MODULE - I

iv) Credit authorization scheme:

Introduced in 1965, it is used by the RBI to allow banks to give credit to large
public and private sector borrowers. Under the scheme, commercial banks are
required to seek prior authorization from the RBI and to report later to large credit
facilities given to large private and public sector undertakings.

DEFLATION:

Deflation is the opposite of inflation. Just as inflation is a phenomenon of rising prices,

deflation is a phenomenon of falling prices. In the words of Crowther, “Deflation is that state
of the economy where the value of money is rising or the prices are falling.” No doubt
deflation is associated with falling prices, but it is not that each and every fall in price will be
termed as deflation.

Only those falls in prices which result in unemployment, overproduction and a fall in the
economic activity are deflationary. In short, deflation is a situation in which falling prices are
accompanied by falling levels of employment, output and income.

CAUSES OF DEFLATION:

Deflation is a situation in which falling prices are accompanied by falling levels of

employment, income and output. Deflation may be due to certain natural causes, or it may be
due to a deliberate policy of the government.

The following are the important causes of deflation:

1. Keynes’ Explanation:

(i) Deficient Aggregate Demand:

The main reason for deflation is the deficiency of aggregate demand which leads to
over-production and unemployment. Aggregate demand consists of aggregate consumption
expenditure and aggregate investment expenditure.

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(ii) Less Investment Expenditure:
Private investment is governed by marginal efficiency of capital (MEC) and rate of interest.
Deflation is the result of decline in investment which is due to (a) low MEC or low
profitability of capital and (b) high rate of interest.

(iii) Fall in MEC:

As the process of economic expansion goes on, certain forces come into operation which
exerts downward pressures on MEC.

These forces are:

(a) During the process of expansion costs of production start rising on account of the
increasing scarcities of materials and equipment. Wage cost also rises because of scarcity of
labour. Rising costs have the depressing effect on MEC.

(b) Increasing abundance of output resulting from industrial expansion leads to lessen the
returns below expectations which also depress MEC.

(iv) Less Consumption:

The basic cause of deflation or depression lies in Keynes’ concept of consumption function or
his psychological law of consumption. According to this law, the consumers do not spend the
whole of the increment of their incomes on consumer goods.

As the income increases, the community spends a smaller proportion of its increased income
on consumer goods. The reduced sale of consumer goods leads to the accumulation of stock of
consumer goods (or overproduction). This also has adverse effect on business expectations and
MEC.

(v) Rise in Rate of Interest:

The fall in the MEC is followed by a rise in demand for money or rise in liquidity preference
(i.e., the tendency of the people to keep money in cash form). No one likes to purchase goods
or securities when the prices are falling. Given the supply of money, increase in liquidity
preference results in the rise in the rate of interest which also reduces investment.

To sum up, according to Keynes, rising rate of interest, declining MEC, falling tendency of
consumption- all these factors lead to reduce aggregate demand which ultimately result in
deflationary conditions in the economy.

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2. Contractionary Monetary Policy:

When the government adopts a contractionary monetary policy, it makes the availability of
credit more costly by raising the rate of interest and reducing the supply of money. This results
in fall in prices. Various contractionary monetary measures are- raising the bank rate, sale of
government securities, raising the cash reserve ratio, reducing the currency, etc.

3. Reduction in Government Expenditure:

If the government decides to reduce public expenditure, it will reduce national income and
employment multiple times (through the adverse working of multiplier). This will reduce
aggregate demand, discourage investment and affect the economic activity of the economy
adversely.

4. Heavy Taxes:

Heavy taxes imposed by the government reduce the disposable income with the people.
This leads to the decline in both consumption and investment expenditure and results in
deflationary conditions.

5. Increasing Economic Inequalities:

Increasing inequalities of income and wealth make the rich more rich and the poor more poor.
Since the marginal propensity to consume (MPC) of the rich is less than that of the poor,
growing inequalities of income will reduce consumption expenditure and will lead to
deflationary situation.

6. Public Borrowing:

When the government borrows from the public, it results in the transfer of money from the
public to the government. This reduces aggregate demand and brings deflation in the economy.

7. Psychological Factors:

Some economists feel that deflation and depression are the result of waves of optimism and
pessimism. During the optimistic conditions of boom, they make over- investment. As a
consequence, they fail to find buyers for their products, suffer losses, grow pessimistic about

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the prospects of business and curtail their productive activities. Thus, the discovery of error of
optimism gives birth to the opposite error of pessimism.

8. Other Factors:

Some other non-economic and non-monetary factors, such as, wars, earth quakes, strikes, crop
failures, etc. may also cause deflationary conditions.

CONTROL OF INFLATION:

To fight deflation, attempts must be made to raise the volume of aggregate effective demand. It
will increase output, income and employment in the economy, Effective demand can be
increased partly by encouraging consumption expenditure and partly by increasing investment
expenditure.

Various measures can be taken to increase consumption and investment expenditures in the
economy:

1. Reduction in Taxation:

The government should reduce the number and burden of various taxes levied on
commodities. This will increase the purchasing power of the people. As a result, the demand
for goods and services will increase. Moreover, sufficient tax relief should be given to
businessmen to encourage investment.

2. Redistribution of Income:

Marginal propensity to consume can be raised by a redistribution of income and wealth from
the rich to the poor. Since the marginal propensity to consume of the poor is high and that of
the rich is low, such a measure will help increasing the aggregate demand in the economy.

3. Repayment of Public Debt:

During deflation period, the government can repay the old public debts. This will increase the
purchasing power of the people and push up effective demand.

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4. Subsidies:

The government should give subsidies to induce the businessmen to increase investment.

5. Public Works Programme:

The government should also directly undertake public works programme and thus increase
expenditure in public sector. Care should, however, be taken that the public works policy of
the government does not adversely affect investment in the private sector; it should
supplement, and not supplant, private investment.

For this, it is important that only those projects should be selected for the government’s public
works policies which are either too big or not so profitable to attract private investment.

6. Deficit Financing:

In order to have significant expansionary effects, the government’s public works schemes
should be financed by the method of deficit financing, i.e., by printing new money. The
government should adopt a budgetary deficit (excess of government expenditure over its
revenue) and cover this deficit through deficit financing.

Deficit financing makes available to the government sufficient resources for its developmental
programmes without adversely affecting investment in the private sector.

7. Reduction in Interest Rate:

By adopting a cheap money policy, the monetary authority of a country reduces the interest
rate which stimulates investment and thereby expands economic activity in the economy.

8. Credit Expansion:

The central bank and the commercial banks should adopt a policy of credit expansion to
promote business and industry in the country. Bank credit should be made easily available to
the entrepreneurs for productive purposes.

9. Foreign Trade Policy:

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To control deflation, the government should adopt such a foreign trade policy that, on the one
hand, increases exports, and, on the other hand, reduces imports. This kind of policy will go a
long way in solving the problem of overproduction, and help overcoming deflation.

10. Regulation of Production:

Production in the economy should be regulated in such a way that the problem of
over-production does not arise. Attempts should be made to adjust production with the existing
demand to avoid over-production.

In short, fiscal policy alone or monetary policy alone is not sufficient to check deflation in an
economy. A proper co- ordination of fiscal, monetary and other measures is essential to
effectively deal with the deflationary situation.

QUANTITY THEORY OF MONEY:

The classical theory of demand for money, popularly known as the Quantity
theory of Money (QTM), is basically is a theory of the price-level.

According to the quantity theory of money, if the amount of money in an economy doubles, all
else equal, price levels will also double. This means that the consumer will pay twice as much
for the same amount of goods and services. This increase in price levels will eventually result
in a rising inflation level; inflation is a measure of the rate of rising prices of goods and
services in an economy.

The same forces that influence the supply and demand of any commodity also influence the
supply and demand of money: an increase in the supply of money decreases the marginal value
of money–in other words, when the money supply increases, but with all else being equal or
ceteris paribus, the buying capacity of one unit of currency decreases. As a way of adjusting
for this decrease in money's marginal value, the prices of goods and services rises; this results
in a higher inflation level.

In its simplest form, it states that the general price level (P) in an economy is directly
dependent on the money supply (M);

P = f(M)

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If M doubles, P will double. If M is reduced to half, P will decline by the same amount. This is
the essence of the quantity theory of money. Though the theory was first stated in 1586, it
received its full-fledged popularity at the hands of Irving Fisher in 1911. Later, an alternative
approach was given by a group of Cambridge economists. However, the basic conclusion of
these two theories is same price level varies directly with and proportionally to money supply.

Assumptions:

The classical quantity theory of money is based on two fundamental assumptions: First is the
operation of Say’s Law of Market. Say’s law states that, “Supply creates its own demand.”
This means that the sum of values of all goods produced is equivalent to the sum of values of
all goods bought.

Thus, by definition, there cannot be deficiency of demand or under utilisation of resources.

There will always be full employment in the economy. Second is the assumption of full
employment that follows from the Say’s Law.

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There are two versions of the Quantity Theory of Money: (1) The Transaction Approach and
(2) The Cash Balance Approach.

The Transaction Approach:

Fisher’s transaction approach to the Quantity Theory of Money may be explained with the
following equation of exchange.

MV = PT

Where, M is the total supply of money

V is the velocity of circulation of money

P is the general price level

T is the total transactions in physical goods.

This equation is an identity, that is, a relationship that holds by definition. It means, in an
economy the total value of all goods sold during any period (PT) must be equal to the total
quantity of money spent during that period (MV). Fisher assumed that (1) at full employment
total physical transactions T in an economy will be a constant, and (2) the velocity of
circulation remain constant in the short run because it largely depends on the spending habits
of the people. When these two assumptions are made the Equation of Exchange becomes the
Quantity Theory of Money which shows that there is an exact, proportional relationship
between money supply and the price level. In other words, the level of prices in the economy
is directly proportional to the quantity of money in circulation. That is, doubling the total
supply of money would double the price level.

The Cash-Balance Approach:

The Cash-Balance Approach to the Quantity Theory of Money may be expressed as:

p = kR/M …………………………(1)

where p = the purchasing power of money

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k = the proportion of income that people like to hold in the form of money;

R = the volume of real income; and

M = the stock of supply of money in the country at a given time.

This equation shows that the purchasing power of money or the value of money (p) varies
directly with k or R, and inversely with M.

Since p is the reciprocal of the general price level; that is p = 1/P, the equation, p = kR/M can
be expressed alternatively as:

1/P = kR/M ……………………..........(2)

or M = kRP ………………………...(3)

If we multiply the volume of real income (R) by the general price level(P), we have the money
national income(Y). Therefore,

M = kY …………………………….........(4)

where Y is the country’s total money income. We can also write equation (3) in terms of the
general price level thus:

P = M/kR ………………………...........(5)

This equation implies that the price level (P) varies inversely with k or R and directly with M.

In the Cash Balance approach k was more significant than M for explaining changes in the
purchasing power (or value) of money. This means that the value of money depends upon the
demand of the people to hold money.

b) DEVELOPMENT OF COMMERCIAL BANKS IN INDIA:

The commercial banking industry in India started in 1786 with the establishment of the Bank
of Bengal in Calcutta. The Indian Government at the time established three Presidency banks,

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viz., the Bank of Bengal (established in 1809), the Bank of Bombay (established in 1840) and
the Bank of Madras (established in 1843). In 1921, the three Presidency banks were
amalgamated to form the Imperial Bank of India, which took up the role of a commercial bank,
a bankers’ bank and a banker to the Government. The Imperial Bank of India was
established with mainly European shareholders. It was only with the establishment of
Reserve Bank of India (RBI) as the central bank of the country in 1935, that the
quasi-central banking role of the Imperial Bank of India came to an end. In 1860, the
concept of limited liability was introduced in Indian banking, resulting in the
establishment of joint-stock banks. In 1865, the Allahabad Bank was established with purely
Indian shareholders. Punjab National Bank came into being in 1895.

Between 1906 and 1913, other banks like Bank of India, Central Bank of India, Bank of
Baroda, Canara Bank, Indian Bank, and Bank of Mysore were set up. After independence, the
Government of India started taking steps to encourage the spread of banking in India.
In order to serve the economy in general and the rural sector in particular, the All
India Rural Credit Survey Committee recommended the creation of a state-partnered and
state-sponsored bank taking over the Imperial Bank of India and integrating with it, the
former state-owned and state-associate banks. Accordingly, State Bank of India (SBI) was
constituted in 1955. Subsequently in 1959, the State Bank of India (subsidiary bank) Act was
passed, enabling the SBI to take over eight former state-associate banks as its subsidiaries.

One important feature of the reforms of the 1990s was that the entry of new private sector
banks was permitted. Following this decision, new banks such as ICICI Bank, HDFC Bank,
IDBI Bank and UTI Bank were set up. Commercial banks in India have traditionally focused
on meeting the short-term financial needs of industry, trade and agriculture. However,
given the increasing sophistication and diversification of the Indian economy, the range
of services extended by commercial banks has increased significantly, leading to an overlap
with the functions performed by other financial institutions. Further, the share of long-term

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financing (in total bank financing) to meet capital goods and project-financing needs of
industry has also increased over the years.

PROCESS OF MONEY CREATION/CREDIT

CREATION:
It is one of the most important activities of commercial banks. Through the process of money
creation, commercial banks are able to create credit.

This process can be better understood by making two assumptions:

i) the entire commercial banking system is one unit and is termed as ‘Banks’.
ii) all the receipts and payments in the economy are routed through Banks,i.e all payments are
made through cheques and all receipts are deposited in the banks.

The deposits held by Banks are used for giving loans. However, banks cannot use the whole of
deposit for lending. It is legally compulsory for the banks to keep a certain minimum fraction
of their deposits as reserves. This fraction is called the Legal Reserve Ratio (LRR) and is
fixed by the central bank. Banks do not keep 100% reserves against the deposits. They keep
only reserves to the extent indicated by the central bank.

Why only a fraction of deposits are kept as Cash Reserves?

Banks keep a fraction of deposits as Cash Reserves because a prudent banker, by his
experience, knows two things:

i) all the depositors do not approach the banks for withdrawal of money at the same time and
also they do not withdraw the entire amount in one go.
ii) there is a constant flow of new deposits into the banks.

So to meet the daily demand for withdrawal of cash, it is sufficient for banks to keep only a
fraction of deposits as cash reserve. It means, if experience of the banks show that withdrawals
are generally around 20% of the deposits,then it needs to keep only 20% of deposits as LRR.

Let us now understand the process of credit creation through an example:

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 ● Suppose, initial deposits in the Banks is 1000/- and LRR is 20%. It means, banks are
required to keep only 200/- as cash reserves and are free to lend 800/-. Suppose they lend
800/-. Banks do not lend this money by giving amount in cash. Rather, they open the
accounts in the names of borrowers, who are free to withdraw the amount whenever they
like.
● Suppose borrowers withdraw the entire amount of 800/- for making payments. As all the
transactions are routed through the banks, the money spent by the borrowers comes back
into the banks in the form of deposit accounts of those who have received this payment.
It will increase the demand deposits of banks by 800/-.
● With new deposits of 800/-, banks keep 20% as cash reserves and lend the balance 640/-.
Borrowers use these loans for making payments, which again comes back into the
accounts of those who have received the payments. This time the bank deposits rise by
640/-.
● The deposits keep on increasing in each round by 80% of the last round deposits. At the
same time, cash reserves also go on increasing, each time by 80% of the last cash
reserve. Deposit creation comes to an end when total cash reserves become equal to the
initial deposit.

5 rounds Deposits (rupees) Loans (rupees) Cash reserve

(LRR = 20%)
Initial deposit 1,000 800 200
Round I 800 640 160
Round II 640 512 128
… … … …
… … … …
… … … …
Total 5000 4000 1000

As seen in the table, banks are able to create total deposits of 5000/- with the initial deposit of
just 1000/-. It means, total deposits become five times of the initial deposit. Five times is
nothing but the value of Money Multiplier.
Money Multiplier:

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Money multiplier or deposit multiplier measures the amount of money that the banks are able
to create in the formof deposits with every unit of money it keeps as reserves. It is calculates
as:
Money Multiplier = 1/LRR

In the given example, LRR is 20% or 0.2. So,

Money Multiplier = 1/0.2 = 5.

It signifies that for every unit of money kept as reserves, banks are able to create 5 units of
money. The value of money multiplier is determined by LRR. Higher the value of LRR, lower
is the value of money multiplier and less money is created by the banking system.

Money creation by commercial banks raises the national income: commercial banks lend
money mainly to investors. The rise in investment in the economy leads to rise in National
Income through the multiplier effect.

RECENT REFORSM IN COMMERCIAL BANKING:

NATIONALISATION OF BANKS:
Nationalization refers to the transfer of public sector assets to be operated or owned by the
state or central government. In India, the banks which were previously functioning under the
private sector were transferred to the public sector by the act of nationalization and thus the
nationalized banks came into existence.

Reasons for the Nationalization of Banks

For Social Welfare

For Developing Banking Habits

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For Expansion of Banking Sector
For Controlling Private Monopolies
To Reduce Regional Imbalance
For Prioritizing Sector Lending
The government through the Banking Companies (Acquisition and Transfer of Undertakings)
Ordinance, 1969, and nationalized the 14 largest commercial banks on 19 July 1969. These
lenders held over 80 percent of bank deposits in the country. Soon, the parliament passed the
Banking Companies (Acquisition and Transfer of Undertaking) Bill, and it received
presidential approval on 9 August 1969.

The banks that were nationalized included Allahabad Bank, Bank of Baroda, Bank of India,
Bank of Maharashtra, Central Bank of India, Canara Bank, Dena Bank, Indian Bank, Indian
Overseas Bank, Punjab National Bank, Syndicate Bank, UCO Bank, Union Bank and United
Bank of India.

