in this situation and
can use a large amount of primary deposits for credit creation.
But exactly opposite will be the case, if the people of a
community have more preference towards making cash
transactions.
Check Your Progress :
1. Define a commercial bank.
2. Distinguish between Banking and non banking functions of a
commercial bank.
3. In the process of credit creation banks creates moneyExplain.
4. State the limitations to the credit creation activities of
commercial banks.
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

7.5

COMMERCIAL BANKING DEVELOPMENT IN

INDIA SINCE 1969

The role of the public sector in commercial banking has been

greatly enhanced through progressive nationalisation of banks. The
first bank which was nationalised and became the Central Bank of
India was the Reserve Bank of India, from 1 January, 1949. Two
more banks were nationalised in 1955 followed by 8 more banks in
1959. After that 14 major Indian scheduled banks were nationalised
in July 1969 and of 6 more in April 1980. As a result of
nationalisation, the public sector banks occupy a dominant place in
commercial banking in India. Among the commercial banks, the
State bank of India ( SBI ) group of banks is the largest chain of
commercial banks in India.
During the last more than three decades since 1969, tremendous
change have taken place under which banks have performed not
only their traditional functions but also innovating, improving and
coming out with the innovative and variety of services to cater to the
emerging needs of their customers.
1. Branch expansion : There has been a considerable rise in the
number of banking branches. The number of bank branches

96
increased from 4151 during First Plan Period to 68,561 by June
2003. Thus there was a more than fifteen fold increase in the
number of banking branches. The averages population per
bank branch has been reduced from 87,000 in 1951 to 16,000
during the same time indicating that the commercial banks are
making their best efforts to reach the masses.
2. Banks in unbanked areas : After nationalisation of banks they
were supposed to open their branches in unbanked areas to
reduce regional disparities. Since 1969 ( till March 2001 )of the
53,516 offices were opened by Indian banks, out of which more
than half were opened in unbanked centers. Such unbanked
states are Assam, Manipur, Meghalaya, Nagaland, Orissa,
Tripura, U. P., Bihar, J & K, West Bengal account for the large
part of these new offices.
3. Expansion of Banking in Rural Areas :
Until 1969,
commercial banks did not make any attempt to expand in rural
areas. The share in the total number of banking offices in rural
areas was 22.4 percent out of 8262 branches. It has gone up to
56.1 per cent by March 1994.
4. Branches in Foreign countries : Indian banks have also
opened their branches in foreign countries i. e. In 24 countries,
with a network of 93 branches, 3 off-shore banking units, 5 joint
ventures, 16 subsidiaries and 14 representative offices. These
branches specialise in various areas of international banking
including financial of foreign trade. By helping the Indian
exporters, they form an integral part of the domestic banking
system.
5. Deposits Mobilisation : There was more than twenty fold
increase in bank deposits after nationalisation of banks. The
bank deposits increased from Rs. 662crores as on June 1951
to Rs. 1,120,853crores by March 2003. Deposits mobilised by
banks are utilised for loans and advances for borrowers,
investments in government securities and other approved
securities, investment in mutual funds, leasing and other
related activities.
6. Increase in Investment : Commercial banks have to invest a
part of their deposits in government securities, bonds and
debenture of government associated bodies as a liquidity
requirement stipulated by the Reserve Bank of India. The
investment of bank in government and other approved
securities has been increase from Rs. 1,361crore in June 1969
to Rs. 5,47,546 crores in March 2003.These investment of
deposits by banks in securities are used by the government for
financing the plan programs.

97
7. Differential Interest Rate Scheme : Under this scheme Banks
charge nominal rate of interest of 4 per cent from low-income
groups which needs financial assistance for productive
activities. Public sector banks required to fulfill the target of
lending of at least one percent of the total advances in each
financial year to the weak section of the society. The scheme
covers poor borrowers having an annual income of not more
than Rs. 6,400 in rural areas and Rs.7,200 in other areas and
not having more than 2.5 acres of non irrigated or one acre of
irrigated land.
8. Lead Bank Scheme : Under this scheme, a particular area is
assign for the operation to the commercial bank. The lead bank
of a particular district has been assigned the responsibility to
assess the resources and potential for expansion of branches
and diversification of credit facilities in the district allotted to
them.
9. Regional Rural Banks ( RRBs ) : Regional Rural Bank, first
established in the country on October 2, 1975 form an integral
part of the rural financial architecture in India. Though these
banks proved as weak financial institution but in recent years
some reforms were introduced to improve their profitability,
viability, competitiveness and efficiency besides recapitalisation of weak RRBs.
10. Lending to priority sectors and weaker sections : The
priority sector lending has been made available to agriculture,
small scale industries, road and water transport operations at
concessional rate. The amount given by public sector banks to
the priority sector has been increased from Rs. 441crore in
June 1969 to Rs. 1,34,107 crore by September 2000.
The higher credit to agriculture and housing sector constituted
more than two-thirds of incremental priority sector lending.
Higher credit to small scale sector lending has increased from
22.6 per cent in 2005-06 as compared to 12.6 percent during
2004-05.
11. Deposit Insurance : To established public confidence in Indian
Banking, Deposit Insurance Corporation has started functioning
in 1962. The Corporation re-named as Deposit Insurance and
Credit Guarantee Corporation. The limit of insurance cover per
depositor for deposits in an insured bank has been fixed at Rs.
1,00,000.
12. Para banking activities : The economic reforms introduced in
1992 allowed banks to introduce varieties of para- banking
activities. It mainly includes leasing, hire purchase, factoring

98
etc. The Reserve Bank of India advised their certain banks to
select their certain branches to undertake these activities.

13. Social Banking : Under the concept of social banking, banks

are coming forward to help weaker section of society. In order
to improve living standard of the poor, banks are financing
more loans to the small and marginal farmers, landless
labourers, rural artisans, scheduled caste and scheduled tribes
etc.
14. Merchant Banking : The major activities undertaken by the
banks under merchant banking mainly include manning public
issues of equities and debentures, extending underwriting and
stand by support, management of fixed deposit and advising on
various non-resident equity/ debenture issues.
15. Bank entry in Insurance Business : The amendment in the
Insurance Development Authority Act opens the way for private
sector entry into the insurance sector. Any scheduled
commercial bank can enter into insurance business with prior
permission of the Reserve Bank of India.
16. Abolition of Banking Service Recruitment Board : Earlier
established Banking Service Recruitment Board have been
abolished to provide liberty to the banks to recruit best suited
human resource to face competition. Accordingly banks are
free to formulate their own recruitment policies.
17. Customer service : In recent years, Banks shown qualitative
improvement in the services rendered to its customers.
PGRAMS is an exhaustive software for computerising public
grievances redressal mechanism which also provide for on line
lodging and monitoring of grievances.
18. Varieties of Attractive Scheme : Commercial banks in
years have introduced a number of attractive schemes.
include mainly Regional Loan Schemes, Credit
Travelling cheques, Investment Advisory Services,
Agency Work etc.

recent
These
cards,
Travel

19. Technology Banking : To modernised the banking

operations, new technology and computerisation of bank
accounts has been introduced. In recent years efforts have
been made to computerised more and more bank branches
and installed Advanced Ledger Posting Machine in order to
obtain greater efficiency in banking operations. One of the
easiest ways to save time and generate more business is
through E-Banking ( Electronic Banking ). The wide use of
electronics in Banking working transactions is called as E-

99
Banking. It involves elimination of paper-based transaction and
radical change in the operations of banking services. It is
expected to results in high productivity and efficiency for the
bank. E-Banking is forecasted as the future of banking
business in the new millennium. It is operated through internet,
extranet and over the internet. It is the banking without tellers,
ques, restricted office hours etc.
20. Opening of Private sector banks : The Reserve Bank of India
has recently permitted setting up of private sector banks in the
country. These banks will be governed by the provisions of the
Banking Regulation Act 1949 with regard to their authorised,
subscribed and paid up capital. Example of such banks are UTI
Bank, IDBI Bank, ICICI Banking Corporation Ltd, HDFC Bank
etc.
21. Development of New Specialised Financial Institutions : In
order to lend long term loans to industries several specialised
financial institutions have been established. Some of the
important institutions established under this category are
Industrial Development Bank of India ( IDBI ), Industrial
Finance Corporation ( IFC ), Industrial Credit and Investment
Corporation Of India ( ICICI ) etc.
22. Banking Ombudsman Scheme : This scheme is in operation
since 1995. It banking Ombudsman is an independent body
with legal powers to settle disputes quickly and inexpensively. It
works under the control and supervision of the Reserve Bank of
India ( RBI ). RBI has appointed 15 Banking Ombudsman all
over the country. Any customer whose grievance has not been
resolved by bank to his satisfaction can approach Banking
Ombudsman. The Scheme has been revised by RBI, in
consultation with Government of India, with an important
amendment of Arbitration and Reconciliation Procedure which
empowers the Banking Ombudsman to act as an Arbitrator. For
popularising the Scheme, advertisement in daily newspapers is
issue from time to time. The Chief Executives of the Banks
have been requested to ensure that the awards of the Banking
Ombudsman are honoured without raising unnecessary
objections.
23. Banking on Profitability : An analysis of financial position of
Public Sector Banks as on 31st March 2003 reveals that all the
27 Public Sector Banks posted net profit aggregating Rs.
12,295.46 crores during the year ended 31 st March 2003 as
against an aggregate net profit of Rs. 8301.24 crores during the
year ended 31st March 2002.

7.6 SUMMARY

100
a.

The commercial banks are-the oldest institutions dealing with

lending and borrowing of funds.

b.

They perform two main functions of accepting deposits and

lending money.

The financial development of a country depends upon the

expansion of commercial banks.

The commercial banks create the secondary or derivative

deposits with the help of multiple credit creation process.

There are many limitations to the process of multiple credit

creation.

The role of the public sector in commercial banking has been

greatly enhanced through progressive nationalisation of banks.
As a result of nationalisation, the public sector banks occupy a
dominant place in commercial banking in India.

7.7

QUESTIONS

What are commercial banks? How are they different from the
central bank?

Discuss the functions of the commercial banks

Explain with the help of an example the process of multiple

credit creation.

Write short notes :a)

Liquidity and profitability of the commercial banks.
b)
Functions of the commercial banks.
c)
Credit creation by the commercial banks.

5.

What are the objectives of nationalization of commercial

banks?

101

8
CENTRAL BANK
Unit Structure :
8.0
Objectives
8.1
Introduction of the Central bank
8.2
Meaning and definition of a central bank
8.3
Difference between a central bank and a commercial bank
8.4
Functions of a central bank
8.5
Meaning of Monetary policy
8.6
Objectives of Monetary policy
8.7
Conflicts among the objectives of Monetary policy
8.8
Instruments and techniques of Monetary policy
8.9
Limitations of Monetary policy
8.10 Summary
8.11 Questions

8.0
1.
2.
3.
4.
5.
6.
7.
8.
9.

8.1

OBJECTIVES
To understand the central bank
To study the meaning and definition of a central bank
To differentiate between a central bank and a commercial
bank
To study the traditional and promotional functions of the
central bank
To study the meaning of Monetary policy
To study the objectives of Monetary policy
To study the conflict between the objectives of the Monetary
policy
To study the quantitative and qualitative credit control
instruments and techniques of monetary policy
To study the limitations of Monetary policy

INTRODUCTION OF THE CENTRAL BANK

In the modern times, the central bank is the most important

institution in the financial structure of an economy. It is the agent of
the government and through the central bank the policies of the
government regarding monetary and fiscal issues are implemented.
The activities of a central bank play very important role in the
proper functioning of economy and in the fiscal functions of the
government.
The Riksbank in Sweden was established in the year 1668
which was example*of early central banks. The Bank of England

102
was established in 1694 which became a full-fledged central bank
in 1844. The Bank of England happened to be the first Central Bank
in the history of central banking on the guidelines of which many
other central banks were established. So the history of central bank
coincides with the development of Bank of England. 6y the end of
19th Century, almost every European country had a central bank
Today every independent country has a Central bank. Many of
these central banks were established after 1940.

8.2 MEANING AND DEFINITION OF A CENTRAL

BANK
The definition of the Central bank is derived from its functions.
Since the functions of central bank are various, it is difficult to
define central bank in the exact manner. Following are some of the
important definitions:
De Cock

D.C. Rowan :

Vera Smith

A central bank is a bank which constitutes the

apex of the monetary and banking structure of its
country.
The central bank is an institution which is often
but not always owned by the state, which has an
overriding duty of conducting the Monetary Policy
of the government
The banking system in which a single bank has
either a complete or residuary monopoly in the
note issue is called a central banking system.

Thus different economists have defined Central banking

differently taking into consideration the functions to be performed by
the central bank. From the definitions of the central bank we may
understand the functions of central bank as follows:
- Regulation of currency according to the requirement of business.
- Keeping the cash reserve of commercial banks.
- Performing general banking and agency functions for the
government.
- Management of the stock of foreign exchange for the country.
- Granting loans or credit to the commercial banks and other
financial institutions as per the need.
- Settling the balance between the different banks in the country.
- Supervising the activities of commercial banks and other financial
institutions.
- Controlling credit flow in the economy in accordance with the
needs of business.

103

8.3 DIFFERENCE BETWEEN A CENTRAL BANK AND

A COMMERCIAL BANK.
A commercial bank is basically a profit earning institution and
hence its main objective is to earn maximum profits. The central
bank mainly thinks about the impact of its operations on the working
of financial and banking structure of the economy. The commercial
banks can be many and they mainly deal with the general public.
The Central bank is only one and it does not carry on the normal
banking service like accepting deposits, giving loans to the general
public In 'fact, the central bank does not come into contact with the
general public. To conclude in the words of M.H De Cock " A further
requisite of a real Central bank is that it should not, to any great
extent, perform such banking functions as accepting deposits from
the general public and accommodating regular commercial
customers with discounts and advances. It is now almost generally
accepted that a central bank should conduct direct dealings with the
public only much forms and to such extent as, in a circumstances of
a particular country it considers absolutely necessary for the
purpose of carrying out its monetary and banking policy"

8.4 FUNCTIONS OF A CENTRAL BANK

The functions of a central bank can be studied under two heads :I] Regular/Traditional Functions
II] Promotional Functions.
8.4.1 Traditional Functions of a central bank.
1) Bank of Issue :Issuing of Currency notes is the sole responsibility of the
government of any bank and on behalf of government the central
bank issues currency notes. Earlier, each bank was allowed to
issue currency note. But over the years, the entire responsibility
was given to the central bank. So note issuing is one of the most
important functions of the central bank. The monopoly of note issue
was given to the central bank because of the following reasons :
-

to control the excessive credit expansion i.e. to control the

supply of money in the economy
- To bring about confidence and uniformity with regard to
currency notes.
- For proper supervision and control over the entire activity of
note issuing and circulation.
- To solve the problems related to monetary management single
handed.
- To give a special power to the central bank so that it stands
different from the other banks.

104

2)

Government's banker:
The central bank acts as a banker, adviser and agent to the
government of that country.
As a Banker the Central Bank does regular banking jobs for
the government. It accepts deposits in terms of cash, cheques or
drafts for different levels of government central, state and local. It
becomes the depositor of the government money It also gives loans
to the government whenever needed. It accepts the tax on behalf of
government The temporary loans are adjusted against the tax
receipts. The management of treasury bills is .done through the
central bank. It also controls and manager foreign exchange affairs
for the government Thus, it provides those services to the
government that commercial banks would provide to their
customers. So it is called the banker to the government
As an adviser to the government, a central bank undertakes
surveys in the economy and guides the government to act in a
particular way to solve country's-financial problems. It gives advice
to the government on monetary, matters, money markets and
capital markets. The government may also seek an advice from the
central bank on the issues related to balance of payments, deficit
financing, foreign exchange reserves, etc
As an agent to the government, a central bank has to perform
many activities. It has to execute the Monetary Policy of the
Government, it has to manage public debt, deal with the
government securities, represent the government on the issues
regarding international finance and foreign exchange, deficit
financing.
3)

Banker's Bank :
The.' central bank acts as an agent not only for the
government but also for the other commercial banks of the country.
It is the apex of the entire financial structure and the banking
institutions. So it is the head of all the banks and hence it controls
and supervises the activities of all these institutions. Under this role
of the central bank following activities are done :a)

The central bank accepts and keeps cash reserve of the

commercial banks.

b)

The central bank discounts bills of commercial banks to make

credit available to them whenever they need.

c)

The central bank is considered to be the lender of last resort

for the commercial banks because it is the ultimate source of
credit or financial assistance to the banks.

