Unit 5

Macroeconomic Issues and Policies

Inflation

Concept of Inflation
In general, inflation means the increase in general level of prices. Due to the increase in general
price level (GPL), the value or purchasing power of money declines.
Some definitions:
Crowther: Inflation means a state in which the value of money is falling, i.e. prices are
rising.
Coulborne: Inflation is too much money chasing too few goods.
Milton Friedman: Inflation is always and everywhere a monetary phenomenon. [Monetarist’s
View]
J.M. Keynes: Inflation is the result of excess demand over available supply of output after full
employment. (He calls it as real or true inflation). [Keynesian View]
There are basically three features of inflation:
a. Inflation is the real increase in prices.
b. Inflation is not a temporary fluctuation in price, but it is a sustained and appreciable
increase in prices.
c. Inflation means the increase in GPL, not the increase in individual prices.
Thus, in ordinary sense, inflation means high price. In reality high price does not show the
existence of inflation. Hence, inflation implies a persistent and appreciable rise in the GPL.

Types of Inflation
There are different types of inflation. The major types of inflation are explained below:

1. On the Basis of Speed or Rate of Change in Price

i. Creeping inflation
This is the mildest type of inflation. In this situation, prices rise within a range of
20% per decade or two percent per annum.
ii. Walking inflation
This is the situation when prices rise by more than from 20% and within a range of
40-50% over a decade. It is a warning signal to the economy.
iii. Running inflation
In this situation, prices rise rapidly. Running inflation may record more than 100%
rise in prices over a decade or 10% per annum.

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 iv. Galloping inflation
It is also called hyperinflation. In this case prices rise every moment. If within a year
prices rise by 100% or more, it is the case of galloping inflation which is the most
dangerous one.
2. On the Basis of Government Control
i. Open inflation
If the government does not try to control the increase in price, it is known as open
inflation. The increase in price due to the lack of any control on expenditure when
income increases is known as open-inflation. In this situation, the market mechanism
works freely without government intervention. According to Friedman "Open
inflation is that process in which price is allowed to increase without suppression by
government price control policy." Such inflation has occurred in 1920 in Germany
and Russia, and in 1940 in China.
ii. Suppressed inflation
If government intervenes to stop or suppress the increase in price, it is called
suppressed inflation. If there is control on expenditure due to which price cannot
rise, it is called suppressed inflation. The government adopts the methods such as
direct price control and rationing. According to Friedman, suppressed inflation is
more dangerous than open inflation due to following reasons:
 The expectation that goods will be scarce in the future is high. It increases the
demand which is one of the causes of inflation.
 There is increase in black marketing and corruption.
 Since it does not allow the price mechanism to work, economic resources are
diverted from essential industries to non-essential industries. It is because the
price of essential goods is controlled by the government whereas the prices of
non-essential goods are left uncontrolled.
3. On the Basis of Employment
i. Partial inflation
Inflation before full-employment is known as partial inflation. If prices increase due
to the increase in money supply before the situation of full-employment, it is known
as partial inflation.
ii. Full inflation
If there is increase in money supply after full employment, output and employment
do not increase. The resources are already fully employed. Due to this, prices
increase continuously without any obstacles. This is known as full inflation.
4. On the Basis of Inducement
i. Currency induced inflation
Due to the excessive supply of money, demand for goods and services increase
thereby increasing the price level known as currency induced inflation.

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 ii. Credit induced inflation
Due to expansion of credit by commercial banks, people demand more goods which
leads to increase in price level known as credit induced inflation.
iii. Profit induced inflation
If producers increase price in order to attain more profits, it is known as profit
induced inflation.
iv. Deficit induced inflation
This type of inflation is common in underdeveloped countries where the
government implements deficit budgeting. In order to meet the gap between income
and expenditure, the government prints new currencies which leads to increase in
price known as deficit induced inflation. Friedman calls it "printing press
phenomena".
v. Wage induced inflation
Due to the collective bargaining of labor unions, producers are forced to increase the
price because cost of production is increased through the increase in wage. This type
of inflation is known as wage induced inflation.
vi. Scarcity induced inflation
The increase in price level due to the scarcity of goods, services and raw materials is
known as scarcity induced inflation.
5. On the Basis of Cause
i. Demand-pull inflation
If aggregate demand is greater than the available supply of output in the economy,
it is known as demand-pull inflation.
ii. Cost-push inflation
If prices increase due to the increase in cost of production, it is known as cost-push
inflation.

Measurement of Inflation Rate

Inflation is measured by calculating the percentage change in the current price index over the
previous price index. The common formula for calculating the rate of inflation can be
expressed as:
Pt – Pt-1
Rate of Inflation = Pt-1 × 100
Where,
Pt = Price index of current year
Pt–1 = Price index of previous year
Example The price index for a specific basket of goods in 2013 was 240 and it increased to 260 in 2014. Find the
rate of inflation.
Solution:
Given,
Price index (2013) = 240
Price index (2014) = 260
Now,

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 Price index (2014) – Price index (2013)
Rate of inflation = Price index (2013) × 100
260 – 240
= 240 × 100
= 8.33% [

The price indices are obtained by making actual survey of market prices of various goods and
services under consideration. There are three popular methods for measuring inflation. They
are - Consumer Price Index (CPI), Wholesale Price Index (WPI) and GDP Deflator.

Theories of Inflation: Demand-pull and Cost-push Inflation

1. Demand-pull Inflation
If aggregate demand exceeds aggregate supply of output available in the economy, it is known
as demand- pull inflation. When money supply increases, it reduces interest rate. The
reduction in interest rate leads to the increase in investment. When investment increases,
money income rises. This leads to the increase in demand for goods and services causing
demand-pull inflation.
Demand for goods and services increases due to the following reasons causing demand-pull
inflation.
i. Increase in money supply and bank credit
If money supply or bank credit increases, interest rate falls in the economy which leads
to increase in investment. The increase in investment increases income thereby increasing
demand for goods. The increase in demand for goods finally increases price level.
ii. Increase in public expenditure
If the government performs deficit budget by printing new currencies, it creates demand-
pull inflation.
iii. Increase in private expenditure
The increase in private investment leads to increase in income of the people so that
consumption will increase rapidly. The increase in private expenditure on consumption
increases price level.
iv. Reduction in taxation
If the government reduces tax, the purchasing power of the people increases or
disposable income of the people increases. The increase in disposable income increases
the consumption expenditure thereby increasing price level.
v. Increase in exports
If goods are excessively exported, there will be shortage of those goods in the domestic
country. This creates excess demand thereby increasing price level.
vi. Shortage of goods and services
If demand for goods exceed the supply of goods in an economy, price level will increase
causing demand-pull inflation.

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vii. Repayment of past debt
If the government pays back the loans taken from people, it increases the consumption of
the people thereby increasing price level.
Graphical analysis

AS

General price level (P)

P3 e3
P2 e2
P1 e1 AD3
AD2
AD1
O Q1 Q2
Aggregate demand and supply (AD and AS)

In the given figure, aggregate supply curve (AS) is upward sloping up to Q2 level of output
and then it is vertical. The initial price and output are P1 and Q1 respectively. When demand
increases, the aggregate demand curve AD1 shifts upward to AD2 such that prices increase to
P2 and output is Q2. This type of inflation is known as partial or semi inflation. Q2 is full
employment output. If aggregate demand increases continuously from AD1 to AD2 and AD3
price level also increases from P1 to P2 and P3 respectively, without increasing the level of
output. This type of inflation is known as pure inflation (full inflation) according to Keynes.
Partial inflation is a tonic for economic development but pure inflation invites evils in the
economy because with the increase in price level, output, employment and income do not
increase.

