Economics 4th Sem Notes University

Note: Economics, IV Semester 5 Year BA LLB, Govt.
Law College, Trivandrum

Asst.Prof : Midhun V P
Paper – II
MONEY, BANKING, PUBLIC FINANCE AND

INTERNATIONAL TRADE
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Note: Economics, IV Semester 5 Year BA LLB, Govt. Law College, Trivandrum
Syllabus
I (a) Money – its functions, Inflation and deflation, causes and control Quantity theory of
money. I/S and L/M curve theory.
(b) Development of commercial Banks in India, Balance sheet of Bank , Process of credit
creation – Recent reforms in commercial banking – Nationalisation of banks - Recent trends of
disinvestment in the Banking sector.
(c) Theory of central banking- objectives and methods of credit control – Money and capital
markets in India.
II (a) Meaning and scope of public finance, The principle of Maximum social advantage
(b) Difference sources of public revenue – principles of taxation – Public expenditure and causes
of its increase and impact of public expenditure and financial policy.
(c) Sources of public debt. Effect of public debt, Redemption of public debt, Role of Budget
and budgetary process.
III (a) International Trade – Internal and international Trade, Theories of absolute advantage,
comparative advantage , Heckscher – Ohlin theory of international trade , Tariffs and quotas in
international trade.
(b) Balance of trade and Balance of payments – Disequilibrium in balance of payments and How
is it rectified.
IV Functions of IMF, IBRD and WTO in International Trade and economic relations.
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Reading Lists:
1. R.S.Sayers : Modern Banking
2. S.K.Basu :A Survey of contemporary Banking Trends
3. Decock : Central Banking
4. Reserve Bank of India : Report on currency and Banking
5. Narasimhan Committee Report
6. Musgrave .R and :Public Finance Theory and practice Musgrave .R.B
7. Mithani.D.M :Modern Public Finance
8. Bhargava.R.N :The timing and working of woman finance in India
9. Govt.Of India :Economic Survey Browning :Public Finance and the Price
Systems, Pearson.
10. Cnossen :Public Finance and Public Policy in new century, Pearson.
11. Kenan.P.B(1994) :The International Economy, Cambridge University Press, London
12. Kindlberger. C.F (1973) :International Economics, R.D.Irwin, Homewood
Krugman.P.R. and M.Obstageld (1194) :International Economics: Theory and Policy,
Glenview, Foresman.
13. Salvatore,D.L(1997) : International Economics, prentice Hall, Upper Saddle Rivewr,N.J
14. Sodersten,B(1991) :International Economics, Macmillan Press Ltd, London
15. Aggarwal,M.R.(1979) : Regional Economic Corporation in South Asia, S.Chand and Co,
New Delhi.
16. Bhagwati,J.(Ed)(1981) :International Trade, Selected Readings, Cambridge University
Press, Mass.
17. Crockett,A(1982) :International Money:issue and Analysis,ELBS and Nelson, London.
20.Greenway,D(1983) :International Macmillan Publishers Ltd, London
18. Heller,H.R (1968) :International Monetary Economics, Prentice Hall India
19. Joshi.V.andI.M.D.Little(1998):India’s Economic Reforms, 1999-2001, Oxford University
Press, Delhi.
20. Nayyar.D (1976) : India’s Exports and Export Policies in the 1960’s, Cambridge
University Press, Cambridge.
21. Panchmukhi,V.R(1978) : Trade Policies of India: A quantitative Analysis, Concept
Publishing company, New Delhi
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22. Patel,S.J (1995) : Indian Economy Towards the 21st Century, University Press Ltd,
India.
23. Singh,M (1964) : India Export Trends and the Prospects for Self-sustained Growth,
Oxford University Press, Oxford.
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Important Questions
2 marks
1. Money
2. Inflation
3. Credit Creation
4. Money market
5. Capital market
6. MSA Maximum Social Advantage
7. Balance of Payments
8. Balance of Trade
9. Public debt
10. Tariff
11. Quota
12. Absolute Advantage
13. Comparative Cost advantage
14. IMF
15. WTO
16. IBRD
17. Barter System
5 Marks
1. Money and its Functions
2. Meaning, type s and Reasons for inflation
3. Brief note on Nationalization of Banks
4. Recent Reform in Commercial Bank/ Narasimham Committee Report
/disinvestment in banking sector (May be Essay)
5. Write note on Credit Creation by Commercial Bank
6. Meaning and Scope of Public Finance
7. Principle of Maximum Social advantage
8. Sources of Public Revenue
9. Sources of Public Debt
10. Absolute Cost Advantage
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11. Relative Cost Advantage/ Comparative Cost Advantage

12. Difference between internal and International Trade
13. Structure of Balance of payments
14. Difference between Balance of Trade and Balance of Payments
15. Wagner’s Law and Peacock Wiseman thesis
16. Canon/Principles of Taxation
17. Balance sheet of Commercial bank
18. Impact of Public expenditure
19. Budgetary Process
Essays
1. Nationalization of Commercial Banks and its achievements
2. Monetary policy of Central / Credit Control by central Banks
3. Development of Capital Market in India
4. The Reasons for the growth of public expenditure in India
5. Public debt and methods of redemption of public debt
6. Balance of Payments and How is it Rectified
7. Role of IMF and IBRD in international Trade (may be 5)
8. WTO and international trade (may be 5)
Most Important Topics Chapter wise (important questions and chapter wise topic are
almost same)
I Chapter
1. Meaning, type s and Reasons for inflation
2. Money and its Functions 5
3. Nationalization of Commercial Banks and its achievements Essay
4. Write note on Credit Creation by Commercial Bank
5. Recent reforms in commercial banking, narasimham, disinvestment Essay
6. Monetary policy of Central / Credit Control by central Banks Essay
7. Development of Capital Market in India Essay
8. Money Market 5 or 2
II Chapter
1. Meaning and Scope of Public Finance 5
2. Principle of Maximum Social advantage 5
3. Sources of Public Revenue 5
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4. Canon/Principles of Taxation 5
5. The Reasons for the growth of public expenditure in India Essay or 5
6. Wagner’s Law and Peacock Wiseman thesis 5
7. Public debt and methods of redemption of public debt Essay
9) sources of public debt 5
III Chapter
1. Balance of Payments , disequilibrium and How is it Rectified Essay
2. Absolute Cost Advantage 5
3. Relative Cost Advantage/ Comparative Cost Advantage 5
4. tariff and quota (Max 5 marks) 2 or 5
5. BOP and BOT 5
6. IMF IBRD and WTO : Meaning …structure …Objective … …Performance
(enough) (Essay or 5 Marks)
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Money and Banking

Barter system
Barter system is a system that was used in ancient times to exchange goods. In other words, this
system was used to exchange one commodity for another before the monetary system came into
existence. For example, if a person having rice wants tea, then he can exchange rice with a
person who has tea and needs rice. The economy having the barter system was called 'C-C
economy', i.e. commodity is exchanged for commodity.
The various drawbacks of the barter system are as follows:
1. Problem of double coincidence of wants
Double coincidence of wants implies that needs of two individuals should complement each
other for the exchange to take place. For example, in the above case, the second person must
need rice in exchange of tea.
2. Lack of common unit of value
Under barter system there was no common unit for measuring the value of one good in terms of
the other good for the purpose of exchange. For example, a horse cannot be measured in terms of
rice in the case of exchange between rice and horse.
3. Difficulty in wealth storage
It was very difficult to store commodities for future exchange purposes. The perishable goods
like grains, milk and meat could not be stored to exchange goods in future. Therefore, wealth
storage was a major difficulty of batter system.
4. Lack of standard of deferred payments
The future payments could not be met in a C-C economy (barter system) as wealth could not be
stored. It was very difficult to pay back loans.
Definition of Money
It is very difficult to give a precise definition of money. Various authors have given different
definition of money. According to Crowther, “Money can be defined as anything that is
generally acceptable as a means of exchange and that at the same time acts as a measure
and a store of value”. Professor D H Robertson defines money as “anything which is widely
accepted in payment for goods or in discharge of other kinds of business obligations. From
the above two definitions of money two important things about money can be noted. Firstly,
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money has been defined in terms of the functions it performs. That is why some economists
defined money as “money is what money does”. It implies that money is anything which
performs the functions of money. Secondly, an essential requirement of any kind of money is
that it must be generally acceptable to every member of the society. Money has a value for ‘A’
only when he thinks that ‘B’ will accept it in exchange for the goods. And money is useful for
‘B’ only when he is confident that ‘C’ will accept it in settlement of debts. But the general
acceptability is not the physical quality possessed by the good. General acceptability is a social
phenomenon and is conferred upon a good when the society by law or convention adopts it as a
medium of exchange.
Functions of Money
FUNCTIONS OF MONEY: Functions of money can be classified into Primary and Secondary
Primary/Basic functions:-
The primary functions of money are;
• Medium of exchange and
• Measure of value
1. Medium of exchange
Money acts as a medium of exchange as it facilitates exchange through a common medium, i.e.
currency. In other words, money helps in the buying and selling of goods. For example, a person
can sell his goods to another for money and that person can use money to purchase goods of his
choice. Money solves the problem of double coincidence of wants.
2. Unit of value
The values of goods can be measured in terms of money. It is a common medium through which
we can calculate the value of each and every good. The value of a good in terms of money is
called the price. In barter system the lack of a common denominator for measuring values of
goods was a major drawback.
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II. Secondary functions

The secondary functions of money are;
3. Store of value
This function explains the importance of money as value storage. This implies that wealth in the
form of money can be stored easily as a medium of exchange for future use. For example, money
can be stored in banks for meeting emergency and future needs.
4. Standard of deferred payments
Payments can easily be made through the medium of money. In other words, it is very difficult to
pay back a loan in terms of goods and services. However, with the advent of money the
payments of loans or interests can easily be made.
III. Contingent functions
The important contingent functions of money are;
(i) Basis of credit
It is with the development of money market the credit market began to flourish.
(ii) Distribution of national income
Being a common measure of value, money serves as the best medium to distribute the national
income among the four factors of production.
(iii) Transfer of value
Money helps to transfer value from one place to another.
(iv) Medium of compensations
Accidents and carelessness cause damage to the property and life. Compensation can be paid to
such damages in terms of money.
(v) Liquidity
Liquidity means the ready purchasing power or convertibility of money in to any commodity.
Money is the most liquid form of all assets.
(vi) Money guide in production and consumption.
Utility of goods and services can be expressed in terms of money. Similarly, marginal
productivity is measured in terms of prices of goods and factors. Thus money become the base of
measurement and which directs the production and consumption.
(vii) Guarantor of solvency
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Solvency refers to the ability to pay off debt. Persons and firms have to be solvent while doing
the business. The deposits of money serves as the best guarantor of solvency.
MONEY SUPPLY: refers to total volume of money held by public at a particular point of time in
an economy.
M1=currency held by public + Demand deposits + other deposits with Reserve Bank of India.
M2=M1+saving deposits with post office saving bank
M3=M1+net time deposit with the bank
M4=M3 + total deposits with post office saving bank excluding national saving certificate
HIGH POWERED MONEY: Refers to, currency with the public (notes +coins) and cash reserve
of banks.
INFLATION AND DEFLATION
I. Meaning of Inflation
Inflation is a highly controversial term. By inflation we mean a general rise in prices. More
precisely, inflation is a persistent rise in the general price level rather than a once-for-all rise in
it. It was first defined by neo-classical economists. They meant by it a galloping rise in prices as
a result of the excessive increase in the quantity of money. To the neo-classical and their
followers at the University of Chicago, inflation is fundamentally a monetary phenomenon. In
the words of Friedman, “Inflation is always and everywhere a monetary phenomenon and can be
produced only by a morse rapid increase in the quantity of money than output”. Coulborn defines
inflation as “too much money chasing too few goods.” But many economists do not agree that
money supply alone is the cause of inflation. As pointed out by Hicks, ‘Our present troubles are
not of a monetary character’. Economists, therefore, define inflation in terms of a continuous rise
in prices. Johnson defines “inflation as a sustained rise in prices”. Brooman defines it as “a
continuing increase in the general price level”. According to Crowther, inflation is a “state in
which the value of money is falling, ie. the prices are rising.”
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Types of Inflation
Inflation is of various types. We can discuss some of its important types.
1. Creeping Inflation.
When the rise in prices is very slow like that of a snail or creeper, it is called creeping inflation.
In terms of speed, a sustained rise in prices of annual increase of less than 3 percent per annum is
characterized as creeping inflation. Such an increase in prices is regarded as safe and essential
for growth.
2. Walking or Trotting Inflation
When prices rise moderately and the annual inflation rate is a single digit such an inflation is
called walking inflation. In other words, the rate of rise in prices is in the intermediate range of 3
to 6 per cent per annum or less than 10 per cent. Inflation at this rate is a warning signal for the
government to control it before it turns into running inflation.
3. Running Inflation
When prices rise rapidly like the running of a horse at a rate or speed of 10 to 20 per cent per
annum, it is called running inflation. Such an inflation affects the poor and middle classes
adversely. Its control requires strong monetary and fiscal measures, otherwise, it leads to
hyperinflation.
4. Hyper Inflation
When prices rise very fast at double or triple digit rates from more than 20 to 100 per cent per
annum or more, it is usually called ‘runway or galloping inflation. It is also characterized as
hyperinflation. In reality, hyperinflation is a situation when the rate of inflation becomes
immeasurable and absolutely uncontrollable. Prices rise many times every day. Such a situation
brings a total collapse of the monetary system because of the continuous fall in the purchasing
power of money.
5. Open inflation
Inflation is open when ‘markets for goods or factors of production are allowed to function freely,
setting prices of goods and factors without normal interference by the authorities.’ Thus open
inflation is as a result of uninterrupted operation of the market mechanism. There are no controls
on the distribution of commodities by the government. Unchecked open inflation may leads to
hyper inflation.
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6. Suppressed inflation
When the government imposes physical and monetary controls to check inflation, it is known as
suppressed or repressed inflation. The market mechanism is not allowed to function normally by
the use of licensing, price controls and rationing in order to suppress the expensive rise in prices.
So long as such controls exist, the present demand is postponed and there is diversion of demand
from controlled to uncontrolled commodities.
7.Stagflation
Stagflation is a new term which has been added to economic literature in the 1970s. It is a
paradoxical phenomenon where the economy experiences stagnation as well as inflation. The
word stagflation is the combination of ‘stag’ plus ‘flation’ taking ‘stag’ from stagnation and
‘flation’ from inflation. Stagflation is a situation when recession is accompanied by a high rate of
inflation. It is, therefore, also called inflationary recession. The principal cause of this
phenomenon has been excessive demand in the commodity markets thereby causing prices to
rise, and at the same time the demand for labour is deficient thereby creating unemployment in
the economy. Three factors responsible for the existence of stagflation in the advanced countries
since, 1970 are; a. rise in oil prices and other commodity prices along with adverse changes in
the terms of trade; b. the steady and sustained growth of the labour force; and c) rigidities in the
wage structure due to strong trade unions.
Inflation can also be classified into two broad categories: demand-pull inflation and cost
push inflation.
1. DEMAND PULL INFLATION
Demand pull inflation is a situation where price rises due to the excess demand in the economy.
In this sense, inflation is defined as “too much money chasing too few goods”. In other words, an
excess of aggregate demand over aggregate supply causes inflationary rise in prices in the
economy. This can be explained easily with the quantity theory of money. The theory states that
prices rise in proportion to the increase in money supply. Given the full employment level of
output, doubling the money supply will double the price level. So inflation proceeds at the same
rate at which the money supply expands. In this analysis the aggregate supply is assumed to be
fixed and there is always full employment in the economy. Modern quantity theorists led by
Friedman hold that “inflation is always and everywhere a monetary phenomenon.” The higher
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the growth rate of the nominal money supply, the higher is the rate of inflation. When the money
supply increases, people spend more in relation to the available supply of goods and services.
This bids prices up. Modern quantity theorists neither assume full employment as a normal
situation nor a stable velocity of money. Still they regard inflation as a result of increase in the
money supply.
The demand pull inflation is illustrated in the following figure. Suppose the economy is initially
in full employment equilibrium at the point E. At this point equilibrium price is determined by
the intersection of demand and supply curves D and SS1 respectively. Now with the increase in
the quantity of money, the aggregate demand increases. As a result the demand curve shifts to
the right to D1.Since the aggregate supply is fixed which is shown by the vertical portion of the
supply curve SS1, the demand curveD1 intersects it at the point E1. This raises the price level to
OP1.The Keynesian theory on demand-pull inflation is based on the argument that, so long as
there are unemployed resources in the economy, an increase in investment expenditure will lead
to increase in employment, income and output. Once full employment is reached and bottlenecks
appear, further increase in expenditure will lead to excess demand because output ceases to rise,
thereby leading to inflation.
2. COST PUSH INFLATION
Cost push inflation is caused by rise in the cost of production – that is, rise in wages, price of raw
materials or profits.
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a) Rise in wages
The basic cause of cost-push inflation is the rise in the money wages more rapidly than the
productivity of labour. In advanced countries, the trade unions are very powerful. They press the
employers to raise the wages. This leads to increase in cost of production of commodities.
Employers, in turn, raise the prices of their products. Higher wages enable the workersto buy as
much as before, in spite of higher prices. On the other hand, the increase in pricesinduces trade
unions to demand still higher wages. In this way, the wage-cost spiral continues,thereby leading
to cost-push or wage-push inflation.
b) Sectoral rise in prices
A few sectors of the economy may be affected by money wage increases and prices of their
productsmay be rising. In many cases, these products may be used as inputs by other sectors. As
aresult, production costs of other sectors will rise and thereby pushes the prices of their
products.Thus wage-push inflation in a few sectors of the economy may soon lead to inflationary
rise inprices in the entire economy.
c) Rise in prices of imported raw materials
An increase in the prices of imported raw materials may lead to cost-push inflation. Since
rawmaterials are used as inputs by the manufactures of the finished goods, they enter into the
cost ofproduction of the latter. Thus a continuous rise in the prices of raw materials tends to sets
off a costpush inflation.
d) Profit-push inflation
Monopolist and Oligopolist firms raise the prices of their products to offset the rise in labour
andproduction costs so as to earn higher profits. Profit-pull inflation is, therefore, also
calledadministered price theory of inflation or price-push inflation or sellers’ inflation or
marketpower inflation.
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COMMERCIAL BANKING
A bank is an institution which accepts deposits from the public and in turn advances
loans by creating credit. It is different from other financial institutions in that they cannot create
credit though they may be accepting deposits and making advances.
A commercial bank is a business organization which deals money; it borrows and lends
money. In this process of borrowing and lending of money it makes profit. The distinction
between money lender and a commercial bank may be noted. Whereas a money lender only
lends money to others and that too from his own sources, a commercial bank does both the
lending and borrowing business. A commercial bank raises its resources through borrowing from
the public in the form of deposits and lends them to the businessmen. Its lending rate of interest
is greater than that it pays to its depositors. It is because of this difference in lending and
borrowing rates of interest that it is able to make profit.
Functions of Commercial Banks
Commercial banks perform a variety of functions. They can be categorized as accepting deposits,
advancing loans, credit creation, agency functions and miscellaneous functions.
1. Accepting deposits
The banks borrow in the form of deposits. This function is important because banks mainly
depend on the funds deposited with them by the public. The deposits received by the banks can
be of three types;
a)Demand or current account deposits: In this type of deposits the depositor can withdraw the
money in part or in full at any time he likes without notice. These accounts are generally kept by
the businessmen whose requirements of making business payments are quite uncertain. Usually,
noninterest is paid on them, because the bank cannot utilize these short term deposits and must
keep almost cent percent reserve against them. But in return for these current account deposits,
the banks offer some facilities or concession to the account holders. The most important is the
cheque facilitymade available to them. Further, on behalf of the current account deposits, bank
collects cheques, drafts, dividend warrants, postal orders, etc.
b)Fixed deposits or time deposits: These deposits are made for a fixed period of time, which
varies from fifteen days to a few years. These deposits cannot, therefore, be withdrawn before
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the expiry of that period. However, a loan can be taken from the bank against the security of this
deposit within that period. A higher rate of interest is paid on the fixed deposits based on the
period of the deposits.
c) Saving bank deposits: In this case the depositor can withdraw money usually once a week.
These deposits are generally made by the people of small means, usually people with fixed
salaries, for holding short-term savings. Like the current account deposits, the saving bank
deposits are payable on demand and also they can be drawn upon through cheques. But in order
to discourage people to use the saving bank deposits very frequently, there are some restrictions
on the number of times withdrawals can be made from these accounts. The saving deposits carry
lower rate of interest than the fixed deposits.
2. Advancing loans
One of the primary functions of the commercial bank is to advance loans to its customers.A bank
lends a certain percentage of the cash lying in deposits on a higher interest rate than it payson
such deposits. Thus the bank earns profits and carries on its business.The bank advances loans in
the following ways:
a) Cash credit: The bank advances loan to businessmen against certain specified securities. The
amount of loan is credited to the current account of the borrower. In the case of a new customer
aloan account for the sum is opened. The borrower can withdraw money through cheques
accordingto his requirements but pays interest on the full amount.
b) Call loans : These are very short-term loans advanced to the bill brokers for not more than
fifteendays. They are advanced against first class bill or securities. Such loans can be recalled at
a very short notice. In normal times they can also be renewed.
c) Overdraft: A bank often permits a businessmen to draw cheques for a sum greater than the
balance lying in his current account. This is done by providing the overdraft facility up to a
specific amount to the businessmen. But he is charged interest only on the amount by which his
current account is actually overdrawn and not by the full amount of the overdraft sanctioned to
him by the bank.
d) Discounting bills of exchange: If a creditor holding a bill of exchange wants money
Immediately, the bank provides money by discounting the bill of exchange. It deposits the
amount of the bill in the current account of the bill holder after deducting the rate of interest for
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the period of the loan which is not more than 90 days. When the bill of exchange matures, the
bank gets its payment from the banker of the debtor who accepted the bill.
3. Credit creation
Credit creation is one of the most important functions of the commercial banks. Like other
financial institutions, they aim at earning profits. For this purpose, they accept deposits and
advance loans beekeeping a small amount of cash as reserve for day-to-day transactions. When a
bank advances a loan, it opens an account in the name of customer and does not pay him in cash
but allows him to draw the money by cheque according to his needs. By granting a loan, the bank
creates credit or deposit.
3. Financing Foreign Trade
A commercial bank finances foreign trade of its customers by accepting foreign bills of exchange
and collecting them from foreign banks. It also transacts other foreign exchange business and
sells foreign currency.
4. Investment
It is obligatory for commercial banks to invest a part of their funds in approved securities. Other
optional avenues of investments are also available. Investments in government securities are
useful in two ways. One is that, the commercial banks can get income from their surplus funds.
The other is that the liquidity, that is, encash ability of securities is higher than that of loans.
5.Agency Services
Commercial bands act as an agent of its customers in collecting and paying cheques, bills
ofexchange, drafts, dividends, etc. It also buys and sells shares, securities, debentures, etc. for its
customers. Further, it pays subscriptions, insurance premium, rent, electric and water bills,
andother similar charges on behalf of its clients. It also acts as a trustee and executor of the
propertyand will of its customers. Moreover, the bank acts as an income tax consultant to its
clients. Forsome of these service, the bank charges a nominal fee while it renders others free of
charge.
6.Miscellaneous Services
Besides the above noted services, the commercial bank performs a number of other services.It
acts as a custodian of the valuables of its customers by providing them lockers where they
cankeep their jewellery and valuable documents. it issues various forms of credit instruments,
such ascheques, drafts, travellers’ cheques, etc. which facilitate transactions. The bank also
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issues letters ofcredit and acts as a referee to its clients. It underwrites shares and debentures of
companies andhelps in the collection of funds from the public. ATM stands for Automated Teller
Machine. It isalso depicted as Any Time Money as it provides the customers to withdraw money
24 hours subjectto certain restrictions.
Innovative Functions
The adoption of Information and Communication technology enable banks to provide many
innovative services to the customers such as;
1. ATM services
Automated Teller Machine (ATM) is an electronic telecommunications device that enables
theclients of banks to perform financial transactions by using a plastic card. Automated Teller
Machines areestablished by banks to enable its customers to have anytime money. It is used to
withdraw money, checkbalance, transfer funds, get mini statement, make payments etc. It is
available at 24 hours a day and 7 days aweek.
2. Debit card and credit card facility
Debit card is an electronic card issued by a bank which allows bank clients access to their
account towithdraw cash or pay for goods and services. It can be used in ATMs, Point of Sale
terminals, ecommercesites etc. Debit card removes the need for cheques as it immediately
transfers money from the client'saccount to the business account. Credit card is a card issued by a
financial institution giving the holder anoption to borrow funds, usually at point of sale. Credit
cards charge interest and are primarilyused for shorttermfinancing.
3. Tele-banking :
Telephone banking is a service provided by a bank or other financial institution, that
enablescustomers to perform financial transactions over the telephone, without the need to visit a
bank branch orautomated teller machine
4. Internet Banking:
Online banking (or Internet banking or E-banking) is a facility that allows customers of a
financialinstitution to conduct financial transactions on a secured website operated by the
institution. To access afinancial institution's online banking facility, a customer must register
with the institution for the service,and set up some password for customer verification. Online
banking can be used to checkbalances, transfermoney, shop onlline, pay bills etc.
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6. Mobile Banking:
Mobile banking is a system that allows customers of a financial institution to conduct a number
of financial transactions through a mobile device such as a mobile phone or personal digital
assistant. It allows the customers to bank anytime anywhere through their mobile phone.
Customers can access their banking information and make transactions on Savings Accounts,
Demat Accounts, Loan Accounts and Credit Cards at absolutely no cost.
7. Electronic Clearing Services :
It is a mode of electronic funds transfer from one bank account to another bank account using the
services of a Clearing House. This is normally for bulk transfers from one account to many
accounts or viceversa. This can be used both for making payments like distribution of dividend,
interest, salary, pension, etc.by institutions or for collection of amounts for purposes such as
payments to utility companies like telephone, electricity, or charges such as house tax, water tax
etc
8. Electronic Fund Transfer/National Electronic Fund Transfer(NEFT):
National Electronic Funds Transfer (NEFT) is a nation-wide payment system facilitating one-to-
one funds transfer. Under this Scheme, individuals, firms and corporate can electronically
transfer funds from any bank branch to any individual, firm or corporate having an account with
any other bank branch in the country participating in the Scheme. In NEFT, the funds are
transferred based on a deferred net settlement in which there are 11 settlements in week days and
5 settlements in Saturdays.
9. Real Time Gross Settlement System(RTGS):
It can be defined as the continuous (real-time) settlement of funds transfers individually on an
order by order basis . 'Real Time' means the processing of instructions at the time they are
received rather than at some later time. It is the fastest possible money transfer system in the
country.
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Role of commercial banks in a developing economy