105
d)

The central bank acts as a clearing agency for the commercial

banks. Each commercial bank keeps a minimum stipulated
amount of cash reserves with the central bank. So all the
claims of that commercial bank with the central bank are
cleared through these reserves.

e)

Inter-bank transactions are also settled down through the

central bank. So all the financial transactions of the member
banks or commercial banks between each other are facilitated
through the central bank. This helps in clearing the claims
without actually using the cash.

4)

Controller of Credit:

The central bank being an apex of all financial and banking

institutions has to control the credit flow in the economy. This is
essential to maintain stability in the economy Controlling of credit
means to make money available in a large quantity when the
economy needs it and vice versa. For example during-the boom
period, when more funds are demanded, the central bank should be
in a position to make funds available. During the slack season,
when funds are not demanded in the larger quantity, a central bank
should be in a position to reduce their supply. This is needed for
maintaining economic stability.
As a controller of credit, the central bank of a country controls
and manages the direction use and volume of credit in the
economy. (A detail analysis of credit control is done in the next
unit). This is done with the help of many instruments like bank rate,
open market operations, variable reserve ratio, selective credit
control measures, etc.
5)

Custodian of foreign exchange reserves.

The exchange rate stability is one of the important objectives
of any country. To achieve this objective, it is necessary to regulate
and manage the foreign exchange reserves of a country in the best
possible way. The central bank of a country also has a
responsibility of maintaining foreign exchange reserves. Under the
gold standard system, the central bank was supposed to maintain
stable exchange rate by increasing or decreasing the money supply
in the economy Even after the breakdown of gold standard, the
central bank is supposed to control the buying and selling of foreign
currency and all other matters related to foreign exchange
transactions. The gold reserves & foreign exchange reserves are
kept as a basis for issuing notes by the central bank by maintaining
and controlling the foreign exchange reserves.
All those are the traditional functions of the central
bank/Central bank of any country - whether a developed or an
underdeveloped country. Apart from these regular functions, the

106
central bank of a developing country has to perform certain
additional functions. Due to the slow pace of development of many
sectors in the economy, a central bank of such countries has to
perform some typical functions which are known as promotional
functions of the central bank.
8.4.2

Promotional Functions of a central bank.

Through the promotional functions, the central banks of
developing countries help the governments to achieve the
objectives of economic development and dynamic growth of a
country. Since the central banks in the developing countries were
established very late in 1940s and 1950s and since these countries
have aimed at rapid economic development, the central banks also
have been one of the instruments to achieve this objective.
Following is a brief analysis of promotional functions of the central
bank :
1)

Expansion of banking system.

The developing countries have slow expansion of their
banking sector. The rural areas do not have adequate banking
facilities. The central bank of such countries has to play an
important role to expand the banking sector. Generally, the
commercial banks are not interested in providing credit to the
agricultural sector and small scale industrial sector. By making it
compulsory to direct a part of credit towards rural areas, the central
bank can make the commercial banks to play an important role.
2)

Establishment of New Financial institutions.

The industrial sector of the developing countries needs
financial-resources. To ensure adequate credit to these sectors, the
central bank takes initiative to start new financial institutions. For
example, the RBI played an important role in establishing financial
institutions like IDBI, NABARD, LIC, etc., which are now actively
involved in providing loan facilities to the industrial sector.
3)

Development of money and capital market.

A money market is a place where the short term loans are
given. A capital market is a place where long term loans are given.
The money and capital market function with different types of
financial institutions. In the developing countries, the central bank
plays an important role in establishment and development of such
institutions. The central bank also monitors the development of
these markets. It makes available various credit instruments
because of which lending and borrowing of money is facilitated.
4)

Promote Investment:
With the help of appropriate monetary policies, the central
bank encourages savings from the people and make the funds
available for the investors. By adopting the differential interest rate
policy, the central bank promotes the development of priority

107
sectors in the economy. For example; the RBI insists on charging
low interest rate on the loans provided to the small scale industries,
export sector, agriculture and other priority sectors. By making it
legally compulsory to do so, the RBI makes the commercial banks
to follow a policy of different interest rates to different sectors.
Check Your Progress :
1. Define a Central Bank.
2. Differentiate between traditional and promotional functions of
a central bank.
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8.5

MONETARY POLICY

Monetary Policy is an important instrument in the hands of the

central bank. Many macro-economic goals can be achieved through
Monetary Policy. It is this policy instrument through which the
central bank tries to achieve broad objectives like price stability, full
employment, exchange rate stability, etc. According to H.G.
Johnson, monetary Policy is a policy employing the central bank's
control of the supply of money as an instrument for achieving the
objectives of general economic policy.
It is through the monetary Policy that the availability, cost and
use of money in the economy are influenced This policy empowers
the central bank to regulate the supply of money in the economy
and direct the use of money and credit to the most productive areas

8.6 OBJECTIVES OF MONETARY POLICY

Since the Monetary Policy is a part a general economic policy
of the government it assists the government to achieve general
economic objectives, put forward through economic planning The
role played by the Monetary Policy depends upon the nature of
economy, level of development of the economy and specific
requirements of each sub-sectors in the economy The objectives of
Monetary Policy in general are discussed below':1)

Economic Growth:
Economic growth is defined as a continuous increase in the
production of goods and services in the economy, and hence in the
national income of a country. To achieve this objective, the
Monetary Policy may contribute in the following way .

the central bank encourages saving and investment in the

economy.

108

By attracting more and more savings through innovative

saving encouragement schemes, the central bank can
increase the saving percentage in the economy.

By making regular and cheaper credit available to the

industrial sector it can make investment levels go up.

By promoting the development of banking and non-banking

financial institutions, the central bank can develop the financial
system of a country.
The non-monetised sectors and parts of the economy can be
brought under the banking operations so that the monetisation
level of an economy goes up.

By taking appropriate actions to control unwanted expansion or

contraction in the money supply
3}
Price Stability :
Economic growth along with price stability is an important objective
of any developing or developed country. By economic stability, we
do not mean constant prices over a period of time. But a
reasonable rise in prices is also essential for inducement to
investment. Price stability implies that the goods and services are
available at a reasonable price to the people and also an
investment is encouraged to ensure economic growth. By
controlling supply of money, the central bank aims at controlling
inflationary and deflationary situations. The inflation or rapidly rising
prices have negative effects on saving capacity of the people,
distribution of income among the people becomes more unequal,
balance of payments problems may be created. Deflation or falling
prices also may result in discouragement to investment,
unemployment and instability in the economy. It is for these
reasons that the prices should increase at a stable rate. Through
monetary Policy, the central bank tries to maintain the level of
prices.
4)

Full Employment:
The Great Depression 6f 1930s made the world aware the
dangers of uncontrolled market economy. The depressionary
situation lead to unemployment problem and hence, the monetary
Policy through its instruments must aim at full employment. The
level of employment in the economy depends upon the level of
investment which in turn depends upon the many factors - one
important factor being the interest rate structure. Monetary Policy
can control the interest rate structure in such a way as to increase
the rate of investment. The availability of quick and cheap credit
facilities is also necessary for which existence of adequate number
of financial institutions is required. The central bank through its

109
monetary Policy can influence the establishment of financial
institutions in both the money and capital markets.
5)

Exchange Rate stability :

A smooth working of economy not only requires an internal
balance but also an external balance. Exchange rate stability is an
important pre-condition for promoting international trade. By
maintaining the value of domestic currency, the monetary Policy of
a country can influence the exchange rate between the domestic
and foreign currency Necessary actions should be taken whenever
there is a problem regarding balance of payments.

6)

Neutrality of Money :
Maintaining neutrality of money is another important objective
of the monetary Policy. According to this objective money should
not influence the economy and it should remain only as s medium
of exchange. This objective, however, has lost its validity in the
recent times. Money does have a positive role to play it does
influence many other economic variables and so money can not
remain neutral.
The Monetary Policy can not achieve all these objectives
simultaneously. There is a conflict between different objectives.
That means the steps taken through the Monetary Policy to achieve
a particular objective may go against the other objective For
example, rapid economic growth and price stability may not be
achieved together. Growth requires investment, rapid investment is
possible when the price level is rising rapidly and if the prices are
rising, stability can not be maintained. So the monetary authorises
have to compromise between these two objective The objective of
rapid economic growth also clashes with the objective of exchange
rate stability or balance of payment equilibrium. Rapid growth
implies more imports of heavy goods and machinery which in turn
may increase our import fill in brief, all the objectives of Monetary
Policy cannot be achieved together. The authorities have to
maintain some kind of balance between them. Depending upon
current situation, the importance of certain objective may be more
than that of the other.

8.7 CONFLICT AMONG

MONETARY POLICY

THE

OBJECTIVES

OF

All the objectives of monetary policy can not be achieved

Simultaneously. While giving importance to one objective of
monetary policy, we have to sacrifice the other objective. This is
called a trade off or conflict among different objectives. Following
are some areas of conflict.
(1)

Full employment and Price Stability

110
An eminent economist Phillips has brought to the forth a trade
off between fall employment and stable prices. According to him. in
order to achieve higher rates of employment, a country has to
accept higher inflation rates-Particularly in the short run. To
increase employment opportunities, a country has to increase the
level of investment. This results in an increase in the price level
during the gestation period (a period between the investment and
actual, output). Because of this, the monetary authorities have to
choose or maintain a balance between these two objectives.
(2)

Full employment and Growth

Growth is a continuous increase in country's national income.
Growth is not only possible by increasing resources, of a country
but also by improving technology In the earlier case when a country
grows by increasing its resource base, employment opportunities
may be generated. But in the latter case not many opportunities for
labour may be generated because improving technology needs
more use of capital and not so much of labour. Here growth is
possible without increase in employment. This trade off however, is
not so serious
(3)

Full Employment and Balance of payments

Economic growth along with the full employment brings about
an increase in income of the people on the one hand, and increase
in the price level of the country on the other hand. This increases
the imports and discourages exports because the exports now
become more expensive, This results in the disequilibrium in the
balance of payments of a country To solve the problem of balance
of payments, the domestic expenditure has to be brought down
which ultimately may lead to fall in the level of employment. Thus, a
country can either give priority of full employment or to the
equilibrium in balance of payments, but it can not achieve both of
them together.
(4)

Economic growth and exchange stability

One of the ways to achieve faster economic growth is by
importing capital and other required goods from the countries. This,
however, has a negative impact on the rate of exchange between
the domestic and foreign currency. Thus both these objectives can
not go hand in hand.
Check Your Progress:
1. What is monetary policy?
2. There is no conflict between the objectives of monetary
policy Explain.
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111

8.8 INSTRUMENTS AND TECHNIQUES OF

MONETARY POLICY
As seen earlier, the central bank along with its monetary Policy
has to guide the economy and achieve certain important macroeconomic objectives. There are many monetary instruments with
the help of which the monetary authorities control, direct and guide
the banking sector of the country. These instruments are :A. Quantitative / General credit control instruments:
i) Bank Rate,
ii) Open market operations
iii) Variable Reserve Requirement
a) CRR
b) SLR
B
Qualitative / Selective credit control instruments.
i) Margin Requirements.
ii) Regulation of Consumer Credit
iii) Direct Action.
w) Rationing of credit
v) Moral suasion
Following is the analysis of all the instruments of credit control.
8.8.1 Quantitative Credit control
The Monetary Policy influences the cost and availability of
credit through various methods During the busy season when credit
requirement is more, the monetary Policy is framed in such a way
that more credit will be available and vice versa. Those traditional
instruments which affect the volume or quantity of credit, are called
quantitative credit control instruments These are as follows . i)
Bank Rate :
A bank rate of interest at which the central bank advances
loans to the commercial banks It is that minimum rate at which the
central bank discount first, class bills of exchange The bank rate is
an important rate because it is on this rate that the other rates of
interest in the economy depend The other rates of interest are
those which are charged by the commercial banks from their
customers.
A central bank uses bank rate to achieve its monetary
objectives Suppose the central bank v/ants to expand credit
facilities, it will bring down the bank rate and advance loans to the
commercial banks at a cheaper rate. Since the Commercial bank
get loans cheaply or at lower interest rate they will also charge less
from their customers. Other rates of interest in the economy will
also go down. This will increase the demand for credit, more money
will be borrowed, more investment will take place.

112

On the other hand, if the central bank wants to contract credit

available in the market, it will increase the bank rate, other rates of
interest will also go up, credit will be costlier, there will be less
borrowings and so there will be a contraction of credit.
We can explain the process of bank rate policy with the help of
example. Suppose the current bank rate is 5%. If there is a
deflation in the economy, investments have to be encouraged,
more credit has to be made available. Under this situation the
central bank will reduce the bank rate say to 3%. commercial banks
can get loans from the central bank cheaply, the other rates of
interest will also come down. The demand for bans or advances will
go up and economy will be brought out of deflation.
If, on the other hand, there is inflation in the economy, money
is available in more than adequate quantity, the central bank will
raise the bank rate, commercial banks will find it costly to borrow
from the central bank, they will also increase other rates of interest,
borrowing will be costlier to the investors also so investment will
come down and so money supply in the economy will also come
under control, ii) Open market operations :
This is another instrument of the Monetary Policy of the central
bank. O.M.O. imply the buying and selling of government securities
to the commercial banks.
Whenever the central bank wants to reduce the credit
availability in the in the market, it will sell the government securities
to the commercial banks. The banks will pay cash and the credit
available with the banks will be reduced. This will restrict the credit
creation capacity of the commercial banks and hence the
availability of credit in the market will be reduced.
Whenever the central bank wants to expand credit, it will buy
the government securities from the commercial banks, give them
cash which is utilized by the commercial banks for credit expansion
This will increase the availability of cre.dit in the economy iii)
Variable Reserve Requirements :
By law. the commercial banks are required to maintain a
certain % percentage of their deposits in cash with the central bank.
This % can be changed by the central bank as per the currentsituation. This is called variable reserve requirements.
When there is too much of money m the economy, the central
bank follows a policy by which the % of cash reserves to be
maintained with the central bank is increased. A * larger part of
cash reserves of the commercial banks is maintained with the

113
central bank and the credit creation capacity of the commercial
banks goes down.
Exactly opposite procedure is followed when the central bank
wants to expand the credit availability in the economy, it officially
reduces the % of reserves the banks have to keep with the central
bank. More cash lies with the commercial banks, their credit
creation capacity increases and the economy expands rapidly
The CRR is a very effective measure of credit control It is an
immediate measure, there is no time lag between the policy
measure taken and the effect of that measure. The CRR doesn't
require organized bill market. But still there are a few problems
related to CRR
1)
2)
3)
4)

frequently changes in CRR are not advisable

Depending upon the size of bank and amount of its reserves,
the effect of CRR may be different.
CRR reduces the credit creation capacity as well as the profit
earning capacity of the commercial banks.
In the depressionary period, when all the economic variables
are falling, the CRR also proves to be an ineffective measure.
Sometimes the commercial banks have to maintain a certain
percentage of their holdings in terms of government securities
and other liquid assets. This is known as statutory liquidity
Ratio (SLR). The SLR can go up as high as 40% of the total
deposit.