2. Cost-push Inflation (Supply Side Inflation)

Inflation also occurs due to the increase in cost of production. Inflation that occurs due to the
pressure of increased cost is called cost-push inflation. It is also known as supply side inflation.

In general cost-push inflation occurs due to the following reasons.

i. Increase in wage (wage push inflation)

If pressure of labor union forces the firm to increase wage rate, cost of production
increases so that price level increases.
ii. Increase in profit margin (profit push inflation)
If firms collectively increase their profit level, it increases price level known as profit push
inflation.
iii. International reason (supply shock inflation)
If the prices of consumption goods, raw materials and capital goods increase in foreign
market, it causes increase in price level in the domestic country.

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 iv. Weak and corrupted administration
If the administration of the country is weak and corrupted, entrepreneurs become the
victims of bribery which leads to increase in production cost. This increase in production
cost is finally compensated by the increase in price level.
v. Industrial Revolution
The violence found in industrial areas is also one of the reasons of cost-push inflation
because it increases the cost of production of the firm.
Graphical analysis

General price level (P)

P3 e3
e2
P2
P1 A e1
3
AD
A2
A1
Q3 Q2 Q1 O
Aggregate demand and supply (AD and AS)

In the figure, AD is the aggregate demand curve and A1 S, A2 S and A3 S are aggregate supply
curves. P1 is the initial price level. When cost of production increases, aggregate supply curve
shifts upward to left from A1S to A2S. Due to this reason, price level rises from P1 to P2. When
cost of production further rises, the aggregate supply curve shifts upward to A3S and the price
level rises to P3. Hence, increase in cost leads to increase in price. The increase in price due to
the increase in cost leads to below full employment output from full employment output i.e.,
from Q1 to Q2 and Q3. This implies that cost-push inflation leads the economy to less than full
employment equilibrium. It is more dangerous than demand-pull inflation because it reduces
output, employment and income with increase in price level.

Effects of Inflation
Inflation has severe social, political and economic effects. Hence, economists prefer to call it
"worse than taxes" and "legal robber". According to C.N. Vakil, "Inflation may be compared to
a robbery - both deprive the victim with the difference that robbery is visible, inflation is
invisible, the robber's victim may be one or few, and the victim of inflation is whole nation.
The robber may be dragged to the court of law, but inflation is legal."

1. Economic Effects
a. Effects on Production
i. Decline in the value of money
Inflation increases expenditure and discourages saving. Capital for nation is
reduced. During inflation, too much money chases too few goods creating decline in
value of money such that investment decreases and unemployment increases.

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 ii. Change in the structure of production
The hyperinflation (galloping inflation) diverts the production resources from
necessary goods industries to the luxury goods industry.
iii. Decline in the quality of products
During inflation demand is very high and there is no difficulty to sell any kind of
commodities. Hence, the profit mongers are encouraged to increase profit by
reducing the quality of products.
iv. Hoarding of commodities
During inflation, traders and consumers both indulge in hoarding anticipating of
further price rise.
v. Loss of faith in local currency
During inflation there is continuous fall in value of money (domestic currency).
Hence people lose faith in local currency and they begin to buy foreign currencies.
vi. Discourages foreign capital or foreign direct investment (FDI)
High rate of inflation reduces the value of money such that it affects foreign
investment in the economy. As a result, profit for the foreign investors decreases
substantially that leads to decrease in foreign investment.
b. Effects on Distribution
i. Fixed income group
During inflation the cost of living increases rapidly but income of this group remains
fixed. So inflation severely hurts this group of people.
ii. Debtors and creditors
Since the purchasing power of money falls during inflation, debtors gain and
creditors lose.
iii. Wage and salary earners
The wage and salary do not increase as the increase in price level. Thus wage and
salary earners lose during inflation.
iv Entrepreneurs
They enjoy wind fall gains (handsome profit) during inflation.
v. Investors
Investors on bonds and debentures lose because their returns are fixed where as
investors on equities gain because their returns increase with the increase in profit
of the firms during inflation.
vi. Farmers
Like other producers, farmers gain from inflation. When agricultural products
produced by farmers are sold in the market during inflation, they get higher prices.
However, small scale farmers are losers in times of high inflation.

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 c. Effects on Output and Employment
Mild or creeping inflation is a tonic for increasing output and employment in the economy.
However, hyperinflation has adverse effects on the economy because it reduces output
and employment.
d. Effects on Savings
Inflation has adverse effects on savings. Due to increased price level, the real value of the
investors in the form of bank deposits and government securities fall rapidly such that it
discourages savings in the economy.

e. Effects on Balance of Payments

Inflation decreases the competitiveness of the domestic products that are exported. This
implies that exportable products become more expensive in the foreign market which
reduces the export. On the other hand, imports becomes relatively cheaper leading to
increase in import. Since, export decreases and import increases, there will be adverse
effect on the balance of payments.

2. Non-Economic Effects
a. Social and Moral Effects
Hyperinflation is often associated with social and moral degradation. It has led to thefts,
robberies and widespread corruption. Inflation adversely affects business and people
morality and ethics.
b. Political Effects
Continuous inflation leads to unpopularity of the government thereby creating political
instability. It corrupts the politicians and weakens the political discipline.

Anti-inflationary Measures / Remedies of Inflation

The measures to control inflation can be explained below in point wise manner.
a. Monetary Measures
The central bank adopts appropriate monetary policy to control the expansion of credit.
The main instruments of monetary policy are:
i. Increase in bank rate
Bank rate is the lending rate of central bank to commercial banks. The central bank
raises the bank rate to control inflation as it discourages borrowing by commercial
banks from central bank.
ii. Open market operation
Under this method, the central bank sells government securities to the people.
People buy securities with central bank by withdrawing deposits from bank.
iii. Increase in cash reserve ratio
Commercial banks should keep certain portion of their deposit with the central bank
as cash reserve. If cash reserve ratio is increased, the capacity of commercial banks

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 to create credit is reduced. Hence, the central bank increases cash reserve ratio to
control inflation.
b. Fiscal Measures
The instruments of fiscal policy to control inflation are as follows:
i. Reduction of government expenditure
An effective method to reduce aggregate demand is the reduction of government
expenditure. This reduces the fiscal deficit. If the government remains with the limit
permitted by its revenue, the fiscal discipline is maintained and the government
need not issue new notes. From this there is automatic control in the expansion of
money.
ii. Imposition of taxes
The existing tax rate should be increased to reduce consumption demand and new
taxes should be introduced. The personal income tax is regarded as the most
effective anti-inflationary measure. Import tax should be reduced so that shortage
creating excess demand is avoided.
iii. Public borrowing
The government can take voluntary and forced loan from people to reduce the
additional purchasing power. The government can take voluntary loan by providing
attractive interest and security.
iv. Control deficit
While launching deficit budget, government can control inflation by increasing tax
rate. In times of inflation deficit budget should not be implemented by printing new
currencies.
c. Direct Measures
The direct measures to control inflation are explained below:
i. Output adjustment
Since inflation is the outcome of inadequate production, the basic solution of
inflation is the increase in production. The government should divert resources form
luxury goods industry to necessary good industry in times of inflation.
ii. Price control and rationing
The government should directly control prices to prevent the prices from going
above the maximum limit. The government may fix quota in the purchase and sale
of some commodities to make essential goods available and to prevent price rise.
iii. Saving encouragement
In the periods of inflation, government should encourage people to reduce
consumption and increase saving. The government should formulate attractive
programs and policies in order to encourage saving and control inflation.
Conclusion: The above explanation indicates that not a single measure is sufficient to control
inflation. Hence, economists prescribed these different methods. They should be implemented
together for an effective control on inflation. The policies adopted usually reflect a
combination of what is politically, socially and economically desirable.

