Business Economics II-munotes

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1 MODULE 1
1
INTRODUCTION
Unit Structure :
1.0 Objectives
1.1 Introduction
1.2 Distinction between Microeconomics and Macroeconomics
1.3 Meaning of Circular Flow of Income
1.4 Circular Flow of Income
1.5 Circular Flow of Income and Expenditure in a two – sector
Economy Model
1.6 Circular Flow of Money in a two sector Economy with Savings
and Investment
1.7 Circular Flow of Income in a three sector Economy
1.8 Circular Flow of Money with the Foreign Sector or Circular Flow
of Money in Four sector Open Econom y
1.9 Importance of Circular Flow of Income
1.10 Gross National Product (GNP)
1.11 Gross Domestic Product (GDP)
1.12 Personal Income
1.13 Disposable Income
1.14 Methods of Measurement of National Income
1.15 Net Output or Value Added Method
1.16 Factor - Income Method
1.17 Expenditure Method
1.18 Measurement of National Income in India
1.19 Summary
1.20 Questions
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2 1.0 OBJECTIVES
 To understand the meaning, subject matter, uses and limitations of
Microeconomics and Macroeconomics
 To study the meaning of Cir cular flow of income
 To study the circular flow of income and expenditure in a two sector
model economy
 To study circular flow of money with saving and investment in a two
sector economy
 To understand circular flow of income in three sector economy
 To unde rstand circular flow of income in a four sector economy
 To understand the importance of circular flow of income
 To study the concepts of GNP, GDP, NNP and NDP
 To understand the meaning of personal income and disposable income
 To study different methods of measurement of national income
1.1 INTRODUCTION
Macroeconomics study examine the economy as a whole i.e. it is a study
of aggregates. To study the income and expenditure of the country
macroeconomics provides several tools. Therefore study of these tools
used to explain national income and expenditure and how to measure it
becomes inevitable.
1.2 DISTINCTION BETWEEN MICROECONOMICS
AND MACROECONOMICS
1.2.1 Meaning : -
Macroeconomics is concerned with the nature, relationships and behaviour
of such aggregate quantities and averages as national income, total
consumption, savings and investment, total employment, general price
level, aggregate expenditure and aggregate supply of goods and services.
As macroeconomics deals with aggregate quantities of the economy as a
whole, it is also called as aggregative economics.
1.2.2 Subject matter : -
Theories of National Income, consumption, saving and investment, theory
of employment, theories of economic growth, business cycles and
stabilization policies, theories of mon ey supply and demand and theory of
foreign trade broadly constitute the subject matter of macroeconomics.
Macroeconomic theories seek to answer questions such as how is the level
of National Income of a country determined? What determines the levels munotes.in

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Introduction
3 of ove rall economic activities in a country? What determines the level of
total employment? How is the general level of price determined? etc.
1.2.3 Uses : -
The main justification for macroeconomics lies in the need for
generalising the behaviour of and relation ships between economic
aggregates. To study the system as a whole and to explain the behaviour of
aggregate quantities and the relationship between them is extremely
difficult. Macroeconomic approach has made it possible. It ignores the
details pertaining to the individual economic agents and quantities and
compresses the unmanageable economic facts to a manageable size and
makes them capable of interpretation. Macroeconomic theories are used in
formulating public policies. They provide clarity to the macro economic
concepts and quantities and bring out the relationship between macro
variables of the economy in the form of models or equations.
1.2.4 Limitations : -
Study of macroeconomics is limited to only aggregates. It cannot be
applied to explain the behav iour of individual components of the
economic system and the individual quantities. Secondly, it ignores the
structural changes in constituent elements of the aggregate. Hence
conclusions drawn from the analysis of aggregates may involve error of
judgement and may be misleading.
1.3 MEANING OF CIRCULAR FLOW OF INCOME
The circular flow of money refers to the process whereby money
payments and receipts of an economy flow in a circular manner
continuously over a period of time. The various components of money
payments and receipts are saving, investment, taxation, loans, government
purchases, exports, imports, etc. These are shown in diagram in the form
of current and cross -current in such a manner that the total money
payments equals the total money receipts i n the economy.
1.4 CIRCULAR FLOW OF INCOME
The modern economy is a monetary economy, where money is used in the
process of exchange. The modern economy performs economic activities
such as production, exchange, consumption and investment. In order to
carry out these economic activities people are involved in buying and
selling of goods and services. The transactions take place between
different sectors of the economy. The process of production and exchange
generates two kinds of flows.
1. Product or real fl ow, that is the flow of goods and services, and
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4 Product and money flow in opposite direction in a circular way. The
product flow consists of a) factor flow, that is flow of factor services and
b) goods flow that is flow of goods and services. In a monetized economy
the flow of factor services generates money flows in the form of factor
payments which take the form of money flows. The factor payments and
expenditure on consumer goods and services take the form of expenditure
flow. Expenditure f low is in the form of money flow. Both income and
expenditure flow in a circular manner in opposite direction. The entire
economic system can therefore be viewed as circular flows of income and
expenditure. The magnitude of these flows determines the size of national
income. We can explain how these flows are generated and how they
make the system work.
The economists, however use simplified models to explain the circular
flow of income and expenditure dividing the economy into four sectors
namely, I) Hous ehold sector, II) Business or Firms sector , III)
Government sector, and IV) Foreign sector. These sectors are combined to
make the following three models for the purpose of showing the circular
flow of income.
I) Two- sector model including the househol d and business sectors;
II) Three - sector model including the household, business and
government sectors; and
III) Four - sector model including the household, business, government and
the foreign sectors.
1.5 CIRCULAR FLOW OF INCOME AND
EXPENDITURE IN A TWO – SECTOR ECONOMY
MODEL
We begin with a simple hypothetical economy where there are only two –
sectors, the household and business firms which represent a closed
economy and there is no government and no foreign trade. The household
sector owns all the fac tors of production that is land, labour, capital and
enterprise. This sector receives income in the form of rent, wages, interest
and profit, by selling the services of these factors to the business sector.
The business sector consists of producers who pro duce goods and sell
them to the household sector. The household sector consists of consumers
who buy goods produced by the business sector.
Thus in the first instance, money flows in the form of such income
payments as rent, wages, interest and profits fro m the business sector to
the household sector when the former buys the services of the factors of
production to produce goods. Money so received is, in turn, spent by the
household sector to buy goods produced by the business sector. In this
way money flow s in a circular manner form the business sector to the
household sector and from the household sector to the business sector in
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5 The circular flow in a two sector economy is depicted in Fig. 1.1 where
the flow of money as income payments from t he business sector to the
household sector is shown in the form of an arrow in the upper portion of
the diagram. On the other hand, the flow of money as consumption
expenditure on the purchase of goods and services by the household sector
is shown to go th e business sector by an arrow in the lower portion of the
diagram. As long as income payments by the business sector for factor
services are returned by the household sector to purchase goods, the
circular flow of income payments and consumption expenditur e tends to
continue indefinitely. Production equals sales or supply equals demand,
and the economy will continue to operate at this level in a circular flow of
money.
Factors of Production - Land, Labour, Capital & Enterprise











Flow of goods and services
Fig. 1.1
The above analysis of circular flow of income and expenditure in a two –
sector closed economy is based on following assumptions.
1. The economy consist of two sectors namely household and business
or firms;
2. Household sector spends their entire income received in the form of
rent, wages, interest and profits from the business sector on buying of
goods and services produced by the firms. They do not hold or save
any part of their income. Factor income = Wages, Rent, Interest and Profits






Payments for goods and services Household Sector
Factor Owners
and Consumers of Firms Sector Factor Users
and Producer of goods and Factor Market
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6 3. The business firms keep th eir production exactly equally to their sales
or as much as demanded by the households. There are no changes in
their inventories.
4. The business sector does not keep any undistributed money as reserve.
The money it receives by selling goods and services to the household
sector is fully spent in making payments as rent, wages, interest and
profits to the household sector.
5. There are no government operations.
6. There is no inflow or outflow of income or no foreign trade.
It is these assumptions that keep the flo w of money to move in a
circular manner in the economy. But these assumptions are unrealistic and
do not fit in the actual working of the economy.
1.6 CIRCULAR FLOW OF MONEY IN A TWO SECTOR
ECONOMY WITH SAVINGS AND INVESTMENT
In the analysis of circular fl ow of income in a two sector economy, we
have assumed that, all money income received by the households is
spending on consumer goods and services. But in reality, the households
do not spend their entire money income on goods and services. They save
a par t of their income for various purposes. Let us now explain if
households save a part of their income, how their savings will affect
money flow in the economy.
When households save, their expenditure on goods and services will
decline to that extent and as a result money flow to business firms will
contract. With reduced money income firms will hire fewer workers or
reduce payments to the factors of production. This will lead to the fall in
total income of the households. Thus, savings reduce the flow of mo ney
expenditure to business firms and cause a fall in economy’s total income.
Economist, therefore call savings a leakage from the money expenditure
flow.
But savings by households will not reduce aggregate expenditure and
income, if their savings are brou ght back into the flow of expenditure. In
free market economies financial market consists of commercial banks,
stock market and non -bank financial institutions etc. plays an important
role of mobilization of savings, where households deposit their savings.
On the other hand, business firms borrow money from the financial market
for the purpose of investment. Thus, through the financial market savings
and investment are again brought into the expenditure stream and as a
result total flow of spending does not decrease. Circular flow of money
with savings and investment is explained with the help of following
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7 1. All the households need to deposit their savings with the financial
institutions \ market.
2. There are no inter -households borrowings.
In the f ollowing figure, in the middle of the circle a box represents
financial market. Money flow of savings is shown from households
towards the financial market. Then the flow of investment expenditure is
shown as borrowing by business firms from the financial market.
The circular flow of money with savings and investment is shown in the
following fig. 1.2.
Factors of production - Land, Labour, Capital & Entrepreneurship












Flow of goods & services
Fig.1.2
The necessary condition for the constant flo w of income is savings must
be equal to investment. As mentioned above, saving a part of income is
not spent on consumer goods and services. In other words, saving is
withdrawal of some money from the income flow. On the other hand,
investment means some money is spent on buying new capital goods to
expand production capacity. In other words, investment is injection of
some money in circular flow of income. But savings and investments in an
economy need not necessarily be equal.
If planned savings is more than planned investment expenditure, income,
output and employment will fall and therefore, flow of money will
decline. On the contrary, if planned investment expenditure is more than Factor Incomes - Rent, Wages, Interest & Profit







Consumer Expenditure



Savings Investment


Payments for goods & services Households Business Fi rms
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8 planned savings, income, output and employment will rise and therefore,
flow of money will increase. Thus, the economy will be in equilibrium if
planned savings is equal to planned investment expenditure.
It is clear from the above analysis that, the flow of money will continue at
a constant level only when the condition of e quality between planned
savings and planned investment is satisfied.
1.7 CIRCULAR FLOW OF INCOME IN A THREE
SECTOR ECONOMY
The two sector economy model consists of households and business firms.
But in a three sector economy additional sector is government sector.
Government affects the economy in many ways. Here we will concentrate
on its taxing, spending and borrowing roles. In the modern economy
government plays variety of role. Government performs different
functions. For this it requires huge amount of income. Government
receives income in the form of taxes from households and business firms.
Taxes are paid by the households and business firms which not only
reduces their disposable income but also their expenditure and savings.
Governments’ spending i ncludes expenditure on goods and services,
pension payments, unemployment allowance etc. Money spent by
Government is an injection of income into the economy which further
received by the households and business firms.
Another important method of financin g Government expenditure is
borrowing from financial market. This is represented by money flow from
the financial market to the Government is labelled as Government
borrowing.
In a three sector economy we have the following three economic agents.
1. Hous eholds and business firms
2. Financial sector
3. Government
The circular flow of income in a three sector economy is shown in the
following fig. 1.3.
Wages, Salaries & Payments Purchase of goods & services



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9
















Taxes






Taxes
Fig. 1.3
The above figure clearly shows that, income received by the Government
in the form of taxes from households and business firms is used for
spending in the form of wages, salaries, allowances, pension, subsidies
and purchases of goods and services from them. Money spent by the
Government is received by the households and business firms.
Thus, the leakages (withdrawal) in the form of savings and taxes arise in
the circular flow of income. The savings and taxes are further get injected
back into the circular flow of income in the form of investment and
Government spending. When these leakages (withdrawal) are equal to
injections in the form of investment and Government spending the flow of
money in the economy operates smoothly.
The inclusion of the Government sector significantly affects the overall
economic situation. Total expenditure flow in the economy is the sum of
consumption expenditure (C), investment expenditure (I), and
Government expenditure (G).
Thus, it is symbolically expressed as,
Total expenditure (E) = C + I + G
Total income (Y) receive d is allocated to consumption (C), savings (S)
and taxes (T). Factors of Production



Fl Factor Income (W+R+I+P)




Flow of good

Flow of goods & services S I


Payments for goods & services Business Firm Households Government Taxes
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10 Thus, symbolically expressed as,
Y = C + S + T
Since expenditure (E) made must be equal to the income received (Y)
from equation above we have
C + I + G = C + S + T
Since C occurs on both sides of the equation and will therefore be
cancelled out, we have
I + G = S + T
By rearranging we obtain
G – T = S – I
This equation is very significant because it shows what would be the
consequences if Government budget is not balanced. If Government
expenditure (G) is greater than the tax (T), the Government will have a
budget deficit. To finance the budget deficit, the Government will borrow
from the financial market. For this purpose, then private investment by
busines s firms must be less than the savings of the households. Thus
Government borrowing reduces private investment in the economy.
1.8 CIRCULAR FLOW OF MONEY WITH THE
FOREIGN SECTOR OR CIRCULAR FLOW OF
MONEY IN FOUR SECTOR OPEN ECONOMY
So far the circular flo w of money has been shown in the case of a closed
economy. But the actual economy is an open one where foreign trade
plays an important role. Exports are an injection or inflows into the
circular flow of money. They create incomes for the domestic firms. W hen
foreigners buy goods and services produced by domestic firms, they are
exports in the circular flow of money. On the other hand, imports are
leakages from the circular flow of money. They are expenditure incurred
by the household sector to purchase goo ds and services from foreign
countries. These exports and imports in the circular flow are shown in
fig. 1.4.
Take the inflows and outflows of the household, business and government
sectors in relation to the foreign sector. The household sec tor buys goods
imported from abroad and makes payments for them which is a leakage
from the circular flow of money. The householders may receive transfer
payments from the foreign sector for the services rendered by them in
foreign countries.
On the other hand, the business sector exports goods to foreign countries
and its receipts are an injection in the circular flow of money. Similarly,
there are many services rendered by the business firms to foreign countries
such as shipping, insurance, banking etc. f or which they receive payments
from abroad. They also receive royalties, interest, dividends, profits, etc.
for investment made in foreign countries. On the other hand, the business
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11 machinery, raw materials, consumer goods and services from abroad.
These are the leakages from circular flow of money.
X – M (Exports - Imports)










X – M
Fig.1.4
Like the business sector, modern governments also export and import of
goods an d services, and lend to and borrow from foreign countries. For all
exports of goods, the government receives payments from abroad.
Similarly, the government receives payments from foreigners when they
visit the country as tourists and for receiving educati on, etc. and also when
the government provides shipping, insurance and banking services to
foreigners through the state -owned agencies. It also receives royalties,
interests, dividends, etc. for investments made abroad. These are injections
into the circul ar flow of money. On the other hand, the leakages are
payments made to foreigners for the purchase of goods and services.
Figure 1.4 shows the circular flow of money in four sector open economy
with saving at the right hand and taxes and imports at the lef t hand shown
as leakages from the circular flow on the upper side of the figure, and
investment, and government purchase (spending) on the right hand side
and exports as injections into the circular flow, on the lower level left hand
side of the figure. Fu rther, imports, exports and transfer payments have
been shown to arise from the three domestic sectors - the household, the
business and the government. These outflows and inflows pass through the
foreign sector which is also called the ‘Balance of Payments Sector.’
Thus Figure 1.4 shows the circular flow of money where there are inflows
and outflows of money, receipts and payments among the business sector,
the household sector, the government sector, and the foreign sector in
current s and cross - currents.
F C
A Taxation Govt. Spending O Savings
C N
T S
O U
R M
I P
N Taxation Govt. Spending T Inve stments
C I
O O
M N
E Household Sector
Business Sector World
Economy Financial
Sector Government
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12 1.9 IMPORTANCE OF CIRCULAR FLOW OF INCOME
1. To understand the functioning of the economy - Money being the life
blood of a modern economy, its circular flow gives a clear picture of
the economy. We can know from its study whether the economy is
working smoo thly of there is any disturbance in its smooth
functioning. The circular flow of money is important for studying the
functioning of the economy and for helping the government in
formulating polity measures.
2. To understand the link between producers and cons umers – The
circular flow of money establishes a link between producers and
consumers. It is through money that producers buy the services of
factors of production from the household sector and in turn household
sector purchases goods and sector from the p roducers.
3. To find out the leakages in circular flow of income – Leakages or
injections in the circular flow of money disturb the smooth function of
the economy. For example, saving is a leakage out of the expenditure
stream. If saving increases, this contr acts the circular flow of money.
This tends to reduce employment, income and prices thereby leading a
deflationary process in the economy. On the other hand, consumption
expenditure and investment are injections in the circular flow of
money which help to increase employment, income, output and prices
and thus lead to inflationary tendencies.
4. Highlights the importance of monetary and fiscal policies – The study
of the circular flow of money also highlights the importance of
monetary policy in bringing about the equality between savings and
investment through the capital market. Similarly, it also points out the
importance of fiscal policy in bringing about the equality between
saving plus taxes and investment plus government expenditure.
To conclude, the cir cular flow of money possesses much theoretical and
practical significance in an economy.
1.10 GROSS NATIONAL PRODUCT (GNP)
GNP is the total market value of all final goods and services produced in a
year plus net income from abroad. This is the basic socia l accounting
measure of the total output or aggregate supply of goods and services.
GNP includes four type of final goods and services. First, consumer’s
goods and services to satisfy, the immediate needs and wants of the
people. Second, gross private dome stic investment. Third, goods and
services produced by government and four, net income from abroad i.e.
net export of goods and services GNP is the total amount of current
production of final goods and services
There are two things which have to be noted i n regard to gross national
product Firstly, it measures the market value of annual output or it is a munotes.in

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Introduction
13 monetary measure . This enables the process of adding up the different
types of goods and services produced in a year. However, for accuracy, the
figure for GNP is adjusted for price changes Secondly, for calculating
gross national product accurately, all goods and services produced in
any given year must be counted only once. GNP includes only the market
value of final goods and ignores transactions involvin g intermediate
goods. Final goods are those goods, which are being purchased for
final use and not for further processing. The inclusion of intermediate
goods will involve double counting. This will give us an inflated figure
of the national product.
In na tional income accounting, GNP is calculated both at market prices
and factor cost. In order to calculate GNP at market prices, the outputs of
all final goods and services are valued at market price and the values thus
obtained are added. The market price o f a good includes indirect taxes
such as the sales tax and excise tax. Thus it is greater than the price received
by the seller. Sometimes, the government may grant subsidy on a product. In
this case, the market price would be less than the price received by the
seller GNP at factor cost eliminates the influences of indirect taxes and
subsidies. It provides an estimate of the total value of the final goods and
services produced during a year at cost of production.
GNP at factor cost is obtained by subtracti ng net indirect taxes from GNP at
market prices. GNP at Factor cost = GNP at market price - Net indirect
taxes = GNP at market prices - (Total indirect taxes - Subsidies)
National income is usually calculated by 3 methods
(a) The product method.
(b) The income met hod
(c) The expenditure method
In the product method, GNP is the value added by the various industries and
activities of the economy in a particular year. In the income method, we
add up the income earned by the owners of factors of products in a
particul ar year. This gives the gross national income (GNI). In the
expenditure method; we add up the final expenditure of all residents in a
country. All the three different ways of looking at one and the same thing.
1.11 GROSS DOMESTIC PRODUCT (GDP)
GDP refers t o the value of final goods and services produced within the
country in a, particular year. GDP is different from GNP. A part of GNP
may be produced outside the country For example the money earned by
the lndian ’s working in USA is a part of India's GNP But it is not a part of
GDP since they are earned abroad. Therefore the boundaries of GNP are
determined by the citizens of a country whereas the boundaries of GDP are
determined by the geographical limits of a country. It is also clear that the
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14 If the citizens of a country are earning more from abroad than foreigners
are earning in that country, GNP exceeds GDP If the foreigners in the
country are earning more than its citizens are earnin g abroad, GNP is less
than GDP
1.11.1 Net National Product : -
This is a very important concept of national income. In the production of
gross national product, during a year, some capital is used up or consumed
i.e. equipment, machinery etc. the capital goods wear out or undergo
depreciation. Capital goods fall in value due to its use in production process.
By deducting the charges for depreciation from the gross national
product, we get the net national product. It means the market value of
all the final g oods and services after providing for depreciation. It is
called national income at market prices. In other words, net national
product is the total value of final goods and services produced in the
country during a year after deducting the depreciation, p lus net income from
abroad.
1.11.2 Net Domestic Products: -
NDP is obtained by subtracting the depreciation from the GDP. NDP
differs from MNP due to the net income from abroad. If the net income
from abroad is positive, NDP will be less than NNP If the net income
from abroad is negative, NDP will be greater than NNP NDP is also
calculated either at market price or at factor cost.
National Income at Factor Cost: - means sum total of all income earned
by resource suppliers for their contribution of land, labou r, capital and
entrepreneurial ability which go into the years net production. National
income at factor cost shows how much it costs society In terms of
economic resources to produce the net output. We use the term national
income for the national income at factor prices.
National Income at factor cost = Net national product ( National Income
at market prices) - (indirect taxes +Subsidies)
1.12 PERSONAL INCOME
Personal income is the sum of the income actually received by individuals or
households during a given year. Personal incomes earned are different from
national income. Some incomes which are earned such as social security
contributions corporate income taxes and undistributed corporate profits
are not actually received by households. In the same mann er, some incomes
which are received like transfer payments are not currently earned ex Old age
pension, unemployment compensation, relief payments interest
payments etc. To get personal income from national we must subtract
from National income the three t ypes of incomes which are earned but not
received and add incomes that are not currently earned, Personal income =
N.I. - Social Security - contributions - corporate income taxes -
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15 1.13 DISPOSABLE INCOME
The personal income which remains after payment of taxes to the
government in the form of income tax, personal property tax etc., is
called disposable income. Disposable income = Personal Income -
Personal Taxes. An individual can decide to consume or save t he
disposable income as he wishes.
Check Your Progress :
1. Generally three methods are use to calculate national Income -
Explain.
2. Distinction Between : NNP and NDP
1.14 METHODS OF MEASUREMENT OF NATIONAL
INCOME
For measuring national income, the economy throu gh which people
participate in economic activities, earn their livelihood, produce goods and
services and share the national products is viewed from three different
angles :
1. The national economy is considered as an aggregate of producing units
combinin g different sectors such as agriculture, mining,
manufacturing, trade and commerce, etc.
2. The whole national economy is viewed as a combination of individuals
and households owing different kinds of factors of production which
they use themselves or sel l factor services to make their livelihood.
3. The national economy may also be viewed as a collection of
consuming, saving and investing units (individuals, households and
government).
National income may be measured by three different corresponding
metho ds :
A) Net product method
B) Factor -income method
C) Expenditure method
1.15 NET OUTPUT OR VALUE ADDED MET HOD
It is also called the Value Added Method. It consists of three stages: i)
estimating the gross value of domestic output in the various branches of
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16 the depreciation of physical assets; iii) deducting these costs and
depreciation from gross value to obtain the net value of domestic output.
Measuring gross value : For measuri ng the gross value of domestic
product, output is classified under various categories and it is computed in
two alternative ways : i) by multiplying the output of each category of
sector by their respective market price and adding them together, or ii) by
collective data about the gross sales and changes in inventories from the
account of the manufacturing enterprises and computing the value of GDP
on the basis thereof. If there are gaps in data, some estimates are made
thereof and gaps are filled.
Estimati ng cost of production : is, however a relatively more complicated
and difficult task because of non -availability of adequate and requisite
data. Countries adopting net -product method find some ways and means to
calculate the deductible cost. The costs are estimated either in absolute
terms or as an overall ratio of input to the total output. The general
practice in estimating depreciation is to follow the usual business practice
of depreciation accounting.
Following a suitable method, deductible costs inclu ding depreciation are
estimated for each sector. The cost estimates are then deducted from the
sectoral gross output to obtain the net sectoral products. The net sectoral
products are then added together. The total thus obtained is taken to be the
measure of net national products or national income by net product
method.
1.16 FACTOR - INCOME METHOD
This method is also known as income method and factor -income method.
Under this method, the national income is calculated by adding up all he
―incomes accruing to the basic factors of production used in producing
the national product. The total factor -incomes are grouped under three
categories :
Labour income : included in the national income have three components :
a) wages and salaries paid to the residents of the country including bonus
and commission and social security payments; b) supplementary labour
incomes including employer‘s contribution to soc ial security and
employers welfare funds and direct pension payments to retired
employees; c) supplementary lab our incomes in kind, e.g. free health and
education, food and clothing, and accommodation, etc. Compensations in
kind in the form of domestic servants and other free -of-cost services
provided to the employees are included in labour income. War bonuses,
pensions, service grants, are not included in labour income as they are
regarded as transfer payments. Certain other categories of income, e.g.,
incomes from incidental jobs, gratuities, tips etc., are ignored for lack of
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Introduction
17 Capital income : According to S tudens ki, capital income include the
following capital earnings
Dividends excluding inter -corporate dividends;
Undistributed before -tax profits of corporations;
Interest on bonds, mortgages, and savings deposits (excluding interests on
war bonds, and on co nsumer -credit)
Interest earned by insurance companies and credited to the insurance
policy reserves;
Net interest paid out by commercial bank
Net rents from land, building, etc., including imputed net rents on owner -
occupied dwellings;
Royalties;
Profits o f government enterprises.
iii) Mixed income : include earnings from
Farming enterprises;
Sole proprietorship (not included under profit or capital income)
c) Other professions, e.g., legal and medical practices, consultancy
services, trading and transporti ng etc. This category also includes the
incomes of those who earn their living through various sources as wages,
rent on own property, interest on own capital, etc.
All these three kinds of incomes added together give the measure of
national income by fact or income method.
1.17 EXPENDITURE METHOD
Also known as final product method, measures national income at the final
expenditure stages. In estimating the total national expenditure, any of the
two following methods are follows;
First, all the money expendi tures at market price are computed and added
up together, and Second, the value of all the products finally disposed of
are computed and added up, to arrive at the total national expenditure.
The items of expenditure which are taken into account under the first
method are
Private consumption expenditure;
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18 Payments to the non -profit making institutions and charitable
organizations like schools, hospitals, orphanages, etc. , Private savings.
Under the second method, the following items are considered
Private consumer goods and services;
Private investment goods;
Public goods and services;
Net investment abroad.
The second method is more extensively used because the data required in
this method can be collected with greater ease and accuracy.
Treatment of Net Income from abroad :
Nowadays, most economies are open in the sense that they carry out
foreign trade in goods and services and financial transactions with the rest
of the world. In the process, some nations get net income through foreign
trade while some lose their income to foreigners. The net earnings or loss
in foreign trade affects the national income. In measuring the national
income, therefore, the net result of external transactions are adjusted to the
total. Net incomes from abroad are added to, and net losses to the
foreigners are deducted from the total national income arrived at through
any of the above three methods.
Briefly speaking, all exports of merchandise and of services like shipping,
insurance, banking, tourism and gifts are added to the national income.
And all the imports of the corresponding items are deducted from the
value of national output to arrive at the approximate measure of national
income. To this is added the net income fro m foreign investment. These
adjustments for international transactions are based on the international
balance of payments of the nations.
1.18 MEASUREM ENT OF NATIONAL INCOME IN
INDIA
In India, a systematic measurement of national income was first attempted
in 1949. Earlier, many attempts were made by some individuals and
institutions. The earliest estimate of India‘s national income was made by
Dadabhai Naoroji in 1867 -68. Since then many attempts were made,
mostly by economists and the government authoriti es to estimate India‘s
national income These estimates differ in coverage, concepts and
methodology and are not comparable. Besides, earlier estimates were
mostly for one year, only some estimates covered a period of 3 to 4 years.
It was therefore not poss ible to construct a consistent series of national
income and assess the performance of the economy over a period of time.
In 1949, a National Income Committee (NIC) was appointed with P.C.
Mahalnobis as its Chairman, and Dr. D.R. Gadgil and V.K.R.V. Rao as munotes.in

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Introduction
19 members. The NIC not only highlighted the limitations of the statistical
system of that time but also suggested ways and means to improve data
collection systems. On the recommendation of the Committee, the
Directorate of National Sample Survey was set up to collect additional
data required for estimating nation al income. Besides, the NIC esti mated
the country ’s national income for the period from 1948 -49 to 1950 -52. In
its estimates, the NIC also provided the methodology for estimating
national income, wh ich was followed till 1967.
In 1967, the task of estimating national income was given to the Central
statistical Organization (CSO). Till 1967, the CSO had followed the
methodology laid down by the NIC. Thereafter, the CSO adopted a
relatively improved met hodology and procedure which had become
possible due to increased availability of data. The improvements pertain
mainly to the industrial classification of the activities. The CSO publishes
its estimates in its publication, Estimates of National Income.
Methodology : - Currently, output and income methods are used by the
CSO to estimate the national income of the country. The output method is
used for agriculture and manufacturing sectors, i.e., the commodity
producing sectors. For these sectors, the value a dded method is adopted.
Income method is used for the service sectors including trade, commerce,
transport and government services. In its conventional series of national
income statistics from 1950 -51to 1966 -67, the CSO had categorized the
income in 13 se ctors. But, in the revised series, it had adopted the
following 15 break ups of the national economy for estimating the national
income;
Forestry and logging;
Fishing;
Mining and quarrying;
Large -scale manufacturing;
Small -scale manufacturing;
Construction ;
Electricity, gas and water supply;
Transport and communication;
Real estate and dwellings;
Public administration and Defenc e;
Other services;
External transactions.
National Income is estimated at both constant and current prices.


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20 Check Your Progress :
1. Write notes on the following :
Net output method
Factor income method
c) Expenditure method
1.19 SUMMARY
1. As macroeconomics deals with aggregate quantities of the economy as
a whole, it is also called as aggregative economics. Theories of
National Income , consumption, saving and investment, theory of
employment, theories of economic growth, business cycles and
stabilization policies, theories of money supply and demand and theory
of foreign trade broadly constitute the subject matter of
macroeconomics. Ma croeconomic theories are used in formulating
public policies. They provide clarity to the macroeconomic concepts
and quantities and bring out the relationship between macro variables
of the economy in the form of models or equations.

2. The circular flow of money refers to the process whereby money
payments and receipts of an economy flow in a circular manner
continuously over a period of time.

3. Product and money flow in opposite direction in a circular way. The
product flow consists of a) factor flow, that i s flow of factor services
and b) goods flow that is flow of goods and services. In a monetized
economy the flow of factor services generates money flows in the
form of factor payments which take the form of money flows. The
factor payments and expenditure on consumer goods and services take
the form of expenditure flow. Expenditure flow is in the form of
money flow. Both income and expenditure flow in a circular manner in
opposite direction.

4. In a two sector model of circular flow, the household and busines s
firms which represent a closed economy and there is no government
and no foreign trade. The household sector owns all the factors of
production that is land, labour, capital and enterprise. This sector
receives income in the form of rent, wages, interest and profit, by
selling the services of these factors to the business sector. The business
sector consists of producers who produce goods and sell them to the
household sector. The household sector consists of consumers who
buy goods produced by the busine ss sector.

5. In a three sector economy additional sector is government sector.
Government affects the economy in many ways. Government receives
income in the form of taxes from households and business firms.
Taxes are paid by the households and business fir ms which not only
reduces their disposable income but also their expenditure and savings. munotes.in

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Introduction
21 Governments’ spending includes expenditure on goods and services,
pension payments, unemployment allowance etc. Money spent by
Government is an injection of income i nto the economy which further
received by the households and business firms. Another important
method of financing Government expenditure is borrowing from
financial market. This is represented by money flow from the financial
market to the Government is l abeled as Government borrowing.

6. Four sector open economy the circular flow of income shows where
there are inflows and outflows of money, receipts and payments
among the business sector, the household sector, the government
sector, and the foreign sector in current s and cross - currents.

7. GNP is the total market value of all final goods and services produced
in a year plus net income from abroad. This is the basic social
accounting measure of the total output or aggregate supply of goods
and services.

8. GDP refers to the value of final goods and services produced within the
country in a, particular year. GDP is different from GNP.

9. Net national product is the total value of final goods and services
produced in the country during a year after deducting the de preciation,
plus net income from abroad.

10. NDP is obtained by subtracting the depreciation from the GDP.

11. Personal income is the sum of the income actually received by
individuals or households during a given year. Personal income = N.I -
Social Security - contributions - corporate income taxes -undistributed
corporate profit + Transfer Payments

12. The personal income which remains after payment of taxes to the
government in the form of income tax, personal property tax etc., is
called disposable income. Dispo sable income = Personal Income -
Personal Taxes.
13. National income may be measured by three different corresponding
methods :
A) Net product method
B) Factor -income method
C) Expenditure method


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22 1.20 QUESTIONS
1. Explain the scope and importance of macroec onomics.
2. Explain the circular flow of national income in a two sector economy.
3. Discuss the three sector model of circular flow of national income.
4. Briefly explain circular flow of national income in an open economy.
5. Explain various national income accounti ng concepts.
6. Differentiate between personal income and disposable income.
7. Describe various methods of measurement of national income.



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23 2
TRADE CYCLES
Unit Structure :
2.0 Objectives
2.1 Introduction
2.2 Features of Business / Trade Cycles
2.3 Phases pf Business Cycles
2.4 Introduction of the Classical Theory of Income and Employment
2.5 Say's Law of Market
2.6 Summary
2.7 Questions
2.0 OBJECTIVES
 To study various features of Trade cycle
 To understand different phases of trade cycles
 To understand the meaning of different phases of trade cycles
 To study classical theory of macroeconomics
2.1 INTRODUCTION
Business cycles / trade cycles a re inevitable in an economy. To study their
different phases and features therefore helps the economy to take remedial
measures to maintain economic stability.
National income and employment are macroeconomic concepts which
helps to achieve economic growt h and development of the country at a
faster rate. The views of classical economists are useful to understand
these concepts.
2.2 FEATURES OF BUSINESS / TRADE CYCLES
Though different business cycles differ in duration and intensity they have
some common fe atures which can explain below.
1. A business cycle is a wave like movement in macro economic activity
like income, output and employment which shows upward and
downward trend in the economy.
2. Business cycles are recurrent and have been occurring periodi cally.
They do not show some regularity. munotes.in

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24 3. They have some distinct phases such as prosperity, recession,
depression and recovery.
4. The duration of business cycles may vary from minimum of two years
to a maximum of ten to twelve years.
5. Business cycle s are synchronic. That is they do not cause changes in
any single industry or sector but are of all embracing character. For
example, depression or contraction occurs simultaneously in all
industries or sectors of the economy. Recession passes from one
industry to another and chain reaction continues till the whole
economy is in the grip of recession. Similar process is at work in the
expansion phase or prosperity.
6. There are different types of business cycles. Some are minor and others
are major. Minor c ycles operate for a period of three to four years and
major business cycles operate for a period of four to eight years.
Though business cycles differ in timing, they have a common pattern
of sequential phases.
7. Expansion and contraction phases of busin ess cycle are cumulative in
effect.
8. It has been observed that fluctuations occur not only in level of
production but also simultaneously in other variables such as
employment, investment, consumption, rate of interest and price level.
9. Another importa nt feature of business cycles is that downswing is
more sudden than the changes in upswing.
10. An important feature of business cycles is profits fluctuate more than
any other type of income. The occurrence of business cycles causes a
lot of uncertainty for business and makes it difficult to forecast the
economic conditions.
11. Lastly, business cycles are international in character. That is once
started in one country they spread to other countries through trade
relations between.
2.3 PHASES OF BUSINESS CYCLES
Business cycles have shown distinct phases, the study of which is useful to
understand their fundamental causes. Generally, a business cycle has four
phases.
1. Prosperity (Expansion, Boom, or Upswing)
2. Recession (upper turning point)

3. Depression (Cont raction or Downswing) and
4. Revival or Recovery (lower turning point) munotes.in

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Trade Cycles
25 The four phases of business cycle are shown in the following figure. It
starts from trough or lower turning point when the level of economic
activity is at the lowest level. Then it passe s through recovery and
prosperity phase, but due to the causes explained below the expansion
cannot continue indefinitely, and after reaching peak, recession and
depression or downswing starts. The downswing continues till the lowest
turning point and reac hes to trough. It is important to note that no phase
has any definite time period or time interval. Similarly any two business
cycles are not the same.
The prosperity starts at trough and ends at peak. The recession starts at
peak and ends at trough. One c omplete period of such movement is called
as a trade cycle.