8.8.2

Selective Credit Control:

As we have seen earlier, the quantitative or general credit
control measures influence the availability and quantity of credit in
the economy. The quantitative credit control measures or selective
credit control measure influence the use of credit. The selective
credit control measures are applicable only to certain specified
economic activities and they are not general. These credit control
measures are basically to grant credit at lower of interest to
particular activity to discourage demand for the non-essential
goods, to minimize the wastage of reserves
Following are different selective credit control measures
1)

Margin Requirements :Margin is a difference between the market price of financial

assets and the amount of loan raised against those assets. For
example if the market price of an asset is Rs 10.000 and the margin
requirement is 10%, then the loans borrowed against the assets will
be of Rs. 9.000/-. This % can be changed. The margin
requirements are useful to stop the hoarding activity in case of

114
essential goods. Higher the margin requirement, lower is the loan
that can be raised against their assets.
2)

Regulation of consumer credit:

The method of credit control was first adopted in the USA.
Under this method, the purchase of consumer durable like houses,
electrical appliances, furniture, etc. is regulated. A large part of
consumers credit is used for buying these durables. During
inflation, demand for these good also is on the increase. So to
control the inflationary trend, the central bank may put a regulation
on the amount of credit sanctioned for the consumer durables
3)

Direct Action :
Direct action refers to all those direction and guidelines given
by the central bank on all the commercial banks regarding lending
and investment. The central bank may enforce these directions
either by refusing discounting facilities or advancing loans to the
commercial banks or also by penalizing the banks which are not
following the orders.
4)
Rationing of credit:
Under this measure, a central bank has a power to allow only a
fixed amount of accommodation or advances to a commercial bank.
In the situations of excessive credit expansion, the central bank can
restrict the credit facilities given to the commercial bank. In the
socialist countries, this method is used quite often.
5)

Moral suasion:
Moral suasion implies an exerting a pressure or an influence
over the commercial banks in the framing of their policies. If there is
an atmosphere of co-operation and understanding between the
central bank and the commercial banks, it is possible for the central
bank to make commercial banks to follow certain rules and orders
just by an informal request. For example, during the inflationary
conditions, a central bank may request the commercial banks to
contract loans and not to grant too many loans to control the supply
of money in the economy.

8.9

LIMITATIONS OF MONETARY POLICY

The Conflicts between different objectives of monetary policy and

various other difficulties faced by the instruments of monetary policy
are responsible for making monetary policy less effective under
certain circumstances. Following are some of the important
limitations of the monetary policy :(1)

Monetary policy alone can not solve some of the problems like
rising inflation. This policy has to be accompanied by the other
policy instruments like fiscal, industrial or income policies.

115
(2)

In the underdeveloped countries, there is an existence of

dualism m the money market That is, the money market is
grouped into two sectors; organised and unorganised. The
monetary policy has no influence over the unorganised part of
money market.

(3)

Similarly, in a large part of the underdeveloped countries, cash

transaction are still preferred to the cheque payments. This
also reduces the hold of monetary policy in the economy.

(4)

In most of the countries, the central bank acts as an agent of

the government and advocates the policies of government
rather than functioning independently This brings about the
bias in the policy decisions of the central bank. The monetary
policy of central bank can not be based purely on the
economic or rational grounds.

(5)

An existence of parallel economy in the form of black money is

also an important limitation of the monetary policy. In India, the
size of parallel economy or unaccounted money is about 50%
of the Gross Domestic products of India.

(6)

It is also found out that the monetary policy becomes less

effective during either depression or boom period. Other
policies like fiscal policy may be more useful to bring the
economy out of depression.

Check Your Progress:

1. Distinguish between Quantitative and Qualitative credit
control instruments.
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

8.10

SUMMARY

In this unit we have focused on the functions of a central bank in

both developed and developing countries. We may conclude with
the help of following points.
a)
b)
c)

The central bank is the apex institution in the entire financial

structure
The concept of central bank is defined in many ways
depending upon its functions.
The primary or traditional functions of the central bank include
the right to note issue, controlling of credit, acting as

116
government's agent, bankers' bank and custodian of foreign
exchange reserves.
d)

e)
f)

g)
h)

i)
j)

The promotional functions of a central bank are important

particularly in the developing countries where the central bank
has to take important steps to develop different sectors in the
economy.
The monetary Policy is an important instrument in the hands of
central banks to control credit flow in the economy.
Many macro-economic objectives like economic growth, price
stability, exchange ratio stability, etc. can be achieved through
monetary Policy.
There are conflicts among various objectives of monetary
Policy.
Bank rate policy, open market operations and variable reserve
requirements are the general or quantitative credit control
measures.
Selective or qualitative credit controls aim at restricting and
directing the use of credit,
Through the credit control techniques, the central bank
enforces the economic objectives on the activities of
commercial banks.

8.11
1)
2)
3)
4)

5)
6)

7)
8)
9)

QUESTIONS

Define central bank. Discuss its functions.

What is a difference between a central bank and a commercial
bank? Why a central bank an apex institution?
Discuss the role of central bank in developing countries.
Write short notes on :
a) Traditional Functions of a central bank.
b) Promotional Functions of a central bank.
What is Monetary Policy? Discuss its objective in detail.
What are the various objectives of a monetary Policy? Can all
the objectives be achieved simultaneously? What are the
limitations and conflicts?
Discuss the qualitative and quantitative methods of credit
control?
What is the difference between general and selective credit
controls? Which of the two is superior?
Write short notes :a) Bank Rate Policy.
b) Open Market Operations.
c) Variable Reserve Requirement.
d) General credit control Measures.
e) Selective Credit Control Measure,
f) Objectives of Monetary Policy.

117

9
INDIAN MONEY MARKET
AND CAPITAL MARKET
Unit Structure :
9.0 Objectives
9.1 Introduction of the Money Market
9.2 Features/Defects of Indian Money Market
9.3 Instruments of Indian Money market
9.4 Meaning and definition of Capital market
9.5 Primary market
9.6 Secondary market
9.7 Role of capital market in economic development
9.8 Securities and Exchange Board of India (SEBI)
9.9 Summary
9.10 Questions

9.0
1.
2.
3.
4.
5.
6.
7.
8.

OBJECTIVES
To study the Indian money market
To study the features/defects of Indian money market
To study the various instruments used by Indian money
market
To Study and understand the meaning and definition of Indian
capital
market
To study the Primary market/ New issue market
To study the Secondary market/ stock market
To study the importance of the capital market in economic
development of the country
To study the SEBI

9.1 INTRODUCTION OF INDIAN MONEY MARKET

Indian money market is the market for lending and borrowing of
short-term funds. It is the market where the short-term surplus
investible funds of banks and other financial institutions are
demanded by borrowers comprising individuals, companies and the
government. Commercial banks are both suppliers of funds in the
money market and borrowers.
The Indian money market consists of two parts: the unorganised
and the organised sectors. The unorganised sector consists of
indigenous bankers and non banking financial companies
(NBFCs). The organised sector comprises the Reserve Bank, the
State Bank of India and its associate banks, the 20 nationalised
banks and private sector banks, both Indian and foreign.

118
The organised money market in India has a number of submarkets, each one of which deals in a particular type of short term
credit.
i)
Call money market : It is the market for very short-term
funds. It is also known as money at call and short notice. This
market has actually two segments, viz. a) the call market or
overnight market, and b) short notice market. The rate at which
funds are borrowed and lent in this market is called the call money
rate.
Call money rates are market determined, i.e. by demand for and
supply of short term funds. The public sector banks account for
about 80 per cent of the demand and foreign banks and Indian
private sector banks account for the balance of 20 per cent of
borrowings. Non-banking financial institutions such as IDBI, LIC,
GIC, etc. enter the call money market as lenders and supply up to
80 per cent of the short term funds. The balance of 20 per cent of
the funds is supplied by the banking system. While some banks
operate both as lenders and borrowers, others are either only
borrowers or only lenders in the call money market.
ii)
Bill market in India : In this market short term billsnormally up to 90 days-are bought and sold. It is further divided into
commercial bill market and treasury bill market.
In India, the 91-day treasury bills are the most common market
where government raises funds for the short period. There are also
182, 364 days treasury bills. And even 14 day intermediate treasury
bills.
Reserve Bank of India has the responsibility to guide and control
the institutions of the money market.
9.2

FEATURES / DEFECTS OF THE INDIAN MONEY

MARKET

1. Existence of Unorganised money market : This is the major

defect of the Indian money market. These indigenous bankers
and Non Bank Financial Companies do not distinguish between
short term and long term finance and even there is no distinction
between the purposes of finance. People attracted towards this
market because of less documentation and easy sanctions.
They are outside the supervision and control of RBI.
2. Absence of integration : Indian money market was divided into
several segments or sections which were loosely connected
with each other. The relations between these sections were not
cordial. But now, according to the Banking Regulation Act, 1949,
all banks have been treated equally by RBI as regards licensing,
opening of branches, share capital, the type of loans and

119
advances etc. In this way, the Indian money market is getting
closely integrated.
RBI is in a position to control the operations of the organised
sector. RBI guides and direct them in their lending policies and
regularly inspects the books of scheduled commercial banks.
However, RBIs control and monitoring of the commercial
banking sector are not always fully effective.
3. Differential rates of interest : There are too many rates of
interest the borrowing rate of the Government, the deposit and
lending rates of commercial banks, deposit and lending rates of
cooperative banks, the lending rates of DFIs, etc. These rates
of interest are different because of the immobility of funds from
one section of the money market to another.
4. Absence of well-organised banking system : Before
Independence, there were only a few big banks in the country
and they have been concentrated in big towns and cities. There
were different rates of interest in different regions and lack of
mobility of funds leads to slow branch banking and expansion.
After Independence and passing of the Banking Regulation Act,
1949, the RBI has been controlling the banking system. Through
mergers and amalgamations the number of banks has been
considerably reduced. After nationalisation of banks in 1969,
branch banking has been speeded up.
Despite of the various steps taken by the RBI to strengthen the
Indian banking system, RBI has failed to control and guide it.
The cases like Harshad Mehta, Ketan Parikh shows that the
Indian banking system is still far from being a well organised
and effectively supervised system
5. Seasonal stringency of money : There are wide seasonal
fluctuations in the
Indian money market. During the busy
season i.e. from November to June, when funds are required to
move crops from villages to cities, the rate of interest is high.
Whereas during slack season, from July to October, banks have
large surplus funds and the rate of interest is low. RBI attempts
to reduce these fluctuations by pumping money into the money
market during busy seasons and withdrawing the same during
slack seasons.
6. Absence of the Bill market : A well organised Bill market is
necessary for linking up the various credit agencies to RBI. Bill
market was not developed in India because of practice of banks
keeping a large amount of cash for liquidity purposes,
preference of industry and trade for borrowing rather than
rediscounting bills, the improper drafting of the bazaar hundis,

120
the system of cash credit as the main form of borrowing from
banks, the preference of cash transactions in certain lines of
activity, the absence of warehousing facilities for storing
agricultural produce etc.
RBI introduced a bill market scheme known as the New Bill
Market Scheme in 1970. It was not developed fully as was
expected.
Development of a bill market is extremely useful to the country
from the point of expanding credit as well as from the point of
monetary policy.
7. Highly volatile call money market : Call money rates are
market determined, i.e. by demand for and supply of short term
funds. Despite of all the efforts of the RBI to moderate the
fluctuations in the call money rates, they have continued to be
highly volatile.
The high rates reflect the huge demand for short term funds by
the banking system specially to meet the RBI requirement of
minimum CRR. RBI attempts to moderate the fluctuations
through supporting the market with additional funds, however it
has only a limited success in its efforts.
8. Availability of credit instruments : Till 1985-86, the Indian
money market did not have adequate short term paper
instruments. Apart from call money market, there was only the
treasury bill market. At the same time there were no specialist
dealers and brokers dealing in different kinds of paper
instruments. RBI started introducing new paper instruments
such as 182 days treasury bills, later converted to 364 days
treasury bills, certificate of deposits (CDs) and commercial
paper(CPs).

9.3 INSTRUMENTS OF THE INDIAN MONEY MARKET

(The Reforms of the Indian money market)
On the Recommendations of the Sukhmoy Chakravarty
Committee on the Review of the Working of the monetary
system, and the Narsimham Committee Report on the
Working of the Financial System in India, 1991, RBI has
initiated a series of money market reforms to overcome the
defects of the Indian money market.
1. Relaxation of Interest rate regulation : Following the
recommendations of the Narsimham Committee in 1991,
interest rates were deregulated and banking and financial
institutions were told to determine and adopt market related

121
rates of interest. The present position of interest rate regulations
is :
i) RBI continued to reduce the bank rate from 10 per cent in
1990-91 to 6 per cent in 2006-07 because of improved
liquidity position with the banking system and also because
of the need to stimulate the economy.
ii) RBI depends more on the repo rate than the bank rate to
influence the volume of lending by banks. Repo rate is the
rate at which RBI purchases securities from the market.
iii) Interest rates on domestic term deposits have been broadly
decontrolled.
iv) The administered interest rates in India has been
dismantled.
2. Introduction of new instruments in the money market : The
91 day Treasury bill has been the traditional instrument through
which Government of India raised funds from the market for
short periods and in which commercial banks invested their
short term funds. From January 1993, the Government
introduced the system of selling 91 day treasury bills through
weekly auctions. Besides these treasury bills, other new
instruments have been introduced as follows:
a) 182 days treasury bills: are having variable interest rates and
are sold through fortnightly auctions. The yield of these longdated papers had become attractive for a highly liquid
instrument. These were replaced by 364 day Treasury bills.
They have been reintroduced during 1999-2000.
b) 364 days Treasury bills: The 364 day Treasury bills have
become an important instrument of Government borrowing
from the market and also leading money market instrument.
The fortnightly offerings of these bills bring in, annually,
about Rs. 20,000 crs. to the Government. These bills are
entirely held by the market and RBI does not subscribe to
them.
RBI introduced two more Treasury bills in 1997 :
i)
14 day Intermediate Treasury Bills : from April 1997 at a
discount rate equivalent to the rate of interest on ways and
means advances to the Government of India these bills
cater to the needs of State Governments, foreign central
banks and other specified bodies.
ii)

A new category of 14 day Treasury bills sold through auction

for the first time in June 1997, to meet the cash management
requirements of various sections of the economy.

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c)

Dated Government securities : The Government of India

have decided to sell dated securities (of 5 year and 10 year
maturity) on an auction basis. As against the traditional
method of borrowing through dated securities with fixed
coupon rates, the Government switched over to auctioning
them at market related interest rates. These relates to new
borrowing and recycling of old below-market rate securities
which mature during the year. They are now auctioned and
naturally they carry market related interest rates.

d) Repos and Reverse Repos : Repos are now a regular

feature of RBIs market operations. If the banking system
experiences liquidity shortage and consequently, the rate
of interest is rising, RBI comes to assist the banking
system by repurchasing Government securities. When
Government securities are repurchased from the market,
payment is made by RBI to commercial banks, and this
add to their liquidity and enables them to expand their
credit to industry and trade.
Since November 1996, RBI has introduced Reverse Repo,
i.e. to sell dated government securities through auction at
fix cut-off rate of interest. The objective is to provide short
term avenue to banks to park their surplus funds when
there is considerable liquidity in the money market and the
call rate has a tendency to decline
Liquidity Adjustment Facility (LAF) :This policy of using
Repos and Reverse Repos is now called the Liquidity
Adjustment Facility. RBI has adopted LAF as an important
tool for adjusting liquidity through Repos and Reverse
Repos on a day to day basis.
e) Certificates of deposits (CDs) : The CDs were issued by
banks in multiple of Rs.25 lakhs to expand the investor
base for CDs, the minimum value was reduced and is
presently Rs. 1 lakh. The maturity is between 3 months and
one year. They are issued at a discount to the face value
and the discount rate is freely determined according to
market conditions. CDs are freely transferable after the
date of issue. The CDs became immediately popular with
banks for raising resources at competitive rates of interest.
f)

Commercial Paper (CP) : is issued by companies with a

net worth of Rs. 10 crs. later reduced to Rs 5 crs. The CP
is issued in multiples of Rs. 25 lakhs subject to a minimum
issue of Rs. 1 cr. The maturity of CP is between 3 to 6
months. The CPs are issued at a discount to face value
and the discount rate is freely determined. The maximum

123
amount of CP that a company can raise was limited to 29
per cent of the maximum permissible bank finance.
Check Your Progress :
1.
What do you understand by Indian money market?
2.
Indian money market is free from all the defects-Examine.
3.
What reforms have been taken place to improve the
conditions of Indian money market?
---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Capital market : Primary market and Secondary market

9.4 MEANING AND DEFINITION OF CAPITAL MARKET

The term capital market refers to as an organised
mechanism concerned with transfer of money, capital or financial
resources from investors to entrepreneurs engaged in industry or
commerce.
Capital market consists of channels through which the savings
of peoples are made available to industrial and commercial
purposes so as also to public authorities on long term basis. The
demand for long term funds comes mainly from the private
companies, agriculture and government. The government both at
the central and state level require capital not only for economic
overheads such as power, transport, irrigation etc., but also for
basic industries or even consumer goods industries. The supply of
funds mainly comes from individual savings, corporate savings,
banks, insurance companies such as the Life Insurance
Corporation (LIC) and General Insurance Corporation (GIC) and
Financial Intermediaries.
Features of capital market :
1.
Deals in Long term securities : Capital market deals in long
term securities like share, debentures and bonds.
2.