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 Concept of Deflation and Stagflation
Deflation is the opposite of inflation. Just as inflation is a phenomenon of rising prices, deflation is
a phenomenon of falling prices. In the words of Crowther, "Deflation is that state of the economy
where the value of money is rising or the prices are falling." No doubt deflation is associated with
falling prices, but it is not that each and every fall in price will be termed as deflation. Only those
falls in prices which result in unemployment, overproduction and fall in the economic activity are
deflationary. In short, deflation is a situation in which falling prices are accompanied by falling
levels of employment, output and income. Deflation is worse than inflation because producers are
discouraged to produce output so that employment, income and the profit in the economy are
reduced. It is to be noted that deflation and disinflation are different economic situations.
Disinflation is an attempt of government to reduce prices when they are abnormally high. The main
causes of deflation are:
1. Deficiency in aggregate demand
2. Decline in investment expenditure
3. Less consumption of goods
4. Increase in rate of interest
5. Decline in money supply
6. Reduction in government expenditure
7. Imposition of heavy tax
On the other hand, stagflation is a situation of high inflation accompanied by high
unemployment. In other words, it is a situation in which there is positive association between
inflation and unemployment. Stagflation disobeys the concept of Phillips curve (trade-off
between inflation and unemployment.) The main causes of stagflation are:
1. Restriction in labor supply
2. Indirect taxes
3. External factors

Unemployment
Concept of Unemployment
Unemployment is a complicated phenomenon. It is very difficult to define unemployment. In
ordinary sense, unemployment is the situation of not getting jobs by the people. In strict
economic sense, unemployment is defined a situation in which people who are able and
willing to work at the prevailing wage rate are deprived of jobs. Unemployment may be
voluntary or involuntary.
Voluntary unemployment is defined as the unemployment at wish. Voluntary unemployment
can be found in lazy rich person or lazy poor people. Similarly, anti-social people like thieves,
robbers and beggars also fall in this category.
Involuntary unemployment is defined as the unemployment against wish. In this case, people
are reaching jobs according to their standards, yet they are unable to find jobs.

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The rate of unemployment can be calculated by the following formula:
Number of persons unemployed
Rate of Unemployment = Number of Labor force × 100

Where,
Number of labor force = Number of persons employed + Number of persons
unemployed
For example, if the total labor force of an economy is 110 million, out of which the number of
people unemployed is 20 million, the unemployment rate can be calculated as:
20
Rate of Unemployment = 110 × 100 = 18.18%

Types of Unemployment
The major types of unemployment are explained below:
1. Cyclical Unemployment
Unemployment due to conditions of depression or downswing in an economy is known
as cyclical unemployment. It is mainly observed in capitalist economy. Cyclical
unemployment is involuntary unemployment due to a lack of demand for goods and
services. This is also known as Keynesian unemployment or demand-deficient
unemployment. When there is a recession or a steep slowdown in growth, we see a rising
unemployment because of plant closures, business failures and an increase in worker lay-
offs and redundancies. This is due to a fall in demand leading to a contraction in output
across many industries. Cyclical unemployment has been a major problem for a number
of European Union economies who have suffered from a deep and persistent recession
in recent years. For example in 2012, Spanish unemployment rose above 6 million for the
first time, with 27% of the workforce unemployed.
2. Structural Unemployment
It is defined as the situation where people are unemployed due to limited job
opportunities in an economy. The limited job opportunities arise due to lack of capital
and other resources. It is mainly observed in underdeveloped countries like Nepal.
Structural unemployment happens when there is a long-term decline in demand in an
industry leading to fewer jobs as demand for labor falls away. Structural unemployment
exists where there is a mismatch between their skills and the requirements of the new job
opportunities. This problem is due to occupational and geographical immobility of labor
and requires investment to improve skills, give the unemployed suitable and effective
training and work experience and make them able to move location if needed to take a
new job.
3. Frictional Unemployment
Unemployment between jobs is known as frictional unemployment. People leave jobs
due to some dissatisfaction and search another job. During this period, we see
temporarily unemployment often known as frictional unemployment. Frictional
unemployment occurs because of the normal turnover in the labor market and the time
it takes for workers to find new jobs. Throughout the course of the year in the labor
market, some workers change jobs. When they do, it takes time to match up potential

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 employees with new employers. Even if there are enough workers to satisfy every job
opening, it takes time for workers to learn about these new job opportunities, and for
them to be considered, interviewed and hired. Other causes of frictional unemployment
are breakdown of machineries, contraction of (closing down) old industries and political
instability.
4. Open Unemployment
If people are completely idle, it is known as open unemployment. The situation of
unemployment in which people have absolutely no productive work to do is open
unemployment.
5. Disguised Unemployment
If people are apparently engaged in productive work but in reality they are unemployed,
it is known as disguised unemployment. It is basically observed in agricultural sector.
6. Underemployment
It is the situation in which people are engaged in economic activity but they are not able
to get wage or work according to their standards.
7. Educated Unemployment
The situation of unemployment of people on the basis of qualification is known as
educated unemployment. In other words, unemployment found among the educated
people is termed as educated unemployment. In Nepalese context, most of the educated
people are unemployed due to lack of job opportunities.
8. Hardcore Unemployment
Hardcore unemployment is defined as a situation of unemployment of physically
handicapped workers. It is mainly caused by unwillingness of organizations to provide
job to them and they are not fit in all jobs due to physical disability

Natural Rate of Unemployment

Natural rate of unemployment is defined as the rate of unemployment that exists when
there is no cyclical unemployment. Natural rate of unemployment equals the percentage
of labor force that is frictionally and structurally unemployed at a point in time.

Cost of Unemployment
Persistently high unemployment creates huge costs for individuals and for the economy as a
whole. The economic, social and political costs of unemployment can be explained below:

1. Economic Cost
a. Loss of income
Unemployment normally results in a loss of income. The majority of the unemployed
experience a decline in their living standards and are worse off out of work. This leads to
a decline in spending power and the rise of falling into debt problems. The unemployed
for example may find it difficult to keep up with their mortgage repayments.

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 b. Loss of national output
Unemployment involves a loss of potential national output (i.e. GDP operating well
below potential) and is a waste of scarce resources. If some people choose to leave the
labor market permanently because they have lost the motivation to search for work, this
can have a negative effect on long run aggregate supply and thereby damage the
economy’s growth potential. When unemployment is high there will be an increase in
spare capacity - in other words the output gap will become negative and this can have
deflationary forces on prices, profits and output.
c. Fiscal costs ( Burden to the Government)
The government loses out because of a fall in tax revenues and higher spending on welfare
payments for families with people out of work. The result can be an increase in the budget
deficit which then increases the risk that the government will have to raise taxation or
scale back plans for public spending on public and merit goods.
d. Increase in poverty
Unemployment leads to widespread poverty in the economy which is undesirable.

2. Social Cost
Rising unemployment is linked to social deprivation. For example, there is a
relationship with crime and social dislocation including increased divorce rates,
worsening health and lower life expectancy. Regions that suffer from persistently high
long-term unemployment see falling real incomes and a widening of inequality of
income and wealth.

3. Political Cost
The government becomes unpopular due to unemployment such that there will be the
situation of political instability in the economy. The rise of Hitler in Germany and ten
years long political conflict in Nepal was due to mass unemployment.

Business Cycle / Trade Cycle

Meaning of Trade Cycle/ Business Cycle

Business environment fluctuates over time. Trade cycle is an important feature of a capitalist
economy. Trade cycle is defined as the economic fluctuation observed in a country. Trade
cycle is also known as business cycle. Those fluctuations which occur periodically with certain
regularity are called trade cycles. According to Prof. Benham "Trade cycle refers to a period
of prosperity followed by the period of depression". Keynes defines trade cycle more
explicitly as "A trade cycle is composed of periods of good trade characterized by rising
prices and low unemployment percentage altering with periods of bad trade characterized
by falling prices and high unemployment percentage".