Fig. 2.1
Four phase of trade cycles are briefly explained as follows.
1. Prosperity – Prosperity is ‘a stage in which the money income,
consumption, production and level of employment are high or rising and
there are no idle resources or unemployed workers.’
This stage is characterized by increased production, high capital
investment, expansion of bank credit, high prices, high profit, a high rate
of interest, full employment income, effective demand, inflation MEC,
profits, standard of living, full employment of resources, and overall
business optimism etc.
The prosperity comes to an end when forces become weak and therefore,
bottlenecks start to appear at the peak of prosperity. Due to high profit,
inflation and over optimism make the entrepreneurs to invest more and
more. But because of shortage of raw material and scarcity of factors of
production prices of goods and services rises. As a result there is fall in
demand and profit, business calculations go wrong. Thus their over
optimism is replaced by over pessimism. Thus prosperity digs its own
grave.
2. Recession - When the phase of prosperity ends, recession starts.
Recession is an upper turning point. This is a phase of contraction or
slowing down of economic activities. Recession is generally of a short
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Business Economics
26 After boom, demand falls, production becomes excess and investment
results in over investment. Finally, it leads to recession.
During this phase pro fit, investment and share prices falls significantly,
Because of lack of investment the demand for bank credit, rate of interest,
income employment, and demand for goods and services falls.
If recession continues for a long period of time then finally, it reaches to
the phase of depression.
3. Depression – It is a period in which business or economic activity in a
country is far below the normal. Depression is ‘a stage in which the
money income, consumption, production and level of employment falls,
idle r esources and unemployment increases.’
It is characterized by a sharp reduction of production, mass
unemployment, low employment, falling prices, falling profits, low wages,
and contraction of credit, fall in aggregate income, effective demand,
MEC, a high rate of business failure and atmosphere of all round
pessimism etc. The depression may be of a short duration or may continue
for a long period of time.
After a period of time, moderate increase in the demand for goods and
services helps to increase in inv estment, production, employment, income
and effective demand. Finally, it leads to recovery.
4. Recovery – Depression phase is generally followed by recovery.
Various exogenous and endogenous factors are responsible for reviving
the economy. When the econo my enters the phase of recovery, economic
activity once again gathers momentum in terms of income, output,
employment, investment and effective demand. But the growth rate lies
below the steady growth path.
Thus, a recovery phase starts which is called the lower turning point. It is
characterized by improvement in demand for capital stock, rise in demand
for consumption good, rise in prices and profits, improvement in the
expectations of the entrepreneurs, slowing rising MEC, slowly increasing
investment, r ise in employment, output and income, rise in bank credit,
stock market becomes more sensitive and revival slowly emerges etc.
The phase of recovery once started, it slowly takes the economy on the
path of expansion and prosperity. With this the cycle repe ats itself.
Check your Progress :
1. What is a business cycle? What are its different features?
2. What is a business cycle? Explain the di fferent phases of a trade cycle.

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27 2.4 INTRODUCTION OF THE CLASSICAL THEORY OF
INCOME AND EMPLOYMENT :
The study of classical theory of income and employment is essential
because some of the aspects of classical theory are more relevant to the
conditions prevailing in the developing countries. Classical theory
highlights those factors, which govern income and employmen t in these
countries. In fact Keynesian macro economic model is not able to explain
the conditions of unemployment and underemployment in less developed
countries. Hence it cannot explain the determination of income and
employment in such countries.
Hence it is necessary to study the classical theory
The classical theory of employment is a supply -oriented theory. It is the
product of an accumulation and refineme nt of ideas developed by the 18th
and 19th century economists. The classical economists were basi cally
concerned with the long run problem of growth of the economy's
production capacity and efficient allocation of the given resources at full
employment. The classical economists focused their attention more on the
supply side and demand side was neglec ted while discussing the growth
process. According to Adam Smith, Ricardo, Say, Mill and followers of
classical thought, except Malthus believed that there is no problem on the
demand side as the aggregate demand would always take care of itself.
Hence the main problem is that of supply rather than demand.
According to the classical economists if prices and wage rates were
flexible, there would be a built in tendency for the economy to operate at
full employment. As a result they ignored the problems of une mployment.
The classical economists focused on the following problems: -
1 The different types of goods and services that would be produced in
the economy
2. The allocation of productive resources among the competing firms and
industries. The classical eco nomists tried to find out the conditions
leading to the most efficient use and optimum allocation of the given
resources.
3 The relative price structure of different goods and factors
4 The distribution of real income among the productive factors. The
main postulates of the classical theory of employment are the
following.
1. Long term analysis
2 Full employment
3. Say's law of markets
4 interest Rate and Flexibility
5. Wage rate and Flexibility
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28 2.4.1 The Assumption of Full Employment: -
The classical econ omists believed in the prevalence of a stable equilibrium
at full employment as the normal characteristic in the long run. Any
deviation from this is abnormal under perfect competition in a free
capitalist economy, forces operate in the economic system whi ch tend to
maintain full employment without inflation. As a result, the level of output
is always at full employment with the optimum use of resources in the
long run. Full employment is a condition where there is absence of
involuntary unemployment to res tore full employment again.
The classical theory believed m full employment as a normal condition.
This was on certain basic assumptions. –
1. Say‘s law of market - .Supply creates its own demand according lo
Say's law. Hence there can never be any deficie ncy of demand.
2. Any unemployment that in the process of a competitive system is
automatically eliminated by the free market price system
2.5 SAY'S LAW OF MARKET
The belief of classical theory regarding the existence of full employment
in the economy is b ased on Say's Law put forward by a French economist
J B. Say. According to J. B. Say's law. "Supply creates its own demand".
This implies that any increase in production made possible by the increase
in the productive capacity or the stock of fixed capital will be sold in the
market. There will be no problem of lack of demand. This appears to be a
simple proposition. But it has a number of implications.
Say's law contends that the production of output in itself generates
purchasing power, equal to the value of that output, supply creates its own
demand. Production increases not only the supply of goods but by virtue
of the requisite cost payment to the factor of production, also creates the
demand to purchase these goods. Any production process has two effec ts:
1. As factors are employed in production process, income is generated in
the economy on account of the payment of remuneration to the factors of
production.
2. It results in the production of a certain level of output, which is supplied
in the market. According to Say's law additional output creates additional
incomes which creates an equal amount of extra expenditure.
A new production process, by paying out income to its employed factors
generates demand at the same time, as it adds to supply. Thus any increase
in production is followed by a matching increase in demand.
In the original form Say's law was applicable to a barter economy. In a
barter economy, people produce goods either to consume or to exchange
them for other products. In the process the aggregate demand for goods
equals the aggregate supply of goods. Hence there is no possibility of over
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Trade Cycles
29 Money is used only as a medium of exchange. The classical theorists
believed that m oney is neutral and does not influence the real process of
production and distribution. There is a circular flow of money from the
firm to house holds and from households to firms. The firm purchases
inputs for production. They pay in the form of wages, re nt, interest and
profits. This becomes the income of households. The households spend
their income on goods and services produced by firms. In this circular
flow there is no saving and hoarding. All income received is spent. In case
the household saves a p art of the income, the circular flow can still be
maintained if savings are equal to investment.
If there is a divergence between saving and investment, the equality is
maintained through the flexibility of money interest. Interest is a reward
for saving. Higher the interest, more are the savings and vice -versa. At the
same time, lower the interest rate, higher the demand for investment and
vice-versa. If I > S rate of interest will rise. Savings will also increase and
investment will fall till the two beco me equal.
2.5.1 Assumptions of the Law
The following assump tion forms the backbone of Say’ s law.
1. Optimum Allocation of Resources: - The resources are optimally
allocated in different channels of production on the basis of equality of
marginal products an d proportionality.
2. Perfect Equilibrium: - Demand and supply equilibrium leads to the
fixing of commodity price and factor prices.
3. Perfect Competition: - The commodity and the factor markets have
perfect competition as the market conditions.
4. There is a free enterprise or free market economy.
5. Laissez -faire policy of the government: - There is no government
intervention in the economic field. Laissez -fair policy leads to
automatic adjustment and smooth working of the market mechanism in
the capitalist system.
6. Elastic Market: - The market is very wide and spread out without
limits. Therefore as the output product increases, markets also expand.
7. Market Automatism: - A free market economy stimulates capital
formation. In an expanding economy, new work ers and firms will be
automatically absorbed into the production channels. There is no
displacement of workers or firm.
8. Circular Flow: - There is no break in the circular flow of income and
expenditure Income is automatically spent through consumption
expenditure, and investment expenditure.

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

Figure 2.2
2.5.2 Implications of Say’s Law: -
1. Automatic Adjustment of Full Employment - A free enterprise
economy automatically reaches a stage of full employ ment level. There
are no obstacles to full employment General employment and over
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Trade Cycles
31 2. Self-adjusting Mechanism: - Increase in supply will ensure an increase
in demand in the process of the functioning of a free capitalist economy
There is no need for government intervention.
3. Resource adjustment and utilisation of resources take place
automatically in an expanding capitalist economy. When new workers and
firms start operating, they also help to produce additional output and
income . The entire economy becomes richer with the increased National
Income. The unused and new resources are also productively employed in
such a way as to benefit the whole society.
4. Money plays a passive role. It is only a medium of exchange to
facilitate transactions. Behind the flow of money, there is a real flow of
goods and services, which is important. As a result, changes in the supply
of money has no effect on the economy‘s process of equilibrium at full
employment level.
5. A free enterprise econom y under Laissez -faire policy has built in
flexibility. Market mechanism helps in optimum adjustments in the
economy.
6. Rate of interest is an equilibrating factor in classical theory. Flexible
interest rates lead to equilibrium between savings and investm ent.
2.5.3 Criticism: -
J.M. Keynes vehemently criticized the classical theory. The assumptions
on which the classical theory is based can be criticized The Great
Depression of 1930's has revealed the weaknesses of the classical theory.
The classical theor y could not suggest a solution to the problem of a
depressed economy facing large scale unemployment.
1. Unrealistic Assumptions at Full Employment: - According to Keynes.
The basic assumption of full employment itself is unrealistic. An
economy can be in a state of equilibrium. In under employment
situation also full employment equilibrium is just one possible
equilibrium condition according to Keynes.
2. Too much emphasis on Long Run: - Keynes gave importance to the
short run According to him. In the long r un, we are all dead.
3. Keynes refuted Say's Law of Markets: - According to Keynes, the
classical economists failed to examine the level of aggregate demand.
Supply may not create demand. Over production is a possibility and
reality according to Keynes. Sup ply can exceed demand. Hence
automatic self adjusting mechanism will not work.
4. Interest is not an equilibrating factor: - Keynes attacked the classical
theory in regard to savings and investment. Flexible interest rates will
not lead to equilibrium savin gs and investment. Changes in income
bring about the equilibrium between savings and investment according
to Keynes. munotes.in

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Business Economics
32 5. Role of money is neglected: - The classical economists considered
money as a veil. It s role is neutral. Keynes recognized the importance
of precautionary measures and speculative demand for money He also
recognized the effect of money on output, incomes, employment.
6. Keynes attacked the Laissez faire policy of classical economists. In the
conditions -of the modern world, state interventio n is necessary to
solve the problem of unemployment. Government spending, taxation
and borrowing are important instruments to increase employment and
income in an economy.
7. Wage cut policy is not practical. Due to the strong trade unionism it is
not pos sible to cut wage rates as suggested by the classical economists
as a remedy to employ more workers. A wage cut may in fact lead to
reduced purchasing power with workers which will lead to reduced
effective demand for products. This will adversely affect t he levels of
employment. Hence a general wage cut will lead to reduced volume of
employment. The workers will revolt if the money wages are cut. This
is due to money illusion.
8. The classical system will work only if there is perfect competition. In
such a case there should not be trade unionism, wage legislation etc.
But in. reality, all these factors exist. Hence classical theory will not
become applicable.
Check Your Progress :
1. Examine the statement : The classical theory was a supply oriented
theor y.
2. What are the main postulates of classical theory of employment?
3. State the assumptions of Say s Law of Markets.
2.6 SUMMARY
1. Though different business cycles differ in duration and intensity they
have some common features.
2. A business cycle has fou r phases.
 Prosperity (Expansion, Boom, or Upswing)
 Recession (upper turning point)
 Depression (Contraction or Downswing) and
 Revival or Recovery (lower turning point)
3. Prosperity is a stage in which the money income, consumption,
production and level of em ployment are high or rising and there are no
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33 4. When the phase of prosperity ends, recession starts. Recession is an
upper turning point. This is a phase of contraction or slowing down of
economic activities. Recession is generally of a short duration.
5. Depression is a stage in which the money income, consumption,
production and level of employment falls, idle resources and
unemployment increases.
6. When the economy enters the phase of recovery, economic activity
once again g athers momentum in terms of income, output,
employment, investment and effective demand.
7. The belief of classical theory regarding the existence of full
employment in the economy is based on Say's Law put forward by a
French economist J B. Say. According to J. B. Say's law. "Supply
creates its own demand". This implies that any increase in production
made possible by the increase in the productive capacity or the stock
of fixed capital will be sold in the market. There will be no problem of
lack of demand.
2.7 QUESTIONS
1. What are the features of trade cycle?
2. What is a business cycle? Explain the different phases of a trade cycle.
3. Explain classical macroeconomics with special reference to Say’s Law
of Markets.
4. State and explain the Say’s Law of markets.



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34 MODULE 2
3
MONEY, PRICES AND INFLATION -I
Unit Structure :
3.0 Objectives
3.1 Introduction
3.2 Concept of Money Supply
3.3 Constituents of Money Supply
3.4 Determinants of Money Supply
3.5 Velocity of Circulation of Money
3.6 Meaning of Money
3.7 Keynes’ Theory of Demand for Money
3.8 The Liquidity Preference Theory of Interest
3.10 Friedman’s Theory of Demand for Money
3.10 Questions
3.11 Summary
3.0 OBJECTIVES

 To understand the concept, constituents and determinants of money
supply
 To study the concept of velocity of circulation of money
 To study Keynesian theory of demand for money
 To study Keynesian Liquidity Preference Theory of rate of Interest
 To study Friedman’s theory of demand for money
3.1 INTRODUCTION
In this module we will study the concepts an d theories rated to money as
one of the important aspect in macroeconomics. What are the constituents
of money supply, what factors determine the supply of money in an
economy, and the Keynesian and Friedman’s approach to demand for
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35 3.2 CONCEPT OF MONEY SUPPLY
Money supply refers to the amount of money which is in circulation in
an economy at any given time. It is the total stock of money held by
the people consisting of individuals, firms, State and its constituent
bodies e xcept the State treasury, Central Bank and Commercial
Banks . The cash balances held by the Federal and federating
governments with the Central Bank and in treasuries are not considered as
part of money supply because they are created through the administr ative
and non -commercial operations of the government. Further money supply
refers to the disposable stock of money. Therefore money supply is stock
of money in circulation. Money supply can be looked at from two points
of views, namely, money supply as a stock and money supply as a flow.
Thus at a given point of time, the total stock of money and the total supply
of money is different. Money supply viewed at a point of point is the
stock of money held by the people on a given day whereas money supply
viewed overtime is viewed as a flow. Units of money are spent and re -
spent several times during a given period. The average number of times
a unit of money circulates amongst the people in a given year is
known as Velocity of Circulation of Money. The f low of money is
measured by multiplying the stock of money with the coefficient of
velocity of circulation of money.
3.3 CONSTITUENTS OF MONEY SUPPLY
There are two approaches to the constituents of money supply. They are
the traditional and the modern approaches.
1. Traditional Approach: According to the traditional approach, the
money supply consists of currency money consisting of coins and
notes and bank money consisting of checkable demand deposits with
commercial banks. The currency money is consid ered high powered
money because of the legal backing of the State. The Central Bank of
a country issues currency notes and coins because it has the monopoly
of note and coin issue. The supply of money in a country depends
upon the system of note issue ad opted by the country. For instance,
India adopted the Minimum Reserve System in 195 3. Under this
system, the Reserve Bank of India has to maintain a minimum reserve
of Rs .200 Crores consisting of gold and foreign securities. Out of this,
the value of gold should not be less than Rs .115 Crores. With this
reserve s, the Reserve Bank of India has the power to issue unlimited
amount of currency in the country.
Checkable demand deposits of commercial banks are used in the
settlement of debt. Payments made through checks change the volume
of demand deposits by creating derivative deposits. The creation of
demand deposits is determined by the credit creation activities of the
commercial banks. Bank money is considered as secondary money
whereas cash money is known as high powered money. Thus
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36 sum of high powered money and secondary money or currency and
bank money. The ratio of bank money to currency money depends
upon the extent of monet ization, banking habits and banking
development in a country. In advanced countries, ratio of bank money
to currency money is high whereas in poor countries the ratio of
currency money to bank money is high.
2. The Modern Approach: According to the modern approach, money
supply includes currency money and near money. Money supply
therefore consists of coins, currency notes, demand deposits of
commercial banks, time deposits of commercial banks, financial
assets, treasury bills and commercial bills of excha nge, bonds and
equities.
RESERVE BANK OF INDIA’S APPROACH TO THE
MEASUEMENT OF MONEY SUPPLY:
According to the Reserve Bank of India since its inception in 1935, money
supply in the narrow sense of the term was the sum of currency with the
people and demand deposits with the commercial banking system.
Narrow money was denoted by the RBI by M 1. In 1964 -65, the concept of
broad money or aggregate monetary resources was introduced. Broad
money was considered equal to M 1 + Time deposits with commercial
banks. In March, 1970 the RBI accepted the report of the Second
Working Group on Money Supply. This report was published in the year
1977 and it gave a broad definition of money supply. Accordingly, four
measures of money supply were brought into effect.
These four measures are as follows:
1. M 1 = Currency with the public + Demand deposits with the
commercial Banks + Other deposits with the RBI.
2. M 2 =M1 + Post Office Savings Bank Deposits.
3. M 3 =M1 + Time deposits with the commercial banks.
4. M 4 =M3 + Total Post Office Deposits (excluding NSCs).
The Reserve Bank of India gives importance to narrow money (M 1) and
broad money (M 3). Narrow money excludes time deposits because they
are not liquid and are income earning assets while broad money include s
time deposits because some liquidity is involved in it as these assets earns
interest income in future. Since time deposits have become convertible in
recent times, they have become more liquid than what they were before.
The M 2 and M 4 measures of mone y supply include post office savings and
other deposits with the post offices.
The third working group on money supply recommended the
following measures of monetary aggregates through their report
submitted in 1998:
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37 1. M0 =Currency in circulation + Bank ers’ deposits with the RBI +
Other deposits with the RBI. (M 0 is compiled on weekly basis).
2. M 1 =Currency with the public + Demand deposits with the banking
System + Other deposits with the RBI = Currency with the
public + Current deposits with the banking system + Demand
liabilities Portion of Savings Deposits with the banking system +
other Deposits with the RBI.
3. M 2 = M1 + Time liabilities portion of saving deposits with the
banking System + Certificates of deposits issued by the banks +
Term D eposits [excluding FCNR (B) deposits] with a contractual
maturity of up to and including one year with the banking system
=Currency with the public + current deposits with the banking
System + Savings deposits with the banking system +
CertificatesOf Depos its issued by the banks + Term deposits
[excluding
FCNR (B) deposits] with a contractual maturity up to and including one
year with the banking system + other deposits with the RBI.
4. M 3 = M2 + Term deposits [excluding FCNR (B) deposits] with a
Contract ual maturity of over one year with the banking system
+Call borrowings from Non -depository financial corporations by
the Banking system. (M 1, M2 & M 3 are compiled every
fortnight).
In addition to the monetary measures stated above, the following liquidity
aggregates to be compiled on monthly basis were also recommended by
the working group:
1. L1 =M 3 + All deposits with the Post Office Savings Banks
(excluding National Savings Certificates).
2. L2 = L 1 + Term deposits with Term lending institutions and
refinancing Institutions (FIs) + Term borrowing by FIs + Certificates of
Deposits issued by FIs.
3. L3 =L2 + Public deposits of Non -banking Financial Companies.
(L3 is compiled on quarterly basis).
3.4 DETERMINANTS OF MONEY SUPPLY
Currency in circulation and demand deposits are the main constituents of
money supply. While the demand deposits are created by the commercial
banks, currency is issued by the Central Bank and the Government. The
supply of money is determined by the following factors:
1. Size of the Monetary Base: Money supply depends upon the size of
the monetary base. The monetary base refers to the group of assets
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38 Money supply changes with changes in the monetary base. The
monetary base of an economy consists of monetary gold stock, reserve
assets such as government securities, bonds and bullion, foreign
exchange reserve with the central bank and the amount of central
bank’s credit outstanding. In the present times, gold stoc k is not
considered as part of the monetary base.
2. Community’s Choice: The relative amount of cash and demand
deposits held by the people also influences the supply of money. If
the people prefer to make check payments much more than cash
payments, the total money supply maintained by a given monetary
base would be larger and vice versa. Since money deposited in
commercial banks generates derivative deposits and expand the supply
of bank money through the credit multiplier, people’s preference of
bank m oney to cash would increase the supply of money. However,
the choice of the community is determined by factors such as banking
habits, per capita income, availability of banking facilities and the
level of economic development. If these factors are devel oped, the
money supply would be larger and vice versa.
3. Extent of Monetization: Monetization refers to the use of money as a
medium of exchange. The choice of the community for money as a
liquid asset depends upon the extent of monetization of the economy.
If monetization is high, demand for money would be high and vice
versa.
4. Cash Reserve Ratio: The Cash Reserve Ratio refers to the ratio of a
bank’s cash holdings to its total deposit liabilities. It determines the
coefficient of the credit multipli er. The CRR is determined by the
Central Bank of a country. The credit multiplier (m) is determined as
the reciprocal of the CRR (r). Therefore m = 1/r. Excess funds with
the commercial banks multiplied by the credit multiplier will give us
the exten t of credit creation by the commercial banks. Lower the
CRR, greater will be value of the credit multiplier and therefore
greater will be the supply of bank money and vice versa.
5. Monetary Policy of the Central Bank: Monetary policy is defined as
the polic y of the Central Bank with regard to the cost and availability
of credit in the economy. The monetary policy of the Central Bank of
any country will be according to the macro -economic conditions.
Thus under inflationary conditions, the Central Bank may f ollow
restrictive monetary policy and thereby reduce the supply of bank
money by pursuing both qualitative and quantitative measures of
controlling money supply. Similarly under recessionary conditions the
Central Bank may follow expansionary monetary pol icy and thereby
raise the supply of money in the economy.
6. Fiscal Policy of the Government: Fiscal Policy is defined as a policy
concerning the income and expenditure of the government. While the
government raises revenue through various sources like diff erent types
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39 raised for various developmental and non -developmental purposes.
When the government raises revenue by imposing fresh taxes or by
raising the existing level of taxes, it he lps to reduce money supply.
Similarly, market borrowing by the government reduces money supply
and raises the market interest rates. This is known as the crowding out
effect of government borrowing. When the government spends the
money so raised, money supply increases. However, when the
government runs a deficit budget, it adds to the existing stock of
money supply and thus raises the supply of money in the economy.
The opposite will be the impact of a surplus budget but surplus
budgets are a rari ty in modern times.
7. Velocity of Circulation of Money: Velocity of circulation of money
refers to the average number of times a unit of money as a medium of
exchange changes hands during a given year. Money supply is
measured as total money in circulati on multiplied by the velocity of
circulation (M V). Thus higher the velocity of circulation of money,
higher will be the money supply and vice versa.
3.5 VELOCITY OF CIRCULATION OF MONEY
The velocity of circulation of money determines the flow of money su pply
in an economy in a given period of time, normally such a period is one
year. The average number of times a unit of money changes hands is
known as the velocity of circulation of money. The supply of money in a
given period is obtained by multiplying the money in circulation with the
coefficient of velocity of circulation i.e., M  V where M refers to the total
amount of money in circulation and V refer to the velocity of circulation
of money in the given period.
Factors Determining Velocity of Circul ation of Money: The velocity of
circulation of money is determined by the following factors:
1. Time Unit of Income Receipts: The more frequently people
receive income, the shorter will be the average time period of
holding money and greater will be the vel ocity of circulation of
money. Thus if in a given society large number of people receive
income on daily basis, the velocity of circulation of money would be
higher than the one in which people receive income on weekly,
fortnightly or monthly basis.
2. Metho d and Habits of Payment: The velocity of circulation of
money would be high if large number of people pr efers to make
payment on instal ment basis. As a result, the same unit of money
will change hands more often than when payments are made in full.
3. Regularity of Income Receipts: If in a society people receive
income on a regular basis, they will spend their current income
without bothering about future and hence the velocity of circulation
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40 uncertain, people will not spend more money in the present and
hence the velocity will be less.
4. Saving Habits of the People: If the marginal propensity to save is
high in a society, then the people will be spending less in the present
and hence the velocit y will be less. Similarly, if the marginal
propensity to consume is high the people will spend more and the
velocity of circulation of money will be high.
5. Income Distribution: Income distribution may be more equal or
more unequal in a society. If inequal ities of income are high in a
society with the top 20 % taking away a major portion of the national
income, velocity of circulation of money would be low because the
richer sections of the society will be holding more idle cash
balances. However, if incom e distribution is more equal or less
unequal, the bottom 40% of the people will receive more incomes
and spend more thereby increasing the velocity of circulation of
money.
6. Development of Banking and Financial System : If the banking
and financial instituti ons in a country are well developed,
mobilization of savings can be effectively carried out and more
credit made available to the needy. This not only prevents hoarding
of cash balances but also increases the velocity of circulation of both
currency and b ank money.
7. Business Cycle: During the prosperity phase of the business cycle,
investment, output, income, employment and prices rise. Thus the
velocity of circulation of money would be high during the prosperity
phase. However, during the downturn of t he business cycle,
investment, output, income, employment and prices begin to decline
thereby reducing the velocity of circulation of money.
8. Liquidity Preference of the People: If the liquidity preference of
the people is high i.e., if they wish to hold a greater part of their
income in the form of idle cash balances, the velocity of circulation
of money would be low and vice versa.
9. Speedy Clearance of Checks and Transfer of Funds: A more
advanced banking system would help speedy clearance of checks
and tr ansfer of funds from one account to another account, thereby
increasing the velocity of circulation of money.
3.6 MEANING OF MONEY
Money is defined in Economics as ‘anything that is generally accepted
in payment for goods and services as a medium of exch ange.’ Money
consists of currency and checkable demand deposits. Money is different
from income and wealth. While income refers to a flow of purchasing
power which is used to make payments for the services obtained from the
factors of production, wealth is a stock of accumulated purchasing power.
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41 time, wealth is a stock variable that is measured at a given point of time.
While income is generally in the form of money and income in t he form of
money is known as nominal income, income in the form of goods and
services is known as income in kind or real income. Real income is also
measured in terms of constant prices. Wealth can be held in the form of
monetary assets. Saving is the primary source of wealth. Money is the
most liquid asset. The liquidity of assets refers to the ease with which an
asset can be converted into a medium of exchange. Assets are classified
as either financial assets or real assets and are ranked according to their
liquidity. Currency, checkable deposits, savings deposits are the examples
of liquid financial assets. Stocks and bonds are relatively less liquid
financial assets. Precious metals like silver, gold, platinum etc are liquid
real assets. Artwo rk, machinery and real estate are the examples of less
liquid real assets. The liquidity of an asset is determined by the following
factors:
1. Existence of a well established market in which the asset can be
quickly sold.
2. Size of transaction costs (br okers fees, time costs)
3. Stability of the asset’s price.
The price of a rupee is always a rupee. The prices of other assets
measured in terms of money generally fluctuate. However, the value of a
rupee is not fixed as it is measured in terms of purchas ing power. For
instance, at current prices a potato vada would cost you Rupees Ten a
piece. In 1974 when I was studying in the fifth standard, Rupees Ten
would fetch me 100 pieces of potato vada and with that money I could
have arranged a potato vada par ty for 100 students. (The value of money:
Vm = 1/P, where ‘P’ stands for price level.
3.6.1 FUNCTIONS OF MONEY:
Money is a matter of functions four: medium, measure, standard and store.
Money therefore has four important functions.
1. Medium Of Exchange: Money functions as a medium of exchange
and hence permits a time interval between buying and selling goods
and services. M oney replaces barter where goods or services are
traded directly for other goods or services. Barter does not provide a
time interval b etween buying and selling goods and services. Money
eliminates the need for a double coincidence of wants. For instance, a
farmer who has jowar in his stocks and wants to trade it for wheat
must find a person who has wheat and also wants to trade wheat f or
jowar. Money greatly improves the efficiency of transactions by
reducing transactions costs. In a barter economy, transaction costs
would include cost of search. The cost of search is eliminated in a
monetary economy. In a monetary economy, the farm er only needs to
find a person who wants to buy jowar and has the purchasing power to
pay for it. The farmer need not be bothered if the person has wheat
and is willing to trade wheat for jowar. The need for double co -
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42 2. Unit of Account: A unit of account is a standard numerical unit of
measurement of the market value of goods, services and other
transactions. It is also known as a "measure" or "standard" of relative
worth and deferred payment. Money a s a unit of account is essential
for entering into commercial agreements that involve debt and future
payments. Money is divisible into small units without destroying its
value. Precious metals can be coined from bars and melted down to
bars again. Mon ey is fungible, i.e. , one unit or piece must be
perceived as equivalent to any other commodity or service. Hence
diamonds or works of art are not suitable as money. A specific
weight, or measure, or size must be verifiably countable. For instance,
coins a re often made with ridges around the edges so that any removal
of material from the coin leading to fall in its intrinsic value will be
easy to detect . The unit of account is the unit in which values are
stated, recorded and settled. Money is a means of m easuring and
recording value. Wheat is measured in kilograms. Distance is
measured in kilometers. Value is measured in units of money. In
barter, the value or price of every good and service must be measured
in terms of the value of every other good and service. In a barter
economy with only 100 goods there would be: [(N(N -1))/2] = 4950
prices. However, in a monetary economy with only 100 goods, there
would be only 100 prices. At current prices, a kilogram of wheat
would be accounted in the range of Rs. 25 to Rs.35 and a kilogram of
rice would be accounted in the range of Rs.30 to Rs.50.
3. Store of Value: Since money, as a medium of exchange, represents
purchasing power, it can be stored and used in the future. Money is a
store of value but it is not usual ly a good store of value. During
inflation, money looses its value. The value of money is inversely
related to the price level. Higher the price level, lower will be the
value of money and vice versa. Symbolically, the value of money can
be found out with the following formula:
Vm=1/P
Assuming the price level to be 100, the value of Rs. 100 would be 100.
If the price level goes up to 200, the value of Rs. 100 would be only
50. Money may therefore not be acceptable as a store of value during
periods of high inflation. Instead, people may prefer to store value in
the form of gold and real estate.
4. Standard of Deferred Payments: Deferred payment means future
payments. Money is used as a standard of deferred payments and
hence debt contracts are si gned in monetary terms. Loans and future
payments are agreed and contracted in monetary terms as money units
are accepted as the means of settling future accounts. However, during
periods of very high inflation, money may not be used as a standard of
deferred payments because the future value of present money is
inversely related to the general price level i.e. when the price level
goes up, the value of money falls. Thus during inflationary periods,
money may be used as a medium of exchange but not as a standard of
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43 3.7 KEYNES’ THEORY OF DEMAND FOR MONEY
Keynes put forward his theory of demand for money in his famous work
“The General Theory of Employment, Interest and Money” (1936).
According to Keynes, people hold cash balances on acc ount of three
reasons or motives. These are the transaction motive, the precautionary
motive and the speculative motive. Accordingly the demand for money
can be separated into three parts namely transaction demand,
precautionary demand and speculative de mand for money. The total
demand for money or cash balances can be divided into two namely;
active and idle cash balances.
Active Cash Balances:
Demand for active cash balances is divided into transaction and
precautionary demand for money. The transac tion demand for money
arises due to the fact that money is a medium of exchange. Further
receipts and payments do not take place simultaneously. There is always a
time gap between two successive receipts and payments are an ongoing
affair in the routine course. Hence people need to hold cash balances to
pay for their regular transactions. According to Keynes, transaction
motive for holding money is the need of cash for the current transactions
of personal and business expenditure. Therefore, households and firms
hold money on account of the transaction motive. Their respective
transactions motives can be referred to as income and business motives.
The income motive refers to the transaction motive of households.
Families hold cash balances to execute routine transactions. Household
demand for money depends upon the following factors:
1. The Level of Income : Transaction demand for money by the
households is directly related to the level of income, i.e. higher the
level of income, higher will be the tra nsaction demand for money and
vice versa.
2. The Price Level : Higher the price level, higher will be the
transaction demand for money and vice versa. When prices rise, more
money will be required to purchase the same quantity of goods and
services and henc e the transaction demand for money would rise when
prices rise.
3. The Spending Habits : If the people in a society are thrifty, they
would require less money for transactions purposes. However, if large
number of persons in a society is spendthrift, they w ould require more
money for transaction purposes.
4. The Time Interval: If the time interval between two successive
income receipts is big, then the people will hold larger cash balances
under transaction motive and vice versa.
Similarly, firms need cash ba lances to pay for raw materials, transport,
wages and salaries and other payments. Cash balance held by firms to
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44 quantum of money held under business motive is directly related to t he
turnover of firms i.e. larger the turnover, larger will be the amount of
money held under business motive.
Transactions demand for money is therefore the sum of money held under
income motive and business motive. It is income determined and remains
stable in the short run because income change takes place only in the long
run. Transactions demand for money is an increasing function of income.
Symbolically, the transactions demand for money function can be stated as
follows: -
Lt = f (Y)
Wher e; L t = Liquidity preference under transactions motive.
Y = Level of national income.
People also hold cash balances to provide for unforeseen requirements.
The amount of cash balances held by people to provide for unforeseen
requiremen ts is referred to as precautionary demand for money or money
held under precautionary motive. Sickness, unemployment, death,
accidents etc are some of the unforeseen events which may take place in
the lives of people. The precautionary demand for money d epends upon
uncertainty of future receipts. It is directly related to income and
relatively stable. The precautionary demand for money is interest inelastic
and changes in response to changes in uncertainty. Symbolically, the
precautionary demand for mo ney can be stated as follows:
Lp = f (Y)
Where; L p = Liquidity preference under precautionary motive.
The transaction and precautionary demand for money cannot be easily
separated in practice and since both the money demand functions are
income d etermined and also interest inelastic, they are collectively known
as active balances . Symbolically, the demand for active balances can be
stated as follows:
L1 = Lt + L p
Both transaction and precautionary demand for money is income
determined, we can restate the money demand function for active balances
as follows:
L1=f (Y)
The demand for active balances is graphically depicted in Fig. 3.1 below.
You will notice that at income level OY 1, OM 1 is the demand for active
cash balances. When income level rises to OY 2, the demand for active
cash balances also rises to OM 2. The demand for active cash balances is
proportionate to changes in income.
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45 Y

L1 = L t + L p



M2


M1





O Y1 Y 2 X

Income
Fig. 3.1: Demand for Active Cash Balances

Idle Cash Balances (Speculative Demand for Money):
The cash balances held by people for speculative purposes are known as
demand for idle cash balances. The speculative motive for holding cash
balances originates from uncertainty about the future rate of interest.
Speculative demand for money arises because of the store of value
function of money. The speculator holds cash balances in order t o make
speculative gains from investment in securities. According to Keynes,
investors make capital gains by speculating in securities or bonds. The
speculative demand for money depends upon the rate of interest. The
demand for speculative cash balances is inversely related to the rate of
interest. When people expect the prices of income yielding assets such as
bonds to fall, the speculative demand for money rises and vice versa.
Symbolically, the speculative demand for money can be stated as follows
L2=f (i)
Where; L 2 = Speculative demand for money.
I = Rate of interest.
The opposite relationship between rate of interest and speculative demand
for money is shown in Fig. 3.2 below:





Demand for Money
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46 Y

20%








2% Liquidity Trap L 2



O X
Speculative Demand for Money
Fig. 3.2: Demand for Idle Cash Balances
You will notice that the speculative demand for money is inversely related
to the rate of interest. When the rate of interest falls, the speculative
demand for money rises and vi ce versa. Speculative demand for money is
therefore highly interest elastic. However, at a very low interest rate, the
speculative demand for money becomes perfectly elastic i.e., the entire
income is held in the form of idle cash balances. This is due to the fact
that bond prices and interest rates move in opposite directions. When the
interest rate rises, the bond or security prices fall and vice versa. The
speculative demand for money is also income determining and not income
determined as in the ca se of transaction and precautionary demand for
money. When the interest rate is expected to rise, people prefer to hold
cash balances at the current interest rate so that they can take advantage of
a rise in interest rate in the future. When speculative demand for money is
rising, it indicates a greater preference for liquidity.
The Concept of Liquidity Trap:
At a very low rate of interest, the speculative demand for money is
perfectly elastic i.e., the entire income is held by people in the form of
cash balances for speculative purposes. In the situation of liquidity trap,
percentage change in the demand for money in response to a percentage
change in the rate of interest is equal to infinity. Symbolically, the
liquidity trap situation can be stated as follows:
M  i  
M i
You will notice that the L 2 curve in Fig.5.2 shows the liquidity preference
under the speculative motive at different rates of interest. At a very high
interest rate of 20%, the speculative demand for mon ey is very low and
vice versa. However, when the interest rate is only 2%, the speculative
demand for money becomes perfectly elastic. At this point, any increase
Rate of Interest
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47 in money supply or income will be held by the people in the form of idle
cash balances. In the diagram, the liquidity trap situation is shown by
highlighting the horizontal segment of the liquidity preference curve. The
liquidity trap situation arises because at very low rate of interest, the
opportunity cost of holding cash balances is neglig ible and that in future
the opportunity cost of holding cash balances is expected to rise.
Aggregate Demand for Money:
The aggregate or total demand for money is the sum of transaction,
precautionary and speculative demands for money. Symbolically, the
aggregate demand for money can be stated as follows:
L=L 1  L2
Where; L=Aggregate demand for money.
The functional relationship between aggregate demand for money and the
determining variables: nominal level of aggregate income and the rate of
interes t can be stated as follows:
L=f (Y, i)
The liquidity preference schedule of a community can be obtained by
superimposing the L 1 curves at each level of income on the L 2 curves.
The liquidity preference schedule of a community is shown in Fig. 3.3
below.
In Fig. 3.3, Panel (A) shows the schedule of active balances (the sum of
transaction and precautionary demand for money) held by people at
different levels of income. The demand for active balances is perfectly
inelastic to changes in interest rate in the s hort run and changes
proportionately to the changes in the level of income. Accordingly, L 1
(Y1) shows the demand for active cash balances at Y 1 level of income and
so on and so forth. The L 1 curves are vertically sloping because they are
interest -inelas tic. In Panel (B), the L 2 curves shows demand for idle cash
balances or speculative demand for money. You will recall that
speculative demand for money is interest -elastic and inversely related to
the rate of interest. Hence the L 2 curve is downward slop ing. However, at
a very low rate of interest, it becomes horizontal indicating that the entire
income is held in the form of idle cash balances. In Panel (C), the
liquidity preference curve indicating total demand for money is shown. It
is the result of super -imposition of the L 1 curves on the L 2 curves.
Accordingly, the curves L(Y 1), L(Y 2) and L(Y 3) are obtained and they
represent the liquidity preference schedules of the community at various
levels of interest rates and national income.
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48

Fig. 3.3: T otal Demand for Money
THE LIQUIDITY PREFERNECE THEORY OF INTEREST
3.8 THE LIQUIDITY PREFERNECE THEORY OF
INTEREST
According to Keynes, the rate of interest is determined by the demand for
and supply of money. Interest is the reward for lending liquidity o r
temporarily giving up cash balances held by the people. Symbolically, the
rate of interest can be stated as follows:
Ri = f (D M, SM)
Where, Ri = Rate of interest.
DM = Demand for money, and
SM = Supply of money.
The demand for money can be expressed in the form of a liquidity
preference schedule. Further, the demand for money as stated earlier is
the sum of demand for active and idle cash balances. While the demand
for active cash balances is determined by the transaction and preca utionary
motives, the demand for idle cash balances is determined by speculative
motive. There is a direct relationship with the demand for active cash
balances and the level of income. Whereas, the demand for idle cash
balances is inversely related to t he rate of interest. The total demand for
money can be symbolically stated as follows:
L = L1  L2
Where; L = Aggregate demand for money.
L1 = Demand for active cash balances.
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49 The total demand for money can t herefore be symbolically re -stated as
follows:
L = f (r, y)
Where L = Aggregate demand for money.
r = Rate of interest.
y = Level of national income.
DETERMINATION OF THE RATE OF INTERST:
The equilibrium rate of interest is determined by the intersec tion between
the demand curve for and supply curve of money. The supply of money is
determined and controlled by the monetary authority and the banking
system. At any time, the stock of money is fixed. The supply of money is
a stock rather than a flow. Hence, it is represented by a vertical straight
line. The money held by all the people in the country is the total supply of
money held as shown in Figure 3.4. In this figure, OM is the supply of
money. SM is the vertical supply curve of money and LP is the demand or
liquidity preference curve. They intersect with each other at point E. EM
or OR is the equilibrium rate of interest. It shows that the demand for
money is exactly equal to the supply of money. Any change in the
demand or supply of money will bring about a change in the rate of
interest. If the supply of money alone increases, the equilibrium rate of
interest would fall and vice versa. This is shown in Figure 5.5. It can be
seen in this figure that the original equilibrium rate of inter est is OR. The
original supply of money is OM. When the supply of money alone
increases to OM 1, the equilibrium rate of interest would fall to OR 1 and
vice versa. On the supply side, the rate of interest is influenced by the
supply of money. By control ling the supply of money, the monetary
authority can influence the rate of interest and the liquidity preference.
Y S






R E


LP



O M X


Fig. 3.4 – Determination of Interest Rate Rate of Interest
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50
Y S 1 S2






E1
R1

R2 E2 LP1



O M 1 M2 X

.
Fig. 3.5 (A) – Changes in the Rate of Interes t

Y
S1



R2 E2



R1 E1 LP2


LP1



O M 1 X
.