A well developed banking system is necessary pre-condition for economic development of any
economy. Apart from providing resources for growth of industrialization, banks also
influencedirection in which these resources are utilised. In underdeveloped and developing
nations banking facilities are limited to few developed cities and their activities are focused on
trade & commerce paying little attention to industry &agriculture. Commercial banks contributes
to a country’s economic development in the following ways.
1. Capital formation
Most important determinant of economic development is capital formation. It has 3
distinctive stages
Generation of savings
Mobilisation of savings
Canalisation of saving
Banks promote capital formation in all these stages. They promote habit of savings by offering
attractive rate of return for savers. Banks are maintaining different types of accounts demobilize
savings aiming different types of customers. They make widespread arrangements to collect
savings by opening branches even in remote villages. Moreover, banks offer their resources for
productive activities only.
2. Encouragement to entrepreneurial innovations
Entrepreneurs in developing economies, generally hesitate to invest & undertakeinnovations due
to lack of fund. Bank loan facilities enable them to introduce innovative ideas andincrease
productive capacity of the economy.
3. Monetisation of economy
Monetisation means allow money to play an active role in the economy. Banks, which are
creators and distributors of money, help the monetisation in two ways;
They monetise debt i.e., buy debts (securities) which are not as acceptable as money and
convert them to demand deposits which are acceptable as money.
By spreading branches in rural areas they convert non-monetised sectors of the economy to
monetised sectors.
21
4. Influencing economic activity

They can directly influence the economic activity & pace of economic development throughits
influence on
(a) The rate of interest (reduction in rates make investment more profitable and stimulates
economic activity)
(b) Availability of credit. (Through Credit creation banks helps in increasing supply of
purchasing power)
5. Implementation of monetary policy
Well developed banking system is necessary for effective implementation of monetarypolicy.
Control and regulation of credit is not possible without active co-operation of banks.
6. Promotion of trade and industry
Economic progress of industrialised countries in last 2 centuries is mainly due to
expansionintrade & industrialisation which could not have been made possible without
development of agood banking system. Use of cheques, drafts and BoE as a medium of exchange
has revolutionalised the internal and international trade which in turn accelerated the pace of
industrialisation.
7. Encouraging right type of industries
In a planned economy it is necessary that banks should formulate their loan policies in
accordance with the broad objectives and strategy of industrialisation as adopted in the plan.
8. Regional development
Banks can play role in achieving balanced development in different regions of the economy.
They can transfer surplus funds from developed region to less developed regions, where there
isshortage of funds.
9. Development of agricultural & other neglected sectors
Under developed economies primarily agricultural economies and majority of the population live
in rural areas. So far banks were paying more attention to trade and commerce andhave almost
neglected agriculture and industry. Banks must diversify their activities not onl y to extend credit
to trade, but also to provide medium and long term loans to industry and agriculture.
22
BANKING SECTOR REFORMS
Structure in India since Independence.
In India, commercial banks are the oldest, largest and fastest growing financial
intermediaries. They have been playing a very important role in the process of development. In
1949 RBI was nationalized followed by nationalization of Imperal Bank Of India (New State
Bank Of India) in 1995. In July 1969, 14 major commercial banks were nationalized and in April
1980, 6 more were nationalized. Reforms in banking sector have led to the setting up of new
private sector banks as well as entry of more foreign banks.
B) STRUCTURE OF BANKING IN INDIA :-
Banking system in India is classified in to scheduled and Non-scheduled banks.
Scheduled banks consist of State co-operative banks and Commercial banks. Non-scheduled
consist of Central Co-operative Banks and primary credit society and Commercial Banks.
STRUCTURE OF BANKING IN INDIA
Scheduled Non – Scheduled
State co-op bank Commercial bank Central Co-op Banks Commercial

and Primary credit society. Bank
1. Scheduled Banks :-
Under RBI Act of 1934, banks were classified as scheduled and non-scheduled banks. The
scheduled banks are those which are entered in second schedule of RBI Act of 1934. They are
eligible for certain facilities. All commercial banks (India and foreign, regional rural banks) and
state co-operatives are scheduled banks.
A scheduled must have a paid up capital and reserves of not less than Rs. 5 lakhs. It must
also satisfy RBI that it affairs are not conducted in a manner detrimental to the interest of its
depositors.
2. Non-Scheduled Banks :-
23
Non-scheduled Banks are those which have not been included in the second Schedule of RBI
Act. The number of non-scheduled banks is declining as many of them are attaining the status of
scheduled banks in 2008.
The first phase of banking sector reforms in India Or The recommendations of
Narasimham Committee report of 1991 and the measures adopted by Government to
implement them.
Since nationalisation of banks in 1969, the banking sector had been dominated by the
public sector. There was financial repression, role of technology was limited, no risk
management etc. This resulted in low profitability and poor asset quality. The country was
caught in deep economic crises. The Government decided to introduce comprehensive economic
reforms. Banking sector reforms were part of this package. In august 1991, the Government
appointed a committee on financial system under the chairmanship of M. Narasimhan.
FIRST PHASE OF BANKING SECTOR REFORMS / NARASIMHAN COMMITTEE

REPORT – 1991 :-
To promote healthy development of financial sector, the Narasimhan committee
made recommendations.
I) RECOMMENDATIONS OF NARASIMHAN COMMITTEE :-
1. Establishment of 4 tier hierarchy for banking structure with 3 to 4 large banks (including SBI) at
top and at bottom rural banks engaged in agricultural activities.
2. The supervisory functions over banks and financial institutions can be assigned to a quasi-
autonomous body sponsored by RBI.
3. Phased reduction in statutory liquidity ratio.
4. Phased achievement of 8% capital adequacy ratio.
5. Abolition of branch licensing policy.
6. Proper classification of assets and full disclosure of accounts of banks and financial institutions.
7. Deregulation of Interest rates.
8. Delegation of direct lending activity of IDBI to a separate corporate body.
9. Competition among financial institutions on participating approach.
10. Setting up asset Reconstruction fund to take over a portion of loan portfolio of banks whose
recovery has become difficult.
24
II) Banking Reform Measures Of Government :-

On the recommendations of Narasimhan Committee, following measures were undertaken by
government since 1991 :-
1. Lowering SLR And CRR
The high SLR and CRR reduced the profits of the banks. The SLR has been reduced from
38.5% in 1991 to 25% in 1997. This has left more funds with banks for allocation to agriculture,
industry, trade etc.
The Cash Reserve Ratio (CRR) is the cash ratio of a banks total deposits to be maintained with
RBI. The CRR has been brought down from 15% in 1991 to 4.1% in June 2003. The purpose is
to release the funds locked up with RBI.
2. Prudential Norms :-
Prudential norms have been started by RBI in order to impart professionalism in
commercial banks. The purpose of prudential norms include proper disclosure of income,
classification of assets and provision for Bad debts so as to ensure hat the books of commercial
banks reflect the accurate and correct picture of financial position.
Prudential norms required banks to make 100% provision for all Non-performing Assets (NPAs).
Funding for this purpose was placed at Rs. 10,000 crores phased
over 2 years.
3. Capital Adequacy Norms (CAN) :-
Capital Adequacy ratio is the ratio of minimum capital to risk asset ratio. In April 1992 RBI
fixed CAN at 8%. By March 1996, all public sector banks had attained the ratio of 8%. It was
also attained by foreign banks.
4. Deregulation Of Interest Rates :-
The Narasimhan Committee advocated that interest rates should be allowed to be determined
by market forces. Since 1992, interest rates has become much simpler and freer.
a) Scheduled Commercial banks have now the freedom to set interest rates on their deposits
subject to minimum floor rates and maximum ceiling rates.
b) Interest rate on domestic term deposits has been decontrolled.
c) The prime lending rate of SBI and other banks on general advances of over Rs. 2 lakhs has been
reduced.
d) Rate of Interest on bank loans above Rs. 2 lakhs has been fully decontrolled.
25
e) The interest rates on deposits and advances of all Co-operative banks have been deregulated
subject to a minimum lending rate of 13%.
5. Recovery Of Debts :-
The Government of India passed the “Recovery of debts due to Banks and Financial
Institutions Act 1993” in order to facilitate and speed up the recovery of debts due to banks and
financial institutions. Six Special Recovery Tribunals have been set up. An Appellate Tribunal
has also been set up in Mumbai.
6. Competition From New Private Sector Banks :-
Now banking is open to private sector. New private sector banks have already started
functioning. These new private sector banks are allowed to raise capital contribution from
foreign institutional investors up to 20% and from NRIs up to 40%. This has led to increased
competition.
7. Phasing Out Of Directed Credit :-
The committee suggested phasing out of the directed credit programme. It suggested that credit
target for priority sector should be reduced to 10% from 40%. It would not be easy for
government as farmers, small industrialists and transporters have powerful lobbies.
8. Access To Capital Market :-
The Banking Companies (Acquisation and Transfer of Undertakings) Act was amended to
enable the banks to raise capital through public issues. This is subject to provision that the
holding of Central Government would not fall below 51% of paid-up-capital. SBI has already
raised substantial amount of funds through equity and bonds.
9. Freedom Of Operation :-
Scheduled Commercial Banks are given freedom to open new branches and upgrade extension
counters, after attaining capital adequacy ratio and prudental accounting norms. The banks are
also permitted to close non-viable branches other than in rural areas.
10. Local Area banks (LABs) :-
In 1996, RBI issued guidelines for setting up of Local Area Banks and it gave Its approval for
setting up of 7 LABs in private sector. LABs will help in mobilizing rural savings and in
channeling them in to investment in local areas.
11. Supervision Of Commercial Banks :-
26
The RBI has set up a Board of financial Supervision with an advisory Council to strengthen the
supervision of banks and financial institutions. In 1993, RBI established a new department
known as Department of Supervision as an independent unit for supervision of commercial
banks.
SECOND PHASE OF REFORMS OF BANKING SECTOR (1998) / NARASIMHAN

COMMITTEE REPORT 1988 :-
To make banking sector stronger the government appointed Committee on banking
sector Reforms under the Chairmanship of M. Narasimhan. It submitted its report in April 1998.
The Committee placed greater importance on structural measures and improvement in standards
of disclosure and levels of transparency. Following are the recommendations of Narasimhan
Committee :-
1) Committee suggested a strong banking system especially in the context of capital Account
Convertibility (CAC). The committee cautioned the merger of strong banks with weak ones as
this may have negative effect on stronger banks.
2) It suggested that 2 or 3 large banks should be given international orientation and global
character.
3) There should be 8 to10 national banks and large number of local banks.
4) It suggested new and higher norms for capital adequacy.
5) To take over the baddebts of banks committee suggested setting up of Asset Reconstruction
Fund.
6) A board for Financial Regulation and supervision (BFRS) can be set up to supervise the
activities of banks and financial institutions.
7) There is urgent need to review and amend the provisions of RBI Act, Banking Regulation Act,
etc. to bring them in line with current needs of industry.
8) Net Non-performing Assets for all banks was to be brought down to 3% by 2002.
9) Rationalization of bank branches and staff was emphasized. Licensing policy for new private
banks can be continued.
10) Foreign banks may be allowed to set up subsidiaries and joint ventures.
On the recommendations of committee following reforms have been taken :-
1) New Areas :-
27
New areas for bank financing have been opened up, such as :- Insurance, credit cards, asset
management, leasing, gold banking, investment banking etc.
2) New Instruments :-
For greater flexibility and better risk management new instruments have been introduced such as
:- Interest rate swaps, cross currency forward contracts, forward rate agreements, liquidity
adjustment facility for meeting day-to-day liquidity mismatch.
3) Risk Management :-
Banks have started specialized committees to measure and monitor various risks. They are
regularly upgrading their skills and systems.
4) Strengthening Technology :-
For payment and settlement system technology infrastructure has been strengthened with
electronic funds transfer, centralized fund management system, etc.
5) Increase Inflow Of Credit :-
Measures are taken to increase the flow of credit to priority sector through focus on Micro Credit
and Self Help Groups.
6) Increase in FDI Limit :-
In private banks the limit for FDI has been increased from 49% to 74%.
7) Universal banking :-
Universal banking refers to combination of commercial banking and investment banking. For
evolution of universal banking guidelines have been given.
8) Adoption Of Global Standards :-
RBI has introduced Risk Based Supervision of banks. Best international practices in accounting
systems, corporate governance, payment and settlement systems etc. are being adopted.
9) Information Technology :-
Banks have introduced online banking, E-banking, internet banking, telephone banking etc.
Measures have been taken facilitate delivery of banking services through electronic channels.
10) Management Of NPAs:-
RBI and central government have taken measures for management of non-performing assets
(NPAs), such as corporate Debt Restructuring (CDR), Debt Recovery Tribunals (DRTs) and Lok
Adalts.
11) Mergers And Amalgamation :-
28
In May 2005, RBI has issued guidelines for merger and Amalgamation of private sector banks.
12) Guidelines For Anti-Money Laundering :-
In recent times, prevention of money laundering has been given importance in international
financial relationships. In 2004, RBI revised the guidelines on know your customer (KYC)
principles.
13) Managerial Autonomy :-
In February. 2005, the Government of India has issued a managerial autonomy package for
public sector banks to provide them a level playing field with private sector banks in India.
14) Customer Service:-
In recent years, to improve customer service, RBI has taken many steps such as :- Credit Card
Facilities, banking ombudsman, settlement off claims of deceased depositors etc.
15) Base Rate System Of Interest Rates:-
In 2003 the system of Benchmark Prime Lending Rate (BPLR) was introduced to serve as a
benchmark rate for banks pricing of their loan products so as to ensure that it truly reflected the
actual cost. However the BPLR system tell short of its objective. RBi introduced the system of
Base Rate since 1st July, 2010. The base rate is the minimum rate for all loans. For banking
system as a whole, the base rates were in the range of 5.50% - 9.00% as on 13th October, 2010.
CONCLUSION :-
To satisfy the growing demands from customers for high quality service, commercial banks will
have to find out new ways and method to face new challenges.
29
Nationalization of commercial bank
The nationalisation of commercial banks increased the role of public sector banks. Vari-
ous authorities have advocated many reasons for the nationalisation of major commercial bank.
Let us see their views one by one.
A. The then Prime Minister, Smt. Indira Gandhi
In her broadcast to the nation on the eve of nationalisation of the fourteen leading Indian banks,
she summed up the objectives of the nationalisation as, "The present decision to nationalise
major banks is to accelerate the achievements of our objectives.
The purpose is to expand bank credit to priority areas which have hitherto been somewhat
neglected. It also includes,
(i) The removal of control by a few
(ii) Provision of adequate credit facilities to agriculture, small industry and exports
(iii) The giving of professional bent to bank management
(iv) The encouragement of new classes of entrepreneurs, and
(v) The provision of adequate training as well as reasonable terms of service for bank staff ".
B. Prof. Sayers
Prof. Sayers supports the nationalisation and gives his views under the following four issues.
1. Efficiency issue:
According to Sayers, nationalisation will increase the efficiency of commercial banks as given
below.
(i) Deposits will increase because of increasing confidence in public sector bank. Increase in
bank resources will lead to economics of scale.
(ii) The government can appoint experienced personnel to run and manage the banks.
(iii) Govt, has the countrywide administrative network. Hence, it can make suitable changes in
the banking policies according to the prevailing trends in the economy.
(iv) Nationalised banks can have the main motive of public service.
(v) Public sector banks can give preference to priority sectors in advancing loans. Thus,
nationalisation promotes efficiency.
2. Monetisation issue:
30
Commercial banks accumulate deposits from the public. Therefore, they are in a position to bring
changes in the supply of money. Such an important power should not be in the private sector. It
is the public sector that should have the control over money supply.
3. Integration issue:
Central Banks are established by the Govt, for overall monetary control in the economy and is
not aiming at profit. But commercial banks are started mainly to earn profit. Thus, there are
contradicting objectives between Central Bank and commercial banks.
In this situation, the Central Bank may find it difficult to implement its policies when the
commercial banks oppose them. Therefore, in the interest of co-ordination and cooperation
between them, commercial banks should be nationalised.
4. Socialisation issue:
When a country aims at socialistic pattern of society, then the rol^ of public sector undertaking
should be extended in all spheres of the economy. To start and run the public sector undertaking
Govt, requires enormous financial requirements.
Private commercial banks may obstruct such policies and may not finance public sector
undertakings and above all they may discriminate against them. Therefore, the nationalisation of
commercial banks will be necessary if the government wants to establish socialism.
C. Views given by others
1. Preventing concentration of economic power:
Initially, a few leading industrial and "business houses had close association with commercial
banks. The directors of these banks happened to be the same industrialists who established
monopoly control on the bank finance.
They exploited the bank resources in such a way that the new business units cannot enter in any
line of business in competition with these business houses. Nationalisation of banks, thus,
prevents the spread of the monopoly enterprise.
2. Social control was not adequate:
The 'social control' measures of the government did not work well. Some banks did not follow
the regulations given under social control. Thus, the nationalisation was necessitated by the
failure of social control.
3. Channel the bank finance to plan - priority sectors:
31
Banks collect savings from the general public. If it is in the hand of private sector, the national
interests may be neglected, besides, in Five-Year Plans, the government gives priority to some
specified sectors like agriculture, small-industries etc. Thus, nationalisation of banks ensures the
availability of resources to the plan-priority sectors.
4. Greater mobilisation of deposits:
The public sector banks open branches in rural areas where the private sector has failed. Because
of such rapid branch expansion there is possibility to mobilise rural savings.
5. Help to agriculture:
If banks fail to assist the agriculture in many ways, agriculture cannot prosper, that too, a country
like India where more than 70% of the population depends upon agriculture. Thus, for providing
increased finance to agriculture banks have to be nationalised.
6. Balanced Regional development:
In a country, certain areas remained backward for lack of financial resource and credit facilities.
Private Banks neglected the backward areas because of poor business potential and profit
opportunities. Nationalisation helps to provide bank finance in such a way as to achieve balanced
inter-regional development and remove regional disparities.
7. Greater control by the Reserve Bank:
In a developing country like India there is need for exercising strict control over credit created by
banks. If banks are under the control of the Govt., it becomes easy for the Central Bank to bring
about co-ordinated credit control. This necessitated the nationalisation of banks.
8. Small stake of shareholders:
The nationalised banks had deposits totalling Rs. 2742 crore at the end of December 1968. But
the capital contributed by their shareholders was only Rs. 28.5 crore, which was just 1% of
deposits. Even if we include the reserves, the amount comes to only 2.4% of the banks deposits
with such a small and insignificant stake, it is unjustifiable to allow the private shareholders to
exercise control over such vital credit machinery with large resources.
9. Greater Stability of banking structure:
Nationalised banks are sure to command more confidence with the customers about the safety of
their deposits. Besides this, the planned development of nationalised banks will impart greater
stability for the banking structure.
32
10. March Forward towards Socialism:

India aims at socialism. This requires the financial institutions to run under the government's
control and only through nationalisation, this objective can be effectively achieved.
11. Better service conditions to staff:
Nationalisation ensures the staff of banks to enjoy greater job security and higher emoluments. It
can provide other benefits as well. In this way the banks can motivate their staff and thereby the
operational efficiency of banks will be increased.
12. New schemes:
Through nationalised banks, new schemes like village adoption scheme, Lead Bank Scheme can
be formulated and implemented. Besides, different types of financial facilities can be extended to
persons like Doctors, Engineers, Self-employed persons like artisans etc.
Nationalisation of banks creates great interest among various sections of the public. Many hopes
were raised in the middle class and poor people with regard to the financial assistance. The
nationalised banks drew up a number of schemes to assist new types of customers and are plans
to make each of these banks to adopt a few select districts and concentrate on their intensive
development.
Banking Progress
From above we can see that as compared to new private sector banks and foreign banks the
performance of public sector banks is very low.
B. Profit Per Employee :-
In public sector banks the business per employee has increased from Rs. 88.5 lakh in 1997-98 to
2.9 lakh in 2005-06. In new private sector banks it was rs. 6.3 lakhs and in foreign banks profit
was rs. 26.5 lakh in 2005-06. The profits per employee is the highest in foreign banks followed
by new private sector banks.
PROFITS PER EMPLOYEE (RS. IN LAKH)
Year Public sector banks New Private Sector Foreign Banks

banks
1997-98 0.7 11.4 4.5
2005-06 2.9 6.3 26.5
Source :- New Century Publications , 2008
33
C. Business per Branch :-

In India, business per branch has been increasing. In 2004-05 per branch business was Rs. 4,242
lakh in nationalized banks, Rs. 7,454 lakh in SBI and its associates, Rs. 21,656 lakh in new
private sector banks and Rs.1,14,768 lakh in foreign banks.
BUSINESS PER BRANCH (RS. IN LAKH)
Year Nationalized SBI and its New Sector Pvt. Foreign Banks
banks Associates Banks
1999-2000 2,152 2,860 14,989 54,800
2004-05 4,242 7,454 21,656 1,14,768
Source :- New Century Publications, 2008
The per branch business is lower in public sector banks as compared to new private sector banks
and foreign banks. After the introduction of reforms the productivity of public sector Banks have
started to rise.
2) Profitability Of Commercial Banks :-
Profitability of commercial Banks has been shown by following indicators:-
a) Interest Income Ratio :-

Interest Income Ratio (as percentage of total assets) of public sector banks has fallen from 8.8%
in 2000-01 to 6.90% in 2009-10 and of foreign banks from 9.3%, in 2000-01 to 6.09% in 2009-
10. New private banks has fallen marginally from 8.2% in 2000-01 to 7.07% in 2009-10.
b) Interest Expanded Ratio :-
Interest expanded Ratio (as percentage of total assets) has fallen for all groups. It has fallen for
foreign banks from 5.6% in 2000-01 to 2.06% in 2009-10. For Public sector banks it has fallen
from 6% to 4.77% and new private sector banks from 6% to 4.21% during same period.
c) Intermediation Cost To Asset Ratio (ICAR) :-
The ICAR of public sector banks hs fallen from 2.7% in 2000-01 to 1.49% in 2009-10. For new
private sector banks it has risen from 1.7%to 2.04% and for foreign banks again it has fallen
from 3% to 2.56% for same period.
d) Return On Assets :-
34
It is rate of net profit to total assets. The ROA of all banks has risen. For public sector banks it
has risen from 0.4% in 2000-01 to 0.88 in 2009-10. For new private sector banks it has risen
from 0.8% to 1.22%, and foreign banks from 0.9% to 1.09% for the same period.
e) Net / Spread interest Margin :-
Spread is an Important indicator of efficiency. In 2000-01 the spread interest margin of public
sector banks was 2.9%, New private sector Banks was 2.1% and foreign banks was 3.6%. In the
year 2009-10the public sector banks spread is of 2.13%, new private sector banks is 2.86% and
the highest spread is of foreign banks 4.035.
3) Asset Quality :-
Asset quality of banks is shown by the level of non-performing assets (NPAs).
GROSS AND NET NPAS OF COMMERCAIL BANKS
(As at end of March)
Banks Total NPAs as % to total Net NPAs as % to Net
advances Advances
2009 2010 2009 2010
Public Sector 1.97 2.19 .94 1.10
New private Sector 3.05 2.87 1.40 1.09
Foreign Banks 3.80 4.29 1.81 1.82
Source: - RBI Website
The gross NPAs as percent of total advances and net NPAs as percent of net advances of public
sector banks have declined marginally in 2010 and that of new private banks and foreign banks
have increased. In case of public sector banks the gross NPA ratio was 2.19% and net NPA ratio
was 1.10% in 2010. For new private sector banks the gross NPA ratio decreased from 3.05% to
2.87% and net NPA ratio decreased from 1.40% to 1.09% during 2009 and 2010. The gross NPA
ratio of foreign banks rose to 4.29% in 2010 and net NPAs rose to 1.82% in 2010.
4) Financial Soundness :-
The Capital Adequacy ratio (CAR) is the most important indicator of financial soundness of
banks. As on 31st March, 2009, all commercial banks in India have become Basel II complaint.
Under Basel II Indian Banks have to maintain a stipulated minimum capital to Risk Weighted
35
Assets Ratio (CRAR) of 9%. The CRAR of Indian banks has risen from 14% at end March 2009
to 14.5% at end March 2010.
5) Customer services :-
Indian banks have began to offer many financial services to clients / customers. Core banking
Solutions (CBS) is increasing very fast. Under CBS, a number of services are provided like :-
anywhere banking, ‘everywhere access’ and quick transfer of funds in an efficient manner and at
reasonable cost. The no. of branches of PSBs that have implemented CBS increased from 79.4%
in march 2009 to 90% at the end of March 2010.
Important new technologies introduced in banking in India.

A) NEW TECHNOLOGY IN BANKING :-
The IT (Information Technology) has changed the Indian structure of Indian Banking.
Technology has been identified by banks as an important element in their strategy to improve
productivity and render sufficient customer service. In banking computerization has taken place
all over the world. The purpose is to bring technology to the counter and to enable Employees to
have information at their fingertips. The New technologies that are being used in banks are :-
1. Electronic Fund Transfer (EFT) :-
It is easy transfer of funds from one place to another. It enables the beneficiary to receive money
on same day or next day. The customer can transfer money instantly from one bank to another,
from one bank account to another or from one branch to other or a different bank not only within
the country but also anywhere else in t5hre world through electronic message.
2. Credit Card :-
Credit Card (post Card) is a convenient medium of exchange. With the help of credit card a
customer can purchase goods and services from authorized outlets without making immediate
cash payments but, within the prescribed limit.
3. Debit Card :-
36
Debit Card is a prepaid card and it allows customers anytime anywhere access to his saving or
current account. For using debit card a PIN (Personal Identification Number) is issued to
customers. Any transaction taking place is directly debited to the customers bank account.
4. Phone banking :-
In phone banking a customer can do entire non-cash related banking services on telephone,
anywhere at any time. He can talk to a phone banking officer for transacting a banking business.
5. Telebanking :-
Telebanking is a 24 hour banking facility based on the voice processing facility available on
bank computers. Here banking services or products are rendered through telephone to its
customers.
6. Internet Banking :-
Internet banking is on-line banking. It is a product of E–commerce. Internet banking enables
customers to open accounts, paybills, know account balances, view and print copies of cheques,
stop payments etc.
7. Mobile Banking :-
Everybody with a mobile phone can access banking services, irrespective of their location. It is
an extension of Internet banking. It provides services like account balance, mobile alerts about
credit card or debit card transactions, mini account statement etc.
8. Door Step Banking :-

Here, there is no need for customer to visit the branch for getting services or products from the
bank. This means banking services and products are made available to a customer at his place of
residence or work.
9. Point Of Sale (POS) :-

In an online environment the POS terminal is a machine that facilities transactions through swipe
of a card.
37
10. ATMs:-
ATMs are emerging as the most useful tool to ensure ‘any time banking’ and ‘anywhere
banking’ or ‘anytime money’. ATMs are self service vendor machines that help the banks to
provide round the clock banking services to their customers at convenient places without visiting
bank premises. The customers are provided with ATM card.
11. Virtual Banking:-

It means rendering banking and its related services through use of IT. Some of the most
important types of virtual banking are :-ATMs, electronic fund transfer phone – banking, credit
card, debit card, internet banking etc.
12. Electronic Clearing Services (ECS) :-

It is non – paper based movement of funds. It consists of Electronic Credit Clearing and
Electronic Debit Clearing.
B) CONCLUSION :-
As banks are expanding in to virtual banking, supervision and audit will have to be strengthened.
Banks will have to pay greater attention to fool proof security arrangements and systems to
safeguard against frauds.
38
FUNCTIONS OF CENTRAL BANK:
i) Currency authority or bank of issue: Central bank is a sole authority to issue currency
in the country. Central Bank is obliged to back the currency with assets of equal value
(usually gold coins, gold bullions, foreign securities etc.,) Advantages of sole
authority of note issue: a) Uniformity in note circulation b) Better supervision and
control c) It is easy to control credit d) Ensures public faith e) Stabilization of internal
and external value of currency
ii) ii) Banker to the Government: As a banker it carries out all banking business of the
Government and maintains current account for keeping cash balances of the
government. Accepts receipts and makes payments for the government. It also gives
loans and Advances to the government.
iii) iii) Banker’s bank and supervisor: Acts as a banker to other banks in the country— a)
Custodian of cash reserves:- Commercial banks must keep a certain proportion of
cash reserves with the central bank (CRR) b) Lender of last resort: - When
commercial banks fail to need their financial requirements from other sources, they
approach Central Bank which gives loans and advances. c) Clearing house: - Since
the Central Bank holds the cash reserves of commercial banks it is easier and more
convenient to act as clearing house of commercial banks.
iv) iv) Controller of money supply and credit: - Central Bank or RBI plays an important
role during the times of economic fluctuations. It influences the money supply
through 83 quantitative and qualitative instruments. Former refers to the volume of
credit and the latter refers to regulate the direction of credit.
v) v) Custodian of foreign exchange reserves. Another important function of Central
Bank is the custodian of foreign exchange reserves. Central Bank acts as custodian of
country’s stock of gold and foreign exchange reserves. It helps in stabilizing the
external value of money and maintaining favorable balance of payments in the
economy.
QUANTITATIVE INSTRUMENTS:
i) Bank Rate policy: - It refers to the rate at which the central bank lends money
to commercial banks as a lender of the last resort. Central Bank increases the
39
bank rate during inflation (excess demand) and reduces the same in times of
deflation (deficient demand)
ii) ii) Open Market Operations: It refers to the buying and selling of securities by
the Central Bank from/ to the public and commercial banks. It sells
government securities during inflation/excess demand and buys the securities
during deflation/deficient demand.
iii) iii) Legal Reserve Ratio: R.B.I. can influence the credit creation power of
commercial banks by making changes in CRR and SLR Cash Reserve Ratio
(CRR): It refers to the minimum percentage of net demand and time liabilities
to be kept by commercial banks with central bank. Reserve Bank increases
CRR during inflation and decreases the same during deflation Statutory
Liquidity Ratio (SLR): It refers to minimum percentage of net demand and
time liabilities which commercial banks required to maintain with
themselves. SLR is increased during inflation or excess demand and
decreased during deflation or deficient demand.
QUALITATIVE INSTRUMENTS:
1. Margin Requirements: It is the difference between the amount of loan and market
value of the security offered by the borrower against the loan. Margin requirements
are increased during inflation and decreased during deflation.
2. Moral suasion: It is a combination of persuasion and pressure that Central Bank
applies on other banks in order to get them act in a manner in line with its policy.
. Selective credit controls: Central Bank gives direction to other banks to give or not
to give credit for certain purposes to particular sectors.
40
MONETARY POLICY:-Methods of Credit Control / Controlling Inflation

Monetary policy is a regulatory policy by which the central bank or monetary authority of a
country controls the supply of money, availability of bank credit and cost of money, that is, the
rate of Interest.
Monetary policy / monetary management is regarded as an important tool of economic

management in India. RBI controls the supply of money and bank credit. The Central bank has
the duty to see that legitimate credit requirements are met and at the same credit is not used for
unproductive and speculative purposes. RBI rightly calls its credit policy as one of controlled
expansion.
B)OBJECTIVES OF MONETARY POLICY OF INDIA :-
The main objective of monetary policy in India is ‘growth with stability’. Monetary Management
regulates availability, cost and use of money and credit. It also brings institutional changes in the
financial sector of the economy. Following are the main objectives of monetary policy in India :-
1. Growth With Stability :-
Traditionally, RBI’s monetary policy was focused on controlling inflation through contraction of
money supply and credit. This resulted in poor growth performance. Thus, RBI have now
adopted the policy of ‘Growth with Stability’. This means sufficient credit will be available for
growing needs of different sectors of economy and at the same time, inflation will be controlled
with in a certain limit.
2. Regulation, Supervision And Development Of Financial Stability :-
Financial stability means the ability of the economy to absorb shocks and maintain confidence in
financial system. Threats to financial stability can come from internal and external shocks. Such
shocks can destabilize the country’s financial system. Thus, greater importance is being given to
RBI’s role in maintaining confidence in financial system through proper regulation and controls,
without sacrificing the objective of growth. Therefore, RBI is focusing on regulation, supervision
and development of financial system.
3. Promoting Priority Sector :-
Priority sector includes agriculture, export and small scale enterprises and weaker section of
population. RBI with the help of bank provides timely and adequately credit at affordable cost of
weaker sections and low income groups. RBI, along with NABARD, is focusing on microfinance
through the promotion of Self Help groups and other institutions.
41
4. Generation Of Employment :-
Monetary policy helps in employment generation by influencing the rate of investment and
allocation of investment among various economic activities of different labour Intensities.
5. External Stability :-
With the growth of imports and exports India’s linkages with global economy are getting
stronger. Earlier, RBI controlled foreign exchange market by determining eaxchange rate. Now,
RBI has only indirect control over external stability through the mechanism of ‘managed
Flexibility’, where it influences exchange rate by buying and selling foreign currencies in open
market.
6. Encouraging Savings And Investments :-
RBI by offering attractive interest rates encourage savings in the economy. A high rate of saving
promotes investment. Thus the monetary management by influencing rates of interest can
influence saving mobilization in the country.
7. Redistribution Of income And Wealth :-
By control of inflation and deployment of credit to weaker sectors of society the monetary policy
may redistribute income and wealth favouring to weaker sections.
8. Regulation Of NBFIs:-
Non – Banking Financial Institutions (NBFIs), like UTI, IDBI, IFCI plays an important role in
deployment of credit and mobilization of savings. RBI does not have any direct control on the
functioning of such institutions. However it can indirectly affects the policies and functions of
NBFIs through its monetary policy.
.RESERVE BANK OF INDIA (RBI) :-
The Reserve Bank of India is the central bank of India it was established as a shareholder’s bank
on 1st April 1935. Its share capital was Rs. 5 crore, divided in to 5 lakhs fully paid up shares of
Rs. 100 each. On 1st January 1949 it was nationalized. Its headquarters is at Mumbai. RBI, like
42
any other bank performs almost all traditional Central banking functions. Due to country’s
development it has also undertaken developmental and promotional functions.
A. FUNCTIONS OF RBI :-
RBI performs many functions, some of them are:-
1. Issue Of Currency Notes :-
Under section 22 of RBI Act, the bank has the sole right to issue currency notes of all
denominations except one rupee coins and notes. The one-rupee notes and coins and small coins
are issued by Central Government and their distribution is undertaken by RBI as the agent of the
government. The RBI has a separate issue department which is entrusted with the issue of
currency notes.
2. Banker To The Government :-
The RBI acts as a banker agent and adviser to the government. It has obligation to transact the
banking business of Central Government as well as State Governments. E.g.:- RBI receives and
makes all payments on behalf of government, remits its funds, buys and sells foreign currencies
for it and gives it advice on all banking matters. RBI helps the Government – both Central and
state – to float new loans and manage public debt. The bank makes ways and meets advances of
the government. On behalf of central government it sells treasury bills and thereby provides
short-term finance.
3. Banker’s bank And Lender Off Last Resort :-
RBI acts as a banker to other banks. It provides financial assistance to scheduled banks and state
co-operative banks in form of rediscounting of eligible bills and loans and advances against
approved securities.
RBI acts as a lender of last resort. It provides funds to bank when they fail to get it from other
sources. It also acts as a clearing house. Through RBI, banks make interbanks payments.
4. Controller Of Credit :-
RBI has power to control the volume of credit created by banks. The RBI through its various
quantitative and qualitative techniques regulates total supply of money and bank credit in the
interest of economy. RBI pumps in money during busy season and withdraws money during
slack season.
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5. Exchange control And Custodian Of Foreign Reserve :-
RBI has the responsibility of maintaining fixed exchange rates with all member countries of
IMF. For this, RBI has centralized all foreign exchange reserves (FOREX). RBI functions as
custodian of nations foreign exchange reserves. It has to maintain external valu of Rupee. RBI
achieves this aim through appropriate monetary fiscal and trade policies and exchange control.
6. Collection And Publication Of Data :-
The RBI collects and complies statistical information on banking and financial operations of the
economy. The Reserve Bank Of India’ Bulletian is a monthly publication. It not only provides
information, but also results of important studies and investigations conducted by reserve bank
are given. ‘The Report on currency and finance’ is an annual publication. It provides review of
various developments of economic and financial importance.
7. Regulatory And Supervisory Functions :-
The RBI has wide powers of supervision and control over commercial and co-operative banks,
relating to licensing, establishment, branch expansion, liquidity of Assets, management and
methods of working, amalgamation, re-construction and liquidation. The supervisory functions
of RBI have helped a great in improving the standard of banking in India to develop on sound
lines and to improve the methods of their operation.
8. Clearing House Functions :-
The RBI acts as a clearing house for all member banks. This avoids unnecessary transfer of
funds between the various banks.
9. Development And Promotional Functions :-
The RBI has helped in setting up Industrial Finance Corporations of India (IFCI), State Financial
Corporations (SFCs), Deposit Insurance Corporation, Agricultural Refinance and Development
Corporation (ARDC), units Trust of India (UTI) etc. these institutions were set up to mobilize
savings, promote saving habits and to provide industrial and agricultural finance.
44
RBI has a special Agricultural Credit Department (ACD) which studies the problems of
agricultural credit. For this Regional Rural banks, Co-operative, NABARD etc. were established.
The RBI has also taken measures to promote organized bill market to create elasticity in Indian
Money Market in order to satisfy seasonal credit needs.
Thus RBI has contributed to economic growth by promoting rural credit, industrial financing,
export trade etc.
MONETARY POLICY OF RBI :-
The Monetary Policy of RBI is not merely one of credit restriction, but it has also the duty to see
that legitimate credit requirements are met and at the same time credit is not used for
unproductive and speculative purposes RBI has various weapons of monetary control and by
using them, it hopes to achieve its monetary policy.
I) General I Quantitative Credit Control Methods :-
In India, the legal framework of RBI’s control over the credit structure has been provided
Under Reserve Bank of India Act, 1934 and the Banking RegulationAct, 1949. Quantitative
credit controls are used to maintain proper quantity of credit o money supply in market. Some of
the important general credit control methods are:-
1. Bank Rate Policy :-
Bank rate is the rate at which the Central bank lends money to the commercial banks for their
liquidity requirements. Bank rate is also called discount rate. In other words bank rate is the rate
at which the central bank rediscounts eligible papers (like approved securities, bills of exchange,
commercial papers etc) held by commercial banks.
Bank rate is important because its is the pace setter to other marketrates of
interest. Bank rates have been changed several times by RBI to control inflation
and recession. By 2003, the bank rate has been reduced to 6% p.a.
2. Open market operations :-
It refers to buying and selling of government securities in open market in order to expand or
contract the amount of money in the banking system.This technique is superior to bank rate
policy. Purchases inject money into the banking system while sale of securities do the opposite.
During last two decades the RBI has been undertaking switch operations. These involve the
purchase of one loan against the sale of another or, vice-versa. This policy aims at preventing
unrestricted increase in liquidity.
45
3. Cash Reserve Ratio (CRR)
The Gash Reserve Ratio (CRR) is an effective instrument of credit control. Under the RBl Act
of, l934 every commercial bank has to keep certain minimum cash reserves with RBI. The RBI is
empowered to vary the CRR between 3% and 15%. A high CRR reduces the cash for lending
and a low CRR increases the cash for lending. The CRR has been brought down from 15% in
1991 to 7.5% in May 2001. It further reduced to 5.5% in December 2001. It stood at 5% on
January 2009. In January 2010, RBI increased the CRR from 5% to 5.75%. It further increased in
April 2010 to 6% as inflationary pressures had started building up in the economy. As of March
2011, CRR is 6%.
4. Statutory Liquidity Ratio (SLR)
Under SLR, the government has imposed an obligation on the banks to ,maintain a certain ratio
to its total deposits with RBI in the form of liquid assets like cash, gold and other securities. The
RBI has power to fix SLR in the range of 25% and 40% between 1990 and 1992 SLR was as
high as 38.5%. Narasimham Committee did not favour maintenance of high SLR. The SLR was
lowered down to 25% from 10thOctober 1997.It was further reduced to 24% on November 2008.
At present it is 25%.
5. Repo And Reverse Repo Rates
In determining interest rate trends, the repo and reverse repo rates are becoming important. Repo
means Sale and Repurchase Agreement. Repo is a swap deal involving the immediate Sale of
Securities and simultaneous purchase of those securities at a future date, at a predetermined
price. Repo rate helps commercial banks to acquire funds from RBI by selling securities and also
agreeing to repurchase at a later date.
Reverse repo rate is the rate that banks get from RBI for parking their short term excess funds
with RBI. Repo and reverse repo operations are used by RBI in its Liquidity Adjustment Facility.
RBI contracts credit by increasing the repo and reverse repo rates and by decreasing them it
expands credit. Repo rate was 6.75% in March 2011 and Reverse repo rate was 5.75% for the
same period. On May 2011 RBI announced Monetary Policy for 2011-12. To reduce inflation it
hiked repo rate to,7.25% and Reverse repo to 6.25%
II) SELECTIVE / QUALITATIVE CREDIT CONTROL METHODS :-
Under Selective Credit Control, credit is provided to selected borrowersfor selected purpose,
depending upon the use to which the control try to regulate the quality of credit - the direction
towards the credit flows. The Selective Controls are :-
1. Ceiling on Credit
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The Ceiling on level of credit restricts the lending capacity of a bank to grant advances against
certain controlled securities.
2. Margin Requirements:-
A loan is sanctioned against Collateral Security. Margin means that proportion of the value of
security against which loan is not given. Margin against a particular security is reduced or
increased in order to encourageor to discourage the flow of credit to a particular sector. It varies
from 20% to 80%. For agricultural commodities it is as high as 75%. Higher the margin lesser
will be the loan sanctioned.
3. Discriminatory Interest Rate (DIR)
Through DIR, RBI makes credit flow to certain priority or weaker sectors by charging
concessional rates of interest. RBI issues supplementary instructions regarding granting of
additional credit against sensitive commodities, issue of guarantees, making advances etc. .
4. Directives:-
The RBI issues directives to banks regarding advances. Directives are regarding the purpose for
which loans may or may not be given.
5. Direct Action
It is too severe and is therefore rarely followed. It may involve refusal by RBI to rediscount bills
or cancellation of license, if the bank has failed to comply with the directives of RBI.
6. Moral Suasion
Under Moral Suasion, RBI issues periodical letters to bank to exercise control over credit in
general or advances against particular commodities. Periodic discussions are held with
authorities of commercial banks in this respect.
FAILURES I LIMITATIONS OF MONETARY POLICY
1. Huge Budgetary Deficits :-
RBI makes every possible attempt to control inflation and to balance money supply in the
market. However Central Government's huge budgetary deficits have made monetary policy
ineffective. Huge budgetary deficits have resulted in excessive monetary growth.
2. Coverage Of Only Commercial Banks :-
47
Instruments of monetary policy cover only commercial banks so inflationary pressures caused by
banking finance can be controlled by RBI, but in India, inflation also results from deficit
financing and scarcity of goods on which RBI may not have any control.
3. Problem Of Management Of Banks And Financial Institutions :-
The monetary policy can succeed to control inflation and to bring overall development only
when the management of banks and Financial institutions are efficient and dedicated. Many
officials of banks and financial institutions are corrupt and inefficient which leads to financial
scams in this way overall economy is affected.
4. Unorganised Money Market :-
Presence of unorganised sector of money market is one of the main obstacle in effective working
of the monetary policy. As RBI has no power over the unorganised sector of money market, its
monetary policy becomes less effective.
5. Less Accountability:-
At present time, the goals of monetary policy in India, are not set out in specific terms and there
is insufficient freedom in the use of instruments. In such a setting, accountability tends to be
weak as there is lack of clarity in the responsibility of governments and RBI.
6. Black Money :-
There is a growing presence of black money in the economy. Black money falls beyond the
purview of banking control of RBI. It means large proposition of total money Supply in a
country remains outside the purview of RBI's monetary management.
7. Increase Volatility :-
The integration of domestic and foreign exchange markets could lead to increased volatility in
the domestic market as the impact of exogenous factors could be transmitted to domestic market.
The widening of foreign exchange market and development of rupee - foreign exchange swap
would reduce risks and volatility.
8. Lack Of Transparency :-
According to S. S. Tarapore, the monetary policy formulation, in its present form in India, cannot
be continued indefinitely. For a more effective policy, it would be necessary to have greater
transparency in the policy formulation and transmission process and the RBI would need to be
clearly demarcated.
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B. CONCLUSION :-
Thus, from above we can say that despite several problems RBI has made a good effort for
effective implementation of the monetary policy in India.
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Meaning & Scope of Public Finance
Meaning of Public Finance