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 Characteristics of Business Cycle
Trade cycle consists of the following characteristics
1. Regularity
Trade cycle is regular. It is a wave like movement. The prosperity and depression comes
one after another, regularly. For example: prosperity may remain for 10 years, depression
comes thereafter. But it cannot be predicted how long these phase remain.
2. Capitalist Economy
Trade cycle enjoys more in capitalist economy. Capitalist economy implies no state
intervention on productive activities. In this case, the effects of trade cycle are not
controlled by the government. But due to planning and control trade cycle is not effective
in socialist economy.
3. Unequal Effects
Since trade cycle is synchronic, its effect are observed in all sectors of the economy, but
the effects of trade cycle are unequal on different sectors, for example, the effects of trade
cycle in capital goods industry are more as compared to consumer goods industry.
4. International Character
Different countries are linked with each other through the medium of international trade.
Therefore, prosperity or depression occurs in a country that transmits to other countries
as well. The impact of business cycle is felt all over the world.
5. Synchronism
There is synchronism in business cycle. It means that business cycle is of general nature.
All business in the country are in the form of interdependent economic organs. Therefore,
if prosperity or depression occurs in a part of the economy, other sectors also feel the
effect of it.
6. Self-Generating
There are self-generating forces in trade cycle. Such force ends the phase of prosperity or
depression. It implies that unlimited depression cannot remain. Likewise there is no
period of permanent boom.
7. Recurrent
If depression comes after prosperity, again new prosperity recurs after depression. It is
rhythmic and is of recognized pattern.

Phases / Stages of Business Cycles

A trade cycle is commonly divided into four well-defined and interrelated recurring phases.
1. Prosperity (expansion/upswing)
2. Recession (upper turning point)
3. Depression (contraction/downswing)
4. Recovery or revival (lower turning point)

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Diagrammatic representation of phases of trade cycle

(Boom)


Economic activity
B (Trend line/Steady
(Boom/peak) growth line)

Recession

Line of cycle
A

(Trough)

O
Time

Explanation of the Phases

1. Prosperity
During the prosperity, demand, output employment and income are rising at high level.
They tend to increase prices but wages, salaries, interest rates, rentals and taxes do not
rise in proportion to the rise in prices. The gap between prices and cost increases the profit
margin. The prosperity is characterized by;
a. Large volume of production and trade.
b. High level of employment and income.
c. High marginal efficiency of capital.
d. High price.
e. Huge expansion of bank credit.
f. High level of real investment.
g. Rise in wages and profits.
h. Overall business optimism.
i. Operation of economy at full capacity.
The extreme point of prosperity is known as peak/Boom. Bottle necks begin to appear at
the peak of prosperity. It is the symptom of the end of prosperity phase and the beginning
of recession. Thus all economic activities increase at an increasing rate during prosperity
and they lie above the trend line. The longest sustained period of prosperity occur in the
USA between 1923 and 1929 with some minor interruption in 1924 A.D.
2. Recession
When prosperity ends, recession begins. Recession refers to an upper turning point. It
lasts relatively for a short period of time. During recession, the banking system and the
people in general try to attain greater liquidity. Therefore, credit supplies contract. These
is a tendency to reduce the scale of operation which leads to an increase in unemployment
and decline in the level of income. Decline in income leads to a decrease in aggregate
expenditure i.e. effective demand. The decline in effective demand causes a decline in
prices and profits. The 1951-58 A.D. recession in the USA was a severe one.

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3. Depression
The features of depression are just the reverse of prosperity. In depression, real income
and rate of employment fall rapidly due to idle resources and capacity. In order words,
there is a substantial decline in the production of goods and services and in the volume
of employment. The general decline in the economic activity leads to a fall in the bank
deposit. A depression is characterized by:
a. Shrinkage in the volume of output.
b. Rise in the level of unemployment.
c. Price deflation.
d. Fall in the aggregate income.
e. Reduction in effective demand.
f. Decline in the level of investment.
g. Decline in bank credits.
When the economy bottoms out, a trough occurs. It is shorted lived or it may continue
for a considerable time. During depression, clouds of over pessimism cover the entire
economy and all economic activities lie below the trend line. The two longest depression
in the US history were those of 1873 – 1979 A.D. (65 months) and 1929-1933 A.D. (44
months).
4. Recovery
Recovery refers to the lower turning point. The recovery begins with the improvement in
demand for capital goods. In order to meet this increased demand, the investment and
employment increase in capital good industry, which in turn, lead to rise in income. The
increased income pushes up the level of effective demand, which in turn, leads to rise in
prices, profits, further investment, employment, output and income at a slow rate, and
these economic activity lie below the trend line.

Measures of Economic Stabilization (Measures to Control Trade Cycle)

Economic stabilization is one of the main remedies to control trade cycle in a capitalist
economy. An economic stabilization policy is as action taken by government to influence
aggregate demand to moderate the expansion and contraction phases of business cycle. The
main policies of controlling trade cycle are:
1. Monetary Policy
The basic problem of monetary policy in relation to trade cycle is to control and regulate
the volume of credit in such a way as to attain economic stability. During depression,
credit must be expanded and during inflationary boom, credit must be checked. The
instruments of monetary policy adopted by central bank are of two types, quantitative
and qualitative (selective)
Quantitative techniques are direct controls whereas selective controls are indirect
controls. The quantitative credit control includes cash reserve ratio, open market
operation and bank rate. The selective credit controls aim at controlling specific types of
credit. They include regulation of consumer credit, direct action, publicity, etc.

16
 At times of depression, central bank has adopted expansionary credit policy. Under this
policy, central bank tries to encourage the expansion of credit through reducing bank rate
or cash reserve ratio or purchasing securities in open market or implementing
appropriate selective credit control measure.
But at the time of boom, central bank has adopted contractionary credit policy, to check
the flow of credit in the economy. Under this policy, bank tries to discourage the
expansion of credit through rising bank rate or cash reserve ratio or selling securities in
open market or implementing appropriate selective measures.
2. Fiscal Policy
Fiscal policy is a powerful instrument of economic stabilization. Fiscal policy refers to
government actions affecting its receipts and expenditures. Budget is the principal
instrument of fiscal policy. When there are deflationary tendency in the economy, the
government should increase its expenditure through deficit budgeting and reduction in
taxation. An increase in public expenditure during depression increases aggregate
demand and price level leads to increase income and employment. A reduction in tax has
the effect of increasing disposable income, thereby increasing consumption and
investment expenditure of people.
On the other hand, when there is inflationary tendency, the government should cut down
its expenditure by having surplus budget and increasing tax in order to stabilize the
economy at full employment level. A reduction of public expenditure during inflation
reduces aggregate demand, national income, employment, output and prices. Similarly an
increase in taxes reduces disposable income and thereby reduces consumption and
investment expenditure.
3. Direct Controls
The aim of direct controls is to ensure proper allocation of scare resources for the purpose
of price stabilization. They affect particular consumers and producers. Such controls are
in the form of licensing, rationing, price and wage controls, export duties, exchange
controls, quota arrangement, anti-hoarding etc. Their success depends upon the existence
of an efficient and honest administration.

Concept of Money Supply

Money supply is a stock as well as a flow concept. When money supply is viewed as a point
of time, it is a stock, and when viewed over a period of time it is a flow. Money supply at a
particular moment of time is the stock of money held by the public at a moment of time. It
refers to the total currency notes, coins and demand deposits with the bank held by the public.
Over a period of time, money supply becomes a flow concept. In Fisher's equation, PT = MV,
MV refers to the flow of money supply over a period of time, where M stands for the stock of
money held by the public and V for velocity of money.