Fig. 3.5 (B) – Changes in the Rate of Interest

CRITICAL ANALYSIS OF THE LP THEORY OF INTEREST:
The Keynesian theory of interest has been criticized by Hansen,
Robertson, Knight, Hazlitt, Hutt and oth ers. The following are the main
criticisms:
1. The theory lacks in realism and comprehensiveness: Speculative
demand for money is the most important component which determines
interest rate according to Keynes. The theory assumes that people will
hold more money by selling bonds when the rate of interest falls and Rate of Interest
Demand & Supply of Money
Demand & Supply of Money Rate of Interest
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51 hold less cash but more bonds in the case of the rise in the interest rate.
However, Robertson does not regard bonds as the only alternative to
money. The theory is therefore not realistic and l acks
comprehensiveness.
2. Methodologically Inadequate: A change in the quantity of money
would tend to change the price of the good in the same proportion but
not the price of bonds. There is no functional relationship between the
price level and the rate of interest. Monetary changes do not have
direct or lasting effect on the rate of interest. By assuming a functional
relationship between the quantity of money and the rate of interest, the
Keynesian theory is found to be methodologically inadequate.
3. Only Speculative Demand for money is considered to be
rewarding: Keynes believed that money held as a store of wealth
does not bear any fruit whereas money held for speculative purpose
yields rate of interest as a reward. According to WH Hutt, money is as
productive as all other assets and the demand for money assets is a
demand for productive resources.
4. Saving is Essential for Liquidity: Keynes believed that the rate of
interest is the reward for parting with liquidity and not for saving.
Saving is essenti al for making investments. According to Viner,
“Without saving there can be no liquidity to surrender. The rate of
interest is the return for saving without liquidity”.
5. Liquidity Trap does not exist: In reality the liquidity preference
schedule may be p erfectly inelastic at a low rate of interest. It is
wrong to assume that people will expect the rate of interest to go up in
a depression.
6. Incomplete Theory: Hicks, Hansen, Somers, Lerner and others says
that the rate of interest along with the level of income is determined by
four factors, namely: the investment demand function or MEC, the
saving function or the consumption function, the liquidity preference
function and the quantity of money function. Keynes did not bring all
these factors in his inter est theory and therefore failed to provide an
integrated and determinate theory of interest.
3.9 FRIEDMAN’S THEORY OF DEMAND FOR
MONEY
According to Milton Friedman who restated the quantity theory of
money and prices there are four determinants of demand for money (i)
the level of prices (ii) the level of real income and output (iii) the rate of
interest (iv) rate of change in general price level.
Friedman Classifies the holders of money into (a) ultimate wealth holders
(b) business enterprises His theory is relevant to the ultimate wealth
holders
Friedman has given a very broad concept of wealth which includes all
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52 money is a demand for capital asset since money like capital assets
provide s services and returns. Bonds are monetary assets in which the
people can hold their wealth and enjoy fixed interest income. The return
on bonds is the sum of the coupon rate of interest and the anticipated
capital gains or losses due to the expected chang e in the market rates of
the interest People can also hold their wealth in the form of equity shares
and enjoy returns in the form of dividend income and capital gains or
losses Milton Friedman gave his demand function in the following manner
Md = f (w. h. rm, rb , re , P., u)
This is the nominal  money demand function. The demand for real
money balances can be derived by dividing the nominal money demand by
the price level
Md = f (w. h, r m, r b, re, P . ____ , u)
Where. .  = demand for real money balances.
w = wealth of the individual
h = the proportion of human wealth to the total wealth held by
the individuals
rm = the rate of return on money or interest
rb = the rate of interest on bonds
re = the rate of return on equity shares
p = the price level
u = Institutional factors.
The simpl ified version of Friedrm an's demand function for money can
be written as,
. = f (r, Yp, u)
The demand -function of Friedman, though it looks similar to Keynes
equation is different from Keynes in some ways : -
(1) Keynes gave importance to current income whereas Friedman gave
importance to wealth
(2) Friedrm an's theory does not consider unstable elements like the
Keynes speculative demand for money
(3) Friedman did not c onsider the possibility of a liquidity trap
situation.
Check Your Progress :
1. What is the Keynesian approach to demand for money?
2. Explain the concept of Liquidity trap.
3. What are the Friedman‘s determinan ts of demand for
money?
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53 3.10 SUMMARY
1. Money supply refers to the amount of money which is in circulation in
an economy at any given time. It is the total stock of money held by
the people consisting of individuals, firms, State and its constituent
bodies except the State treasury, Central Bank and Commer cial Banks.

2. The velocity of circulation of money determines the flow of money
supply in an economy in a given period of time, normally such a
period is one year. The average number of times a unit of money
changes hands is known as the velocity of circ ulation of money. The
supply of money in a given period is obtained by multiplying the
money in circulation with the coefficient of velocity of circulation i.e.,
M  V where M refers to the total amount of money in circulation and
V refer to the velocity of circulation of money in the given period.

3. Money is defined in Economics as ‘anything that is generally accepted
in payment for goods and services as a medium of exchange.’

4. According to Keynes, people hold cash balances on account of three
reasons or m otives. Accordingly the demand for money can be
separated into three parts namely transaction demand, precautionary
demand and speculative demand for money. The total demand for
money or cash balances can be divided into two namely; active and
idle cash balances.

5. According to Keynes, the rate of interest is determined by the demand
for and supply of money. Interest is the reward for lending liquidity or
temporarily giving up cash balances held by the people. Symbolically,
the rate of interest can be st ated as follows:
Ri = f (DM, SM)
According to Milton Friedman who restated the quantity theory of
money and prices there are four determinants of demand for money (i)
the level of prices (ii) the level of real income and output (iii) the rate
of int erest (iv) rate of change in general price level.
3.11 QUESTIONS
1. Explain the meaning and constituents of money supply.
2. What are the factors affecting velocity of circulation of money?
3. Discuss Keynesian approach to demand for money.
4. Critically analyze Keyn esian Liquidity Preference theory of rate of
interest.
5. Explain Friedman’s approach to demand for money.


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54 4
MONEY AND PRICES AND INFLATION -II
Unit Structure :
4.0 Objectives
4.1 Introduction
4.2 The Classical Approach to Demand for Money
4.3 The Fisher’s Approach to Demand for Money
4.4 The Neo -Classical or Cambridge Approach to Demand for Money
4.5 The Keyn esian Approach of Demand for Money
4.6 Meaning of Inflation
4.7 Demand Pull, Cost Push and Structural Inflation
4.8 Causes of Inflation
4.9 Effect of Inflation
4.10 Measures to Control Inflation
4.11 Summary
4.12 Questions
4.0 OBJECTIVES

 To study classi cal approach to demand for money
 To study Fisher’s equation of exchange
 To study Cambridge approach to demand for money
 To understand the meaning and types of inflation
 To study various causes of inflation
 To understand various effects of inflation
 To know the measures to control inflation
4.1 INTRODUCTION
As against the Keynesian and Friedman’s approach to demand for money
in previous unit, the views of Classical economists and Cambridge
economists to demand for money is explained in this unit. The meanin g,
types, causes, effects and measures to inflation in an economy is explained
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55 4.2 THE CLASSICAL APPROACH TO DEMAND FOR
MONEY
The classical economists emphasized the medium of exchange
function of money According to the classical economists like J.S. Mill.
David Hume and Irving Fisher, the demand for money arises since money
facilitates the exchange of real goods and services among individuals.
Hence money is demanded for buying and selling goods and services or for
spending over a period of tim e The classical economists believed that the
demand for money depends on objective factors like the volume of
exchange transactions of goods and services produced and supplied
during a given period of time, the amount of money needed to buy the
goods and s ervices and by the velocity of circulation. Since the volume of
goods and services changes from time to time, the demand for money also
changes The classical approach to the demand for money can be grouped
into the Fisher’s cash -- Transactions Approach an d the Cambridge
economists' cash -Balances approach
4.3 THE FISHER’S APPRO ACH TO DEMAND
FOR MONEY
Irving Fisher's Equation of Exchange is one of the most prominent
explanations which analyse the demand for money. According to Fisher,
the demand for money me ans the amount of money to be held to
undertake a given volume of transactions over a period of time. Fisher's
equation of exchange is given as MV = PT, where M is the money
supply, V the transaction velocity, T transactions and 'P‘ the price level.
'PT' i n the equation represents the demand for money and MV stands for
the supply of money. The demand for money (Md) is equal to (Ms) . It
means that the demand for money is equal to 'P' multiplied by 'T' over a
period of time and divided by V The demand for mon ey depends on the
amount of money which people have to hold in order to carry on a volume
of transactions over a period of time. According to Fisher 'V and 'T' are
constant during the short period As a result, the demand for money varies
with changes in 'P '. According to Fisher the supply of money (Ms) is equal
to demand for money (Md). It means that the demand for money is always
equal to the supply of money. Fisher‘s version of demand for money
stresses the role of money in spending and not saving The dem and
for money changes in proportion to the changes in the price level. V
also determines the demand for money.
4.4 THE NEO -CLASSICAL OR CAMBRIDGE
APPROACH TO DEMAND FOR MONEY :
The Cambridge approach or the cash balances approach was given by
Marshall, Pig ou, Robertson and Keynes. These economists stressed the
store of value function of money. This approach concentrates on what
individual want to hold for satisfying the transaction motive and
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56 money refers to the cash balances held by all individuals in an economy.
The following factors influence the decisions of individuals in holding cash.
(i) The prevailing prices of goods and services and the expected
changes.
(ii) The existing interest rates and exp ected changes in future.
(iii)The wealth in the hands of the people.
These factors remain constant according to the Cambridge
economists. The total demand for money or cash balances is a certain
proportion of national income. The demand for money can be expressed
as, Md = KPY, where MD is the demand for money, K is the constant
proportion of income Y. It is the proportion of national income which
people desire to keep in the form of cash balances and Py is the nominal
national Income. According to the Camb ridge economists the demand for
money is the constant proportion (K) of Y. Wherever there is a change
in the price level or in the real national income, the demand for money
also changes in equal proportion For example if MD is Rs. 2000 crores
and the mone y income is Rs 6000 crores per year K = 1/3 per year.
This imples that on an average the public likes to hold money
amounting to 1/3 of the annual income.
Check Your Progress :
1. Distinguish between Cash transaction and Cash balance approach
to demand for money.
4.5 THE KEYNESIA N APPROACH OF DEMAND FOR
MONEY
J M Keynes introduces his theory on the demand for money through his
book titled, the "General Theory of Employment. Interest and
Money" in 1936. According to Keynes money was demanded due to three
main motives i.e. the transactions motive, the precautionary motive
and the speculative motive. The speculative motive of demand for
money is a special contribution of Keynes.
(i) The transaction motive :
It refers to the transaction demand for money as a me dium of exchange for
carrying on current trade and business transactions. Money is demanded
for transaction purposes since it is received at discrete intervals of time
and expenditure goes on continuously. Keynes classified the transactions
motive into (a) income motive and (b) business motive.
(a) The income motive :
People hold cash to bridge the gap between the receipt of income and
expenditure. The income in the form of salary or wages is recovered at a
certain time like once in a week or once in a mont h. But expenditure
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57 of the income has to be held in the form of liquid cash. The following
factors decide the amount of money held by people:
(i) Level of Income As the level of income incre ases, the transaction
demand for money of the individual will increase and vice versa.
(ii) Tune Interval: The longer the time interval between the receipt
of income and expenditure, the higher the amount of money held by
people for transaction purposes.
(iii) The standard of Living : The higher standard of living, the larger
the amount of money held and vice versa.
(b) The business Motive :
The businessmen and the firms also hold cash balance in order to
bridge the interval between the time of incurring busines s costs or
expenses and the receipt of the sale proceeds. The larger the volume of
turnover or transactions for the business firms, the greater will be the
amount of money held for this purpose. The amount of money held by
the business firms depends on the size of their income and their turnover.
The aggregate demand for money for satisfying the transaction
motive is the sum total of the individuals demand for cash as well as
the individual firm's demand for cash. This aggregate demand for money
will depend upon total size of national income, the level employment and
the price level.
The transactions demand for money primarily depends on the level of
income. The transaction demand for money which is income -elastic can
be expressed in the following manner.
L = (fy) where Lt with transaction demand for money, T stands for
function of and y stands for the national income. The figure below shows
the transaction demand for money.

Figure 4.1
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58 In the above figure, dd is rising indicating that, with the increase in national
income, the demand for money for transaction purposes also rises,
(ii) The Precautionary Motive :
Besides the money kept also for transaction purposes, people hold
additional amount of money to meet unexpected or unforeseen
contingencies, emergencies or unexpected events. Money held for such
precautions is known as precautionary motive. The accessibility of
individuals and firms to the credit market determines the amount of
money held for this purpose. If borrowing is easy or the assets of the
people c an be easily connected into cash, the amount of money held for
this motive will be very low and vice versa. Uncertainty regarding
future will make individuals and firms keep aside money for precaution
purposes. The precautionary motive of demand for money depends on
the income level ie. L = f(y), where 'Lp‘ stands for precautionary motive,
T a function of and y, the level of income,
(iii) Speculative motive :
People hold money as a store of wealth or liquid asset for investment and
lending, with a view to make sp eculative gains. People speculate about
the future prices of bonds or securities or future interest rates. People
prefer to hold securities where prices are expected to rise in future and
vice-versa. People make capital gains from speculative about the pri ces
of bond or securities or future interest rates. According to Keynes. The
speculations motive is the desire to earn profit by knowing better than
the market what the future will bring forth The individuals have to
choose between holding money or other a ssets Uncertainly regarding
the behavior of the future interests and price of bonds leads to
speculation. If the rate of interest is high and the prices of bonds are low,
the lower will be liquidity preference. In such a case money will be lent
or bonds will be purchased. There is an inverse relation between the
prices of bonds and interest rate.
If the interest rate is expected to rise, or the prices of bonds to fall,
people sell the bonds or assets and hold more cash. The people will
buy the bonds when th eir prices actually fall . On the other hand, if the
people expect the rate of interest to fall, or prices of bonds to rise,
people will buy bonds whose prices are expected to go up. This leads to a
fall in liquidity preference. This shows that speculative demand for money
is interest elastic. –




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59 L = f(i) where. L2 is the demand for money for speculative purpose, (i)
the rate of interest

Liquidity preference (Speculative demand for money)
Figure 4.2
The above figure shows the inverse relation between t he rate of interest
and the speculative demand for money. It slopes downwards from left to
right indicating that when the rate of interest is high, the demand for
money is low and vice versa.
4.6 MEANING OF INFLATION
A sustained rise in the general pri ce level over a period of time is known
as inflation. Conversely, a sustained fall in the general price level would
be known as deflation. Inflation is measured in terms of a price index.
For instance in India, we have the wholesale price index (WPI) an d the
consumer price index (CPI). The Price Index is based on a basket of
goods and services. Within a given basket, the prices of some goods and
services may rise or fall. However, when there is a net increase the price
of the basket, it is called infl ation.
Inflation is a rate of change in the price level. The rate of change is
measured with reference to the base year so that a long term perspective is
obtained with regard to price rise. For all practical purposes, inflation rate
is measured on year ly basis. However, in recent years, the inflation rate is
also measured on monthly and weekly basis. The rate of inflation can be
measured as: P = (P1  P0) P0  100. For example, the price
index based on the Wholesale Prices in India for the ye ar 2003 -04 was
180.3 and in 2004 -05, it was 189.5. The rate of inflation for the year
2004 -05 was 5.1 per cent. Inflation rate measured on the basis of
wholesale price index (WPI) for the period 2005 -06 to 2012 -13 in India is
given in Table 4.1.

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TYPES OF INFLATION BASED ON RATES OF INFLATION
On the basis of the rate of price rise, inflation is classified into five
categories. They are creeping or moderate inflation, walking, running,
galloping and hyper inf lation . When the rate of price rise is less than
three per cent per annum, it is called creeping inflation. An inflation rate
of about three per cent per annum is considered creeping. When prices
creep upwards at a moderate rate, inflation serves as an incentive to
investment. As a result, the rate of investment, employment, output and
aggregate demand rises in the economy and the economy moves into the
prosperity phase.
When inflation rate crosses the three per cent mark and remains within
single digi ts i.e. below the 10 per cent mark, it becomes walking inflation.
Walking inflation leads to a much rapid fall in the purchasing power of
money. However, the negative consequences of single digit inflation are
not widely felt and hence it is considered w ithin the tolerable limits.
However, both monetary and fiscal policies are swung into action to
control the rate of inflation and keep it within single digits.
When inflation rate is in double digits, it is known as running inflation.
When prices begi n to rise by more than 10 per cent per annum and the rate
of inflation accelerates, money begins to flow away from productive
activities into unproductive or speculative activities. As a result, the
supply of goods and services fall in the economy and the ir prices begin to
rise more rapidly. Thus commodity prices rise rapidly for want of
investment and prices of gold, real estate and stocks rise more rapidly Tabl e 4.1
Inflation Rate based on Wholesale Price Index (WPI)
in India for the period 2005 -06 to 2012 -13.
Year Wholesale
Price Index Inflation Rate (%)
P = (P1  P0) P0  100
2005 -06 104.5 -
2006 -07 111.4 111.4 – 104.5/104.5  100 = 6.6%
2007 -08 116.6 116.6 –111.4/111.4  100 = 4.6%
2008 -09 126.0 126.0 – 116.6/116.6 × 100 = 4.06
2009 -10 130.8 130.8 – 126.0/126.0 × 100 = 3.80
2010 -11 143.3 143.3 – 130.8/130.8 × 100 = 9.55
2011 -12 156.1 156.1 – 143.3/143.3 × 100 = 4.93
2012 -13 164.8 164.8 – 156.1/156.1 × 100 = 5.57
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61 because more and more money is diverted from the productive sector to
the unproductive sector.
When prices rise by about 100 per cent annum, the situation is known as
galloping inflation and when the inflation rate is over 1000 per cent a year,
it is called hyper inflation. Both galloping and hyper inflation signals the
collapse of the economy. Pr oductive activity is at an all time low, people
lose confidence in the currency and the economy looks like more of a
barter economy. During world war one, countries like Austria, Hungary,
Germany, Poland and Russia experienced hyper inflation. For instan ce
between1920 -23, the German price index rose from one to one billion. In
1994, the inflation rate in Georgia was 15000 per cent per annum. In
2008, the inflation rate in Zimbabwe was 11.2 million per cent. I n
such situations, the paper on which money is printed become more
valuable than the money itself i.e. the intrinsic value of even paper money
becomes greater than the face value. Thus if you sell money by kilograms
you may get more money in return than by exchanging money in the
market for goods and services.
4.7 DEMAND PULL, COST PUSH AND STRUCTUAL
INFLATION
Broadly speaking, there are three types of inflation which constitutes the
causes of inflation. Demand side factors will cause demand pull inflation,
supply side factors will cause cost push inflation and structural factors will
cause structural inflation. Here in this section, we will analyze these three
major types of inflation.
1. Demand -pull Inflation: Demand pull inflation takes place due to
rise in aggregate demand. Aggregate deman d may rise due to combined
effect of higher demand from the various sectors of the economy such as
the firms, households and the government. According to Keynes, inflation
arises when there is an inflationary gap in the economy. Inflationary gap
arises w hen aggregate demand is greater than aggregate supply at full
employment level of output. Keynes explained inflation in terms of
demand pull forces. When the economy is operating at the full
employment level of output, supply cannot increase in response to
increase in demand and hence prices rise.





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62
AS



P 4


P 3 AD 4

AD 3
P 2

P 1 AD 2

AD 1




O Y 1 Y 2 Y 3

Aggregate Demand & Supply

Fig. 4.3: Demand Pull Inflation
Demand pull inflation is depicted in Fig. 4.3. You may note that aggregate
deman d and supply curves are measured along the X -axis and the general
price level is measured along the Y -axis. The aggregate supply curve AS
rises upward in the beginning and becomes vertical when full employment
level of output is achieved at point OY f. Th is is because the supply of
output cannot be increased once full employment level of output is
achieved. When the aggregate demand curve is AD 1, the equilibrium is
less than full employment level and the price level OP 1 is determined.
When aggregate dema nd increases to AD 2, the price level rises to OP 2 due
to excess demand at price level OP 1. Since the economy is operating at
less than full employment level, the real sector of the economy responds to
rise in prices and hence the output increases to OY 2. When the aggregate
demand further rises to AD 3, the price level rises to OP 3 followed by
increase in output to OY f. When the aggregate demand further rises to
AD 4, the aggregate supply does not respond to remain constant at OY f and
only the price level rises to OP 4. After the full employment level of output
the aggregate supply curve becomes perfectly inelastic and parallel to the
Y-axis.
2. Cost -push Inflation:
In the absence of rise in aggregate demand, prices may rise due to increase
in cost in t erms of higher wages, higher input costs and higher profits.
These are known to be autonomous increases in costs. Inflation on
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63 a) Wage -push Inflation: Powerful trade unions may bargain for higher
wages and also get it even when the cost of living has not changed or
the general price level is constant and there is no change in the
productivity of labor. When employers have no choice but to yield to
the demands of the trade union, they may pass on the higher costs to
the consumers by charging higher prices on the goods and services
produced. Such a situation leads to Cost -push inflation. In case of
Cost-push inflation, the aggregate demand curve shifts to the left
leading to fall in output and rise in the price level. Cost push inflation
is also known as stagflation. Cost -push inflation is depicted in
Fig. 4.2
b) Profit -push Inflation: Firms operating under imperfect market
conditions such as monopoly, monopolistic and oligopoly market s
may hike their profit margins either autonomously or through
collusion. When prices rise on account of hike in profit margins, it is
called profit -push inflation. Profit push inflation may lead to cost push
inflation if the products are used as inputs by other firms. When prices
of capital goods, intermediate goods and raw materials are increased to
increase the profit margin by firms operating under imperfect
competition and when these goods are used as inputs by other firms,
the cost of production of these firms go up, thereby leading to cost
push inflation.
c) Input Cost Inflation: Supply shocks leading to rise in input costs is
an important cause of input -cost inflation. For instance, the oil price
shocks of 1970s. The sharp rise in world oil price s during 1973 -75
and in 1979 -80 created supply shocks and cost -push inflation. Recent
increases in the prices of crude oil also caused the inflation rate to go
up. For instance, the weekly inflation rate in India was 12.34% during
the second week of Sept ember 2008 as a result of sharp increase in the
international prices of crude oil to $150 per barrel. The government of
India took monetary and fiscal measures to bring down the prices.
Fortunately, the crude oil prices also fell below the $50 per barrel
mark in January 2009 and the weekly inflation rate in India also fell
down to 6.4 per cent from the high of 12.34 per cent in September
2004.
d) In January 2009 and the weekly inflation rate in India also fell down to
6.4 per cent from the high of 12.34 per cent in September 200 4.





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64
AS 2


AS 1


P 2 E2

P 1 E 1


AD


O Y 2 Y1
Aggregate Ou tput

Fig. 4.4 Cost -push Inflation




AS 3
AS 2
AS 1
P 3 E 3

P 2 E 2


P 1 E 1

AD



O Y 3 Y 2 Y1
Aggregate Output
Fig. 4.5 Cost -push Infl ation & Direct and Indirect
Effects of Supply Shocks
Cost push inflation as a result of rise in input prices is depicted in Fig. 4.4.
Oil price shocks and rise in the price of other inputs have direct and
indirect effects on the price level. When prices actually rise due to rise in
input costs, the workers revise their price expectations upward. With
upward price expectations, real wage rate declines and hence less labor is
supplied at the given nominal wage rate. With the upward revision in the
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65 expect ed price level, the aggregate supply curve shifts to the left. This is
known as the indirect effect of an expected upward price revision. In
Fig.4.5, you will notice that the AS 1 curve shifts to the left to AS 2 and the
price level rises to P 2 on account of oil price shock. This is known as the
direct effect of a rise in the input cost. Now that the price level has gone
up, the workers will revise the expected price level to P 2 . This pushes the
AS curve further left to AS 3 and further rise in price lev el to P 3. The
movement from AS 2 to AS 3 is known as the indirect effect of oil price
shock.
4.8 CAUSES OF INFLATION
The causes of inflation are classified into two categories. They are
demand side and supply side factors. These factors are discussed in t his
section.
Demand side Factors Causing Inflation:
Inflation is caused by a rise in aggregate demand over aggregate supply.
Factors causing in aggregate demand over aggregate supply are as follows.
1. Increase in Public Expenditure: Public expenditure has b een
increasing by leaps and bounds since the emergence of the Welfare
State in the second half of the 20th century. Particularly in mixed
economies with a pre -dominant public sector, the rise in public
expenditure has been phenomenal. The interventionist role of the
State has increased over time and the governments are seen to be
responsible for building social and economic infrastructure.
For instance, Government expenditure has regularly increased in India.
The Government expenditure in India has con tinuously increased since
the beginning of economic planning. Rising government expenditure
has been an important cause of inflation in India. The government or
public expenditure was 15.3 per cent of GDP in 1960 -61 and since
then it has been on a contin uous rise. In 1990 -91, it was 31 per cent of
the GDP. It further rose to 31.2 per cent in 2000 -01. About 48% of
the public expenditure in India is on non -developmental activities.
Expenditure on defense, interest payments and governmental
machinery con stitutes non -developmental expenditure. Expanding
governmental machinery, rising defense expenditure, expenditure on
subsidies and growing public borrowing has contributed to the rise in
non-developmental expenditure. While non -developmental
expenditure in creases aggregate demand in the economy, it does not
increase aggregate supply and hence price rise.
2. Deficit Financing: There is no surplus or even a balanced budget.
Governments do not spend according to their incomes. Government
budgets are always def icit budgets which means, government
expenditure is always greater than income. Increasing fiscal deficit is
a general feature of the government budgets of developing countries.
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66 public borrowing and also borrowing from their Central Banks. In
order to raise resources for repaying public debt, governments may
raise the existing tax rates or raise new taxes. Deficit financing leads
to rise in public expenditure and hence rise in aggregat e demand,
thereby causing inflation.
For example, the expenditure of the government of India has been
more than its income. The gap between expenditure and income or the
deficit is filled through deficit financing. The deficit is financed by
borrowing funds from the banking system. If the borrowed funds are
used for unproductive purposes, they will give rise to inflation. The
government of India has used the borrowed funds for non -
developmental purposes in a careless manner. The fiscal deficit durin g
the year 2002 -03 was Rs.145072 crore and in the year 2007 -08, it was
Rs.150948 crore.
3. Increase in Money Supply: Increase in money supply over and
above the quantity of output produced in the economy would result in
price rise. Irving Fisher’s quantity theory of money explains how
increase in money supply without a proportionate increase in output
leads to rise in prices and fall in the value of money. Commenting on
the effect of money supply on prices, Dr. C Rangarajan, former
Governor of the Reserve Bank of India states that “Money has an
impact on both output and price. The process of money creation is a
process of credit creation. Money comes into existence because credit
is given either to the government or the private sector or the foreign
secto r. Since credit facilitates the production process, it has favorable
impact on output. But at the same time the increased money supply
raises the demand with an upward pressure on prices”. Dr.
Rangarajan has therefore accepted the fact in India, price effect of
money supply is greater than output effect.
If increase in money supply was the only reason for rising prices then
the rise in prices should be equal to the difference between the increase
in money supply and increase in output. In the Indian context, no such
relationship is found between the increase in money supply and the
inflation rate. For instance, the inflation rate in the year 2004 -05 was
5.1 per cent and the excess of money supply over real GDP was only
4.8 per cent. Going by Irving Fisher’s formula, the inflation rate must
be equal to excess money supply. However, in the Indian context, the
inflation rate was slightly higher than the excess money supply. In
subsequent years, it is surprising to find that the inflation rate has bee n
much lower than the excess of money supply over real GDP.
Divergence between excess money supply and the inflation rate is
brought out in Table 4.2. It clearly means that there are other factors
also which lead to increase in prices.


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67 Table 4.2
Comparis on between Money Supply,
Real GDP and Inflation Rate in India

Source: IES 2007 -04.
4. Corruption and Black Money: Financial corruption leads to creation
of black money. Corruption by public servants and ministers amounts
to unearned income and leakages in the system. Any leakage in the
flow of production would reduce the total quantity of output and
increase in aggregate demand. Further unreported incomes or black
money would also cause rise in prices. Although unreported incomes
are not enti rely unearned incomes, they do contribute to excessive
consumption expenditure and therefore cause rise in prices.
According to Transparency International, India and Centre for Media
Studies; India Corruption Report 2007, the below the poverty line
house holds (BPL) in India paid a total bribe of Rs.8830 million to
obtain public services in the year 2007. This amount is only the tip of
the iceberg. Out of the 180 countries surveyed by Transparency
International for corruption, India’s rank was 74 with an index of 3.5
in the year 2006. An index of 10 indicates complete freedom from
corruption and an index of zero indicates total corruption. Countries
like Finland, Denmark and New Zealand with a CPI (corruption
perception index) score of 9.4 were found to be least corrupt.
Countries with a CPI score of less than five are considered to have
serious problem. India is therefore one of the most seriously corrupted
countries in the world. Myanmar and Somalia with a CPI score of two
were the most corrupt count ries of the world.
Supply Side Factors Causing Inflation:
Supply lags in the economy causes aggregate supply to fall short of
aggregate demand and cause price rise. These supply side causes are as
follows.