Public Finance is the branch of economics that studies the taxing and spending activities of
government. The discipline of public finance describes and analyses government services,
subsidies and welfare payments, and the methods by which the expenditures to these ends are
covered through taxation, borrowing, foreign aid and the creation of money.
Definition
According to Findlay Shirras
“Public finance is the study of principles underlying the spending and raising of funds by
public authorities”.
According to H.L Lutz
“Public finance deals with the provision,custody and disbursement of resources needed for
conduct of public or government function.”
According to Hugh Dalton
“Public finance is concerned with the income and expenditure of public authorities, and with
the adjustment of the one to the other.
Scope of Public Finance

Public finance not only includes the income and expenditure of the government but also the
sources of income and the way of expenditure of various government corporations, public
companies and quasi government ventures. Thus the scope of public finance extends to the study
of independent bodies acting under the government’s direct and indirect control. The Scope of
public finance includes:
Public Revenue
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Public finance deals with all those sources or methods through which a government earns
revenue. It studies the principles of taxation, methods of raising revenue, classification of
revenue, deficit financing etc.
Public Expenditure
Public expenditure studies how the government distributes the resources for the fulfillment of
various expenses. It also studies principles that the government should keep in view while
allocating resources to various sectors and effects of such expenditure.
Public debt
It deals with borrowing by the government from internal and external sources. AT any time
government may exceed its revenue. To meet the deficit, government raises loans. The study of
public fiancé focuses on the problems of raising loans and the methods of repayment of loans.
Financial/Fiscal administration
The scope of financial administration is wider. It covers all the financial functions of the
government. It includes drafting and sanctioning of the budget, auditing of the budget, etc.
Financial administration is concerned with the organization and functioning of the government
machinery responsible for performing the various financial functions of the state. The budget is
the master financial plan of the government.
Economic Stabilization and Growth
In the present times, public finance is mainly concerned with the economic stability and other
related problems of a country. For the attainment of these objectives, the government formulates
its fiscal policy comprising of various fiscal instruments directed towards the economic stability
of the nation.
Federal Finance
Distribution of the sources of income and expenditure between the central and the state
governments in the federal system of government is also studied as the subject matter of the
public finance. This branch of public finance is popularly known as Federal Finance.
Theory of Maximum Social Advantage
Introduction: This theory was put forward by the British economist, Hugh Daltotn. According to
him, that system of public finance is the best which secures maximum social advantage to the
community. The fiscal operation of the state should therefore be determined by the principle of
maximum social advantage.
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Assumptions:
1.All taxes result in sacrifice and all public expenditures lead to benefit.
2. Public revenue consist of only taxes and there is no other source of income to the government.
3. The govt. has no surplus or deficit budget but only a balanced budget.
Conditions of Maximum Social Advantage
The main conditions of maximum Social Advantage are as follows:
The social benefit from the rupee spent (MSB) on public expenditure should be equal to the
sacrifice (MSS) from the last rupee collected by way of a tax. It implies that MSB=MSS.
Public expenditure should be so distributed among various schemes that benefit of last rupee
spent on every scheme should be equal.
Taxations should be levied in different directions such that scarify or disutility from last rupee
collected from every direction should be equal.
THE THEORY: Taxation leads to some loss of purchasing power by the taxed people. This is the
social sacrifice of taxation. Likewise, the spending of money by the state leads to gain of utility
by those who are benefited by it. This is the social benefit of public expenditure.
State should continue with it's fiscal operations so long as the social benefit exceeds the social
sacrifice, because thereby the community will be the net gainer. The state shall be maximsing
the net social advantage by continuing with it's fiscal operations. But the state should not
proceed beyond the point where the social sacrifice equals the the social benefit. In case it does
so, the net social advantage shall be less than the maximum. The net social advantage shall be
maximum only at the point where the social sacrifice equals the social benefit.
Introducing the concept of margin on both sides,the state should secure maximum social
advantage by equating the marginal social sacrifice (involved in taxation) with the marginal
social benefit (flowing from public expenditure). The point of equality between the marginal
social sacrifice and the marginal social benefit is known as the point of maximum social
advantage or the point of least aggregate social sacrifice.
Diagrammatical Explanation
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In the above diagram, MSS is the marginal social sacrifice curve sloping upward from left to
right. This rising curve indicates that the marginal social sacrifice goes on increasing with every
additional dose of taxation. MSB is the marginal social benefit curve sloping downwards from
the left to right. This falling curve indicates that the marginal social benefit diminishes with
every additional dose of public expenditure. The two curves MSS and MSB intersect each other
at the point P. PM represents both marginal social sacrifice as well as marginal social benefit.
Both are equal at OM which represents the maximum social advantage.
Criticism:-
1. Non measurability of social sacrifice and social benefit:-

The major drawback of this principle is that it is not possible in actual practice to measure the
MSS and MSB involved in the fiscal operation of the state.
2. Non applicability of the low of equimarginal utility in public expenditure:- The low of
equimarginal utility may be applicable to private expenditure but certainly not to public
expenditure.
3.All taxes don't result in sacrifice and all public expenditures donot lead to benefit.
4. Public revenue don't consist only of taxes and there is other source of income also to the
government.
4. "The govt. has no surplus or deficit budget but only a balanced budget."- is an invalid
assumption.
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Summing up:-
Despite of all the limitations, the theory of maximum social advantage has been occupying an
important place in economics as a leading theory of public finance.
A. PUBLIC REVENUE
Any public authority or government needs income for the performance of a variety of functions
and meeting its expenditure. The income of the government through all sources is called public
income or public revenue. According to Dalton, public income can be classified as Public
Revenue and Public Receipts.
1) Public Revenue :-
Public revenue refers to income of a government from all sources raised, in order to meet public
expenditure. Public revenue consists of taxes, revenue from administrative activities like fines,
fees, income from public enterprises, gifts and grants.
2) Public Receipts :-
It includes public revenue plus the receipts from public borrowings, the receipts from sale of
public assets and printing and issuing new currency notes. It includes other sources of public
income along with public revenue. Public Revenue can be classified as Tax Revenue and Non -
Tax Revenue.
SOURCES OF PUBLIC REVENUE :-
Public revenue is divided into two groups:- Tax Revenue and Non - tax Revenue.
1) Tax Revenue :-
The revenue raised by the government through various taxes is known as tax revenue. Tax
revenue is the most important source of public revenue. A tax is a compulsory payment levied by
the government on individuals or companies to meet the expenditure which is required for public
welfare.
According to Hugh Dalton, "a tax is a compulsory contribution imposed by a public authority,
irrespective of the exact amount of service rendered to the tax payers in return and not imposed
as a penalty for any legal offence."
1) Characteristics Of Tax :-
a) Tax is a compulsory payment imposed by the government
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b) People on whom a tax is imposed must pay the tax.
c) Refusal to pay tax is a punishable offence.
d) Tax is imposed on incomes or commodities.
e) Every tax involves some sacrifice on part of the tax payer.
f) There is no quid - pro - quo between a tax payer and public authorities. This means that
the tax payer cannot claim any specific benefit in return for the payment of a tax.
g) A tax is levied to meet public spending incurred by the government in the general interest
of the nation.
h) A tax is payable regularly and periodically as determined by the taxing authority.
Government collects tax revenue by way of direct and indirect taxes. Let us explain:-
2) Direct Taxes: - It includes :-
a) Personal Income Tax :-
Personal Income Tax is levied on the taxable income of individuals and Hindu Undivided
Families (HUFs). Here various exemptions and deductions are allowed. At present, male and
female tax payers (below 60 years) are exempted from income tax upto Rs. 1,80,000 and Rs.
1,90,000 respectively. Senior citizens are exempted upto Rs. 2,50,000. In 2009-10 in absolute
terms, personal income tax revenue of Central Government was estimated at about Rs. 1,22,280
crore.
b) Corporate Tax :-
Corporate Tax is levied on taxable income of registered corporate firms. Under various sections
of Income Tax Act, exemptions and deductions are allowed. At present corporate tax rate for
domestic companies is 30% + Surcharge and for foreign companies in India it is 40% +
Surcharge. In 2009-10, in absolute terms corporate tax revenue of Central Government was
estimated at about Rs. 2,44,630 crore.
c) Other Direct Taxes :-
There are various other direct taxes & their share is negligible. For eg :- Interest tax, wealth tax,
estateduty, expenditure tax etc.
1) Indirect Taxes :- It includes
a) Customs Duty :-
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Customs Duty is levied on imports and on selective exports. The customs duty at present has
been reduced to 10%.
In 2009-10, customs duty revenue to Central Government was estimated at Rs. 84,244 crore.
b) Excise Duty :-
Excise duty is levied on goods produced. Over the years the rate of Excise duty has been reduced
on most of the items.
In 2009-10, excise duty revenue of Central Government was estimated at Rs. 1,04,659 crores.
c) Service Tax :-
Service tax was introduced in 1994-95. In February 2010, service tax was reduced
to 10% from12%. About 117 services were subject to service tax. In 2009-10. Service tax of
central government was Rs. 58,454 crore.
II) Non - Tax Revenue
The revenue obtained by the government from sources other than tax is called non - tax revenue’.
In 2009-10, the non - tax revenue contributed was about 22% of total revenue of Central
Government and 2% of GDP. The main sources of non - tax revenue are as follows
1) Administrative Revenues :-
The government gets revenue from public for administrative work in following forms :-
a) Fees :-
A fee is charged by the public authorities for rendering service to the members of public. There
is no compulsion involved in case of fees. For Eg. Fees charged for issuing licenses, passports,
registrations, filing of court cases etc. In case of fees there is some sort of quid-pro-quo.
b) Fines And Penalties :-
Fines or penalties are imposed as a form of punishment for breach of law or non - fulfillment or
failure to observe some regulations. Fines are compulsory payments without quid-pro-quo. For
Eg. fines are imposed for rash driving, not disclosing taxable income, travelling without tickets
etc.
c) Special Assessment Of Betterment Levy :-
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 Eg. due to public park in a locality or due
to construction of road, people in that locality may experience an appreciation in the value of
56
their property or land. Special assessment is levied once for all on unearned income. There is
direct quid-pro-quo.
2) Profits Of Government Enterprises :-
The Government gets revenue by way of surplus from public enterprises. For Eg: - Surplus from
railways, telephones, profits of state undertakings etc. Earnings from state enterprises depend on
prices charged by them for their goods and services and the surplus derived. There is some sort
of quid-pro-quo in cases of surplus from public enterprises. This is because, the public gets
goods and services, and the government gets prices, and consequently profits from selling such
goods and services.
3) Gifts And Grants :-
Gifts are voluntary contributions by individuals or institutions to the government. Gifts are
important source of revenue during the times of war and emergency. There is no element of
quid-pro-quo. The donor may not get anything in return.
In modern days grants from one government to another is an important sources of revenue.
Grants are provided by Central Government to State Governments or by State Governments to
local authorities to carry out their functions. Grants from foreign countries is know as foreign
aid.
Canons of Taxation / Principles of Taxation / Characteristics of good tax system :

A good tax system should follow certain principles which become its characteristics thus a good
tax system is based on certain principles which are known as canons of taxation. Adam Smith
was probably the first economist who stated the general principles of taxation or rules of
taxation. They are even now considered as the Characteristics of taxation of good tax system.
According to Adam Smith father of economics there are 4 main cannons of taxation which are as
fallows
• Canon of Equality: - The cannon of equality equity or justice is most important cannon of
taxation. It means that every person should pay tax according to his ability and not the same
amount. it also means that every body should not pay at the same rate rather every tax payer
should pay the tax in proportion to his income. The rich should pay more than the poor whose
income is less.
• Canon of Certainty : - Acc to smith there should be certainty in taxation because uncertainty
breeds corruption. The certainty aspects of a tax are
• Certainty of effective incidence i.e. who shall bear the tax burden. Certainty of tax amount
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payable in a certain time period . Certainty of Revenue to the government how much govt. shall
have estimated collection of revenue during a given time period.
3. Canon of economy -: every tax should satisfy the canon of economy in two ways . It should be
economical for the state to collect it . It should be economical for the tax payer it means he
should have sufficient money left with him after paying the tax.
4.Canon of convenience: - According to Adam Smith every tax ought to be levied at the time or
in the manner in which it is more likely to be convenient for the contributor to pay it .it implies
that taxes should be imposed in such a manner and at the time which is the most convenient for
the tax payer,e.g. the best time for the collection of land revenue is the time of harvest.
Some other writer like Bastable added a few more canons of taxation to the Adam Smith's four
canons of Taxation these are:
• Canon of productivity: - The productivity of a tax may be observed in two easy ,in the first
place ,a tax must yield a sufficient revenue for the maintenance of the government. Secondly, the
taxes should obstruct and discourage production in the short as well as in the long run.
• Canon of Elasticity: Taxation should be elastic in nature this canon implied that the yields of
the taxes may be increased or decreased according to the changing needs of the govt. The govt.
resources can be raised in emergencies like war floods droughts etc quickly only when the tax
system is elastic. Taxes on property and commodities are not so elastic as income tax .
• Canon of Simplicity :- this canon suggest that tax system should be easily understandable to tax
payer i.e its nature, its aim, time of payment, methods and basis of estimation should all be easily
followed by the each tax payer. However it is not very easy to observe this canon in the modern
tax system, which has become quite complex in nature.
• Canon of expediency : - Acc to this cannon a tax should be based on sound principles so that it
requires no justification from the side of government. the possibility of imposition of taxes should
be taken from different angles, i.e. its reaction upon tax payers .some times it may be desirable
and may have most of the characteristics of a good tax system but the govt. may not find it
expedient to impose it,e.g. progressive agriculture income tax is very much desirable in India,
but it has not been imposed so far in the manner it should have been imposed.
• Canon of diversity: - There should be variety of taxes a single tax. Would neither meet the
revenue requirement of state nor satisfy the canon of equity thus there should be a variety of
taxes so that all citizens should contribute towards state revenue acc to their ability to pay.
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• Canon of co-ordination : In a democratic country taxes are imposed by central, state and local
govts. It is therefore very much desirable that there is vo-ordination between different taxes that
are imposed by different taxing authorities. it is very much needed considering the interest of tax
payer and the govt. both .
MEANING OF PUBLIC EXPENDITURE:-
Public Expenditure refers to Government Expenditure. It is incurred by Central and State