17
 There are basically two types of monetary aggregates or money supply measures. They are
narrow money (M1) and broad money (M2) which are explained below:

i. Narrow Money (M1)

Narrow money supply refers to the sum of currency held by the public and demand deposits
with commercial banks and other deposits with central bank. Narrow money is expressed as
M1 = C + DD
Where,
C = Currency held by the public
DD = Demand deposits with commercial banks and
other deposits with central bank

ii. Broad Money (M2)

Broad money is defined as the sum of narrow money (M1) and time deposits (TD). Time
deposits consist of saving deposits, fixed deposits, call deposits and margin deposits. Broad
money is expressed as
M2 = M1 + TD

Balance of Payments

Concept of Balance of Payments

Balance of payments is a systematic record of all economic transactions: visible as well as
invisible, in a period, between one country and the rest of the world. It shows the relationship
between one country's total payments to all other countries and its total receipts from them.
Thus, Balance of payments is a statement of payments and receipts on international
transactions. Payments and receipts on international account are of three kinds: (a) the visible
balance of trade; (b) the invisible items; and (c) capital transfers.
Kindle Berger defines balance of payments as "a systematic record of all economic transactions
between the residents of the reporting country and the residents of foreign countries during
a given period of time." In the words of Benham, "Balance of payments of a country is a
record of the monetary transactions over a period with the rest of the world."

Components of Balance of Payments

A balance of payments statement consists of three parts: (i) current account
(ii) capital account and (iii) financial account or foreign exchange reserve account.
i. Current Account
It includes mainly the trade in goods; trade in services along with income transfers. The
trade account balance which is the difference between exports and imports of goods,
usually referred to visible or tangible items. Trade account balance tells as whether a
country enjoys a surplus or deficit on that account. An industrial country with its
industrial products comprising consumer and capital goods always had an advantageous

18
 position. Developing countries with its export of primary goods had most of the time
suffered from a deficit in their trade balance. The Balance of Trade is also referred as the
'Balance of Visible Trade' or 'Balance of Merchandise Trade'.
Till recently, goods dominated international trade. However, there is a growing scope of
trade in services. This involves export of services, interests, profits, dividends and
unilateral receipts from abroad, and the import of services, interests, profits, dividends
and unilateral payments to abroad.
There can be either surplus or deficit in current account. The deficit will take place when
the debits are more than credits or when payments are more than receipts and the current
account surplus will take place when the credits are more than debits.
ii. Capital Account
It is difference between the receipts and payments on account of capital account. The
capital account involves inflows and outflows relating to investments, short term
borrowings/lending, and medium term to long term borrowing/lending. The purchase
or sell of the real assets (like land, building, acquiring the production plants etc) are
included in this section. There can be surplus or deficit in capital account. The surplus
will take place when the credits are more than debits and the deficit will take place when
the debits are more than credits.
iii. Financial Account/Foreign Exchange Reserves
Foreign exchange reserves shows the reserves which are held in the form of foreign
currencies usually in hard currencies like dollar, pound etc., gold and Special Drawing
Rights (SDRs) with the International Monetary Fund. Besides, it also includes the
investment of a country’s citizens in the credit instruments like bond, share and
debenture of a company from other country. When a country enjoys a net surplus both
in current account & capital account, it increases foreign exchange reserves.

Exchange Rate
Concept of Exchange Rate
Exchange rate is the price of a currency in terms of another currency. It is the rate at which one
currency is exchanged for another currency.
According to Crowther,” The rate of exchange measures the number of units of one currency
which will exchange in the foreign exchange market for another.”
Foreign exchange market is the organizational set up under which foreign currencies are
bought and sold. The constituents or the structure of foreign exchange market are (a) central
bank (b) foreign exchange brokers and (c) commercial banks.

Types of Exchange Rate

Exchange rate can be broadly divided into two types. They are:
1. Flexible (Floating/ Free) Exchange Rate
Flexible or free exchange rate system is a system where the value of one currency in terms
of another is free to fluctuate and establish its equilibrium level in the exchange market
through the forces of demand and supply. Under the flexible exchange rate system, the

19
 rate of exchange is allowed to vary to suit the economic policies of the government. The
flexible exchange rates are determined by the forces of demand and supply in the
exchange market. There are no restrictions on the buying and selling of the foreign
currencies by the monetary authority and the exchange rates are free to change according
to the changes in the demand and supply of foreign exchange.
The demand-supply approach to theory of flexible exchange rate states that the
interaction between demand for and supply of foreign exchange determines the
equilibrium exchange rate in free exchange market.
The demand for foreign exchange schedule shows the negative relationship between
different exchange rates and the corresponding amounts of foreign exchange demanded.
Higher the exchange rate, lower the amounts of foreign exchange demanded and vice
versa. Hence the demand for foreign exchange curve slopes downward from left to right.
The supply of foreign exchange schedule shows the positive relationship between
different exchange rates and the corresponding amounts of foreign exchange supplied.
Higher the exchange rate, higher will be the amounts of foreign exchange supplied and
vice versa. Hence the supply of foreign exchange curve slopes upward from left to right.
Graphical Analysis

Y
D S1
S>D
r2
a b
Exchange rate (r)

e
r1

r0 c d

D>S
S D1

O X
Q1 Quantity of $

In the figure, the demand for foreign exchange curve (DD1) and the supply of foreign
exchange curve (SS1) intersect each other at point e where the equilibrium exchange rate
r1 is determined at Q1 amounts of dollars. At any exchange rate above r1(say at r2), S > D
by ab which implies that there is excess supply of dollars which causes fall in exchange
rate from r2 to r1 where demand and supply are equal. At any exchange rate below r1(say
at r0), D > S by cd which implies that there is excess demand for dollars which drives the
exchange rate upward to r1 where the equilibrium is restored.
2. Fixed ( Pegged/ Stable) Exchange Rate
Fixed exchange rate system is a system where the rate of exchange between two or more
countries does not vary or varies only within narrow limits. Under the fixed or stable
exchange rate system, the government of a country adjusts its economic policies in such
a manner that a stable exchange rate is maintained. In modern times, the fixed exchange
rate system is identified with adjustable peg system of the International Monetary Fund
(IMF) under which the exchange rate is determined by the government and enforced
through pegging operations or through some exchange controls. Nepal has fixed
exchange rate system with India.

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Economic Growth and Economic Development

Economic Growth
Economic growth refers to a long-term expansion in the productive potential of the economy
to satisfy the wants of individuals in the society. Economic growth can be defined as an
increase in the capacity of an economy to produce goods and services within a specific period
of time. Sustained economic growth of a country has a positive impact on the national income
and level of employment, which further results in higher living standards. Apart from this, it
plays a vital role in stimulating government finances by enhancing tax revenues. This enables
the government to earn extra income for the further development of an economy. The
economic growth of a country can be measured by comparing the level of Gross Domestic
Product (GDP) of a year with the GDP of the previous year. The economic growth rate can be
calculated by the following formula:
Yt – Yt-1
GY = Yt-1 × 100
Where,
GY = Economic growth rate
Yt = GDP of current year (t)
Yt–1 = GDP of previous year (t–1)
Some of the popular definitions regarding economic growth can be highlighted below:
Edward Shapiro: Economic growth can be most simply defined as the increase in the
economy's output over time. Our best measure of the economy's output is
real GNP or GNP in constant prices.
Todaro & Smith: Economic growth is the steady process by which the productive capacity
of the economy is increased over time to bring about rising levels of
national output and income.
Jacob Viner: Economic growth is an issue of reducing mass poverty.
Simon Kuznet has presented the following six important features of modern economic
growth:
i. High rates of growth per capita output and population.
ii. High rates of increase in total factor productivity.
iii. High rates of structural transformation of the economy.
iv. High rates of social and ideological transformation.
v. The propensity of economically developed countries to reach out the rest of the world for
markets and raw materials.
vi. The limited spread of this economic growth to only one–third of the world's population.