Deals in marketable and non marketable securities :

Marketable securities are those which can be easily
transferred like shares, debentures or government bonds etc.
Non marketable securities are those which can not be
transferred like term deposits with banks and other financial
institutions.

124
3.

Deals individual and Institution Investors : The capital market

comprise the institutional investors mainly include are Life
Insurance Corporation of India, Unit Trust of India, Mutual
funds etc.

4.

Comprise primary and secondary market : Primary market

concerned with sale of new shares, and secondary market
concerned to sale and purchase of existing shares.

5.

Conduct through Intermediaries : which mainly include as

under writers, stock brokers, mutual fund etc.

Special features :
6.
Greater reliance on debt instruments as against equity and in
particular, borrowing from financial institutions.
7.

Issue of debentures, particularly convertible debentures with

automatic or compulsory conversion into equity without the
normal option given to investors.

8.

Flotation of mega issue for the purpose of takeover,

amalgamation, etc and avoidance of borrowing from financial
institutions for the fear of their discipline and conversion
clause by the bigger companies.

9.

Avoidance of underwriting by some companies to reduce the

costs and avoid scrutiny by financial institutions.

10.

Fast growth of mutual funds and subsidiaries of banks for

financial services leading to larger mobilisation of savings
from the capital market.

Classification of Capital Market:

The capital market can be classified broadly on the basis of status
and stages.
i)
On the basis of status of the market :
a)
Organised capital market : The constituent of organised form
of capital market includes central bank of the country, long
term financing of commercial banks, special financial
institutions and stock market.
b)
Un-organised capital market :It consists of indigenous
bankers, money lenders, chit-funds, hire-purchase and
investment companies. It supplies funds mainly to small
business units.
ii)
a)

On the basis of stages:

Primary market: is the market wherein funds are raised by
issue of shares, debentures and bonds issued by industrial
enterprises. Such type of market concerned with new issues.
Capital market originates as primary market in the initial

125

b)

stage but later on secondary market develops to support the

primary market.
Secondary market: It is the market which facilitates transfer of
ownership of securities. It makes purchase and sale of
securities easy and creates liquidity. In developed economies
secondary market plays significant role.

9.4 PRIMARY MARKET : NEW ISSUE MARKET

The New Issues market plays a role for attracting investible
resources in the corporate sector. Corporate sector raises capital
from this market for setting up new enterprises or for the expansion
and diversification of the existing ones.
Floating of New Issues : Prior to 1992, the Capital Issues (Control)
Act 1947 regulated the primary or New Issue market. The Act was
administered by the Controller of Capital Issues, (CCI). The Act
required prior approval or consent for issues of capital to the public
and pricing of issues. The timing of new issues, composition of
securities and other aspects of the issues were also regulated.
1992 : The Capital Issues (Control) Act, 1947 was repealed,
allowing issuers of securities to raise capital from the market
without requiring any consent from any authority either for floating
the issues or for pricing it.
1992 and After : The new issue of capital has been brought under
SEBIs purview and the issuers are required to meet SEBIs
guidelines for disclosure and investor protection.
Ways of Floating New Issues :
i)
By the issue of prospectus to the public: It is an open
invitation to the public to subscribe to the issue by giving the
details in the prospectus regarding the company, the issue,
the underwriters, etc.
ii)
By private placement: The issue is not offered to the public
for subscription but placed privately with a few big financiers
including brokers who may sell them to clients or to the
public.
iii)
By the right issue to the existing shareholders of the
company: Invitation to the existing shareholders to subscribe
to a part or whole of the new issue.
Types of Issues:
Initial issues: issues of the new companies. It is raised by issuing
ordinary and preference shares.
Further issues: issues by the existing companies. It can be raised
by issuing ordinary shares, preference shares and debentures.
Major forms of New Issues:
Depending on the raising of capital of ownership or debt, the new

126
issues may take the form of equity shares ordinary shares and
preference shares and debentures.
i)

ii)
iii)

Ordinary shares :- These are ownership securities. These

involve permanent investment, but could be viewed as liquid
by exercising the option of selling these in the secondary
market.
Preference shares :- It is an ownership security, but carries a
fixed rate of return.
Debentures/Bonds :- A creditorship security with a fixed rate
of return and fixed maturity period.

Services associated with New Issues:

i)
Origination: The proposal of the company raising capital
through new issues needs to be evaluated by investigating
viability and the prospects of the new project. A careful
scrutiny of new issues proposal in technical, financial and
marketing aspects improves the acceptability by the public
and institutional investors.
ii)
Underwriting: The underwriting is to ensure the success of
new issues by guaranteeing subscription of a stipulated
amount of new issues. The part of the public issues which is
not subscribed by the public is taken up by the underwriter.
iii)
Distribution
These services are rendered by the intermediaries like brokers,
merchant bankers who mediate between the issuers of securities
and the individual savers and the institutional investors willing to
subscribe to the issues.

9.6

SECONDARY
EXCHANGES

CAPITAL

MARKET

STOCK

Stock Exchange is defined as any body or individuals whether

incorporated or not, constituted for the purpose of assisting,
regulating or controlling in the business of buying, selling or dealing
in securities.
There are at present 21 stock exchanges in India recognised under
the Securities Contract (Regulation) Act, 1956. There is also Over
The Counter Exchange of India OTCEI and National Stock
Exchange (NSE). OTCEI was set up in 1992 and the National Stock
Exchange started its operations in 1994. The number of listed
companies was 9877 by the year 1998-99. The listed securities
are securities that appear on the approved lists of stock exchanges.
Bombay Stock exchange is the leading exchange distinguished by
its size, its share in the listed companies and market capitalisation
i.e., the market value of the issues listed.
Functions of Stock exchanges :

127
Stock Exchanges help the corporate sector in raising funds equity
and debt from the market. Stock Exchanges extend facilities for
trading i.e., buying and selling in corporate securities and public
sector bonds.
The prime function of a stock exchange is to offer liquidity to the
existing securities.
Stock Exchanges provide an opportunity to all concerned to invest
in securities as and when they like. This opens a way for the
continuous inflow of funds into the market. Investment in new
issues is facilitated greatly by operations of the secondary market.
Secondary Capital Market: Reform measures during 1990s:
-Open outcry trading system replaced by on-line screen-based
electronic trading. 23 stock Exchanges have 8000 trading terminals.
-Trading and settlement cycles shortened from 14 days to 7 days.
-1992: Regulation of Insider trading- SEBI formulated the Insider
trading regulations prohibiting insider trading.
-Structural changes: a) boards of various stock exchanges have
been made broad based to represent different interests.
b) permitted corporate and institutional members and also a
member to be a member of another stock exchange.
-Depositories Act, 1996 passed to provide legal framework for the
establishment of depositories to record ownership details in book
entry form and to facilitate the dematerialisation of securities.
-Disclosure standards have been strengthened:
a) Disclosure of information having a bearing on the
performance/operations of a company is required to be made
available to the public.
b) The stock exchanges have to disclose carry forward positionscript wise and broker wise at the beginning of carry forward
session.
-Setting up Trade/Settlement Guarantee fund:
a) to ensure timely completion of settlements
b) 10 stock exchange have set up trade/settlement guarantee fund.
- Permission given to Foreign Institutional Investors (FIIs) to
operate in the primary and secondary segments of the Indian
capital market.
- Indian companies have been allowed to raise capital markets in
the form of instruments such as Global Depository Receipts (GDR),
American Depository Receipts (ADR), Foreign Currency

128
Convertible bonds (FCCBs) and External Commercial Borrowings
(ECBs).
- Companies allowed to buy back their own shares for capital
restructuring.
National Stock Exchange (NSE) : was incorporated in November
1992 with an equity capital of Rs.25 crore. It started operations in
November 1994. The NSE initially began with debt instruments like
PSU bonds, UTI units, Treasury Bills, Government Securities and
call money. Equities and debentures also have been added on the
trading list lately. NSE is a country-wide, screen-based, on-line
trading system conforming to international standards.
Objectives :
i)
The establishment of a nationwide trading facility for equities,
debt and hybrids.
ii)
Facilitation of equal access to investors across the country.
iii)
Fairness, efficiency and transparency of securities trading.
iv)
Shorter settlement cycles and book entry settlement.
v)
Meeting international securities market standards.
Operations :
The NSE has its control centre located at Mumbai. NSE members
all over India are linked via satellite and cables to the system. The
automated quotation system allows brokers to buy and sell
electronics. It has set up a Clearing Corporation (CC) designed on
the basis of the National Clearing Corporation in the USA. The CC
clears and settles all trades. It guarantees all the trades put through
NSE. It is able to determine who owes what and to whom. Since all
the securities are physically stored in the Central Securities
Depository (CSD), book entries suffice to conclude deals. Financial
data about every deal concluded by the NSE flows into the National
Settlement System (NSS) computers every day after trading hours.
In early 1996 the NSE got linked up with internet; now price
movements in any of the Indian stock markets are available to the
net users. Internet subscribers all over the world can now deal on
NSE.
Securities and Exchange Board of India (SEBI) :
The Securities and exchange Board of India (SEBI) was set up on
April 12, 1988, to act as a unifying force in bringing together the
scattered legislation and offer better protection to the Indian Stock
investor. Initially, the SEBI was set up as a non-statutory body.
Statutory powers were conferred by the SEBI Act, 1992.
Securities Trading Corporation of India (STCI) :
The STCI was promoted by RBI as its majority owned subsidiary in
May 1994 with a paid up capital of Rs. 500 crores. The objective
was to foster the development of an active secondary market for

129
Government Securities and to deepen the debt market in general.
RBI fully divested its holdings in STCI by 2002. Presently, the STCI
is owned by commercial banks and financial institutions.
Clearing Corporation of India Ltd. (CCIL): The CCIL commenced
operations from February 15, 2002. It has been set up for clearing
and settlement of transactions in government securities. The CClL
provides guaranteed settlement and has put in place risk
management systems.
Credit Rating Institutions :
Credit Rating is a symbolic indicator of an expert opinion by a rating
agency on the relative willingness and ability of the issuer of a debt
instrument to meet the debt servicing obligations in time and in full.
Equities are not rated as their risk is not measurable and the equity
holders as the owners have to bear the residual risk. Following are
some Credit Rating agencies:
a)
CRISIL: Credit Rating Information Services of India Limited
b)
ICRA: Investment Information and Credit Rating Agency of
India Limited.
c)
CARE: Credit Analysis and Research Limited.

9.7 ROLE OF CAPITAL MARKET IN ECONOMIC

DEVELOPMENT
1.

Basis for industrialisation :- Capital market grants long

term and medium term loans to entrepreneurs to enable them
to establish, expand and modernise business units. The
capital market promotes healthier industrialisation in the
economy.

2.

Faces business risks :- Investment of capital is full of risk.

Those who subscribe in the capital market undertake risk.
There are fair chances for the investor to earn profit as well
as to incur losses. Development of healthy capital market
faces such risk and provides basis to bear the loss of capital.

3.

Accelerating the speed of growth :- Availability of funds for

medium and long period on easy and favourable condition
encourages the entrepreneurs to launch profitable ventures in
the field of trade, industry, commerce and agriculture. It helps
to speed up the rate of growth.

4.

Building sound financial structure :- The individuals

business and financial institutions dealing in long and
medium term funds are important constituents of capital
market. These institutions have spread their large network of
activities in every part of the country and supply required
funds to the industrial enterprise. A healthy capital market is

130
responsible for encourage of individual to save and mobilise
savings for industrial investment.
5.

Promoting organised stock market :- An organised stock

market emerges only in a sound capital market. Industrial and
business enterprises subscribes for the shares, debenture
and securities liberally if organised stock market facilitates
their transfer, purchase and sale. It also helps in the
subscription of capital issue. Broker as the agents of the
investor and middlemen offer valuable services in the
purchase and sale of securities.

6.

Generating liquidity :- Liquidity refers to convertibility of

instruments dealing in the capital market into cash. In case of
financial requirement, shares of the public companies can be
sold in the market and the funds can be obtained. A sound
capital market develops under the structure of sound capital
market where securities can easily be converted into cash.
Government securities termed as gilt edge securities are the
most liquid assets.

7.

Availability of foreign capital :- A sound capital market is

the true indicator of the financial health of the country.
Foreign do not hesitate in making investment in such an
economy if the capital market is capable enough to present
true picture of financial health of the economy. Easy and
available on favourable terms and conditions of foreign
capital accelerate the pace of economic growth and
development.

9.8 SECURITIES AND EXCHANGE BOARD OF INDIA (

SEBI )
To develop and regulate the Indian capital market, Securities and
Exchange Board of India was constituted by Department of
Economic Affairs, Government of India on 12th April, 1988. Initially
SEBI was set up as a non-statutory body but in January 1992 it was
made a statutory body. SEBI was authorised to regulate all
merchant banks on issue activity, lay guidelines and supervise and
regulate the working of mutual funds and oversee the working of
stock exchanges in India.
The Capital Issues (Control) Act,1947 governed capital issues in
India to ensure sound capital structure for corporate enterprises, to
promote rational and healthy expansion of the joint stock
companies in India and to protect the interests of the investing
public from the fraudulent practices of fast operators. The capital
issues control was administered by the Controller of Capital Issues
(CCI) according to the principles and policies were laid down by the
Central Government. The Narasimham Committee on the Reform

131
of the Financial System in India(1991) recommended the abolition
of CCI and wanted SEBI to protect the investors and take over the
regulatory function of CCI. The Government of India accepted this
recommendation, repealed the Capital Issues (Control) Act, 1947
and abolished the post of CCI. SEBI was given the power to control
and regulate the new issue market as well as the old issue market.
Primary Market Reforms in India :- SEBI has introduced various
guidelines and regulatory measures for capital issues. Companies
issuing capital in the primary market are now required to disclose all
material facts and specific risk factors with their projects, they
should also give information regarding the basic of calculation of
premium leaving the companies free to fix the premium. SEBI has
also introduced a code of advertisement for public issues for
ensuring fair and truthful disclosures.
In recent years, private placement market has become popular with
issuers. Low cost of issuance, ease of structuring investments and
saving of time lag in issuance has led to the rapid growth of private
placement market.
To reduce the cost of issue, SEBI has made underwriting of issue
optional, subject to the condition that if an issue was not
underwritten and was not able to collect 90% of the amount offered
to the public, the entire amount collected would be refunded to the
investors. The lead managers have to issue due diligence
certificate which has now been made part of the offer document.
SEBI has raised the minimum application size and also the
proportion of each issue allowed for firm allotment to institutions
such as mutual funds. SEBI has also introduced regulations
governing substantial acquisition of shares and take-overs and lays
down the conditions under which disclosures and mandatory public
offers have to be made to the shareholders.
Merchant banking has been statutorily brought under the regulatory
framework of SEBI. They have now a greater degree of
accountability in the offer document and issue process.
In order to induce companies to exercise greater care and diligence
for timely action in matters relating to the public issue of capital,
SEBI has advised stock exchanges to collect from companies
making public issues, a deposit of one per cent of the issue amount
which could be forfeited in case of non-compliance of the provisions
of the listing agreement and non-despatch of refund orders and
share certificates by registered post within the prescribed time.
SEBI has advised stock exchanges to amend the listing agreement
to ensure that a listed company furnishes annual statement to the
stock exchanges showing the variations between financial

132
projections and projected utilisation of funds in the offer documents
and the actual utilisation. This would enable the share-holders to
make comparisons between promises and performance.
Secondary Market Reforms in India :- SEBI has started the process
of registration of intermediaries, such as the stock brokers and subbrokers under the provisions of the Securities and Stock Exchange
Board Act,1992. The registration is on the basis of certain eligibility
norms such as capital adequacy, infrastructure, etc.
SEBI has notified regulations on insider trading under the
provisions of SEBI Act. Such regulations are meant to protect and
preserve the integrity of stock markets and, in the long run, help
inspire investor confidence in the stock exchange.
Since 1992, SEBI has constantly reviewed the traditional trading
systems in Indian Stock exchanges. It is simplifying procedures and
achieving transparency in costs and prices at which customers
orders are executed, speeding up clearing and settlement and
finally, transfer of shares in the name of buyers.
The Government has allowed foreign institutional investors (FIIs)
such as pension funds, mutual funds, investment trusts, asset or
portfolio management companies etc. to invest in the Indian capital
market provided they are registered with SEBI.
To prevent excessive speculation and volatility in the stock market,
SEBI has introduced rolling settlements from 2001, under which
settlement has to be made every day. This, however, has not
succeeded extreme volatility in the stock market.
Strengthening of SEBI :- In January 1995, the Government of India
amended SEBI Act,1992 so as to arm SEBI with additional powers
for ensuring the orderly development of capital market and to
enhance its ability to protect the interest of the investors. The
important features of the ordinance are as follows:
1.