Governments. The Public Expenditure is incurred on various activities for the welfare of the
people and also for the economic development, especially in developing countries. In other
words The Expenditure incurred by Public authorities like Central, State and local governments
to satisfy the collective social wants of the people is known as public expenditure.
A. NEED I IMPORTANCE/ SIGNIFICANCE OF PUBLIC EXPENDITURE :-
In modern economic activities public expenditure has to play an important role. It helps to
accelerate economic growth and ensure economic stability. Public Expenditure can promote
economic development as follows :-
1. To promote rapid economic development.
2. To promote trade and commerce.
3. To promote rural development
4. To promote balanced regional growth
5. To develop agricultural and industrial sectors
6. To build socio-economic overheads eg. roadways, railways, power etc.
7. To exploit and develop mineral resources like coal and oil.
8. To provide collective wants and maximise social welfare.
9. To promote full - employment and maintain price stability.
10. To ensure an equitable distribution of income.
Thus public expenditure has to create and maintain conditions conducive to economic
development. It has to improve the climate for investment. It should provide incentives to save,
invest and innovate.
B. OBJECTIVES OF PUBLIC EXPENDITURE :-
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The major objectives of public expenditure are
1) Administration of law and order and justice.
2) Maintenance of police force.
3) Maintenance of army and provision for defence goods.
4) Maintenance of diplomats in foreign countries.
5) Public Administration.
6) Servicing of public debt.
7) Development of industries.
8) Development of transport and communication.
9) Provision for public health.
10) Creation of social goods.
Theories of Public Expenditure

Introduction
Public expenditure is one of the important subject matters of public finance. Public expenditure
studies about the expenditure incurred by an authority or a government. Today, the scope of
public expenditure increased largely since all the economies of the world are focusing on
development, growth, welfare, safety etc. Therefore public expenditure can be considered as a
vital tool of a government to ensure and boost the process of development of a country. Anyway,
with regarding to the public expenditure, there are three important theories. They are
i) Adolf Wagner’s Hypothesis
ii) Peacock and Wiseman Hypothesis, and
iii) Colin Clark’s Critical Limit Hypothesis.
Each of the theories and its idea are briefly explained below.
Adolf Wagner’s’ Hypothesis
Adolph Wagner, the German economist made an in depth study relating to rise in government
expenditure in the late 19thcentury. Based on his study, he propounded a law called "The Law of
Increasing State Activity".
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Wagnar's law states that "as the economy develops over time, the activities and functions of the
government increase".
According to Adolph Wagner, "Comprehensive comparisons of different countries and different

times show that among progressive peoples (societies), with which alone we are concerned; an
increase regularly takes place in the activity of both the central government and local
governments constantly undertake new functions, while they perform both old and new functions
more efficiently and more completely. In this way economic needs of the people to an increasing
extent and in a more satisfactory fashion, are satisfied by the central and local Governments."
Wagner's Statement Indicates Following Points
✓ In progressive societies, the activities of the central and local government

increase on a regular basis.
✓ The increase in government activities is both extensive and intensive.
✓ The governments undertake new functions in the interest of the society.
✓ The old and the new functions are performed more efficiently and completely
than before.
✓ The purpose of the government activities is to meet the economic needs of the
people.
✓ The expansion and intensification of government function and activities lead to
increase in public expenditure.
✓ though Wagner studied the economic growth of Germany, it applies to other
countries too both developed and developing.
The principal criticisms of Wagner's law have concerned his view of history and of the
relationship between the state and its citizens. Peacock and Wiseman also queried whether
Wagner's ideas could be applied to all societies at all times and suggested that the time pattern of
actual public expenditure growth did not fit well with Wagner's law.
It can be explained with the help of a diagram as showing below.
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According to Wagner, there is a fundamental cause and effect relationship between economic
growth with respect to the growth in public expenditure. In the figure, real per capita income or
growth is represented on the ‘x’ axis and changes in public expenditure on ‘y’ axis. There will be
a positive and direct relationship between these two variables. In short, higher public expenditure
automatically increases the function of the state. This will gradually lead to higher economic
growth. There are many reasons for increasing the trend of public expenditure like planning,
modernization, higher social demand, industrial development etc.
II) PEACOCK AND WISEMAN HYPOTHESIS
Peacock and Wiseman conducted a new study based on Wagner's Law. They studied the public
expenditure from 1891 to 1955 in U.K. They found out that Wagner's Law is still valid.
Peacock and Wiseman further stated that :-
"The rise in public expenditure greatly depends on revenue collection. Over the years, economic
development results in substantial revenue to the governments, this enabled to increase public
expenditure".
Here also like Adolf Wagner, these economists talks about the relationship between
growth of an economy and public expenditure. But there is wide difference between these two
theories. Here, Peacock and Wiseman says that, public expenditure will increase with respect to
the growth of an economy. But the growing trend will not as like in the Adolf Wagner’s theory.
Further, it will be in a step like manner. The hypothesis can be explained with the help of a
diagram as showing below.
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In the figure, real per capita income or growth rate is represented on ‘x’ axis and public
expenditure on ‘y’ axis. According to this hypothesis, there are three basic effects in an economy
which can see in the growing path of a country. They are
a) Displacement effect
b) Inspection effect, and
c) Concentration effect.
a) Displacement effect: Every economy challenges many social disturbances in different periods.
Social disturbances may question the economic stability. Some of the social disturbances are
war, natural calamities, political instabilities etc. In such cases government requires huge public
expenditure to restructure the economy. In simple words, displacement effect is the increasing of
public expenditure due to social disturbances. So, the economy will change its current position in
public finance. Point ‘D’ in the figure represents displacement effect.
b) Inspection effect: Once an economy experienced displacement effect, new and higher public
expenditure will came in to existence. Along with the raise in public expenditure, government
also undertakes some improvements in public revenue by adjusting tax. This will lead to a new
equilibrium in public finance, which will be greater than the previous equilibrium level. Point ‘I’
in the figure represents inspection effect.
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c) Concentration effect: after the displacement effect, the economy will follow a new equilibrium
level in the public finance. Concentration effect refers that, this condition will follow until a new
social and economical displacement arises.
In short, according to Peacock and Wiseman, an economy can grow after experiencing social
disturbances. Such economic challenges will promote the authority to increase its expenditure.
This will resulted in the growth of an economy.
iii) Colin Clark’s Critical Limit Hypothesis
Colin Clark’s idea on public expenditure is associated with the idea of tax tolerance. He says
that, public expenditure should not exceed more than 25 percentage of the total expenditure
since it may create inflation even in the balanced budget. Further, higher public expenditure will
increase the income of the people. Which may tending to reduce production because of fear on
higher tax payment among people. In fact, Colin Clark highlighted the precautions for public
expenditure.
Conclusion
Public expenditure theories are dealing with the role of public expenditure for the economic
growth and development. As mentioned above, there are three basic theories in public
expenditure. Each of them agreed with the necessity of public expenditure to enter a country in
to the path of development.
CAUSES OF INCREASE IN PUBLIC EXPENDITURE IN INDIA :-
During the planning period, the expenditure of Central and State Government’s have increased.
The Central Government’s expenditure has increased over 10 times
The following are the main causes of growth of public expenditure in India :-
1) Growing Population :-
A high growth of population naturally calls for increase in public expenses as all state functions
are to be performed more extensively^ Population growth has made necessary for governments
of most countries to spend increasing amounts on education, health, infrastructure, subsidies and
social security. In 2011, :he population of India has increased to 121 crores.
POPULATION
OF INDIA
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Year Rs. Crore
1951 36.1
2001 102.9
2011 121.0
2) Defence Expenditure :-
The defence expenditure of the Central Government has increased over the years. The defence
expenditure minimises the possibility of external threats, which in turn creates a good
environment for social and economic activities of the nation. In India Defence expenditure has
increased from Rs. 10,874 crores in 1990-91 to Rs. 90,688 crore in 2009-10.
3) Interest Payments :- ,
Government borrowings are on increase. The government borrows funds from domestic market
and foreign sources to meet expenditure on various government activities. As a result, the
government has to incur huge interest payments. The interest payments of Central Government
has increased from Rs. 21,498 crores in 1990-91 to Rs. 2,11,643 crores in 2009-10.
4) Subsidies :-
Government of India has been providing subsidies on number of items such as food, fertilizers,
fuels, education etc. Because of massive amount of subsidies, the government expenditure has
increased over the years. In 1990-91 the Central Government’s subsidies was Rs. 9,581 crores
which increased to Rs. 1,23,396 crores in 2009-10. In order to reduce unproductive expenditure,
Central Government must make attempts to reduce subsidies.
5) Administration :-
The Central Governments expenditure on administration has increased due to growth in

population and economic development. Government incurs on law and order, tax administration,
civil administration etc. Due to inflation the government has to revise the payscale periodically.
The production cost of public goods and services has also risen due to rising prices.
6) Rise In National Income :-
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The national income of the country has increased over the years. The increase in national income
resulted in more revenue to the government by way of tax revenue and other income, which in
turn enabled the government to increase its expenditure. For Eg. From 1980-81 to 2007-08, the
N.I. has increased at the rate of 5.7% p.a. Percapita Income has also risen.
7) Urbanisation :-
Urbanisation has led to increasing expenditure on civil administration. Government expenditure

on courts, police, transport, railways, schools and colleges, public health measures, water and
electricity supply, public parks, libraries etc. have increased due to growth of towns and cities.
8) Rural Development :-
In developing countries, government has to undertake community development projects and

other social measures to promote rural development. Such measures cause a rise in public
expenditure.
9) Inflation :-
Rise in prices have caused an increase in public expenditure. The cost of supplying public goods
and services has increased. Rising prices have also necessiated the payment of higher salaries
and dearness allowances.
10) Democratic Government :-
A democratic government has to incur increasing expenditure on elections, legislatures,

ministries, international conferences, embassies abroad etc. Public expenditure also increases
when a country becomes a member of international organisations like UNO, WHO etc.
11) Social Security Measures :-
For the welfare of the people government provides social security measures which increases its
expenditure. It provides measures such as sickness benefits, old - age pensions, free education,
medical facilities, public works and relief programmes etc.
12) Growth Of Transport And Communication :-
The government has to incur huge expenditure on construction of railways, roadways, national
highways, bridges etc. to promote mobility and economic development. Thus with growth of
transport and v- communication public expenditure have increased.
13) Development Of Agriculture :-
The government may develop agriculture by providing seeds, fertilisers, irrigation facilities,
modern implements, cheap loans etc. All these will increase public expenditure.
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14) Development Of Industry :-
The government may encourage the growth of private sector industries through protection,
subsidies to exporters, loans at cheap rate of interest etc. causing a rise in public expenditure.
15) Poverty Alleviation Programmes :-
In developing countries, governments are spending a good amount of funds on poverty

alleviation and employment generation programmes. Some of the programmes are Swarnajayanti
Gram Swarojgar Yojana, Indira Awas Yojana, National Food for Work Programme etc.
16) Research And Development :-
Research and Development is important to improve quality and to reduce costs. The government
finances Research and Development projects undertaken by non - government organisations,
universities and i other educational organisations.
17) Economic Planning :-
To promote rapid economic development modern governments adopt economic planning. The
public sector outlay on various sectors has been increasing with the increasing role of
government.
CONCEPT OF PUBLIC DEBT
Meaning :
Public debt refers to the loans raised by government from within or outside the country. Every
govt. has to borrow when its expenditure exceeds its revenue. The borrowing or taking loans by
the govt Is known as public debt.
Comparison between Public and Private Debt:
1. Compulsion :- The government can compel the people or institution in a country to lend funds
to it in case of war, economic crises or any other emergencies but no private individuals can
force or compel another private individual to lend them money
2. Repudiation :- Under abnormal conditions the govt. can refuse the payments of loan taken by
it from people but the private individuals cannot do so under any circumstances.
3. Time Period :- The government can borrow from public for longer periods because it is a
permanent institution and people have faith in it. Private individual can barrow for short period
of time due to risks involved on the part of the lender.
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4. Rate of interest :- Because of its high credit worthiness government can borrow at lower rate
of interest but it is not so in case of private borrower who has to pay a very high rate of interest
because risk is involved in it.
5. Sources :- The government can take loan within the country and also from abroad but a
private borrower can borrow only from within the country.
6. Mode of Payment :- The government repays its loan by taxiing the people but in case of
private debt the borrower has to repay loan out of his own saving.
7. Effect on the economy: - Public debt makes its effect on production distribution of income and
wealth in country but private loans make no such effects due to its micro nature.
Sources of Public debt :
There are 2 main sources.
(1)Internal (2) external
(1) Sources of internal debt :- It refers to govt. loans floated in capital markets within the
political boundaries of the country . the main sources of internal borrowing are:
i) Individuals.
ii) Banking & non-banking institutions.
iii) Central Bank.
Sources of external debts:-
It refers to govt. loans floated in foreign capital market. The main sources are.
i) Foreign governments.
ii) International Monetary agency like world bank IMF, International finance corporation
international development association.
Debt Redemption or Debt Management (Repayment)
Redemption of public debt means repayment of debt. Public debt is to be repaid by the
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government within the time limit fixed for its repayment. The various methods of debt redemption
are.
(1) Repudiation of debt :- it means refusal to pay a debt all together. The government refuses to
pay the interest as well as the principle amount. This method of debt redemption is not practical
because the government reputation may be at stake the consequences of this method may be
dangerous. Debt repudiation is not popular in modern times. Russia did so in 1971.
(2) Debt conversion :- In this method the debt with high interest rate is converted into new debt
when the market rate of interest falls. The government borrows at low rate of interest and repays
the past debt even before it matures. The lender is free to take his money back or get his loan
converted into a fresh loan. However conversion can be successfully carried out ,if the credit of
the govt.is good.
(3) Budgetary surplus A policy of surplus budget may be followed annually for clearing of public
debt gradually instead of creating a fund for its repayment on maturity. But in recent years due
to rapidly increasing public expenditure ,surplus budget is a rare phenomenon
(4) Terminal annuities: - under this method the physical authorities clear off. Part of public debt
on the basis of terminal annuities into equal annual installments including interest along with the
principle amount. This is the easiest method similar to sinking fund. According to this method
,the burden of debt goes on diminishing and by the time of maturity ,it is already fully paid off.
(5) Refunding:- In this method. There is issue of new bonds and securities by the government in
order to repay the matured loans. refunding is the process by which the maturing bonds are
replaced by new bonds .A major drawback of this method is that the govt. would be tempted to
postpone its obligations of debt redemption and the total burden of debt would continue to
increase in future.
(6) Sinking fund :- In this system the government establishes a separate fund known as sinking
fund. A fixed amount of money is credited by the government to this fund every year. By the time
one debt matures. There is enough amount in fund to pay off loans along with the rate of interest.
In practice sinking funds are not accumulated, Government do not create such fund if even if
they create they utilize it for the other purposes whenever they are in need of funds.
(7) Capital levy :- It refers to a very heavy tax on property and wealth. It is a once for all taxes
imposed on the capital assets above the certain value. in fact capital levy is advocated
immediately after the war to repay the unproductive war debts.
(8) Reduction of rate of interest : sometimes the govt. takes statuary decision to reduce the rate
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of interest. Payable on its public debt. The creditors are forced to accept the reduced rate of
interest. This method is normally used by the govt. during financial crisis.
(9) Additional provision of taxation :- In this method new taxes are imposed to collect revenue. It
is a method of redistribution of income by transferring it from the tax payer into the hands of
bonds holders.
Debt Trap : It refers to a phenomenon where the government of a country has to raise fresh loan
just in order to pay the interest charged on the earlier loan borrowed by govt. and it is very
difficult to repay to the amount. The govt. is trapped in vicious circle of borrowing.
Burden of public debt:
It tells both internal & external debt may be direct money burden, indirect money burden, direct
real burden and indirect real burden.
i. Direct Money Burden :- It refers to the amount of money to be raised to meet the revenue
requirements. In case of internal public debt there is no direct money burden because in this
case money changes hands only. But in case of external debt money burden is heavy.
ii. Indirect money burden :- When govt. spends the loans it result in the creation demand for
certain commodities as a consequences the prices of goods and services rise imposing additional
burden on the society.
iii. Direct Real burden :- It is in the form of reduction in economic welfare and this strains and
stresses tax payers.
iv. Indirect Real burden :- The indirect real burden of a debt is also felt through the ultimate
effects on production when the govt. imposes taxes to repay loans and interest it discourages the
willingness of the tax payers to work more & save more, thus it adversely affect the production in
a country and the indirect real burden of a tax will be heavy.
POSITIVE EFECTS OF PUBLIC DEBT :
1 Mobilization of resources: - Public borrowing is very helpful in implementing 5 year plans and
various other projects. with the help of borrowing govt. can easily make various types of plans to
mobilizes the resources efficiently.
2 Increase in the productive capacity :- With increase in barrowing productive capacity of a

country can easily be increased. Borrowing is very much helpful in using capital intensive
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techniques to increase the productive capacity of a country.
3 To promote Investments: - Public borrowing helps in promoting investments, borrower fund

can be utilized for strengthening infrastructure and promoting economic development of
country.
4 Developmental expenditure: - Barrowing can be used to meet the developmental expenditure

like roads, communication system, railways telecom, finance etc.
5 Obtaining foreign exchange:- Borrowing in the form of foreign exchange can be used to meet
developmental activities. For development purpose govt. tries to acquire money capital, raw
material from foreign countries. It can then only be possible if we have good stock of foreign
exchanges with us.
ADVERSE AFFECTS OF PUBLIC DEBT :
1) Inflationary impact :- With increase in the public borrowing money supply in the market also
increases which increases the prices of the commodity.
2) Additional tax burden :- To repay the old loans. Government has to impose new taxes on
people which will be extra tax burden on the people and it pinches a lot.
3) Adverse effect on saving and in vest anent :- for the repayment of loan when govt. imposes
new taxes on the people there will be adverse effect on saving and investment b/c more saving &
more investment means more tax.
4) Effects on distribution of income :- Public debt may sometime effect distribution of income
among people. Govt. raises loans from higher income group people and the return of it is also
given to them only. Thus rich becomes richer and poor becomes poorer.
5) Unproductive debt:- a part of the loan taken by the govt. is used to meet the non
developmental expenditure which never helps in increasing the production in the country. Thus it
is called dead weight debt which is very difficult to repay.
6) Debt servicing burden :- The annual interest paid by the govt. in lieu of debt increase is
known as debt servicing burden. There is very large increase in debt servicing burden in every
country in modern times which has very dangerous consequences.
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COMPOSITION AND GROWTH I TRENDS OF PUBLIC DEBT IN INDIA
During recent years public debt in India has been growing at an alarming rate, with the budget
deficit increasing significantly. Debt obligation of Central Government are divided into internal
liabilities and external debts. The following are the various components of public debt :-
(I) Internal Debt:-
Internal debt refers to loans raised from open market. Internal debt of Central Government has
increased from Rs.1,54,004 crores in 1990-91 to Rs.23,37,682 crores in 2009-10.
INTERNAL DEBT LIABILITIES OF GOVERNMENT OF INDIA
1. Market Loans :-
Market loans have a maturity period of 12 months or more and they generally bear interest.
These loans are raised in the open market by sale of securities or otherwise. Market loan stood at
17,34,505 crore in 2009-10.
2. Treasury Bills
This is a major source of short term funds for the government to bridge the gap between revenue
and expenditure. They have a maturity of 91 days, 181 days and 364 days Treasury bills are
issued to the Reserve Bank of India, State Governments, Commercial Banks and other parties.
3. Securities Against Small Savings :-
Under the new Accounting System of National Small Savings Funds (NSSF), a substantial part
of small savings have been converted into Central Government Securities from the year 1999 -
2000. As a result, there has been a sharp rise in internal debt and the corresponding decline in
other liabilities in form of small savings.
4. Special Securities Issued Bv RBI :-
The Government obtains temporary loans for a period of maximum 12 months from RBI and
issues special securities, which are non-negotiable, and non-interest bearing.. Such securities
provide short term funds to the Government.
5. Special Floating And Other Loans :-
It refers to the contribution of government 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 and non -
interest bearing securities and the Government of India is supposed to make repayment at the call
of these institutions.
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6. Bonds And Expired Loans :-
It comprises balance of expired loans, gold bonds and compensation and other bonds such as
National Rural Development Bonds, Central Investment Bonds. The bonds are issued at different
maturityperiods which may range from 3 year to 10 year period
7. Ways and means Advances:-
The government of India takes ways and means advances from RBI to meet its short period
expenditure.
II) Other Internal Liabilities
Apart from internal borrowings, the government also obtains funds from following :-
1) Small Savings :-
Schemes like National Savings Certificates, National Savings Scheme etc. contributed to rise in
small savings. These schemes provide tax concessions to tax payers. As a result they have been
successful in attracting more funds in small savings.
2) Provident Funds :-
Provident funds are divided into two categories State Provident Fund and Public Provident Fund.
Deposits in Public Provident Funds are repayable after 15 years.
3) Reserve Funds And Deposits :-
Reserve Funds and Deposits are divided into two categories - interest bearing and 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.
III) External Debt
The government obtains funds not only from internal sources but also from external sources.
External debt has increased from Rs.31,525 crore in 1990-91 to Rs. 1,39,581 crore in 2009-10
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What is Trade? Meaning and Nature
Trade refers to buying and selling of goods and services for money or money's worth. It involves
transfer or exchange of goods and services for money or money's worth. The manufacturers or
producer produces the goods, then moves on to the wholesaler, then to retailer and finally to the
ultimate consumer.
Trade is essential for satisfaction of human wants, Trade is conducted not only for the sake of
earning profit; it also provides service to the consumers. Trade is an important social activity
because the society needs uninterrupted supply of goods forever increasing and ever changing
but never ending human wants. Trade has taken birth with the beginning of human life and shall
continue as long as human life exists on the earth. It enhances the standard of living of
consumers. Thus we can say that trade is a very important social activity.
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Different Types of Trade
Trade can be divided into following two types, viz.,