Thereafter, in 1980, six more banks that were nationalized included Punjab and Sind Bank,
Vijaya Bank, Oriental Bank of India, Corporate Bank, Andhra Bank, and New Bank of India.

c) THEORY OF CENTRAL BANKING:

OBJECTIVES AND METHODS OF CREDIT CONTROL:

Credit Control is a function performed by the Central Bank (Reserve Bank of India), to control
the credit, i.e. the demand and supply of money or say liquidity in the economy. With this
function, the central bank regulates the credit granted by the commercial banks to its
customers. It aims to achieve economic development with stability as well as to manage the
inflationary and deflationary pressure.

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It involves limiting the credit volume created by the commercial bank, regulating the credit
volume, directing credit to productive uses, and implementing measures that strengthen the
structure of banks.

Objectives:
To attain stability in the internal price level.
To obtain stability in the foreign exchange rates, which maintains the external value of the
currency.
To maintain stability in the money market through liquidity control measures.
To promote overall economic growth and development, by maximizing income, employment
and output.
To promote national interest.

Methods:
The methods can be classified into two - quantitative methods and qualitative methods.

Quantitative Methods:
Quantitative Methods of Credit Control are related to Quantity or Volume of Money and are
aimed at regulating the total volume of bank credit. These tools are indirect in nature and they
tend to influence the loanable funds of the commercial banks.

The total quantity of deposits created by the commercial banks is expected to be controlled and
adjusted using these methods. It maintains a balance between savings and investment.

1. Bank Rate ( or discount rate):

Bank rate is the rate at which the central bank of a country lends money to commercial
banks to meet their long term needs. RBI has been actively using Bank rate to control
credit. Bank rate has the same effect as that of Repo rate, i.e. an increase in Bank rate
increases the cost of borrowings from the central bank, which leads to an increase in

15
 lending rates by commercial banks. It discourages borrowers from taking loans, which
reduces the ability of commercial banks to create credit.

2. Open Market Operations:

OMO refers to buying and selling of government securities by the central bank from/to
the public and commercial banks. RBIis authorized to sell or purchase treasury bills and
government securities. It does not matter whether the securities are bought or sold to the
public or banks because ultimately the amounts will be deposited in or transferred from
some bank.

Sale of securities by central bank reduces the reserves of commercial banks. It adversely
affects the bank’s ability to create credit and therefore decreases the money supply in the
economy.

Purchase of securities by central bank increases the reserves and raises the bank’s ability
to give credit.

3. Legal Reserve Requirements (Variable Reserve Ratio Methods):

According to legal reserve requirements, commercial banks are required to maintain
reserves. It is a very quick and direct method for controlling the credit creating power of
commercial banks. Commercial banks are required to maintain reserves on two
accounts:
i) Cash Reserve Ratio (CRR):
It refers to the minimum percentage of net demand and time liabilities, to be kept by
commercial banks with the central bank. A change in CRR affects the ability of
commercial banks to create credit. For instance, an increase in CRR reduces the excess
reserves of the commercial banks and limits their credit creating power.

ii) Statutory Liquidity Ratio (SLR):

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 It refers to the minimum percentage of net demand and time liabilities which
commercial banks are required to maintain with themselves. SLR is maintained in the
form of designated liquid assets such as excess reserves, unencumbered,government and
other approved securities or current account balances with other banks. Change is SLR
affects the freedom of banks to sell government securities or borrow against them from
the Central bank. An increase in SLR reduces the ability of banks to give credit and
vice-versa.

Qualitative or Selective methods:

Qualitative Methods are used in addition to general credit control methods. there are a
number of situations wherein quantitative methods may not work effectively and may
cause harm to particular sectors. As the quantitative methods of credit control, control
the volume of credit, as a whole. So, there are chances that it may affect genuine
productive purposes.

In this way, the qualitative methods of credit control come into the picture, wherein the
credit is made available to productive and priority sectors, while the others are restricted.

1. Fixation of margin requirements:

In this technique, the central bank determines the margin which commercial banks and
financial institutions need to maintain for the amount extended by them in the form of
loans, against commodities, stocks and shares. The central bank also prescribes margin
requirements for the underlying securities, so as to restrict speculative dealing in stock
exchanges.

2. Credit Rationing:
As per this method, the central bank attempts to restrict the upper ceiling of loans and
advances to a particular sector. Moreover, in specific cases, the central bank may also fix

17
the ceiling for different categories of loans and advances. Also, commercial banks are
expected to stick to this limit. This facilitates the lessingt of bank credit exposure to
unwanted sectors.

3. Regulation of Consumer Credit:

With an aim of regulating consumer credit, the apex bank determines the down payments
and the length of the period over which installments are to be spread. At the time of
inflation, higher restrictions are levied to control the prices by controlling demands
whereas, at the time of depression, relaxations are provided so as to increase demand for
goods.

4. Control through directives:

In this technique, the central bank issues directives from time to time so as to regulate
the credit created by the commercial banks. These can be written orders, warnings,
notices, or appeals.

It can help in regulating lending policies of the commercial banks or to fix a maximum
limit of credit for specific purposes and also to restrain the flow of bank credit into
non-essential lines. It may result in diverting the credit to productive use.

5. Moral Suasion:
As per this method, the Reserve Bank of India exercises a moral influence on the
commercial banks, in the form of advice, suggestion, guidelines, directives, request, and
persuasion.

This is to ensure cooperation from the central bank. However, if the commercial bank
does not comply with the advice extended by RBI, then they are not subject to any penal
action. The success of this method mainly relies on the cooperation between the two
banks i.e. central and commercial. It is helpful in limiting credit at the time of inflation
in the economy.

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6. Publicity:
As per this method, the central bank publishes numerous reports in the form of bulletins, to
state the good and the bad in the system, as well as to educate people about its view regarding
credit expansion and contraction. This can help in informing the commercial bank to direct the
supply of credit in the desired sectors.

In this way, the commercial banks get guidance from the Central bank and can modify their
lending policies accordingly.

7. Direct Action:
This technique is used by the central bank to enforce both quantitative and qualitative
methods, and used as an adjunct to other methods. Further, the apex bank is authorized to take
action against those banks which do not comply with the instructions extended or directives as
well as it may refuse to rediscount their bills of exchange and commercial papers.

Also, RBI can refuse to supply credit to these banks, whose borrowings are greater than their
capital. Even, the central bank is authorized to put a ban on a particular bank, if they do not
adhere to the directives.

MONEY MARKET AND CAPITAL MARKET:

Money Market;
The Money Market is a market for lending and borrowing of short-term funds. It deals in funds
and financial instruments having a maturity period of one day to one year. It covers money and
financial assets that are close substitutes for money. The instruments in the money market are
of short term nature and highly liquid.

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Structure or components of Indian money market:

(A) Organized Money Market Instruments and Features

1. Call and Notice Money Market: Under call money market, funds are transacted on
overnight basis. Under notice money market funds are transacted for the period between 2
days and 14 days. The funds lent in the notice money market do not have a specified
repayment date when the deal is made. The lender issues a notice to the borrower 2-3 days
before the funds are to be paid. On receipt of this notice, the borrower will have to repay the
funds within the given time. Generally, banks rely on the call money market where they raise
funds for a single day. The main participants in the call money market are commercial banks
(excluding RRBs), cooperative banks and primary dealers. Discount and Finance House of
India (DFHI), Non-banking financial institutions such as LIC, GIC, UTI, NABARD etc. are
allowed to participate in the call money market as lenders.

2. Treasury Bills (T-Bills): Treasury bills are short-term securities issued by RBI on behalf of
Government of India. They are the main instruments of short term borrowing by the
Government. They are useful in managing short-term liquidity. At present, the Government of
India issues three types of treasury bills through auctions, namely – 91 days, 182-day and
364-day treasury bills. There are no treasury bills issued by state governments. With the
introduction of the auction system, interest rates on all types of TBs are being determined by
the market forces.

3. Commercial Bills: Commercial bill is a short-term, negotiable, and self-liquidating

instrument with low risk. They are negotiable instruments drawn by a seller on the buyer for
the value of goods delivered by him. Such bills are called trade bills. When trade bills are
accepted by commercial banks, they are called commercial bills. If the seller gives some time
for payment, the bill is payable at future date (i.e. usance bill). Generally the maturity period is
upto 90 days. During the usance period, if the seller is in need of funds, he may approach his
bank for discounting the bill.

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Commercial banks can provide credit to customers by discounting commercial bills. The banks
can rediscount the commercial bills any number of times during the usance period of bill and
get money.

4. Certificates of Deposits (CDs): CDs are unsecured, negotiable promissory notes issued at a
discount to the face value. They are issued by commercial banks and development financial
institutions. CDs are marketable receipts of funds deposited in a bank for a fixed period at a
specified rate of interest. CDs were introduced in India in June 1989. The main purpose of the
scheme was to enable commercial banks to raise funds from the market through CDs.
According to the original scheme, CDs were issued in multiples of Rs.25 lakh subject to
minimum size of an issue being Rs.1 crore. They had the maturity period of 3 months to one
year. They are freely transferable but only after the lock in period of 45 days after the date of
issue.

5. Commercial Papers (CPs): Commercial Paper (CP) is an unsecured money market

instrument issued in the form of a promissory note with fixed maturity. They indicate the
short-term obligation of an issuer. They are quite safe and highly liquid. They are generally
issued by the leading, nationally reputed, highly rates and credit worthy large manufacturing
and finance companies is the public as well as private sector. CPs were introduced in India
January 1990. CPs were launched in India with a view to enable highly rated corporate
borrowers to diversify their sources of short-term borrowings and also to provide an additional
instrument to investors. RBI has modified its original scheme in order to widen the market for
CPs.
Corporates and primary dealers (PDs) and the all India financial institutions can issue CPs. A
corporate can issue CPs provided they fulfill the following conditions:
(a) The tangible net worth of the company is not less than Rs.4 crore.
(b) The company has been sanctioned working capital limit by banks or all India financial
institutions, and

21
(c) The borrowed account of the company is classified as a standard asset by the financing
institution or bank.

6. Repos: A repo or reverse repo is a transaction in which two parties agree to sell and
repurchase the same security. Under repo, the seller gets immediate funds by selling specified
securities with an agreement to repurchase the same at a mutually decided future date and
price. Similarly, the buyer purchases the securities with an agreement to resell the same to the
seller at an agreed date and price. The repos in government securities were first introduced in
India since December 1992. Since November 1996, RBI has introduced “Reverse Repos”, i.e.
to sell government securities through auction.
7. Discount and Finance House of India (DFHI): It was set up by RBI in April 1988 with
the objective of deepening and activating money market. It is jointly owned by RBI, public
sector banks and all India financial institutions which have contributed to its paid up capital.
The DFHI deals in treasury bills, commercial bills, CDs, CPs, short-term deposits, call money
market and government securities. The presence of DFHI as an intermediary in the money
market has helped the corporate entities, banks, and financial institutions to invest their
short-term surpluses in money market instruments.

8. Money Market Mutual Funds (MMMFs): RBI introduced MMMFs in April 1992 to
enable small investors to participate in the money market. MMMFs mobilizes savings from
small investors and invest them in short-term debt instruments or money market instruments
such as call money, repos, treasury bills, CDs and CPs. These instruments are forms of debt
that mature in less than a year.

(B) UNORGANIZED SECTOR OF INDIAN MONEY MARKET

The unorganized Indian money market is largely made up of indigenous bankers, money
lenders and unregulated non-bank financial intermediaries. They do operate in urban centers
but their activities are largely confined to the rural sector. This market is unorganized because
it’s activities are not systematically coordinated by the RBI.

22
The main components of unorganized money market are:

1. Indigenous Bankers:
They are financial intermediaries which operate as banks, receive deposits and give loans and
deals in hundies. The hundi is a short term credit instrument. It is the indigenous bill of
exchange. The rate of interest differs from one market to another and from one bank to
another. They do not depend on deposits entirely, they may use their own funds.

2. Money Lenders:
They are those whose primary business is money lending. Money lenders predominate in
villages. However, they are also found in urban areas. Interest rates are generally high. Large
amount of loans are given for unproductive purposes. The borrowers are generally
agricultural labourers, marginal and small farmers, artisans, factory workers, small traders, etc.

3. Unregulated non-bank Financial Intermediaries:

Theconsist of Chit Funds, Nithis, Loan companies and others.
(a) Chit Funds: They are saving institutions. The members make regular contribution to the
fund. The collected funds is given to some member based on previously agreed criterion (by
bids or by draws). Chit Fund is more famous in Kerala and Tamilnadu.

(b) Nidhis: They deal with members and act as mutual benefit funds. The deposits from the
members are the major source of funds and they make loans to members at reasonable rate of
interest for the purposes like house construction or repairs. They are highly localized and
peculiar to South India. Both chit funds and Nidhis are unregulated.

4. Finance Brokers:
They are found in all major urban markets specially in cloth markets, grain markets and
commodity markets. They are middlemen between lenders and borrowers.

23
Capital Markets:
Capital market is the market for medium and long term funds. It refers to all the facilities and
the institutional arrangements for borrowing and lending term funds (medium-term and
long-term funds). The demand for long-term funds comes mainly from industry, trade,
agriculture and government. The central and state governments invest not only on economic
overheads such as transport, irrigation, and power supply but also an basic and consumer
goods industries and hence require large sums from capital market. The supply of funds comes
largely from individual savers, corporate savings, banks, insurance companies, specialized
financial institutions and government.

Structure/composition of capital market:

(1) Gilt- Edged Market:

Gilt-edged market is also known as the government securities market. As the securities are risk
free, they are known as gilt-edged i.e. the best quality securities. The investors in the
gilt-edged market are predominantly institutions. They are required by law to invest a certain
portion of their funds in these securities. These institutions include commercial banks, LIC,
GIC, and the provident funds. The transactions in the government securities market are very
large. Each transaction may run into several crores or even hundred crores of rupees. Since
June 1992, government securities have been mostly issued sealed bid auctions. RBI plays a
dominant role in the gilt-edged market through its open market operations. Thus, government
securities are the most liquid debt instruments.

(2) The Industrial Securities Market:

It is a market of shares, debentures and bonds which can be bought and sold freely. This
market is divided into two categories:
(A) Primary Market:
The new issue market called the primary market and (b) old issue market, commonly known as

24
stock exchange or stock market. It is called the secondary market. The new issue market is
concerned with the raising of new capital in the form of shares, bonds and debentures. Many
public limited companies often raise capital through the primary market for expanding their
business. It may be noted that the new issue market is important because of its impact on
economic growth of the country.
(B) Secondary Market:
The stock exchange market or the secondary market is a market of the purchase and sale of
quoted or listed securities. It is a highly organized market for regulating and controlling
business in buying, selling and dealing in securities.

(3) Financial Institutions:

We have mentioned that there are special financial institutions which provide long-term capital
to the private sector in the capital market. These institutions are called Development Financial
Institutions.

(4) Financial Intermediaries:

The Indian capital market has shown steady improvement after 1951. During the Five-Year
Plans, the Capital market has witnessed rapid growth. Both the volume of saving and
investment have shown phenomenal improvement. In fact, in the last two decades, the volume
of capital market transactions has increased substantially. Besides, its functioning has been
diversified indicating the growth of the Indian economy.

25
 MODULE - II
a) Meaning and scope of public finance:
Meaning:

Public finance deals with the income and expenditure of public authorities. It include
all sorts of governments. That is, it deals with finance of the Government- Central, state and
Local. It also deals with the problems of adjustments of income and expenditure of the
Government.

According to Prof. Dalton, “It is concerned with the income and expenditure of public
authorities and with the adjustments of one to another”.

According to Adam Smith “Public finance is an investigation into the nature and
principles of state revenue and expenditure”.

Scope of Public Finance:

a) Stabilization of Prices:
Public finance avoids fluctuations and maintains stability in the prices of goods and
services. The government uses this tool for monitoring inflation and deflation like situations in
country. During the time of deflation, government reduces the prices of goods for increasing
demand by cutting down their tax rate. Whereas during inflation, the government raises capital
expenditure and tax rate.

b) Equal Distribution of Wealth:

It helps in equal distribution of income and wealth among people in an economy.
Inequalities in income and wealth distribution is one of the serious problems faced by
underdeveloped countries. Rich persons receive more and more but poor are not even getting

26
enough to fulfill their basic needs. Therefore to overcome this issue the government is required
to spend on development activities for poor peoples.

c) Economic Stability:
Stabilization of a country's economy is another important role played by public finance.
The government uses taxation as a tool to control and improve the economic conditions. When
an economy faces prosperity and people have more funds in their hands, it increases the tax
rate. On the other hand, it reduces the tax rate to bring up the demand during the deflation
Period.

d) Proper Allocation of Resources:

Efficient allocation of resources is a must for the growth of every economy. Public
finance supports the government for optimum utilization of all-natural and man-made
resources. The government may impose lower tax rates or even provide subsidies on highly
desirable goods. Whereas, on goods which are less demandable government may impose a
higher tax rate.

e) Encourages Savings and Investment:

Public finance is a tool that helps the government in motivating its people for saving
and investment habits. People are generally not able to save their income due to large spending
on consumption activities leading to low or zero investment. Government by decreasing the
tax rates and giving some relief on goods prices can encourage people for saving and
investment activities.

f) Promote Exports:
Export of goods and services is essential for earning sufficient foreign exchange for every
country. Public finance assists the government in promoting exports and disfavouring of
imports in an economy. Goods to be exported are imposed to lower tax rate or even exempted
from the tax category. Whereas, imports of goods are restricted by charging higher tax rates on

27
Them.

g) Develops Infrastructure Facilities:

Infrastructural development in a country requires the huge costs to be incurred by the
government. Public fiancé raises sufficient funds for the government for meeting these
expenses. It enables in providing better and well maintained public amenities such as hospitals,
roads, railways, educational facilities, etc.

THE PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE

The principle of Maximum social advantage is the ‘Principle of Public Finance’. It is the
fundamental principle which determines fiscal operations of the government. This principle
was formulated and popularised by Dr. Dalton and Prof. Pigou. Dr. Dalton called it ‘The
Principle of Maximum Social Advantage’ and Prof. Pigou described it as ‘The Principle
of Maximum Aggregate Welfare’. The principle provides guidance to the Govt. regarding
public revenue and public expenditure or public finance operations so as to maximise
social advantage or welfare.