Year Increase in
Money
Supply
M3 (%) Change in
GDP (%)
at 1999 -2000
Prices Excess of
Money Supply
Over Real GDP
(%) Inflation
Rate
(WPI based)
2003 -04 -
2004 -05 12.3 7.5 4.8 5.1
2005 -06 17.0 9.4 7.6 4.1
2006 -07 21.3 9.6 11.7 5.9
2007 -08 22.4 4.7 13.7 4.1
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68 1. Fluctuating Agricultural Growth: The rate of grow th of output of
food grains must be equal to the rate of growth of demand for food
grains. Demand for food grains increases due to rise in incomes and
rise in population. In poor countries, the income elasticity of demand
for food grains is high. In poo r countries, the agricultural sector is
under -developed and largely dependent on nature. Thus when the
agricultural sector fails to produce adequate output, the prices of
agricultural goods rise.
In the Indian context, population growth rate and the rate of growth of
agricultural output has remained the same in the last twenty years.
Indian agriculture is dependent on monsoons. Thus bad and poor
monsoons mean crop failure and rise in food prices leading to rise in
the general price level in the country. In the year 2004 -05, food
production fell by seven per cent. In the subsequent two years, food
production was by 5.2 and 4.2 per cent but once again fell to 0.9 per
cent in the year 2007 -04. The growth in real national income was
much higher than the ri se in food production thereby causing the
prices to rise.
2. Hoarding of Essential Goods: When the agricultural sector fails, food
pries begin to rise more rapidly than non -food prices. The problem of
food price rise is compounded by hoarding of agricultural goods by
traders. Artificial scarcity is created by both whole -sellers and
retailers. As a result, there is much greater increase in prices than
what is justified by real shortages. In the Indian context, both the big
farmers and agricultural traders i ndulge in hoarding of agricultural
goods during the periods of crop failure. In times of food scarcity,
hoarding of food grains and other food products only helps the prices
to rise further.
3. Inadequate Rise in Industrial Production: In the prosperity phas e of
the business cycle, there is a sustained rise in investment demand
which causes a sustained rise in demand for industrial goods. If the
capital goods industry fails to respond to the rise in demand, the prices
of industrial goods will rise and when t he prices of industrial goods
goes up, the prices of consumer goods also rise. In the Indian
context, during the period 1995 -96 to 2001 -02, the industrial sector
registered slow growth. Inadequate increase in industrial production
has also been an impo rtant cause of inflation in India.
4.9 EFFECT OF INFLATION
EFFECT OF INFLATION ON PRODUCTION AND ECONOMIC
GROWTH, DISTRIBUTION OF INCOME AND WEALTH AND
CONSUMPTION AND ECONOMIC WELFARE
Inflation is a theft of income of the unprotected segments of the socie ty.
Inflation is therefore a crime against the poor who experience a fall in
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69 the three most important functions of an economy namely; production,
consumption and distribution i n an adverse manner.
(A) Effect of Inflation on Production and Economic Growth:
In economies where labor is largely unorganized, single digit or creeping
inflation will increase profitability and therefore lead to greater
investment, employment, output, inc ome, demand and prices. This is
because the wages of unorganized labor is not indexed to inflation. The
real wages of unorganized labor will always fall overtime during inflation
whether anticipated or not. In the case of unanticipated inflation, the re al
wages of organized labor will also fall and may be compensated with a
time lag. The firms will gain during the intervening period between
unanticipated price rise and its compensation to labor. Thus from the
point of view of production and economic gr owth, single digit inflation
has a positive impact .
(B) Effect of Inflation on Distribution of Income and Wealth:
The impact of inflation with regard to distribution of income and wealth is
not even on all sections of the society. In case of labor, the sectio n that is
protected from inflation is the organized labor whose wages and salaries
are indexed to inflation. But unorganized labor is not protected from
inflation and therefore their real incomes decrease on account of inflation.
Similarly debtors who ha ve borrowed money on fixed interest gain on
account of inflation because real interest rate falls during a period of rising
inflation while creditors lose because at times the real interest rate may be
zero and even negative. Similarly people holding owne rship capital like
equity shares, balanced and growth funds make capital gains because of
rising profits of business enterprises while people holding creditor capital
like bonds, debentures, fixed deposits and income funds lose due to the
fall in real inte rest rates. Broadly speaking, during an inflationary period,
households lose and firms gain. Hence it is said that during inflation the
rich become richer and poor become poorer.
(C) Effect of Inflation on Consumption and Economic Welfare:
Inflation is kno wn as a poor man’s tax. It reduces the purchasing power of
money earned by the poor people and hence their economic welfare. The
workers who do not get compensated for the increase in price rise,
experience reduction in real incomes because their nominal income
remains constant over a long period of time. Even those workers who get
compensated for the price rise lose purchasing power during the
intervening period between the rise in prices and the compensation in
price rise. For instance, the Central an d State Government employees in
India get compensated for inflation twice in a year and there is always a
lag of six months before such compensations are given. Economic welfare
depends upon consumption of goods and services and during a period of
sustain ed rise in prices, the people are able to consume less goods and
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70 4.10 MEASURES TO CONTROL INFLATION
Inflation is the result of excess demand over the supply of goods and
services. Inflation man agement, however, needs both demand and supply
management as well. Both monetary and fiscal measures can be adopted
to control inflation.
Attempt to control inflation in India was made for the first time in the
early sixties after experiencing rapid ris e in prices during the second five
year plan. However, measures taken by the government were not effective
to control inflation. Prices continued to rise throughout the planning era
except the first five year plan. One of the important tasks of the
gover nment was to maintain price stability under the new economic
policy. Accordingly, the government undertook various measures to
control inflation in the country. These measures were as follows:
(A) MONETARY POLICY MEASURES:
The Central Bank’s policy with re gard to cost and availability of credit is
known as monetary policy. The RBI can raise the rate of interest and
increase the cost of credit and also reduce the availability of credit.
Quantitative instruments of credit control such as the bank rate, the cash
reserve ratio and the statutory liquidity ratio can be used to reduce
aggregate demand in the economy. Increase in the bank rate by the RBI
will increase the market interest rate in the country. This will reduce the
demand for credit and further lead to reduction in aggregate demand.
Similarly, if the CRR and SLR are increased, the banks will have less
money at their disposal to give loans and advances to the bo rrowers.
Monetary expansion due to rising foreign exchange reserves was
controlled by ster ilization of foreign exchange reserves. Commenting on
the effect of money supply on prices, Dr. C Rangarajan, former Governor
of the Reserve Bank of India states that “Money has an impa ct on both
output and price. Since credit facilitates the production p rocess, it has
favorable impact on output. But at the same time the increased money
supply raises the demand with an upward pressure on prices”. Dr.
Rangarajan has therefore accepted the fact in India that price effect
of money supply is greater than outp ut effect.
1. The Bank Rate: Bank rate is the rate at which Reserve Bank provides
loans to the commercial banks in the country. It is also called the
discount rate because the Central Bank provides finance to commercial
banks by rediscounting bills of exch ange. The bank rate in India was
10 per cent in the 1980s. It was raised to 12 per cent in October 1991.
The bank rate was not a very effective in controlling money supply in
the pre -reform period. However, in the post reform period, the bank
rate ha s been made more effective and in keeping with the objective of
low inflation and high economic growth, the bank rate was reduced to
6 per cent in April 1998 and it continued to be retained at 6 per cent
until July 2010. The bank rate however went up to 9.5 % as on 29th
March 2012 on account of inflationary pressures in the Indian
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71 view of recessionary trend in the Indian economy. However, due to
sustained inflationary pressures, the bank ra te was raised to 10.25% in
July 2013.
2. The Repo and Reverse Repo Rates: The bank rate as a credit control
instrument is losing importance. The repo and reverse repo rates are
becoming important in deciding interest rate trends in the Indian
economy. The Repo (sale and repurchase agreement) is a swap deal
involving the immediate sale of securities and simultaneous purchase
of those securities at a future date at a predetermined price. These
swap deals take place between the RBI and financial institutions . The
repo or the repurchase rate is the rate at which the Central Bank
provides funds to banks. Continuing with its anti -inflationary
monetary policy stance, between March, 2010 and April, 2011, the
RBI has raised the policy rates six times. The repo rat e was 5% in
March 2010 and in April, 2011 the repo rate went up to 6.75%. The
repo rate was further raised to 4.5 % on 25th October, 2011 on the
occasion of the Second Quarter Review of the Monetary Policy for the
year 2011 -12. The reverse repo rate is t he rate at which the Central
Bank takes funds from banks and the reverse repo rate in March 2010
was 3.5% and in April, 2011 was 5.75 per cent. In October, 2011, the
reverse repo rate was raised to 7.5 per cent. In June 2013, the repo rate
was 7.25 and t he reverse repo rate was 6.25%. Until July 2013, these
rates have been retained by the RBI.
3. Open Market Operations: Open market operations means the
buying and selling of securities by the central bank. The sale of
securities leads to contraction of cr edit and purchase of securities lead
to credit expansion. The RBI uses switch operations for buying and
selling government securities. Switch operations involve purchase of
one loan against sale of another. The use of switch operations
prevents unrestric ted increase in money supply. Recently, in January
2011, when the SLR was reduced from 25% to 24%, the RBI
neutralized the excess liquidity through OMOs. The SLR was further
reduced to 23% in the year 2012 and continues to remain at 23%. The
RBI conduct ed Open Market Sales of Government of India Securities
of Rs.12,000 crore on July 18, 2013.The RBI, however, could gain Rs.
2,532 crore from the auction, as rest of the bids received had quoted
yield rates higher then acceptable to the RBI.
4. The Cash Reserv e Ratio: The CRR is an effective instrument of
credit control. It refers to the cash which the banks have to maintain
with the Reserve Bank as a certain percentage of their demand and
time liabilities. Changes in the CRR bring about changes in the
loanable resources of the banks, particularly the commercial banks.
In the late 1980s, there was a rapid growth in money supply and hence
the CRR was raised from 10 per cent to 15 per cent. In the post reform
period, the CRR was brought down according to th e recommendation
of the Narasimham Committee to below the 10 per cent level.
However, in August 1994, the CRR was raised to 15 per cent to
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72 pressures were reduced in the economy and a ccordingly the CRR was
progressively reduced to 4.5 per cent in June 2003. The RBI had to
increase the CRR to five per cent in October 2004 and further to 7.5
per cent in October 2007. In August 2008, the CRR was raised to nine
per cent. As part of the anti-recessionary policy in the wake of global
financial crisis of 2008 -09, the CRR was reduced to five per cent in
January, 2009. It was raised to 5.75 per cent in February, 2010 and
further to six per cent in April 2010 as inflationary pressures started
building in the economy on account of the huge fiscal stimulus that
was given by the government in the aftermath of the financial crisis of
2008 -09 and its negative impact on economic growth in India. In the
first quarter review of the monetary policy fo r the year 2010 -11,
released in July 2010, the CRR was retained at 6 per cent by the RBI.
Subsequently, the CRR was reduced to 4.75 per cent in March 2012 to
ease liquidity conditions in the money market. In June 2013, the CRR
was 4.0% and it continues t o be 4 % in July 2013.
5. The Statutory Liquidity Ratio: The Banking Regulation
(Amendment) Act 1962 provides for maintaining a minimum SLR of
25% by the banks against their net demand and time liabilities. The
SLR is fixed at 25% for co -operative banks, no n-scheduled banks and
the regional rural banks. In case of commercial banks, it can be raised
to 40%. The RBI has used this instrument quite often during the 70s
and 80s. In September 1990, the SLR was raised to 3 4.5 per cent and it
remained at this lev el up to January 1993. This was done to control
inflationary pressures and make larger resources available to the
government. The Narasimham Committee recommended reduction of
SLR to 25 per cent and accordingly the SLR was reduced to 25% in a
phased mann er in October, 1997. In November 2008, the SLR was
further reduced to 24 per cent and in October, 2009, the SLR was
restored to 25 per cent once again. However, in December 2010, the
SLR was once again reduced to 24%. The SLR was further reduced to
23% i n the year 2012 and continues to remain at 23%.
(B) FISCAL POLICY:
The fiscal policy of a country refers to the policy of the Government with
regard to income and expenditure. Expansionary fiscal policy is adopted
during the periods of economic stability or d uring the times of recession.
In contrast, a tight fiscal policy is adopted when the economy is in the grip
of inflation. In order to promote growth, the government may reduce both
direct and indirect taxes and increase the level of aggregate demand. Th e
government may also increase public expenditure to increase the level of
aggregate demand and achieve a higher economic growth rate. However,
in order to control inflation, the Government may raises taxes, add new
taxes and reduce public expenditure by reducing the fiscal deficit.
The Government of India made attempts to remove fiscal imbalance from
1991 -92 by bringing down fiscal deficit from 6.6 per cent to 4.7 per cent
of GDP. However, in 1993 -94 the fiscal deficit rose to 6.4 per cent. It
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73 down to below the five percent mark. During the decade 1995 -2005, the
government has been able to keep the average inflation rate below the five
per cent level. However, between 2005 -06 and 2 012-13, the government
had failed to control inflation rate and fiscal deficit once again went up to
6.0 and 6.5 % in the years 2008 -09 and 2009 -10. The fiscal deficit during
the year 2010 -11 was Rs.3, 69,043crores and in the year 2011 -012, it was
Rs.4, 12 ,817crores. The budget for 2010 -11 announced going back to
fiscal consolidation and the projected fiscal deficit for 2010 -11, 2011 -12
and 2012 -13 is 5.5%, 4.8% and 4.1 % respectively. The actual fiscal
deficit figures in the years 2010 -11 and 2011 -12 w ere below the projected
figures. However, fiscal deficit in 2008 -09 and 2009 -10, had gone up due
to fiscal intervention made by the Government of India in the wake of the
Global Financial Crisis. Near double digit inflation and a very high food
price inf lation in the last three years is the price paid by the people of
India for the fiscal profligacy of the Government of India.
(C) SUPPLY SIDE MEASURES:
Inflation is the result of mismatch between aggregate demand and
aggregate supply. Both monetary and fiscal policies can act on the
demand and supply side through interest rates, money supply, taxation and
public expenditure. However, some measures can directly influence the
supply of goods and services. These measures are explained below.
1. Public Distribut ion System: The Public Distribution System was
established in the country to provide essential consumer goods
particularly to the poor people at low prices. The entire country is
covered by this system. However, one cannot say that the system has
been ab le to control price rise. The agricultural price support policy of
the government has worked against the objective of price stability. As
a result of faulty agricultural policy, food production in India had
failed to keep pace with rising demand for food. The recently enacted
Food Security Act by the Government of India promises cheap and
heavily subsidized food for about 65 % of the population. It remains
to be seen whether this measure will bring down food price inflation
in the coming years.
2. Import of Essential Commodities: In order to improve the supply of
essential commodities, the government of India had allowed food
imports. During 1995 -96, imports of edible oils, palmolein, sugar and
pulses were allowed. The Food Corporation of India sold rice and
wheat in the open market to control market prices of these food
grains. Excise duties on a number of industrial products were reduced
to improve the supply of manufactured goods.
3. Capacity Utilization and Increase in Aggregate Supply: The
productive c apacity of the economy should be fully utilized. Widespread
unemployment can only lead to rising price level because the unemployed
generates demand for goods and services without contributing to their
production. The productive apparatus in the country c onsisting of farm
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74 utilized. Under utilization of the potential and sometimes the actual
productive capacity will lead to shortage of aggregate supply and hence
price rise.
(D) INCOME POL ICY:
Income freeze is an important policy measure to counter inflation. Here
income freeze refers to inflationary income. Revision in wage rates on
account of payment of dearness allowance to organized workers and
revision in wage rates to all kind of wo rkers due to rise in the cost of
living is an example of wage push inflation. Factor incomes such as rent,
wages, interest and profit should reflect the marginal productivity of the
given factor. Policy that delinks factor incomes from the price level ma y
help stabilizing the prices and may be the price level comes back to the
original level in due course. However, the policy of freezing only wages
will not be accepted by organized labor. The argument that wage rate
must reflect the marginal productivit y of labor is economically sound. But
the same argument must be extended to other factors of production.
4.11 SUMMARY
1. The classical economists emphasized the medium of exchange
function of money According to the classical economists like J.S. Mill.
David Hume and Irving Fisher, the demand for money arises since money
facilitates the exchange of real goods and services among individuals.
Hence money is demanded for buying and selling goods and services or
for spending over a period of time The classical eco nomists believed
that the demand for money depends on objective factors like the
volume of exchange transactions of goods and services produced and
supplied during a given period of time, the amount of money needed to
buy the goods and services and by the velocity of circulation.

2. According to Fisher, the demand for money means the amount of
money to be held to undertake a given volume of transactions over a
period of time. Fisher's equation of exchange is given as MV = PT,
where M is the money supply, V th e transaction velocity, T
transactions and 'P‘ the price level. 'PT' in the equation represents the
demand for money and MV stands for the supply of money.

3. The Cambridge approach or the cash balances approach was given by
Marshall, Pigou, Robertson and Ke ynes. These economists stressed the
store of value function of money. This approach concentrates on what
individual want to hold for satisfying the transaction motive and
precautionary motive. According to this approach, the demand for
money refers to the cash balances held by all individuals in an
economy. The following factors influence the decisions of individuals
in holding cash.


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Money And Prices And
Inflation -II
75 4. A sustained rise in the general price level over a period of time is
known as inflation. Conversely, a sustained fall in th e general price
level would be known as deflation. Inflation is measured in terms of a
price index.

5. Broadly speaking, there are three types of inflation which constitutes
the causes of inflation. Demand side factors will cause demand pull
inflation, sup ply side factors will cause cost push inflation and
structural factors will cause structural inflation.

6. Inflation is the result of excess demand over the supply of goods and
services. Inflation management, however, needs both demand and
supply manageme nt as well. Both monetary and fiscal measures can
be adopted to control inflation.
4.12 QUESTIONS
1. Explain Fisher’s approach to demand for money.
2. Explain Cambridge approach to demand for money.
3. Discuss the meaning and types of inflation.
4. What are the cau ses of inflation?
5. Differentiate between demand pull and cost push inflation.
6. Discuss various effects of inflation.
7. What measures can be adopted to control inflation?




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76 MODULE 3
5
MEANING OF PUBLIC FINANCE
Unit structure :
5.0 Objectives
5.1 Meaning of Public Finance
5.2 Scope of Public Finance
5.3 Functions of Public Finance
5.4 The Role of Government in an Economy
5.5 Principle of maximum social advantage
5.6 Hugh Dalton’s view of maximum social advantage
5.7 Richard Musgrave: Maximum welfare principle of budget
determination
5.8 Limitations o f the Principle Of Maximum Social Advantage
5.9 Summary
5.10 Questions
5.0 OBJECTIVES
 To know the meaning of public finance
 To understand the scope of public finance
 To understand the functions of public finance
 To understand the role of government in functioning of economy
 To know the principle of Public Finance
 To understand the Hugh Dal ton Principle of Maximum social
advantage
 To know the limitations of the principle of maximum social advantage


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77 5.1 MEANING OF PUBLIC FINANCE
Public finance is the study of the role of the government in the economy .
It is the branch of economics that asses ses the government
revenue and government expenditure of the public authorities and the
adjustment of one or the other to achieve desirable effects and avoid
undesirable ones.
Classical and neo -classical economists discussed public finance in the
context of money raising and money spending activities of the
government.
According to Philip E. Taylor, “public finance deals with the finances
of the government. The finances of the government include raising
and disbursement of government funds”.
According to Ursula Hicks, “the main content of public finance
consists of the examination and appraisal of the methods by which
government bodies provide for the collective satisfaction of wants and
secure necessary funds to carry out their purposes”.
According to Richar d Musgrave, “public finance is concerned with the
complex of problems that centre around the revenue – expenditure
process of government”. However, “the basic problems are not issues
of finance. They are not concerned with money, liquidity or capital
marke ts. Rather, they are problems of source allocation, the
distribution of income, full employment, price level stability and
growth”.
From the above definitions it is clear that the subject matter of public
finance includes public revenue, public expenditure , public debt and
financial administration.
Prof. Dalton in his book Principles of Public Finance states that “Public
Finance is concerned with income and expenditure of public authorities
and with the adjustment of one to the other”
From the above defini tions it is clear that the subject matter of public
finance includes public revenue, public expenditure, public debt and
financial administration.
The classical and the neo -classical economists generally confined the
study of public finance to the narrow area of government’s financial
activities only. They also believed that government intervention in the
economy should be kept minimal.Economics believed that public
expenditure should be kept to the minimum and taxation should be limited
to what is necessa ry to fulfill the basic public expenditure. Governments
should follow balanced budget wherever possible.
It was John Maynard Keynes , in his General Theory of Employment,
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78 that the role of State needed to expand when the markets failed to correct
themselves. He advocated that the financial or fiscal operations of the
government can be used to remove distortions in the economy. The
financial operations could be used to influence the level of aggregate
demand and employment. The public budget could be used to mobilize
resources for rapid growth, balanced development and social justice.
These policies were successful in reviving US economy from the Great
Depression and have been widely follo wed by most market economies
since then, giving rise to the concept of Functional Finance .
5.2 SCOPE OF PUBLIC FINANCE
The scope of public finance is not just to study the composition of public
revenue and public expenditure . It covers a full discussion o f the
influence of government fiscal operations on the level of overall activity,
employment, prices and growth process of the economic system as a
whole. The scope of public finance is extended to the following fiscal
operational areas through the instrum ent of budget. The important areas
are :
1. Public Revenue : It is the means for public expenditure. The necessity
of raising the public revenue follows from the necessity of incurring
public expenditure. Public revenue deals with the methods of raising
incom e from tax and non -tax sources. In this connection we study the
principles of taxation, incidence of taxation and the effects of taxation.
Since tax revenue can be raised from both direct and indirect taxes, we
also study the relative merits and demerits o f direct and indirect taxes.
Since non -tax revenues consist of surpluses of public enterprises,
public borrowing and deficit financing, we also study about the
methods of raising revenues through these sources.
2. Public Expenditure : It refers to the expens es of public authorities –
central, state and local governments. Public expenditure is a major tool
for implementing various policies of the government with respect to
welfare, growth, stabilization and so on. Thus, public expenditure
occupies an important place in the study of public finance. In this
connection we study the principles of public expenditure, justification
for various kinds of public expenditure and effects of public
expenditure. We also study the changes in the pattern of public
expenditure over the years.
3. Public Debt : With the increase in the activity of the state, the
shortfalls in income of the state is frequently made up through loans.
Thus, public debt has become an important source of revenue both in
the developed and developing coun tries. In modern times, borrowing
by the government has become a normal method of government
finance along with the other sources of public finance. In all countries
of the world, public debt has shown a tendency to increase. Thus, the
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79 The problems relating to the raising and repayment of public loans are
studied under this part of the public finance. In this connection we
study about the sources of public loans, methods of raising the publ ic
loans, methods of repayment of principal amount of loan and interest,
and burden of public debt.
4. Financial Administration : The scope and subject matter of public
finance is not confined only to the study of public expenditure, public
revenue and public debt. We also have to examine the mechanism by
which these processes are carried out. In this context we are concerned
with the organization and functioning of the government machinery
which is responsible for carrying out the various functions. This is
done by the government through the budget.
Thus, public finance involves the study of budget which is the
financial plan of the government. The budget gives a complete picture
of the estimated receipts and expenditure of the government during the
year. In India the budget is divided into 2 parts, that is (i) Revenue
budget and (ii) Capital budget. The revenue budget deals with the
receipts from taxation, public enterprises, etc. and the expenditure
incurred on the normal running of government departments an d
services, etc. On the other hand, capital budget deals with the capital
receipts which include the market loans, borrowing by government
from R.B.I. etc. The Capital expenditure is the expenditure incurred
for the acquisition of assets like land, equipme nt, etc. for the
development purposes.
5.3 FUNCTIONS OF PUBLIC FINANCE
The scope and functions of public finance has gone to many changes. The
classical idea of sound Finance was no more popular.
At present all the governments through the budget and fiscal operations
aim to discharge the following functions.
(a) Allocation of resources : The most important objective of fiscal
operations is to determine how the country’s resources will be
allocated to different sectors of the economy in order to achieve
predete rmined goals. Allocation of resources depends upon the
collection of taxes and size and composition of government
expenditure. The national budget determines how funds are allocated
to different heads of expenses. The policy of public expenditure is
used b y the government to directly undertake resource allocation for
different sectors. On the other hand, the government can use taxation
and subsidies to indirectly influence resource allocation. The market
mechanism cannot provide all goods and services for t he satisfaction
of collective wants through public goods like defence, justice and
security. The government has to adjust between allocation of resources
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80 In India, the central government through its ann ual budget allocates
expenditure to different sectors and sub -sectors. These sectors include
the essential activities like defence, law and order, justice and other
essential social activities such as education and health, as suggested by
classical economi sts, but also various developmental activities
connected to agriculture, industries and service sectors. Private
investment is promoted or discouraged through positive and negative
incentives.
(b) Distribution : Fiscal operations can be effectively used to af fect the
distribution of national income and resources. Taxation and public
expenditure policies are used by the government to reduce inequalities.
Progressive direct taxes impose heavier burden on the rich than the
poor. Public expenditure on social infra structure and subsidies on
food, housing, health and education help reduce income inequality.
India’s direct tax system is progressive where tax rates range from 5
percent to 30 percent plus surcharge. The newly introduced Goods and
Services Tax (GST) is a lso varies depending on the nature of goods
and services. The GST ranges from 5 percent to 28 percent. Essential
goods and services are either exempted from the GST or taxed at a low
percent. Through the budget, Government of India spends money to
provide ‘Food Security’, health care and employment to the poorer
sections of the society. The state governments too have introduced
many welfare schemes to reduce the inequality of income.
(c) Stabilisation : Developed economies expenditure business cycles.
Economic stability implies absence of sharp cyclical movements in the
form of booms and depressions. To bring about such stability, counter -
cyclical fiscal operations are adopted. To counter depression and
recession, government expenditure is increased to generate
employment and taxes are reduced to encourage consumption and
investment. During inflation, public expenditure is reduced and taxes
are raised.
In 1930s depression, British economist Lord J.M. Keynes advised the
USA government to use fiscal instruments to spend more to provide
employment, thus more income in the hands of people leading more
consumption and additional investment. The entire process was
expected to revive economic activities and bring the economy out of
depression. This approach led to the b irth of the concept of functional
finance.
5.4 THE ROLE OF GOVERNMENT IN AN ECONOMY
Two important concepts associated with public finance are (i) fiscal
policy, and (ii) budgetary policy
(i) Fiscal policy is the part of government policy that deals with rais ing
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81 and pattern of public expenditure. In most modern economies, the
government deals with fiscal policy while the central bank is
responsible for monetary policy . Fiscal policy is composed of tax
policy, expenditure policy, investment or disinvestment strategies and
public debt management.
(ii) Budgetary policy refers to government’s strategies to implement and
manage a budget. It is a more specific policy than fiscal policy.
5.5 PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE
The principle of Maximum social advantage is the important Principle of
Public Finance. It is the fundamental principle which should determine
fiscal operations of the government. This principle is formulated and
popularized by Dr. Hugh Dalton. The principle provides guidance to the
Govt. regarding public revenue and public expenditure or public finance
operations so as to maximise social advantage or welfare.
Budgetary activities of the government result in transfer of purchasing
power within society. Taxation causes transfer of purchasing power from
tax payers to the public authorities, while public expenditure results in
transfers back from the public authorities to people. When the income tax
is paid by an individual to the gover nment he experiences sacrifice or
disutility , and whenever in return government spends or it does
expenditure by providing social benefit an individual receives benefits or
utility .
Therefore, financial operations of the government cause sacrifice or
disut ility on one hand and benefits or utility on the other. This results in
changes in pattern of production, consumption and distribution of
income and wealth . It is important to consider whether these changes are
socially advantageous or not. If they are soc ially advantageous, then the
financial operations are justified, otherwise not. According to Hugh
Dalton, The best system of public finance is that which secures the
maximum social advantage from the operations which it conducts.
The principle was develope d by Hugh Dalton and was later interpreted by
Richard Musgrave .
5.6 HUGH DALTON’S PRINCIPLE OF MAXIMUM
SOCIAL ADVANTAGE
The Principle states: The state should collect revenue and spend the
money so as to maximize the welfare of the people. When the state
imposes taxes, some disutility is created. On the other hand, when the state
spends some money, there is gain in utility. The state should so adjust
revenue and expenditure that surplus of utility is maximised and disutility
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82 According to Dalt on, the main objective of public finance is the
maximization of social advantage and the principle he used to explain the
achievement of this objective is the principle of Maximum Social
Advantage (MSA). The MSA is the fundamental principle on which
public finance is based.
The principle of MSA is based on the following assumptions :
1. All taxes result in sacrifice and all public expenditures lead to benefits.
2. Public revenue consists of only taxes. No other source of income to the
government is considered.
3. The government has only balanced budget, that is, revenue is equal to
expenditure.
4. Public expenditure is subject to diminishing marginal social benefit .
5. Taxes are subject to increasing marginal social sacrifice.
The principle of MSA states that public finan ce leads to maximum
economic welfare when public expenditure and taxation are
carried out up to that point where the benefits derived from the
marginal utility of expenditure is equal to marginal disutility of
the sacrifice imposed by taxation . In other wo rds, when marginal
social benefit of government expenditure is equal to marginal social
sacrifice of the taxation of social welfare is maximum.
Marginal Social Sacrifice (MSS)
Taxes cause sacrifice to people who have to give up some part of their
income. T he sacrifice that is experienced by the people when the
government imposes an additional unit of taxation is known as the
marginal social sacrifice (MSS) .
The marginal social sacrifice of taxation increases as the revenue collected
by the government from taxes become larger. As the community pays
more and more taxes to the government, the sacrifice they experience, in
paying every additional unit of money in the form of tax increases. Thus
taxes are subject to increasing marginal social sacrifice . This is based on
the principle of marginal utility , according to which the less of a
commodity (or money) an individual has, the more will be the disutility or
sacrifice she will experience in parting with an additional unit of the
commodity (or money).
The curve representing MSS is an upward rising curve. Taxes put a real
burden on the people as either they have to cut down their consumption to
pay taxes or they have to reduce their level of savings. As additional units
of taxation are imposed on them, individual s are forced to cut more and
more of their consumption and savings. Therefore, with each additional
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Meaning of Public
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83 imposes additional taxes to raise additional revenue the MSS curve is
increasing an increasing rate due to increasing disutility or sacrifice
incurred by the taxed people. Therefore, MSS curve rises upward from left
to right

Figure 5.1 Increasing Marginal Social Sacrifice Curve
In Figure 5.1, when the amount of tax is OM, the MSS imp osed by
taxation is OS. When the tax rises to OM 2, MSS rises to OS 2, and as tax is
further raised to OM 3, MSS rises to OS 3.
Marginal Social Benefit (MSB)
Public expenditure is carried out by the government to provide social
goods like defence, justice syst em, free or subsidized food, housing and
education, transport system and many other infrastructural facilities to the
people. The primary objective of public expenditure is to generate welfare
or benefits to the society.
While taxes result in sacrifice by the people, public expenditure results in
benefits to them. All public expenditure, assuming they are wisely and
productively spent by the government, result in some benefits. The benefit
given to society, by an additional unit of public expenditure is kn own as
marginal social benefit (MSB).
MSB declines with increase in public expenditure, that is, with every
additional unit of money spent by the government on the community, the
social benefits tend to decline. In other words, the MSB or the marginal
utility of public expenditure, like that of everything else, diminishes as the
community has more of it. This is based on the principle of diminishing
marginal utility . To a consumer, the marginal utility from a commodity
declines as more and more units of the commodity are made available to
him. In the same manner, the social benefit from each additional unit of
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84 are spent. In the beginning, the units of public expenditure are spent on the
most essential social activities. Subsequent increases in public expenditure
are spent on less important social activities. As a result MSB from public
expenditure declines with increase in volume of expenditure.
The curve representing MSB slopes downwar ds from left to right as
shown in figure 5.2.

Fig. 5.2: Diminishing Marginal Social Benefit Curve
When public expenditure is OM 1, MSB is OB 1 and when public
expenditure rises to OM 1, MSB falls to OB 2, MSB falls to OB 2. A further
increase in public expend iture to OM 3 results in MSB falling to OB 3.
Maximum Social Advantage
Social advantage is maximized at that level of taxation and public
expenditure at which MSS is equal to MSB. Any other level of taxation
and expenditure will achieve less than maximum soc ial advantage.
The difference between the MSS and the MSB measures net social
advantage (NSA) . As long as MSB is greater than MSS, NSA will be
positive and will add to total social advantage. When MSS is equal to
MSB, NSA is zero and maximum social advant age is achieved. When
MSS is greater than MSB, NSB will be negative resulting in reduction in
total social advantage.
Thus, as long as MSB is greater than MSS (and NSA is positive), the
government should expand the level of taxation and public
expenditure . It should stop its budgetary activities at the point where
MSS is equal to MSB (and NSA is zero). Any further expansion in the
level of taxation and public expenditure will result in MSS being greater
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85

Fig. 5.3 : Maximum Social Advantage is obtained at the Point of
Intersection of MSS and MSB Curves
In Fig. 5.3 the level of taxation and public expenditure (size of budget
activities) is represented on the X -axis and MSS and MSB are represented
on the Y -axis. Social advantage is maximized at the point where the
MSS curve cuts the MSB curve . This is the point P in the Figure 5.3.
Corresponding to P, on the X -axis, OQ represents that level of taxation
and public expenditure at which the social adv antage is maximum. Any
other level of taxation and public expenditure will result in less than
maximum social advantage. This is the optimum budget size .
Consider level OQ 1 on the X -axis. At this level of taxation and
expenditure, MSB is P 1 Q1 and MSS is S1Q5. Since MSB is greater than
MSS, the government should increase the level of taxation and public
expenditure. This is because, each additional unit of revenue raised
through taxation and spent through public expenditure, will lead to an
increase in net social advantage . This situation will continue as long as
the levels of taxation and public expenditure are towards the left of the
point P.
Once the level of taxation and public expenditure reaches OQ, MSS
becomes equal to MSB and the point of maximum social advantage is
reached.
Any further increase in the level of taxation and public expenditure will
bring down the social advantage as subsequent units will add more to
sacrifice than to benefits and NSA will become negative. For example, at
point OQ 2, MSS will be S 2Q2 and MSB will be P 2Q2. Since MSS is greater
than MSB, social advantage will reduce and the government should reduce
the level of taxation and expenditure from OQ 2 to OQ to reach maximum
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86 Thus, Maximum social advantage is a chieved at the point where the
marginal social benefit of public expenditure and the marginal social
sacrifice of taxation are equated, that is MSS – MSB .
5.7 RICHARD MUSGRAVE: MAXIMUM WELFARE
PRINCIPLE OF BUDGET DETERMINATION
The principle of Maximum Soci al Advantage has been interpreted by
economist Richard Musgrave who termed it as Maximum Welfare
Principle of Budget Determination. According to Musgrave, the principle
explains that taxation and public expenditure should be carried out up to
that level wh ere satisfaction obtained from the last unit of money spent
is equal to the sacrifice from the last unit of money taken in taxes . In
other words, it should be carried out up to the point where marginal social
benefit is equal to marginal social sacrifice.
To illustrate his interpretation, Musgrave used Figure 5.4 in which, the
size of the budget (level of taxation and public expenditure) is shown on
the X -axis. On the positive part of Y -axis MSB is measured and on the
negative part, MSS is measured.

Fig. 5.4 : Gains and Losses from Budget Operation
The curve EE represents the marginal social benefit (MSB) of successive
units of money spent as public expenditure, allocated optimally between
different pubic uses. It falls from left to right because of publ ic
expenditure increases, MSB declines. The curve TT represents the
marginal social sacrifice (MSS). As additional units of taxation are
raised from the people, MSS increases. Accordingly the curve TT slopes
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87 The curve NN measures marginal net benefits (MNB) which is derived
from successive addition to public budget. MNB is calculated by
deducting MSS from MSB. The vertical distance between EE curve and
TT curve measures MNB at different sizes of t he budget.
The optimum size of the budget is determined at OM, where MNB is
zero. At this size of the budget, the marginal social benefit MP is equal the
marginal social sacrifice MQ (MSB = MSS) . Since MSB and MSS are
measured in opposite directions, marg inal net benefit is zero at M (MSB -
MSS = 0). At this point the MNB curve NN cuts the X -axis.
At any point to the left of M, say M 1 MSB will be greater than MSS and
MNB will be positive. It is beneficial to increase size of the budget as long
as MNB is posi tive. So there will be a tendency to move from M 1 towards
M. If the budget size exceeds M , say M 2, then MSS will exceed MSB and
MNB will be negative. Therefore it will be beneficial for the government
to cut down the size of the budget and move from M 2 towards M.
According to Musgrave the optimum size of the budget is given by the
point where the marginal net benefit is zero. This point corresponds to
the point of maximum social advantage, as at this point MSB = MSS.
5.8 LIMITATIONS OF THE PRINCIPLE OF MAXI MUM
SOCIAL ADVANTAGE
The principle has been criticized on some fundamental grounds :
(i) Objective measurement not possible : The principle of maximum
social advantage is theoretically explained with the help of the
marginal utility analysis. The marginal util ity analysis. The marginal
utility anlaysis itself is criticized because it is not possible to
accurately measure utility or disutility experienced by people. The
marginal benefits of public expenditure and the marginal disutility or
sacrifice of public re venue are concepts whose objective measurement
is extremely difficult. Besides, the terms “benefit” and “sacrifice” are
vague and abstract. It is not possible to quantify them and find their
exact implications.
(ii) Large budget size : The financial operations of the government
involve collection of large sums of money from taxation and other
sources and the disbursement of large amounts by way of public
expenditure. The effects of small additional amounts of these on the
community are difficult to measure. The refore, in practice, the public
authorities are not in a position to estimate the marginal benefits and
the marginal sacrifices. It is almost impossible to determine the
particular size of budget that will maximize welfare of the community.
(iii)Unrealistic ass umption : It is unrealistic to assume that government
expenditure is always beneficial and that every tax is a burden to
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88 to society, whereas taxes on education or essential commoditie s may
harm general interest of society. Similarly, expenditure on social
overheads like health care will give rise to social benefit whereas
unnecessary increases in expenditure on defence may divert resources
from productive activities causing loss of wel fare to society.
(iv) Lack of disability : In order to equate the marginal benefit from
public expenditure with marginal sacrifice from taxation, government
resources are required to be divided into smaller units. But it is not
possible because of the lack of divisibility of public expenditure and
taxes in small units.
(v) Ignores non -tax revenues : This principle takes into consideration the
sacrifice on the part of tax payers and ignores non -tax revenues. Non
tax revenues like fines, fees, market borrowings, pro fits of public
undertakings etc. are equally important as sources of revenue and in
their effects on social benefit.
(vi) Changes in conditions : Conditions in an economy are not static and
are continuously changing. What might be considered as the point of
maximum social advantage under some conditions may not be so
under some other. For example, in times of war government
expenditure and revenue must increase, and the increase is to the
advantage of the community. What is optimum at one level of national
incom e may not be so at a higher level. Therefore, it is difficult to
determine the point of maximum social advantage and no definite
volume of government expenditure and revenue can be considered as
being the best.
(vii) Different periods : The impact of many publi c projects is felt over
the long period by both the present and the future generations. In order
to determine maximum social advantage it becomes necessary to
calculate social benefits from public expenditure in short period and in
long period separately. It is not possible to equate marginal benefits of
expenditures over projects relating to different time periods.
(viii) Non-economic implications : Public authorities use the principle of
maximum social advantage after carefully estimating the economic
advantages and disadvantages of any proposed expenditure and
taxation policy. They compare the balance of probable gain and loss to
the community from various alternative proposed policies. Such
estimates and comparisons are, however, not easy. They are difficult
partly because all the possible results of a policy measure cannot be
correctly visualized and because there are innumerable economic and
non-economic implications of every single measure. Political and
social criteria often put economic criteria in the back ground. There are
various taxes and public expenditure measures, whose social and
political impacts are far greater than their economic effects. It is not
possible to objectively measure non -economic effects of public
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89 (ix) Conceptual differences : Tax es are paid by individuals and the
sacrifice involved is felt at an individual or micro level. Whereas,
public expenditure gives rise to public goods that are jointly consumed
by all in a community. The benefits therefore are felt at a macro level.
Many ec onomists argue that it is neither possible nor desirable to
compare micro and macro concepts by using the same criteria. Also, it
is not possible to compare the marginal benefits accruing to people in
one area from a given public expenditure with the margi nal sacrifice
underground by people who are taxed in some other area. Marginal
sacrifice is a subjective concept. Marginal sacrifice of the same
amounts of tax paid by two persons, having different living standard
will be different.
5.9 SUMMARY
5. Public finance is the study of the role of the government in
the economy . It is the branch of economics that assesses the government
revenue andgovernment expenditure of the public authorities and the
adjustment of one or the other to achieve desirable effects and avoid
undesirable ones.
2. The scope of public finance is not just to study the composition
of public revenue and public expenditure . It covers a full discussion
of the influence of government fiscal operations on the level of overall
activity, employment , prices and growth process of the economic
system as a whole.
3. All the governments through the budget and fiscal operations aim to
discharge the functions of public finance.
4. Two important concepts associated with public finance are (i) fiscal
polic y, and (ii) budgetary policy
5. The principle of Maximum social advantage is the important Principle
of Public Finance. It is the fundamental principle which should
determine fiscal operations of the government. This principle is
formulated and popularized by Dr. Hugh Dalton.
6. According to Dalton, the main objective of public finance is the
maximization of social advantage and the principle he used to explain
the achievement of this objective is the principle of Maximum Social
Advantage (MSA). The MSA is the fundamental principle on which
public finance is based.
7. The principle of Maximum Social Advantage has been interpreted by
economist Richard Musgrave who termed it as Maximum Welfare
Principle of Budget Determination. According to Musgrave, the
principle explains that taxation and public expenditure should be carried
out up to that level where satisfaction obtained from the last unit of
money spent is equal to the sacrifice from the last unit of money
taken in taxes . munotes.in

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90 5.10 QUESTIONS
1. Discuss the meani ng and scope of public finance.
2. Explain the various functions of public finance.
3. Explain the principle of Maximum Social Advantage as stated by
Hugh Dalton.
4. Explain the limitation of Maximum Social Advantage.
5. Explain maximum welfare principle of budget det ermination.