Internal or Home or Domestic trade.
External or Foreign or International trade
1. Internal Trade
Internal trade is also known as Home trade. It is conducted within the political and geographical
boundaries of a country. It can be at local level, regional level or national level. Hence trade
carried on among traders of Delhi, Mumbai, etc. is called home trade.
Internal trade can be further sub-divided into two groups, viz.,
Wholesale Trade : It involves buying in large quantities from producers or manufacturers and
selling in lots to retailers for resale to consumers. The wholesaler is a link between manufacturer
and retailer. A wholesaler occupies prominent position since manufacturers as well as retailers
both are dependent upon him. Wholesaler act as a intermediary between producers and retailers.
Retail Trade : It involves buying in smaller lots from the wholesalers and selling in very small
quantities to the consumers for personal use. The retailer is the last link in the chain of
distribution. He establishes a link between wholesalers and consumers. There are different types
of retailers small as well as large. Small scale retailers includes hawkers, pedlars, general shops,
etc.
2. External Trade
External trade also called as Foreign trade. It refers to buying and selling between two or more
countries. For instance, If Mr.X who is a trader from Mumbai, sells his goods to Mr.Y another
trader from New York then this is an example of foreign trade.
External trade can be further sub-divided into three groups, viz.,
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Export Trade : When a trader from home country sells his goods to a trader located in another
country, it is called export trade. For e.g. a trader from India sells his goods to a trader located in
China.
Import Trade : When a trader in home country obtains or purchase goods from a trader located in
another country, it is called import trade. For e.g. a trader from India purchase goods from a
trader located in China.
Entrepot Trade : When goods are imported from one country and then re-exported after doing
some processing, it is called entrepot trade. In brief, it can be also called as re-export of
processed imported goods. For e.g. an indian trader (from India) purchase some raw material or
spare parts from a japanese trader (from Japan), then assembles it i.e. convert into finished goods
and then re-export to an american trader (in U.S.A).
Need and Importance of Foreign Trade

Following points explain the need and importance of foreign trade to a nation.
1. Division of labour and specialisation
2. Optimum allocation and utilisation of resources
3. Equality of prices
4. Availability of multiple choices
5. Ensures quality and standard goods
6. Raises standard of living of the people
7. Generate employment opportunities
8. Facilitate economic development
9. Assitance during natural calamities
10. Maintains balance of payment position
11. Brings reputation and helps earn goodwill
12. Promotes World Peace
Intro - Classical Theory of International Trade
In 1817, David Ricardo, an English political economist, contributed theory of comparative

advantage in his book 'Principles of Political Economy and Taxation'. This theory of comparative
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advantage, also called comparative cost theory, is regarded as the classical theory of international
trade.
According to the classical theory of international trade, every country will produce their
commodities for the production of which it is most suited in terms of its natural endowments
climate quality of soil, means of transport, capital, etc. It will produce these commodities in
excess of its own requirement and will exchange the surplus with the imports of goods from
other countries for the production of which it is not well suited or which it cannot produce at all.
Thus all countries produce and export these commodities in which they have cost advantages and
import those commodities in which they have cost disadvantages.
Types of Cost Difference in Production
Economists speak about three types of cost difference in production, they are
Absolute cost difference,

Comparative cost difference.
1. Absolute Cost Differences:-
Adam Smith in his book 'Wealth of Nation' argued that international trade is advantageous for all
the participating countries only if they enjoy absolute differences in the cost of production of the
commodity which they specialise. As in the case of individuals where each specialises in the
production of that commodity in which he has an absolutely superiority in terms of cost, so also
each country specialises in production of goods based on absolute advantage.
The principle of absolute difference in cost can be explained with the help of table given below.
Let us assume that we have 2 countries, I and II specialising in the production of X and Y.
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In country I, one day's labour produces 20x or 10y. The internal exchange rate is 2 : 1. In country
II, one day's labour produce 10x or 20y which gives us the domestic exchange rate of 1 : 2.
Country I has the absolute advantage in the production of X (as 20 > 10) and country II in Y ( as
10 < 20). If these countries enter into trade with the international exchange of 1 : 1, both
countries stand to benefit. Country I will have 1y for 1x as against 1/2y for 1x within the country.
Similarly country II will have 1x for 1y as against 1/2x for 1y within the country.
Based on this example, according to Adam Smith, it can be pointed out that international trade to
be beneficial, each country must enjoy absolute difference in cost of production.
Comparative Difference in Cost :-

David Ricardo agreed that absolute difference in cost gives a clear reason for trade to take place.
He, however, went further to argue that even that the country has absolute advantage in the
production of both commodities it is beneficial for that country to specialise in the production of
that commodity in which it has a greater comparative advantage. The other country can be left to
specialise in the production of that commodity in which it has less comparative advantage.
According to Ricardo the essence for international trade is not the absolute difference in cost but
comparative difference in cost.
Ricardo's Theory of Comparative Advantage
David Ricardo stated a theory that other things being equal a country tends to specialise in and
exports those commodities in the production of which it has maximum comparative cost
advantage or minimum comparative disadvantage. Similarly the country's imports will be of
goods having relatively less comparative cost advantage or greater disadvantage.
1. Ricardo's Assumptions :-
Ricardo explains his theory with the help of following assumptions :-

1. There are two countries and two commodities.
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2. There is a perfect competition both in commodity and factor market.

3. Cost of production is expressed in terms of labour i.e. value of a commodity is measured
in terms of labour hours/days required to produce it. Commodities are also exchanged on
the basis of labour content of each good.
4. Labour is the only factor of production other than natural resources.
5. Labour is homogeneous i.e. identical in efficiency, in a particular country.
6. Labour is perfectly mobile within a country but perfectly immobile between countries.
7. There is free trade i.e. the movement of goods between countries is not hindered by any
restrictions.
8. Production is subject to constant returns to scale.
9. There is no technological change.
10. Trade between two countries takes place on barter system.
11. Full employment exists in both countries.
12. There is no transport cost.
2. Ricardo's Example :-
On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by
taking an example of England and Portugal as two countries & Wine and Cloth as two
commodities.
As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of
comparative advantage expressed in labour hours by the following table.
Portugal requires less hours of labour for both wine and cloth. One unit of wine in Portugal is
produced with the help of 80 labour hours as above 120 labour hours required in England. In
the case of cloth too, Portugal requires less labour hours than England. From this it could be
argued that there is no need for trade as Portugal produces both commodities at a lower cost.
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Ricardo however tried to prove that Portugal stands to gain by specialising in the commodity in
which it has a greater comparative advantage. Comparative cost advantage of Portugal can be
expressed in terms of cost ratio.
Cost ratios of producing Wine and Cloth
Portugal has advantage of lower cost of production both in wine and cloth. However the
difference in cost, that is the comparative advantage is greater in the production of wine (1.5 —
0.66 = 0.84) than in cloth (1.11 — 0.9 = 0.21).
Even in the terms of absolute number of days of labour Portugal has a large comparative
advantage in wine, that is, 40 labourers less than England as compared to cloth where the
difference is only 10, (40 > 10). Accordingly Portugal specialises in the production of wine
where its comparative advantage is larger. England specialises in the production of cloth where
its comparative disadvantage is lesser than in wine.
• Comparative Cost Benefits Both Participants ↓
Let us explain Ricardian contention that comparative cost benefits both the participants, though
one of them had clear cost advantage in both commodities. To prove it, let us work out the
internal exchange ratio.
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Let us assume these 2 countries enter into trade at an international exchange rate (Terms of
Trade) 1 : 1.
At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine.
At home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of
cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth.
Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of
cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the
trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of
cloth for one unit of wine.
In this example, Portugal specialises in wine where it has greater comparative advantage leaving
cloth for England in which it has less comparative disadvantage.
Thus comparative cost theory states that each country produces & exports those goods in which
they enjoy cost advantage & imports those goods suffering cost disadvantage.
Criticisms
1. This theory is not applicable if there are more than two countries and more than two
commodities
2. In every country there is more or les government intervention in international trade
3. There is cost of transportation form one country to another country
4. The units of labor are not homogeneous and the workers are paid more or less in different
countries
5. There may be increasing or decreasing returns to scale
6. Labor is not perfectly mobile within the country too. In the modern era, there is mobility
of labor form one country to another
7. The commodities produced in the different countries differ in quality, taste, size, quantity
etc.
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EMERGENCE OF WTO:-
After the Second World War, many countries got down together to work on ways and
means to promote international trade. The result was signing of General Agreement on Tariffs
and Trade (GATT) by 23 countries in 1947. India was one of the founder members of GATT.
GATT was created to reduce global depression and to liberalise and regulate the world
trade by reducing tariff barriers. GATT has been replaced by WTO in 1995. WTO is wider in
scope as it regulates world trade in goods, as well as in services intellectual property rights, and
investment. In January 2010, the membership of WTO was 153 countries. Its rules and policies
are the outcome of negotiations among WTO members. Thus WTO is a member driven,
consensus based organization.
B. PRINCIPAL OBJECTIVES OF WTO
1) Trade Without Discrimination :-
Trade without discrimination through the application of Most Favoured Nation (MFN)
Principle. As per MFN clause, a member nation of WTO must accord (give) the same
preferential treatment to other member nations which it gives to any other member nation.
2) Raising The Standard Of Living :-
Raising the standard of living and incomes and ensuring full employment of the citizens
of its member nations.
3) Optimum Use Of World's Resources :-
Ensuring optimum use of world's resources and, thereby, expanding world production
and trade of goods as well as services.
4) Settlement Of Disputes :-
Settlement of disputes among members through consultation, conciliation, and as a last
resort through dispute settlement procedures.
5) Growth Of Less Developed Countries (LDCs) :-
It recognises the need for positive efforts designed to ensure that developing countries
especially the LDCs, secure a better share of growth in international trade.
6) Protection Of Environment
Preserving and protecting the environment of the world so as to benefit all the nations
of the world.
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7) Enlargement Of Production And Trade

WTO aims to enlarge production and trade of goods as well as services.
8) Employment
WTO aims at generating full employment and increase in effective demand.
C) FUNCTIONS OF WTO
WTO has following functions
1) Implementation Of Reduction In Trade Barriers
WTO shall check the implementation of tariff cuts and reduction of non-tariff measures agreed
upon the member nations at the conclusion of Uruguay Round.
2) Forum For Negotiation
WTO shall provide the forum of negotiations among its members concerning their
multilateral trade relations.
3) Settlement Of Disputes
WTO shall administer the understanding on rules and procedures governing the settlement
of disputes.
4) Assistance To IMF And IBRD
WTO shall co-operate with IMF, IBRD and its affiliated agencies to achieve greater
coherence in global economic policy.
5) Administration Of Agreements
WTO shall look after the administration of 29 agreements (signed at the conclusion of
Uruguay Round in 1994), plus a number of other agreements, entered into after Uruguay Round.
6) Examination Of Trade Policies
WTO shall regularly examine the foreign trade policies of member nations, to see that
such policies are in line with WTO’s guidelines.
7) Consultancy Services
WTO shall keep a watch on the developments in the world economy and it provides
consultancy services to its member nations.
8) Collection Of Foreign Trade Information
WTO shall collect information on import - export trade and on various trade measures and
other trade statistics of member nations.
IMPACT OF WTO AGREEMENTS ON INDIAN ECONOMY :-
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The signing of WTO agreements will have far reaching effects not only on India’s
foreign trade but also on its internal economy. Although the ultimate goal of WTO is to free
world trade in the interest of all nations of the world, yet in reality the WTO agreements has
benefitted the developed nations more as compared to developing ones. The impact of WTO on
India’s economy is staged as follows :-
I. Positive Impact, Benefits , Advantages OR Gains from WTO :-
The Positive impact of WTO on India's economy can be viewed from the following
points:-
1) Increase In Export Earnings :-
Estimates made by World Bank, Organisation for Economic Co-operation and
Development (OECD) and the GATT Secretariat, shows that the income effects of the
implementation of Uruguay Round package will be an increase in traded merchandise goods. It
is expected that India’s share in world exports would improve.
2) Agricultural Exports :-
Reduction of trade barriers and domestic subsidies in agriculture is likely to raise
international prices of agricultural products. India hopes to benefit from this in form of higher
export earnings from agriculture. This seems to be possible because all major agriculture
development programmes in India will be exempted from the provisions of WTO Agreement.
3) Export Of Textiles And Clothing :-
With the phasing out of MFA (Multi - Fibre Arrangement), exports of textiles and
clothing will increase and this will be beneficial for India. The developed countries demanded a
15 year period of phasing out of MFA, the developing countries, including India, insisted that it
be done in 10 years. The Uruguay Round accepted the demand of the latter. But the phasing out
Schedule favours the developed countries because a major portion of quota regime is going to be
removed only in the tenth year, i.e. 2005. The removal of quotas will benefit not only India but
also every other country'.
4) Multilateral Rules And Disciplines :-
The Uruguay Round Agreement has strengthened Multilateral rules and disciplines. The
most important of these relate to anti - dumping, subsidies and countervailing measures,
safeguards and disputes settlement. This is likely to ensure greater security and predictability of
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the international trading system and thus create a more favourable environment for India in the
New World Economic Order.
5) Growth To Services Exports :-
Under GATS agreement, member nations have liberalised service sector. India would
benefit from this agreement. For Eg:- India’s services exports have increased from about 5
billion US $ in 1995 to 96 billion US $ in 2009-10. Software services accounted for about 45%
of service exports.
6) Foreign Investment :-
India has withdrawn a number of measures against foreign investment, as er the
commitments made to WTO. As a result of this, foreign investment and FDI has increased over
the years. A number of initiatives has been taken to attract FDI in India between 2000 and 2002.
In 2009-10, the net FDI in India was US $ 18.8 billion.
II. Negative Impact / Problems I Disadvantages Of WTO Agreements on Indian Economy :-

1) TRIPs :-
The Agreement on TRIPs at Uruguay Round weights heavily in favour of Multinational
Corporations and developed countries as they hold a very large number of patents. Agreement on
TRIPs will work against India in several ways and will lead to rponopoly of patent holding
MNCs. As a member of WTO, India has to comply with standards of TRIPs.
The negative impact of agreement on TRIPs on Indian economy can be stated as follows
a) Pharmaceutical Sector :-
Under the Patents Act, 1970, only process patents were granted to chemicals, drugs and
medicines. This means an Indian pharmaceutical company only needed to develop and patent a
process to produce and sell that drug. This proved beneficial to Indian pharmaceutical companies
as they were in a position to sell quality medicines at low prices both in domestic as well as in
international markets. However, under the agreement on TRIPs, product patents needs to be
granted. This will benefit the MNCs and it is feared that they will increase the prices of
medicines heavily, keeping them out of reach of poor. Again many Indian pharmaceutical
companies may be closed down or taken over by large MNCs.
b) Agriculture :-
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The Agreement on TRIPs extends to agriculture through the patenting of plant varieties.
This may have serious implications for Indian agriculture. Patenting of plant varieties may
transfer all gains in the hands of MNCs who will be in a position to develop almost all new
varieties with the help of their huge financial resources and expertise.
c) Microorganisms :-
The Agreement on TRIPs also extends to Microorganisms as well. Research in micro -
organisms is closely linked with the development of agriculture, pharmaceuticals and industrial
biotechnology. Patenting of micro - organisms will again benefit large MNCs as they already
have patents in several areas and will acquire more at a much faster rate.
2) TRIMs :-
Agreement on TRIMs provide for treatment of foreign investment on par with domestic
investment. This Agreement too weights in favour of developed countries. There are no
provisions in Agreement to formulate international rules for controlling restrictive business
practices of foreign investors. Jn case of developing countries like India, complying with
Agreement on TRIMs would mean giving up any plan or strategy of self - reliant growth based
on locally available technology and resources.
3) GATS :-
One of the main features of Uruguay Round was the inclusion of trade in services in
negotiations. This too will go in favour of developed countries. Under GATS agreements, the
member nations have to openup services sector for foreign companies. The developing countries
including India have opened up services sector in respect of banking, insurance, communication,
telecom, transport etc. to foreign firms. The domestic firms of developing countries may find it
difficult to compete with giant foreign firms due to lack of resources & professional skills.
4) Non - Tariff Barriers :-
Several countries have put up trade barriers and non - tariff barriers following the
formation of WTO. This has affected the exports from developing countries. The Union
Commerce Ministry has identified 13 different non - tariff barriers put up by 16 countries against
India. For eg. MFA (Multi - fibre arrangements) put by USA and European Union is a major
barrier for Indian textile exports.
5) Agreement On Agriculture (AOA)
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The AOA is biased in favour of developed countries. The issue of food security to
developing countries is not addressed adequately in AOA. The existence of global surpluses of
food grains does not imply that the poor countries can afford to buy. The dependence on
necessary item like foodgrains would adversely affect the Balance of Payment position.
6) Inequality Within The Structure Of WTO
There is inequality within the structure of WTO because the agreements and amendments
are in favour of developed countries. The member countries have to accept all WTO agreements
irrespective of their level of economic development.
7) LDC Exports
The 6th Ministerial Conference took place at Hong Kong in December 2005. In this
Conference, it was agreed that all developed country members and all developing countries
declaring themselves in a position to do so, will provide duty - free and quota - free market
access on a lasting basis to all products originating from all Least Developed Countries (LDC).
India has agreed to this. Now India's export will have to compete with cheap LDC exports
internationally. Not only this, the cheap LDC exports will come to Indian market and compete
with domestically produced goods.
India will face several problems in the process of complying with WTO agreements, but
it can also reap benefits by taking advantage of changing international business environment. For
this it needs to develop and concentrate on its areas of core competencies.
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BALANCE OF PAYMENTS
MEANING :
Balance of payment can be defined as systematic record of all economic transactions between the
residence of one country and the residence of another country during a given period of
time.Economic transactions can broadly be categorized in to four heads which are:
1. VISIBLE ITEMS : visible items include all those tangible goods which can be imported and
exported. These are visible as they are made up of some matter or material. this is known as
merchandise also.
2. INVISIBLE ITEMS: invisible items include all types of services like shipping,banking,tourist
etc.
3. UNILATERAL TRANSFERS: These are those payments which are made without expecting
anything in return of it like donations ,gifts etc.
4. CAPITAL TRANSFERS: Capital transfers are concerned with capital receipts and capital
payments. It includes the transfer of assets.
COMPONENTS OF BALANCE OF PAYMENT:

1. CURRENT ACCOUNT: current account deals with the movement of exports and imports of
goods and services. Merchandise may be private or government .It is the major item of the
current account. Items of current account are as under:
A Exports and imports of visible items i.e. goods. It is also known as balance of trade.
B. invisible items
C services
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D unilateral transfers
E miscellaneous- commission, advertisement, royalties, patent fee etc.
Each one of these items has credit and debit depending on the principle of double entry book
keeping.
2. CAPITAL ACCOUNT: deals with financial transactions between one country and rest of the
world. These financial or capital transactions can be private ,government or institutional. It can
be classified as short term and long term capital movements. These capital movements are of two
types:
1. Autonomous capital : refers to those capital flows which take place because of economic
considerations such as earning of interest income, dividends and other income by foreign
investment etc. e.g. if MNCs are making investment in India ,this is done with the objective of
earning income.
2. Accommodating capital : It takes place to bring the BOP in equilibrium.e.g. if there is current
account deficit in BOP. This deficit is settled by capital inflows from abroad either by borrowing
from abroad or by running down cash balances by the government.
Main Components of Capital Account :

1. FOREIGN INVESTMENT : It has two sub parts (a) Foreign direct investment : it refers
to the investment undertaken in the firms belonging to other countries by acquiring
control over them. e.g. purchase of a firm by reliance in a foreign country.
(b) Portfolio investment : It refers to the form of investment under which companies and
residents of a country purchase shares of foreign companies or buy bonds issued by
foreign governments.e.g. purchase of shares of a company by reliance in foreign country.
2. LOANS :
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(a) Commercial borrowing
(b) Borrowing as external assistance
(c) Banking capital transactions

DISEQUILIBRIUM IN BALANCE OF PAYMENT :
When there is either deficit or surplus balance of payment it is said to be in disequilibrium.
When a country is incurring more payments from abroad than it has to make then it is
considered favourable balance of payment which is in surplus. Contrary to it if a country
makes more payments abroad than what it receives then BOP is said to be unfavourable
because it is in deficit.
The main causes of adverse BOP are:
1. Fall in export demand: When demand for the country’s goods fall in the foreign market
Due to changes in the taste and preferences of the consumers export decreases and the BOP
will be unfavourable. However the deficit in BOP due to fall in export demand is more
inclined in underdeveloped countries than advance countries.
2. Growth of population : In underdeveloped countries aggregate consumption demand rises

due to rapid growth of population consequently imports of goods increases and the export
decreases. This creates the deficit in the balance of payment of less developed countries.
3. Inflation: Increase in prices due to higher wages and higher prices of raw materials
etc.makes export costlier. The export in this case decreases and at the same time demand for
imports increases .This results in deficit BOP.
4. Huge international borrowings : Country may tend to have an adverse BOP when it
borrows heavily from other country while the lending country will tend to have a favourable
BOP.
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5. Development programmes :The other reason for adverse BOP in developing countries is a
large investment in development schemes. These development schemes require import of
huge quantity of capital goods ,technical knowledge and essential raw materials. This
increases imports which makes BOP unfavourable.
6. Change in foreign exchange rates : When external value of the domestic currency goes up
imports become cheaper and exports costlier. Thus imports encouraged and exports
discouraged leading to disequilibrium of BOP.
7. Demonstration effect : It is another most important factor causing deficit in BOP of a

country especially of an underdeveloped country. When people of underdeveloped countries
come into the contact with those of advanced countries they start adopting western style and
pattern of consumption. Due to this reason their import increases and it leads to adverse
BOP.
METHODS TO CORRECT BALANCE OF PAYMENTS :