To enable SEBI to respond speedily to market conditions and

to reinforce its autonomy, SEBI has been empowered to file
complaints i courts and to notify its regulations without prior
approval of the Government.

2.

SEBI is now provided with regulatory powers over companies

in the issuance of capital, the transfer of securities and other
related matters.

3.

SEBI is now empowered to impose monetary penalties on

capital market intermediaries and other participants for a
listed range of violations. The amendment proposes to create
adjudicating mechanism within SEBI for leaving penalties and

133
also constitute a separate tribunal to deal with cases of
appeal against orders of the adjudicating authority.
4.

SEBI is now given the power to summon the attendance of

and call for documents from all categories of market
intermediaries, including persons from the securities market.
Likewise, SEBI has now power to issue directions to all
intermediaries and persons connected with the securities
markets with a view to protect investors or secure the orderly
development of the securities market.

Check Your Progress :

1.
What are the features of Indian capital market/
2.
Explain the classification of Indian capital market.
3.
What are the ways of floating New Issues?
4.
Explain the functions of Stock exchanges.
5.
Write a note on :a)National Stock exchange b) SEBI
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

9.9 SUMMARY
1.

Indian money market is the market for lending and borrowing

of short-term funds. It is the market where the short-term
surplus investible funds of banks and other financial
institutions are demanded by borrowers comprising
individuals, companies and the government.

2.

There are several defects of the Indian money market like

existence of unorganised sector, seasonal stringency etc.

3.

Several instruments are used by Indian money market.

4.

Capital market refers to as an organised mechanism

concerned with transfer of money, capital or financial
resources from investors to entrepreneurs engaged in
industry or commerce.

5.

Primary market is also called as New Issue Market. The New

Issues market plays a role for attracting investible resources
in the corporate sector.

134
6.

Secondary market is also called as Stock market. Stock

Exchange is defined as any body or individuals whether
incorporated or not, constituted for the purpose of assisting,
regulating or controlling in the business of buying, selling or
dealing in securities.

9.9 QUESTIONS
1.
2.
3.
4.
5.
6.

Define the Indian money market and explain the features of it.
Explain fully all the instruments of Indian money market.
Explain the Indian capital market.
What are the various types of capital market?
Explain the role of capital market in economic development of
the country.
Write a note on SEBI.

135

10
Module 5

NATURE AND SCOPE OF

PUBLIC FINANCE
Unit Structure :
10.0 Objectives
10.1 Meaning and Definition of public finance
10.2 Scope and subject matter of public finance
10.3 Public finance Vs Private finance
10.4 Meaning of public revenue
10.5 Sources of public revenue (Tax and Non tax revenue)
10.6 Canons of Taxation
10.7 Meaning of Direct and Indirect taxes
10.8 Merits and Demerits of Direct taxes
10.9 Merits and demerits of Indirect taxes
10.10 Summary
10.11 Questions

10.0 OBJECTIVES
1.
2.
3.
4.
5.
6.
7.
8.
9.

To study the meaning and definition of public revenue

To study the scope and subject matter of public finance
To differentiate between Public finance and Private finance
To study the meaning of public revenue
To study the Tax and Non tax sources of public revenue
To study the Canons of taxation
To study the meaning of Direct and Indirect taxes
To study the merits and demerits of Direct taxes
To study the merits and demerits of Indirect taxes

10.1 MEANING
FINANCE

AND

DEFINITION

OF

PUBLIC

Public Finance lies on the boarder line between economics

and politics. It deals with problems relating to the raising and
spending of money by public authorities. Public authorities include
the Central Government, State Government and local bodies.
Different definitions by different economists offer a broad idea about
the meaning of public finance. This can be understood by studying
some leading definitions.
H. Dalton

: " Public finance is concerned with the income

and expenditure of public authorities, and with
the adjustment of the one to the other.

136

Philip Taylor

: " Public finance is the fiscal science, its policies

are fiscal policies, its problems are fiscal
problems.

R. Musgrave

: "The complex problems that centre around the

income and expenditure process of the
government is referred to as public finance."

J. Buchanan

: "Public finance studies the economic activity of

the government as a unit.'

Findlay Shirras : " Public finance is the study Of the principles

underlying the spending and raising of funds by
public authorities."
The above definitions show that the public finance is a
systematic analytical study of the economic behaviour of the
government as a relationship between multiple social wants and
scarce productive resources having alternative uses, aiming at the
attainment of the general wellbeing of the citizens.

10.2

SCOPE AND SUBJECT MATTER OF PUBLIC

FINANCE

The study of public finance is divided into five parts.

10.2.1 Public Revenue : Public revenue deals with the methods of
raising funds through both tax and non-tax sources. Public revenue
includes the classification of public revenue, the canons or
principles of taxation, incidence and effects of taxations, etc
10.2.2 Public expenditure : Here we deal with the principle and
problem relating to the allocation of public expenditure It involves
the study of principles, justification and effects of public
expenditure.
10.2.3 Public debt: Here we are concerned with the public debts
created by public borrowing, methods of public borrowing, methods
Of public borrowing, impact or effects of public debt and retirement
and management of public debt.
10.2.4 Financial Administration : This deals with the organisation
of Financial machinery to raise and spend funds, preparation and
sanction of budget, evaluation of budget, etc.
10.2.5 Fiscal Policy: This refers to measures to avoid economic
fluctuations and promote economic stability. It is also concerned
with measures to promote growth and development.

137
In addition to the income and expenditure of the government, the
scope of public finance includes the following functions of the
budgetary policy of a government. According to Musgrave, the
three functions of budget policy are
10.2.a The Allocation Function : is the adjustment in the
allocation of resources In an economy by means of revenue and
expenditure policies, to achieve certain objectives.
10.2.b. This Distribution Function : is concerned with the
measures to be taken for bringing about an equitable distribution of
income in an economy.
10.2.c. The Stabilisation Function: is concerned with the
measures to be taken to maintain the price stability and full
employment.
Thus, public finance plays a very great role in the modern
economics to promote maximum social welfare. It deals with
various aspects of financial operations of the government.

10.3

PUBLIC FINANCE VS PRIVATE FINANCE

Public Finance refers to the financial operations of the

government, while private finance refers to the financial operations
of an individual economic unit such as a firm or a house In certain
respects, public finance is similar to private finance, while, in other
respects, they differ from each other,
10.3.1. Similarities between Public Finance and Private Finance
a Satisfaction of wants :
Both the private and public sectors are engaged in satisfaction
of wants of the society to Maximum return.
Since both public and private sectors have limited resources
they try to obtain maximum return by making optimum use of
their limited resources.
c

Borrowing Both the public and private finance resort to

borrowing from different sources, when the revenue falls short
of expenditure.

Financial Activities : Both private and public Sectors are

engaged in similar activities like production, saving,
investment, capital accumulation, etc.
In order to finance these operations they attempt to increase
the size of resources

10.3.2 Difference between Public Finance and Private Finance :

a Income-expenditure adjustment:

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In case of private finance, expenditure is within the limits of
income. An individual plans his expenditure pattern on the
basis of the income he expects to receive. But in case of
public finance, income is adjusted to expenditure. The
government first decides the expenditure and then arranges
for collecting the necessary revenue.
b

Objective:
The motive of the government is to maximize the welfare of
the community. That is government is interested in promotion
of 'social welfare', whereas the motive of private finance is to
maximize individual welfare. That is private individual is guided
by 'private motive'.

c.

Nature of resources:
The government has many sources to raise revenue, while
private individual has limited sources. The government can
raise revenue through tax and non-tax sources. Moreover,
whenever necessary government cart issue currency to meet
the raising expenditure. The government can borrow, at more
liberal terms, both internally and externally, whereas individual
earn his income, from work and property. When expenditure
exceeds income individual can borrow only internally. Thus the
capacity of the government to raise revenue is much larger
than that of the individual.

Methods of collecting revenue :

Government can raise revenue by using force. It can compel
people to pay taxes and even lend money during war. But
individual can earn his revenue only voluntarily. He cannot use
force to get income.

Foresightedness
Government is far sighted. It being permanent institution, has
a long term perspective It is the custodian of the interest of
future generation. So through budget, government make
provision for long term projects like railways and power
projects. But while planning the budget individual is short
sighted in his perspective. He thinks only for the present or
near future

f.

Secrecy vs publicity .
Private finance is a secret affair. Individual maintains secrecy
with regard to sources of income and expenditure. But public
finance is an open and public affair. Government budget is
given widest publicity. It is widely discussed, appreciated as
well as criticised.
In short public finance is a wider affair. The rules of private
finance cannot be applied to public finance. Dalton said that,

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due to these differences. Public finance and private finance
are studied as separate branches of economics.
Check Your Progress :
1. Define Public finance.
2. Public finance plays a very important role to maximize social
welfare Explain.
3. Distinguish between Public finance and Private finance.
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10.4

MEANING OF PUBLIC REVENUE

The income of the government from all sources is called public

revenue. According to Dalton public income can be classified as
1.
2.

Public Revenue and

Public Receipts

1. Public Revenue : Consists of taxes, revenue from

administrative activities like tines, fees, income from public
enterprises, gifts and grants. This is public revenue in the-narrow
sense.
2.
Public Receipts : Includes public revenue plus the
receipts from public borrowings the receipts from the sale of public
assets and printing and issuing new currency notes Thus public
revenue includes other sources of public income. This is public
revenue in the broad sense.
In India receipts of government are divided into Revenue
receipts and Capital receipts. Revenue receipts include current
receipts such as taxes, profit, interest receipts, dividends revenue
from various administrative services. Whereas Capital receipts
include borrowing internal as well as external, recoveries of loans,
etc.

10.5 SOURCES OF PUBLIC REVENUE

Sources of Public Revenue are broadly classified into
A. Tax Revenue
B Non-Tax Revenue

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A.

Tax Revenue : The revenue raised by the government

through various direct and indirect taxes is known as tax
revenue Direct taxes are imposed on income and wealth E.g.
income tax, wealth lax, etc. whereas Indirect taxes are
imposed on purchase or sale of commodities e.g. Sales tax,
Excise and custom duties, etc. The main-characteristics of tax
are
a.
b
c

A tax is a compulsory payment to the government.

Refusal to pay tax is a punishable offence.
There is no direct quid-pro-quo between the tax payers
and the government as there is no direct benefit against
payment. The tax-payer cannot claim reciprocal benefit
against taxes paid.
Tax has to be paid regularly and periodically as
determined by the taxing authority, e. Every tax involves
some sacrifice on the part of the tax payer

In modern public finance, the tax revenue accounts for a larger

share in the total public revenue Taxes imply forced saving.
Progressive taxes help to reduce inequalities of income and wealth.
Taxation affects production, consumption and distribution. Tax
discourages conspicuous consumption. It can be used as an
effective instrument to achieve price stability Taxes constitute an
important source of development finance
B.

Non Tax Revenue :

The revenue received form sources other than tax revenue is
known as non-tax revenue. As compared to tax revenue, nontax revenue accounts for a smaller share in the total revenue
Following are the important sources of non-tax revenue

a.

Fees : A fee is charged by government for rendering a service

to the people e g Court fees, passport fees, license fees for
issuing driving licenses, import licenses, etc Generally fees are
charged to recover the cost of service le a fee is lump sum
payment in exchange of receiving services. Fees are paid by
those who receive .some special advantages. There exists
quid-pro-quo. So fees differ from tax.

b.

Prices : Government offers various goods and services for

which it charges the price Therefore this is the revenue earned
by selling something e.g. Railway Tickets.
Prices are different from Fees Prices are a payment for
business whereas fees are paid for administrative services.
Prices are voluntary payments whereas fees are compulsory
payments. But both are made for special services- Fees may
not cover the cost of services whereas price is never lesser
than" the cost of production.

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c.

Fines and Penalties : Fines and penalties are levied and

collected from offenders of laws as punishment. The main
object of such levies is not to earn income but to prevent the
offending of laws. Hence they are an insignificant source of
revenue. Fines and penalties are arbitrarily determined. They
are not related to government activities.

d.

Special Assessment: When the government undertakes

public projects like construction of roads, drainage system, etc.
it may confer special benefits to those possessing properties
nearby. The values of these properties may rise. So the
government imposes a special levy in proportion to the
increase in the value of the property, so as to recover a part of
the cost of the project.
The special assessments are known as 'betterment levy' in
India. Betterment levy is imposed on land when its value is
enhanced by the construction of social overhead capital.
Special assessment is levied once for all on unearned income.
There is direct quid pro quo.

e.

Profits of Government Enterprises :

This is an important source of revenue to the government e.g.
surplus form Railways, Telephones, Profits of the State
undertakings like HMT, STC etc. are an important sources of
revenue to the government.
Profits from government enterprises depends on the prices
charged by them for their goods and services and the surplus
derived. The price policy of state undertakings should be self
supporting and reasonably profit oriented. Many public
enterprises like postal services run on a cost-to-cost basis.
The prices are charged just to cover the cost of rendering such
services. However when the government has absolute
monopoly, prices having high profit element are charged.

f.

Grants and Gifts :These are voluntary contributions and form

a very small part of public revenue. Quite often, patriotic
people or institutions may make gifts to the government.
Specially during war-time or an emergency, gifts have some
significance
In modern times, grants from one government to another has a
greater importance Local governments receive grants from
state governments and state governments from the center to
enable them to carry out their functions.

When grants are made by one country's government to

another, it is called 'Foreign aid. Usually poor countries receive
such aid from advanced countries e.g. military aid, economic aid.

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food aid technological aid etc. However such grants are normally
conditional. There are lot of uncertainties and difficulties associated
with such grants. Funds acquired by way of grants are not
significant.
So far we studied the sources of public revenue. Public
receipts would include public revenue and the following three items.
3
4
5

Deficit Financing
Borrowings
Miscellaneous sources.

3.

Deficit Financing : Implies an excess of public spending over

public revenue. The gap is filled by printing more currency.
However this method is inflationary because it increases the
supply of money without a corresponding increase in real
output. This leads to the rise in price level. Most of the
developing countries are resorting to this method in order to
finance their rising expenditure.

4.

Borrowings : In order to cover budgetary deficit, a

government may borrow from individuals and financial
institutions within the country and also from foreign countries
and international financial institutions. Loans taken by a
government from internal sources may be voluntary or
compulsory. However on all borrowings government has a
repayment liability with interest.

5.

Miscellaneous Sources : This includes income received by

government by sale of public assets, claim of government to
private properties, unclaimed bank deposits, etc. Government
often owns property in the forms of lands and buildings and
earns rent and land revenue from it. Government sometimes
also sell its assets like land, gold etc. in the market. However
this is an insignificant source of its income.

10.6

CANONS OF TAXATION

The characteristics or qualities which a good tax should

possess are described as canons of taxation. Canons of taxation
refer to the administrative aspect of a tax. They relate to the rate of
tax, the amount of tax, the method of levy and the collection of a
tax.
Canons refer to the qualities of an isolated tax and not the tax
system as a whole. According to Adam Smith, there are four
canons (maxims) of taxation. They are as follows :
1
2

Canon of equality or equity,

Canon of certainty,

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3.
4.