Modern states are welfare states whose main objective is to ensure maximum social welfare
for the people. The fiscal operations of the government have significant effect on the
economy as a whole. Government collects revenue through taxation and public expenditure
brings out changes in consumption, production and distribution of national income. Public
finance plays a key role in the determination of national income, employment, output and
other parameters in the economy. Thus, it is desirable that some criterion or principle must
guide operations of the government. This guiding principle has been technically called the
principle of maximum social advantage or principle of public finance. The principle of public
finance has been named differently by different economists. Prof. Dalton has named it as

28
‘Principle of Maximum Social Advantage’ while Pigou calls it as ‘Principle of Maximum
Aggregate welfare’.

The optimum financial activities of a state should, therefore, be determined by the principle of
maximum social advantage. It is obvious that taxation by itself is a loss of utility to the people,
while public expenditure by itself is a gain of utility to the community. When the state imposes
taxes, some disutility or dissatisfaction is experienced in society. This disutility is in the form
of sacrifice involved in the payment of taxes — in parting with the purchasing power.
As such, the maximum social advantage is achieved when the state in its financial activities
maximise the surplus of social gain or utility (resulting from public expenditure) over the
social sacrifice or disutility (involved in payment of taxes.)

The principle of maximum social advantage implies that public expenditure is

subject to diminishing marginal social benefits and taxes are subject to increasing
marginal social costs. So it is necessary to get an equilibrium position where
marginal social benefits of public expenditures are equal to the marginal social
sacrifice of taxation to maximise social advantage. According to Dalton “Public
expenditure in every direction should be carried just so far, that the advantages to
the community of a further small increase in any direction is just counterbalanced
by the disadvantage of a corresponding small increase in taxation or in receipts
from any other sources of public expenditure and public income.”

This principle is however based on the following assumptions:

1. All taxes result in sacrifice and all public expenditures lead to benefits.
2. Public revenue consists of only taxes and no other sources of income to the government.
3. The government has no surplus or deficit budget but only a balanced budget.
4. Public expenditure is subject to diminishing marginal social benefit and taxes are subject to
increasing marginal social sacrifice.

29
The 'Principle of Maximum Social Advantage (MSA)' is the fundamental principle of Public
Finance. The Principle of Maximum Social Advantage states that public finance leads to
economic welfare when public expenditure & taxation are carried out up to that point where
the benefits derived from the MU (Marginal Utility) of expenditure is equal to the Marginal
Disutility or the sacrifice imposed by taxation. Hugh Dalton explains the principle of
maximum social advantage with reference to Marginal Social Sacrifice and Marginal Social
Benefits:

Marginal Social Sacrifice (MSS):

Marginal Social Sacrifice (MSS) refers to the amount of social sacrifice undergone by the
public due to the imposition of an additional unit of tax. Every unit of tax imposed by the
government taxes result in loss of utility. Dalton says that the additional burden (marginal
sacrifice) resulting from additional units of taxation goes on increasing i.e. the total social
sacrifice increases at an increasing rate. This is because, when taxes are imposed, the stock of
money with the community diminishes. As a result of diminishing stock of money, the
marginal utility of money goes on increasing. Eventually every additional unit of taxation
creates a greater amount of impact and greater amount of sacrifice on the society. That is why
the marginal social sacrifice goes on increasing. We can see the Marginal social sacrifice in the
following diagram:

30
The above diagram indicates that the Marginal Social Sacrifice (MSS) curve rises upwards
from left to right. This indicates that with each additional unit of taxation, the level of sacrifice
also increases. When the unit of taxation was OM1, the marginal social sacrifice was OS1, and
with the increase in taxation at OM2, the marginal social sacrifice rises to OS2 and so on.

Marginal Social Benefit (MSB):

While imposition of tax puts burden on the people, public expenditure confers benefits. The
benefit conferred on the society, by an additional unit of public expenditure is known as
Marginal Social Benefit (MSB). Just as the marginal utility from a commodity to a consumer
declines as more and more units of the commodity are made available to him, the social
benefit from each additional unit of public expenditure declines as more and more units of
public expenditure are spent. In the beginning, the units of public expenditure are spent on
the most essential social activities. Subsequent doses of public expenditure are spent on less
and less important social activities. As a result, the curve of marginal social benefits slopes
downward from left to right as shown in figure below:

31
In the above diagram, the marginal social benefit (MSB) curve slopes downward from left to
right. This indicates that the social benefit derived out of public expenditure is reducing at a
diminishing rate. When the public expenditure was OM1, the marginal social benefit was OB1,
and when the public expenditure is OM2, the marginal social benefit is reduced at OB2 and so
on.

The Point of Maximum Social Advantage:

Social advantage is maximised at the point where marginal social sacrifice cuts the marginal
social benefits curve. In the diagram, the marginal disutility or social sacrifice is equal to the
marginal utility or social benefit at the point P. Beyond this point, the marginal disutility or
social sacrifice will be higher, and the marginal utility or social benefit will be lower.

At point P social advantage is maximum. If we consider Point P1, at this point marginal social
benefit is P1Q1. This is greater than marginal social sacrifice S1Q1. Since the marginal social
sacrifice is lower than the marginal social benefit, it makes more sense to increase the level of
taxation and public expenditure. This is due to the fact that additional units of revenue raised
and spent by the government leads to increase in the net social advantage. This situation of

32
increasing taxation and public expenditure continues, as long as the levels of taxation and
expenditure are towards the left of the point P. At point P, the units of taxation and public
expenditure moves up to OQ, the marginal utility or social benefit becomes equal to marginal
disutility or social sacrifice at this point. Therefore at this point, the maximum social
advantage is achieved. If we moved forward to OQ levels of units, the marginal social sacrifice
S2Q2 is greater than marginal social benefit P2Q2. Therefore, beyond the point P, any further
increase in the level of taxation and public expenditure may bring down the social advantage.
This is because; each subsequent unit of additional taxation will increase the marginal
disutility or social sacrifice, which will be more than marginal utility or social benefit. This
shows that maximum social advantage is attained only at point P & this is the point where
marginal social benefit of public expenditure is equal to the marginal social sacrifice of
taxation.

The principle of maximum social advantage has been criticized on various

grounds. The main practical difficulties are as follows:

( i) Difficulties in Measuring Social Benefits:

The principle of maximum social advantage is theoretically explained with the help of the
marginal utility analysis. The Marginal benefits of public expenditure and the marginal
disutility on sacrifice of public revenue are concepts, the objective measurement of which is
extremely difficult.

(ii) Unrealistic Assumptions:

It is unrealistic to assume that government expenditure is always beneficial and that every tax
is a burden to society. For example, taxes on cigarettes or alcohol can provide benefit to
society; expenditure on social overheads like health care will give rise to social benefit
whereas unnecessary increase in expenditure on defence may divert resource from
productive activities causing loss of welfare to society.

33
(iii) Neglect of Non – Tax Revenue:
The principle says that the entire public expenditure is financed by taxation. But, in practice, a
significant portion of public expenditure is also financed by other sources like public
borrowing, profits from public sector enterprises, imposition of fees, penalties etc. Dalton fails
to take into account all such other sources.

(iv) Lack of divisibility:

The marginal benefit from public expenditure and marginal sacrifice from taxation can be
equated only when public expenditure and taxation are divided into smaller units. But it is not
possible practically.

(v) Large Budget Size:

The financial operations of the government involve collection of large sums of money from
taxation and other sources and the disbursement of large amounts by way of public
expenditure. The effects of small additional amounts of these on the community are difficult to
measure. Therefore, in practice, the public authorities are not in a position to estimate the
marginal benefits and the marginal sacrifice.

(vi) Change in Condition:

Conditions in an economy are not static and are continuously changing. What might be
considered as the point of maximum social advantage under some conditions may not be so
under some others. For example, in times of war government expenditure and revenue must
increase, and the increase is to the advantage of the community. What is optimum at one level
of national income may not be so at a higher level. Therefore, it is difficult to determine the
point of maximum social advantage.

(vii) Different Periods:

The impact of many public projects is felt over the long period by both the present and the
future generations. In order to determine maximum social advantage it becomes necessary

34
to calculate social benefits from public expenditure in a short period and in a long period.

(viii) Conceptual differences:

Taxes are paid by individuals and the sacrifice involved is felt at an individual or micro level.
Whereas, all the people are jointly benefited at macro level through public expenditure in a
community. Many economists argue that it is neither possible nor desirable to compare micro
and macro concepts by using the same criteria.

(ix) Misuse of Government Funds:

The principle of Maximum social advantage is based on the assumption that the government
funds are utilised in the most effective manner to generate marginal social benefit. However,
quite often a large share of government funds is misused for unproductive purposes which do
not provide any social benefits.

(x) Contra – Cyclical Measures:

The Government has to undertake contra – cyclical measures to Control inflation, Overcome
recession, Reduce increasing level of unemployment, etc. In such a situation, the concept of
Maximum social advantage cannot be adopted. For instance, to control recession, the
government may introduce certain measures such as reduction in taxation in order to increase
effective demand. Also, during inflationary periods, the government may increase tax rate in
order to reduce demand and increase interest rates, so as to encourage savings on the part of
people.

b) DIFFERENT SOURCES OF PUBLIC REVENUE:

Public Revenue is an important concept of Public Finance. It refers to the income of the
Government from different sources. Dalton in his “Principles of Public Finance”
mentioned two kinds of public revenue. Public revenue includes income from taxes and
goods and services of public enterprises, revenue from administrative activities such as

35
fees, fines etc. and gifts and grants. On the other hand public receipts include all the
incomes of the government received from formal sources.

Sources of Public Revenue:

A. Tax Revenue:
Taxes are the first and foremost sources of public revenue. Taxes are compulsory
payments to the government without expecting direct benefit or return by the
tax-payer. Taxes collected by the Government are used to provide common
benefits to all. Taxes do not guarantee any direct benefit for the person who pays
the tax. It is not based on “quid pro quo principle.”The Tax has been divided into
two types such as Direct Taxes and Indirect Taxes:

1. Direct Taxes:
i) personal income tax:
is a tax imposed on the excess income earned by an individual over and
above the limit decided by the finance ministry form time to time. It is
progressive in nature.

ii) corporate tax:

s a tax levied on the profits earned by registered companies.

iii) capital gains tax:

is a tax imposed on the net profits earned through capital investment in stock
market ,Real estate, Gold and Jewelry etc.

iv) wealth tax or property tax:

is a tax levied upon the property owned by individuals. The property
includes Land, Building, shares, Bonds, Fixed Deposits, Gold and Jewelry
etc.

36
 v) other taxes:
These taxes include taxes like Gift tax and Estate duty.

2. Indirect Taxes:
Indirect taxes are those taxes which are imposed on one group of people, but
the ultimate burden will fall on another group of people. The impact of tax
and incidence of tax are on different people. In case of Indirect taxes tax
burden can be shifted. There are middlemen between the Government
and the taxpayer. The important Indirect Taxes are as follows:

i) Excise Duty:
is a tax imposed on the manufacturers as per the value of goods produced
but the ultimate burden will fall on the final consumers.

ii) Customs Duty:

is a tax imposed on import and export of Goods. Customs duty may be
specific or ad valorem. Ad Valorem duty is a tax imposed on the basis the
value of goods imported while specific duty is imposed as per the number of
units imported.

iii) Value Added Tax (VAT):

is a part of a sales tax imposed by the state government.

iv) Sales Tax:

revenue goes to the state government when sale or purchase takes place
within the tate. Sales tax revenue on interstate transactions goes to the
central government.

v) Service Tax:

37
 is tax imposed on services provided. The impact is on the service provider
and the incidence of tax false on the customers. Service tax is the fastest
growing tax in India.

vi) Octroi:
Is a tax levied on transfer of goods from one state to another or from one
region to another.

B. Non-Tax Revenue:
1) Grants:
are made by a higher public authority to a lower one, for example, from the Central to
the State government or from the State to the local government. Grants are given so that a
public authority is able to perform certain activities at the local level. There is no repayment
obligation in case of grants.

2) Gifts:
Gifts and donations are voluntarily made by individuals, organizations, foreign governments to
the funds of the government, e.g. Prime Minister’s Relief Fund. Such gifts are usually made at
the time of crisis like war or floods. Gifts cannot be considered a regular source of revenue.

3) Fees:
Fees are an important source of administrative non-tax revenue to the government.The
government provides certain services and charges, certain fees for them. For example, fees are
charged for issuing of passports, granting licenses to telecom companies, driving licenses etc.

4) Fines and Penalties:

Another source of administrative non-tax revenue includes fines and penalties. They are
imposed as a form of punishment for breaking law or non-fulfillment of certain conditions or

38
for failure to observe some regulations. They are not expected to be a major source of revenue
to the government.

5) Special Assessment:
It is a kind of special charge levied on certain members of the community who are
beneficiaries of certain government activities or public projects. For example, due to public
park in a locality or due to the construction of a road, people in the locality may experience an
appreciation in the value of their property or land.

6) Surpluses of Public Enterprises:

Most countries have government departments and public sector enterprises involved in
commercial activities. The surpluses of these departments and enterprises are an important
source of non-tax revenue. These revenues are in the form of profits and interests and are
termed as commercial revenues.

7) Borrowings:
When government revenue is not sufficient to meet the public expenditure government
borrows either from internal or external sources. Borrowing is income of the government
which creates liability because the government has to repay the borrowings with interest.

PRINCIPLES OF TAXATION:
(a) The Benefit Principle:

This principle recognizes that the purpose of taxation is to pay for government services.
Therefore, those who gain the most from government services should pay the most. If the
government follows the benefit principle of taxation it must estimate how much various
individuals and groups benefit and set taxes accordingly.

39
The Benefit Principle simply holds that different individuals should be taxed in proportion to
the benefit they receive from government programmes. Just as people pay money in proportion
to their consumption of private bread, a person’s taxes’ should be related to his (or her) use of
collective goods like public roads or parks. Those who receive numerous benefits should pay
more than those who receive few.

However, this principle is difficult to apply in practice and it is normally observed that those
who receive the maximum benefit from public expenditure pay very little — if any — tax. So
another principle of taxation has been developed.

(b) The Ability-to-pay Principle:

It is the principle that states that individuals should pay taxes according to their ability to pay.
If the government sets taxes according to this benefit principle it does not redistribute income.
But if it sets taxes according to ability to pay, the rich should pay more than the poor. The
ability-to-pay principle simply states that the amount of taxes people pay should relate to their
income or wealth.

The higher the wealth or income, the higher the taxes. Usually tax systems organized along the
ability-to-pay principle are also redistributive, meaning that they raise funds from
higher-income people to increase the incomes’ and consumption of poorer groups. An
individual who earns Rs. 50,000 per month is able to pay more taxes than an individual who
earns Rs. 2,500 per month.

If the government levies a progressive tax on income and wealth and, at the same time,
provides assistance to poor people, it would substantially redistribute income from the rich to
the poor.

40
However, this principle may be simple to state but it is not easy to implement. The government
levies many taxes and most of these are proportional or even regressive. Overall high income
groups pay only a slightly higher percentage of their incomes in taxes than do low income
groups. It is on the expenditure side the government has its greatest effect in redistributing
income.

Conclusion:
The basic object of taxation should be to ensure equality or fairness. This is of two types —
horizontal and vertical. The former refers to the rule of taxation whereby equal income is taxed
equally — no matter how it is earned.

According to the latter the rule of taxation should be such as unequal income is treated
unequally — perhaps according to the ability to pay or to the benefits received. If the
government is to achieve equity, a tax system should have certain desirable characteristics —
known as the canons of simplicity, convenience, productivity and so on. Most tax systems are
based on a realistic compromise among different principles and canons.

Canons of Taxation:
Tax is levied compulsorily in order to defray the expenses of the government. In the opinion of
economists, collection of taxes should be based upon some principles or canons. These are
also known as the qualities of a good tax system.

Adam Smith laid down the following canons of taxation:

1. Canon of Ability:
The State is necessary for all—rich and poor. Without the State, nobody’s life or property is
safe. So everyone is required to pay taxes to meet the expenses of the State. But a person who
earns Rs. 50,000 a year has not the same taxable capacity as the person who earns Rs. 10,000 a
year. The canon of ability states that a person should be made to pay taxes according to his

41
ability to pay. If everyone pays according to his ability, there is equality of sacrifice. So this
rule of Adam Smith is also known as the canon of equity.

2. Canon of Certainty:
The principle of certainty requires that the tax which every individual has to pay should be
certain and not arbitrary. “The time of payment, the amount to be paid ought all to be clear and
plain to the contributor and to every other person.”

3. Canon of Convenience:
The time and manner of tax payments should be made as convenient to tax-payers as possible.
The Pay- As-You-Earn (PAYE) method of collecting personal taxation under which an
employer deducts tax on behalf of employees and pays it to the Finance Department is a good
example of this quality. For this reason, the salaried persons are taxed at the source, that is at
the source of income.

Some taxes are collected by installments so as to make it convenient for the tax-payer to make
the payment in small amounts. On the other hand, self-employed people and companies have
to put aside money reserves to pay the tax when they are assessed.

4. Canon of Economy:
According to Smith again — “every tax ought to be so contrived as both to take out and to
keep out of the pockets of the people as little as possible over and above what it brings into the
public treasury of the State.” A tax whose collection involves high expenditure should be
avoided. Taxes should be levied in such a way as to minimize the cost of collection in terms of
resources collected. In modern times two other canons of taxation are also recognized as
beneficial.

5. Canon of Elasticity:

42
A tax should be sufficiently elastic in yield. The amount of tax ought to be so contrived that it
can be varied according to the needs of the government. For instance, the rate of income tax is
variable. In modern times, all taxes and their rates can be varied.

The rate of income tax is liable to be changed according to the changes in the level of income
of the people. The land revenue is, however, fixed for a period. It is not liable to be changed as
is possible in the case of income tax. In case of crop failure, the government can, of course,
grant remission.