There are several methods to correct BOP disequilibrium. The methods can be classified in to
two groups:
1. Monetary methods: Monetary methods of correction effect the BOP by changing the value or
flow of currencies both domestic and foreign. Following are the monetary methods:
(a) Deflation : Deflation means a reduction in the quantity of money so as to bring about a fall
in the prices and the money income of the people .Falling prices encourage exports and
discourage imports .Hence deflationary policy restores equilibrium in BOP.
Deflation is not considered as a suitable method of correcting adverse BOP because it reduces
income and causes unemployment in the country
(b) Devaluation: It means decreasing the value of domestic currency in respect of a foreign
currency. Devaluation is done by the government of the country which has unfavourable BOP. It
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is done deliberately to get its advantages . The government officially declares devaluation
indicating the extent of decrease in the value of currency. specific currency will be determined
with which it is devalued. Devaluation is irreversible. The country can not change the value of
currency frequently.
With a decrease in the value of its currency the country has to pay more in exchange for a
foreign currency. In this case the export becomes cheaper at the same time import becomes
expensive. With this export increases and import decreases. However the success of devaluation
depends on the following:
(i) The elasticity of demand for the country’s export should be high.
(ii) The elasticity of demand for country’s import should be fairly elastic
Devaluation as a method of correcting adverse BOP suffers from the following defects:
(i) It reduces the public confidence in country’s currency as it is an indicator of country’s

weakness.
(ii) It increases the burden of public debt
(iii) It encourages inflationary tendencies in the home country.
(c) Exchange Depreciation : Depreciation refers to decline in the rate of exchange of one
currency in terms of other currency. It is similar to devaluation but not done by the government.
It is done in the exchange market with the help of demand and supply of the currency. It takes
place in a flexible exchange rate system. It is automatic and can correct the adverse BOP of the
country. But method of exchange depreciation suffers from following defects:
(i) It is not suitable for a country which has adopted a fixed exchange rate system
(ii) It makes international trade risky and thus reduces the volume of trade.
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(iii) The terms of trade go against the country whose currency depreciates
(iv) Depreciation may generate inflationary pressure by making the commodity more expensive.
(d) exchange control : It is the most widely used method for correcting adverse BOP. It refers
to the control by the central bank over the use of foreign exchange. In this method all the
exporters are directed by the Central bank to surrender the foreign exchange earnings and it is
rationed out among the licensed importers, It means only license holders can import goods.
Exchange control, does not remove the process of adverse BOP, It simply does not allow the
situation to worsen. Hence it is not considered a proper method to correct adverse BOP.
(e) Capital movement: In flow of capital from the individuals and government of other
countries as well as borrowings from international financial institutions like World bank,IMF etc.
can be used to correct the deficit in BOP.
(f) Pegging operation: Pegging down the value. The central bank depending on the need may
artificially increase or decrease the value of currency temporarily. Pegging operation can be done
any no. of times. It is reversible. It offers the flexibility to the government to manage the
currency of value for its advantage.
2. Non monetary measures: Non monetary measures deal with the real sector for correcting
disequilibrium in BOP. Following are the important non monetary measures:
(a) Export promotion : To control adverse BOP the country may adopt export promotion
measures which are as follows:
(i) Cash assistance and subsidies can be given to exporters to increase export
(ii) Export duties may be reduced to encourage exports.
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(iii) Goods meant for exports can be exempted from all types of taxes
(iv) Export oriented industries can be encouraged by providing better infrastructure, better raw
material, making favourable loan facilities etc.
(b) Import substitutes : The economy can develop technology of import substitution. Industries
producing import substitutes can be encouraged by capital goods ,better technology etc. Policy of
import substitution can help the country to become self reliant.
(c) Import licensing : The government can have strong control over the exports by having
strict rules and regulations for providing licenses to importers
(d) Import quotas : Fixing import quotas may be a better device for correcting the adverse
BOP as they have the immediate effect of restricting imports .Import quotas are important non
tariff barriers. They are positive restrictions on incoming of goods.
(e) Tariff : It is a tax duty imposed on imports .The objective is to make imports expensive .It
reduces the demand for imports and the deficit in BOP gets corrected.
(f) Monetary policy: The central bank can reduce the volume of credit by raising the bank rate,
by selling securities in open market and by increasing cash reserve ratio. This will make
borrowing from commercial banks costlier .It will lead to fall in investment and hence fall in
income and employment and output. Any such decrease in income decreases the demand for
imports and disequilibrium in BOP can be corrected.
(g) Fiscal policy: A restricted fiscal policy can also be used to wipe out BOP deficit by
reducing the total expenditure in the economy and increase in direct taxes will reduce the
disposable income and hence there will be reduction in demand for imports. The decrease in
government expenditure will also have the same effect on decreasing the demand for imported
goods.
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Every country has to use the combination of monetary and non monetary methods to correct
BOP disequilibrium and also prevent retaliation from any developed country.
BALANCE OF PAYMENT MUST ALWAYS BALANCE :
In accounting sense BOP of a country is always in equilibrium. It is because of the reason BOP
is prepared in terms of credits and debits based on the system of double entry book keeping.
Under this system each transaction gives rise to two equal entries. One credit entry and one debit
entry. Thus total debits and total credits must be equal. Similarly an international transaction
generates two equal entries and sum of all international receipts are equal to sum of international
payments. Surplus on current account can lead to the grant of loans to other countries by the
government or it can lead to increase in the country’s foreign exchange reserve. Contrary to it a
deficit on current account can be met by borrowing from abroad or by running down country’s
foreign exchange reserves. Thus the two sides are necessarily balanced.
IMF International Monetary Fund
IMF came into being on December 27, 1945 when 29 countries of the world signed on “Articles
of Agreement”. It started functioning in March 1947.
Structure of IMF:
The Board of Governors is the supreme body of IMF, which is headed by a Governor and an
alternate Governor who are appointed by the members of the Fund. The board of Governors
deals with the entry of new members, determination of quotas and distribution of SDRs. Board
of Governors consists of one Governor from each of its 184 members. 24 of the Governors sit on
International Monetary and financial committee and meet twice a year. There is an annual
meeting of the Fund which is held once in a year all members participate in it.
Till the end of 2003 the total staffs of IMF was 2800 which was from 141 countries. The Fund
has its headquarters at Washington with its offices at Paris and Genera.
Objectives of the IMF:
In the first article of the Fund’s Charter there have been described the six objectives of IMF.
They are as:
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1. To increase international cooperation by providing consultancy services regarding

international monetary issues.
2. To assist in the balanced growth of world trade, which will be helpful in raising the efficiency,
employment and income of the world.
3. To Stabilize the exchange rate and discourage the tendency of competitive devaluation.
4. To abolish those restrictions which are obstacles in the way of World Trade and create a multi-
lateral system of payments.
5. The countries facing deficit in their balance of payments can borrow from IMF to finance
temporarily.
6. To reduce the volume and time period of disequilibrium (deficit) in balance of payments.
Functions of IMF:
Following are some functions performed by IMF.
1. Exchange Arrangements:
As a result of 2nd amendment in Articles each country can opt for any one of the following in
connection with exchange rate.
(1) A country can represent the value of its currency in terms of any other currency like dollar.
(2) The par value of a currency can be represented in SDRs.
(3) The exchange rate can be expressed in terms of some currency composite.
(4) No country is allowed to represent its currency in terms of gold.
(5) The members can make such arrangements where they can show the par value in terms of the
currencies.
2. Surveillance:
It is the responsibility of the Fund to see whether the members are serious regarding their
functions, whether they get guidance from Fund regarding exchange rate policies. In respect of
conduct of exchange rate policies fund has approved three principles (1) A member in order to
get undue benefit will not prefer any other member (2) For the sake of abolition of destabilizing
forces in exchange rate govt. should interfere in foreign exchange market (3) Regarding such
intervention is should be kept in view that the interests of the other countries be not affected.
Thus under this function there is regular dialogue and policy advice which IMF offers to each
member. Hence IMF makes an appraisal of each member’s economy.
3. Exchange Restrictions:
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In the light of Article VIII of the Fund, no country can put any type of restrictions on the
payments regarding Current Account. However a country can impose restrictions on the
movement regarding capital amount. Again no country can impose restrictions that the
transactions will be made in certain currencies.
4. Consultation and Technical Assistance:
For the sake of effective performance of its functions fund must be having the information
regarding the economic policies and economic conditions of its member countries. This will be
possible if the fund and the members are linked to each other. In 1984, 118 countries completed
their talks with fund under Article IV. Again the Fund provides technical assistance to its
members regarding strengthening their capacity to design and implement effective policies. Fund
assists in the areas of fiscal policy, monetary policy, exchange rate, banking and financial system
etc.
5. Lending For BOP Difficulties:
Basically Fund is aimed to provide financial assistance to those member countries which suffer
from BOP difficulties. But to the poor countries, it also assists in the attainment of growth and
alleviation of poverty.
Resources of the IMF:
The main source of the Fund is those subscriptions which are paid by the members in form of
quotas. We also know that each country has to pay 75% of its quotas in terms of the domestic
currency and 25% in terms of SDRs. In 8th General Review which was promulgated in
November, 1983, it was decided that 25% of quota can be paid in those currencies which are
allowed by the Fund instead of SDRs. The New Arrangement to Borrow (NAB) introduced in
1997 with 25 participating countries and institutions. Under the GAB and NAB the IMF has upto
SDRs 34 billion or $46 billion available to borrow.
Fund gets three types of charges against the use of resources.
1. Each country has to pay 0.5% as service charges.
2. The agreement free is 25% per annum.
3. The borrowing country has to pay 7% as interest charges. However they very from facility to
facility.
Performance of IMF:
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We know that IMF was setup in 1947 and has completed, its 60 years in 2004. Therefore we see
how far the IMF has been successful in attaining its objectives. The role of IMF is discussed
below.
1. IMF has been much more of value for developed countries. It not only plays an important role
in the determination of exchange rate, but IMF arrangement provided the opportunities to
European industrial countries to follow macro-economic management policies in better way.
They followed the realistic exchange rates. They reduced the restrictions over world trade and
foreign exchange, and depended upon monetary policy for economic stability. As a result not
only their deficits decreased, but the inflation was also controlled. All this means that IMF
helped in attaining both internal and external balances.
2. In 1960 IMF brought two big changes in operation. To increase its resources to finance the
deficit countries it introduced GAB where by the IMF could be able to borrow from 10 big
industrial countries. Secondly because of shortage of world’s liquidity in was authorized to issue
SDRs.
3. During 1960’s IMF paid special attention on the under-developed countries. It introduced two
facilities like CFF and BSF with aim of assisting those poor countries which faced fall in their
export earnings.
4. During 1970’s, because of oil price like under-developed countries had to face soaring
deficits. Moreover the world has to see melodrama of inflation and unemployment. In such
circumstances, there was fear that rate of exchange will face big fluctuations and there will be
big devaluation like 1940’s. In order to compensate the oil affected countries IMF introduced for
oil Facility and 2nd oil Facility. In 1976, IMF set up TF, while in 1977 it formed SFF.
5. In 1986 and 1987 the Structural Adjustment Facility (ESAF) were introduced. Under these
facilities, IMF helps those countries which are engaged in removing price distortions,
maintaining real exchange rate and enhancing productive capacity. The purpose of such all
reforms is to create a suitable environment for economic development. The above facilities have
been renewed in 1944 with the aim of providing loans to developing countries at the
concessionary rates so that they could initiate medium term programme of macro-economic
stability.
6. In 1933 IMF initiated “Temporary Systematic Transformation Facility” for the assistance of
former states of Soviet Union. As a result of such facility, the Central Asian States will be
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assisted which are transferring themselves from command economies to market-economics.

Moreover IMF is providing training facilities to the staff of these states so that they could train
themselves for a better macro economic management.
7. During 1977-98 Asian Financial Crisis, Fund pledged $21 billion to assist Korean to reform
economy, restructure its financial and corporate sectors and recover from recession.
8. In the year 2000 IMF approved an additional sum of $52 million loan for Kenya to cope with
sever effects of drought und PRGF.
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World Bank: its Objectives and Functions

Read this article to learn about the organisation, structure, capital resources, objectives and
function of world bank. The International Bank for Reconstruction and Development (IBRD),
commonly referred to as the World Bank, is an international financial institution whose purposes
include assisting the development of its member nation’s territories, promoting and
supplementing private foreign investment and promoting long-range balance growth in
international trade.
The World Bank was established in December 1945 at the United Nations Monetary and
Financial Conference in Bretton Woods, New Hampshire. It opened for business in June 1946
and helped in the reconstruction of nations devastated by World War II. Since 1960s the World
Bank has shifted its focus from the advanced industrialized nations to developing third-world
countries.
Organization and Structure:
The organization of the bank consists of the Board of Governors, the Board of Executive
Directors and the Advisory Committee, the Loan Committee and the president and other staff
members. All the powers of the bank are vested in the Board of Governors which the supreme
policy is making body of the bank.
The board consists of one Governor and one Alternative Governor appointed for five years by
each member country. Each Governor has the voting power which is related to the financial
contribution of the Government which he represents.
Capital Resources of World Bank:
The initial authorized capital of the World Bank was $ 10,000 million, which was divided in 1
lakh shares of $ 1 lakh each. The authorized capital of the Bank has been increased from time to
time with the approval of member countries.
On June 30, 1996, the authorized capital of the Bank was $ 188 billion out of which $ 180.6
billion (96% of total authorized capital) was issued to member countries in the form of shares.
Member countries repay the share amount to the World Bank in the following ways:
1. 2% of allotted share are repaid in gold, US dollar or Special Drawing Rights (SDR).
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2. Every member country is free to repay 18% of its capital share in its own currency.
3. The remaining 80% share deposited by the member country only on demand by the World
Bank.
Objectives:
The following objectives are assigned by the World Bank:

1. To provide long-run capital to member countries for economic reconstruction and
development.
2. To induce long-run capital investment for assuring Balance of Payments (BoP) equilibrium
and balanced development of international trade.
3. To provide guarantee for loans granted to small and large units and other projects of member
countries.
4. To ensure the implementation of development projects so as to bring about a smooth
transference from a war-time to peace economy.
5. To promote capital investment in member countries by the following ways;
(a) To provide guarantee on private loans or capital investment.
(b) If private capital is not available even after providing guarantee, then IBRD provides loans
for productive activities on considerate conditions.
Functions:
World Bank is playing main role of providing loans for development works to member countries,
especially to underdeveloped countries. The World Bank provides long-term loans for various
development projects of 5 to 20 years duration.
The main functions can be explained with the help of the following points:
1. World Bank provides various technical services to the member countries. For this purpose, the
Bank has established “The Economic Development Institute” and a Staff College in Washington.
2. Bank can grant loans to a member country up to 20% of its share in the paid-up capital.
3. The quantities of loans, interest rate and terms and conditions are determined by the Bank
itself.
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4. Generally, Bank grants loans for a particular project duly submitted to the Bank by the
member country.
5. The debtor nation has to repay either in reserve currencies or in the currency in which the loan
was sanctioned.
6. Bank also provides loan to private investors belonging to member countries on its own
guarantee, but for this loan private investors have to seek prior permission from those counties
where this amount will be collected..
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MEANING OF MONEY MARKET(Part of Money and Banking Ist chapter)

A money market is a market for borrowing and lending of short-term funds. It deals in
funds and financial instruments having a maturity period of one day to one year. It is a
mechanism through which short-term funds are loaned or borrowed and through which a large
part of financial transactions of a particular country or of the world are cleared.
It is different from stock market. It is not a single market but a collection of markets for
several instruments like call money market, Commercial bill market etc. The Reserve Bank of
India is the most important constituent of Indian money market.
II. PLAYERS OF MONEY MARKET :-

In money market the players are :-Government, RBI, DFHI (Discount and finance House of
India) Banks, Mutual Funds, Corporate Investors, Provident Funds, PSUs (Public Sector
Undertakings), NBFCs (Non-Banking Finance Companies) etc.
FUNCTIONS OF MONEY MARKET :-

1) It caters to the short-term financial needs of the economy.
2) It helps the RBI in effective implementation of monetary policy.
3) It provides mechanism to achieve equilibrium between demand and supply of short-term
funds.
4) It helps in allocation of short term funds through inter-bank transactions and money market
Instruments.
5) It also provides funds in non-inflationary way to the government to meet its deficits.
6) It facilitates economic development.
COMPONENTS I CONSTITUENTS / STRUCTURE OF INDIANMONEY MARKET :-

Indian money market is characterised by its dichotomy i.e. there are two sectors of
moneymarket. Theorganised sector and unorganised sector. The organised sector is within the
direct purview of RBI regulations. The unorganisedsector consist of indigenous bankers, money
lenders, non-banking financial institutions etc.
STRUCTURE OF INDIAN MONEY MARKET
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Organised Sector Unorganised Sector

Call and Notice Money Market Indigenous Bankers
Treasury Bill Market Money Lenders
Commercial Bills NBFI
Certificate of Deposits
Commercial Papers
Money Market Mutual Funds
The REPO Market
DFHI
I. Organised Sector Of Money Market :-
Organised Money Market is not a single market, it consist of number of markets. Following
are the instruments which are traded in money market
1) Call And Notice Money Market :-
The market for extremely short-period is referred as call money market. Under call money
market, funds are transacted on overnight basis. The participants are mostly banks. Therefore it
is also called Inter-Bank Money Market. Under notice money market funds are transacted for 2
days and 14 days period.
Discount and Finance House of India (DFHI), Non-banking financial institutions like LIC,
GIC, UTI, NABARD etc. are allowed to participate in call money market as lenders.
2) Treasury Bill Market (T - Bills) :-
This market deals in Treasury Bills of short term duration issued by RBI on behalf of
Government of India. At present three types of treasury bills are issued through auctions, namely
91 day, 182 day and364day treasury bills. State government does not issue any treasury bills.
3) Commercial Bills :-
Commercial bills are short term, negotiable and self liquidating money market instruments
with low risk. A bill of exchange is drawn by a seller on the buyer to make payment within a
certain period of time.
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4) Certificate Of Deposits (CDs) :-

CDs are issued by Commercial banks and development financial institutions. CDs are
unsecured, negotiable promissory notes issued at a discount to the face value. The scheme of
CDs was introduced in 1989 by RBI. The main purpose was to enable the commercial banks to
raise funds from market. At present, the maturity period of CDs ranges from 3 months to 1 year.
They are issued in multiples of Rs. 25 lakh subject to a minimum size of Rs. 1 crore.
5) Commercial Papers (CP) :-

. Commercial Papers were introduced in January 1990. The Commercial Papers can be
issued by listed company which have working capital of not less than Rs. 5 crores. They could be
issued in multiple of Rs. 25 lakhs. The minimum size of issue being Rs. 1 crore. At present the
maturity period of CPs ranges between 7 days to 1 year. CPs are issued at a discount to its face
value and redeemed at its face value.
II. Unorganised Sector Of Money Market :-

The economy on one hand performs through organised sector and on other hand in rural
areas there is continuance of unorganised, informal and indigenous sector. The main constituents
of unorganised money market are:-
1) Indigenous Bankers (IBs)
Indigenous bankers are individuals or private firms who receive deposits and give loans and
thereby operate as banks. IBs accept deposits as well as lend money. They mostly operate in
urban areas, especially in western and southern regions of the country. The volume of their credit
operations is however not known.
2) Money Lenders (MLs)
They are those whose primary business is money lending. Money lending in India is very
popular both in urban and rural areas. Interest rates are generally high. Large amount of loans are
given for unproductive purposes.
3) Non - Banking Financial Companies (NBFCs)
They consist of :-
1. Chit Funds
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Chit funds are savings institutions. It has regular members who make periodic subscriptions
to the fund. The beneficiary may be selected by drawing of lots. Chit fund is more popular in
Kerala and Tamilnadu. Rbi has no control over the lending activities of chit funds.
2. Nidhis :-
Nidhis operate as a kind of mutual benefit for their members only. The loans are given to
members at a reasonable rate of interest. Nidhis operate particularly in South India.
3. Loan Or Finance Companies
Loan companies are found in all parts of the country. Their total capital consists of
borrowings, deposits and owned funds. They give loans to retailers, wholesalers, artisans and self
employed persons. They offer a high rate of interest along with other incentives to attract
deposits. They charge high rate of interest varying from 36% to 48% p.a.
4. Finance Brokers
They are found in all major urban markets specially in cloth, grain and commodity markets.
They act as middlemen between lenders and borrowers. They charge commission for their
services.
FEATURES I DEFICIENCIES OF INDIAN MONEY MARKET

Indian money market is relatively underdeveloped when compared with advanced markets
like New York and London Money Markets. Its' main features / defects are as follows
1. Dichotomy:-
A major feature of Indian Money Market is the existence of dichotomy i.e. existence of two
markets: -Organised Money Market and Unorganised Money Market. It is difficult for RBI to
integrate the Organised and Unorganised Money Markets.
2. Lack Of Co-ordination And Integration :-
It is difficult for RBI to integrate the organised and unorganised sector of money market
3. Diversity In Interest Rates :-
4. Seasonality Of Money Market :-
5. Shortage Of Funds :-
6. Absence Of Organised Bill Market :-
7. Inadequate Banking Facilities :-
8. Inefficient And Corrupt Management :-
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CONCLUSION :-
The above features / defects of Indian Money Market clearly indicate that it is relatively
less developed and has yet to acquire sufficient depth and width. The deficiencies are slowly and
steadily overcomed by policy measures undertaken by RBI from time to time.
Capital Market
The structure and constituents of Capital Market in India.
CAPITAL MARKET :-
Capital market deals with medium term and long term funds. It refers to all facilities and
the institutional arrangements for borrowing and lending term funds (medium term and long
term). The demand for long term funds comes from private business corporations, public
corporations and the government. The supply of funds comes largely from individual and
institutional investors, banks and special industrial financial institutions and Government.
B) STRUCTURE I CONSTITUENTS I CLASSIFICATION OF CAPITAL MARKET :-