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91 6
EFFICIENCY – MARKET - GOVERNMENT
Unit structure :
6.0 Objectives
6.1 Meaning of Efficiency
6.2 Concept of Consumer and Producer Surplus
6.3 Market
6.4 Market Failure
6.5 Public Goods
6.6 Role of Government
6.7 Summary
6.8 Questions
6.0 OBJECTIV ES
 To know the concept of Allocative and Productive efficiency
 To understand producer and consumer surplus
 To know the concept of Market
 To understand the reasons for market failure
 To know what is public good
 To understand the role of government in the ec onomy
6.1 MEANING OF EFFICIENCY
Economic efficiency is a state where every resource is allocated optimally
so that each person is served in the best possible way and inefficiency and
waste are minimized. Efficiency in economics also explained as “that
society is getting the maximum benefits from the scarce resources”. In a
free economy, market allocates scarce resources with forces of supply and
demand, and equilibrium of supply and demand typically implies an
efficient allocation of resources. Under ideal conditions markets ensure
that the economy is pareto efficient. In Adam Smith’s words the “invisible
hand” of market place leads self -interested buyers and sellers in a market
to maximize the total benefit that society derives from that market.
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92 Producti ve Efficiency
Productive efficiency is concerned with producing goods and services
with the optimal combination of inputs to produce maximum output for
the minimum cost.
To be productively efficient means the economy must be producing on
its production possibility frontier . (i.e. it is impossible to produce more of
one good without producing less of another).
In Fig. 6.1 AB is the production possibility curve. The points b, d, c are
the points wh ere the maximum (optimum) output of goods X and Y can be
produced. Any point inside the curve such as a, is productively inefficient.
When we move from a to c, we increase the production of X from X to X 1,
without reducing output of Y. similarly if we move from A to b , we
produce more of Y (i.e. YY 1,), without having less of X. When we move
from a to c or a to b , we achieve productive efficiency in terms of goods
X in the first case and in terms of good Y in the second case.

Fig. 6.1
Productive efficienc y in an economy is achieved when an economy
produces at any point on its production possibility curve and not at any
point inside the PPC.
Productive efficiency is achieved when it is impossible to reallocate
resources as to produce more of one product wit hout producing less of the
other product.
In case of a firm, productive efficiency requires that it produces its output
with least cost input combination. In other words, maximum output is
produced with minimum cost. It is a point where output is produced in
such a way that the ratio of marginal products of each pair of factors is
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93 When we apply this condition to an industry, productive efficiency is
obtained when the marginal cost of producing the last unit of output of a
firm must be the same for each firm in any industry.
Definition of allocative efficiency
This occurs when there is an optimal distribution of goods and services,
taking into account consumer’s preferences.A more precise definition of
allocative effi ciency is at an output level where the Price equals the
Marginal Cost (MC) of production. This is because the price that
consumers are willing to pay is equivalent to the marginal utility that they
get. Therefore, the optimal distribution is achieved when the marginal
utility of the good equals the marginal cost.
Example using diagram

Fig. 6.2
At an output of 40, the marginal cost of the good is Rs 6, but at this output,
consumers would be willing to pay a price of Rs15. The price (which
reflects the good’s marginal utility) is greater than marginal cost –
suggesting under -consumption. If output increased and price fell, society
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94

Fig. 6.3
At an output of 110, the marginal cost is Rs17, but the price people are
willing to pay is only Rs7. At this output, the marginal cost (Rs17) is
much greater than the marginal benefit (Rs7) so there is over -
consumption. Society is over -producing this good.
Allocative efficiency will occur at a price of Rs11. This is where the
marginal cost (MC) = marginal utility.

Fig. 6.4
 Firms in perfect competition are said to produce at an allocative
efficient level because at Q1, P=MC
 Monopolies can increase price above the marginal cos t of
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95 monopolies have market power and can increase price to reduce
consumer surplus.

Fig. 6.5
 Monopo ly sets a price of Pm. This is allocatively inefficient because at
this output of Qm, price is greater than MC.
 Allocative efficiency would occur at the point where the MC cuts the
Demand curve so Price = MC.
 The area of deadweight welfare loss shows the d egree of allocative
inefficiency in the economy.
6.6. CRITERION OF SUM OF CONSUMER AND
PRODUCER SURPLUS
A free market economy functions to maximize benefit or welfare of both
consumers and producers. One of the measures adopted by economists or
economic pl anners is the criterion of sum of consumer and producer
surplus.
To understand this measure let us recall the measurement of consumer and
producer surplus.
Consumer’s = The price a consumer is willing to= Price paid by buyers
Surplus pay (Value to buyers )
Producers’= Market price of the commodity = Minimum price the
Surplus (Price received by sellers) producer must receive
(Cost to sellers)
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96 Total surplus = (Value to buyers – Price p aid by buyers)
+ (Price received by sellers – Cost to Seller)
The price paid by buyers equals to the price received by sellers, therefore
the middle two terms in the above measure cancel each other.
Therefore, Total Surplus = Value to buyers – Cost t o sellers
We explain the above concept with help of a diagram.
In a perfectly competitive market both producers and consumers stand to
gain by obtaining surplus.

Fig. 6.6
Fig. 6.6, OQ is the equilibrium output, sold at price OP per unit. The area
above the supply curve (AS x) and below the price line (PE) is the
producer’s surplus. The area below the demand line (D x) and above the
price line (PE) is the consumer’s surplus. At the equilibrium point E, and
output OQ, under perfect competition, the market ef ficiency enables
producers and consumers to maximize their surplus. Production less than
OQ reduces surplus of both producers and consumers. Production beyond
OQ, will make producers to incur cost more than the price they receive as
the price is lower than the supply curve (cost). Similarly beyond point E,
that is output more than OQ will make consumers to pay more than what
they are willing to pay, as the price is higher than the demand curve. A
perfectly competitive market ensures maximum possible benefit both to
the producers and consumers.
Any point prior to beyond point E, is less efficient in consumption and
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97

Fig. 6.7
Quantity less than equilibrium quantity, e.g. Q 1, the value to buyers
exceeds the cost to selle rs. At quantity greater than equilibrium quantity
e.g. Q 2, the cost to sellers exceeds the value to the buyers. Only at the
equilibrium quantity (Q), the sum of producer and consumer surplus is
maximum.
From the above analysis we can arrive at the followin g observations :
1. Free markets allocate the supply of goods to the buyers who value
them most highly, as measured by their willingness to pay.
2. Free market allocates the demand for goods to the sellers who can
produce them at the lowest cost.
3. Free markets pr oduce the quantity of goods that maximizes the sum of
consumers and producer surplus.
The above observations tell us that market forces (demand and supply)
maximize the sum of consumers’ and producers’ surplus. The above
outcome is unlikely, if the economy is managed by the government totally
(Socialist or Communist) or partially, that is mixed economy as it is in
India.
It is, therefore, best to leave the economy to the market forces. The policy
of leaving the economic decisions to the market is called Laissez faire ,
the French expression, which means “allow them to do” .

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98 6.3 MARKET
A market, as we knew, is a place where sellers (producers) and buyers
meet for settling a transaction. A market is defined “as a group of firms
and individuals that are in to uch with each other in order to buy and sell
some goods:.
According to N. George Mankiw, a market with many buyers and sellers,
trading identical products, so that each buyer and seller is a price taker is
called a competitive market. It is also sometimes called a perfectly
competitive market.
Sellers aim at maximizing their profit, and buyers attempt to maximize
their total utility or satisfaction, in an ideal market, what is usually called
perfect competition.
In reality, markets do not fulfill all the required conditions to make them
perfectly competitive.
6.4 MARKET FAILURE
Market failure occurs when the price mechanism fails to account for all of
the costs and benefits necessary to provide and consume a good. The
market will fail by not supplying th e socially optimal amount of the good.
Prior to market failure, the supply and demand within the market do not
produce quantities of the goods where the price reflects the marginal
benefit of consumption. The imbalance causes allocative inefficiency,
which is the over - or under -consumption of the good.
The structure of market systems contributes to market failure. In the real
world, it is not possible for markets to be perfect due to inefficient
producers, externalities, environmental concerns, and lack of public goods.
An externality is an effect on a third party which is caused by the
production or consumption of a good or service.
Market failure is an economic term that involves a situation where, in any
given market, the quantity of a product demanded by consumers does not
equate to the quantity supplied by suppliers. Market failure occurs when
resources are misallocated, or allocated inefficiently. In other words,
market failure occurs when markets fail to produce and allocate scare
resources in the most efficient way; i.e. the market may not always
allocate scarce resources efficiently in a way that achieves the highest total
social welfare.
Michael Todaro explains market failure as a “phenomenon that results
from the existence of market imperfections t hat weaken the functioning of
a free market economy i.e. it ‘fails’ to realize its theoretical beneficial
results. He attributes market failure to monopoly power, factor immobility,
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99 One is the failure of th e market system to achieve efficiency in the
allocation of society’s resources.
The other is the failure of the market system to serve social goals other
than efficiency, such as achieving some desired distribution of income or
preserving our value system .
M.G. Mankiw defines market failure as “a situation in which a market left
on its own fails to allocate resources efficiently”.
Causes of Market Failure
Markets do not function in a perfect manner as they are expected to do so
in a theoretical model. The y fail to perform efficiently due to a number of
reasons such as availability of public goods, business corporate acquiring
monopoly power in real world market which is full of imperfections,
externalities arising out of economic activities, imperfect or a symmetric
information, unequal income distribution and many other factors. Let us
briefly discuss these factors.
1. PUBLIC GOODS
Most goods in the economy are allocated in markets, where buyers pay for
what they receive and sellers are paid for what they provide. For these
goods, prices are the signals that guide the decisions of buyers and sellers,
and these decisions lead to an efficient allocation of resources.
A public good is a special type of good that can be consumed by everyone,
regardless of whet her they have paid for the good. When goods are
available free of charge, however, the market forces that normally allocate
resources in the economy are absent.
6. MARKET POWER
An imperfectly competitive market is one where the assumption of large
number of buyers and sellers does not hold. These types of market
organizations include monopoly, monopsony, oligopoly, and monopolistic
competition.
None of these markets are efficient. In general, the firms do not produce
the socially optimal quantities (they tend or under -produce) and the price
is higher than it would be under perfect competition. The condition P =
MC does not hold, and the system does not produce the most efficient
product mix.
Market control (or market power) arises when buyers or sellers ar e able
to exert influence over the price of a good and/or the quantity exchanged.
The ability to control the market, especially the market price, prevents a
market from equating demand price and supply price.
Market control on the supply side allows selle rs to set a demand price,
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100 An extreme example of market control on the supply side exists with
monopoly, a market with a single seller. A less extreme, but more
common example is oligopo ly, a market with a small number of large
sellers.
Market control on the demand side allows buyers to set a supply price,
the value of goods not produced, below the value of the good produced.
An extreme example of market control on the demand side exists with
monopsony , a market with a single buyer. A less extreme, but more
common example is oligopsony , a market with a small number of large
buyers.
Common examples of markets with supply -side or demand -side control
include city -wide electrical distribution (monopoly), automobile
manufacturing (oligopoly), employment in a company in town
(monopsony), and employment in professional sports (oligopsony).
The existence of monopoly power is often thought to create the potential
for market failure and a need for intervention to correct for some of the
welfare consequences of monopoly power.
The classical economic case against monopoly is that :
(a) Price is higher and output is lower under monopoly than in a
competitive market.
(b) This causes a net economic welfare loss of both consumer and
producer surplus.
(c) Price > marginal cost – leading to allocative inefficiency and a
Pareto sub -optimal equilibriuim.
(d) Rent seeking behaviour by the monopolist might add to the
standard costs of monopoly. This includes high (possibly
excessive) amounts of spending on persuasive advertising and
marketing.
(e) If the monopolist allows cost efficiency to drop then an upward
drift in costs takes place. Lack of effective competitive in the
market -place can lead to consumers facing higher prices and a
reduction in their real standard of living.
EXTERNALITIES
An externality arises when a person engages in an activity that influences
the well being of a bystander (or third party) and yet neither pays nor
receives any compensation for that effect. Thir d parties are individuals,
organizations, or communities indirectly benefitting or suffering as a result
of the actions of consumers and producers attempting to pursue their own
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101 the social optimum output or level of consumption diverges from the
private optimum.
If the impact on the bystander (or third party) in adverse, it is called a
negative externality (e.g. consumers and producers may fail to take into
account the effects o f their actions on third parties, such as car drivers,
who may fail to take into account the traffic congestion they create for
others; or producers fail to take into account pollution, radiation, and other
production by products). If it is beneficial it i s called a positive
externality (e.g., the benefits of education extend beyond those receiving
the education and thus beyond the market exchange).
Negative externalities lead markets to produce a larger quantity than is
socially desirable e.g., when the fi rms do not pay for the pollution their
cost would be low and they would produce more.
Positive externalities lead markets to produce a smaller quantity than is
socially desirable e.g. if an entrepreneur stages a fireworks show, people
can watch the show fr om their windows or backyards. Because the
entrepreneur cannot charge a fee for consumption, the fireworks show
may go unproduced, even if demand for the show is strong.
To remedy the problem, governments can internalize the externality by
taxing goods th at have negative externalities and subsidizing the goods
that have positive externalities.
ASYMMETRIC INFORMATION
Asymmetric information is a market situation in which one party in a
transaction has more information than the other party. This can affect t he
firm’s strategy. It can lead to market failures.
The lack of information among buyers or sellers often means that the
demand price does not reflect all benefits of a good or the supply price
does not reflect all opportunity costs of production. That is , buyers might
be willing to pay more or less for a good because they don’t know the true
benefits generated. Or sellers might be willing to accept more or less for a
good than the true opportunity cost of production.
In many cases, sellers have better inf ormation about a good than buyers.
Sellers own and control the good, they have direct contract with the good.
If there are defects or problems with the good, they are likely to know
Buyers, in contrast, have much less familiarity with a good, perhaps only
knowing the information provided by the sellers. In this case, buyers are
likely to have different demand price than the value of the good produced,
a value based on more complete information. In other words, markets may
not provide enough information beca use, during a market transaction, it
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102 Asymmetric information can lead to poorly functioning markets, that is,
too much or too little of a good may be produced. Consumer s may fear
purchasing goods when they know that the seller knows more about the
quality of a good than they do. The greater the information asymmetry
between sellers and consumers, the greater the scope for deception and
fraud.
A downward economic activit ies may be due to asymmetric information
between economic agents.
Asymmetric information leads to market inefficiencies and thus to market
failures. Thus, government has to take measures to improve the
information for consumers, investors and other market participants.
INEQUALITY
Markets may also fail to limit the size of the gap between income earners,
the so called income gap. Market transactions reward consumers and
producers with incomes and profits, but these rewards may be
concentrated in the hands o f a few. There is nothing in the market
mechanism that guarantees an equitable distribution of income in the
society.
Market failure can also be caused by the existence of inequality
throughout the economy. Wide differences in income and wealth between
different groups within an economy lead to a wide gap in living standards
between wealthy households and those experiencing poverty. Society may
come to the view (a value judgment) that too much inequality is
unacceptable or undesirable.
MISSING MARKETS AND INCOMPLETE MARKETS
A market considered to be complete when it provides all goods and
services for which the cost of provision is less than what individuals are
willing to pay. Whenever private markets fail to provide a good or service
eventhough the cost of providing it is less than what individuals are
willing to pay, they are considered as incomplete markets. Incomplete
markets are the cases of market failures.
Markets may fail to perform, resulting in a failure to meet a need or want,
such as the need for public goods, like defence, street lighting, and
highways. In the latter case (incomplete markets) markets may fail to
produce enough merit goods, such as education and healthcare.
A missing market is a situation where resource allocation based on a
competitive market does not exist. Missing markets are nothing but market
failures. Externalities, public goods, etc. are the cases of missing markets.

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103 MERIT GOODS
Merit Goods are those goods and services that the government feels that
people left to them selves will under -consume and which therefore ought to
be subsidized or provided free at the point of use.
Both the public and private sector of the economy can provide merit goods
and services. Consumption of merit goods is thought to generate positive
externality effects where the social benefit from consumption exceeds the
private benefit.
Example include; health services, education, work training, public
libraries, vaccinations.
UNSTABLE MARKETS
Sometimes markets become highly unstable, and a stable e quilibrium may
not be established, such as with certain agricultural markets, foreign
exchange, and credit markets. Such volatility may require intervention.
DE-MERIT GOODS
Markets may also fail to control the manufacture and sale of goods like
cigarettes and alcohol, which have less merit that consumers perceive.
PROPERTY RIGHTS
Markets work most effectively when consumers and producers are granted
the right to own property, but in many cases property rights cannot easily
be allocated to certain resource s. Failure to assign property rights may
limit the ability of markets to form.
6.5 PUBLIC GOODS
A public good is a special type of good that can be consumed by
everyone, regardless of whether they have paid for the good. When goods
are available free of ch arge, however, the market forces that normally
allocate resources in the economy are absent.
To understand how public goods differ from other goods and what
problems they present for society consider their characteristics;
(a) Non excludability : where it is not possible to provide a good or
service to one person without it thereby being available for others to
enjoy. A good is not excludable because it is impossible to prevent
someone from using the good or availing of its benefits.
(b) Non-rivalry : where the co nsumption of a good or service by one
person will not prevent others from enjoying it. A good is non rival in
consumption because one person’s enjoyment of the good/s does not
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104 Since the benefits of such goods are ava ilable to all, consumers will not
voluntarily pay for those goods. This is the free-rider problem that
accompanies public goods. Since it is difficult to exclude anyone from
using them, those who benefit from the public goods have an incentive to
avoid pay ing for them. Hence, the market failure occurs in the provision of
public goods.
Common examples of public goods include street lighting/light house
protection, national and domestic security i.e. national defence and police
services, public health, flood defence systems, public parks and beaches,
public welfare programmes, education, roads, research and development,
and a clean environment. In each case consumption by one does not
impose an opportunity cost on others and non payers cannot be excluded
from consumption. In each case, markets fail to efficiently allocate the
production, consumption, or provision of the goods.
Markets will not supply public goods or if they supply they will not supply
enough of public goods. Since the markets fail in the above cases, public
goods provide a rationale for many government activities.
6.6 ROLE OF GOVERNMENT
The state or the government can play an important role to correct market
failures and improve economic efficiency. The presence of government
may reflect the po litical and social ideologies prevailing in the country.
More importantly, the prevalence of governments reflects the fact that the
market mechanism alone cannot perform all economic functions.
Government intervention is needed in the economy for the follo wing
reasons :
(i) To improve economic efficiency by correcting market failures.
(ii) To pursue social values of equity by altering market outcomes.
(iii) To pursue other social objectives by the provision of public and
merit goods and at the same time prohibiting the c onsumption of
demerit goods.
The role of the state or the government is explained below :
1. Securing conditions for the functioning of market mechanism : It is
argued that market mechanism leads to an efficient allocation of
resources, that is, it produces what consumers want most and does so
in the cheapest way. This argument is based on the condition that there
is perfect competition in the factor and product markets. For this, there
must not be any obstacles to free entry into and exit from the market. It
also requires that consumers and producers have complete knowledge
about the market. Government regulation and measures will be needed
to secure the conditions necessary for the functioning of market
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105 The government has an important role in cor recting market failures
arising from imperfect information, imperfect competition,
externalities and public goods. In the case of imperfect competitions,
firms use their market power to raise prices and reduce output. The
Monopoly MRTP Act or Competition P olicy Act of the government
of the India can help to maintain competitive force and restrain firms
from abusing their monopoly power. Similarly, imperfect information
can lead to inefficient functioning of product and labour markets.
Government can set up regulatory authorities such as SEBI (Securities
Exchange Board of India) to compel the firms to provide information
about their financial conditions and other aspects.
2. Providing legal framework : The contractual arrangements and
exchanges needed for market operation cannot exist without the
protection and enforcement of a governmentally provided legal
framework. In this respect, government can provide necessary legal
structure and ensure their implementation by the firms and other
parties in the market. In I ndia regulatory authorities like SEBI provide
the legal framework.
3. Provision of public goods and merit goods :Even if the legal
structure is provided and barriers to competition are removed, the
production or consumption characteristics of certain goods li ke public
goods and merit goods are such that they cannot be provided through
the market. In the case of public goods there is the free rider problem.
As a consequence the market fails in the provision of public goods.
Thus, government has to ensure their provision. On the other hand
merit goods are the goods that the governments consider as good for
the people, for example education. If they are provided by the market
people may under consume such goods. Thus they have to be
subsidized or provided free by the government.
4. Correcting the prob lems arising from externalities : Externalities
lead to “market failure”. This requires correction by the government
either by way of budgetary provisions, subsidies or taxation. In the
case of goods with positive externa lities (like research), firms produce
too little of goods and in the case of goods with negative externalities
(such as that generate pollution), firms produce too much of goods.
Governments can subsidise the production of goods with positive
externalities and tax or regulate those with negative externalities.
5. Correcting inequal distribution of income and wealth : The
distribution of income and wealth which results from the market
system and from the transfer of property rights through inheritance is
likely to be unequal, in the market system, individual’s incomes are
related to their ownership of assets and their productivity. In most of
the countries, wealth is concentrated in the hands of a few. In many
countries inequalities are linked to inheritance. Ev en in wages and
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106 payment. The government has to work towards redistribution of
income from the rich to the poor through welfare programmes and
taxation policies.
6. Securing important social obje ctives : The market system does not
necessarily bring high employment, price level stability, social desired
rate of growth, poverty eradication and economic development.
Government policies are needed to secure these objectives.
7. Provision of social securi ty: The market system cannot provide social
security to citizens, suffering from unemployment, sickness, old age
disability and so on. The government has to step in to provide social
security to its citizens.
8. Guiding the use of natural resources : Public a nd private points of
view on discounts used in the valuation of future relative to present
consumption differ. The considerably affects the use of natural
resources. The market mechanism cannot bring about appropriate
allocation of natural resources for th e present and future. Similarly, the
market mechanism may not be able to control the pollution of
environment. Therefore, consumption of natural resources, pollution
control, etc. should be guided by government policies.
9. Public ownership : If the governmen t feels that, under free market
conditions, some industries would charge unreasonably high price and
earn abnormal or monopoly profit, it could nationalize the industry and
provide goods and services at a desired price. Alternatively, the
government may ap ply rules and regulations to force industries to
charge a reasonable price. Nationalisation of major commercial banks
in India in 1969 was aimed to meet the financial needs of the poor
section of the society at reasonable conditions and price (interest).
2.7 SUMMARY
1. Economic efficiency is a state where every resource is allocated
optimally so that each person is served in the best possible way and
inefficiency and waste are minimized.
6. Productive efficiency is concerned with producing goods and services
with the optimal combination of inputs to produce maximum output
for the minimum cost.
3. A free market economy functions to maximize benefit or welfare of
both consumers and producers. One of the measures adopted by
economists or economic planners is the criterion of sum of consumer
and producer surplus.
4. A market is defined “as a group of firms and individuals that are in
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107 5. Market failure occurs when resources are misallocated, or allocated
inefficiently. In other words, market failure occurs when markets fail
to produce and allocate scare resources in the most efficient way; i.e.
the market may not always allocate scarce resources efficiently in a
way that achieves the highest total social wel fare.
6. Markets fail to perform efficiently due to a number of reasons such as
availability of public goods, business corporate acquiring monopoly
power in real world market which is full of imperfections, externalities
arising out of economic activities , imperfect or asymmetric
information, unequal income distribution and many other factors.
7. A public good is a special type of good that can be consumed by
everyone, regardless of whether they have paid for the good. When
goods are available free of char ge, however, the market forces that
normally allocate resources in the economy are absent.
8. The state or the government can play an important role to correct
market failures and improve economic efficiency. The presence /
intervention of government may r eflect the political and social
ideologies prevailing in the country. More importantly, the prevalence
of governments reflects the fact that the market mechanism alone
cannot perform all economic functions.
2.8 QUESTIONS
1. Explain the term Market failure and w rite down different causes of
market failure?
2. Define and write short note on productive and allocative efficiency?
3. What are public goods? Explain using examples.
4. Explain the role of government in correcting Market failure





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108 MODULE 4
7
PUBLIC REVENUE
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Meaning of Public Revenue
7.3 Sources of Public Revenue
7.4 Canons of Taxation
7.5 Characteristics of a Good Tax Structure / Sys tem
7.6 Direct Taxes : Meaning
7.7 Indirect Taxes : Meaning
7.8 Objectives of Taxation
7.9 Tax Base and Rates of Taxation
7.10 Summary
7.11 Questions
7.0 OBJECTIVES
 To understand the meaning and sources of Public Revenue
 To study various objectives of taxation
 To study the canons of taxation
 To understand the types of taxes
 To understand the concepts of tax base and rates of taxation
7.1 INTRODUCTION
The study of public finance is the deep study of all finance operations
related to the state which is therefore concerned with complete income and
expenditure of public authorities and administrative structures that are
adjusted with one another.
Public finance is a concept that includes Public expenditure, public debt
and public revenue and income.
Public revenue is exactly income generated from sources of government in
order to meet requirements of expenses of public.

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109 7.2 MEANING OF PUBLIC REVENUE
Public revenue generally refers to government revenue. Some important
sources or concepts that are included i n public revenue consist of taxes,
fees, sale of public goods and services, fines, donations, etc.
Public revenue refers to the income side of the financial operations of the
state. It is the revenue or income of public authorities namely central,
State, Local bodies etc.
According to Dalton, public revenue can be viewed from a broad as well
as a narrow sense. He therefore, makes a distinction between public
revenue and public receipts. In a broad sense, the income of public
authorities includes all receipt s from all possible sources during a specific
period, normally a year. It is called public receipts.
In a narrow sense, it refers only to those sources which bring income to
the government. These sources are known as revenue sources and include
only the non-tax sources of public revenue.
7.3 SOURCES OF PUBLIC REVENUE
The main sources of public revenue are: Tax and Non-tax revenue
1. Tax Revenue:
The chief source of public revenue is Tax. To define tax, it is said that tax
is a mandatory imposition of duty on p ublic authority by government
organizations to meet requirements of general public as a whole.
Therefore, with the above defined term, some points are highlighted as
below:
i) A Tax is a compulsory duty levied by the government. If any
individual refuses to comply with tax payments, he can be punished or
penalized
ii) Tax basically involves some understanding and sacrifice on the basis
of a tax payer
iii) Tax is a duty and not a penalty
iv) Most part of revenue income is generated from tax by the central
government.
Broad classification of taxes is: Direct and Indirect Taxes Direct taxes:
Direct taxes are levied on wealth and income of individuals or
organizations. These taxes are personal income tax, corporate tax, and gift
or wealth tax. The impact of direct taxes is on t he same person.
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110 the tax base. Progressive direct taxes are involved in falling income
discrimination especially in rising countries.
Indirect Taxes:
These taxes are levied on manuf actured goods and consumable goods in
India. Excise duty is the chief and single largest source to generate
revenue income.
Rates of excise duty faces a declining trend.
Customs Duty is imposed on exports of selective range and imports. With
revenue point of view, Custom duty has less importance. Service Tax is
imposed by specific category of firms, agencies or persons. Rate of service
taxes have been increased progressively. Goods and service tax includes
range of all taxes like excise duty, service tax, goods tax, VAT, etc. It
covers goods and service charges in mostly all sectors. It generally
simplifies the complexity of charges on good and services
2. Non tax revenues
Non Tax Revenue comprises all revenues apart from taxes accumulated to
the Government. Non tax revenues are funds that are generated from
internal sources.
The sources of revenue are: Administrative revenue , Commercial revenue ,
Grants and gifts
Important sources of Non tax revenues include
a) Special Assessment:
This can be called as betterment c harge. This tax is imposed to a certain
category of members of a community who are generally benefited from
governmental activities or public functions like constructions of road,
railways, parks, etc. Therefore, government imposes special charges on
such properties.
b) Surplus of Public Enterprises
The government has arranged public sector enterprises that are concerned
in commercial activities. The surpluses generated of these enterprises are a
significant source of non-tax revenue. These incomes are in the form of
profits that are known as commercial revenues.
c) Fees:
A fee is a significant source of managerial non -tax revenue charged by
Government authorities for depiction services to the members of the
public. There is no compulsion to pay fees. All those utilize services may
pay fees. Fees may be charged for getting licenses, passports or
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111 d) Fine and Penalties
These are general sources of administrative non tax revenues. These may
be applied on public for non complianc e with certain rules and
regulations. These are not considered as the major source of revenue for
the government.
e) Grants and Gifts
Grants are financial support. These are provided to public authority to
perform certain social activities. These are generate d by higher public
authority to lower ones e.g. World bank gives grants to State bank. There
is no repayment compulsion. Gifts and donations are voluntarily made
by individuals, organizations or foreign governments to the Central
Government. These gifts ar e made by natural feeling in case of disasters or
natural calamities. Gifts are not considered as a source of income.
Therefore, tax plays an important part in generating government revenue.
Non tax is important in developing revenue.
7.4 CANONS OF TAXATIO N
Canons of Taxation are the main basic principles (i.e. rules) set to build a
'Good Tax System'. Canons of Taxation were first originally laid down by
economist Adam Smith in his famous book "The Wealth of Nations".
In this book, Adam smith only gave four canons of taxation. These
original four canons are now known as the "Original or Main Canons of
Taxation".
As the time changed, governance expanded and became much more
complex than what it was at the Adam Smith's time. Soon a need was felt
by modern econ omists to expand Smith's principles of taxation and as a
response they put forward some additional modern canons of taxation.
Adam Smith's Four Main Canons of Taxation
A good tax system is one which is designed on the basis of an
appropriate set of princi ples (rules). The tax system should strike a
balance between the interest of the taxpayer and that of tax authorities.
Adam Smith was the first economist to develop a list of Canons of
Taxation. These canons are still regarded as characteristics or feature s of a
good tax system.
Adam Smith gave following four important canons of taxation.
1. Canon of Equity
The principle aims at providing economic and social justice to the
people. According to this principle, every person should pay to the
government depending upon his ability to pay. The rich class people
should pay higher taxes to the government, because without the protection
of the government authorities (Police, Defence, etc.) they could not have
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112 should be proportional to income, i.e., citizens should pay the taxes in
proportion to the revenue which they respectively enjoy under the
protection of the state.
2. Canon of Certainty
According to Adam Smith, the tax which an individual has to pay sho uld
be certain, not arbitrary. The tax payer should know in advance how much
tax he has to pay, at what time he has to pay the tax, and in what form
the tax is to be paid to the government. In other words, every tax should
satisfy the canon of certainty. A t the same time a good tax system also
ensures that the government is also certain about the amount that will be
collected by way of tax.
3. Canon of Convenience
The mode and timing of tax payment should be as far as possible,
convenient to the tax payers. For example, land revenue is collected at
time of harvest income tax is deducted at source. Convenient tax system
will encourage people to pay tax and will increase tax revenue.
4. Canon of Economy
This principle states that there should be economy in tax admin istration.
The cost of tax collection should be lower than the amount of tax
collected. It may not serve any purpose, if the taxes imposed are
widespread but are difficult to administer. Therefore, it would make no
sense to impose certain taxes, if it is d ifficult to administer.
Additional Canons of Taxation
Activities and functions of the government have increased significantly
since Adam Smith's time. Government are expected to maintain economic
stability, full employment, reduce income inequality & prom ote growth
and development. Tax system should be such that it meets the
requirements of growing state activities.
Accordingly, modern economists gave following additional canons of
taxation.
5. Canon of Productivity
It is also known as the canon of fiscal adequacy. According to this
principle, the tax system should be able to yield enough revenue for the
treasury and the government should have no need to resort to deficit
financing. This is a good principle to follow in a developing economy.
6. Canon of Elasticit y
According to this canon, every tax imposed by the government should be
elastic in nature. In other words, the income from tax should be capable
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113 For example, if the government needs more income at time of crisis, the
tax should be capable of yielding more income through increase in its rate.
7. Canon of Flexibility
It should be easily possible for the authorities to revise the tax structure
both with respect to its coverage and rates, to suit the changing
requirements of the economy. With changing time and conditions the tax
system needs to be changed without much difficulty. The tax system must
be flexible and not rigid.
8. Canon of Simplicity
The tax system should not be complicated. That makes it difficult to
understand and administer and results in problems of interpretation
and disputes. In India, the efforts of the government in recent years have
been to make the system simple.
9. Canon of Diversity
This principle states that the governmen t should collect taxes from
different sources rather than concentrating on a single source of tax. It is
not advisable for the government to depend upon a single source of tax, it
may result in inequity to the certain section of the society; uncertainty fo r
the government to raise funds. If the tax revenue comes from diversified
source, then any reduction in tax revenue on account of any one cause is
bound to be small.
7.5 CHARACTERISTICS OF A GOOD TAX
STRUCTURE/ SYSTEM
The tax structure is a part of eco nomic organisation of a society and
therefore fit in its overall economic environment. No tax system that does
not satisfy these basic condition can be termed a good one. However, the
state should pursue mainly following principles in structuring its tax
system :-
1. The distribution of tax burden should be equitable. Everyone should be
made to pay as per their ability. It collects more from richer section
and less from poorer section.
2. The tax system should encourage productive efficiency. It should
provide in centive to increase savings and investment. It may lead to
favourable allocation of resources.
3. A tax system should be diversified. It may rely on different bases,
such as , income, wealth and expenditure.
4. The primary aim of the tax should be to raise adequ ate revenue to meet
public expenditure since the modern government performs various
functions in the economy.
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114 5. The tax system should be flexible to change with changing
requirements of the government and the economy.
6. A good tax system should recognize the basic rights of the tax payer,
and therefore, it should be simple, certain and convenient.
7. The tax system should be economical. Administrative machinery
should be efficient and honest. It should involve minimum cost of
collection.
8. A good tax system should also facilitate stability and growth
objectives. Growth with stability is an important objective for both
developed and developing countries.
In general a good tax system should run in harmony with important
national objectives and if possible should assis t the society in achieving
them. Thus, the good tax system should be designed so as to meet the
requirements of equity in the distribution of tax burden, efficiency in the
tax use, goals of macroeconomic policy and ease of administration.
Direct and Indire ct Taxes
With the budget session around the corner, there is lot of noise about
taxes. Taxes don’t just mean your income -tax; there are many other
forms of tax that an individual pays without directly seeing the hit. While
income -tax is a direct tax, the l atter are called indirect taxes. Here’s a look
at what the two categories cover and how they impact you.
7.6 DIRECT TAXES : MEANING
A direct tax is one, which is paid by a person on whom it is legally
imposed and the burden of which cannot be shifted to an y other person.
The person from whom it is collected cannot shift its burden to anybody
else. The tax-payer is the tax-bearer. The impact i.e. the initial burden
and its incidence i.e. the ultimate burden of direct tax is on the same
person. For e.g. Incom e tax, wealth tax, property tax, estate duties, capital
gain tax, corporate / company tax, etc. are all direct taxes.
This kind of levy is payable directly by the individual or company, whose
obligation it is to pay. It can’t be transferred to anyone else. The most
common form of direct tax is income -tax, which has to be paid by
individuals, hindu undivided families (HUFs), cooperative societies and
trusts on the total income they earn. This can include income from salary,
income from house property, busine ss and professional income, capital
gains and income from other sources such as interest. The tax liability
depends on the residential status and gender of the person being taxed.
Companies are also taxed on the income they earn. For Indian companies,
tax is obligatory on income earned in India and overseas, whereas in case
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115 A house owner has to pay property tax, which is applied as per state rules.
Lastly, if you receive a gift in excess of Rs.50,000 per year, you will have
to pay gift tax.
The onus of declaring income for the purpose of calculating direct tax
liability is on you. Non -payment or tax evasion can incur heavy penalty.
Advantages / Merits of Direct Taxes :
Following are the important advantages or merits of Direct Taxes :-
1. Equity
There is social justice in the allocation of tax burden in case of direct
taxes as they are based on the principle of ability to pay. Persons in a
similar economic situation are taxed at the same rate . Persons with
different economic standing are taxed at a different rate. Hence, there is
both horizontal and vertical equity under direct taxation. Progressive direct
taxation can reduce income inequalities and bring about adequate social &
economic justice.
For example, in the Indian Budget of 2007, individual with an income of
up to Rs. 1,10,000 are exempted from payment of income tax and in the
case of women tax payer, the exemption limit is Rs. 1,45,000.
2. Certainty
As far as direct taxes are concerned, the tax payer is certain as to how
much he is expected to pay, as the tax rates are decided in advance. The
Government can also estimate the tax revenue from direct taxes with a
fair accuracy. Accordingly, the Government can make adjustments in its
income and expenditure.
3. Relatively Elastic
The direct taxes are relatively elastic. With an increase in income and
wealth of individuals and companies, the yield from direct taxes will
also increase. Elasticity also implies that the government's revenue can
be increased by raising the rates of taxation. An increase in tax rates
would increase the tax revenue.
4. Creates Public Consciousness
They have educative value. In the case of direct taxes, the taxpayers are
made to feel directly the burden of taxes and hence take keen interest in
how public funds are spent. The taxpayers are likely to be more aware
about their rights and responsibilities as citizens of the state.
5. Economical
Direct taxes are generally economical to collect. For instances, in the case
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116 or salaries of the individuals. Therefore, the government does not have to
spend much in tax collection as far as personal income tax is concerned.
However, in the case of indirect taxes, the government has to set up an
elaborate machinery to collect taxes.
6. Anti-inflationary
The direct taxes can help to control inflation. During inflationary periods,
the government may increase the tax rate. With an increase in tax rate, the
consumption demand may decline, which in turn may reduce inflation.
advantages / Demerits of Direct Taxes
Though direct taxes possess above mentioned merits, the economist have
criticised them on the following grounds :-
1. Tax Evasion
In India, there is good amount of tax evasio n. The tax evasion is due to
High tax rates, Documentation and formalities, Poor and corrupt tax
administration. It is easier for the businessmen to evade direct taxes. They
invariable suppress correct information about their incomes by
manipulating their accounts and evade tax on it.
In less developed countries like India, due to high rate of progressive tax
evasion & avoidance are extensive and led to rise in black money.
2. Arbitrary Rates
The direct taxes tend to be arbitrary. Critics point out that there cannot be
any objective basis for determining tax rates of direct taxes. Also, the
exemption limits in the case of personal income tax, wealth tax, etc., are
determined in an arbitrary manner. A precise degree of progression in
taxation is also difficult to achieve. Therefore direct taxes may not always
fulfill the canon of equity.
3. Inconvenient
Direct taxes are inconvenient in the sense that they involve several
procedures and formalities in filing of returns. For most people payment
of direct tax is not only inconvenient, it is psychological painful also.
When people are required to pay a sizeable part of their income as a tax to
the state, they feel very much hurt and their propensity to evade tax
remains high. Further every one who is required to pay a direct tax has to
furnish appropriate evidence in support of the statement of his income &
wealth & for this he has to maintain his accounts in proper form. Direct
tax is considered inconvenient by some people because they have to make
few lump sum payments to the governments, whereas their income
receipts are distributed over the whole year.
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117 4. Narrow Coverage
In India, there is a narrow coverage of direct taxes. It is estimated that
only three percent of the population pay personal income tax. Due to low
cove rage, the government does not get enough funds for public
expenditure. Estate duty & wealth tax are equally narrow based and thus
revenue proceeds from these taxes are invariably small.
5. Affects Capital Formation
The direct taxes can affect savings and inve stment. Due to taxes, the net
income of the people gets reduced. This in turn reduces savings.
Reduction in savings results in low investment. The low investment
affects capital formation in the country.
6. Effect on Willingness and Ability to Work
Highly pro gressive direct taxes reduce people's ability and willingness to
work and save. This in turn may have a negative impact on investment
and productive capacity in the economy. If tax burden is high, people's
consumption level gets adversely affected and this has an impact on their
ability to work and save. High taxes also discourage people from working
harder in order to earn and save more.
7. Sectoral Imbalance
In India, there is Sectoral imbalance as far as direct taxes are
concerned. Certain sectors like the corporate sector is heavily taxed,
whereas, the agriculture sector is 100% tax free. Even the large rich
farmers are exempted from payment of personal income tax.
Conclusion on Direct Taxes
In direct tax burden of tax cannot be shifted. The disadvantage of direct
taxation are mainly due to administrative difficulties and inefficiencies.
The extent of direct taxation should depend on the economic state of the
country. A rich country has greater scope for direct taxation than a poor
country. However direct taxation is an important aspect of the modern
financial system.
7.7 INDIRECT TAXES : MEANING
Indirect tax is levied by the government and collected by an intermediary
from the person who bears the ultimate economic burden of the tax. What
this means is that if you are purchasing goods or services from anywhere
and you are the final consumer, then the tax levied on the manufacturer
will ultimately get passed on to you. This kind of tax increases the total
amount you pay for something. Sometimes it may be repr esented
separately from the price of the item or may be shown together with the
cost of the product itself. For example, the service tax paid on a food bill
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118 An indirect tax is one in which the burden can be shifted to others. The tax
payer is not the tax bearer. The impact and incidence of indirect taxes are
on different persons. An indirect tax is levied on and collected from a
person who manages to pass it on to some other person or persons on
whom the real burden of tax falls. For e.g. commodity taxes or sales tax,
excise duty, custom duties, etc. are indirect taxes.
There are many forms of indirect taxes. Customs duty is a tax levied on
items imported (and exported out of) into I ndia. The central government
also charges an excise duty or a tax payable on goods manufactured in
India for domestic consumption. Service tax is a charge applied on
services such as food and beverage, travel and recreation by the provider,
while value -added tax is applied at each stage of sale of a product and the
final tax is borne by the last consumer. Lastly, there is securities
transaction tax levied on all transactions done on a stock exchange.
The reason why these are called indirect taxes is because unlike direct
taxes, the person paying the tax to the government can pass it on to
another person. They are charged first at the manufacturers’ level, but
ultimately get passed on to the consumer, which is you.
Hicks classifies direct & indirect taxes on the basis of administrative
arrangements. In case of direct tax -there is a direct relationship between
the taxpayer and the revenue authorities. A tax collecting agency
directly collects the tax from the taxpayers, whereas in case of indirect
taxes there is no direct relationship between the taxpayers and the revenue
authorities. They are collected through traders and manufacturers.
Over the years the share of indirect tax has declined in India due to
reduction in the rates of indirect taxes.
Advantages / Merits of Indirect Taxes
The merits of indirect taxes are briefly explained as follows :-
1. Convenient
Indirect taxes are imposed on production, sale and movements of goods
and services. These are imposed on manufacturers, sellers and traders, but
their burd en may be shifted to consumers of goods and services who are
the final taxpayers. Such taxes, in the form of higher prices, are paid
only on purchase of a commodity or the enjoyment of a service. So
taxpayers do not feel the burden of these taxes. Besides, money burden of
indirect taxes is not completely felt since the tax amount is actually
hidden in the price of the commodity bought. They are also convenient
because generally they are paid in small amounts and at intervals and are
not in one lump sum. The y are convenient from the point of view of the
government also, since the tax amount is collected generally as a lump sum
from manufacturers or traders.
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119 2. Difficult to evade
Indirect taxes have in built safeguards against tax evasion. The indirect
taxes are paid by customers, and the sellers have to collect it and remit it
to the Government. In the case of many products, the selling price is
inclusive of indirect taxes. Therefore, the customer has no option to evade
the indirect taxes.
3. Wide Coverage
Unlike d irect taxes, the indirect taxes have a wide coverage. Majority of
the products or services are subject to indirect taxes. The consumers or
users of such products and services have to pay them.
4. Elastic
Some of the indirect taxes are elastic in nature. When government feels it
necessary to increase its revenues, it increases these taxes. In times of
prosperity indirect taxes produce huge revenues to the government.
5. Universality
Indirect taxes are paid by all classes of people and so they are broad
based. Poor people may be out of the net of the income tax, but they pay
indirect taxes while buying goods.
6. Influence on Pattern of Production
By imposing taxes on certain commodities or sectors, the government can
achieve better allocation of resources. For e.g. By Imposing taxes on
luxury goods and making them more expensive, government can divert
resources from these sectors to sector producing necessary goods.
7. May not affect motivation to work and save
The indirect taxes may not affect the motivation to work and to save.
Since, most of the indirect taxes are not progressive in nature, individuals
may not mind to pay them. In other words, indirect taxes are generally
regressive in nature. Therefore, individuals would not be demotivated to
work and to save, which may increase investment.
8. Social Welfare
The indirect taxes promote social welfare. The amount collected by way
of taxes is utilized by the government for social welfare activities,
including education, health and family welfare.
Secondly, very high taxes are imposed on the consumption of harmful
products such as alcoholic products, tobacco products, and such other
products. So it is not only to check their consumption but also enables the
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120 9. Flexibility and Buoyancy
The indirect taxes are more flexible and buoyant. Flexibility is the
ability of the tax system to generate proportionately higher tax revenue
with a change in tax base, and buoyancy is a wider concept, as it involves
the ability of the tax system to generate proportionately higher tax revenue
with a change in tax base, as well as tax rates.
Disadvantages / Demerits of Indirect Taxes
Although indirect taxes have become quite popular in both developed &
Under developed countries alike, they suffer from various demerits, of
which the following are important.
1. High Cost of Collection
Indirect tax fails to satisfy the principle of economy. The government has
to set up elaborate machinery to administer indirect taxes. Therefore,
cost of tax collection per uni t of revenue raised is generally higher in the
case of most of the indirect taxes.
2. Increase income inequalities
Generally, the indirect taxes are regressive in nature. The rich and the
poor have to pay the same rate of indirect taxes on certain commodities of
mass consumption. This may further increase income disparities among
the rich and the poor.
3. Affects Consumption
Indirect taxes affects consumption of certain products. For instance, a high
rate of duty on certain products such as consumer durables may restrict the
use of such products. Consumers belonging to the middle class group may
delay their purchases, or they may not buy at all. The reduction in
consumption affects the investment and production activities, which in
turn hampers economic growth.
4. Lack of Social Consciousness
Indirect taxes do not create any social consciousness as the taxpayers do
not feel the burden of the taxes they pay.
5. Uncertainty
Indirect taxes are often rather uncertain. Taxes on commodities with
elastic demand are particularly uncertain, since quantity demanded will
greatly affect as prices go up due to the imposition of tax. In fact a higher
rate of tax on a particular commodity may not bring in more revenue.