6. Canon of Productivity:
All taxes should be productive. It is better not to impose a tax whose yield is negligible. The
canon of productivity implies that taxes should be imposed in such a manner as not to hamper
production or to decrease the volume of resources collected. In other words, the levy of a tax
should not only increase the income of the State, it must not also destroy the incentives of the
people to undertake productive enterprises.

These canons of taxation are regarded as characteristics of a good tax system. However, most
of these characteristics are not present in India. Firstly, the Indian tax system is regressive in
nature. The major portion of the Government of India’s revenue is derived from indirect taxes.
Such taxes are usually imposed on consumption spending. Poor people spend the major
portion of their income on consumption goods and, thus, they pay the major portion of taxes.

The Indian tax system is not equitable either. It creates inequality. Since the poor people pay
the major portion of indirect taxes there is more and more inequality in the distribution of
income. The Indian tax system is not productive either. Although the rate of income tax in
India is very high the collection from such tax is very low.

43
Moreover, the Indian tax system is not simple. It is very complicated. There is not only tax on
finished goods that we buy but also on raw materials and intermediate goods. So indirect taxes
cause inflation from the supply side by creating cost-push pressures.

PUBLIC EXPENDITURE AND CAUSES OF ITS

INCREASE:
Expenses incurred by the public authorities—central, state and local self- governments—are
called public expenditure. Such expenditures are made for the maintenance of the governments
as well as for the benefit of the society as whole.

As a modern state is termed a ‘welfare state’, the horizon of activities of the government has
expanded in length and breadth. Now we can point out the reasons for enormous increase in
public expenditure throughout the world even in the capitalist countries where laissez-faire
principle operates. These are the following.

Causes of its increase:

(a) Size of the Country and Population:
We see an expansion of geographical area of almost all countries. Even in no-man’s land one
finds the activities of the modern government.

Assuming a fixed size of a country, developing world has seen an enormous increase in
population growth. Consequently, the expansion in administrative activities of the government
(like defence, police, and judiciary) has resulted in a growth of public expenditures in these
areas.

(b) Defence Expenditure:

The tremendous growth of public expenditure can be attributed to threats of war. No great war
has been conducted in the second half of the twentieth century. But the threats of war have not

44
vanished; rather it looms large. Thus, mere sovereignty, demands a larger allocation of
financial sources for defence preparedness.

(c) Welfare State:

The 19th century state was a ‘police state’ while, in 20th and 21st centuries modern state is a
‘welfare state’. Even in a capitalist framework, socialistic principles are not altogether
discarded. Since socialistic principles are respected here, modern governments have come out
openly for socio-economic uplift of the masses.

Various socio-economic programmes are undertaken to promote people’s welfare. Modern

governments spend huge money for the purpose of economic development. It plays an active
role in the production of goods and services. Such investment is financed by the government.

Besides development activities, welfare activities have grown tremendously. It spends money
for providing various social security benefits. Social sectors like health, education, etc., receive
a special treatment under the government patronage. It builds up not only social infrastructure
but also economic infrastructure in the form of transport, electricity, etc.

Provision of all these require huge finance. Since a hefty sum is required for financing these
activities, modern governments are the only providers of money. However, various welfare
activities of the government are largely shaped and influenced by the political leaders
(Ministers, MPs, and MLAs to have a political mileage, as well as by the bureaucrats
(MPLAD)).

(d) Economic Development:

Modern government has a great role to play in shaping an economy. Private capitalists are
utterly incapable of financing economic development of a country. This incapacity of the
private sector has prompted modern governments to invest in various sectors so that economic
development occurs.

45
Economic development is largely conditioned by the availability of economic infrastructure.
Only by building up economic infrastructure, road, transport, electricity, etc., the structure of
an economy can be made to improve. Obviously, for financing these activities, government
spends money.

(e) Price Rise:

Increase in government expenditure is often ascribed to inflationary price rise. Higher price
level compels the government to spend an increased amount on purchase of goods and
services. Increase in public revenue – with the rise in public revenue government is bound to
increase the public expenditure.

Importance of public expenditure:

An old-fashioned dictum says that “The very best of all plans of finance is to spend little, and
the best of all taxes is that which is least in amount.” No one today believes this philosophy. In
the 1930s, J. M. Keynes emphasized the importance of public expenditure.

The modern state is described as the ‘welfare state’. As a result, the activities of the modern
government have widened enormously. Modern governments are undertaking various social
and economic activities, particularly in less developed countries (LDCs).

i. Economic Development:
Without government support and backing, a poor country cannot make huge investments to
bring about a favourable change in the economic base of a country. That is why massive
investments are made by the government in the development of basic and key industries,
agriculture, consumable goods, etc.

Public expenditure has the expansionary effect on the growth of national income, employment
opportunities, etc. Economic development also requires development of economic

46
infrastructures. A developing country like India must undertake various projects, like
road-bridge-dam construction, power plants, transport and communications, etc.

These social overhead capital or economic infrastructures are of crucial importance for
accelerating the pace of economic development. It is to be remembered here that private
investors are incapable of making such massive investments on the various infrastructural
projects. It is imperative that the government undertakes such projects. Greater the public
expenditure, higher is the level of economic development.

ii. Fiscal Policy Instrument:

Public expenditure is considered as an important tool of fiscal policy. Public expenditure
creates and increases the scope of employment opportunities during depression. Thus, public
expenditure can prevent periodic cyclical fluctuations. During depression, it is recommended
that there should be more and more governmental expenditures on the ground that it creates
jobs and incomes.

On the contrary, a cut-back in government’s expenditure is necessary when the economy faces
the problem of inflation. That is why it is said that by manipulating public expenditure,
cyclical fluctuations can be lessened greatly. In other words, variation of public expenditure is
a part of the anti- cyclical fiscal policy.

It is to be kept in mind that it is not just the amount of public expenditure that is incurred
which is of importance to the economy. What is equally, if not more, important is the purpose
of such expenditure or the quality of expenditure. The quality of expenditure determines the
adequacy and effectiveness of such expenditure. Excessive expenditures may cause inflation.

Moreover, if the government has to impose taxes at high rates there will be loss of incentives.
So, it is necessary to avoid unnecessary expenditure as far as practicable, otherwise benefits of

47
better economic development may not be reaped. As a fiscal policy instrument, it may be
counter-productive.

iii. Redistribution of Income:

Public expenditure is used as a powerful fiscal instrument to bring about an equitable
distribution of income and wealth. There are good much public expenditure that benefit poor
income groups. By providing subsidies, free education and health care facilities to the poor
people, government can improve the economic position of these people.

iv. Balanced Regional Growth:

Public expenditure can correct regional disparities. By diverting resources in backward
regions, government can bring about all-round development there so as to compete with the
advanced regions of the country.

This is what is required to maintain integration and unity among people of all the regions.
Unbalanced regional growth encourages disintegrating forces to rise. Public expenditure is an
antidote for these reactionary elements.

Thus, public expenditure has both economic and social objectives. It is necessary to ensure
that the government’s expenditure is made solely in the public interest and does not serve any
individual’s interest or that of any political party or a group of persons.

Impact/effect of public distribution:

A. Effect on production:
According to Dalton, public expenditure tends to affect the level of production in the
following manner:
1. Capacity to work and save:

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 As a result of public expenditure, the capacity to save and work tends to rise.
Government expenditure providesvarious kinds of social and economic facilities
stimulating the capacity of the people to work. Increased capacity implies
increased efficiency adn greater level of employment. Level of income and savings
tend to rise facilitating greater investment and adds to the pace of growth.

2. Desire to work and save:

Expenditure incurred by government promotes the will to work and save. As a
result their income and standard of living tend to rise.

3. Productive Utilization of Resources:

Public expenditure restores a balance in the economy by focusing on the areas of
production which generates a maximum linkages effect. Public expenditure acts as
a pump - priming and attracting idle resources to their productive utilization.
Accordingly, production level tends to raise the resources from unproductive
resources to productive ones. This results in an incrase in production.

B. Effect on distribution:

1. Regional equality:
This is how public expenditure can promote equality across different regions of a
country:
i) government expenditure should focus on development of backward areas, increasing
the level of production and income of the people in those areas. Their standard of living
will increase to catch up with the living standards of those living in the developed
regions of the country.

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 ii) Public expenditure should include financial help to small scale and cottage industries.
These industries have the merit of easy diversification across different parts of the
country.

2. Distribution of the Dividents of Industrial Development:

As a result of public expenditure there is an increase in the number of public sector
industires in the country. The workers employed in these industries are paid higher
wages. They get better facilites than others. Following the public sector industries, the
private sector industries also provide higher wages and other facilities to the workers.
Increase in the workers wages will lead to reduction in income inequality.

3. Benefit to the weaker sections:

If the government makes public expenditure on social services like education, medical
care, unemployment allowance, labour welfare etc. after collecting resources by way of
taxes from the rich, it will result in the increase of real income of the poor people, thus
tilting the distribution further in their favour.

4. Increase in the ability to work for the poor:

This objective can be achieved in two ways:
i) Direct help:
Government can provide direct help in the form of cash, commodities and service.
ii) indirect help:
Government can provide loans to the poor at a low rate of interest. They can provide
them food at a fair price. They can also provide them social services. As a result of this their
efficiency will be increased.

C. Effect on economic stability:

Cyclical changes are an inherent character of the market economy. These cycles are called
Trade cycles and are manifested as the state recession, depression, recovery and boom.

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The sttes of recession and depression are particularly dangerous for restricitng the pace of
growth. Inflation is equally bad when it tends to be galloping or hyper. Public expenditure
facilitates economic stability by:

1. Public expenditure and Depression:

During depression the prices of commodities tend to fall. Accoringly there is a fall in
production and emplyment. Unemployment increases. Both producers and consumers
become pessimistic. Producers reduce output because of lack of demand. Consumers,
hoping for a further fall in prices suspend their existing consumption needs.
Accordingly, reduction in demand is compounded. As a consequence, the vicious cycle
of reduced demand, reduced production adn reduced emplyement sets in. Here comes
the significance of public expenditure. According to Keynes, in the state of depression,
the government should plan for a comprehensive increase in the public expenditure.
It can be of two types:

i) compensatory expenditure:
It includes those spending which the government makes on public works so as to
increase employemnt and aggregate demand. Such expenditure generates multiplier effct
on income. Income rises in consonance with increased emplyemnt acting as an anti-dote
for the situation of depression.

ii) Pump Priming expenditure:

During the depression periods, investment is low. If investment is made in the public
sector, it will prompt private investment as well. Public expenditure thus made is called
pump priming. Intial expenditure by the government especially on infra-structural
facilities, tends to be conductive for an all round growth of private investment.

Taylor categorises public expenditure during depression as:

a) Home relief:

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 Home relief is provided to the poor so as to increase consumption, without getting
their services. This si the kind of transfer payments expected to raise consumption
expenditure.
b) Unemployment compensation plans:
Unemployement compensation fund is set with the help of employers, employees
and the government. Help is provided to the workers during the period of
unemployemnt out of this fund.
c) Work projects:
It includes public works like construction of roads, bridges and dams etc.
Expenditure on such projects will generate income to combat deflation through
increased demand.

2. Public expenditure and inflation:

i) increase in prodution:
Public expenditure should be utilized for increasing production. Increase in
production during inflation implies increased flow of goods and services in the
economy. In the backdrop of increasing prices, increased flow of goods and
services will help strike a balance between supply and demand.

ii) reduction in consumption:

In a state of price-rise, the government should reduce its consumption expenditure.
This will reduce the pressure on demand for goods and services. Accordingly
prices are expected to fall or alteast their pace of rise will be arrested.

IMPACT OF FISCAL/FINANCIAL POLICY:

Fiscal Policy:
Fiscal policy is based on the theories of British economist John Maynard Keynes,
which hold that increasing or decreasing revenue (taxes) and expenditure
(spending) levels influence inflation, employment and the flow of money through

52
 the economic system. Fiscal policy is often used in combination with monetary
policy. Fiscal policy is paramount to successful economic management since taxes,
spending, inflation and employment all factor into gross domestic product (GDP).

Impact:
A budget deficit may be used to finance an expansionary fiscal policy, which
involves lowering income and corporate taxes (therefore reducing revenue for the
government) and increasing government spending on infrastructure and
investments to attract foreign capital and boost economic growth.

1. Investment opportunities
Businesses will see more investment opportunities related to government
spending. This commonly occurs during an expansionary fiscal policy, when more
money is flowing into the economy from the government and from other sources
since taxation is also low. When a balance between price and demand is met, then
companies can expect to thrive and grow.
2. Slower growth
A contractionary fiscal policy may kick in to prevent inflation when that balance is
broken and demand – and prices – fall. Businesses typically rein in their growth
due to rising taxes and take measures to stay in the black with less money flowing
through the economy.
3. Taxation changes
Depending on your company’s location, your business will face several levels of
taxation: including local, state and federal. Consider how your state and local
government taxes your company and how it interweaves with federal fiscal policy.
Fiscal policy also impacts the amount of taxation on future generations.
Government spending that leads to greater deficits means that taxation will
eventually have to increase to pay interest. Inversely, when the government runs
on a surplus, taxes must eventually be lowered.

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4. Unemployment rates
A major objective of fiscal policy is to minimize unemployment. For example, the
government can lower taxes to put more money back in consumers’ pockets. As
such, consumers have more money to spend and companies may face increased
demand. With increased demand may come additional production tasks for
companies to complete, and businesses can respond by creating more jobs and
hiring more employees. With proper fiscal policy in place, a low unemployment
rate may gradually increase.

Difference between Fiscal Policy and Monetary Policy:

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c) SOURCES OF PUBLIC DEBT:
Public Debt:
Public debt is the debt which State owes to it subjects or to the nationals of other
countries. Public debt arises due to borrowing by the government The government
may borrow from banks, business organisations, business houses and individuals.
The borrowings of the government may be within the country or from outside the
country or both. The public debt is generally in the form of bonds (or treasury
bills, if the loans are required for a short period),which carries with them the
promises of the government to pay interests, to the holders of these bonds at
stipulated rate of interests at regular intervals, or lump sum at the end, in addition
to the principal which has to be repaid at the stated time.

Sources of Public Debt in India:

DEBT OBLIGATIONS OF THE CENTRAL GOVERNMENT:

Public debt in Indian context refers to the borrowings of the central and State
governments. Debt obligations of the Central government are broadly divided into
three categories (1)Internal debt, (2)External debt and (3) Other liabilities. For
analytical purpose, however, other liabilities are to be included in internal debt.

1) Internal Debt:

This includes: (a)current market loans, (b)bonds, (c)Treasury Bills, (d)special

floating and other loans, (e)Special securities issued to reserve Bank of India,
(f)Ways and means Advances, (g)Securities against small savings, (h)Small
savings, (i) Provident Funds, (j) Other accounts and (k)Reserve Funds and
Deposits. Internal debt in India has risen considerably over the years.

a) Market Loans:

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These have a maturity period of 12 months or more at the time of issue and are
generally interest bearing. The government issues such loans almost every year.
These loans are raised in open market by sale of securities or otherwise.

b) Bonds:
This category comprises gold bonds 1998, compensation and other bonds such as
national Rural Development Bonds and Capital Investment Bonds.

c) Treasury Bills:
Treasury bills have been a major source of short term funds for the government to
bridge the gap between revenue and expenditure. They have a maturity of 91 or
182 or 364 days and are issued every Friday. Treasury bills are issued to the
reserve Bank of India, State governments commercial banks and other parties.

d) Special Floating and Other Loans:

Special floating and other loans represent the contribution of Government of India
towards the capital of international financial institutions such as International
Monetary Fund, International Bank for Reconstruction and Development and
International Development Association. These are non-negotiable, non interest
bearing securities and the government of India is liable to pay the amount at the
call of these institutions.

e) Special Securities Issued to RBI:

The government takes loans temporary nature from the Reserve Bank and issues
special securities which are non negotiable and non interest bearing. Such
borrowings are short term (not morethan 12 months).

f) Ways and Means Advances:

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The Government of India takes ways and means advances from the Reserve Bank
of India to meet its short period expenditure. These debts are purely temporary in
nature and usually repaid within three months.

g) Securities Against Small Savings:

Under the new accounting system of national small savings fund (NSSF) a
substantial part of small savings have been converted into Central government
securities with effect from the fiscal year 1999-2000. Securities against small
savings accounted to Rs.2.02,271 crore at end march 2003.

h) Small Savings:
Small savings have consistently increased in volume during recent years due to the
rising money incomes in the economy and also due to the various innovative
schemes introduced by the government. Some of these schemes involved attractive
tax concessions (like 6 years National Savings Certificates) and people were thus
lured into channeling substantial amounts of money through these schemes.

i) Provident Funds:
Provident funds are divided into two categories: (i) State Provident Fund and (ii)
Public Provident Fund Public Provident fund was framed under the Public
Provident Fund Act 1968 for the benefit of general public. Deposits in Public
provident Funds are repayable after 15 years. Facilities of loans and withdrawals
are available.

j) Other Accounts:
these include mainly Postal Insurance and life annuity Fund, Hindu Family
Annuity Fund, borrowing against Compulsory Deposits and Income –Tax Annuity
Deposits, and Special Deposits of Non Government Provident Fund.

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k) Reserve Funds and Deposits:
Reserve funds and deposits are divided into two categories. (i) interest bearing and
(ii) non interest bearing. They include depreciation and Reserve Funds of railways
and Department of Posts and Department of Telecommunications, deposits of
Local funds, departmental and judicial deposits civil deposits etc.

2) External Debt
External debt is usually raised in foreign currency and a substantial part of it is
also repayable in foreign currency. The Government of India has raised foreign
loans from a number of countries like USA, UK France former USSR, Germany,
Japan etc., and international financial institutions like IMF, IBRD and IDA etc.