Capital market is classified in two ways
1) CAPITAL MARKET IN INDIA
Gild – Edged Industrial Development Financial

Market Securities Financial intermediaries
Market Institutions (DFIs)
a) Gilt - Edged Market :-
Gilt - Edged market refers to the market for government and semi-government securities,
which carry fixed rates of interest. RBI plays an important role in this market.
b) Industrial Securities Market :-
It deals with equities and debentures in which shares and debentures of existing companies
are traded and shares and debentures of new companies are bought and sold.
c) Development Financial Institutions :-
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Development financial institutions were set up to meet the medium and long-term
requirements of industry, trade and agriculture. These are IFCI, ICICI, IDBI, SIDBI, IRBI, UTI,
LIC, GIC etc. All Theseinstitutions have been called Public Sector Financial Institutions.
d) Financial Intermediaries :-
Financial Intermediaries include merchant banks, Mutual Fund, Leasing companies etc.
they help in mobilizing savings and supplying funds to capital market.
2) The Second way in which capital market is classified is as follows :-industrial security market
is divided into two :
CAPITAL MARKET IN INDIA
Primary market Secondary market

a) Primary Market :-
Primary market is the new issue market of shares, preference shares and debentures of non-
government public limited companies and issue of public sector bonds.
b) Secondary Market
This refers to old or already issued securities. It is composed of industrial security market
or stock exchange market and gilt-edged market.
ROLE AND IMPORTANCE OF CAPITAL MARKET IN INDIA :-

Capital market has a crucial significance to capital formation. For a speedy economic
development adequate capital formation is necessary. The significance of capital market in
economic development is explained below :-
1. Mobilisation Of Savings And Acceleration Of Capital Formation :-

2. Raising Long - Term Capital :-
3. Promotion Of Industrial Growth :-
4. Ready And Continuous Market :-
5. Technical Assistance :-
An important shortage faced by entrepreneurs in developing countries is technical assistance.
6. Reliable Guide To Performance :-
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The capital market serves as a reliable guide to the performance and financial position of
corporates, and thereby promotes efficiency.
7. Proper Channelisation Of Funds :-
8. Provision Of Variety Of Services :-
The financial institutions functioning in the capital market provide a variety of services such as
grant of long term and medium term loans to entrepreneurs, provision of underwriting facilities,
assistance in promotion of companies, participation in equity capital, giving expert advice etc.
9. Development Of Backward Areas :-
Capital Markets provide funds for projects in backward areas. This facilitates economic
development of backward areas. Long term funds are also provided for development projects in
backward and rural areas.
10. Foreign Capital :-
.
11. Easy Liquidity :-
12. Revival Of Sick Units :-
Explain the growth of Capital Market in India.
Ans. A) GROWTH OF CAPITAL MARKET IN INDIA:-

After Independence capital market has shown a remarkable progress. The first organised stock
exchange was established in India at Bombay in 1887. When the Securities Contracts
(Regulation) Act 1956 was passed, only 7 Stock exchanges Viz. Mumbai, Ahmedabad, Kolkata,
Chennai, Delhi, Hyderabad and Indore, received recognition. By end of March 2004, the number
of stock exchanges increased to 23.
1) Primary I New Issues Market :-

After liberalisation policy of 1991 and the abolition of capital issues control with effect from
May 29,1992, the primary market got a tremendous , boost. This can be seen from following
points :-
a ) New Capital Issues by Private Sector :-
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The number of new capital issues by private sector was only 364 in 1990-91 and the amount
raised by them was `.4,312 crore. The number of new capital issues rose to 1,678 in 1994-95 and
the amount raised by them was `. 26,418 crore. Since 1995 the capital market was sluggish and
the resources raised fell to `.. 10,409 crores in 1996-97. In 2003-04, the amount raised from new
capital issues was only`.3,210 crores. In 2004 it increased again to `.33,475 crore and in
2005 `.30,325 crore of resources were raised on this market. The primary issues of debt securities
felt a low of around `. 66 crore in 2005.
b ) Public Sector Bonds :-

The resources raised by issuing bonds by Public Sector undertakings rose from `.354 crores in
1985-86 to 7,491 crore in 2004-05.
c) Mutual Funds :-
In 1997-98, the total number of mutual funds in the country was 34.
In 1997-98, the mutual funds were able to mobilise `.4,064 crore. In 1999-2000 mutual funds
mobilised a record of `.22,117 crore. There was a massive resource mobilisation of `..41,570
crore by private sector mutual funds in 2003-04, pushing up the total resource mobilisation by all
mutual funds to as high as`.47,873 crore. In 2004-05, resource mobilisation once again declined
to `.3,015 crore.
2) Secondary Market :-
a) Industrial Securities Market :-
In 1991-92, there was an huge rise in the share prices. The RBI All India Index Number of
Ordinary Share Prices rose to 1,485.4 in 1991-92 (base year 1980-81), showing a gain of
181.4%. In 1992-93 due to irregularities the Stock Market declined. The years 1993 and 1994
saw increased activity in stock market due to :- Better performance of companies, Improvement
in Balance of Payment position, Increasing investment by Foreign Institutional investors etc.
India enjoys 2nd.largest investor population in the world next to U.S.A.
b) Bombay Stock Exchange (BSE) :-
The scrip movements In Bombay Stock Exchange reflected the same trend as the RBI index
(BSE sensitive index with base 1978-79 = 100). Market capitalisation of Bombay Stock
Exchange was `.12, 01,207 crore in 2003-04. It rose to `.30, 66,076 crore in 2008-09.
c) National Stock Exchange (NSE) :-
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The NSE of India was set up in 1992 and started its operations in 1994. It provides facility for
trading of equity investments, warrants, debentures, preference shares etc. The market
capitalisation of NSE reached to `.28, 96,194 crore in 2008-09.
d) Over The Counter Of Exchange Of India :-
It was set in August 1989 and started .operating since 1992.
e) Financial Intermediaries :-
Financial Intermediaries are the latest trend in Indian Capital Market. They have to play an
important role in field of venture capital, credit rating etc.
REFORMS I DEVELOPMENTS IN CAPITAL MARKET SINCE 1991:-

The government has taken several measures to develop capital market in post-reform period,
with which the capital market reached new heights. Some of the important measures are
1) Securities And Exchange Board Of India (SEBI) :-
SEBI was established as a non-statutory board in 1988 and in January 1992 it was made a
Statutory body. The main objectives of SEBI are
1) To protect the interest of investors.
2) To bring professionalism in the working of intermediaries in capital markets (brokers, mutual
funds, stock exchanges, demat depositories etc.).
3) To create a good financial climate, so that companies can raise long term funds through issue of
securities (shares and debentures)
In 2002, SEBI is further empowered to do the following:-
1. To file complaints in courts and to notify its regulations without prior approval of government.
2. To regulate issue of capital and transfer of securities.
3. To impose monetary penalties on various intermediaries and other participants for a specified
range of violations.
4. To issue direction to and to call for documents from all intermediaries.
ROLE I POWERS AND FUNCTIONS OF SEBI :-

1. Protection Of Investor's Interest :-
SEBI frames rules and regulations to protect the interest of investors.
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It monitors whether the rules and regulations are being followed by the concerned parties i.e.,
issuing companies, mutual funds, brokers and others. It handles investor grievances or
complaints against brokers, securities issuing companies and others.
2. Restriction On Insider Trading :-
SEBI restricts insider trading activity. It prohibits dealing, communication or counselling on
matters relating to insider trading.
3. Regulates Stock Brokers Activities :-
SEBI has also laid down regulations in respect of brokers and sub-broker.
4. Regulates Merchant Banking :-
SEBI has laid down regulations in respect of merchant banking activities in India.
6. Guidelines On Capital Issues :-
7. Regulates Working Of Mutual Funds :-
SEBI regulates the working of mutual funds.
8. Monitoring Of Stock Exchanges:-
Every recognised stock exchange has to furnish to SEBI annually with a report about its
activities during the previous year.
9. Secondary Market Policy :-
SEBI is responsible for all policy and regulatory issues for secondary market and new
investments products
10. Investors Grievances Redressal :-
It assist investors who want to make complaints to SEBI against listed companies.
11. Institutional Investment Policy :-
It also looks after registration, regulation and monitoring of FIls and domestic mutual funds.
12. Takeovers And Mergers :-
To protect the interest of investors in case of takeovers and mergers SEBI has issued a set of
guidelines.
BALANCE SHEET OF COMMERCIAL BANKS :-
Banks are the most important financial intermediary in an economy. Banks performance
can be analysed by its balance sheet and profit and loss account. Bank publish balance sheet in
their annual accounts. The balance sheet of a commercial Bank is a statement of its liabilities and
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Assets at a particular time. Liabilities show the sources of funds through which bank raises funds
for its business. Assets represents uses of funds to generate income for bank.
Thus, the balance sheet indicates the manner in which bank has raised funds and
invested them in various types of assets.
It is customary to state liabilities on left and assets on right side. A model of balance
sheet of a bank is given below:-
BALANCE SHEET OF A COMMERCIAL BANK
LIABILITIES ASSETS
1) Share Capital (paid up) 1) Cash Balances
a) With Central Bank
b) With other Banks
2) Reserves and surplus 2) Money at call and short notice.
3) Deposits :-
a) Time deposits. 3) Bills discounted, including treasury bills.
b) Demand Deposits
c) Saving Deposits
4) Borrowings 4) Investments
5) Other Liabilities 5) Loans and Advances
6) Other Assets.
B. LIABILITIES OF A COMMERCIAL BANK (LIABILITIES PORTFOLIO) :-

The liabilities of a commercial bank shos how the bank raises funds for its business.
1) Share Capital (Paid-up) :-
It is the contribution made by the shareholders of the bank. This indicates the bank’s
liabilities to its shareholders.
2) Reserves And Surplus :-
It is the amount accumulated over the years out of undistributed profits to meet
contingencies. Reserves and surplus are liabilities of the bank, as they belong to its shareholders.
3) Deposits :-
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Deposits from the public constitute the biggest proportion of banks working funds. The
deposits accepted by bank in current, fixed and savings account are liabilities of bank to t5heir
customers. They are categorized as demand, time and saving deposits. These funds are liabilities
of bank to their customers, which have to be returned to them. But at the same time, these funds
are also assets to bank since the banker can make use of them to get certain interest yielding
assets.
4) Borrowings :-
When a bank borrows from other banks liability is created. It consist of borrowing /
refinance obtained from RBI, commercial banks and other financial institutions. It also includes
overseas borrowings.
5) Other Liabilities :-
In course of its business, miscellaneous liabilities are incurred by bank. They include bills
payable like drafts, travelers cheques, pay slips etc. It also includes income tax provision.
ASSETS OF A COMMERCIAL BANK (ASSETS PORTFOLIO):-
The assets portfolio shows how the bank uses the funds entrusted to it:-
1) Cash Balances :-
A bank holds cash to meet the day-today withdrawls of deposits by its customer. This is
known as cash reserve. Bank hold cash balances with itself, with other banks and with RBI. In
India, Commercial Banks are obliged to keep a certain proportion of total deposits in the form of
cash reserve requirement with RBI. Cash has perfect liquidity, but yields no profit.
2) MONEY AT CALL AND SHORT NOTICE :-
It refers to short term loans made in money market. Such loans are borrowed by
speculators in stock exchange market. Their maturity vary between one day to 15 days. These
loans are repayable on demand and at the option of either lender or borrower. Thus, these forms
of assets are highly liquid and are interest earning too, though at a comparatively low rate.
3) Bills Discounted :-
Banks funds are invested in commercial bills which are short-dated, usually three
months. Banks also invest in treasury bills. These assets are self-liquidating in nature.
4) Investments :-
Investment in various kinds of securities is a major part of assets of a bank. Mainly
commercial banks invest in government securities, shares etc. Securities and bonds are known as
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banks secondary reserves because they are shiftable and Interest yielding. Usually banks prefer
medium and short term securities. This secondary reserve fails to convert securities in to cash at
the same time.
5) Loans And Advances :-
The most important asset item in the Balance sheet of a bank is loans advances. The
profitability of a bank depends upon the extent to which it grants loans advances to customers.
The various types of loans advances provided by banks are :- Cash Credit, Overdraft, Loans,
Installments, purchase and discounting of Bills. Banks mostly grant short term working capital
loans only so that they can have fair liquidity with high profitability.
6) Other Assets :-
It includes fixed assets, furniture and fixtures etc. It will also include the net position of
inter-office account.
CREDIT CREATION BY COMMERCIAL BANKS:-
ASSUMPTIONS :-
The bank deposit multipler, discussed above, is based on the following assumptions:-
1) There is no leakage from the banking system. All the money should remain with banking
system.
2) The banks must receive new deposits.
3) They must be willing to make loans or buy securities.
4) The CRR remains constant through all the stages.
5) People must be willing to borrow.
6) The business conditions are normal.
7) There is no credit control policy of central bank.
8) There should be popular banking habit in the country and a well developed banking system.
Creation of credit is an important function of a commercial bank. Prof. Sayers said

“Banks are not merely purveyors of money but, also in an important sense manufacturers of
money”. In a modern economy Bank’s deposits form a major proportion of total money supply.
A bank’s demand deposits arise mainly from :- Cash deposits by customers and Bank
Loans and Investments.
1. Cash Deposits By Customers :-
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These are termed as primary deposits as they arise from the actual deposits of cash in a
bank made by its customers. In receiving such deposits, the bank plays a passive role. The
creation of primary deposits, however is nothing but transforming the currency money in to
deposit money.
2. Bank Loans And Investments :-
These are termed as derivative or active deposits. The derivative deposits are lent in
the form of loans or advances, discounting of bills or used for purchasing securities or other
assets.
Deposit account in the name of the customer or seller, credits him with the amount of
loan granted or value of security purchased, subject to withdrawl by cheque, as required. Hence
loans advanced or purchases of securities creates deposits.
Thus every loan creates a deposit. They increase the quantity of bank money. The size
of derivative demand deposits is determined by the banks lending and investment activities.
There will be a constant inflow and outflow of cash with the banks. For the sake of liquidity and
safety some proportion of total deposit must be maintained in cash, for e.g. :- 10% to 20% to
meet the demand for cash at the counter. This is known as Cash Reserve Ratio.
Primary deposits serve as a basis for creating derivative deposits, that is credit
creation, and for increasing money supply. Commercial banks are profit seeking institutions and
when they find that large volume of cash received lies Idle, they use these resources for
advancing loans or for making investment in securities, shares etc. there by earning high rate of
interest. The creation of credit also depends on excess cash reserves or cash reserve ratio. The
derivative deposits are used as working capital.
When the borrower withdraws money from his loan account by cheque it is deposited
by the payee in some other bank. Those banks again create deposit on the basis of fresh deposits
received after keeping required reserves. Ultimately, the total volume of credit or derivative
deposits or bank money created by all banks would be a multiple of the original amount of new
cash reserves in the system. Thus multiple expansion of credit takes place.
Example :-
116
Suppose the Cash Reserve Ratio is 20% and a person deposits Rs. 10,000/- with
Bank of India. This is primary deposit. The bank keeps Rs. 2000 as CRR and balance of Rs.
8000 is used for granting credit.
Now suppose Bank of India lends Rs. 8000 to Mr. A and Mr. A pays a cheque of Rs.
8000 to Mr. B, who has an account in Bank Of baroda. Then Bank Of Baroda receives Rs. 8000
as primary deposit. It keeps Rs. 1,600 (20%) as CRR and excess amount of Rs. 6,400 is used for
giving credit. Now if, Mr. C is granted this loan and Mr.C gives a cheque of Rs. 6,400 to another
person who may deposit it in Bank of Maharashtra. Bank of Maharashtra will keep Rs. 1,280 as
CRR and issue a loan of Rs. 5,120. This process continues until the original excess reserves of
Rs. 8000 with the first Bank of India, have been parceled out among various banks and have
been required resources. As a result, the aggregate of derivative deposits in the entire banking
system, approximates 5 times the initial derivative deposit over a period of time.
Let us explain with the help of table:-
PROCESS OF MULTIPLE EXPANSION OF CREDIT
BANKS PRIMARY CRR Credit Creation or

DEPOSIT 20% Creation of
Derivative Deposits
Bank of India 10,000 2000 8000
Bank of Baroda 8,000 1,600 6,400
Bank of 6,400 1,280 5,120
Maharashtra
Total of all Banks 50,000 10,000 40,000
In the above Eg., the credit expansion is five times the initial excess reserve of Rs. 8,000 when
CRR is 20%.
PD – PCR
TC = X 100
CRR
Symbolically,
Where TC = Total Credit

PD = Primary Deposit.
PCR = Primary cash Reserve.
CCR = Cash Reserve Ratio.
117
Cash Creation = 10000 – 2000 = 8000

X 100 X 100 = ` 40,000
20 20
The Credit Multiplier depends on CRR.
r = CRR
If CRR is 20 % then, credit multiplier will be
The Multiple expansion of credit is the inverse of CRR maintained by banks. Higher the
CRR,
Lower the expansion of credit and vice versa.
Tariff and quota (Part of International Trade)

In simplest terms, a tariff is a tax. It adds to the cost of imported goods and is one of several
trade policies that a country can enact.
Why Are Tariffs and Trade Barriers Used?

Tariffs are often created to protect infant industries and developing economies, but are also used
by more advanced economies with developed industries. Here are five of the top reasons tariffs
are used:
1. Protecting Domestic Employment

2. Protecting Consumers
3. protect Infant Industries
4. National Security
Types of Tariffs and Trade Barriers

There are several types of tariffs and barriers that a government can employ:
• Specific tariffs
• Ad valorem Tariff
• Licenses
• Import quotas
• Voluntary export restraints
• Local content requirements
Specific Tariffs
A fixed fee levied on one unit of an imported good is referred to as a specific tariff. Ad Valorem
Tariffs
The phrase ad valorem is Latin for "according to value", and this type of tariff is levied on a
good based on a percentage of that good's value.
Non-tariff barriers to trade include:

118
Licenses
A license is granted to a business by the government, and allows the business to import a certain
type of good into the country.
Import Quotas
An import Quota is a restriction placed on the amount of a particular good that can be imported.
This sort of barrier is often associated with the issuance of licenses.
119

Economics 4th Sem Notes University

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Economics 4th Sem Notes University

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Note: Economics, IV Semester 5 Year BA LLB, Govt.

Law College, Trivandrum

MONEY, BANKING, PUBLIC FINANCE AND

11. Relative Cost Advantage/ Comparative Cost Advantage

Money and Banking

II. Secondary functions

2. COST PUSH INFLATION

Role of commercial banks in a developing economy

4. Influencing economic activity

BANKING SECTOR REFORMS

Structure in India since Independence.

STRUCTURE OF BANKING IN INDIA

Scheduled Non – Scheduled

State co-op bank Commercial bank Central Co-op Banks Commercial

FIRST PHASE OF BANKING SECTOR REFORMS / NARASIMHAN COMMITTEE

II) Banking Reform Measures Of Government :-

SECOND PHASE OF REFORMS OF BANKING SECTOR (1998) / NARASIMHAN

Nationalization of commercial bank

10. March Forward towards Socialism:

Year Public sector banks New Private Sector Foreign Banks

C. Business per Branch :-

a) Interest Income Ratio :-

Important new technologies introduced in banking in India.

8. Door Step Banking :-

9. Point Of Sale (POS) :-

11. Virtual Banking:-

12. Electronic Clearing Services (ECS) :-

FUNCTIONS OF CENTRAL BANK:

MONETARY POLICY:-Methods of Credit Control / Controlling Inflation

Monetary policy / monetary management is regarded as an important tool of economic

B)OBJECTIVES OF MONETARY POLICY OF INDIA :-

1. Growth With Stability :-

2. Regulation, Supervision And Development Of Financial Stability :-

3. Promoting Priority Sector :-

6. Encouraging Savings And Investments :-

7. Redistribution Of income And Wealth :-

.RESERVE BANK OF INDIA (RBI) :-

RBI performs many functions, some of them are:-

1. Issue Of Currency Notes :-

2. Banker To The Government :-

3. Banker’s bank And Lender Off Last Resort :-

5. Exchange control And Custodian Of Foreign Reserve :-

6. Collection And Publication Of Data :-

7. Regulatory And Supervisory Functions :-

8. Clearing House Functions :-

9. Development And Promotional Functions :-

MONETARY POLICY OF RBI :-

I) General I Quantitative Credit Control Methods :-

1. Bank Rate Policy :-

2. Open market operations :-

3. Cash Reserve Ratio (CRR)

4. Statutory Liquidity Ratio (SLR)

5. Repo And Reverse Repo Rates

II) SELECTIVE / QUALITATIVE CREDIT CONTROL METHODS :-

3. Discriminatory Interest Rate (DIR)

FAILURES I LIMITATIONS OF MONETARY POLICY

1. Huge Budgetary Deficits :-

2. Coverage Of Only Commercial Banks :-

3. Problem Of Management Of Banks And Financial Institutions :-

4. Unorganised Money Market :-

Meaning & Scope of Public Finance

Meaning of Public Finance

According to H.L Lutz