Sources or Determinants of Economic Growth

Economists have pointed out various sources or determinants of economic growth. The major
sources of economic growth can be discussed below:
1. Natural Resources

21
 Natural resources are those resources which are free gift of nature. They include soil,
forces, fisheries, water and mineral resources. In the physical sense, natural resources are
something static, fixed and given. But in the economic sense, i.e., in the sense of their
effective exploitation, they are dynamic and shifting.
2. Population Growth: Human Resources
Human resources are important from the viewpoint of economic growth. In fact, there is
two–sided relationship between human resources and economic growth. Human
resources are both ends and means of economic growth. As means of production, human
resources provide the essential factor service in the form of labor. In this role, human
factors determine the amount of production in the economy. On the other hand, human
resources as consumers constitute the end purpose of economic development. Economic
development is undertaken to provide better living conditions to human beings.
3. Capital Formation
The process of adding to the stock of capital in an economy over the years is known as
capital formation or capital accumulation. It is the process of adding to stock of machinery,
tools, building, etc. over time. The advantage of capital formation consists of more goods
the society will be able to production in future years by investing these resources. Thus, the
economy has to give up present consumption in order to get the higher level of output in
the future. The process of capital formation therefore involves a choice between today's
consumption and tomorrow's output, between today's comfort and tomorrow's economic
growth. The process of capital formation involves three stages: (i) generation of savings, (ii)
mobilization of savings and (iii) investment.
Capital formation or accumulation is regarded as the key factor in economic growth and
development of an economy. The vicious circle of poverty according to Prof. Nurkse can
easily be broken in underdeveloped countries through capital formation. It is capital
formation that accelerates the pace of development with further utilization of available
resources.
The higher capital formation in a country means the higher rate of economic growth.
Generally, the rate of capital formation or accumulation is very low in comparison to
advanced countries. In the case of poor and underdeveloped countries, the rate of capital
formation varies between one percent to five percent while in the latter's case, it even
exceeds to 20 percent.
4. Technological Progress
Technological progress is considered as the most important source of economic growth.
Technological progress refers to the application of improved technology in the
production activity. It involves new knowledge and skill about the improved technology,
as well as, the introduction of new technique embodying that knowledge. According to
Schumpeter, technological progress comprises both invention and innovation. Invention
refers to discovery, of a new method of production involving new scientific knowledge.
Innovation is the successful economic application of this invention in the production
process. Thus, technological progress refers to the application of new scientific
knowledge in the form of inventions and innovations in the production activity. It
involves both human capital (in the form of knowledge) and physical capital (in the form
of new technique).

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5. Values and Institutions
'Values' refers to the motivation and incentives on the part of people which would motivate
them to do certain things. An appropriate value system is essential to promote economic
growth and development. Such value system requires higher priority given to economic
values as compared to religious and other values. The importance of a man should be
determined by his economic success rather than his caste or family work and saving. They
should welcome change. They should not be guided by traditional customs and religion.
'Institutions' refers to various institutional arrangements which govern the organization
of the society. It consists of the form of the government, social organization like the joint
family, land tenure system, trade unions, etc. Economic development requires
modification of the old institutions. Rigid caste system and joint family system need to
be abolished for promoting economic development. It is also important to introduce land
reforms for promoting economic development.

Economic Development
Economic growth and development are often used interchangeably but there is a difference.
Economic growth is an increase in the amount of the goods and services produced over a
specific period of time. Generally, economic development refers to policymakers' actions
which promote the health, political, and social well-being of a specific area. Common areas of
development include literacy rates, life expectancy, unemployment, and poverty rates.
Economic development leads to the economic growth of a country.
Economic Growth is a narrower concept than economic development. It is an increase in a
country's real level of national output which can be caused by an increase in the quality of
resources (by education etc.), increase in the quantity of resources & improvements
in technology or in another way an increase in the value of goods and services produced by
every sector of the economy. Economic Growth can be measured by an increase in a
country's GDP (gross domestic product). On the other hand, economic development is a
normative concept i.e. it applies in the context of people's sense of morality (right and wrong,
good and bad). Development alleviates people from low standards of living into proper
employment with suitable shelter. Economic development is concerned with sustainability
which means meeting the needs of the present without compromising future needs.
Economic development is the sustained, concerted actions of policy makers and communities
that promote the standard of living and economic health of a specific area. Economic
development can also be referred to as the quantitative and qualitative changes in the
economy. Such actions can involve multiple areas including development of human capital,
critical infrastructure, regional competitiveness, environmental sustainability, social
inclusion, health, safety, literacy, and other initiatives.
One of the most accurate methods to measure economic development is Human Development
Index (HDI). HDI considers the literacy rate and life expectancy that affect productivity and
leads to economic growth. Thus economic development refers to economic growth plus positive
change.
Some of the popular definitions regarding economic development can be presented below:
M.P. Todaro: Economic development is defined in terms of the reduction of poverty,
inequality and unemployment within the context of growing economy.

23
 Meier & Baldwin: Economic development is the process whereby the real per capita income
of a country increases over a long period of time–subject to the stipulations
that the number below an absolute poverty does not increase, and the
distribution of income does not become more unequal.
Joseph Stiglitz: Development is now seen as a transformation of society, a move from old
ways of thinking, and old forms of social and economic organization, to
new ones.
Amartya Sen: The key idea of development is the enhancement of individuals' abilities
to shape their own lives.

Monetary Policy
Concept
Monetary policy refers to the policy measures undertaken by the central bank to influence the
availability, cost and use of money and credit with the help of monetary measures to achieve
specific goals, such as employment, output, price stability etc. In other words, monetary policy
means the control of expansion and contraction of money and credit by the central bank for
achieving definite economic objectives. According to Shapiro, "Monetary policy is the exercise
of central bank's control over the money supply as an instrument for achieving the objectives
of economic policy". The central bank of a country is the traditional agent which formulates
and operates monetary policy in a country. Nepal Rastra Bank carries out monetary policy in
Nepal.

Types of Monetary Policy

There are two types of monetary policy which are explained below:
1. Expansionary or Cheap Monetary Policy
Monetary policy designed to increase aggregate demand is known as expansionary
monetary policy. Expansionary monetary policy is implemented by the central bank to
overcome recession or depression faced by the economy. It is also known as cheap
monetary policy. In the periods of recession or depression, aggregate demand falls due
to cyclical unemployment so that central bank takes steps to stimulate economy by
increasing money supply and lowering the rate of interest.
2. Contractionary or Dear or Restrictive Monetary Policy
Monetary policy designed to reduce aggregate demand in the economy is known as
contractionary monetary policy or restrictive monetary policy. It is adopted by central
bank to overcome inflationary pressures. It is also known as dear monetary policy.

Instruments of Monetary Policy

Central bank uses various instruments while implementing monetary policy in an economy.
These instruments are discussed below:
1. Quantitative Controls
Quantitative controls refer to those instruments of monetary policy that affect the level of
aggregate demand through the supply of money, cost of money and availability of credit.