Canon of economy, and

Canon of Convenience

To these four canons, economists like Bastable have added a

few more, which are as under
5. Canon of elasticity,
6 Canon of productivity,
7 Canon of simplicity,
8
Canon of diversity, and
9. Canon of expediency We shall briefly describe them as follows
:
1. Canon of Equality or Equity : This implies that burden of
taxation must be equitably distributed in relation to the ability of taxpayers. Taxation must ensure social justice The rich people should
bear a heavier burden of tax and the poor a lesser burden. Hence,
a tax system should contain progressive tax rates based on the tax
payer's ability to pay and scarifies
2.
Canon of Certainty : There should be an element of
certainty on the part of the movement. The tax-payer must be
certain about the amount of tax. tax-payer of payment. If the tax
payer is certain about the time of payment and also the effectively
terms and conditions of payment he can plan his tax to manage
vehement must also be certain about the expected revenue so its
budget effectively. Thus the certainty aspect of taxation refers to the
certainty of effective incidence, certainty of liability and certainty of
revenue.
3. Canon of economy : the cost of collection of tax should be
as minimum as possible. If the cost of collection is high, the net
revenue available to the government would be less. E g in India, the
administrative cost of collecting income tax is very high and it is a
potential source of black money.
Lack of economy in tax collection would result in huge
administrative cost, insufficient revenue, disrupts the smooth
functioning of business and hard work, saving and investments are
discouraged.
4.
Canon of convenience : Tax should be levied and
collected at an appropriate time The tax payer should find it easy
and convenient to make payment E.g. income-tax should be
deducted at the time of paying salaries. Taxes on agricultural
income should be deducted after harvest. Tax should be collected
in a convenient manner from the tax-payer so that it is least felt.
These four canons determine the efficiency of a tax. However,
an efficient tax is also one which facilitates an optimum allocation of
resources and encourages economic growth. To above mentioned

144
Smith's canons of taxation, Bastable have added the following
canons
5. Canon of Simplicity : The individual taxes as well as fax
system should be simple so that it is easy for the common man to
understand and pay it conveniently. The process of administration
of a tax should not be too elaborate. The Indian tax system is so
complicated that tax payers do not understand their liability.
6. Canon of productivity: This implies two things. Firstly,
taxes should be productive i.e. They should bring sufficient revenue
to the stale. Otherwise it is meaningless. Secondly, taxes should
stimulate productive effort of the community and should not
discourage production. Tax should act as an incentive to
production. For Example import duties protect and encourage a
country's infant industries and domestic output.
7. Canon of Diversity : There should be multiple tax system
so as to mobilise revenue from all possible sources. The tax system
should be diverse in nature so that the tax-payer is not burdened
with high incidence of tax in the aggregate.
8. Canon of Elasticity or Canon Of Flexibility or Canon of
buoyancy : The tax system should be flexible or elastic so that it
can be adjusted according to the requirements of the economy. It
should automatically bring additional revenue with the increase in
national income. This canon of Flexibility or buoyancy is an index of
the efficiency and stability of the state.
9. Canon of Expediency : A tax should have economic, social
and political support. It should be acceptable in the economy,
otherwise, it would not bring adequate revenue e.g. Tax on
agricultural income. India lacks social, political or administrative
expediency. Hence there is no agricultural tax in India, though India
is an agricultural economy.
The government must pay due attention to these canons while
levying tax. Based on its objectives, the government should give
priority to the most important canon as compared to a less
important one as it might be difficult to satisfy all the canons.
Check Your Progress :
1. What do you mean by public revenue?
2. Distinguish between Tax and Non tax revenue.
3. What are the characteristics of a good tax system?
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10.7 MEANING OF DIRECT AND INDIRECT TAXES

Taxes have been classified into two - Direct and Indirect
a.

Direct tax is one which is paid by the person on whom it is

legally imposed and the burden of which cannot be shifted to
any other person. According to J.S. Mill, a direct tax is "One
which is demanded from the very persons who. it is intended
or desired, should pay it." The person from whom it is collected
cannot shift its burden to somebody else Thus, the impact, i.e.
the initial burden and the incidence, i.e. the ultimate burden of
a direct tax is on the same person. The tax-payer is the taxbearer e.g. income tax is a direct tax

An indirect tax is one in which the burden can be shifted to

others. According to J.S. Mill, indirect taxes are those * which
are demanded from one person in the expectation and the
intention that he shall indemnify himself at the expense of
another " Thus the impact and incidence of indirect taxes are
on different persons. Hence, in case of indirect taxes, the
taxpayer is not the tax-bearer. For example, commodity taxes
or sales tax. excise duties, custom duties, etc. are indirect
taxes.

The gist of the distinction thus lies in its shifting. A tax which
cannot be shifted is direct and one which can be shifted is indirect
Mrs. U. Hicks classifies taxes on the basis of administrative
arrangements. In case of direct taxes there is direct relationship
between the tax payer and the revenue authorities. Whereas in
case of indirect taxes there is no direct relationship between the tax
payers and the revenue authorities. These taxes may be collected
through traders or manufacturers.
The modern classification of taxes is done on the basis of
assessment. Taxes are assessed on the basis of income received
and expenditure incurred. Hence, taxes which are based on income
are called direct and those which are levied on outlays are called
indirect taxes.

10.8 MERITS AND DEMERITS OF DIRECT TAXES

A

Merits of Direct taxes :

1)

Equity : Direct taxes are considered to be just and equitable.

This is because the burden of such taxes can be equitably
distributed among different sections of the society. This is

146
done accordingly to their 'ability to pay'. Hence, greater
amount of money is collected from the rich and a smaller
amount, from the poor.
2)

Elasticity and productivity : Direct taxes are elastic because

their gradation is such that automatically income from those
taxes goes up when income of the taxpayer increases and
vice-versa. Thus 'built-in-Flexibility' principle is incorporated in
all direct taxes. Direct taxes are productive because they
provide incentive to earn more. Since there is minimum
exemption limit, the people work hard to earn income

3)

Economy in collection : Direct taxes are economical in the

sense that the cost incurred in the collection of tax amount is
less since the employers themselves act as honorary tax
collectors. The employers cut the amount of tax from the
salaries of their employees and pay it to the department
concerned. This saves a lot of public money. That is why they
are called economical.

4)

Certainty : All the direct taxes satisfy the canon of certainty

The taxpayers are certain as how much they are required to
pay on the one hand and on the other hand, the government
can calculate as to how much revenue it is going to get and
accordingly, it can adjust its income and expenditure

5)

Progressive : Direct taxes can serve as an instrument to

reduce inequalities of income and wealth. They may achieve
the objective of social justice, because they -are based on
ability to pay principle of taxation.

6)

Anti-inflationary : Direct taxes can serve as good instrument

of anti-inflationary fiscal policy designed to maintain the price
stability. The excessive purchasing power during inflation can
be seized away from the community through increased direct
taxes

7)

Educative : Direct taxes have an educative value-as they

create a civic sense among the tax-payers. Citizens realise
their duty to pay tax and because of the direct burden of taxes
they become conscious and keep vigil on how the public
income is spent by government in a democratic country.

Demerits of Direct taxes:

1)

Pinching : Since direct taxes are to be paid in lump sum they

pinch the taxpayers more and cause resentment.

2)

Inconvenient: Direct taxes are not convenient as the returns

from income tax, wealth tax have to be filed in time and

147
complete records have to be maintained up-to-date It is also
very inconvenient to pay these taxes as they are collected in
lump sum. The tax laws are so complex having different
interpretations that common people do not understand them.
3)

Evasion and corruption : Evasion is possible under direct

taxation by concealing real income and wealth and filing false
returns. Since the assessment of direct taxation depends on
voluntary declaration of the tax payer, it is a tax on honesty.
Dishonesty is rewarded. Tax evasion also leads to corruption.

4)

Uneconomical: An elaborate machinery is required for the

collection of direct taxes, as each assessee has to be
contacted and checked to prevent tax evasion. The cost of
collecting direct taxes is very high when the tax-base is
narrow.

5)

Narrow based : A large section of the people remain

untouched by direct taxes, mainly the poor sections. Hence,
they may not bring adequate revenue to the government
especially in developing countries.

6)

Arbitrary: The nature and base for direct taxes are arbitrarily
fixed by the government. The gradation and progression of
direct taxes are based on the value judgement of the finance
minister.

7)

Discourage hard work and efficiency - The main

disadvantage of direct taxes is that it kills the incentive to work
hard, save and invest It discourages efficiency as there is no
quid-pro-quo in the payment of direct taxes.
These demerits of direct taxation are mainly due to
administrative difficulties and inefficiencies The extent of direct
taxation should depend on the economic state of the country A
rich country has greater scope for direct taxation than a poor
country. However, direct taxation is an important aspect of
modern financial system.

10.9
A
1)

MERITS AND DEMERITS OF INDIRECT TAXES

Merits of Indirect taxes :

Less Pinching : Since indirect taxes are not felt directly, they
cause less resentment Since, indirect taxes are hidden, the tax
payer does not realise how much tax he has paid on his total'
purchases

148
2)

Can become progressive: Indirect taxes on luxuries and

semi-luxuries are progressive in effect, as they fall on the rich
people's consumption expenditure.

3)

Convenient: Indirect taxes are more convenient to pay. These

taxes, generally being on commodities, are wrapped up in
prices, hence, the tax-payer does not feel the burden directly.

4)

Broad based: Indirect taxes have a broader scope than direct

taxes. The low income group of the society which are
exempted from direct taxes can be easily caught in the net of
taxation through indirect taxes to render the sacrifice
according to their ability-to-pay.

5)

Forced Saving: Indirect taxes take away the consumer's

surplus and divert the saving of the community to the
government. This helps to promote capital formation.

6)

Social value: Indirect taxes help to discourage the

consumption of harmful commodities like cigarettes, tobacco,
etc. They help in the effective allocation of resources. They
help in the effective allocation of resources. They help to
improve the social morale and public health.

7)

Evasion not easy: Indirect taxes are included in prices and

hence they cannot be evaded.

8)

Complementary: Indirect taxes can serve as a

complementary to direct taxes Additional revenue can be
easily obtained through indirect taxes without revealing its
burden to the public. If a person escapes from direct taxation,
he will be caught in the net of indirect taxes.

9)

Promotes economic development: Indirect taxes help to

bring about effective changes in the pattern of production and
consumption through proper allocation of resources. High
indirect taxes discourage the production of luxuries. The
production of necessaries will be encouraged. Export can be
encouraged by abolishing export duties and Import can be
discouraged through import duties. Thus indirect taxes can
help to promote economic development.

Demerits of Indirect taxes :

1)

Inequitable and regressive: Indirect taxes are unjust and

inequitable as they are regressive in effect. Since they are
charged at a proportional rate on commodities of general
consumption their burden falls more heavily upon the poor
sections of the people. They are not levied according to the
principle of ability to pay

149
2)

Less economic and less productive: Indirect taxes do not

confirm to the canons of economy and productivity. As these
taxes involve many stages, the cost of collection is usually
high in relation to the revenue collected. Further, an indirect
tax is not as productive as a direct tax.

3)

Inflation productive: Indirect taxes prove to be inflationary

when excessively relied upon. They sometimes benefit more
the traders than the government when prices tend to go up by
more than the amount of the tax.

4)

Distinctive effect: Indirect taxes discourage savings when

people have to spend more with a rise in the prices of
commodities.

5)

Un-educational: Indirect taxes are invisible as they are

hidden in prices. There is no link between the tax-payers and
the government. Hence, they do not promote civic sense and
have no educative value.

Check Your Progress :

1. Differentiate between Direct taxes and Indirect taxes.
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10.10

SUMMARY

1)

Public finance lies on the border line between economics and

politics

2)

Public finance deals with financial activities of the government.

3)

Study of public finance is divided into five parts:

a) Public revenue.
b) Public expenditure
c) Public debt.
d) Financial administration.
e) Fiscal policy.

4)

Scope of public finance includes following functions of the

budgetary policy of the government:
a) The allocation function.
b) The distribution function.

150
c)

The stabilisation function.

5)

In following respects public finance is similar to private finance

a) Satisfaction of wants.
b) Maximum return.
c) Borrowing
d) Financial activities.

6)

Public finance is different from private finance in following

respects
a) Income : expenditure adjustment
b) Objective
c) Nature of resources
d) Methods of collecting revenue
e) Foresightedness
f) Secrecy vs Publicity

6)

Income of the Government from all sources is called public

revenue.

7)

Sources of public revenue can be classified into a) Tax

revenue and b) Non-tax revenue.

8)

Qualities of a good tax are described as Canons of taxation.'

9)

According to A. Smith there are four Canons (Maxims) of

taxation :
a) Canon of equity
b) Canon of certainty
c) Canon of economy
d) Canon of convenience

10)

Other economists have added few more canons :

a) Canon of elasticity
b) Canon of productivity
c) Canon of simplicity
d) Canon of diversity
e) Canon of expediency

11) Taxes have been classified into:

a) Direct taxes and b) Indirect taxes.
12) Direct taxes have following merits :
a) Equity
b) Elasticity and productivity
c) Economy in collection
d) Certainty
e) Progressive
f) Anti-inflationary
g) Educative
13) Demerits of direct taxes are :
a) Pinching
b) Evasion and corruption

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c)
d)
e)
f)
g)

Inconvenient
Uneconomical
Narrow based
Arbitrary
Discourage hard work and efficiency.

14) Indirect taxes have following advantages:

a) Less pinching
b) Can become progressive.
c) Convenient
d) Broad based
e) Forced saving
f) Social value
g) Evasion not easy
h) Complementary
i) Promotes economic development
15)

Disadvantages of Indirect taxes are:

a) Inequitable and regressive
b) Less economic and less productive.
c) Inflation productive
d) Disincentive effect
e) Un-educational

10.11 QUESTIONS
1)
2)
3)
4)
5)
6)
7)
8)
9)

What is Public Finance?

Discuss the scope and subject matter of public finance.
Examine the similarities and Dissimilarities between public and
private finance.
Distinguish between public and private finance.
What are the various sources of public revenue?
Discuss various canons of taxation
Explain merits and demerits of direct taxes.
Describe various merits and demerits of indirect taxes.
Write notes on :
a) Tax revenue and non lax-revenue
b) Canons of taxation
c) Merits and demerits of direct taxes
d) Merits and demerits of indirect taxes.

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11
PUBLIC EXPENDITURE, PUBLIC
DEBT AND DEFICIT
Unit Structure :
11.0
Objectives
11.1
Meaning of Public expenditure
11.2
Revenue and Capital expenditure
11.3
Causes of Public expenditure growth
11.4
Canons of public expenditure
11.5
Meaning of Public debt
11.6
Types of Public debt
11.7
Burden of Internal debt
11.8
Burden of external debt
11.9
Various types of deficits
11.10 Federal Finance in India
11.11 Summary
11.12 Questions

11.0 OBJECTIVES
1.
To study the meaning of public expenditure
2. To understand the difference between Revenue expenditure
and Capital expenditure
3. To study the causes of growing public expenditure
4. To know the canons of public expenditure
5. To study the meaning of public debt
6. To study various types of public debt
7. To study the burden of Internal debt
8. To study the burden of External debt
9. To study various types of deficits
10. To understand the concept of Federal Finance in India

11.1 MEANING OF PUBLIC EXPENDITURE:

Public expenditure is that expenditure incurred by the public
authorities like Central, state and local governments to satisfy those
common wants which the people in their individual capacity are
unable to satisfy efficiently. Public expenditure tends to satisfy
collective social wants.
Public expenditure has an important role to play in modern
economic activities. The government must ensure supply of

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essential goods and services. Collective wants cannot be provided
by the private sector economically and efficiently. Hence, public
expenditure is essential to fulfill the inadequacy of investment.

11.2 REVENUE AND CAPITAL EXPENDITURE

Technically, in the structure of a budget, most governments
classify public expenditure into two Current (Revenue) expenditure
and capital expenditure.
All sorts of administrative and defence expenditure and debt
services are called current expenditure. They are also called as non
developmental expenditure. They are intended for continuing the
existing flow of goods and-services and maintaining the capital of
the community intact.
On the other hand, capital expenditures are intended for the
creation of net productive assets in the economy. They contribute to
increased productive capacity of the nation and therefore, are
known as developmental expenditures. Expenditures on
construction of dams, public works, state enterprises, agricultural
and industrial development, etc. are instances of capital
expenditure.