DEBT OBLIGATIONS OF STATE GOVERNMENT:

To meet their increasing requirements of expenditure, the state governments have

also to incur large debts like the Central government. Debt obligations of the state
governments are divided into four categories. (1) Internal debt, (2) Loans and
advances from the central government, (3) Provident funds, and (4) Special
securities issued to National Small Savings Fund (NSSF) etc.

Internal debt is divided into (a) Market Loans and Bonds, (b)Ways and means
advances from Reserve Bank of India and (c) Loans from banks and other
institutions.

EFFECT OF PUBLIC DEBT:

IMPACT OFINTERNAL PUBLIC DEBT:

On Consumption and Investment:

When people purchase government securities, it is not always necessary that they

58
do it out of past savings. Sometimes people buy these securities out of their present
income, which they would have otherwise utilized on the consumption of other
commodities. Since they get an opportunity of buying government bonds of small
amounts, they refrain from consuming something and buy them. Therefore, in this
way the consumption is affected in the same way as it is affected by taxes. But,
when the people buy government securities out of there past savings it has its
specified effects. This does not directly affect the expenditure of the people at
present. And, when people buy government securities out of the idle savings, the
expenditure in the present remains the same. Private investment also remains
unaffected in such conditions. If however, it comes from bank deposits, itreduces
the money with the bank. The banks have, therefore, less money to lend to private
business. Hence private investment is affected.

It is generally believed that the public borrowings have adverse effects on

investment. However, if the government borrows from Commercial Banks or the
Central Bank of the country, it will provide extra purchasing power to the
community and therefore, it will provide extra purchasing power to the community
and therefore, it will not press for any curtailment of funds for investment. But
when purchases of securities by banks without excess of reserves or from
individuals is made out of the funds meant for business expansion, it results in
decline in investment. It is however, to be noted that as long as the interest rate is
static and government bonds offer special privileges to bond holders over those
envisaged in existing securities, possibility of reduction in private investment is
very slight.

There will be no contractionary effect at all, if the bonds are sold to the Central
Banking System, or the Commercial Banks if they have excess reserves, or to
lenders who purchase them out of funds which would otherwise lie idle.

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On Production and Distribution:

If people buy government securities by withdrawing money from industrial

concerns, or by selling debentures and shares of industrial concerns, private
investment is adversely affected. The net effect on investment will depend upon
how the money is used by government. If the government utilizes this money in
public undertakings, the total investment available for production may not be
adversely affected, but if the government utilizes it on non-productive works, the
total investment may be adversely affected.

If the people buy government securities from idle funds, private investment are not
affected, but if they buy from bank deposits, private investment may be adversely
affected, because the lending capacity of the bank may be reduced due to reduction
in deposits.

The lending capacity of bank is generally elastic. The power of bank to create
loans depends upon the policy of the central bank of the country. When the latter
encourages for the creation of credit, the likelihood of the expansion of credit is
immense. It can expand credit on the strength, of ad hoc or newly created
securities. Thus the government borrowings may not reduce investment in private
sector, provided there are enough funds for productive purposes. Moreover, the
government will utilize the loans proceeds for making the payments to contractors
for goods and materials purchased and in paying salaries to its employees. This
will release purchasing power and increase bank deposits, which can be utilized
for making loans to private sector. Hence, government borrowings from banks may
not affect investment in private sector.

If government uses the borrowed funds for unproductive purposes, it can only be

60
repaid through additional taxation in future, and this additional taxation in future
may affect consumption. Those utilized for the welfare schemes, increase the
efficiency of the workers and that of production. When production increases,
income of community also increases, and hence, additional taxation may not affect
consumption. If the loans are utilized for productive purposes directly, they
increase the income of the community. Hence, the consumption is not affected, but
it increases. Moreover the interest along with principal can be paid out of
increased income.

The purchaser of government securities are mostly the rich people of the
community, But the burden of taxes, imposed for finding money for interest
payments fall on the poorer classes also. Therefore the tendency of public debt
would be to increase the inequalities of incomes. Hence the public debt may not
have the desirable effects upon distribution. However, if bondholders and the tax
are the same, then there will be no distribution of income. Therefore, the
inequalities of income will not increase, but it is generally not true. Hence some
redistribution of income will take place as long as the taxpayers and the
bondholders belong to different groups, and as explained above, the inequalities of
income may increase.

If public debt is utilized to provide more economic welfare to the lower income
groups then the inequalities of income will decrease and a more equal distribution
of income between different sections of the community would take place,
However if the loan finance created inflation, some of the good effects upon the
distribution of income may be neutralized because of rise in prices. Thus, if the
loan proceeds are spent on welfare schemes, the effects on distribution are
whole-some.

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On Private Sector:

All public expenditure increases the demand for goods, because it increases the
purchasing power of the people and puts more money into circulation. When this
expenditure is financed through taxation, current consumption is not reduced. If
the government utilizes the borrowed money in purchasing goods and materials
produced in private sector the demand for goods in the private sector may increase
to the extent that the government spends borrowed funds for this purpose. Again, a
portion of the borrowed funds may be utilized on salaries and wages of
government officials, who may purchase the goods produced in the private sector.
Hence the effect of expenditure of borrowed funds is that the demand for the
products of industries in private sector increases, without adversely affecting the
supply. Hence, the effects of public debt are said to be favourable.

On Resource Allocation and National Income:

Unlike tax finance, there is little effect of public borrowing on resource allocation
or composition of national production. But, when investment level is reduced, it
causes decrease in the relative output of capital goods as against the total output in
periods of full employment. On the contrary, the capital goods on which the
government expenditure is incurred finds greater incentives for their accelerated
production and, thus, there is also a rise in national income. The consequent
increase in national income will not only be of high level in proportion to the
enlarged investment but also will be a multiple of the increment of the investment
due to multiplier effect, and thereby create larger employment prospects.

On Liquidity and Money Market:

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People who buy government securities possesses highly negotiable and highly
liquid from of assets, which can be converted for any purpose transactions,
precautionary or speculative motive – at any time and, thus, public debt creates
highly liquidated assets. Besides, in time of inflation, the central bank of the
country adopts bank rate, open market operations and other devices, which restrict
the commercial banks “credit creation capacity”. However this effect is generally
nullified because the commercial can increase the reserve at any time by way of
disposal of bonds. Further, existence of large amounts of public debts accounts for
increase in interest obligations of the Government. However, increase in interest
rates has a net expansionary or concretionary effect upon the economy, which
depends on the relative propensity to consume of the taxpayers and bondholders
and the effects of the tax upon investment. Existence of public debt affects the
money market in the following manner. If demand for funds from the private
sector is on a higher level, government will have to fix higher interest rates to
attract purchase of its securities, and vice versa. So when Government borrows
from public, it competes with private investors. Thus, it has to confirm to the
general pattern of demand, supply and prices as any other borrower in the market.
Ultimately, both Government and the private sectors in order to acquire funds in
the market. If the State tries to borrow (especially from Commercial Banks and
Central Bank) more than the available supply at the current rate of interest, this
may lead to currency expansion.

IMPACT OF EXTERNAL PUBLIC DEBT:

External borrowing in the economic development of developing countries have

made possible the import of high priority goods or (capital goods) or goods to be
used to create and build capacity for accelerating the rate of growth of the
economy. It effects both consumption and investment favourably. Again, imports
of foreign goods raises the total available supply of commodities so also the

63
national income and ultimately helps in the betterment of people’s standard of
living. Further, these imports on the one hand, reduce the demand of similar
indigenous goods in the present and on the other their investment would increase
output in future. Thus these imports are anti-inflationary, though; this effect may
be felt more in future. Again, if the goods and services are imported by the
Government and sold to the public then it reduces currency circulation in the
economy. Hence, it enables the state to increase the extent of deficit financing
which can further be used for accelerating the growth and development of the
economy.

Foreign capital supplements the national resources and makes possible a higher
rate of investment than otherwise would be possible. If this higher investment
raises the rate of growth of the economy, the increasing external liabilities need not
cause any concern. Increase of external indebtedness and debt servicing liabilities
even when large, do not necessarily create difficulties for borrowers The increases
of debt servicing payments have to be measured against the development which
has occurred in the borrower’s economy. The basic condition of debt servicing
capacity is the continuing increase in per capita production. It means the capacity
to pay debtservicing charges depends upon the continuing increase in per capita
production.

REDEMPTION OF PUBLIC DEBT:

Redemption of debt refers to the repayment of a public loan. Although public debt
should be paid, debt redemption is desirable too. In order to save the government
from bankruptcy and to raise the confidence of lenders, the government has to
redeem its debts from time to time.

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 Sometimes, the government may resort to an extreme step, such as repudiation of
debt. This extreme step is, of course, violation of the contract. Use of repudiation
of debt by the government is economically unsound.

Important methods for the retirement or redemption of public debt:

i. Refunding:
Refunding of debt implies issue of new bonds and securities for raising new loans in
order to pay off the matured loans (i.e., old debts). When the government uses this method of
refunding, there is no liquidation of the money burden of public debt. Instead, the debt
servicing (i.e., repayment of the interest along with the principal) burden gets accumulated on
account of postponement of the debt- repayment to save future debt.
ii. Conversion:
By debt conversion we mean reduction of interest burden by converting old but
high interestbearing loans into new but low interest-bearing loans. This method
tends to reduce the burden of interest on the taxpayers. As the government is
enabled to reduce the burden of debt which falls, it is not required to raise huge
revenue through taxes to service the debt. Instead, the government can cut down
the tax liability and provide relief to the taxpayers in the event of a reduction in the
rate of interest payable on public debt. It is assumed that since most taxpayers are
poor people while lenders are rich people, such conversion of public debt results in
a less unequal distribution of income.

iii. Sinking Fund:

One of the best methods of redemption of public debt is sinking fund. It is the fund
into which certain portion of revenue is put every year in such a way that it would
be sufficient to pay off the debt from the fund at the time of maturity. In general,
there are, in fact, two ways of crediting a portion of revenue to this fund.

65
The usual procedure is to deposit a certain (fixed) percentage of its annual income
to the fund. Another procedure is to raise a new loan and credit the proceeds to the
sinking fund. However, there are some reservations against the second method.
Dalton has opined that it is in the Tightness of things to accumulate sinking fund
out of the current revenue of the government, not out of new loans. Although
convenient, it is one of the slowest methods of redemption of debt. That is why
capital levy as a form of debt repudiation is often recommended by economists.

iv. Capital Levy:

In times of war or emergencies, most governments follow the practice of raising
money necessary for the redemption of the public debt by imposing a special tax
on capital. A capital levy is just like a wealth tax in as much as it is imposed on
capital assets. This method has certain decisive advantages. Firstly, it enables a
government to repay its (emergency) debt by collecting additional tax revenues
from the rich people (i.e., people who have huge properties). This then reduces
consumption spending of these people and the severity of inflation is weakened.
Secondly, progressive levy on capital helps to reduce inequalities in income and
wealth. But it has certain clear-cut disadvantages too. Firstly, it hampers capital
formation. Secondly, during normal time this method is not suggested.

v. Terminal Annuity:
It is something similar to sinking fund. Under this method, the government pays
off its debt on the basis of terminal annuity. By using this method, the government
pays off the debt in equal annual instalments. This method enables government to
reduce the burden of debt annually and at the time of maturity it is fully paid off. It
is the method of redeeming debts in instalments since the government is not
required to make one huge lump sum payment.

vi. Budget Surplus:

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By making a surplus budget, the government can pay off its debt to the people. As
a general rule, the government makes use of the budgetary surplus to buy back
from the market its own bonds and securities. This method is of little use since
modern governments resort to deficit budget. A surplus budget is usually not
made.

vii. Additional Taxation:

Sometimes, the government imposes additional taxes on people to pay interest on
public debt. By levying new taxes—both direct and indirect— the government can
collect the necessary revenue so as to be able to pay off its old debt. Although an
easier means of repudiation, this method has certain advantages since taxes have
large distortionary effects.

viii. Compulsory Reduction in the Rate of Interest:

The government may pass an ordinance to reduce the rate of interest payable on its
debt. This happens when the government suffers from financial crisis and when
there is a huge deficit in its budget. There are so many instances of such statutory
reductions in the rate of interest. However, such practice is not followed under
normal situations. Instead, the government is forced to adopt this method of debt
repayment when situation so demands.

ROLE OF BUDGET AND BUDGETARY

PROCESS:

BUDGET:
A budget is a microeconomic structure that involves a financial plan for a definite
period, mostly a year. The question of what is budgeting can be presented simply
in a manner as a cumulation of finances for a particular purpose and as a tally of

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expenditures required to meet the goal and incorporate them efficiently into the
three sectors of the Economy. The Budgeting definition may also incorporate
planned sales capacities and revenues, resource containments, trade and expenses,
useful utilities and assets, and cash trades. Organizations, governments,
individuals, and other corporations use it to devise strategic plans of trade or
activities in measurable terms so that it works efficiently along with the trade
conditions and incorporates into the three sectors of the economy. The three
sectors of the economy primarily involve the manufacture, processing and
extraction of commodities and resources that are the pillars of maintaining the
budgeting definition.

ROLE OF BUDGET IN INDIAN ECONOMY:

The importance of budgeting definition with correlation to the three sectors of the
economy of India is very vital as it attempts to draw out a fair and just distribution
of household income as well as trying to draw a fundamental tax structure that in
any way shall be benefiting to low-income sections of the economy. In addition to
these, the union budget comprising; revenue budgeting and capital budgeting also
tries to focus on the allocation of public services and resources to various agencies
of the government.

Some benefits of budgeting definition to the Indian Economy are:

1. Ensure vital allocation of utilities: Grouping resources optimally ensures to have

profit expansion for the government to foster and improve public welfare and
conditions.

2. Minimize wealth and earning disparities: The budget definition of the Indian
economy aims to maintain the distribution of income through subsidies and

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revenue collected from the common public as taxes. The primary focus is to ensure
that a subsequent elevated rate of tax is levied on the flourished level of income
class, thereby decreasing their cumulative income. On the other hand, a lower rate
of revenue is collected from the lower-income group to maintain that they have
sufficient income in their possession.

3. Maintain a quality check on commodities charges and prices: The Union Budget
aims in controlling the economic fluctuations of the country with proper
adjustment to the fundamental three sectors of the economy. That question of what
is budgeting is very essential at this point as it ensures proper management of
inflation and deflation, thus attempting to maintain economic equilibrium. During
inflation, surplus budget policies are brought out, while deficit budget
management strategies are devised whilst the deflation period. Hence in this way,
the budgeting definition aims to contain trade and price stability according to the
present economic conditions.

BUDGETING PROCESS:

The term ‘budget’ has been derived from the French word ‘bougette’, which
means a leather bag or wallet. The first use of the term 'budget' may date back to
1733 financial statement by Walpole as Prime Minister and Chancellor of the
Exchequer.

To function effectively and discharge its duties and obligations, every government
needs resources. Through the budgetary process, the Indian Parliament authorizes
the government of the day to collect funds by way of taxes, duties, cess,
borrowings and so on. The funds so collected by the government are used, with the
approval of Parliament to meet its expenditure. The President of India is obliged
constitutionally to have the Annual financial Statement for the ensuing financial

69
year laid on the table of the House under Article 112. But, according to Art. 77(3),
the Finance Minister has been made responsible to prepare the Annual Financial
Statement and pilot it through Parliament. The budget process in India, like in
most other countries, comprises four distinct phases.

1. Budget formulation: the preparation of estimates of expenditure and

receipts for the ensuing financial year;
2. budget enactment: approval of the proposed Budget by the Legislature
through the enactment of Finance Bill and Appropriation Bill;
3. budget execution: enforcement of the provisions in the Finance Act and
Appropriation Act by the government—collection of receipts and making
disbursements for various services as approved by the Legislature; and
4. Legislative review of budget implementation: audits of government’s
financial operations on behalf of the Legislature.

Normally, the budget-making process starts in the third quarter of the financial
year. In India the Railway Budget is separately presented by the Union Railway
Minister, two days prior to the General Budget. The Railway Budget figures
relating to the receipt and expenditure of the railway are also shown in the General
Budget, since they are a part and parcel of the total receipts and expenditure of the
Government of India.

In the Union government, there is a budget division in the department of

economic affairs under the Ministry of Finance. To start the process, the budget
division issues an annual budget circular around the last week of August or the
first fortnight of September every year. This annual budget circular contains
detailed instructions for the Union government ministries/departments relating to
the form and content of the statement of budget estimates to be prepared by them.
Each form contains the following columns:

70
i. Actuals for the previous Year
ii. Sanctioned Estimate for the Current Year
iii. Revised Estimate for the Current Year
iv. Budget estimate for the next year

Then review and consolidation of all these estimations are getting done by the
respective departments/ministries and after consolidation the same is to be
forwarded to the Finance Minister by the middle of the November.

The Budget Estimates prepared by various administrative ministries are

broadly
divided into three parts:
i. Standing Charges (pay, allowances, honorarium, etc.)
ii. Continuing Scheme
iii. New Scheme

Consultations:
Budget making exercise is not a unilateral work undertaken by Finance Ministry
exclusively. It involves various stakeholders of economy and it holds wide ranged
consultations with:
a. Administrative Ministries ;
b. Interest Groups the consultation with farmers, labour unions, business,
economic and civil society groups etc.
c. State Governments: demands to the state are sent to the concerned finance
ministry department for evaluations.

Once the pre-budget meetings are over. The approved ceiling for expenditure, as
finalized in these meetings, is communicated. It includes internal ceilings of
revenue and capital expenditure. Based on these limits, each ministry/department

71
will prepare a final statement of budget estimate and sent to the budget division.
Then Budget department gets on with the task of preparing the budget documents.
There are more than 13 documents, which are tabled in the Lok sabha.