24
 They are meant to regulate the overall level of credit in the economy through commercial
banks. Quantitative controls include the following instruments:
i. Bank Rate
The bank rate is the minimum lending rate of the central bank to the commercial
banks. When the central bank finds that inflationary pressures have started
emerging within the economy, it raises the bank rate. Borrowing from the central
bank becomes costly and commercial banks borrow less from it. The commercial
banks, in turn, raise their lending rates to the business community and borrowers
borrow less from the commercial banks. There is contraction of credit and prices are
checked from rising further. On the contrary, when prices are depressed, the central
bank lowers the bank rate. It is cheap to borrow from the central bank on the part of
commercial banks. The latter also lower their lending rates. Businessmen are
encouraged to borrow more. Investment is encouraged. Output, employment,
income and demand start rising and the downward movement of prices is checked.

ii. Open Market Operation

Open market operations refer to the sale and purchase of securities in the money
market by the central bank. When prices are rising and there is need to control them,
the central bank sells securities. The reserves of commercial banks are reduced and
they are not in a position to lend more to the business community. Further
investment is discouraged and the rise in prices is checked. Contrariwise, when
recessionary forces start in the economy, the central bank buys securities. The
reserves of commercial banks are raised. They lend more. Investment, output,
employment, income and demand rise, and fall in prices is checked.
iii. Cash Reserve Ratio
This instrument was suggested by Keynes and the USA was the first to adopt it as a
monetary device. Every bank is required by law to keep a certain percentage of its
total deposits in the form of-a reserve fund in its vaults and also a certain percentage
with the central bank. When, prices are rising, the central bank raises the reserve
ratio. Banks are required to keep more with the central bank. Their reserves are
reduced and they lend less. The volume of investment, output and employment are
adversely affected. In the opposite case, when the reserve ratio is lowered, the
reserves of commercial banks are raised. They lend more and the economic activity
is favorably affected.
2. Selective Credit Controls
Selective or qualitative methods of credit control refer to the instruments of monetary
policy that regulate and control the allocation of credit among various users rather than
influencing the general availability of credit. Selective credit controls include the
following instruments:
i. Credit rationing
In order to keep the total credit expansion within desirable limits, the central bank
may recommend ceilings (an upper limit) on the overall credit extended by each
commercial bank. In times of inflation, the maximum limit of taking loans from

25
 central bank is reduced for those commercial banks which do not cooperate with the
central bank in controlling the credit and central bank also provides loans to these
banks at higher bank rate. In this way, commercial banks are forced to control the
expansion of credit during inflation so that aggregate demand falls which ultimately
helps to control inflation.
ii. Regulation of margin requirements
Commercial banks provide loans by mortgaging some stock with them. This loan is
not equal to the stock mortgaged but is less than that. Central bank orders
commercial banks to increase the margin requirements in times of inflationary
pressures. The increase in margin requirements reduces the amount of loans to be
supplied which ultimately controls inflation by decreasing aggregate demand.
Similarly, in times of recession or depression, central bank orders commercial banks
to decrease the margin requirements.

iii. Regulation of consumer credit

Credit facilities of commercial banks are controlled by the central bank in the periods
of inflation. The maturity of installment periods is reduced and amount of down
payments for purchasing durable goods are increased. This leads to reduce the
borrowing capacity of people so that aggregate demand falls and inflation can be
controlled. Similarly in the periods of recession, central bank orders the commercial
banks to increase the maturity of installment periods and reduce the amount of
down payments for purchasing durable goods.
iv. Moral suasion
Central bank gives advice to commercial banks on moral grounds about credit
control by publishing and analyzing data about economic situation of the country.
Central bank suggests commercial banks about the evils of credit expansion and the
need to control it.
v. Direct action
If commercial banks do not follow the credit guidelines of central bank, central bank
can impose a penalty or refuse to discount bill of exchanges of commercial banks.
Goals / Objectives of Monetary Policy
1. To Achieve Full Employment
An appropriate monetary policy helps to achieve full employment. In developed
countries, monetary policy is thought to be appropriate in maintaining full employment.
The case of developing countries is different from those of developed countries. Open
unemployment and under employment have been the main problems of developing
countries. Unemployment shatters the dream of rapid economic growth and creates
socio-economic instability. Hence, the developing countries have been giving top priority
to the removal of unemployment. For the cure of unemployment through monetary
policy, first of all the cause of unemployment should be found out. If low investment is
the cause of unemployment, rate of interest should be reduced. On account of this
businessmen are encouraged to borrow from banks and financial institutions.

26
 Consequently, the economic activities increase, production increases and finally the level
of employment increases.
2. Economic Development
One of the major objectives of monetary policy is to accelerate the pace of economic
development. All the sector like agriculture, industry are under developed in developing
countries. The level of saving and investment are very low. For economic development,
it is essential to increase the rate of capital formation. There must be encouragement to
saving and investment. Saving is the source of capital formation. For encouraging saving,
interest rate on deposit should be kept higher than the rate of inflation. Similarly to
encourage investment, cheap interest rate on credit must be implemented.
3. Price Stability
Keynes has suggested that the price level should be controlled through monetary policy.
The instability like inflation and deflation disrupts the economy. Inflation hurts poor, low
income people and increases income inequality. On the other hand, deflation reduces the
level of employment by discouraging investment. Hence, the central bank should control
the volume of credit and money in appropriate way. For price stability, the rate of interest
should be increased during inflation and it should be reduced during deflation.
4. Foreign Exchange Rate Stability
The instability in foreign exchange rate has adverse effects on international trade and
balance of payments. If the instability is more serious, it also affects the internal prices,
production and employment. The instability in exchange rate may also affect the
international business and personal relation. It encourages speculation and smuggling in
domestic foreign exchange market. The country loses credibility due to instability which
reduces foreign investment. Hence, the developing countries should keep foreign
exchange rate stable. For this, frequent devaluation of money should be controlled
through monetary policy.
5. Reduction of Economic Inequality
Monetary policy may also be used to reduce the inequality in the distribution of income
and wealth. For this purpose central bank should launch different programs that benefit
the poor. It should devise the interest rate structure so as to encourage investment
towards poverty alleviation programs. The low interest rate should be fixed for the small
farmers and rural industries.
6. Correct Adverse Balance of Payments
The developing countries import goods like machinery, equipment, raw materials,
fertilizers, petrol in large quantities for development works. They export primary
products with low value in limited quantity. Hence they face Balance of Payments (BOP)
problem. The adverse BOP can be corrected through monetary policy. The exchange rate
should be made stable. For this purpose, the institutions like trade promotion centre
should be established to promote exports. Exporters should be given incentives like
export subsidy. The policies like exchange control, quota system should be implemented
to reduce unnecessary imports. To correct the balance of payment (BOP) problems, there
should be stability in foreign exchange rate. The instability in foreign exchange rate has
adverse effects on international trade and balance of payments. If the instability is more
serious, it also affects the internal prices, production and employment. The instability in
exchange rate may also affect the international business and personal relation. It

27
 encourages speculation and smuggling in domestic foreign exchange market. The
country loses credibility due to instability which reduces foreign investment. Hence, the
developing countries should keep foreign exchange rate stable. For this, frequent
devaluation of money should be controlled through monetary policy. This helps to
correct the balance of payment problems. Similarly, export duties should be reduced
which helps to provide incentives to the exporters for exporting products at low cost and
sell them at competitive price in international market.

Fiscal Policy
Concept of Fiscal Policy
The term "fiscal" was originated from Greek word which means 'basket'. This denotes
government purse. In Old Italian language, "Fisc" means treasury. Hence, fiscal policy is
related to government treasury. Fiscal policy is defined as a policy concerning the receipts and
expenditures of government. It operates through changes in government expenditure,
taxation and public borrowing. According to the Arthur Smithies, "Fiscal policy is a policy
under which the government uses its expenditures and revenue programs to produce
desirable effects and avoid undesirable effects on the national income, production and
employment."
Budget is the principal instrument of fiscal policy. J.M Keynes and Hansen have made
important contribution in the development of fiscal policy. The concept of fiscal policy for
development was popular after Keynesian revolution in1930s.