11.3 CAUSES OF PUBLIC EXPENDITURE GROWTH

There has been a persistent and continuous increase in public
expenditure in countries all over the world. The classical ideology of
keeping the government spending at the lowest possible level has
lost its appeal in the modern days. According to Adolf Wagner, a
German economist, there .is a continuous tendency of both
intensive and extensive increase in the functions of the
government, new functions are continuously being undertaken and
old functions are being performed more efficiently and on a larger
scale.
This observations of Wagner, popularly known as 'Wagner's
Law', is universally valid. Wagner argued that there exists a direct
functional relationship between the activities of the state and the
size of public expenditure. Along with the growth of the economy,
the government activities grow faster.
Thus Wagner's law reveals a universally true inductive
generalization about the continuous and substantial growth of
public expenditure. Following factors are responsible
for such tremendous and continuous increase in spending of
modern governments.
1.

Acceptance of welfare state: The concept of welfare state

has been accepted by all the governments the world over. The

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adoption of welfare state has multiplied the responsibility of the
government. In a welfare state the note of government has
significantly widened, in fact there is hardly any Held of
economic activity in which the government is not concerned
directly or indirectly. Huge expenditure has to be incurred by
the government,s welfare items like education, public health,
social security measures like old age persons, unemployment
allowances, subsidies, etc. In short the acceptance of welfare
state has brought about a change in the attitude of the
government towards Public expenditure which has grown
many times.
2.

Impact of Great Depression : The great Depression of 1930,

has widened the economic role of the government. In order to
rectify the bad effects of depression such as unemployment,
investment deficiency, etc. the government has to play an
active role in stabilising the economic activity. Thus, to fight
the depression government is required to incur huge
expenditure

3.

Defence expenditure : Defence has been a traditional

function of the government. In modern times there is
qualitative and quantitative changes in the expenditure on
defence. Such expenditure has to be incurred not only during
war time but also during peace time. All the countries have
always to remain ready for arty emergency. Naturally, huge
expenditure becomes inevitable. If the actual war breaks up
there is further manifold increase in this expenditure. Above all
modern wars have become a costly affair Increasing amounts
have to be spent on modern weapons and other requirements.
The war arms-race among the countries of the world causes
limitless expansion of expenditure defence.

4.

Democratic Institutions : Democracy is a costly affaires the

government has to spend huge amounts on various institutions
to ensure smooth functioning of the system. There is a chain
of such institutions right from village gram panchayats to the
central government at the national level. Large amount
becomes necessary for conducting periodical elections,
allowances of elected representatives, etc. Further
expenditure has to be incurred on constitutional posts. The
acceptance of democracy is one of the causes of growth of
public expenditure.

5.

Growing population : A high growth of population naturally

calls for increase in public expenditure as all state functions
are to be performed more extensively Rising population also
poses various problems in poor countries. The government will
have the added responsibility of solving such problems as
food, unemployment, housing and sanitation. Further, over-

155
populated countries like India will have to check the population
growth. Therefore, the government has to spend more and
before on family planning campaigns every year. s
6.

Urbanization : The spread of urbanization is an important

factor leading to the relative growth of public expenditure in
modern times. With the growth of urban areas, there has been
an increasing tendency of expenditure on civil administration.
Expenses on water supply, electricity, provision of transport,
maintenance of roads, schools and colleges, traffic controls,
public health, parks and libraries, playgrounds etc have
increased enormously in these days. Likewise, the expenditure
on courts, prisons etc. is increasing especially in urban areas.

7.

Development project: In an underdeveloped country, the

government has to spend more and more on developmental
projects, especially in rural areas. It has to undertake schemes
like community development projects and other social
measures for rural development. Huge investment has to be
incurred on infrastructure and basic industries for rapid
economic development of a country. This has increased the
public expenditure

8.

Rising Prices : Inflationary tendencies have become a

common feature of the post world war. The government is
required to spend increasing amounts on completion of the
existing projects and on new ones. During inflation the
government has to pay additional D.A. to the employees
which obviously calls for an extra burden on public
expenditure. Thus inflationary price rise is one of the important
factors that leads to growth of public expenditure.

9.

International responsibility: In modern times all nations have

to become members of international institutions like UNO and
IMF. They have to make subscriptions for their membership.
They have to maintain their delegates on these institutions,
attend and host their conferences. They also have to maintain
their embassies and ambassadors in foreign countries. This
further increases their expenditure.

10. Public borrowing : To finance the development projects the

government has to borrow internally as well as externally.
Interest payment and servicing-of these debts along with
repayment of the principle has increased the expenditure of
modern governments.
Thus the various factors like extension of traditional functions,
acceptance of new functions and increasing importance of
government in economic activities have caused increase for
public expenditure.

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11.4 CANONS OF PUBLIC EXPENDITURE

The expression canon of public expenditure is used for the
fundamental rules or principles governing the spending policy of the
government. Findlay Shirras has suggested Four Canons of Public
Expenditure viz.
1) Canon of benefit.
2) Canon of economy
3) Canon of Sanction
4) Canon of Surplus.
Other economists have also suggested certain canons such as
5) Canon of economic growth.
6) Canon of productivity
7) Canon of elasticity
8) Canon of equitable distribution.
1)

Canon of benefit.: This canon implies that public expenditure

should be incurred in a such way that it promotes maximum
social advantage. The ultimate purpose of public expenditure
should be social benefit. Hence public expenditure should be
directed to those areas which maximise the benefits of the
society as a whole and not as an individual group

2)

Canon of economy: Public expenditure should be productive

and efficient It should be incurred economically avoiding
extravagance and wastes. It should avoid duplication and
involve minimum cost. It should be incurred on essential items
of common benefit. It should ensure optimum utilisation of
resources.

3)

Canon of sanction: All public expenditures should be

incurred after the approval of a proper authority. This sanction
is required for proper allocation of resources and to avoid the
misuse of funds. The expenditures must be audited to ensure
that money is spent for the purpose for which it is sanctioned.

4)

Canon of Surplus: This principle implies that the government

should create a surplus in budget and avoid deficit. An ideal
budget is one which contains a surplus by keeping the public
expenditure below public revenue. This ensures the credit
worthiness of the government.

5)

Canon of economic growth: Growth with stability is an

important objective which governs public expenditure.
Developed countries can maintain the present high rate of
economic growth and under-developed countries can focus on
raising the growth rate and attainment of a higher standard of
living through public expenditure.

157

6)

Canon of productivity: Public expenditure must be

productive so that income and employment can be generated.
A large part of public expenditure should be allocated for
developmental purpose.

7)

Canon of elasticity: This canon implies that the government

spending policy should be fairly elastic according to the
changes in the circumstances and requirements of the
economy.

8)

Canon of equitable distribution : Public expenditure policy

of the government should aim at reducing inequalities of
income and wealth in the economy. Thus the expenditure
policy should provide maximum benefits for the weaker
sections of the society.

Check Your Progress :

1. What do you mean by public expenditure?
2. Distinguish between Revenue and capital expenditure.
3. What are causes of increasing public expenditure in modern
governments?
4. Which rules govern the spending policy of the government?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

11.5

MEANING OF PUBLIC DEBT

Public debt means the loans raised by the government

internally or / and externally. Loans may be obtained from
individuals, banks, financial institutions like IMF, World Bank. etc.
Public debt is considered to be an important source of income
to the government in times of financial crisis, emergencies like war,
droughts, etc. or when current revenue fall short of public
expenditure.
Public borrowing take the form of government bonds or
securities of various kinds. Securities are contract between the
government and the lenders and by issuing securities government
incurs a liability to repay both the interest and the principal amount
as per the contract. Thus public debt refers to financial obligations
of government to pay sums to the lenders at some future date.

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11.6 TYPES OF PUBLIC DEBT

Government loans are of different types. They may differ in
respect of time of repayment. the purpose, condition of repayment,
etc. Thus public debt may be classified into following types
a Internal and External Debt
b Productive and unproductive Debt
c. Compulsory and voluntary Debt.
d Redeemable and Irredeemable Debt.
e Funded and unfunded Debt
f Short-term, Medium term and Long term Debts.
a.

Internal and External Debt : Place of borrowing is the basis

of this classification Government borrowings within the country
from financial institutions or public selling bonds and securities
are called internal debt. Under internal debt, the availability of
total resources m the country does not rise. The resources are
just transferred from financial institutions or public to the
government. Thus internal debt involves a mere transfer of
funds from private hands to government within the country. It
has no direct net money burden.
External debt refers to borrowings by government from abroad
i.e. from foreign countries and international financial
institutions. External debt increases the foreign exchange
resources of the borrowing country when the loans are
received in terms of foreign currencies. But when these loans
are repaid along within interest, the foreign exchange is
reduced to that extent. External debt helps to promote capital
formation and industrialization especially for developing
countries like India

b.

Productive and unproductive Debt: Public debt is said to be

productive when it is raised for productive purpose and is used
to add to the productive capacity of the economy; When
government loans are invested in the construction of railways,
irrigation projects, power generation etc it adds to the
productive capacity of the economy and provides continuous
income to the government The interest and principal amount is
paid out of income earned by the government from these
projects. Thus productive loans are self-liquidating and does
not cause any burden on the community.
Whereas unproductive debts are those which do not add to the
productive capacity of the economy. Such debts are not selfliquidating and therefore are a burden on the community. The
public debts which are raised for war, social services, famine

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c.

relief, etc. are unproductive debt. Such debts are not bad
because they may lead to well-being of the community.
Compulsory and Voluntary Debt: Compulsory debts are
raised by using coercive methods In modem public finance,
compulsory loan is a rare phenomenon, unless there are some
special reasons like war or crisis The rate of interest on such
loans may be low. In India compulsory Deposit Scheme is an
example of compulsory debt.
Generally public debts are voluntary in nature. In this case
government makes an announcement regarding the floating of
loans.
This announcement may be accompanied by some kind of
publicity. The government floats a loan by issuing certificates,
bonds, etc. Individuals, bank and other financial institutions
lend to the government willingly by purchasing these
securities.

d.

Redeemable and Irredeemable Debt : The debts which the

government promises to pay off at some future date are called
redeemable debts. The government has to make arrangement
for repayment of interest and principal amount within a specific
lime period.
Where as in case of irredeemable debt no definite date for
final repayment is promised but the rate of interest is paid
regularly. Hence the government makes arrangements for
interest payment only. Such debts create a burden as taxes
would be raised to pay the debt in the future,

e.

Funded and Unfunded Debt: Funded debt is a long term

debt, exceeding the duration of at least d year. It consists of
securities which are marketable on the stock-exchange.
Funded debt is an obligation to pay a fixed sum of interest,
subject to an option of the government to repay the principal,
in such the creditor bond holder has right only on interest.
On the other hand, unfunded debts are for a comparatively
short duration. They are generally repaid within a year The
rate of interest is low. These debts are incurred to meet
temporary needs of the government,

f.

Short-term, Medium term and Long term Debts : Short

term debt matures within a duration of 3 to 9 months and the
rate of interest on such loans is low. The treasury bills of
government of India, which usually have a maturity period of
90 days, are the best example of such debts.

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On the other hand, long-term debts are repayable after a long
period time, generally 10 years or more. Such loans are raised
for developmental programs and to meet other long-term
needs of public authorities.
Medium term debt has a maturity period between short-term
and long-term loans. The role of interest is intermediate. They
are generally raised for welfare programs.

11.7 BURDEN OF INTERNAL DEBT

Internal debt constitutes a redistribution of resources within the
community. There is no change in the total resources of the
country.
11.7.1 Direct Money Burden : There is no direct money
burden caused by internal debts as all payments cancel out each
other in the aggregate community as a whole.
Whatever is taxed from one section of the community tot
servicing debts is distributed among the bond holders by way of
repayment of loans and interest.
The incomes of the creditors increase to the extent to which
the incomes of the tax payers reduce. The aggregate position of the
community remains the same.
11.7.2 Direct Real Burden : Internal debt involves a direct
real burden based on the transfer of incomes. If the tax-payers and
bond-holders are the same the distribution of wealth remains
unaltered. Hence there will not be any net real burden on the
community.
If the tax-payers and bond-holders belong to different income
groups, there will be a change in the distribution of income resulting
in inequalities of income. If this inequality of income increases, the
net direct real burden of the community increases. If the proportion
of taxes paid by the rich is smaller than the proportion of public
securities held by them, then there will be direct real burden of
internal debts.
11.7.3 Unjustified transfers : The servicing of internal debt
involves transfers of income from the younger to the older
generations and from the active to the inactive enterprises. The
government imposes taxes on enterprises and earnings from
productive efforts for the benefit of the idle, inactive, old and
leisurely class of bond holders. Hence, work and productive risk
taking efforts are penalised for the benefit of accumulated wealth.
This adds to the net real burden of debts.

161
11.7.4 Indirect Real Burden : internal debt involves an
additional indirect real burden on the community This is because
the taxation required for servicing the debts reduces the tax-payer's
ability to work and save and affects production adversely. The
government may also economise social expenditure thereby,
reducing the economic welfare of the people.
Taxation will reduce the personal efficiency and desire to work
more than their increase caused by debt payments. Thus there
would be a net loss in the ability and desire to work. The creditor
class will also not have any incentive to work hard due to the
prospect of receiving interest on bonds. This would further cause a
loss to production and increase the indirect burden of debt. The
indirect real burden of public debt can be reduced by the following:
3.4.a. Minimizing the cost of servicing through a low rate of interest.
3.4.b. Issue of new money for the servicing of debts.
3.4.c. Self liquidating public debts.
Public debt used for productive purposes like public works
programmes, creation of socio-economic overheads etc. will raise
the ability to work; save and invest. This would help to reduce both
direct and indirect real burden imposed by taxation for servicing
debts.

11.8

BURDEN OF EXTERNAL DEBT

External debt is beneficial in the initial stages as it increases

the resources available to the country. But its repayment and
servicing creates a burden on the debtor country.
11.8.1. Direct money Burden and Direct Real Burden :
Direct Money burden of external debt is the sum of money
payments in the form of interest and principal to external creditors
Direct real burden is the loss of economic welfare i.e. the sacrifices
of the consumption of goods and services due to increased
taxation.
Given the direct money burden; the direct real burden will vary
according to the proportion in which the various sections of the
community contribute to payments If the relative burden of taxation
falls heavily on the rich then the direct real burden to the community
as whole will be less. If the relative burden of taxes falls heavily on
the poor, then the direct real burden to the community as a whole
will be more.
11.8.2. Decline in Domestic Resources: The transfer of
resources of foreign countries at the time of payment would reduce
the availability of domestic resources. This would reduce
consumption and affect economic welfare.

162

There may also be a drain on foreign exchange reserves. If

the export earnings are inadequate and the propensity to import is
inelastic, then the borrowing country will have a greater problem in
repaying foreign loans. The debtor country will be forced to raise
additional foreign loans just for servicing. This would affect their
progress and welfare.
11.8.3. Purpose of External debt: The burden to the
community depends upon the purpose of external debt.
External debts incurred for war expenditure and other such
unproductive uses will add to the net real burden of the community.
In case of short term loans, the current generation will repay. But in
case of long-term loans, the burden will fall on posterity.
External debts for productive purposes like investments in
social and economic overheads, expansion of export sector, etc.
wilt provide benefits to the debtor country. The posterity will also
reap the fruits of such economic growth and earn additional income
The real burden incurred in repayment of such external debt is not
much. External debts incurred for development purposes is a
profitable venture.
11.8.4. Decline in the value of currency : The repayment of
external debt involves an increase in the demand for the currency
of the creditor country. This will raise the exchange rate of the
creditor country's currency, causing a decline in the external
countries currency value and aggravate the problem of foreign
exchange crisis.
The creditor country may also be adversely affected if it is
induced to import more from the debtor country. This may hinder
the growth of their domestic industries and cause unemployment m
11.8.5.
Indirect Burden : 'The indirect burden of external
debt is that it affects production adversely due to the following
reasons: .
a.
b

Disincentive effects of taxation

Contraction of public expenditure

11.9

TYPES OF DEFICITS

1.
Budget deficit : Budget deficit is the difference between total
expenditure and total receipts of the central government It is the
excess of total expenditure, meaning revenue expenditure plus
capital account expenditure, total receipts from revenue and capital
account Such deficit is financed by newly treated money and thus
add to money supply in the economy. It can be a major cause of

163
inflationary rise in prices. However this is considered as a narrow
measure of deficit.
2. Revenue deficit :
It is the deficit between revenue receipt and revenue
expenditure. The revenue receipts are derived from tax and non tax
sources like fees, profits, etc. The revenue expenditure covers
administration, justice, defence and subsidies. Such expenditures
create no assets and therefore it must be met by revenue which
creates no liabilities. If revenge deficit is covered by borrowing,
pressure on revenue expenditure in the form of payment of high
interest, increases and this leads to further rise in revenue deficit.
Thus may lead the country into internal debt trap. However, in India
for the last several years, there has been revenue deficit, due to
increase in current expenditures such as general administration,
defence, interest payments and so on.
3. Fiscal deficit: It is an important measure of deficit. Fiscal
deficit is the excess of total government expenditure over revenue
receipts and non-borrowing types of capital receipts like recoveries
of loans and grants. In other words, fiscal deficit is equal to
budgetary deficit plus governments market borrowings and
liabilities.
Thus fiscal deficit is total of budgetary deficit and governments
market borrowings and liabilities. It a more comprehensive measure
of budgetary imbalances. It captures the entire short fall in the fiscal
operations of the government. Fiscal deficit fully reflects the
indebtedness of the government. It is financed by borrowing, both
internal and external and by money financing, i.e. by borrowing
from the central bank.
4.
Primary deficit : The primary deficit is obtained by
deducting interest payments from the fiscal deficit Thus primary
deficit is equal to fiscal deficit less interest payments It indicates
real position of government finances as it excludes the interest
burden of the loans taken in the past.
5.
Monetized deficit: This is concerned with the way by
which government deficit leads to expansion of money. It is
measured by rise in net holdings of treasury bills by the central
bank and its contribution to the market borrowings by the
government. The Chakravarty Committee recommended this
concept of deficit. It indicates impact of fiscal operations on
changes in reserve money and therefore potential changes in
money supply. Of course, this concept is narrower than that of fiscal
deficit.