Role of Parliament:
The procedure adopted in parliament dealing with the budget involves following
stages:
1. Presentation of the Budget (PartA&Part B)
2. Discussion on Budget(General &detailed)
3. Budget goes to Standing Committee

The presentation of the Budget for the ensuing fiscal year (beginning April 1) is
usually done on the last working day of February. The Indian constitution has
made the Parliament supreme in financial matters. The Union government, under
Article 112 of the constitution, is required to lay an annual financial statement of
estimated receipts and expenditure before both Houses of Parliament. It can levy
taxes or disburse funds only on approval in both houses of Parliament. However,
the proposal for taxation or expenditure has to be initiated within the Council of
Ministers,specifically by the Minister of Finance. The Finance Minister presents
before the Parliament, a financial statement detailing the estimated receipts and
expenditures of the central government for the forthcoming fiscal year and a
review of the current fiscal year.

Under Article 114 of the Constitution, the government can withdraw money from
the Consolidated Fund of India only on approval from Parliament and so it has to
get the Appropriation Bills approved by Parliament. This authorises the executive
to spend money. Article 265 of the Constitution prohibits the government from
collecting any taxes without the authority of law. Therefore, the government comes
up with the Finance Bill. The Bill may levy new taxes, modify the existing tax

72
structure or continue the existing tax structure beyond the period approved by
Parliament earlier. The bills are forwarded to the Rajya Sabha for comment. The
Lok Sabha, however, is not obligated to accept the comments and the Rajya Sabha
cannot delay passage of these bills. The bills become law when signed by the
President. The Lok Sabha cannot increase the request for funds submitted by the
executive, nor can it authorize new expenditures.

Method of Control:
It is constitutional device to initiate discussion on demands. Usually three types of
cut motions are in vogue to exercise parliamentary supremacy, and they are as
follows:
1. Policy Cut, also known as re 1 cut to express disapproval of policy;
2. Economy cut to press for lump sum cut in budgetary allocation; and
3. Token Cut to or rs. 100 cut to ventilate specific grievances

However the Parliament has no right to seek increase in budgetary allocation. It

can only ask for the reduction. Once budget is approved by the both houses, funds
are allocated to different departments for the expenditure, it has to be audited by
the Constitutionally mandated Comptroller and Auditor General of India
(C&AG).The reports of the same are to be discussed and deliberated by the
Houses and Public Account Committee re-examines it in the light of the report
submitted by the CAG. Thus the whole exercise of Budget

HOW THE BUDGET IS PASSED: IN NUTSHELL

PRESENTATION
➢ Finance Minister presents the budget in Lok Sabha
➢ The budget speech of the Finance Minister has two parts. Part A deals with
general economic survey of the country and policy statements while Part B

73
contains taxation proposals.
➢ “Annual Financial Statement” is laid on the table of Rajya Sabha after the
Finance Minister’s speech.

DISCUSSION
➢ No discussion follows immediately after the budget is presented
➢ Few days later the Lok Sabha discusses the Budget as a whole and not the
details for 2 to 3 days
➢ The FM makes a reply at the end of discussion
➢ A ‘Vote on Account’ for expenditure for the next two months of ensuing
year is obtained from Parliament
➢ The House is adjourned for a fixed period
➢ During this period, the Demands for Grants of various
ministries/departments including Railway are considered by relevant
standing committees.

VOTE
➢ Standing Committee reports are presented to the House. It discusses and
vote on demand for Grants, ministry-wise
➢ The Speaker puts all the outstanding Demands to the vote of the House. This
device is known as “Guillotine”. The Lok Sabha has the power to assent to
or reduce any demand or even to reduce the amount of Grant sought by the
Government
➢ In the Rajya Sabha, there is only a general discussion on the budget.It does
note vote on the Demand for Grants.
➢ After the General Discussion on the Budget proposals and Voting on
Demand for Grants have been completed, government introduces the
Appropriation Bill. The Appropriation Bill is intended to give authority to
the government to incur expenditure from and out of the Consolidated Fund

74
 of India.

MODULE - III
a) INTERNATIONAL TRADE:
INTERNAL TRADE
Buying and selling of goods and services within the boundaries of a nation are
referred to as internal trade. Whether the products are purchased from a neighbourhood shop in
a locality or a central market or a departmental store or a mall or even from any door-to-door
salesperson or from an exhibition, all these are examples of internal trade as the goods are
purchased from an individual or establishment within a country. No custom duty or import
duty is levied on such trade as goods are part of domestic production and are meant for
domestic consumption.

Generally, payment has to be made in the legal tender of the country or any other acceptable
currency. Internal trade can be classified into two broad categories viz., (i) wholesale
trade and (ii) retail trade. Generally, for products, which are to be distributed
to a large number of buyers who are located over a wide geographical area, it becomes very
difficult for the producers to reach all the consumers or users directly. For example, if
vegetable oil or bathing soap or salt produced in a factory in any part of the country are to
reach millions of consumers throughout the country, the help of wholesalers and retailers
becomes very important. Purchase and sale of goods and services in large quantities for the
purpose of resale or intermediate use is referred to as wholesale trade. On the other hand,
purchase and sale of goods in relatively small quantities, generally to the ultimate consumers,
is referred to as retail trade. Traders dealing in wholesale trade are called wholesale traders
and those dealing in retail trade are called retailers. Both retailers and wholesalers are
important marketing intermediaries who perform very useful functions in the process of
exchange of goods and services between producers and users or ultimate consumers.

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Internal trade aims at equitable distribution of goods within a nation speedily and at reasonable
cost.

INTERNATIONAL TRADE:

International trade is the exchange of goods and services among countries across national
boundaries. Countries need to trade to obtain commodities, they cannot produce themselves or
they can purchase elsewhere at a lower price. International trade is the result of specialisation
in production. It benefits the world economy if different countries practise specialisation and
division of labour in the production of commodities or provision of services. Each kind
of specialisation can give rise to trade. Thus, international trade is based on the principle of
comparative advantage, complimentarity and transferability of goods and services and in
principle, should be mutually beneficial to the trading partners.

Types of International Trade:

International trade may be categorised into two types:
(a) Bilateral trade:
Bilateral trade is done by two countries with each other. They enter into agreement to trade
specified commodities amongst them. For example, country A may agree to trade some raw
material with agreement to purchase some other specified item to country B or vice versa.
(b) Multi-lateral trade:
As the term suggests multi-lateral trade is conducted with many trading countries. The same
country can trade with a number of other countries. The country may also grant the status of
the “Most Favoured Nation” (MFN) on some of the trading partners.

THEORY OF ABSOLUTE ADVANTAGE:

The concept of absolute advantage was developed by 18th-century economist Adam Smith in
his book The Wealth of Nations to show how countries can gain from trade by specializing in
producing and exporting the goods that they can produce more efficiently than other countries.

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Adam Smith’s theory of absolute cost advantage in international trade was evolved as a strong
reaction of the restrictive and protectionist mercantilist views on international trade. He upheld
in this theory the necessity of free trade as the only sound guarantee for progressive expansion
of trade and increased prosperity of nations. The free trade, according to Smith, promotes
international division of labour.

Every country tends to specialize in the production of that commodity which it can produce
most cheaply. Undoubtedly, the slogans of self- reliance and protectionism have been raised
from time to time, but the self-reliance has eluded all the countries even up to the recent times.
The free and unfettered international trade can make the countries specialise in the production
and exchange of such commodities in case of which they command some absolute advantage,
when compared with the other countries.

In this context, Adam Smith writes; “Whether the advantage which one country has over
another, be natural or acquired is in this respect of no consequence. As long as one country has
those advantages, and the other wants them, it will always be more advantageous for the latter,
rather to buy of the former than to make.”

When countries specialise on the basis of absolute advantage in costs, they stand to gain
through international trade, just as a tailor does not make his own shoes and shoemaker does
not stitch his own suit and both gain by exchanging shoes and suits.

Suppose there are two countries A and B and they produce two commodities X and Y. The cost
of producing these commodities is measured in terms of labour involved in their production. If
each country has at its disposal 2 man-days and 1 man-day is devoted to the production of each
of the two commodities, the respective production in two countries can be shown through the
hypothetical Table 2.1.

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In country A, I man-day of labour can produce 20 units of X but 10 units of Y. In country B,
on the other hand. I man-day of labour can produce 10 units of X but 20 units of Y. It signifies
that country A has an absolute advantage in producing X while country B enjoys absolute
advantage in producing commodity Y. Country A may be willing to give up 1 unit of X for
having 0.5 unit of Y. At the same time, the country B may be willing to give up 2 units of Y to
have I unit of X. If country A specialises in the production and export of commodity X and
country B specialises in the production and export of commodity Y. both the countries stand to
gain.

The absolute cost advantage of country A in the production of X and that of B in the
production of Y can also be expressed as below:

It is possible to explain the cost difference in two countries A and B concerning the
commodities X and Y geometrically through Fig. 2.1.

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In Fig. 2.1, AA1 is the production possibility curve of country A. Given the techniques and
factor endowments, if all the resources are employed in the production of X commodity, it can
produce OA1 quantity of X. On the contrary, if all resources are used in the production of Y,
country A can produce OA quantity of Y. BB1 is the production possibility curve of country B.

In case of this country, if all resources are employed in the production of X commodity, OB1
quantity can be produced. Alternatively, if all the resources are used in the production of Y, it
is possible to produce OB quantity of Y. The slope of production possibility curve is measured
by the ratio of labour productivity in X to labour productivity in Y in each country.

Slope of AA1 = LXA/LYA

Slope of BB1 = LXB/LYB

Since slope of AA1 is less than the slope of BB1, it signifies that country A has absolute cost
advantage in the production of X commodity, while country B has the absolute cost advantage
in the production of Y commodity.

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Adam Smith also emphasised that specialisation on the basis of absolute cost advantage would
lead to maximisation of world production. The gains from trade for the two trading countries
can be shown through Table 2.2.

Before trade, Country A produces 20 units of X and 10 units of Y. After trade, as it specialises
in the production of X commodity, the total output of 40 units of X is turned out by A and it
produces no unit of Y. Country B produces 10 units of X and 20 units of Y before trade. After
trade it specialises in Y and produces 40 units of Y and no unit of X. The gain is production of
X and Y commodity each is of 10 units. The gain from trade for country A is +20 units of X
and -10 units of Y so that net gain to it from trade is +10 units of X. Similarly net gain to
country B is +10 units of Y.

An interesting aspect of Smith’s analysis of trade has been his ‘Vent for Surplus’ doctrine.
According to him, the surplus of production in a country over what can be absorbed in the
domestic market can be disposed of in the foreign markets. It was basically this desire that led
Mercantilists and subsequent theorists to place much emphasis on the international trade.

The ‘Vent for Surplus’ doctrine implies that the international specialisation is not reversible
and that it is an integral part of the development process in any country. In addition, this
doctrine implies that the foreign trade results in the fullest utilisation of the idle productive
capacity that is likely to exist in the absence of trade. This implication makes a clear departure

80
from the assumption held in the comparative cost approach that the resources are fully
employed even before trade. What trade does is to bring about a more efficient allocation of
them.

Criticisms:
Adam Smith, no doubt, provided a quite lucid explanation of the principle of absolute cost
advantage as the basis of international transactions, yet his theory has certain weaknesses.

Firstly, this theory assumes that each exporting country has an absolute cast advantage in the
production of a specific commodity. This assumption may not hold true, when a country has
no specific line of production in which it has an absolute superiority. In this context Ellsworth
says “Smith’s argument is not very convincing as it assumed without argument that
international trade required a producer of exports to have an absolute advantage, that is, an
exporting country must be able to produce with a given amount of capital and labour a larger
output than any rival. But what if a country has no line of production in which it was clearly
superior.”

Most of the backward countries with inefficient labour and machinery may not be enjoying
absolute advantage in any line of activity. So the principle of absolute cost advantage cannot
provide complete and satisfactory explanation of the basis on which trade proceeds among the
different countries.

Secondly, Adam Smith simply indicated the fundamental basis on which international trade
rests. The absolute cost advantage had failed to explore in any comprehensive manner the
factors influencing trade between two or more countries.

Thirdly, the ‘Vent for Surplus’ doctrine of Adam Smith is not completely satisfactory. This
doctrine can have serious adverse repercussions on the growth process of the backward
countries. These countries do not sell their surplus produce in foreign markets but are

81
constrained to export despite domestic shortages for the reasons of neutralising their balance of
payments deficit.

THEORY OF COMPARATIVE COST ADVANTAGE:

Comparative advantage is an economy's ability to produce a particular good or service at a

lower opportunity cost than its trading partners. Comparative advantage is used to explain why
companies, countries, or individuals can benefit from trade.

When used to describe international trade, comparative advantage refers to the products that a
country can produce more cheaply or easily than other countries. While this usually illustrates
the benefits of trade, some contemporary economists now acknowledge that focusing only on
comparative advantages can result in exploitation and depletion of the country's resources.

The law of comparative advantage is popularly attributed to English political economist David
Ricardo and his book On the Principles of Political Economy and Taxation written in 1817,
although it is likely that Ricardo's mentor, James Mill, originated the analysis.

David Ricardo believed that the international trade is governed by the comparative cost
advantage rather than the absolute cost advantage. A country will specialise in that line of
production in which it has a greater relative or comparative advantage in costs than other
countries and will depend upon imports from abroad of all such commodities in which it has
relative cost disadvantage.

Suppose India produces computers and rice at a high cost while Japan produces both the
commodities at a low cost. It does not mean that Japan will specialise in both rice and
computers and India will have nothing to export. If Japan can produce rice at a relatively lesser
cost than computers, it will decide to specialise in the production and export of computers and

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India, which has less comparative cost disadvantage in the production of rice than computers
will decide to specialise in the production of rice and export it to Japan in exchange of
computers.

The Ricardian comparative costs analysis is based upon the following assumptions:

(i) There is no intervention by the government in economic system.

(ii) Perfect competition exists both in the commodity and factor markets.

(iii) There are static conditions in the economy. It implies that factors supplies, techniques of
production and tastes and preferences are given and constant.

(iv) Production function is homogeneous of the first degree. It implies that output changes
exactly in the same ratio in which the factor inputs are varied. In other words, production is
governed by constant returns to scale.

(v) Labour is the only factor of production and the cost of producing a commodity is expressed
in labour units.

(vi) Labour is perfectly mobile within the country but perfectly immobile among different
countries.

(vii) Transport costs are absent so that production cost, measured in terms of labour input
alone, determines the cost of producing a given commodity.

(viii) There are only two commodities to be exchanged between the two countries.

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(ix) Money is non-existent and prices of different goods are measured by their real cost of
production.

(x) There is full employment of resources in both the countries.

(xi) Trade between two countries takes place on the basis of barter.

This two-country, two-commodity model can be analysed through the Table 2.3.

The Table 2.3 indicates that country A has an absolute advantage in producing both the
commodities through smaller inputs of labour than in country B. In relative terms, however,
country A has comparative advantage in specialising in the production and export of
commodity X while country B will specialise in the production and export of commodity Y.

In country A, domestic exchange ratio between X and Y is 12 : 10, i.e., 1 unit of X = 12/10 or
1.20 units of Y. Alternatively, 1 unit of Y= 10/12 or 0.83 units of X.

In country B, the domestic exchange ratio is 16 : 12, i.e., 1 unit of X = 16/12 or 1.33 units of Y.
Alternatively, 1 unit of Y = 16/12 or 0.75 unit of X.

From the above cost ratios, it follows that country A has comparative cost advantage in the
production of X and B has comparatively lesser cost disadvantage in the production of Y.

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In algebraic terms, let labour cost of producing X-commodity in country A is a1 and in country
B is a2. The labour cost of producing Y-commodity in countries A and B are respectively a3
and a4.

The absolute differences in costs can be measured as:

a1/a2 < 1 < a3/a4

It shows that country A has absolute advantage in producing X and country B has an absolute
advantage in commodity Y.

The comparative differences in costs can be measured as:

a1/a2 < a3/a4 < 1

The Table 2.3 satisfies the condition specified for comparative difference in costs;

a1/a2 < 1 < a3/a4 < 1

12/16 < 10/12 < 1

In case a1/a2 = a3/a4, there are equal differences in costs and there is no possibility of trade
between the two countries.

In Fig. 2.2, AA1 and BB1 are the production possibility curves pertaining to countries A and
B. Given the same amount of productive resources, A can produce larger quantities of both the
commodities than the country B. It means country A has absolute cost advantage over B in
respect of both the commodities.

85
If the curve BC1 is drawn parallel to AA1; the curve BC1 can represent the production
possibility curve of country A. If country A gives up OB quantity of Y and diverts resources to
the production of X, it can produce OC1 quantity of X, which is more than OB1. It means the
country A has comparative cost advantage in the production of X-commodity.

From the point of view of B, it can produce the same quantity OB of Y, if it gives up the
production of smaller quantity OB1 of X. If signifies that country B has less comparative
disadvantage in the production of Y commodity. Accordingly, country A will specialise in the
production and export of X commodity, while country B will specialise in the production and
export of Y-commodity.

Gain from Trade:

The comparative cost principle underlines the fact that two countries will stand to gain through
trade so long as the cost ratios for two countries are not equal. On the basis of Table 2.3,
country A specialises in the production of X commodity, while country B specialises in the
production of Y commodity.

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In the absence of international trade, the domestic exchange ratio between X and Y
commodities in these two countries are:

Country A: 1 unit of X = 12/10 or 1-20 units of Y

Country B: 1 unit of Y = 12/16 or 0-75 unit of X

If trade takes place and two countries agree to exchange 1 unit of X for 1 unit of Y, the gain
from trade for country A amounts to 0.20 units of Y for each unit of X. In case of country B,
the gain from trade amounts to 0.25 unit of X for each unit of Y. Thus the comparative costs
principle confers gain upon both the countries.

HECKSCHER-OHLIN THEORY OF INTERNATIONAL

TRADE:

The Heckscher-Ohlin model is an economic theory that proposes that countries export what
they can most efficiently and plentifully produce. Also referred to as the H-O model or 2x2x2
model, it's used to evaluate trade and, more specifically, the equilibrium of trade between two
countries that have varying specialties and natural resources.