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121 6. Inflationary
The indirect taxes are inflationary in nature. The ta x charged on goods and
services increase their prices. Therefore, to reduce inflationary pressure,
the government may reduce the tax rates, especially, on essential items.
7. Possibility of tax evasion
There is a possibility of evasion of indirect taxes as so me customers may
not pay indirect taxes with the support of sellers. For instance,
individuals may purchase items without a bill, and therefore, may not pay
Sales tax or VAT (Value Added Tax), or may obtain the services
without a bill, and therefore, may e vade the service tax.
Conclusion on Indirect taxes:
Elaborate analysis of merits and demerits of direct and indirect taxes
makes it clear that whereas the direct taxes are generally progressive, and
the nature of most indirect taxes is regressive. The scop e of raising
revenue through direct taxation is however limited and there is no escape
from indirect taxation in spite of attendant problems. There is common
agreement amongst economists that direct & indirect taxes are
complementary and therefore in any rational tax structure both types of
taxes must find a place.
7.8 OBJECTIVES OF TAXATION
The first and the foremost objective of taxation is to raise revenue so as to
meet huge public expenditure. Most of the governmental activities are
financed by taxation . Taxation policy has some non -revenue objectives
also. In the modern economies, taxation is used as an instrument of
economic policy. It affects overall economic activities such as total
volume of production, consumption, investment, balance of payments,
income distribution etc.
1. Economic Development: It is one of the important objectives of
taxation. Economic development of any country is largely depend on the
growth of capital formation and most of the developing and
underdeveloped countries suffer fro m the shortage of capital. For rapid
economic development a rapid capital accumulation is required. With
proper taxation policy and planning, raising the existing rate of taxes or by
imposing new taxes may lead to increase in revenue for capital formation.
Due care is required to be taken while making use of these revenue. The
tax policy has to be employed in such a way that investment occurs in the
productive sectors of the economy, including the infrastructural sectors.
2. Full Employment : Economic devel opment with full employment of
resources is the second objective. To achieve this objective the rates of
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122 effective demand. It stimulates further investment which in turn results in
rise in income and employment through the multiplier mechanism.
7. Price Stability : Thirdly, an effective tax policy ensures price stability
in an economy by controlling inflation. Increase in direct taxes help to
control private spending so that prices of the co mmodities remains stable.
Increase in indirect taxes on commodities may lead to inflationary
tendencies. To maintain price stability with effective use of taxes is
therefore necessary for smooth economic development of the country.
4. Control of Cyclical F luctuations : Fourthly, to control cyclical /
periodic fluctuations occurred due to trade cycles is another objective of
taxation policy. Generally during depression, taxes are cut down to
motivate demand and investment while during boom taxes are increased
so that cyclical fluctuations are tamed.
5. Reduction of BOP Difficulties : Indirect taxes like custom duties are
used to control imports of certain goods with the objective of reducing the
burden of balance of payments and to encourage domestic productio n of
import substitutes.
6. Non -Revenue Objective : One of the important non -revenue objective
of taxation is the reduction of inequalities in income and wealth
distribution. It can be done by taxing the rich at higher rate than the poor
through the system of progressive taxation.
7.9 TAX BASE AND RATES OF TAXATION
Tax base can be defined as the total amount of assets or revenue on which
the government can levy a tax. For example, in the case of income tax, the
tax base is all the income earned by the peopl e. In the case of property
taxes, the tax base is the total value of the property, which changes hands
in a given period of time. Therefore, the tax base is the number to which a
percentage rate is applied to reach the actual amount of the tax that needs
to be paid. For example, if a 30% tax has to be applied to Rs.100000/ -
income, then the Rs.100000/ - is the tax base.
There are different types of taxes that have many different types of tax
bases.
7.9.1 Types of Tax Bases:
1. Value -Based: It is the most commo nly used type of tax base. It is used
in taxes, such as income tax and sales tax. If the value of the tax base
increases, the amount of tax collected will also increase. For example, if
the salary of a person increases from Rs.100000/ - to Rs.200000/ - and i f
the tax base remains the same, then the amount of tax collected will also
increase. Such kind of tax base is also referred to as ad -valorem.
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123 2. Quantity Based: There are certain other types of taxes, such as excise,
where taxes are levied on per unit of go ods produced. Hence, if 100 units
are produced at Rs.10/ - or 100 units are produced at Rs.20/ -, the tax will
remain the same since the base is the number of units, which is
100.Therefore, rising inflation will not have any effect on taxes in such
cases.
3. Market-Based: The true value of many goods and services are
difficult to determine. Therefore, in the case of property taxes, people tend
to show a lower value to the government as compared to the value at
which the transaction has actually taken place. In s uch cases, to protect the
interest of the people the government decides the circle rates which are
used to derive the tax base instead of the market price. This is because the
market price is subject to manipulation.
4. Broad -Based: It is the one that applies to a lot of items such as sales
tax or excise. Therefore, computing these tax bases is quite complex or
difficult. Such type of broad based taxes will not discriminate between
different forms of activities.
5. Narrow Based: Unlike broad based taxes these tax es are one which
applies only to a few items such as housing. Therefore determining and
managing their tax base is relatively easy. Necessary items such as food
are excluded from the tax base in order to make the tax less regressive.
7.9.2 Rates of taxatio n
The tax structure of an economy depends on its tax base, tax rate, and how
the tax rate varies accordingly. The tax base is the amount to which a tax
rate is applied. The tax rate is the percentage of the tax base that must be
paid in taxes. To calculate taxes, it is necessary to know the tax base and
the tax rate. If the tax base equals Rs.100/ - and the tax rate is 9%, then the
tax will be Rs.9 (=100 × 0.09).
1. Proportional taxes : Also known as flat rate taxes. The same tax rate is
applied to any inco me level, or for any size tax base. For e.g. Mr. X earns
Rs.50,000/ - and Mr. Y earns Rs.100,000/ - and the tax rate is 10%, then
Mr. X will have to pay Rs.5,000/ - while Mr. Y will have to pay
Rs.10,000/ - towards taxes. In many countries almost all sales tax es, social
security and medicare taxes are proportional taxes.
2. Regressive taxes : A regressive tax is higher for lower income groups.
Regressive taxes especially hurt the poor. The inequitable effects of
regressive or proportional taxes are often mitig ated by payments to the
poor and by exempting essential products and services, such as food, from
regressive and proportional taxes.
7. Progressive taxes : In case of progressive taxes a higher tax rate is
applied to higher income groups. For e.g. if the t ax rate on Rs.50,000/ - is
10% and 20% for Rs.100,000/ -, then, continuing the above example, Mr.
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124 towards taxes. However, almost all progressive taxes are structured as
a marginal tax , meani ng that the progressive tax rate only applies to that
part of the income exceeding a certain amount. The portion of the tax base
subject to a particular tax rate is known as a tax bracket which always has
a lower and upper limit, except for the top tax bra cket, which has no upper
limit.
7.10 SUMMARY
1. Public revenue refers to the income side of the financial operations of
the state. It is the revenue or income of public authorities namely
central, State, Local bodies etc.
2. The main sources of public revenue are: Tax and Non-tax revenue
7. The chief source of public revenue is Tax. To define tax, it is said that
tax is a mandatory imposition of duty on public authority by
government organizations to meet requirements of general public as
a whole. Broad classification of taxes is: Direct and Indirect Taxes
Direct taxes
4. Non Tax Revenue comprises all revenues apart from taxes accumulated
to the Government. Non tax revenues are funds that are generated
from internal sources.
5. Canons of Taxation are the mai n basic principles (i.e. rules) set to build
a 'Good Tax System'. Canons of Taxation were first originally laid
down by economist Adam Smith in his famous book "The Wealth of
Nations".
6. In general a good tax system should run in harmony with important
national objectives and if possible should assist the society in
achieving them. Thus, the good tax system should be designed so as to
meet the requirements of equity in the distribution of tax burden,
efficiency in the tax use, goals of macroeconomic policy and ease of
administration.
7. A direct tax is one, which is paid by a person on whom it is legally
imposed and the burden of which cannot be shifted to any other
person. The person from whom it is collected cannot shift its burden to
anybody else. The tax-payer is the tax-bearer. The impact i.e. the
initial burden and its incidence i.e. the ultimate burden of direct tax is
on the same person. For e.g. Income tax, wealth tax, property tax,
estate duties, capital gain tax, corporate / company tax, etc. are all
direct taxes.
8. An indirect tax is one in which the burden can be shifted to others. The
tax payer is not the tax bearer. The impact and incidence of indirect
taxes are on different persons. An indirect tax is levied on and
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125 person or persons on whom the real burden of tax falls. For e.g.
commodity taxes or sales tax, excise duty, custom duties, etc. are
indirect taxes.
9. Most of the governmental activities are financed by taxation. Taxati on
policy has some non -revenue objectives also. In the modern
economies, taxation is used as an instrument of economic policy. It
affects overall economic activities such as total volume of production,
consumption, investment, balance of payments, income d istribution
etc.
10. Tax base can be defined as the total amount of assets or revenue on
which the government can levy a tax. For example, in the case of
income tax, the tax base is all the income earned by the people. In the
case of property taxes, the ta x base is the total value of the property,
which changes hands in a given period of time. Therefore, the tax base
is the number to which a percentage rate is applied to reach the actual
amount of the tax that needs to be paid.
11. The tax structure of an e conomy depends on its tax base, tax rate, and
how the tax rate varies accordingly. The tax base is the amount to
which a tax rate is applied. The tax rate is the percentage of the tax
base that must be paid in taxes.
7.11 QUESTIONS
1. Explain the meaning a nd sources of public revenue.
2. Differentiate between tax and non -tax revenue.
7. Discuss Adam Smith’s Canons of taxation.
4. What are the characteristics of a good tax system?
5. Discuss the merits and demerits of direct taxes.
6. Explain the advantages and disadvantages of indirect taxes.
7. What are the objectives of imposition of taxes?
8. Explain the meaning and types of tax base.
9. Explain how tax rates are applied.

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126 8
SHIFTING OF TAX BURDEN
Unit Structure :
8.0 Objectives
8.1 Introduction
8.2 Impact, Shifting and Incidence of Tax
8.3 Economic Effects of Taxation
8.4 Introduction: Redistributive and Anti -Inflationary Nature of
Taxation
8.5 Summary
8.6 Questions
8.0 OBJECTIVES
 To study the meaning of Shifting of Tax Burden and impact and
incidence of taxation
 To understand various economic effects of taxation
 To understand the concepts of redistributive and anti -inflationary
nature of taxation and their implications
8.1 INTRODUCTION
 SHIFTING OF TAX BURDEN
Incidence if taxation has got a relevance so far as the effects of taxation
are concerned. Public finance operations are likely to produce various
effects on the level and pattern of economic activity in country. Th e
systems of public finance becomes acceptable to the people when public
authorities try their utmost to promote and maximise the favourable
effects and to check and minimise the adverse effects of Governmental
budgetary operations.
As per Dr. Dalton tax ation produces various effects which are as follows: -
1) Effect of taxation on production.
a) Effects of taxation on worker’s ability and willingness to work
b) Effect of taxation on people’s ability and willingness to save.
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127 d) Effect of taxation on resource allocation.
e) Effect of taxation investment.
2) Effect of taxation on distribution of income and wealth.
Effect of proportional, Progressive and regressive taxation on the
distri bution of income and wealth
3) Other effects of taxation on employment, structure of industry.
Tendency towards tax etc.
Besides these real effects of taxation there is also a monetary effect of
taxation which is called as incidence of taxation.
Concept : -
The concept of incidence of tax is about the answer to the question as to
who bears the ultimate money burden of a tax? When government imposes
a tax on a person, it is quite possible that he may try to shift it to another
person due to the human tenden cy.
When a person is taxed he may try to shift it to another person say B. If he
succeeds in shifting it to Mr. B, then ultimately Mr. B will bear the money
burden of a tax levied by the government on A. i.e. Mr. A recovers the tax
amount from Mr. B and pa ys it the Government. Thus incidence of tax
refers to the ultimate money burden of a tax. It also means the final resting
point of a tax.
8.2 IMPACT, SHIFTING AND INCIDENCE OF TAX
These are the interrelated terms which are related to imposition, transfer
and settlement of tax. Initially it is the impact that occurs first and
incidence is the end result. In between these two lies the phenomenon of
shifting of tax.
The impact of tax is defined as the initial, immediate and legal money
burden of a tax which fa lls on a person on whom the tax is levied. The
very intention of the government is that the man on whom the tax is levied
should pay the tax. The person who is liable to pay the tax to the
Government bears its impact. Impact of a tax is called immediate mo ney
burden of a tax because the moment tax gets imposed on him, he stands
immediately to make the payment of the tax to Government. It is also
called as initial money burden of tax because the movement a tax levied
upon a person the initial money burden fa lls upon him though he may
succeed later in shifting the tax to some other person. It is also called as a
legal money burden of a tax because legally he is held responsible to bear
the burden of a tax though he may pass it on to some other person. Legally
he is to pay the tax to the Government.
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128 8.2.1 SHIFTING OF A TAX
Shifting is defined as a process of transfer of money burden of tax from
one person to another person. Shifting of tax takes place only in case of
indirect taxes. The indirect taxes which are also known as commodity
taxes like excise duty, sales tax, custom duty, etc. which can only be
shifted to the third party. The direct taxes like income tax, wealth tax etc.
cannot be shifted. It is because in case of direct taxes the impact and the
incide nce fall on the same person. Hence the direct taxes do not involve
the problem of shifting. The problem if shifting arises only in case of
indirect taxes because the impact of tax is on the person on whom the tax
is levied and the incidence is ultimately b orne by the actual user of a
commodity. The tax is shifted through the vehicle of price. When a tax
imposed the price of a commodity rises because the tax gets mixed up
with the price. So a consumer has to pay the gross price i.e. the price plus
tax. Howev er the tax may be shifted without raising the price also
specifically in case of backward shifting.
The shifting is of two types viz.
i) Forward shifting and
ii) Backward shifting.

The forward shifting of a tax and the backward shifting of a tax depend
upon the circumstances.
A forward shifting is one in which the tax is shifted forwardly to the
ultimate users of a commodity through price i.e. the tax gets mixed up
with price and the ultimate user of a commodity has to pay a gross price.
So in case of forward sh ifting of tax prices is used as a vehicle of tax
shifting.
A backward shifting is one in which the tax is shifted backwardly to the
grower of the raw materials. For example when an excise duty is levied on
a sugar producer. A sugar procedure will shift the excise duty backwardly
to the growers of sugar cane by asking him to reduce the price of sugar
cane which he sugar for sugar production and thus by shifting the excise
duty backwardly he recovers the amount of excise duty backwardly from
the sugar cane gr ower. This is done without raising of the price of sugar.
Thus price as a vehicle of tax shifting hardly plays any role so far as
backward shifting is concerned.

Factors influencing shifting: -

1) Magnitude of tax: -
Magnitude means the amount or the qua ntum of tax. If the tax amount is
very small like a few thousand rupees then the tax payer doesn’t feel like
shifting the tax. He feels that it is better to bear the burden of tax that to
shift the tax. Conversely if the tax amount is very big which comes to
crores of rupees then only the tax payer feels like shifting the tax.
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129
2) Range of the commodities taxed: -
If exclusively one commodity is taxed then the tax payer hardly think in
terms of shifting the tax. Conversely when tax is levied upon a wide
varieties of goods like soft drinks. Coke, Pepsi, Limka, Fanta etc. Then the
tax payer feels like shifting the tax.

3) The point of tax : -
If tax is levied at the point of a consumer then there is no possibility of tax
shifting. The consumer has to bear th e brunt of the attack made by a tax
conversely when the tax is imposed at the point of a producer or a seller
then there is a possibility of shifting of a tax.

4) Elasticity of Demand : -
When demand is perfectly elastic then tax can’t be shifted. When th e
demand is fairly elastic then some tax can be shifted. When the demand is
perfectly inelastic then the whole tax can be shifted.

5) Elasticity of supply: -
When the supply is perfectly elastic then the whole tax can ne shifted.
When supply is fairly elastic then tax can be shifted partially. Conversely
when supply is perfectly inelastic then tax cannot be shifted.

6) Period of time: -
During short period of time it is very difficult to shift the tax. Conversely
when the period is very long then only t he tax can be shifted.

7) Market Situation: -
In a monopoly market situation tax can be shifted while under perfect
competition in the long period there is no possibility of tax shifting.

8) Geographical coverage: -
When the geographical coverage is very n arrow i.e. in case of local
markets there is no possibility of shifting conversely when the
geographical coverage of a market is very wide i.e. in case of national and
international markets there is a possibility of shifting.

9) Public policy : -
Shifting depends upon the following Government. If the government
follows the policy of controls and restriction then tax cannot be shifted.
Conversely when Government follows open policy or free policy then
there is a possibility of shifting.

10) Vehicle :
As per Dr. Dalton there must be some vehicle through which a tax can be
shifted. Price is a good vehicle through which through which tax can be
shifted.
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130 8.3 ECONOMIC EFFECTS OF TAXATION
Though raising revenue is the primary objective of taxation, taxes are
considered as instruments of control and regulation with the objective of
influencing the pattern of consumption, production and distribution i.e.
taxes affect an economy in various ways. The economic effects of taxes
are explained below:
1. Effects of Taxat ion on Production:
Effects on production are classified under three heads
(i) Effects on the ability to work, save and invest : In case of poor people,
imposition of taxes results in the reduction of disposable income or the
purchasing capacity of the taxp ayers. It reduces their expenditure on
necessities which are required to improve work efficiency. It further
adversely affects savings and investment.
Whereas imposition of taxes on rich people has the least / negligible effect
on the efficiency and abili ty to work. There are some harmful goods, such
as cigarettes, tobacco, alcohol whose consumption has to be reduced to
increase ability to work. Therefore high rate of taxes are often imposed on
such harmful goods to curb their consumption.
All taxes advers ely affect the ability to save of all people. In case of rich
people, they save more than the poor, so progressive rate of taxes reduces
their savings potentiality which results in low level of investment. The
lower rate of investment further adversely aff ect the economic growth of a
country.
(ii) Effects on the will to work, save and invest :
The effects of taxation on the willingness to work, save and invest are due
to the result of money burden of tax as well as the psychological burden of
tax. Temporar y taxes may not lead to any adverse effect on desire or will
to do work but if these taxes continues to exist then they may lead to
adversely affect the willingness to work. Taxpayers have a feeling that
every tax is a burden. This psychological state of m ind of the taxpayers
has a disincentive effect on the willingness to work for more extra hours.
It is suggested that effects of taxes upon the willingness to work, save and
invest depends on the income elasticity of demand and it varies from
individual to individual.
If the income demand of an individual taxpayer is inelastic, a cut in
income consequent upon the imposition of taxes will induce him to work
more and to save more so that the lost income is at least partially
recovered. On the other hand, the desire to work and save of those people
whose demand for income is elastic will be affected adversely.
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131 (iii) Effects on the allocation of resources :
In economics resources have several uses. By diverting resources use to
the desired directions, taxation can influence the volume and the size of
production in the economy. It may lead to some beneficial effects on
production. High rates taxation on harmful drugs and commodities will
reduce their consumption. It will discourage production of these
commodities and these scarce resources will be diverted from their
production to the other products which are useful for economic growth.
Taxation may also promote regional balanced development by allocating
resources in the backward regions.
2. Effects of Taxation on Income Distribution and wealth:
Taxation affect favorably as well as unfavorably on the distribution of
income and wealth. It depends on the type and rates of taxation. A steeply
progressive taxation system tends to reduce income inequality since the
burden of such taxes falls heavily on the richer persons.
As against the progressive taxation, regressive tax system increases the
inequality of income and distribution of wealth. Taxes imposed heavily on
luxury and non -essential goods tend to have a favorab le impact on income
distribution. Whereas taxes imposed on necessary articles may have
regressive effect on income distribution.
Though the progressive system of taxation has favorable effect on income
distribution but it has disincentive effect on output as rich people are
heavily taxed it leads to disincentive effect on savings and investment. A
high rate of income tax will reduce inequalities but it may lead to some
unfavorable effects on the ability to work, save, investment and output.
3. Other Effect s of Taxation:
i) As taxes have favorable effects on the ability and the desire to work,
save and invest, it may lead to a favorable effect on the employment
situation of a country. If resources collected through taxes are utilized for
development projects , it will increase employment rate in the economy. As
against this if taxes affect the volume of savings and investment adversely
then recession and unemployment problem will arise.
ii) Effect of taxes on the price level may have favorable as well as
unfav orable effect. Sometimes, taxes are imposed to curb inflation which
may lead to rising costs of production. It will further aggravate the
problem of inflation.
In this way, taxation creates both favorable and unfavorable effects on
various ways in an econo my.
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132 8.4 INTRODUCTION: REDISTRIBUTIVE AND ANTI -
INFLATIONARY NATURE OF TAXATION
Taxes seem to have the greatest anti -inflationary effects. However, the
effectiveness of taxes depend not only on the individual taxes but also on
the overall tax structure.
A tax on personal income reduces inflationary pressures by reducing
people’s disposable income. It does have a minimum effect on business
cost, except to the extent that reductions in disposable income lead trade
unions to demand wage increases.
On the contra ry, it does not place a burden on persons who do not fall
under the tax net or who are able to evade taxes or who spend huge sums
from accumulated wealth. Moreover, a major portion of the tax may be
absorbed from savings and thus it may give no direct ince ntive to curtail
spending. Thus, its anti -inflationary effect will be less per rupee than that
of a tax on spending.
Consequently, “if given inflationary pressures are to be checked by the use
of income -tax increases, the tax rates must be higher than they would need
to be with a tax having a greater effect in curtailing spending.
Accordingly, the adverse effect on incentives to work and produce will be
somewhat greater.”
Excise duty and sales tax affect inflationary pressures in a different way.
Demand -shifting excise are designed to discourage persons from buying
particularly scarce commodities. The tax acts as an alternative to the
ration ing system. The policy will prove to be effective only if the demand
for the product is fairly elastic.
Contrarily, de mand -absorbing excise are levied upon commodities hav ing
inelastic purchasing power that would otherwise be used for inflation ary
spending. However, the fact is that most commodities of inelastic demand
are of widespread use and the burden of tax will be distributed in a
regressive manner (i.e., the poor will pay more than the rich).
However, income -tax on companies may be raised to control inflation.
Such a tax is deflationary in two ways. First, to the extent that dividends
are reduced, individual spend ing is curtailed, at least partly. Secondly,
business firms are left with less funds for expansion and so they must
reduce their investment spending.
8.4.1 ANTI - INFLATIONARY NATURE OF TAXATION
In modem welfare states, the government has to incur huge exp enditure to
meet the growing social and economic needs of the people. In such a
situation, taxation becomes an important source of funding such
expenditure. Therefore taxation plays a very important role in modern
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133 consumption in order to make resources available to meet collective needs
of the people and on the other hand, taxation is used to redistribute income
and wealth.
In the growing economies with the huge amount of public expen diture,
there is always the possibility of inflation due to excessive consumption.
In such cases, anti -inflationary taxation is used to reduce propensity to
consume. It is in the form of higher rates of direct and indirect taxes. Anti -
inflationary taxation which reduces consumption is justified if the
resources released from private consumption are used by the government
for welfare activities of the society at large.
The redistributive taxation like progressive direct taxes is designed to
reduce savings, whereas anti -inflationary taxes are designed to reduce
consumption. When the government uses taxation to reduce savings, the
funds raised from such taxes are the funds which might have been left idle
by the people. But in case of anti - inflationary taxatio n used to reduce
consumption, the resources raised by the government are the funds that
people would otherwise have used for consumption. Therefore funds
raised through anti -inflationary taxation should be used wisely and
productively.
The general classic al view is that the all taxes are anti -inflationary and all
public expenditures are inflationary in nature. Whereas, Modern
economists believe that neither all taxes are anti -inflationary nor
expenditures are inflationary. The effects of taxation and publi c
expenditure depend on the state of the economy. During normal situations,
any tax that reduces consumption and promote investment may be anti -
inflationary.
8.4.2 REDISTRIBUTIVE NATURE OF TAXATION
Classical economists considered taxation as a means to r aise revenue. But
modern economists consider taxation as a tool for redistributing income
and wealth among the various sections of society. Modem economists are
of the opinion that taxation can be used for transferring income and wealth
from the rich to th e poor. This is referred to as redistributive taxation.
Redistributive taxation aimed at reducing savings of the rich and using
these resources raised to increase the consumption of the poor.
Unequal distribution of income and wealth harms the economy in m any
ways. It widens the gap between the rich and the poor which is not only
socially undesirable, but is also harmful for the economy’s growth.
Income inequality reduces average propensity to consume and may lead to
depression and unemployment. Therefore, modem economists have
recommended the use of taxation to redistribute income and wealth in a
more socially desirable manner. Most economies use progressive taxation
to redistribute income and wealth. Progressive taxes are generally imposed
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134 A redistributive fiscal policy includes progressive direct taxation and
public expenditure on social security, job creation and promotion of social
equity. Such expenditure are in the form of old age pensions,
unemployment allowances, free and subsidized housing, education, health
care and food distribution. All these are aimed at reducing people’s cost of
living, increasing their capacity to consume and provide social justice
Redi stributive taxation increases people’s average propensity to consume.
When income distribution improves due to transfer of income from the
rich to the poor, larger number of people can increase their consumption
levels. It increases aggregate demand and le ads to increase investment and
employment.
However, highly progressive direct taxes have certain limitations. They
result in tax evasion, which gives rise to black money in an economy. At
the same time, such taxes can adversely affect people’s willingness and
ability to work, save and invest. This can also harm economic progress.
Another limitation of redistributive taxation is that often government use
the redistributive fiscal policy to fulfil their political agenda of winning
elections by providing sub sidies and transfers to a very large extent. This
can result in excessive consumption, causing inflation and lowering the
value of money. Such a fiscal policy may result in large deficit and public
borrowing, pushing interest rates upward. High interest an d high inflation
will harm growth prospects of the economy.
Developing economies tend to rely on the indirect taxation of domestic
and imported goods and services. Indirect taxes are said to be regressive
because they adversely affect consumption rather th an income, and
wealthier people save a higher proportion of their income. In addition,
indirect taxation in developing economies may even increase poverty
depending on the structure of tax rates and the consumption basket of
households at various rungs of the income scale. Lowering taxes on goods
such as food that weigh more in the budget of poor people achieves
relatively little redistribution because wealthier people also consume these
goods.
8.5 SUMMARY
1. Incidence if taxation has got a relevance so far as the effects of taxation
are concerned. Public finance operations are likely to produce various
effects on the level and pattern of economic activity in country. The
systems of public finance becomes acceptable to the people when public
authorities try their utmost to promote and maximise the favourable
effects and to check and minimise the adverse effects of Governmental
budgetary operations.
2. The impact of tax is defined as the initial, immediate and legal money
burden of a tax which falls on a per son on whom the tax is levied. The
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135 should pay the tax. The person who is liable to pay the tax to the
Government bears its impact.
3. Incidence of tax refers to the ultimate money b urden of a tax. It also
means the final resting point of a tax.
8. Shifting is defined as a process of transfer of money burden of tax from
one person to another person. Shifting of tax takes place only in case of
indirect taxes. The indirect taxes which a re also known as commodity
taxes like excise duty, sales tax, custom duty, etc. which can only be
shifted to the third party.
5. Impact, shifting and incidence are the interrelated terms which are
related to imposition, transfer and settlement of tax. Init ially it is the
impact that occurs first and incidence is the end result. In between these
two lies the phenomenon of shifting of tax.
6. The shifting is of two types viz.
i) Forward shifting and
ii) Backward shifting.