164

Federal Finance in India (With respect to latest available

Report) :Financial relations under the Constitution : India has a federal
structure, in which a clear distinction is made between the Union
and State functions and sources of revenue, but the residual
powers belong to the Centre. Although the States have been
assigned certain taxes which are levied and collected by them, they
also share in the revenue of certain Union taxes, and there are
certain other taxes which are levied and collected by the Union but
the proceeds of which wholly go to the States. In addition, the
States receive grants-in-aid of their revenue from the Union which
further increase the amount of transfers between the two levels of
governments. The transfer of resources from the Central
Government to the States is an essential feature of the present
financial system of India.
A) Distribution and Allocation of Central Revenue :
1. There are certain duties which are levied by the Union but
are collected and appropriated by the States. For e.g. stamp
duties and excise duties on medical preparations containing
alcohol or narcotics.
2. There are certain taxes which are levied and collected by the
Union, but the entire proceeds of which are assigned to the
States, in proportion determined by the Parliament. For e.g.
succession and estate duties, terminal taxes on goods and
passengers, taxes on railway freight and fares, taxes on
transactions in stock exchanges and future markets, the
taxes on the sale and purchase of newspapers and
advertisements therein.
3. Central tax on income and Union excise duties were levied
and collected by the Union but were shared by it with the
States in a prescribed manner.
4. The proceeds of additional excise duties on mill-made
textiles, sugar and tobacco, which were levied by the Union
in 1957 in replacement of States sales taxes on these
commodities, are wholly distributed among the States.
B) Grants-in-aid : As important welfare and development
functions are entrusted to the States, gaps between their
revenues and expenditure have to be corrected through
transference of resources from Centre. This is done partly by
arrangements for tax sharing. But grants-in-aid by the Union

165
for specific purposes or general aid have come to occupy an
important place in Union-State financial relations in India.
C) Loans : The States are authorised to raise loans in the
market but they also borrow from the Union Government
which gives the later considerable control over State
borrowing and expenditure.
First Eleven Finance Commission Awards : The appointment of
a Finance Commission at intervals of five years or less has great
significance for the financial relations between the Union and the
States. Periodical examination of the division of resources and
suitable modifications in it imparts a degree of flexibility to the
finance of both the Centre and the units. The recommendations of
the Finance Commissions are in the nature of awards and both the
Centre and the States have to accept them. So far there have been
eleven Finance Commission Awards.
Twelfth Finance Commission Award (2005-10) : The Twelfth
Finance Commission was constituted by the President under the
Article 280 of the Indian Constitution, with Dr, C. Rangarajan as
Chairman.
The Award of the Twelfth Finance Commission:
Vertical imbalance and devolution :- In India, vertical imbalance has
always existed because the Central government has been assigned
more revenues while the States have been entrusted with more and
larger responsibilities. Accordingly, correcting vertical imbalance
necessitates transfers from the Central Government to the State
Governments taken together.
The 12th Finance Commission considered all the relevant factors as
regards receipts and expenditures of the Centre and of the States,
the level of over-all transfers relative to Centres gross revenue
receipts, the relative balance between tax devolution and grants,
etc. It decided an increase of the sharable pool to 30.5 percent to
accommodate the additional excise duty in lieu of sugar, tobacco
and textiles.
Horizontal sharing : The horizontal aspect of transfer relates to
the sharing of the total sharable pool between the States. In
practice, there are considerable horizontal imbalances States differ
in area, size of population, income tax base, forest and mineral
wealth, etc. Horizontal imbalances have to be corrected while
distributing Central resources among all the States in the country.
The 12th Finance Commission considered the recommendations of
previous commissions and also the memoranda submitted by
various States regarding:

166
a)
b)
c)
d)

The contribution of the use of population as a factor

The use of income distance criteria
Continuation of area as a factor
Retaining the tax effort and index of fiscal discipline criteria.

Accordingly the following five states would get the largest share of
the total sharable revenue.
State
% age share
U.P.
19.3
Bihar
11.0
Andhra Pradesh
7.4
West Bengal
7.1
Madhya Pradesh
6.7
The above States would get 51.5% whereas the rest 23 states
would share the balance 48.5% of the sharable pool.
Grants-in-aid : The 12th Finance Commission has recommended
non-plan revenue deficit grants, under Article 275 of the
Constitution to be given to 15 States whose total non-plan revenue
deficit was assessed at Rs. 56,856 crs. for the period 2005-10.
The other grants-in-aid recommended by the 12th Finance
Commission are as follows:
-

Grants for education for 8 States : Rs. 10,172 crs. Over the
award period, with a minimum of Rs. 20 crs. In a year for any
eligible State.
Grants for health for 7 States : Rs. 5,887 crs. Over the award
period, with a minimum of Rs.10 crs. In a year for any eligible
State.
Grants for maintenance of roads and bridges : Rs. 15,000 over
the award period
of public buildings : Rs. 5,000 crs.
of forests : Rs. 1,000 crs.
Grants for heritage conservation : Rs. 625 crs. Over the award
period
Grant for specific needs : Rs. 7,100 crs. Over the award period
for specific needs.

Local Bodies Panchayats and Municipalities : The 12th

Finance Commission felt that there was a case to augment the
consolidated fund of the States through additional grants from the
Centre, keeping in view the special circumstances of the states.
Besides, there was a clear need to provide an impetus to the
decentralization
process.
Accordingly
the
Commission
recommended a sum of Rs. 25,000 crs. For the award period,
(2005-10) as grants-in-aid to supplement the resources of
municipalities and the Panchayats. It has emphasized that, of the
grants allocated to Panchayats, priority should be given to

167
expenditure on the operation and maintenance costs of water
supply and sanitation and at least 50 percent of the grants provided
to each State for the urban local bodies should be earmarked for
the scheme of solid waste management.
Financing of Calamity Relief Expenditure : After a careful study
of the present system of disaster management, the 12th Finance
Commission recommended the continuance of the scheme of
National Calamity Relief Fund (NCRF) in its present form with
contributions from the Centre and the States in the ratio 75:25. The
Commission fix the size of the CRF for the award period, 2005-10
at Rs. 21,333 crs., of which the Centres share would be Rs. 16,000
crs. and the balance would be share of the States (Rs. 5,333 crs.)
The 12th Finance Commission has also recommended continuance
of the scheme of the National Calamity Contingency Fund (NCCF)
in its present form with core corpus of Rs. 500 crs. The outgo from
the NCCF may continue to be replenished by way of collection of
National Calamity Contingency Duty and levy of special surcharges.
Debt Relief to States : The 12th Finance Commission recommended
the following scheme of debt relief
a) Rescheduling of all Central loans outstanding as on end
March 2005 into fresh loans for 20 years carrying 7.5 percent
interest with effect from the year a State enacts the Fiscal
Responsibility Legislation.
b) A debt write-off linked to reduction in revenue deficit of every
State. The quantum of write-off of repayment would be linked
to the absolute amount by which the revenue deficit is
reduced in each successively year during the award period.
Sharing of Profit Petroleum : i) The Centre should share profit
petroleum from NELP areas with the States from where the mineral
oil and mineral gas are produced and the share should be 50:50.
ii) The revenue earned by the Central Government on contracts
signed under the coal bed methane policy should also be shared
with the producing states in the same manner as profit petroleum.
Thirteenth Finance Commission : The Government of India has
constituted the 13th Finance Commission under the Chairmanship
of Mr. Vijay Kelkar to recommend on the devolution of Central taxes
to the States for the five year period, 2010-2015. The Commission
is expected to submit its award to the Central Government by
October 2009.
Apart from the usual terms of reference to the Commission, the
government of India has mandated the Commission to come up

168
with a revised road map on fiscal adjustment after reflecting the
Central Governments off-budget liabilities on oil, food, and fertilizer
bonds in the mainstream fiscal accounting.
Check Your Progress :
1. Define public revenue.
2. Explain briefly various kinds of public debt.
3. Differentiate between internal and external public debt.
4. What are the various types of deficits?
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11.11. SUMMARY:
1)

Public expenditure is end of all financial activities of the

government.

2)

Public expenditure is the expenditure incurred by public

authorities to maximise social welfare.

3)

Public expenditure is classified into:

a) Current or Revenue expenditure.
b) Capital expenditure.

4)

Causes for continuous rise in public expenditure are

a) Acceptance of welfare slate
b) Impact of great depression.
c) Defence expenditure
d) Democratic institutions
e) Growing population
f) Urbanization
g) Development projects. h) Rising prices i) International
responsibility j) Public borrowing

5)

Canons are the Fundamental rules governing the spending

policy of the government

6)

F. Shirras has suggested four canons of public expenditure :

a) Canon of benefit
b) Canon of economy
c) Canon of sanction
d) Canon of surplus

169
7)

8)

9)

Other economist have suggested certain canons such as :

a) Canon of economic growth
b) Canon of productivity
c) Canon of elasticity
d) Canon of equitable distribution
Public debt is an important source of income to the
government in times of financial crisis.
Public debt means loans raised by the government internally
or/and externally.

10) The public debt may be classified into following types :

a) Internal and external debt
b) Productive and unproductive debt
c) Compulsory and voluntary debt
d) Redeemable and Irredeemable Debt
e) Funded and unfunded debt
f) Short-term, medium-term and long-term debt
11) Internal debt constitutes redistribution of resources within the
community and therefore aggregate position of the community
remains the same.
12) External debt is beneficial in the initial stages as it increases
availability of resources to the country. But its repayment and
servicing creates a burden on the debtor country.
13) Deficit financing is used by the government for acquiring
financial resources for economic development.
14) When government cannot raise sufficient revenue through
taxation it resorts to deficit financing.
15) Conceptually government deficit refers to government
expenditure exceeding government revenue in the policy
making process and its economic evaluation.
16) Government deficit can be an indicator of the need for and the
extent of fiscal adjustment for balancing either on the
expenditure or on the revenue side of the budget.
17) in the Indian context to understand the monetary impact of
government deficit and its interaction with public debt it is
useful to review the following concepts of government deficits:
a) Budget deficit
b) Revenue deficit
c) Fiscal deficit .
d) Primary deficit
e) Monetized deficit

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11.12 QUESTIONS
1)
2)
3)

Explain the meaning of public expenditure and bring out

important classification of public expenditure.
Discuss important causes for the rise in public expenditure.
Explain the canons of public expenditure.
Examine various types of public debt.

4)

a
b.

5)

Distinguish between:
a) Internal and External debts.
b)
Productive and dead weight debts.
c)
Voluntary and compulsory debts.
d)
Redeemable and irredeemable debts.
e)
Burden of internal and external debts.

6)
7)

What is deficit financing?

Explain various concepts of fiscal deficit.

8)

Write notes on the following:

a)
Budget deficit
b)
Revenue deficit
c)
Fiscal deficit
d)
Primary deficit
e)
Monetized deficit

9)

What do you understand by burden of public debt?

Analyze the burden of internal and external debt.

Explain the Centre-State financial relations in India.

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REVISED SYLLABUS
ECONOMICS ( Paper II )
MACRO ECONOMICS
For S.Y.B.A.
( To be implemented from the academic year 2009 2010 for
IDE students. )
SECTION I
Module 1 : Introduction
Distinction between Micro Economics and Macro Economics ;
Circular Flow of Economic Activities ; Concepts of National Income
Aggregates : GNP, NNP, GDP, NDP ; Per Capita Income, Personal
Income and Disposable Income ; Methods of Measurement of
National Income ( With special reference to India ). Price Indices.
( 12 lectures )
Module 2 : Determination of Employment
Says Law , Keynesian Concepts of Aggregate Demand, Aggregate
Supply and Effective Demand ; Consumption Function and
Investment Multiplier ; Investment Function ; Savings and
Investment : ex ante and ex post ; Types of Inflation : Demand
pull and Cost push inflation.
(12 lectures )
Module 3 : Money
[a] Meaning and Functions of Money
[b] Supply of Money ; Constituents of Money Supply ;
Determinants of Reserve Money and Money Supply ; Velocity
of Circulation of Money ; Money multiplier ; Measures of
Money Supply in India ( including Liquidity Concepts ).
[c] Demand for Money : Classical and Keynesian Approach.
[d] Value of Money : Quantity Theory of Money : Cash
Transactions and Cash Balances Versions ; Friedmans
Quantity Theory of Money.
( 12 lectures )
SECTION II
Module 4 : Banking and Financial Markets
Commercial Banks : Functions, Multiple Credit Creation Process ;
Commercial Banking Developments in India since 1969.
Central Bank : Functions, Objectives and Instruments of Monetary
Policy ( with special reference to India.)
Money Market : Features of Indian Money Market ; Instruments of
Money Market.
Capital Market : Primary Market and Secondary Market ; Role of
Capital Market in Economic Development ; Securities and
Exchange Board of India ( SEBI ).

172
( 20 lectures )
Module 5 : Public Finance and Fiscal Policy
Nature and Scope of Public Finance ; Sources of Public Revenue ;
Canons of Taxation ; Direct and Indirect Taxes ; Public Expenditure
: Revenue Expenditure and Capital Expenditure ; Public Debt ;
Concepts of Deficit ; Federal Finance in India ( with respect to latest
available Report ).
( 16 lectures )
References :
1. Stonier A. W. & D. C. Hague ( 2004 ), A Textbook of
Economic Theory, Pearson Education , Delhi.
2. Dwiwedi , D. N. ( 2001 ), Macroeconomics : Theory and
Policy , Tata McGraw Hill Publishing company Ltd, New
Delhi.
3. McConnel , C. R. & H. C. Gupta (1984 ), Introduction to
Macro Economics , Tata McGraw Hill Publishing Company
Ltd, New Delhi.
4. Gupta, S. B. (1994 ), Monetary Economics, S. Chand and
Company , Delhi.
5. Bhole, L. M. (1999 ), Financial Institutions and Markets, Tata
McGraw Publishing Company , Delhi.
6. Musgrave, R. And P. Musgrave (1983), Public Finance :
Theory and Practice, Singapore.
7. Hyman, D. N. (1973), The Economics of Governmental
Activity , Halt Rinehart & Winston, New York.
8. Bagchi, A. (ed) (2005), Readings in Public Finance , Oxford
University Press, New Delhi.
9. Pathak, B. V. (2003), Indian Financial System, Pearson
Education, Delhi.
10. Datt, R. & K. P. M. Sundaram (2001), Indian Economy :
Environment and Policy , S. Chand & Company Ltd., New
Delhi.
11. Dhingra, I. C. (2001) , The Indian Economy ; Environment
and Policy , S. Chand & Company Ltd., New Delhi.
12. Misra, S. K. & V. K. Puri (2001), Indian Economy : Its
Development Experience, Himalaya Publishing House,
Mumbai.