The model emphasizes the export of goods requiring factors of production that a country has in
abundance. It also emphasizes the import of goods that a nation cannot produce as efficiently.
It takes the position that countries should ideally export materials and resources of which they
have an excess, while proportionately importing those resources they need.

The classical comparative cost theory did not satisfactorily explain why comparative costs of
producing various commodities differ as between different countries.

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The new theory propounded by Heckscher and Ohlin went deeper into the underlying forces
which cause differences in comparative costs.

They explained that it is differences in factor endowments of different countries and different
factor-proportions needed for producing different commodities that account for difference in
comparative costs. This new theory is therefore-called Heckscher-Ohlin theory of international
trade.

Since there is wide agreement among modern economists about the explanation of
international trade offered by Heckscher and Ohlin this theory is also called modern theory of
international trade. Further, since this theory is based on general equilibrium analysis of price
determination, this is also known as General Equilibrium Theory of International Trade.

It is worthwhile to note that, contrary to the viewpoint of classical economists, Ohlin asserts
that there does not exist any basic difference between the domestic (inter-regional) trade and
international trade. Indeed, according to him, international trade is only a special case of
inter-regional trade.

Thus, Ohlin asserts that it is not the cost of transport which distinguishes international trade
from domestic trade, for transport cost is present in the domestic inter-regional trade. Trade
because currencies of different countries are related to each other through foreign exchange
rates which determine the value or purchasing power of different currencies.

Ohlin, therefore, regards different nations as mere regions separated from each other by
national frontiers, different languages and customs, etc. But these differences are not such that
prevent the occurrence of trade between nations. He, therefore, asserts that general theory of
value which can be applied to explain interregional trade can also be applied equally well to
explain international trade.

88
According to general equilibrium theory of value, relative prices of commodious are
determined by demand for and supply of them. In the long-run equilibrium under conditions of
perfect competition, relative prices of commodities, as determined by demand and supply, are
equal to average cost of production.

The cost of production of a commodity, as is well-known, depends upon the prices paid for the
factors of production employed in the production of that commodity. Factor prices in turn
determine the incomes of the factor owners and hence the demand for goods.

Thus trade is mutual inter-dependence between prices of commodities and prices of factors,
and the exchange of goods and factors between demand for commodities and demand for
factors. This is how general equilibrium theory of value explains prices of commodities and
factors between different individuals in a region or a country.
However, according to Ohlin, the classical analysis presumes it to apply to a single market in a
country and ignores the space factor whose introduction is crucial for explanation of trade
between regions. The factors which explain the trade between different regions also explain
the trade between different nations or countries as well.

Heckscher-Ohlin Theorem:
According to Ricardo and other classical economists, international trade is based on
differences in comparative costs. It is important to note that Heckscher and Ohlin agreed with
this fundamental proposition and only elaborated this by explaining the factors which cause
differences in comparative costs of commodities between different regions or countries.
Ricardo and others who followed him explained differences in comparative costs as arising
from differences in skill and efficiency of labour alone.

This is not a satisfactory explanation of differences in comparative cots. Ohlin pointed out
more significant factors, namely, differences in factor endowments of the nations and
difference in factor proportions of producing different commodities, which account for

89
differences in comparative costs and hence from the ultimate basis of inter-regional or
international trade.

Thus, Heckscher-Ohlin theory does not contradict and supplant the comparative cost theory
but supplements it by offering sufficiently satisfactory explanation of what causes differences
in comparative costs.

According to Ohlin, the underlying forces behind differences in comparative costs are twofold:

1. The different regions or countries have different factor endowments.

2. The different goods require different factor-proportions for their production.

It is a well-known fact that various countries (regions) are differently endowed with productive
factors required for production of goods. Some countries posses relatively more capital, some
relatively more labour, and some relatively more land.

The factor which is relatively abundant in a country will tend to have a lower price and the
factor which is relatively scarce will tend to have a higher price. Thus, according to Ohlin,
factor endowments and factor prices are intimately associated with each other.

Suppose K stands for the availability or supply of capital in a country, L for that of labour and
PK for price of capital and PL for the price of labour. Further, take two countries A and B; in
country A capital is relatively abundant and labour is relatively scarce. The reverse is the case
in country B. Given these factor-endowments, in country A capital will be relatively cheaper.

In symbolic terms:

Since (K/L)A > (K/L)B

90
Since (PK/PL)A < (PK/PL)B
Thus the differences in factor endowments cause differences in factor prices and therefore
account for differences in comparative costs of producing different commodities. Together
with the difference in factor-endowments, differences in factor proportions required for the
production of different commodities also constitute an important force underlying differences
in comparative costs as between different countries.

Some commodities are such that their production requires relatively more capital than other
factors; they are therefore called capital- intensive commodities. Still other commodities
require relatively more land than capital and labour and are therefore called land-intensive
commodities.

These differences in factor-productions (or what is also called differences in factor-intensities)

needed for the production of different commodities account for differences in comparative
costs of producing different commodities. The differences in comparative costs of producing
different commodities lead to the differences in market prices of different commodities in
different countries.

It follows from above that some countries have a comparative advantage in the production of a
commodity for which the required factors are found in abundance and comparative
disadvantage in the production of a commodity for which the required factors are not available
in sufficient quantities.

Thus a country A which has a relative abundance of capital and relative scarcity of labour will
have a comparative advantage in specialising in the production of capital-intensive
commodities and in return will import labour-intensive goods. This is because (PK/PL)A <
(PK/PL)B.

91
On the other hand, a labour-abundant country B with a scarcity of capital will have a
comparative advantage in specialising in the production of labour-intensive commodities and
export some quantities of them and in exchange for import capital-intensive commodities. This
is because in this country (PL/PK)B < (PL/PK)A.

If factor endowments in the two countries are the same and factor-productions used in the
production of different commodities do not differ, there will be no differences in relative factor
prices [i.e. (PK/PL)A < (PK/PL)B] which will mean differences in comparative costs of
producing commodities in the two countries will be non-existent. In this situation the countries
will not gain from entering into trade with each other.

Let us graphically explain the Heckscher-Ohlin theory of international trade. Take two
countries U.S.A. and India. Assume that there is a relative abundance of capital and scarcity of
labour in U.S.A. and, on the contrary, there is a relative abundance of labour and scarcity of
capital in India. (This is the real situation as well).

Given these factor endowments we have drawn the production possibility curves (also known
as transformation curves) between two commodities, cloth and machines of the two countries,
U.S.A. and India in Fig. 23.5 and 23.6 respectively.

92
Since the two countries have different factor endowments their production possibility curves
will differ. As will be seen from Fig. 23.5, the production possibility curve AB of U.S.A.
shows that given its factor endowments, U.S.A. can produce relatively more of
capital-intensive commodity machines and relatively less of labour-intensive commodity cloth.

On the contrary, as will be seen from Fig. 23.6 with given factor endowments, India can
produce relatively more of labour-intensive commodity cloth and relatively less of
capital-intensive commodity machines.

In the absence of foreign trade, equilibrium in each country would be determined by the
following rule:

MRTMC = MRSMC = PM/PC

Where MRSMC stands for a marginal rate of transformation of machines into cloth, MRSMC
for marginal rate of substitution of machines for cloth and PM/PC for the price ratio between
the two commodities.

93
In the geometric terms, the above rule implies that in the absence of foreign trade the
production and consumption in the two countries would take place at the tangency point of the
given production possibility curve with the highest possible community indifference curve.

It will be observed from Figure 23.5 that in the absence of trade, U.S.A. will be in equilibrium
position with production and consumption at point R where its production possibility curve
AB is tangent to its community indifference curve II.

The tangent pp to the production possibility curve AB and the community indifference curve II
at point R indicates the ratio of price of the two commodities (i.e. the domestic rate of
exchange) before trade in U.S.A.

As regards India, as shown in Figure 23.6 before trade, she will be in equilibrium with
production and consumption at point Q at which its production possibility curve is tangent to
its community indifference curve II. Tangent pp at point Q to its production possibility curve
EF and the community indifference curve II shows the domestic rate of exchange of two
commodities before foreign trade.

It will be seen from Figures 23.5 and 23.6 that the price ratio (rate of exchange) of the two
commodities in the two countries differs (slopes of tangents pp in them vary). It will therefore
pay the two countries to enter into trade with each other. Suppose, the terms of trade, that is,
the ratio of exchange of goods between the two countries is given by the line tt.

It will be observed that with terms of trade line tt, U.S.A. will be in equilibrium from the view
point of production at point R’ at which the terms of trade line tt is tangent to its production
possibility curve AB. However, its consumption point after trade is C which is determined by
the tangency of the terms of trade line tt with the community indifference curve III.

94
It will be seen from Figure 23.5 that in U.S.A. the consumption point C after trade lies at a
higher indifference curve than before trade indicating the gain from trade it obtains. The
consumption point C of U.S.A. as compared to its production point R’ after trade reveals that
U.S.A. produces HR’ more of machines and HC less of cloth than it consumes domestically.
Thus U.S.A. will export HR’ of machines and import HC of cloth.

As regards India, it is evident from Figure 23.6 that as a result of trade its production point will
shift to point Q’ where its product possibility curve EF is tangent to the terms of trade line tt.
After trade, consumption in India will take place at point C at which the terms of trade line tt is
tangent to its community indifference curve III.

As a result of trade India has also gained as she has reached a higher community indifference
curve. Thus after trade with the production point Q’ and consumption point C, India will
produce SQ’ more of cloth and SC less of machines than it consumes at home. Thus India will
export SQ’ of cloth and import SC of machines.

It follows from above that due to differences in factor endowments in U.S.A. and India also
and due to different factor proportions required for the production of different commodities the
basis for trade between the two countries exists and both would gain from trade by specialising
in the production of commodities which require factors in respect of which they are well
endowed and will import those commodities which need factors which are relatively in scarce
supply.

Critical Evaluation of Heckscher-Ohlin Theory of International Trade:

Heckscher and Ohlin theory has made invaluable contributions to the explanation of
international trade. Though this theory accepts comparative costs as the basis of international
trade, it makes several improvements in the classical comparative cost theory.

95
First, it rescued the theory of international trade from the grip of labour theory of value and
based it on the general equilibrium theory of value according to which both demand and
supply conditions determine the prices of goods and factors.

Second, Heckscher-Ohlin theory removes the difference between international trade and
inter-regional trade, for the factors determining the two are the same. Third, a significant
improvement is the explanation offered for difference in comparative costs of commodities
between trading countries.

Ricardo thought that the differences in labour efficiency alone accounted for the differences in
comparative costs. According to Heckscher and Ohlin, as seen above, the differences in
factor-endowments of the countries and also the differences in factor proportions required for
producing various commodities explain differences in comparative costs and hence from the
ultimate basis of international trade.

These reasons advanced by Heckscher and Ohlin for differences in comparative costs of
commodities in different countries are considered to be broadly true.

Fourth, as has been pointed out by Prof. Lancaster, Heckscher-Ohlin model provides a
satisfactory picture of the future of foreign trade. According to the Ricardian theory,
international trade exists because of differences in skill and efficiency of labour alone.

This implies that as there is transmission of knowledge between the countries so that they
master the techniques and skills of each other, then differences in comparative costs would
cease to exist and as a result international trade would come to an end. But this is not likely to
occur despite the fact that transmission of knowledge and techniques has greatly increased
these days.

96
Heckscher and Ohlin explain that international trade is due to the differences in
factor-endowments (i.e. differences in supplies of all factors and not only of labour efficiency)
and different factor-proportions required for different commodities. Since the factors such as
land and other natural resources lack mobility, international trade would not cease to exist even
if there is perfect transmission of knowledge between the countries.

Despite the above merits of Heckscher-Ohlin theory, it has some shortcomings which are
briefly discussed below:

1. Leontief Paradox:

In the Heckscher-Ohlin theory it has been assumed that relative factor prices reflect the
relative supplies of factors. That is, a factor which is found in abundance in a country will have
a lower price and vice versa. This means that in the determination of factor-prices supply
outweighs demand.

But if demand for factors prevails over supply, then factor prices so determined would not
conform to the supplies of factors. Thus, if in a country there is abundance of capital and
scarcity of labour in physical terms but there is relatively much greater demand for capital,
then the price of capital would be relatively higher to that of labour.

Then, under these circumstances, contrary to its factor-endowments, the country many export
labour-intensive goods and import capital-intensive goods. Perhaps it is this which lies behind
the empirical findings by Leontief that though America is a capital abundant and labour-scarce
country, in the structure of its imports capital-intensive goods are relatively greater whereas in
the structure of its exports labour- intensive goods are relatively greater. As this is contrary to
the popularly held view, this is known as Leontief Paradox.

2. Difference in Preferences or Demands for Goods:

97
Against Hecksher-Ohlin theorem, it has also been pointed out that differences in tastes and
preferences for goods or, to put it in other words, differences in pattern of demand also give
rise to trade between the countries. This is because under differences in demand or preferences
for goods, the commodity price-ratios would not conform to the cost-ratios based on factor
endowments.

Let us take an extreme example. Suppose there are two countries A and B with same
factor-endowments. According to Heckscher-Ohlin theorem, with same factor endowments
cost-ratio of producing the two commodities and hence the commodity price ratio would be
the same.

Hence there is no possibility of trade between the two countries on the basis of
Heckscher-Ohlin theorem. However, trade between the two countries is possible if the demand
pattern or preferences of the people of the two countries for wheat and rice greatly differ.

98
TARIFFS AND QUOTAS IN INTERNATIONAL TRADE:
The difference between quotas and tariffs:

Quotas and tariffs are both used to protect domestic industries by artificially raising prices in
the domestic market. Their administration and effects, however, differ in specific ways. Quotas
restrict the quantity of a good imported from another country. Tariffs are a charge levied on the
value of goods imported from another country.

While tariffs generate revenue that is paid to the importing country’s treasury, the value of a
quota, also called “quota rents,” generally goes to the foreign exporters who are able to sell
goods subject to the quota at higher prices and collect higher per unit revenue. In both cases,
domestic consumers in the importing country pay the costs of tariffs and quota rents. But with
quotas, the government of the importing country receives no revenue.

Quotas can be much more complicated to administer than tariffs. Tariffs are collected by a
customs authority as goods enter a country. With quotas, customs authorities must either
monitor imports directly to ensure that no goods above the quota amount are imported, or can
award licenses to specific companies, giving them the right to import the amount allowed
under the quota. Quotas can also take the form of a voluntary export restraint (VER), where
the exporting country administers the quota.

The cost of quotas:

Costs and pricing under a tariff regime are more transparent and predictable compared to
quotas. For example, if a good is subject to a 10 percent tariff, then the good should cost about
10 percent more than it did before the tariff was imposed. With a quota, the price of that same
good can increase as long as demand for the good continues and the supply remains
constrained. This can mean that quota rents are ultimately more costly to domestic consumers
than a tariff. In this way, quota regimes may incentivize foreign producers to upgrade the

99
quality of their exports, leading to more direct competition with domestic producers and a
higher-price product mix for consumers.

On the other hand, if foreign producers export low quality goods under a quota regime, prices
and profits for both foreign and domestic producers of low quality goods will rise because of
quotas, while domestic consumers were forced to pay more for lower quality goods.

BALANCE OF TRADE AND BALANCE OF PAYMENTS:

Balance of Trade:

Balance of trade records the volume of good and services imported as well as exported by a
country to other countries. If the value o imports is more than the value of a country’s
exports, the country has negative or unfavourable balance of trade. If the value of
exports is more than the value of imports, then the country has a positive or favourable balance
of trade.

Balance of trade and balance of payments have serious implications for a country’s
economy. A negative balance would mean that the country spends more on buying goods than
it can earn by selling its goods. This would ultimately lead to exhaustion of its financial
Reserves.

Balance of Payments:

100



 






  

  
 





     
  
    
  

   
   
    
  
   
   
   
 
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105
DISEQUILIBRIUM IN BALANCE OF PAYMENTS AND
HOW IT IS RECTIFIED:

Method 1# Trade Policy Measures: Expanding Exports and Restraining Imports:

Trade policy measures to improve the balance of payments refer to the measures adopted to
promote exports and reduce imports.

Exports may be encouraged by reducing or abolishing export duties and lowering the interest
rate on credit used for financing exports. Exports are also encouraged by granting subsidies to
manufacturers and exporters.

Besides, on export earnings lower income tax can be levied to provide incentives to the
exporters to produce and export more goods and services. By imposing lower excise duties,
prices of exports can be reduced to make them competitive in the world markets.

On the other hand, imports may be reduced by imposing or raising tariffs (i.e., import duties)
on imports of goods. Imports may also be restricted through imposing import quotas,
introducing licenses for imports. Imports of some inessential items may be totally prohibited.

Before the economic reforms carried out since 1991. India had been following all the above
policy measures to promote exports and restrict imports so as to improve its balance of
payments position. But they had not achieved full success in their aim to correct balance of
payments disequilibrium.

Therefore, India had to face great difficulties with regard to balance of payments. At several
occasions it approached IMF to bail it out of the foreign exchange crisis that emerged as a
result of huge deficits in the balance of payments. At long last, economic crisis caused by
persistent deficits in balance of payments forced India to introduce structural reforms to
achieve a long-lasting solution of balance of payments problem.

Method 2# Expenditure-Reducing Policies:

The important way to reduce imports and thereby reduce deficit in balance of payments is to
adopt monetary and fiscal policies that aim at reducing aggregate expenditure in the economy.
The fall in aggregate expenditure or aggregate demand in the economy works to reduce
imports and help in solving the balance of payments problem.

106
The two important tools of reducing aggregate expenditure are the use of:

(1) Tight monetary policy and

(2) Concretionary fiscal policy.

We explain them below:

Tight Monetary Policy:

Tight monetary is often used to check aggregate expenditure or demand by raising the cost of
bank credit and restricting the availability of credit. For this bank rate is raised by the Central
Bank of the country which leads to higher lending rates charged by the commercial banks.
This discourages businessmen to borrow for investment and consumers to borrow for buying
durable consumers goods.