A forward shifting is one in which the tax is shifted forwardly to the
ultimate users of a commodity through price i.e. the tax gets mixed up
with price and the ultimate user of a commodity has to pay a gross price.
So in case of forward shifting of tax prices is used as a vehicle of tax
shifting.

A backward shifting is one in which the tax is shifted backwardly to the
grower of the raw materials.
7. Though raising revenue is the primary objective of taxation, taxes are
considered as instruments of control and regulation with the objective of
influencing the pattern of consumption, production and distribution i.e.
taxes affect an economy in various ways.
8. Taxes seem to have the greatest anti -inflationary effects. However, the
effectiveness of taxes depend not only on the individual taxes but also on
the overall tax structure.
9. Taxation plays a very important role in modern economies. Through
taxation, on one hand, the government control private consumption in
order to make resources available to meet collective needs of the people
and on the oth er hand, taxation is used to redistribute income and wealth.
10. The redistributive taxation like progressive direct taxes is designed to
reduce savings, whereas anti -inflationary taxes are designed to reduce
consumption.
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136 8.6 QUESTIONS
1. Explain the mean ing of the concepts of impact, shifting and incidence
of a tax.
2. Discuss the factors influencing shifting of tax.
3. What are the various economic effects of taxation?
8. Explain anti -inflationary and redistributive nature of taxation.



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137 9
PUBLIC EXPENDITURE AND PUBLIC
DEBT
Unit Structure
9.0 Objectives
9.1 Introduction
9.2 Classification of Public Expenditure
9.3 Canons of Public Expenditure
9.4 Effects of Public Expenditure
9.5 Adolph Wagner's Law o f Increasing State Activity
9.6 The Peacock -Wiseman Hypothesis
9.7 Causes of Public Expenditure Grwoth
9.8 Significance of Public Expenditure
9.9 Summary
9.10 Questions
9.0 OBJECTIVES
 To understand the meaning of public expenditure
 To study classification of public expenditure
 To study canons of public expenditure
 To understand the economic effects of public expenditure on
production, consumption, distribution, employment and stabilization
 To study Wagner’s hypothesis and Wiseman Peacock hypothesis
 To understand the causes of in creasing public expenditure
 To study the significance of public expenditure


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138 9.1 INTRODUCTION
1. Public Expenditure : Meaning & Definition
Public expenditure refers to Government expenditure i.e. Government
spending. It is incurred by Central, State and Loc al governments of a
country. Public expenditure can be defined as, "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."
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 .
2. Need / Importance / Significance of Public :
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 indust rial 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.

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139 3. Objectives of Public Expenditure :
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.
In a modern welfare state, the importance of public expenditure has
increased. Throughout the 19th Century, most governments followed
laissez faire economic policies & their functions were only restricted to
defending aggression & maintaining law & order. The size of pubic
expenditure was very small. But now the expenditure of governme nts all
over has significantly increased. In the early 20th Century, John
Maynard Keynes advocated the role of public expenditure in
determination of level of income and its distribution.
In developing countries, public expenditure policy not only accelera tes
economic growth & promotes employment opportunities but also plays a
useful role in reducing poverty and inequalities in income distribution.
9.2 CLASSIFICATION OF PUBLIC EXPENDITURE
Classification of Public expenditure refers to the systematic arrange ment
of different items on which the government incurs expenditure. Different
economists have looked at public expenditure from different point of
view. The following classification is a based on these different views.
A. Functional Classification :
Some econo mists classify public expenditure on the basis of functions for
which they are incurred. The government performs various functions
like defence, social welfare, agriculture, infrastructure and industrial
development. The expenditure incurred on such fun ctions fall under this
classification. These functions are further divided into subsidiary
functions. This kind of classification provides a clear idea about how the
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140 B. Revenue and Capital Expenditure :
Revenue expenditure are current or consumption expenditures incurred on
civil administration, defence forces, public health and education,
maintenance of government machinery. This type of expenditure is of
recurring type which is incurred year after year.
On the other hand, capital expe nditures are incurred on building durable
assets, like highways, multipurpose dams, irrigation projects, buying
machinery and equipment. They are non recurring type of expenditures in
the form of capital investments. Such expenditures are expected to
impro ve the productive capacity of the economy.
C. Transfer and Non-Transfer Expenditure :
A.C. Pigou , the British economist has classified public
expenditure as :-
1. Transfer expenditure
2. Non-transfer expenditure
1. Transfer Expenditure :-
Transfer expenditure relates to the expenditure against which there is
no corresponding return.
Such expenditure includes public expenditure on :-
1. National Old Age Pension Schemes,
2. Interest payments,
3. Subsidies,
4. Unemployment allowances,
5. Welfare benefits to weaker sections, etc.
By incu rring such expenditure, the government does not get anything in
return, but it adds to the welfare of the people, especially belong to the
weaker sections of the society. Such expenditure basically results in
redistribution of money incomes within the soci ety.
2. Non-Transfer Expenditure :-
The non-transfer expenditure relates to expenditure which results in
creation of income or output. The non-transfer expenditure includes
development as well as non-development expenditure that results in
creation of output directly or indirectly. Economic infrastructure such as
power, transport, irrigation, etc.
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141 1. Social infrastructure such as education, health and family welfare.
2. Internal law and order and defence.
3. Public administration, etc.
By incurring such expenditure, the government creates a healthy
conditions or environment for economic activities. Due to economic
growth, the government may be able to generate income in form of duties
and taxes.
D. Productive and Unproductive Expenditure :
This classification was made by Classical economists on the basis of
creation of productive capacity.
1. Productive Expenditure :-
Expenditure on infrastructure development, public enterprises or
development of agriculture increase productive capacity in the economy
and bring income to the government. Thus they are classified as
productive expenditure.
2. Unproductive Expenditure :-
Expenditures in the nature of consumption such as defence, interest
payments, expenditure on law and order, public administration, do not
create any productive asse t which can bring income or returns to the
government. Such expenses are classified as unproductive expenditures.
E. Development and Non-Development Expenditure :
Modern economists have modified this classification into distinction
between development and non-development expenditures.
1. Development Expenditure :-
All expenditures that promote economic growth and development are
termed as development expenditure. These are the same as productive
expenditure.
2. Non-Development Expenditure :-
Unproductive expenditure s are termed as non development expenditures.
F. Grants and Purchase Price :
This classification has been suggested by economist Hugh Dalton .
1. Grants :-
Grants are those payments made by a public authority for which their may
not be any quid-pro-quo, i.e., there will be no receipt of goods or
services. For example, old age pension, unemployment benefits, subsidies,
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142 2. Purchase prices :-
Purchase prices are expenditures for which the government receives goods
and services in return. For example, salaries and wages to government
employees and purchase of consumption and capital goods.
G. Classification According to Benefits :
Public expenditure can be classified on the basis of benefits they confer on
different groups of people.
1. Common benefits to all : Expenditures that confer common benefits
on all the people. For example, expenditure on education, public
health, transport, defence, law and order, general administration.
2. Special benefits to all : Expenditures that confer special benefits on
all. For example, administration of justice, social security measures,
community welfare.
3. Special benefits to some : Expenditures that confer direct special
benefits on certain people and also add to general welfare. For
exampl e, old age pension, subsidies to weaker section, unemployment
benefits.
H. Hugh Dalton's Classification of Public Expenditure
Hugh Dalton has classified public expenditure as follows :-
1. Expenditures on political executives : i.e. maintenance of ceremonial
heads of state, like the president.
2. Administrative expenditure : to maintain the general administration
of the country, like government departments and offices.
3. Security expenditure : to maintain armed forces and the police forces.
4. Expenditure on administrati on of justice : include maintenance of
courts, judges, public prosecutors.
5. Developmental expenditures : to promote growth and development
of the economy, like expenditure on infrastructure, irrigation, etc.
6. Social expenditures : on public health, community welfare, social
security, etc.
7. Pubic debt charges : include payment of interest and repayment of
principle amount.


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143 9.3 CANONS OF PUBLIC EXPENDITURE
The expression canon of public expenditure is used for the fundamental
rules or principles governing the spending policy of the government.
Findlay Shirras has suggested Four Canons of Public Expenditure viz.
1) Canon of benefit
2) Canon of economy
3) Canon of Sanction
4) Canon of Surplus.
Other economists have also suggested certain canons such as
5) Canon of eco nomic growth
6) Canon of productivity
7) Canon of elasticity
8) Canon of equitable distribution
1) Canon of benefit : This canon implies that public expendit ure should
be incurred in a such way that it promotes maximum social advantage.
The ultimate purpose of public expenditure should be social benefit.
Hence public expenditure should be directed to those areas which
maximise the benefits of the society as a whole and not as an individual
group.
2) Canon of economy : Public expenditure should be productive and
efficient. It should be incurred economically avoiding extravagance and
wastes. It should avoid duplication and involve minimum cost. It should
be incurred on essential items of common benefit. It should ensure
optimum utilisation of resources.
3) Canon o f sanction: All public expenditures should be incurred after
the approval of a proper authority. This sanction is required for proper
allocation of resources and to avoid the misuse of funds. The expenditures
must be audited to ensure that money is spent f or the purpose for which it
is sanctioned.
4) Canon of Surplus: This principle implies that the government should
create a surplus in budget and avoid deficit. An ideal budget is one which
contains a surplus by keeping the public expenditure below public
revenue. This ensures the credit worthiness of the government.
5) Canon of economic growth: Growth with stability is an important
objective which governs public expenditure. Developed countries can
maintain the present high rate of economic growth and unde r-developed
countries can focus on raising the growth rate and attainment of a higher
standard of living through public expenditure.
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144 6) Canon of Productivity : Public expenditure must be productive so that
income and employment can be generated. A large p art of public
expenditure should be allocated for developmental purpose.
7) Canon of elasticity : This canon implies that the government spending
policy should be fairly elastic according to the changes in the
circumstances and requirement of the economy.
8) Canon of equitable distribution: Public expenditure policy of the
government should aim at reducing inequalities of income and wealth in
the economy. Thus the expenditure policy should provide maximum
benefits for the weaker sections of the society.
9.4 EFFECTS OF PUBLIC EXPENDITURE
A. Effects on Production
The effect of public expenditure on production can be examined with
reference to its effects on ability & willingness to work, save & invest
and on diversion of resources.
1. Ability to work, save and invest : Socially desirable public
expenditure increases community's productive capacity. Expenditure on
education, health, communication, increases people's productivity at work
and therefore their incomes. With rise in income savings also increa se
and this in turn has a beneficial effect on investment and capital
formation.
2. Willingness to work, save and invest : Public expenditure,
sometimes, brings adverse effects on people's willingness to work and
save. Government expenditure on social securit y facilities may bring such
unfavourable effects. For e.g. Government spends a considerable portion
of its income towards provision of social security benefits such as
unemployment allowances old age pension, insurance benefits, sickness
benefit, medical b enefit, etc. Such benefits reduce the desire to work. In
other words they act as disincentive to work.
3. Effect on allocation of resources among different industries
&trade : Many a times the government expenditure proves to be an
effective instrument to enc ourage investment on a particular industry. For
e.g. If government decides to promote exports, it provides benefits like
subsidies, tax benefits to attract investment towards such industry.
Similarly government can also promote a particular region by provi ding
various incentives for those who make investment in that region.
B. Effects on Distribution
The primary aim of the government is to maximise social benefit through
public expenditure. The objective of maximum social welfare can be
achieved only when the inequality of income is removed or minimised.
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145 collects excess income of the rich through income tax and sales tax on
luxuries. The funds thus mobilised are directed towards welfare
programmes to promote the standard of poor and weaker section. Thus
public expenditure helps to achieve the objective of equal distribution of
income.
Expenditure on social security & subsidies to poor are aimed at increasing
their real income & purchasing power. Public expenditure on education,
communication, health has a positive impact on productivity of the weaker
section of society, thereby increasing their income earning capacity.
C. Effects on Consumption
Public expenditure enables redistribution of income in favour of poor. It
improves the capacity of the poor to consume. Thus public expenditure
promotes consumption and thereby other economic activities. The
government expenditure on welfare programmes like free education,
health care and housing certainly improves the standard of the poor
people. It also promotes their capacity to consume and save.
D. Effects on Economic Stability
Economic instability takes the form of depression, recession and inflation.
Public expenditure is used as a mechanism to control instability. The
modern economist Keynes advocated public expenditure as a better
device to raise effective demand & to get out of depression. Public
expenditure is also useful in controlling inflation & deflation. Expansion
of Public expenditure during deflation & reduction of public expenditure
during inflation control money supply & bring price stability.
E. Effects on Economic Growth
The goals of planning are effectively realized only through government
expenditure. The government allocates funds for the growth of various
sectors like agriculture, industry, transport, communications, education,
energy, health, exports, imports, with a view to achieve impressive
growth.
Government expenditure has been very helpful in maintaining balanced
economic growth. Gover nment takes keen interest to allocate more
resources for development of backward regions. Such efforts reduce
regional inequality and promotes balanced economic growth.
Conclusion
Modern economies have all experienced tremendous growth in public
expenditur e. So it is absolutely necessary for governments to formulate
rational public expenditure policies in order to achieve the desired effects
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146 9.5 ADOLPH WAGNER'S LAW OF INCREASING STATE
ACTIVITY
Adolph Wa gner, 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".
Wagner’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 inc rease 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 peop le
to an increasing extent and in a more satisfactory fashion, are satisfied
by the Central and Local Governments."
Wagner's Statement Indicates Following Points
1. In Progressive societies, the activities of the central and local
government increase on a regular basis.
2. The increase in government activities is both extensive and
intensive.
3. The governments undertake new functions in the interest of the
society.
4. The old and the new functions are performed more efficiently and
completely than before.
5. The purpose of the government activities is to meet the economic
needs of the people.
6. The expansion & intensification of government function & activities
lead to increase in public expenditure.
7. Though Wagner studied the economic growth of Germany, it applies
to other countries too both developed and developing.
9.6 THE PEACOCK -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 :-
1. "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".
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147 2. There e xists a big gap between the expectations of the people about
public expenditure and the tolerance level of taxation. Therefore,
governments cannot ignore the demands made by people regarding
various services, especially, when the revenue collection is increasing
at constant rate of taxation.
3. They further stated that during the times of war, the government
further increases the tax rates, and enlarges the tax structure to
generate more funds to meet the increase in defence expenditure. After
the war, the new tax rates and tax structures may remain the same, as
people get used to them. Therefore, the increase in revenue results in
rise in government expenditure.
Wagner's law and Peacock -Wiseman hypothesis emphasize on the fact
that public expenditure has tende ncy to increase overtime.
9.7 CAUSES OF PUBLIC EXPENDITURE GRWOTH

There has been a persistent and continuous increase in public expenditure
in countries all over the world. The classical ideology of keeping the
government spending at the lowest possible level has lost its appeal in the
modern days. According to Adolf Wagner a German economist, there is a
continuous tendency of the intensive and extensive and increase in the
functions of the government. New functions are continuously being
undertaken and old function are being performed more efficiently and on a
large scale.

This observations of Wagner, popularly known as ‘ Wagner’s Law’ is
universally valid. Wagner argued that there exists a direct functional
relationship between the activities of the sta te and the size of public
expenditure. Along with the growth of the economy the government
activities grow faster.

Thus Wagner’s law reveals an universally true inductive generalization
about the continuous and substantial growth of public expenditure.
Following factors are responsible for such tremendous and continuous
increase in spending of modern governments.

1. Acceptance of welfare state: The concept of welfare state has been
accepted by all the governments the world over. The adoption of welfare
state has multiplied the responsibility of the government. In a welfare state
the role of government has significantly widened. In fact there is hardly
any field of economic activity in which the government is not concerned
directly or indirectly. Huge expen diture has to be incurred by the
government on welfare items like education, public health, social security
measures like old age persons, unemployment allowances, subsidies, etc.
In short the acceptance of welfare state has brought about a change in the
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148 2. Impact of Great Depression: The great Depression of 1930,has
widened the economic role of the government. In order to rectify the bad
effects of the depression such as unem ployment. Investment deficiency,
etc. the government has to play an active role in stabilising the economic
activity. Thus to fight the depression government is required to incur huge
expenditure.

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

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

9. Growing population: A high growth of population naturally calls for
increase in public expenditure as all state function are to be performed
more extensively. Rising population also poses various problems in poor
countries. The government will have the added responsibility of solving
such problems as food. Unemployment, housing, and sanitati on. Further
over-populated countries like India will have to check the population
growth. Therefore the government has to spend more and more on family
planning campaigns every year.

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

7. Development project: In an underdeveloped country, the government
has to spend more and more on developmental projects, especially in rural
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149 and other social measures for rural development. Huge investment has to
be incurred on infrastructure and basis industries for rapid economic
development of a country. This has increased the public expenditure.

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

10. Public Borrowing : To finance the development projects the
government has to borrow internally as well as externally. Interest
payment and servicing of these debts along with repayment of the
principle has increasing the expenditure of modern governments
Thus the various factors like extension of traditional functions, acceptance
of new functions and increasing importance of government in economic
activities have caused i ncrease in public expenditure.
9.8 SIGNIFICANCE OF PUBLIC EXPENDITURE
The significance of the public expenditure arises from the fact that those
services are provided by the government which might not otherwise be
provided in significant amount by priv ate expenditure.
In the 1930s, J. M. Keynes emphasized the importance of public
expenditure. The modern state is described as the ‘welfare state’ . As a
result, the Modern governments are undertaking various social and
economic activities.
i. Economic Deve lopment:
Public expenditure has the expansionary effect on the growth of national
income, employment opportunities, etc. Economic development also
requires development of economic infrastructures. A developing country
like India must undertake various proj ects, like road -bridge -dam
construction, power plants, transport and communications, etc.These
social overhead capital or economic infrastructures are of crucial
importance for accelerating the pace of economic development.
ii. Fiscal Policy Instrument:
Public expenditure is considered as an important tool of fiscal policy. It
creates and increases the scope of employment opportunities during
depression. Thus, public expenditure can prevent periodic cyclical
fluctuations. During depression, it is recommend ed that there should be
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150 jobs and incomes.On the contrary, a cut -back in government’s expenditure
is necessary when the economy faces the problem of inflation.
iii. Redistribution of Income:
Public expenditure is used as a powerful fiscal instrument to bring about
an equitable distribution of income and wealth. By providing subsidies,
free education and health care facilities to the poor people, government
can improve the economic positio n of these people.
iv. Balanced Regional Growth:
Public expenditure can correct regional disparities. By diverting resources
in backward regions, government can bring about all -round development
there so as to compete with the advanced regions of the count ry.
Thus, public expenditure has both economic and social objectives.
1. Low income support: Public expenditure on free education,
unemployment benefit and free medical facilities etc., increase the
purchasing power of the people and especially of low income groups and
it helps to protect and promote the efficiency of the people and the ability
to work and save. Public expenditure for increasing the salaries and wages
of the people and supply of goods and services at cheaper rate will
increase their purchasin g power, standard of living, efficiency and their
ability to work and save may increase.
2. Social insurance programs: it has been argued that the social security
measures like old age pension, provident fund benefit, insurance against
sickness and employment at state expense reduce the desire of a person to
work, save and invest. But practically, it does not adversely affect the
desire to work, save and invest. These measures are socially desirable.
Social security measures should be provided to the extent th ey do not
discourage savings and investment. Therefore, public expenditure should
be incurred in such a way so as to provide social security measures to the
maximum extent which the government can afford without directly
affecting saving and investment exp enditure.
9.9 SUMMARY
1. Public expenditure can be defined as, "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."
2. Classificatio n of Public expenditure refers to the systematic
arrangement of different items on which the government incurs
expenditure. Different economists have looked at public expenditure
from different point of view.
3. The expression canon of public expenditure i s used for the fundamental
rules or principles governing the spending policy of the government. munotes.in

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151 4. Modern economies have all experienced tremendous growth in public
expenditure. So it is absolutely necessary for governments to formulate
rational public exp enditure policies in order to achieve the desired
effects on income, distribution, employment and growth.
9. Wagner’s law states that "as the economy develops over time, the
activities and functions of the government increase".
6. Wagner's law and Peacock -Wiseman hypothesis emphasize on the fact
that public expenditure has tendency to increase overtime.
7. There has been a persistent and continuous increase in public
expenditure in countries all over the world. The classical ideology of
keeping the governme nt spending at the lowest possible level has lost
its appeal in the modern days. According to Adolf Wagner a German
economist, there is a continuous tendency of the intensive and
extensive and increase in the functions of the government.
8. The significanc e of the public expenditure arises from the fact that those
services are provided by the government which might not otherwise be
provided in significant amount by private expenditure. In the 1930s, J.
M. Keynes emphasized the importance of public expenditu re. The
modern state is described as the ‘welfare state’ . As a result, the
Modern governments are undertaking various social and economic
activities.
9.10 QUESTIONS
1. Discuss the meaning and classification of public expenditure.
2. Explain the canons of p ublic expenditure.
3. Explain the various effects of public expenditure.
4. Explain Wagner’s Law of increasing state activity.
9. Discuss Peacock Wiseman hypothesis of increasing public expenditure.
6. What are the causes of growing public expenditure?
7. Explain the significance of public expenditure in a welfare state.



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152 10
PUBLIC DEBT

Unit Structure
10.0 Objectives
10.1 Introduction
10.2 Public Debt : Meaning
10.3 Classification / Types of Public Debt
10.4 The Burden of Public Debt
10.5 Public Debt and Fiscal Solvency
10.6 Summary
10.7 Questions
10.0 OBJECTIVES
 To st udy the meaning
 To understand the classification / types of public debt
 To study the concept of burden of public debt
 To study different solutions to manage public debt
 To understand the concept of public debt and fiscal insolvency
10.1 INTRODUCTION
Publi c debt or public borrowing plays an important role in an economy
when a country’s expenditure is more than its collection of revenue. In
such a situation government has to borrow to meet its spending
requirement. In this chapter, we will study the meaning of public
borrowing, classification of public debt, effects of public debt in an
economy, and the ways to manage public debt by the government.
10.2 PUBLIC DEBT : MEANING
Public debt or public borrowing is considered to be an important source of
income to the government. If revenue collected through taxes & other
sources is not adequate to cover government expenditure government may
resort to borrowing. Such borrowings become necessary more in times of
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153 Public debt may be raised internally or externally. Internal debt refers to
public de bt floated within the country; w hile external debt refers loans
floated outside the country.
The instrument of public debt take the form of government bonds or
securitie s of various kinds. Such securities are drawn as a contract
between the government & the lenders. By issuing securities the
government raises a public loan & incurs a liability to repay both the
principal & interest amount as per contract. In India, govern ment issues
treasury bills, post office savings certificates, National Saving Certificates
as instrument of Public borrowings.
10.3 CLASSIFICATION / TYPES OF PUBLIC DEBT
Government loans are of different kinds, they may differ in respect of time
of repayme nt, the purpose, conditions of repayment, method of covering
liability. Thus the debt may be classified into following types.
1. Productive and Unproductive debts
A. Productive debt :-
Public debt is said to be productive when it is raised for productive
purpose s and is used to add to the productive capacity of the economy.
As Dalton puts, productive debts are those which are fully covered by
assets of equal or greater value.
If the borrowed money is invested in the construction of railways,
irrigation projects, power generations, etc. It adds to the productive
capacity of the economy and also provides a continuous flow of income to
the government. The interest and principal amount is generally paid out
of income earned by the government from these projects.
Produ ctive loans are self liquidating. Generally, such loans should be
repaid within the lifetime of property. Thus, such loans does not cause any
net burden on the community.
Unproductive debt :-
Unproductive debts are those which do not add to the productive capacity
of the economy. Unproductive debts are not necessarily self liquidating.
The interest and the principal amount may have to be paid from other
sources of revenue, generally from taxation, and therefore, such debts are
a burden on the community. Public debt used for war, famine relief, social
services, etc. is considered as unproductive debt.
However, such expenditures are not always bad because they may lead to
well being of the community. But such loans are a net burden on the
community since they are repaid generally through additional taxes.
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154 2. Voluntary and Compulsory Debt
A. Voluntary debt :-
These loans are provided by the members of the public on voluntary basis.
Most of the loans obtained by the government are voluntary in nature. The
voluntary de bt may be obtained in the form of market loans, bonds, etc.
The Government makes an announcement in the media to obtain such
loans. The rate of interest is normally higher than that of compulsory
debt, in order to induce the people to provide loans to the government.
B. Compulsory debt :-
A compulsory debt is a rare phenomenon in modern public finance unless
there are some special circumstances like war or crisis. The rate of
interest on such loans may be low. Considering the compulsion aspect;
these loans are similar to tax, the only difference is that loans are rapid but
tax is not. In India, compulsory deposit scheme is an example of
compulsory debt.
3. Internal and External Debt
A. Internal debt :-
The government borrows funds from internal and external sources.
Internal debt refers to the funds borrowed by the government from various
sources within the country. Over the years, the internal debt of the
Central Government of India has increased from Rs.1.54 lakh crore in
1990 -91 to Rs.13.4 lakh crore in 2005 -010.
The various internal sources from which the government borrows include
individuals, banks, business firms, and others. The various instruments of
internal debt include market loans, bonds, treasury bills, ways and means
advances, etc.
Internal debt is repay able only in domestic currency. It imply a
redistribution of income and wealth within the country & therefore it has
no direct money burden.
B. External debt :-
External loans are raised from foreign countries or international
institutions. These loans are repayable in foreign currencies. External
loans help to take up various developmental programmes in developing
and underdeveloped countries. These loans are usually voluntary.
An external loan involves, initially a transfer of resources from foreign
countrie s to the domestic country but when interest and principal
amount are being repaid a transfer of resources takes place in the reverse
direction.
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155 4. Short -Term, Medium -Term & Long -Term Debts
A. Short -Term debt :-
Short term debt matures within a duration of 3 to 9 months. Generally, rate
of interest is low. For instance, in India, Treasury Bills of 91 days and
182 days are examples of short term debts incurred to cover temporary
shortages of funds. The treasury bills of government of India, which
usually have a ma turity period of 90 days, are the best examples of short
term loans. Interest rates are generally low on such loans.
B. Medium -Term debt :-
The Government may borrow funds for medium term needs. These funds
can be used for development and non development activities. The period
of medium term debt is normally for a period above one year and up to 5
years. One of the main forms of medium term debt is by way of market
loans.
C. Long -Term debt :-
Long term debt has a maturity period of ten years or more. Generally th e
rate of interest is high. Such loans are raised for developmental
programmes and to meet other long term needs of public authorities.
5. Redeemable and Irredeemable Debts
A. Redeemable debt :-
The debt which the government promises to pay off at some future date
are called redeemable debts. Most of the debt is redeemable in nature.
There is certain maturity period of the debt. The government has to make
arrangement to repay the principal & the interest on the due date.
B. Irredeemable debt :-
Such debt has no matu rity period. In this case, the government may pay the
interest regularly, but the repayment date of the principal amount is not
fixed. Irredeemable debt is also called as perpetual debt. Normally, the
government does not resort to such borrowings.
6. Funded and Unfunded Debts
A. Funded debt :-
Funded debt is repayable after a long period of time. The period may be
30 years or more. Funded debt has an obligation to pay fixed sum of
interest subject to an option to the government to repay the principal. The
governm ent may repay it even before the maturity if market conditions are
favourable. Funded debt is Undertaken for meeting more permanent
needs, say building up economic & industrial infrastructure. The
government usually establishes a separate fund to repay thi s debt. Money
is credited by the government into this fund & debt is repaid on maturity
out of this fund.
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156 B. Unfunded debt :-
Unfunded debts are incurred to meet temporary needs of the governments.
In such debts duration is comparatively short say a year. Th e rate of
interest on unfunded debt is very low. Unfunded debt has an obligation to
pay at due date with interest.
10.4 THE BURDEN OF PUBLIC DEBT
Over the years, the public debt of the India's Central and that of State
government has increased considerably during the planning period. The
Government borrows funds by way of public debt to meet the various
development and non-development expenses.
Table below indicates composition of public debt of the Central Govt. of
India.

Apart from internal debt, there are also internal liabilities of the central
government in the form of small savings of the public, provident funds,
reserve funds & deposits of Government department. Both internal and
external debt carry a burden on the economy of nation.
6.1.1 The Burden of Internal Public Debt
1. Internal debt trap
One of the bad effects of internal debt is the interest paid by the
government. Such interest payments increase public expenditure and
may become a cause for fiscal deficit. If internal public debt is not
checked and kept within limits, it may take the country to the worst
position called 'Internal Debt Trap'.
2. More burden on poor and weaker sections
Internal debt provides opportunities for the rich and higher middle class to
earn a higher rate of interest from the stat e on their lending. At the
same time the poor suffer a lot due to the tax burden. The
government levies taxes to repay interest on public debt. But the tax
burden does not necessarily fall on the rich unless it is progressive in
natur e. In the case of indirect taxes, the burden is felt more by the poor
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157 3. Increasing interest burden
Public borrowing may become costlier for the government especially
when it resorts to public borrowing by issuing bonds and debentures. Such
bonds and debentures carry a high rate of interest to the extent of 15
percent. The impact of such interest payments may develop manifold and
still worsen in the future if the government stick to the same policy of
borrowing in the years to come.
4. Unjustified transfer
The servicing of internal debt involves transfers of income from the
younger to the older generations and from the active to the inactive
enterprises. The government imposes taxes on enterprises and earnings
from productive efforts for the benefit of the idle, inactive, old and
leisurely class of bond holders. Hence work and productive risk taking
efforts are penalised for the benefit of accumulated wealth. This adds to
the net real burden of debts.
5. Indirect real burden
Internal debt involves an ad ditional indirect real burden on the
community. This is because the taxation required for servicing the debts
reduces the tax payer's ability to work and save and affects production
adversely. The government may also economise social expenditure
thereby, r educing the economic welfare of the people.
Taxation will reduce the personal efficiency and desire to work. Thus
there would be a net loss in the ability and desire to work. The creditor
class will also not have any incentive to work hard due to the prosp ect
of receiving interest on bonds. This would further cause a loss to
production and increase the indirect burden of debt.
6.1.2 The Burden of External Public Debt
External debt is beneficial in the initial stages as it increases the resources
available to the country. But its repayment & servicing creates a burden
on the debtor country.
1. External debt trap
The external debt creates direct money burden. This is because; it involves
transfer of funds from the debtor country to foreign citizens. The degree of
burde n depends upon the interest rate, and the loan amount. The loans are
normally to be paid in foreign currency. Therefore, the funds are mostly
transferred from export earnings or by raising more funds from foreign
markets. Borrowing by way of additional loa ns would put extra burden on
the country. The situation may become so worse, that the country may be
caught in the external debt trap. It may have to borrow from foreign
markets to repay the interest amount and it would be very difficult to
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158 2. Direct real burden
The external debt may also result in direct real, burden. The citizens of the
debtor will have to suffer loss of economic welfare to the extent of
repayment of principle amount and interest burden.
The foreign currency earne d through exports would have been utilized to
import better goods and technology. Which would have increased the
economic welfare of the citizens of the debtor country. But because of
external debt repayment, they have to restrict their welfare which the
imported goods would have provided. In other words, the citizens of
debtor country are deprived of imported goods and service to the extent
till the loans and interest amount is repaid.
3. Decline in expenditure to public welfare programmes
When the government spends a significant portion of its resources towards
the payment of foreign debt it reduces the government expenditure to that
extent which otherwise would have been spent for public welfare
programmes.
4. Decline in the value of nation's currency
The repay ment of external debt involves an increase in the demand for the
currency of the creditor country. This will raise the exchange rate of the
creditor country's currency, and aggravate the problem of foreign
exchange crisis.
The creditor country may also be adversely affected if it is induced to
import more from the debtor country. This may hinder the growth of
their domestic industries and cause unemployment.
5. Burden of unproductive foreign debt
The magnitude of external debt burden depends upon whether the debt is
incurred for productive purposes or for unproductive purposes. If it is
incurred for unproductive purposes, it will create a greater burden and
sacrifice on the citizens of the debtor country.
6. Political exploitation
In recent years, it was found tha t the lending countries who dominate
international organisations like World Bank & international monetary
fund use the lending opportunity as an instrument to exploit the
borrowing countries economically & politically.
6.1.3 Shifting the Burden of Public Debt
When resources for government expenditure are generated through
taxation, the present generation bears the burden but when resources are
generated through public debt, the future generation pays the interest &
principal and thus bears the burden. Thus in the case of public debt the munotes.in

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159 burden falls on the prosperity. Payment of such projects out of taxation
would be unjustified as it would put burden on the present generation
while benefit would accrue to the future generations. In future when the
time for paymen t of interest & principal comes, the government will have
to tax people to pay money to bond holders. The future tax payers will pay
future bond holders. It would merely imply diversion of funds from one
set of people to another within the country. However , it will involve direct
real burden as the classes of tax payers & bond holders are likely to be
different. The burden of taxation is likely to be heavy on general mass
while the benefit will accrue to small rich class of bond holders.
Whether the burden of public debt is borne by future generations or not
may also depend upon many factors. The loan raised for productive
purposes may not create burden on future generation since it will create
assets and will add to productive capacity of the economy. This would not
only increase income for present generation but also for the posterity. If it
is used for unproductive purposes or emergencies like war it will shift
burden on future generation.
Whether the burden will shift or not also depends on whether the present
generation pays off debts by sacrificing current consumption or
investment. If it is done by reducing current consumption, future
generation will not bear the burden. But if it is done by reducing
investment the future generation will bear the burden .
If loans are short term it can be repaid by the current generation. This will
not shift the burden. In case of long term loans shifting of burden will
depend upon whether the loan is self liquidating or deadweight. It may be
concluded from the above analysis that shifting of the burden of public
debt from present to future generations may be possible, but it depends of
various factors.
10.5 PUBLIC DEBT AND FISCAL SOLVENCY
Public debt is the total amount, including total liabilities, borrowed by the
govern ment to meet its development budget . The term is also used to refer
to overall liabilities of central and state governments. Fiscal solvency is
the ability of the government to meet its long -term debts and financial
obligations. It is an important measure of financial health of the country. It
demonstrates government’s ability to manage its operations into the
foreseeable future. In simple words fiscal solvency refers to the
management of public debt. The objective of the management of public
debt is to ado pt such methods of borrowing funds and the repayment of
loans by the government which helps to maintain economic stability i.e., it
should reduce inflationary and deflationary effects upon the economy.
10.5.1 Definition and significance :
The public debt management is concerned with the decisions regarding the
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160 debts are redeemed or refunded, the proportion in which the different
forms of public debt should be issued, the pattern of ma turities of the debt
and its ownership etc. in short the management of public debt is concerned
with refunding, floating or retirements of public debts etc.
The management of the public debt is very significant because there can
be important economic effe cts of the changes in the size of the public debt
on the operation of the economy. The public debt policy, fiscal policy and
the monetary policy are closely connected with each other for the
determination of economic policy.
10.5.2 Principles of public de bt management
1. The interest cost of servicing public debt must be minimized: The
interest cost of servicing public debt should be kept minimum because
the government has to impose additional taxes or the rates of existing
taxes are raised for the payment of interest cost. The interest can be
minimized, if the central bank of the country is induced to keep the
interest rate low by means of effective monetary policy.
2. Satisfaction of the needs of investors: Public debt should be managed
in such a way that the n eeds of the investors with regard to the types of
the government securities and the terms of issues are satisfied. If the
public debt management fails to satisfy the needs of the investors,
there may be disturbances in the security markets on account of sa le of
securities.
3. Funding of short term debt into Long term debt: Public debt
management should help to fund as much of the short term debt into
long term debt as possible. The funding operations must be undertaken
in such a way that there is no undue rise in the long term interest rates.
4. Public debt policy must be coordinated with fiscal and monetary
policy: the coordination is essential to maintain economic stability and
to promote economic growth.
10.5.3 Redemption of public debt :
Redemption means rep ayment of a loan. All government loans should be
repaid promptly. Advantages of debt redemption are as follows:
1. It saves the government from bankruptcy.
2. It discourages unnecessary expenditure of the government.
3. It maintains confidence of the investors.
4. It would be easy for the government to raise new loans in future.
5. It reduces cost of debt management.
6. When the loans are repaid, the resources may be diverted to their other
potential uses.