Types of Fiscal Policy

There are two types of fiscal policy: Expansionary and Contractionary.
1. Expansionary Fiscal Policy
When an economy is in a recession, expansionary fiscal policy is in order. Typically this
type of fiscal policy results in increased government spending and/or lower taxes. A
recession results in a recessionary gap – meaning that aggregate demand (i.e., GDP) is at
a level lower than it would be in a full employment situation. In order to close this gap, a
government will typically increase their spending which will directly increase the
aggregate demand curve (since government spending creates demand for goods and
services). At the same time, the government may choose to cut taxes, which will indirectly
affect the aggregate demand curve by allowing for consumers to have more money at
their disposal to consume and invest. The actions of this expansionary fiscal policy would
result in a shift of the aggregate demand curve to the right, which would result closing
the recessionary gap and helping an economy grow.
2. Contractionary Fiscal Policy
Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy.
When an economy is in a state where growth is at a rate that is getting out of control
(causing inflation), contractionary fiscal policy can be used to rein it in to a more
sustainable level. If an economy is growing too fast or for example, if unemployment is
too low, an inflationary gap will form. In order to eliminate this inflationary gap a
government may reduce government spending and increase taxes. A decrease in

28
 spending by the government will directly decrease aggregate demand curve by reducing
government demand for goods and services. Increases in tax levels will also slow growth,
as consumers will have less money to consume and invest, thereby indirectly reducing
the aggregate demand curve.

Methods of Fiscal Policy

There are three methods of fiscal policy which are explained below:
1. Automatic stabilization fiscal policy (Built in flexibility)
This is the method of automatic adjustment of government expenditure and taxes with
cyclical fluctuations within the economy. In other words, it is the automatic
adjustment in government expenditure and tax revenue with response to
the change in national income or GDP. Under this method, change in budget
is automatic. Therefore, it is known as the automatic stabilizer.
2. Discretionary fiscal policy
In this method of fiscal policy, government makes deliberate changes in the budget by
changing the tax rates or government expenditure or both. Generally, it takes three
forms which are
 Changing taxes with expenditure constant
 Changing expenditure with taxes constant
 Changing both taxes and government expenditure simultaneously.
The first method is useful during inflation whereas second method is
useful during deflation. The third method is more superior in controlling
both inflationary and deflationary tendencies.
3. Compensatory fiscal policy
In this method of fiscal policy, deliberate budgetary action is taken by the government
in order to compensate for the deficiency in and of excess aggregate demand. This type
of fiscal policy was recommended by J.M. Keynes to counter recession. During recession
and depression, there is gap in demand, consumption and investment. In this situation,
the government attempts to fill gap by injecting extra expenditure to re-establish
demand in the economy. Under the compensatory fiscal policy, government takes
action by the form of deficit or surplus budget. During inflationary tendencies, the
government adopts surplus budget whereas during deflation, the government adopts
deficit budget.

Instruments of Fiscal Policy

There are various instruments used by the government. These instruments can be explained below:
1. Public Expenditure
Public expenditure refers to the expenditure made by the government. It includes
expenditures of central and local government.
Types of public expenditure are
a. Current and capital expenditure
i. Current expenditure

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  Non -development expenditure
 It includes administrative and defense expenditure as well as public debt
services.
ii. Capital expenditure
 Development expenditure
 Expenditure done to enhance productive capacity of an economy is known
as capital expenditure. It is also known as investment expenditure.
b. Direct expenditure and transfer expenditure
Expenditure for the purpose of consumption and investment by the government is
known as direct expenditure. On the other hand, expenditure made by government
on payment of interest on debt, old age pensions, unemployment allowances etc is
known as transfer expenditure.
2. Public Revenue
Income of the government from tax, penalties, fines, grants, gifts etc is known as public
revenue. The main source of revenue for the government results from taxation. Taxes are
classified as Direct tax and indirect tax. Direct tax reduces disposable income of people
and it goes into government treasury. Indirect tax leads to increase in general price level.
Both taxes lead to the reduction in aggregate demand.
3. Public Debt
Public debt refers to the loans taken by government from people or from rest of the world.
If public expenditure exceeds public revenue, government raises funds from public.
There are two types or sources of public debt: internal debt and external debt. Public debt
affects aggregate demand in many ways. If public expenditure does not fall with public
debt, there will be no decrease in demand of private sector. The government can spend
the amount of public debt in order to increase aggregate demand.
4. Deficit Financing
Deficit financing means to finance the deficit in the government budget. When there is a
deficit due to excess of public expenditure over public revenue, it is met by either
borrowing from central bank or by issuing new notes. Deficit financing enables to
increase aggregate demand. Most of the countries implement deficit financing but
excessive deficit financing can lead to inflationary pressures in the economy.

Goals / Objectives of Fiscal Policy

The objectives of fiscal policy can be explained below:
1. To Achieve Full Employment
The problem of unemployment is the most serious problem of the developing countries.
Fiscal policy, therefore, should aim at increasing employment opportunities and
reducing unemployment in these countries. The government can adopt different policies
to raise the level of employment in the country through public expenditure, taxation and
public debt policy. Public expenditure should be made on economic and social overheads

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 in order to generate employment by increasing productivity in the economy. Since
unemployment is the result of low propensity to consume, the government can
redistribute income through taxation so that propensity to consume can be increased.
Similarly public debt policy can be used to control private consumption expenditure and
to raise small savings for financing the development expenditure. These activities of
government can ensure full employment in the economy.
2. Capital Formation
The main feature of developing countries like Nepal is the vicious circle of poverty
existing in the people. Vicious circle of poverty refers to the circular forces tending to act
and react in such a way as to keep a poor country in a state of poverty. The aim of the
fiscal policy is to break this vicious circle of poverty. The high rate of economic growth
should be achieved to remove vicious circle of poverty. It is possible by increasing the
rate of capital formation. In order to increase capital formation, savings must be
increased. The government can implement voluntary and forced saving to collect enough
resources for investment, therefore, fiscal policy should be formulated in such a manner
as to increase the rate of investment both in public as well as private sectors. This requires
large amounts of financial resources which can be obtained by raising the marginal
propensity to save.
3. Economic Development
It is the objective of fiscal policy to increase the speed of economic development in
developing countries. The government can establish a 'welfare state' through the
implementation of appropriate fiscal policies. For achieving economic development, the
government should give priority in fulfilling the basic needs of people. There should be
optimum allocation and mobilization of resources of the economy for achieving economic
development. This helps to increase investment in productive sectors so that the pace of
economic development can be increased.
4. Economic Stability
Underdeveloped countries are delicate to the effects of international cyclical fluctuations.
Their main exports are primary products and main imports are manufactured and capital
goods. Fall in the world prices of primary products turn the terms of trade against
underdeveloped countries. This reduces national income, output and employment. On
the other hand, rise in export prices are not accompanied by an increase in output and
employment because increased export earnings are generally used in conspicuous
consumption, real estate etc. Fiscal policy can be used to minimize the effects of
fluctuations in the world prices of products.
5. Reduction in the Unequal Distribution of Income and Wealth
To maintain the equality of income and wealth is a major objective of fiscal policy. The
government, therefore, should formulate its fiscal policy in such a manner so that it may
reduce the inequalities of the income and wealth. Extreme inequalities create political and
social dissatisfaction and generate instability in the economy. The inequalities of income
and wealth distribution can be reduced by the following ways:
 Progressive tax system should be implemented. Heavy direct tax should be imposed
on the rich people and tax should be exempted to the poor people.

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 Luxury goods consumed by rich section of the society should be taxed heavily.
Necessary goods consumed by poor people should be subject to low tax.
 Government must spend more on those activities which benefit poor people. For
example, expenditure on social services like education, public health should be
increased and these services should be provided free of cost or at lower cost to the
poor people.

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