This therefore leads to the reduction in investment and consumption expenditure. Besides,
availability of credit to lend for investment and consumption purposes is reduced by raising
the cash reserve ratio (CRR) of the banks and also undertaking of open market operations
(selling Government securities in the open market) by the Central Bank of the country.

This also tends to lower aggregate expenditure or demand which will helps in reducing
imports. But there are limitations of the successful use of monetary policy to check imports,
especially in a developing country like India. This is because tight monetary policy adversely
affects investment increase in which is necessary for accelerating economic growth.

If a developing country is experiencing inflation, tight monetary policy is quite effective in

curbing inflation by reducing aggregate demand. This will help in reducing aggregate
expenditure and, depending on the income propensity to import, will curtail imports. Besides,
tight monetary policy helps to reduce prices or lower the rate of inflation. Lower price level or
lower inflation rate will curb the tendency to import, both on the part of businessmen and
consumers.

But when a developing country like India is experiencing recession or slowdown in-economic
growth along with deficits in balance of payments, use of tight monetary policy that reduces
aggregate expenditure or demand will not help much as it will adversely affect economic
growth and deepen economic recession. Therefore, in a developing country, monetary policy

107
has to be used along with other policies such as a appropriate fiscal policy and trade policy to
tackle the problem of disequilibrium in the balance of payments.

Contractionary Fiscal Policy:

Appropriate fiscal policy is also an important means of reducing aggregate expenditure. An

increase in direct taxes such as income tax will reduce aggregate expenditure. A part of
reduction in expenditure may lead to decrease in imports. Increase in indirect taxes such as
excise duties and sales tax will also cause reduction in expenditure.

The other fiscal policy measure is to reduce Government expenditure, especially unproductive
or non-developmental expenditure. The cut in Government expenditure will not only reduce
expenditure directly but also indirectly through the operation of multiplier.

It may be noted that if tight monetary and contractionary fiscal policies succeed in lowing
aggregate expenditure which causes reduction in prices or lowering the rate of inflation, they
will work in two ways to improve the balance of payments. First, fall in domestic prices or
lower rate of inflation will induce people to buy domestic products rather than imported goods.
Second, lower domestic prices or lower rate of inflation will stimulate exports. Fall in imports
and rise in exports will help in reducing deficit in balance of payments.

However, it may be emphasised again that the method of reducing expenditure through
contractionary monetary and fiscal policies is not without limitations. If reduction in aggregate
demand lowers investment, this will adversely affect economic growth. Thus, correction in
balance of payments may be achieved at the expense of economic growth.

Further, it is not easy to reduce substantially government expenditure and impose heavy taxes
as they are likely to affect incentives to work and invest and invite public protest and
opposition. We thus see that correcting the balance of payments through contractionary fiscal
policy is not an easy matter.

Method 3# Expenditure – Switching Policies: Devaluation:

A significant method which is quite often used to correct fundamental disequilibrium in

balance of payments is the use of expenditure-switching policies. Expenditure switching
policies work through changes in relative prices. Prices of imports are increased by making
domestically produced goods relatively cheaper. Expenditure switching policies may lower the
prices of exports which will encourage exports of a country. In this way by changing relative

108
prices, expenditure-switching policies help in correcting disequilibrium in balance of
payments.

The important form of expenditure switching policy is the reduction in foreign exchange rate
of the national currency, namely, devaluation. By devaluation we mean reducing the value or
exchange rate of a national currency with respect to other foreign currencies. It should be
remembered that devaluation is made when a country is under fixed exchange rate system and
occasionally decides to lower the exchange rate of its currency to improve its balance of
payments.

Under the Bretton Woods System adopted in 1946, fixed exchange rate system was adopted,
but to correct fundamental disequilibrium in the balance of payments, the countries were
allowed to make devaluation of their currencies with the permission of IMF. Now, Bretton
Woods System has been abandoned and most of the countries of the world have floated their
currencies and have thus adopted the system of flexible exchange rates as determined by
market forces of demand for and supply of them.

However, even in the present flexible exchange rate system, the value of a currency or its
exchange rate as determined by demand for and supply of it can fall. Fall in the value of a
currency with respect to foreign currencies as determined by demand and supply conditions is
described as depreciation.

If a country permits its currency to depreciate without taking effective steps to check it, it will
have the same effects as devaluation. Thus, in our analysis we will discuss the effects of fall in
value of a currency whether it is brought about through devaluation or depreciation. In July
1991, when India was under Bretton-Woods fixed exchange rate system, it devalued its rupee
to the extent of about 20%. (From Rs. 20 per dollar to Rs. 25 per dollar) to correct
disequilibrium in the balance of payments.

Now, the question is how devaluation of a currency works to improve balance of payments. As
a result of reduction in the exchange rate of a currency with respect to foreign currencies, the
prices of goods to be exported fall, whereas prices of imports go up. This encourages exports
and discourages imports. With exports so stimulated and imports discouraged, the deficit in the
balance of payments will tend to be reduced.

Thus policy of devaluation is also referred to as expenditure switching policy since as a result
of reduction of imports, people of a country switches their expenditure on imports to the
domestically produced goods. It may be noted that as a result of the lowering of prices of

109
exports, export earnings will increase if the demand for a country’s exports is price elastic (i.e.,
er > 1). And also with the rise in prices of imports the value of imports will fall if a country’s
demand for imports is elastic. If demand of a country for imports is inelastic, its expenditure
on imports will rise instead of falling due to higher prices of imports.

Devaluation: Marshall Lerner Condition. It is clear from above that whether devaluation or
depreciation will lead to the rise in export earnings and reduction in import expenditure
depends on the price elasticity of foreign demand for exports and domestic demand for
imports.

Marshall and Lerner have developed a condition which states that devaluation will succeed in
improving the balance of payments if sum of price elasticity of exports and price elasticity of
imports is greater than one. Thus, according to Marshall-Lerner Condition, devaluation
improves balance of payments if

ex + em > 1

where

ex stands for price elasticity of exports

em stands for price elasticity of imports

If in case of a country ex + em < 1, the devaluation will adversely affect balance of payments
position instead of improving it. If ex + em = 1, devaluation will leave the disequilibrium in
the balance of payments unchanged.

Income-Absorption Approach to Devaluation:

Further, for devaluation to be successful in correcting disequilibrium in the balance of

payments a country should have sufficient exportable surplus. If a country does not have
adequate amount of goods and services to be exported, fall in their prices due to devaluation or
depreciation will be of no avail.

This can be explained through income-absorption approach put forward by Sidney S

Alexander. According to this approach, trade balance is the difference between the total output
of goods and services produced in a country and its absorption by it.

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By absorption of output of goods and services we mean how much of them is used up for
consumption and investment in that country. That is, absorption means the sum of
consumption and investment expenditure on domestically produced goods and services.

Expressing algebraically we have;

B=Y–A

Where:

B = trade balance or exportable surplus

Y = national income or value of output of goods and services produced

A = Absorption or sum of consumption and investment expenditure

It follows from above that if expenditure or absorption is less than national product, it will
have positive trade balance or exportable surplus. To create this exportable surplus,
expenditure on domestically produced consumer and investment goods should be reduced or
national product must be raised sufficiently.

To sum up, it follows from above that for devaluation or depreciation to be successful in
correcting disequilibrium in the balance of payments, the sum of price elasticities of demand
for a country s exports and imports should be high (that is, greater than one) and secondly it
should have sufficient exportable surplus. The devaluation will also not be successful in the
achievement of its aim if other countries retaliate and make similar devaluation in their
currencies and thus competitive devaluation of the exchange rate may start.

After Independence India devalued its currency three times, first in 1949, the second in June
1966 and third in July 1991 to correct the disequilibrium in the balance of payments. The
devaluation of June 1966 was not successful for some time to reduce deficit in the balance of
payments.

This is because the demand for bulk of our traditional exports was not very elastic and also we
could not reduce our imports despite their higher prices. However devaluation of July 1991
proved quite successful as after it our exports grew at a rapid rate for some years and growth of
imports remained within safe limits.

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Method 4# Exchange Control:

Finally, there is the method of exchange control. We know that deflation is dangerous;
devaluation has a temporary effect and may provoke others also to devalue. Devaluation also
hits the prestige of a country. These methods are, therefore, avoided and instead foreign
exchange is controlled by the government.

Under it, all the exporters are ordered to surrender their foreign exchange to the central bank of
a country and it is then rationed out among the licensed importers. None else is allowed to
import goods without a licence. The balance of payments is thus rectified by keeping the
imports within limits.

After the Second War World a new international institution’ International Monetary Fund
(IMF)’ was set up for maintaining equilibrium in the balance of payments of member countries
for a short term. Member countries borrow from it for a short period to maintain equilibrium in
the balance of payments. IMF also advises member countries how to correct fundamental
disequilibrium in the balance of Payments when it does arise. It may, however, be mentioned
here that no country now needs to be forced into deflation (and so depression) to root out the
causes underlying disequilibrium as had to be done under the gold standard. On the contrary,
the IMF provides a mechanism by which changes in the rates of foreign exchange can be made
in an orderly fashion.

Conclusion:

In short, correction of disequilibrium calls for a judicious combination of the following

methods:

(i) Monetary and fiscal changes affecting income and prices in the country;

(ii) Exchange rate adjustment, i.e., devaluation or appreciation of the home currency;

(iii) Trade restrictions, i.e., tariffs, quotas, etc.;

(iv) Capital movement, i. e., borrowing or lending aboard; and

(v) Exchange control.

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No reliance can be placed on any single tool. There is room for more than one approach and
for more than one device. But the application of the tools depends on the nature of the
disequilibrium.

There are, we have said, three types of disequilibrium:

(1) Cyclical disequilibrium,

(2) secular disequilibrium,

(3) Structural disequilibrium (at the goods and the factor level).

It is more appropriate that fiscal measures should be used to correct cyclical disequilibrium in
the balance of payments. To correct structural disequilibrium adjustment in exchange rate
should be avoided. Capital movements are needed to offset deep-seated forces in secular
disequilibrium.

The main methods of desirable adjustment are, therefore, monetary and fiscal policies which
directly affect income, and exchange depreciation (that is, devaluation) which affects prices in
the first instance. Devaluation or depreciation of exchange rate can also have income effect
through price effects. Monetary and fiscal policies affect relative prices also.

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 MODULE - IV
FUNCTIONS OF IMF IN INTERNATIONAL TRADE:

Origin of IMF:
The origin of the IMF goes back to the days of international chaos of the 1930s. During the
Second World War, plans for the construction of an international institution for the
establishment of monetary order were taken up.

At the Bretton Woods Conference held in July 1944, delegates from 44 non-communist
countries negotiated an agreement on the structure and operation of the international monetary
system.

The Articles of Agreement of the IMF provided the basis of the international monetary system.
The IMF commenced financial operations on 1 March 1947, though it came into official
existence on 27 December 1945, when 29 countries signed its Articles of Agreement (its
charter). Today (May 2012), the IMF has near-global membership of 188 member countries.
Virtually, the entire world belongs to the IMF. India is one of the founder- members of the
Fund.

Objectives:

Article 1 of the Articles of Agreement (AGA) spell out 6 purposes for which the IMF was set
up.

These are:

I. To promote international monetary cooperation through a permanent institution which

provides the machinery for consolation and collaboration on international monetary problems.

II. To facilitate the expansion and balanced growth of international trade, and to contribute
thereby to the promotion and maintenance of high levels of employment and real income and
to the development of the productive resources of all members as primary objective of
economic policy.

III. To promote exchange stability, to maintain orderly exchange arrangements among

members, and to avoid competitive exchange depreciation.

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IV. To assist in the establishment of a multilateral system of payments in respect of current
transactions between members and in the elimination of foreign exchange restrictions which
hamper the growth of world trade.

V. To give confidence to members by making the general resources of the Fund temporarily
available to them under adequate safeguards, thus providing them with the opportunity to
correct maladjustments in their balance of payments, without resorting to measures destructive
of national or international prosperity.

VI. In accordance with the above, to shorten the duration and lessen the degree of
disequilibrium in the international balance of payments of members.

All these objectives of the IMF may be summarised:

To promote international cooperation; to facilitate the expansion and balanced growth of

international trade; to promote exchange stability; to assist in the establishment of a
multilateral system of payments; to make its general resources available to its members
experiencing balance of payments difficulties under adequate safeguards; and to shorten the
duration and lessen the degree of disequilibrium in the international balance of payments of
members.

Functions:

The principal function of the IMF is to supervise the international monetary system. Several
functions are derived from this. These are: granting of credit to member countries in the midst
of temporary balance of payments deficits, surveillance over the monetary and exchange rate
policy of member countries, issuing policy recommendations. It is to be noted that all these
functions of the IMF may be combined into three.

These are: regulatory, financial, and consultative functions:

Regulatory Function:
The Fund functions as the guardian of a code of rules set by its (AOA— Articles of
Agreement).

Financial Function:
It functions as an agency of providing resources to meet short term and medium term BOP
disequilibrium faced by the member countries.

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Consultative Function:
It functions as a centre for international cooperation and a source of counsel and technical
assistance to its members.

The main function of the IMF is to provide temporary financial support to its members so that
‘fundamental’ BOP disequilibrium can be corrected. However, such granting of credit is
subject to strict conditionality. The conditionality is a direct consequence of the IMF’s
surveillance function over the exchange rate policies or adjustment process of members.

The main conditionality clause is the introduction of structural reforms. Low income countries
drew attraction of the IMF in the early years of 1980s when many of them faced terrible BOP
difficulties and severe debt repayment problems. Against this backdrop, the Fund took up
‘stabilisation programme’ as well as ‘structural adjustment programme’. Stabilisation
programme is a demand management issue, while structural programme concentrates on
supply management. The IMF insists member countries to implement these programmes to
tackle macroeconomic instability.

Its main elements are:

(i) Application of the principles of market economy;

(ii) Opening up of the economy by removing all barriers of trade; and

(iii) Prevention of deflation.

The Fund provides financial assistance. It includes credits and loans to member countries with
balance of payments problems to support policies of adjustment and reform. It makes its
financial resources available to member countries through a variety of financial facilities.

It also provides concessional assistance under its poverty reduction and growth facility and
debt relief initiatives. It provides fund to combat money- laundering and terrorism in view of
the attack on the World Trade Centre of the USA on 11 September 2001.

In addition, technical assistance is also given by the Fund. Technical assistance consists of
expertise and support provided by the IMF to its members in several broad areas : the design
and implementation of fiscal and monetary policy; institution-building, the handling and

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accounting of transactions with the IMF; the collection and retirement of statistical data and
training of officials.

Maintenance of stable exchange rate is another important function of the IMF. It prohibits
multiple exchange rates.

It is to be remembered that unlike the World Bank, the IMF is not a development agency.
Instead of providing development aid, it provides financial support to tide over BOP
difficulties to its members.

FUCNTION OF IBRD/WORLD BANK IN

INTERNATIONAL TRADE:

The International Bank for Reconstitution and Development (popularly known as World Bank)
was set up as a result of the decision taken in Bretton Woods Conference New Hampshire.

There it was decided to set up two organisations i.e., (a) the I.M.F. and (b) the I.B.R.D., to
solve the monetary and financial problems of the less developed countries likely to be faced in
Post-World War II period.

The I.B.R.D. or World Bank was set up on December 27, 1945. When its Articles of
Agreement was signed by 29 members Government in Washington. On 30th June, 1996, 185
countries were its members. If a country resigns its membership, it is required to pay back all
loans with interest on due dates. If the Bank incurs a financial loss in the year in which a
member resigns, it is required to pay its share of the loss on demand.

Functions:
(i) It may lend funds directly, either from its capital funds or from the funds it borrowed in
private investment markets.

(ii) It may guarantee loans advanced by other or it may participate in such loans.

(iii) Loans may be advanced to member countries directly or any of their political
sub-divisions or to private business or agricultural enterprises in the territories of members.

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(iv) It has provided loans to the developing countries for development projects and
programmes because credit rating of many developing countries is poor—hence they feel
difficulties in raising funds in international capital markets.

(v) The World Bank is a vital source to the developing countries, when the member
Government in whose territory the project is located, is not the borrower, the World Bank asks
the member Government for a guarantee.

India and the World Bank:

As we are aware that India is one of the founder members of the Bank and has occupied a
permanent seat on its Board of Executive Directors for a number of years.

Therefore, India is very much attached and is in link with the bank and has received many
benefits which are as follows:

1. The Bank has extended assistance to India in its planned economic development by granting
loans, conducting field surveys, rendering expert advice and training Indian personnel at the
E.D.I. (Economic Development Institute).

2. The Bank has established a Chief of Mission of the Bank at New Delhi, who monitors the
aided projects in India.

3. It is said that India has been the largest receiver of the World Bank assistance.

4. The Bank also helped India to solve amicably its river water dispute with Pakistan.

In the end it can be said that India has gained much for being the member of the World Bank
for the development of agriculture, industry, energy and transport. In future India, will have to
borrow more from the Bank.

FUNCTIONS OF WTO:

WTO is officially defined as the legal and institutional foundation of the multilateral trade
system.

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Unlike GATT, the WTO is a permanent organisation created by international treaty ratified by
the governments and legislatures of member states. As the principal international body
concerned with solving trade problems between countries and providing a forum for
multilateral trade negotiations, it has global status similar to that of the International Monetary
Fund and the World Bank.

Functions of WTO:

WTO has the following five functions to perform:

(1) The WTO provides the framework for implementation, administration and operation of
multilateral trade agreements reached at Uruguay Round.

(2) The WTO provides the forum for further negotiations among its member states concerning
their multilateral trade relations with regard to the matters included in the agreements reached
at Uruguay Round.

(3) The WTO undertakes the task of settlement of disputes among the member states, which
arise from their different understandings of the rules and procedure agreed upon.

(4) The WTO administers the ‘ Trade Review Mechanism.’

(5) In order to evolve a coherent global economic policy to promote free and fair trade among
the different countries, WTO cooperates in an appropriate manner with the IMF; World Bank
and its affiliated agencies.

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