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161 10.5.4 Methods of repayment:
Following are the various methods of de bt repayment.
1. Repudiation: means refusal to pay the debt by the government. It
shakes the confidence of the people and banks in the government. The
government finds it difficult to raise new loans in the near future. In
case external debt, it may create a number of difficulties for the
repudiating country such as economic blockade, military invasion etc.
by the foreign countries.
2. Refunding: When the government sells its bonds to pay its floating
obligations, the debt is said to be refunded. It is process by which
maturing bonds are replaced by the new bonds. The refunding is
undertaken mainly with a view to meeting maturity requirements.
3. Conversion: conversion of public debt means exchange of new debts
for the old ones. In this method, the debt is actually n ot repaid but the
form of debt is changed. The process of conversion consists generally
in converting or altering a public debt from a higher to a lower rate of
interest.
4. Actual repayment: For actual repayment of loans the following
measures can be adopted :
a) Sinking fund: it is a device which has been developed for the regular
retirement of debt. It is a fund into which a certain amount of revenue
is deposited each year for the repayment of out -standing debt. The
fund is used for the purchase of outstanding debt and the ultimate
retirement of loans as they fall due.
b) Surplus revenues: 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.
c) Terminal annuities: The gover nment may issue terminal annuities, a
part of which matures every year according to a serial order
announced or decided by lottery system, so that the debt can be
cleared every year and consequently the burden of interest is also
reduced to that extent eve ry year. Thus it is method of repayment of
loan in instalments.
d) Capital levy: refers to a very heavy tax on property and wealth. It is a
once for all tax imposed on the capital assets above the certain value.
10.5.5 Repayment of external debt :
The redempt ion of external debt is possible only through the earning of
foreign exchanges to pay it. It can be done by creating export surpluses. If
foreign loans are invested in those industries, which increase the supply of
those commodities which are exported, the loans may be easily repaid. If, munotes.in

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162 however loans are utilized for unproductive purpose, and export surplus
may be possible at the cost of home consumption, and hence the burden of
debt may be very much felt by the people.
10.6 SUMMARY
1. Public debt or publi c borrowing is considered to be an important source
of income to the government. If revenue collected through taxes &
other sources is not adequate to cover government expenditure
government may resort to borrowing. Such borrowings become
necessary more in times of financial crises & emergencies like war,
droughts, etc.
2. Public debt may be raised internally or externally. Internal debt refers
to public debt floated within the country; while external debt refers
loans floated outside the country.
3. Govern ment loans are of different kinds, they may differ in respect of
time of repayment, the purpose, conditions of repayment, method of
covering liability. Thus the debt may be classified into following types.
 Productive and Unproductive debts
 Voluntary and Co mpulsory debts
 Internal and external debts
 Short term, Medium term and Long term debts
 Redeemable and Irredeemable debts
 Funded and Unfunded debts
4. Over the years, the public debt of the India's Central and that of State
government has increased consider ably during the planning period.
The Government borrows funds by way of public debt to meet the
various development and non-development expenses.
5. Both internal and external debt carry a burden on the economy of
nation.
10. The burden of public debt adve rsely affect the growth and
development of the economy. Therefore there is a need to effectively
manage public debt. Management of public debt involves; repayment
of public debt, controlling the amount of borrowings and productive use
of borrowed funds for development.
7. Public debt is the total amount, including total liabilities, borrowed by
the government to meet its development budget . Fiscal solvency is the
ability of the government to meet its long -term debts and financial
obligations. It is an impor tant measure of financial health of the munotes.in

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163 country. In simple words fiscal solvency refers to the management of
public debt. The objective of the management of public debt is to adopt
such methods of borrowing funds and the repayment of loans by the
governmen t which helps to maintain economic stability i.e., it should
reduce inflationary and deflationary effects upon the economy.
10.7 QUESTIONS
1. Discuss the meaning of public borrowing.
2. Explain various types of Public debt.
3. Differentiate between Inter nal debt and External debt.
4. Discuss the burden of internal debt and external debt.
5. Explain the concept of shifting of debt burden.
10. Explain the management of public debt in India.



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164 Module 5
11
FISCAL POLICY

Unit structure
11.0 Objectives
11.1 Meaning of fiscal policy
11.2 Functioning of fiscal policy
11.3 Objectives of fiscal Policy
11.4 Constituents
11.5 Limitations
11.6 Classic al and Neo Classical View of Fiscal Policy
11.7 Principles of Sound Finance
11.8 Principles of Functional Finance
11.9 Types of Fiscal Policy
11.10 Summary
11.11 Questions
11.0 OBJECTIVES
 To know the meaning of fiscal policy
 To understand how does the fiscal policy works
 To know the objectives of fiscal policy
 To understands the different constituents of fiscal policy
 To know the limitations of the policy
 To understand the classical principle of sound finance
 To understand neo classical principle of fu nctional finance
 To know the different types of fiscal policy
 To know limitations of fiscal policy


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165 11.1 MEANINGOF FISCAL POLICY
Fiscal policy is the part of government policy that deals with raising
revenue through tax and non -tax sources and deciding on the level and
pattern of public expenditure.
Fiscal policy is composed of several parts. These include, tax policy,
public expenditure policy, investment or disinvestment strategies and
debt or surplus management. Fiscal policy is an important constitutio n
of the overall economic framework of a country and is a therefore
intimately linked with its general economic policy strategy. In most
modern economics, governments deal with fiscal policy while the central
bank is responsible for monetary policy .
These measures included social security expenditures and following
counter cyclical budgetary policy to keep aggregate demand high .
In developing countries , besides traditional functions, governments also
promote economic development . In developing economies, f iscal policy
is used as an important instrument to bring about creation of economic
and social infrastructure, employment generation, poverty reduction
and improvement in income distribution.
11.2 FUNCTIONING OF FISCAL POLICY
According to Keynesian economi sts, the primary objective of fiscal policy
is to maintain high level of aggregate demand through variables like
disposable income, public and private investment, consumption
expenditure, net exports and government purchases. A high level of
aggregate dema nd will result in higher production, employment and
ensure better standard of living. A change in any one of the policy
variables affects all other variables as they are all interrelated.
This interrelationship can be explained as follows :
AD = C + I + G + (X – M)
Where, AD = aggregate demand
C = consumption expenditure
I = investment expenditure
X = exports
M = imports
In the short run,
C = f (Y d) and M = f (Y)
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166 Where, Y = gross income
Y d = disposable income (income left with peo ple for spending)
TR = transfer payments (e.g. pension, subsidies, unemployment benefits)
t = tax rate (direct tax is imposed as a proportion of income Y)
By using fiscal policy measures, the government can influence aggregate
demand (AD) as follows :
(a) C ca n be increased by reducing t and increasing TR as this will raise
the level of disposable income.
(b) Imposition of import duties will reduce M and subsidies and tax
incentives to exports will increase X.
(c) I can be raised through tax exemptions as well as subsi dies to
producers.
(d) G can be increased through government purchases.
All these decisions will increase aggregate demand and national output.
But these decisions will have implications on government’s budget.
Deficits and surplus budgets have their own impa ct on the economy in the
long run. For example, if the government increases G and reduces t in
order to increase AD and achieve higher GDP growth in the short run, it
will run the risk of incurring heavy fiscal deficit. This will cause inflation
as money s upply will rise and it will make it necessary for the government
to borrow heavily, increasing interest burden. Resources may have to be
diverted from other public expenditure heads for interest payments. All
these factors will slow down economic growth in the long run. Therefore,
fiscal policy decisions have to be made with utmost care by the
government.
11.3 OBJECTIVES OF FISCAL POLICY
The fiscal policy is formulated with specific objectives in view. The
objective in developed countries is to achieve econ omic stability and
maintain high aggregate demand .
In developing countries the goal is to achieve economic growth and
development.
Following are some of the objectives of fiscal policy
1. Optimum Allocation of Resources : The most important function of
fiscal policy is to determine how the country’s resources will be
allocated . What should be the share of different sectors of the
economy in terms of resource allocation? This is closely related to the
government’s taxation and expenditure policies. Allocation o f
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167 composition of government expenditure . The national budget
determines how funds are allocated to different heads of expenses. The
policy of public expenditure is used by the government to direct ly
undertake resource allocation for different sectors. On the other hand,
the government can use taxation and subsides to indirectly influence
resource allocation. For example, tax incentives given to SEZ units
will encourage investors to direct resources to those units.
2. Full Employment : The importance of fiscal policy as an economic
tool gained significance during the Great Depression in 1930s when
the developed countries were suffering from unemployment. Thus the
main objective of fiscal policy was def ined as achievement of full
employment. For this the fiscal policy should be designed to keep the
level of aggregate demand high. In developing economies government
expenditure on social and economic infrastructure is used to generate
employment opportunit ies.
3. Economic Stability : Stabilization of the economy is another
important function of fiscal policy, especially in developed economies
that experience business cycles. The cycle nature of the market in
these economies causes fluctuations in variables li ke income, output,
investment and employment causing hardships to the people. When
growth periods end, they are followed by contraction in the form of
recession. Fiscal policy is meant to counter these fluctuations. This
known as counter cyclical fiscal po licy. A counter cyclical fiscal
policy is adopted to counter the effects of recession and depression
by following a deficit budget . This brings about an increase in
government expenditure to generate employment and decrease in taxes
to induce consumption a nd investment. On the other hand, during
inflation, government expenditure and tax rates are lowered to reduce
aggregate demand and prices. A surplus budget is followed.
4. Increasing the Rate of I nvestment and Capital Formation : In
developing countries the p roblem of mass and structural
unemployment . Fiscal policy in such countries is aimed at increasing
the rate of capital formation through investment. This can be done by
giving tax incentives and subsidies to encourage private sector
investment. Also, in ma ny developing countries the government
directly takes part in capital formation through investment in social
and economic infrastructure.
5. Encouraging Sociall y Optimum Pattern of Investment : In
developing countries fiscal policy can direct investment in th ose fields
that are most desirable from social point of view. For example, fiscal
incentive to small scale industries and infrastructure development.
6. Reducing Income Inequalities : Fiscal policy can be effectively used
to manipulate the distribution of nat ional income and resources.
Taxation and public expenditure policies are used by the government
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168 burden on the rich than the poor. Public expenditure on social
infrastructure and subsidies on food, housing, health and education
help reduce income inequality.
7. Reducing Unemployment and Underemployment : Public
expenditure can play an important role in this regard. Public works
programmes can be initiated to create employment and to absorb
surplus labour from areas of underemployment especially in
developing countries.
8. Controlling Inflation : Developing countries need to resort to deficit
financing in order to finance their programmes of industrialization and
infrastructure building. This creates inflationary conditions in the
economy as purchasing power is bound to rise with deficit financing.
In order to control inflation, the ideal fiscal response would be
reduction of public expenditure . But this is unlikely to take place in
a developing country and hence the fiscal response should be in the
form of encouraging supply of goods and services though appropriate
incentives. As supply increases, the inflationary pressure is likely to be
on the decline.
11.4 CONSTITUENTS OF FISCAL POLICY
There are fou r constituents of fiscal policy
1. The Budget : The budget is an estimate of the government’s
expenditure and revenue for a fiscal year. It is an important instrument
of fiscal policy used by most modern governments to fulfill objectives
of economic growth, reduction of inequalities, generation of
employment and economic stability. The budget is used to allocate and
divert resources to the desired sectors. A budget is typically comprised
of the revenue and the capital budget. It can be balanced, surplus or
deficit. According to functional finance, the budget can be used to
reduce the effects of business cycle. During recession, a deficit budget
should be followed and during inflation, a surplus budget should be
followed.
2. Taxation : Taxes are the most importan t sources of revenue to a
government. They are compulsory payments levied on income and
wealth (direct taxes) and on production, sales and movement of
commodities (indirect taxes).
Taxes are not only sources of revenue to the government, but they are
used to reduced income inequality (redistributive taxation) and
maintain price stability (anti -inflationary taxation). Taxes are levied at
progressive, proportional and regressive rates. Progressive taxes, like
income tax, are based on ability to pay and are u sed to reduce income
inequality. Indirect taxes are regressive in nature. Taxes have wide
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169 3. Public Expenditure : The public expenditure policy is the end
objective of fiscal policy. Gover nment spending is classified as
revenue and capital spending. The primary objective of public
expenditure is generation welfare. Public expenditures are financed
through tax and non -tax sources of revenue as well as public
borrowing.
4. Public Debt . :Most gov ernments finance their expenditure through
borrowings when the tax and other sources of revenue prove to be
inadequate. Public debts are classified on the basis of time period,
productive or unproductive, voluntary or compulsory. One of the most
important classifications of public debt is internal and external. Public
debt cause burden of repayment which results in income redistribution.
All the above mentioned constituents of fiscal policy are discussed in
details in different chapters in this book.
11.5 LIMITATIONS OF FISCAL POLICY
The effectiveness of fiscal policy is subject to the following limitations :
1. Practical Difficulties : Theoretically, the outcomes of fiscal policy are
based on certain assumptions. However, real macroeconomic
situations are fa r more complex. Certain assumptions made in theory
may not be present in reality making fiscal policy ineffective. For
example, during inflation, taxes are raised and public expenditure is
lowered. This measures would only be effective in controlling
inflation, if money supply in the economy is not increased by
government’s deficit financing. Also, fiscal policy must be
complementary to monetary policy.
2. Forecasting Difficulties : Reliable forecasting of target variables is a
very important factor in the suc cess of fiscal measures. These variables
include national income, output, price level, employment,
consumption and investment. Forecasting is a function of data
collection and analysis which is difficult in developing economies.
Even in developed economies , forecasting has not been foolproof.
3. Multiplier : The efforts of fiscal measures are transmitted to the
economy through the working of various multipliers like, investment
multiplier, tax multipier. For example, the effect of an induced
government investm ent on infrastructure will lead to an increase in
income and consumption through the multipier process. The exact
impact of such an investment would depend on the investment
multiplier coefficient. Firstly, it is difficult to estimate the values of the
multiplier coefficients due to leakages and uncertainties. Secondly,
there are time lags in the working of the multipliers. It may happen
that by the time the full impact of a fiscal decision is felt on the
economy, economic conditions may have changed in suc h a way that it
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170 example, the government may decide to increase expenditure in order
to boost economic growth. This can lead to rise in fiscal deficit. By the
time economic growth is reviv ed, the fiscal deficit may have growth so
large as to force the government cut down on capital and revenue
expenditure, once again affecting growth.
4. Time Lags : These lags exist in case of discretionary fiscal policy
which are deliberate measures taken by the government. It takes time
for the government to recognize a problem and then decide to
implement a suitable policy to address the problem. These are inside
lags. The outside lag is in the form of time taken for the impact of the
policy to be felt. Thes e lags reduce the effectiveness of fiscal policy.
5. Underdeveloped Economies : Fiscal measures, as well as monetary
policy measures, are not very effective in underdeveloped economies
due factors like, low taxable capacity, large unorganized and non -
monetis ed financial system, low income levels and corruption.
6. Political Influence : While monetary policy is under the central
bank’s control, fiscal policy is implemented by the government. The
central bank is an autonomous institution, relatively free from poli tical
influence. This is not true of the fiscal policy. The democratic
governments often mix politics with economics in their budget
decisions. This limits the effectiveness of fiscal policy. For example,
during election years, the government may increase subsidies and
other expenditures to gain public support. This can increase fiscal
deficit and cause harm to the economy in the long run. Thus, short run
political gains can compromise log run economic goals of fiscal
policy.
11.6 CLASSICAL AND NEO CLASSIC AL VIEW OF
FISCAL POLICY
Fiscal policy deals with government policy in relation to raising revenue
through taxation and other means, and deciding on the level and pattern of
public expenditure. It is composed of tax policy, public expenditure
policy, inves tment or disinvestment strategies and budget management.
In recent history, fiscal policy has been a very important component of
government policy. But until the Great Depression of 1929, the
government’s role was concentrated on traditional functions lik e provision
of defence, law and order and civic amenities. It was believed that the
government need not use fiscal policy to interfere in the market
mechanism, since the market is efficient enough to correct itself, in case it
failed at times. This was kno wn as the principle of sound finance. Most
classical and neo -classical economists advocate sound finance policy.
But after the Depression, it was realised that markets can fail and do not
always correct themselves, causing tremendous hardship to the people .
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171 person. Therefore, most laissez faire capitalist economies transformed
themselves into welfare states. In such economies, the role of the
governments expanded to include several non - traditional activities, like
reduction of inequality, provision of social justice, building economic
infrastructure and most Governments began to use fiscal policy to avoid
another depression, control inflation and keep aggregate demand high.
Therefore, fis cal policy was used as a contra -cyclical measure. This type
of use of fiscal policy to bring about desired changes in the economy is
known as functional finance. The main advocate of this type of fiscal
policy was John Maynard Keynes.
A major problem of fi scal policy is finding a balance between the short
run stabilization objectives and long run goals of growth and development.
At times, the short run policies adopted to deal with cyclical fluctuations
like inflation and recession may conflict with long ru n goals of the
economy.
Two conflicting views on how to achieve the goals of fiscal policy are
represented by the following principles :
(a) The Principle of Sound Finance
(b) The Principle of Functional Finance
The discussion below involves the basic economic, p olitical and
sociological basis for arguments for and against sound finance and
functional finance. In the analysis, the classical school includes the
economic thoughts of economists like Adam Smith, David Ricardo, J.B.
Say, John Stuart Mill and Thomas Mal thus. The term ‘modern’ used in the
context here refers to denote economists who challenged and opposed the
classical principle of sound finance. They include John Maynard Keynes,
A.C. Pigou, Edgeworth and most significantly, Abba P. Lerner.
11.7 PRINCIPLE S OF SOUND FINANCE
Prior to 1930s, classical economists did not include fiscal policy in their
analysis of an economy. It was believed that the less the government
interfered in the economy the better it is. This belief, along with private
ownership of fac tors of production, was the foundation of laissez faire
capitalism, which is a system where economic transactions are largely
between private owners of factors of production and such transactions are
free from government restrictions, taxation and subsidie s. Laissez faire
policy advocates that there should be only enough government regulations
to protect property rights of individuals. The market mechanism should be
left free of any government interference.
Such an economic system formed the basis for clas sical, and later, neo -
classical economic thoughts. In such a system, the role of the government
was expected to be restricted to traditional areas like defence, law and
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172 spending was expected to be restricted to these areas. The classical
economists argued that taxation should be restricted to a limit that was
sufficient for the government to raise funds for performing its traditional
functions. The role of the budget and fiscal polic y did not extend beyond
raising funds through taxation and spending on traditional functions. The
primary belief was that the size of the government’s budget should be
small and the budget should balance. These beliefs form the basis of the
principle of so und finance.
The following are some of the features of sound finance :
1. Say’s Law : Like many other classical principles, the principle of
sound finance is also based on Say’s Law, that is, “Supply creates its
own demand.” Since one man’s expenditure is an other man’s income,
aggregate demand will always be equal to aggregate supply. This
belief forms the base of the argument on which classical economists
argued in favour of sound finance.
2. Full employment : the classical economists argued that since AD =
AS, there cannot be over -production and under -consumption. In other
words, the economy cannot suffer from fluctuations like
unemployment and inflation. Driven by profit motive, the private
sector will ensure optimum use of resources. Therefore, there will be
full employment in the economy. Only voluntary and frictional
unemployment may exist.
3. Invisible hand : Private owners of factors of production will always
achieve maximum level of efficiency in their use of resources, as they
are driven by self -interest an d profit motive. The concept of Adam
Smith’s ‘invisible hand’ is used to explain how private self interest
will result in collective social good.
4. Taxation : According to the classical school of thoughts, taxes are
harmful because they adversely affect will ingness and ability of work,
save and invest. Taxation was expected to be kept at a minimal limit.
High progressive taxation will lead to slow economic progress. They
believed that taxes should not be used to redistribute income.
5. Public expenditure : Gover nment spending was expected to be in the
traditional areas like defence, law and order, justice and provision of
civic amenities. Since government budget was not expected to be large
in size, government spending was not large relative to total spending in
the economy. Therefore, it was believed that government spending
would not have any significant impact on the economy. The classical
school generally viewed the government with suspicion and therefore
any increase in public expenditure during peacetime was not
advocated. Sound finance is based on the belief that government which
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173 6. Balanced budget : In laissez faire capitalism, since all factors of
production are normally owned and used by private individuals, the
government can make use of such factors only by depriving the private
sector. Expenditure incurred by the government would not increase
total demand for factors of production as there is already full
employment. Therefore, there is no justification for the government to
expa nd its expenditure beyond revenue and incur deficit budget.
Budget should always balance except during waritime when
government will have to expand expenditure to fight war. The state
should not take up business activities as private sector is considered t o
be most efficient. Also, there is no justification for large public
expenditure as it is assumed that there is full employment in the
economy.
7. Market efficiency : The market mechanism is assumed to achieve
maximum level of efficiency. Market failures are only temporary and
the market is fully capable of correcting itself. Therefore there is no
justification of any government regulation and restrictions on the
market.
8. Ricardian Equivalence Theorem : Budget deficits are uneconomical,
harmful and socially un desirable. They lead to inflation and harm
economic progress. This belief was based on Ricardian Equivalence
Theorem. According to this theorem, deficits will not boost the
economy. Deficits will have to be later met by raising taxes. This is
known to the people and they will increase their savings to pay higher
taxes later. As their savings increase, they will not increase
consumption and therefore, increased public expenditure will not be
able to boost demand, production and boost growth.
11.8 PRINCIPLES OF FUNCTIONAL FINANCE
In the 1920s, Europe, and the 1930s, the United States, began to
experience depression. During this time, economists, like A.C. Pigou, F.
Knight, and J.M. Keynes, began to question sound finance principles. Low
profit expectations dur ing depression kept investment spending low,
causing unemployment to rise. The economists favoured, at least
temporarily, giving up the sound finance principles and using government
spending to stimulate the economy.
Increased government spending during d epression would mean running a
deficit budget. But this was considered necessary as private investment
was not forthcoming. Increased government expenditure in infrastructure
building, job creation and paying social security would increase income.
This wou ld encourage spending and aggregate demand would rise and
ultimately would help pull the economy out of the depression or recession.
It was generally agreed by economists and policy makers that fiscal policy
could be of some use in helping pull an economy out of a severe recession.
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174 policy. This view that fiscal policy can be used to offset undersirable
cyclical fluctuations in output was later termed as ‘functional finance’ by
Abba P. Lerner.
The concept of functional finance has the following features :
1. Market failure : Unlike classical economists, modern economists
believe that markets are not perfect and they can fail. They do not
always correct themselves. Market failures can have severe e conomic
consequences in the form of depression and hyper -inflation. The Great
depression of 1930s brought the powerful US economy down. In more
recent times, the financial crisis of 2007 -08 in the USA showed that
due to excessive de -regulation, financial m arkets can fail and become
the cause of a severe and long standing recession. Also, due to
globalization, this recession had affected the economic prospects of
almost every country in the world.
2. Importance of fiscal policy : According to Abba P. Lerner, who
advocated the concept functional finance, fiscal policy is the most
important part of any economic policy. Taxation, public expenditure
and public debt must be adopted according to the needs of the time.
While classical economists believed that the main a im of public
finance is to raise revenue, modern economists believe that the main
objective of public finance is to correct imbalances in the economy.
They are the most important instruments of promoting economic
stability and progress. Budget must act as an instrument of economic
change.
3. Aggregate demand : While classical economists believed that supply
creates its own demand, modern economists, particularly Keynesians,
believed that it is demand that leads to investment. Consumption and
investment can ri se or fall together. Aggregate demand consists of
consumption demand, investment demand, government expenditure
and net foreign income. Modern economists believed that it is
aggregate demand that determine level of national income and
employment. Deficienc y in aggregate demand results in
unemployment. Government expenditure needs to be increased during
such times to boost aggregate demand to stimulate the economy.
4. Budget : Modern economists believe that the government, through
public expenditure, taxation, or deficit financing, can maintain full
employment. During recession and depression, public expenditure
should be increased and the budget should be expanded to increase
aggregate demand. A deficit budget is perfectly justifiable to pull the
economy out of recession. On the other hand, during inflation, the
government may have a surplus budget by raising taxes to control
consumption. Modern economists have rejected the principle of a
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175 5. Income redistribution : According to modern economists, the
distribution of national income is as important as its size. A more even
distribution of income would increase the average propensity to
consume (APC) and increase the level of investment and employment.
A government aiming at full employm ent should try to redistribute
national income in such a way that the savings never exceed current
investment. Re -distribution taxation has been suggested as the best
means for achieving this. This implies imposing high taxes on the rich
and redistributing them to the poor through pension, welfare schemes
and allowances. This will improve APC and increase schemes and
allowances. This will improve APC and increase aggregate demand,
boosting investment, employment, production and profits. Thus fiscal
policy c an provide social justice through better income distribution as
well as benefit economic growth through higher investment.
6. Welfare capitalism : Karl Marx had predicted that, due to the inherent
crisis, the capitalist system will collapse and make way for a new,
more equal system. The Great Depression was a situation very close to
what Marx had predicted. But it was Keynes who advocated fiscal
measures for regulating capitalism and preventing its collapse. Keynes
gave importance to compensatory actions thro ugh fiscal measures for
improving and maintaining the level of effective demand and thus the
level of economic activity in the country. The concept of functional
finance forms the basis of welfare capitalism that now exists in most of
the advanced economie s.
7. Social objectives : Advocates of functional finance believe that public
finance has no function in the interest of the entire society. Taxation,
expenditure, borrowing policy and ownership and operation of public
utilities must be measured on the basis of their effects on the entire
society. Objective of taxation should be to redistribute income in the
most socially just manner Expenditure on social security, poverty
eradication, medical care and education will always be justified as they
bring in distri butive justice. Public expenditure and taxation should
follow the objective of equalizing marginal social cost and marginal
social benefit. Social objectives are the primary focus of functional
finance.
Though the concept of functional finance has been se verely criticized by
conservative economists and politicians, it has had very wide acceptability
in the last few decades in most of the major developed as well as
developing countries. After following functional finance policy for
decades, in 1980s, many a dvanced countries began to adopt different
versions of laissez faire capitalism by promoting privatization and
reducing public expenditure on welfare measures. This coincided with
globalization of trade and capital movement. There was high degree of
market deregulation. This resulted in unprecedented increase in world
trade and capital movement. This also led to high growth in emerging
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176 deregulation resulted in multiple market failures. The US A experienced a
major financial crisis followed by a long recession with high level of
unemployment. The recession in the advanced economies effected the
world economy, including the rapidly growing emerging countries. It
became necessary for the advanced economies to expand their budgets and
increase public expenditure to provide stimulus to their economies, thus
reviving the policy of functional finance. Similarly, the emerging
economies too had to expand their budgets to revive growth.
11.9 TYPES OF FISC AL POLICY
Based on their experiences of following sound and functional finance
policies, countries have evolved fiscal policies to suit their own
requirements. Most modern economies follow some version of functional
finance in deciding on their fiscal poli cy. In most developed economies
the primary objective of fiscal policy is to counter the harmful effects of
economic fluctuations.
Following are some of the types of fiscal policies used :
1. Automatic Stabilisers :
Many developed economies have built -in flexibility in their tax and public
expenditure structure that lead to automatic stabilization of the economy
during inflation and recession. Due to built -in flexibility automatic
adjustment takes place in government expenditure and tax revenue in
response to changes in the national income.
When the national income rises and the economy experiences prosperity
and inflation takes place. During such times, tax revenue automatically
increases and government expenditure on social security like
unemployment ben efits reduces as less people are unemployed. This keeps
effective demand under control and slows down the growth of aggregate
demand preventing inflation.
On the other hand, during recession, public expenditure on unemployment
benefits and other social sec urity measures automatically go up while tax
revenue falls. Due to this the growth of aggregate demand increases.
Production rises, unemployment falls and this prevents the economy from
going into depression.
These changes in tax revenue and government exp enditure take place
automatically due to the built -in flexibility in the fiscal system. This leads
to automatic stabilization of the economy.
Automatic stabilizers work only under certain conditions. They will be
ineffective in case of cost push inflation or inflation caused due to deficit
financing. If the economy is affected by external factors like worldwide
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177 to developing economies where built -in flexibility in the first system is
very limited.
2. Discretionary Fiscal Policy
In this type of fiscal policy, the government makes deliberate changes in
its taxation and expenditure policies in order to achieve some targets.
Changes are made in tax rates and structures, size and comp osition of
public expenditure and debt. changes in tax rates, addition or abolition of
taxes, result in changing the disposable income of people and bring about
the desired changes in aggregate demand.
Discretionary changes in government expenditure take t he form of
expansion or reduction in the size of expenditure, changing the
composition and sources of financing, changes in transfer payments like
pensions, unemployment benefits etc. surplus or deficit in the budget and
methods of financing deficit. All t hese changes have an impact on
aggregate demand through consumption and investment expenditure.
Discretionary fiscal policy is effective only when it is used for short run
corrections in the economy. For long run structural changes there should
be effecti ve automatic stabilizers. Besides, time lags in recognizing a
particular problem and implementing the discretionary policy measure
reduce the impact of the policy.
3. Contra -cyclical Fiscal Policy or Compensatory Fiscal Policy :
The main objective of cont ra-cyclical fiscal policy is to achieve economic
stability. The purpose is to counter the phases of business cycle and
minimize their negative impact on the economy. Such a fiscal policy is
discretionary in nature and consists of deliberate budgetary actio n taken to
manipulate aggregate demand. The budget is the primary instrument of
compensatory fiscal policy.
A. Fiscal policy during Recession and Depression : During recession and
depression the level of aggregate spending is very low. People reduce
their con sumption spending and businesses reduce their investment
spending. Many resources remain unutilized as production levels of
goods and services decline. There is under consumption and unsold
inventories are high. The government has to then formulate a fisca l
policy that will bring the economy out of such a situation.
During depression, deficit budget is followed. The government
increases its expenditure and reduced taxes to encourage spending.
The government can increase spending in the economy either
Indir ectlyor through direct spending. Taxes are lowered in order to
increase people’s disposable income and encourage them to spend.
Government can also undertake massive expenditure on public works
programme in order to generate employment and transfer money t o the
people. Indirect taxes are also lowered to give benefits to businesses
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178 and employ people. A cut in corporate income tax is also done to
encourage investment.
In public expenditure policy during recession and depression, the
government can use the following;
(i) Pump -priming : The term originated in the United States of America
in 1932. Here the government tries to revive economic activities in
those sectors that are stagnant and their revival is necessary to take the
economy out of recession, for example the banking sector.
Government spending in these sectors should stimulate private
spending by increasing purchasing power of the people. The policy of
pump -priming was used to revive t he US economy during the
recession that began in 2008. The Japanse government under Prime
Minister Shinzo Abe has been using this policy to revive the economy
from the two decades of recession.
(ii) Compensatory spending : This kind of spending is adopted to
compensate the decline in private investment during recession and
depression. Such expenditures are in the form of government
investment in infrastructure building and introducing new social
security measures. Compensatory spending should be carried out only
as long as private sector investment is low and should be withdrawn
once private investment picks up to a desired level. The problem with
using such policies is that the governments are not able to time the
beginning of recession and therefore may begin c ompensatory
spending after recession has become serious. Secondly, expenditure on
public works and infrastructure cannot be withdrawn easily as they
have long gestation period. The programmes often continue even after
the economy has revived. Such expendit ure requires the government to
borrow and this increases the debt servicing burden of the economy.
In view of the limitations of compensatory financing, many
economists argue that the government should spend on social security
measures like unemployment b enefits and old age pension to increase
purchasing power and revive the economy through indirect measures.
In conclusion, we can say that to revive the economy from recession
and depression, the government should follow a deficit budget.
B. Fiscal Policy duri ng Inflation : Inflation causes the value to money
to decline people can buy less with their income. During inflation, the
poor suffer the most and hence every government is concerned about
reducing the harmful effects of high rate of inflation. Fiscal pol icy
during inflation would include policy related to government spending,
taxation and public borrowings.
(i) Government expenditure : During inflation, aggregate demand is
high, there is unregulated private spending and the goods and services
available are n ot sufficient to meet the rising demand. The policy to be
followed during such a situation is to reduce government spending in munotes.in

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179 order to reduce purchasing power and bring down the price level.
However, there are certain limitations to this policy. The gover nment
cannot reduce its spending in the short run to tackle inflation. Many
public spending are medium to long -term commitments and they
cannot be withdrawn at short notice.
(ii) Taxation : Due to the difficulties regarding expenditure reducing
policy, the gov ernment usually resorts to raising tax rates and
imposing new taxes to control inflation. The objective of anti -
inflationary taxation is to reduce aggregate demand and also to control
speculative expenditure, like those on housing, stock market and
commodi ties markets. However, taxes also cannot be increased
indiscriminately as that will lead to tax evasion and will affect
willingness and ability to work, save and invest.
(iii) Public Borrowings : Along with increased taxation, the government
could follow a pol icy of increasing public borrowing. The government
can borrow by issuing bonds (long term) and treasury bills (short term)
on a large scale. During inflation, people and the banking system have
excess cash. Therefore, government debt instruments, with attr active
interest rates, become a good source of earning for those who have
excess cash. The sale of these instruments will absorb the excess
money from the system and help to reduce purchasing power. Massive
public borrowing also raises interest rate and th is discourages
borrowing also raises interest rate and this discourages borrowing from
banks and encourages savings. All these measures help to reduce the
rising aggregate demand and lower the price level. However, while
following such a policy the governm ent has to keep in mind the fact
that massive increase in public borrowing will increase its debt burden
and will enlarge fiscal deficit.
Fiscal policy followed during inflation will result in a surplus budget.
It is generally observed that fiscal policy may not be a very effective in
countering the effects of inflation but it is much more effective in
countering the effects of recession and depression. It is clear, that in order
to achieve economic stability and to counter the effects of business cycle,
the government will not be able to maintain balanced budget but will have
to resort to either deficit or surplus budget.
11.10 SUMMARY
1. Fiscal policy is the part of government policy that deals with raising
revenue through tax and non -tax sources and dec iding on the level and
pattern of public expenditure. Fiscal policy is composed of several
parts. These include, tax policy, public expenditure policy, investment
or disinvestment strategies and debt or surplus management.
2. According to Keynesian economi sts, the primary objective of fiscal
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180 like disposable income, public and private investment, consumption
expenditure, net exports and government purchases. A high level of
aggregate dema nd will result in higher production, employment and
ensure better standard of living. A change in any one of the policy
variables affects all other variables as they are all interrelated.
3. The fiscal policy is formulated with specific objectives in view. The
objective in developed countries is to achieve economic stability and
maintain high aggregate demand. In developing countries the goal is to
achieve economic growth and development.
4. A major problem of fiscal policy is finding a balance between the short
run stabilization objectives and long run goals of growth and
development. At times, the short run policies adopted to deal with
cyclical fluctuations like inflation and recession may conflict with lon g
run goals of the economy. Two conflicting views on how to achieve
the goals of fiscal policy are represented by the following principles :
(a) The Principle of Sound Finance
(b) The Principle of Functional Finance
11.11 QUESTIONS
1. Define fiscal policy. Explain how fiscal policy functions
2. Discuss the obje ctives of fiscal policy.
3. Discuss the constituents of fiscal policy.
4. What are the limitations of fiscal policy?
5. Discuss the principles of sound finance .
6. Write down the features of functional finance .
7. Explain discretionary and contra cyclical fiscal po licy.
8. Write a note on Automatic stabilisers .



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181 12
PUBLIC BUDGET, DEFICIT AND FRBM
ACT 2003
Unit structure :
12.0 Objectives
12.1 Meaning and objectives of budget
12.2 Important types of public budget
12.3 Structure of Union Budget
12.4 Types of Deficit
12.5 FRBM ACT 2003
12.6 Classification of govern ment Into Unitary and Federal
Governments.
12.7 Meaning of Fiscal Federalism
12.8 Meaning of Fiscal decentralization
12.9 Financial relation between center and state
12.10 Summary
12.11 Questions
12.0 OBJECTIVES
 To know the meaning of budget
 To understand the objectives of Budget
 To know different types of Budget
 To understands the structure of union budget
 To understand the concept of fiscal responsibility and budget
management
 To know the limitations of the FRBM
 To know broad classification of government
 To understand the meaning of fiscal federalism
 To know the Meaning of Fiscal decentralization
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182 12.1 MEANING AND OBJECTIVES
Meaning of Budget
A budget is a description of the spending and financi ng plans of an
individual, a company or a government. The government budget shows the
planned expenditure programmes of the government and the expected
revenues from taxes and other sources during a given year. The budget
contains a list of specific progra mmes like education, defence, welfare,
etc. which give rise to government spending. It also contains tax sources
like income tax, commodity tax, etc. which give revenues to the
government. The revenue sources differ depending on the level of
government (i. e. central, state and local). Although the central government
collects most of the taxes, states and local governments also have a wide
list of choices with respect to taxing.
When all taxes and other revenues exceed government expenditures for a
given ye ar, there is a budget surplus. When government expenditures
exceed taxes and other revenues, there is a budget deficit. When revenues
and expenditures are equal during a given year, the government has a
balanced budget. Balanced budget is a rare phenomenon .
Fig. 12.1 shows government expenditure and revenue in relation to
national income. Government expenditure is assumed constant and
revenue is assumed to rise with national income. At the point E, budget is
balanced. To the left of E the government budget is in deficit and to the
right of E the budget is in surplus.

Fig. 12.1
When the government incurs a budget deficit, it is financed by borrowing.
The government borrows from the public by issuing government bonds.
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183 Objectives of Public Budget
In a laissez faire economy, with minimal government intervention, the
public budget was considered merely a statement of receipts and
expenditures of the government. The objective of the budget was to ensure
that th e government taxed as little as possible and that the revenue was
sufficient to provide essential activities of the government. But as most
laissez faire economies converted into welfare states, the budget was no
longer considered to be a mere statement of receipts and expenditures, but
became an important instrument of fiscal policy through which the
government could fulfill many objectives. The functions and role of the
government expanded to cover a very wide area and the primary objective
of such functi ons is to promote general welfare of the people.
Some of the objectives of the public budget in any modern economy
are :
1. Allocation of Resources : This is the primary objective of any public
budget. In order to fulfill all the other objectives, the govern ment
needs to first direct the allocation of resources in a desired manner.
Resources are public or privately owned. In order to divert private
resources to desired sectors, the government makes provisions in the
budget that includes; (a) tax concessions; and (b) subsidies. For
example, government may make provisions of both (a) and (b) for the
MSME sector in order to encourage investment in this sector as the
sector has large capacity to generate employment. In order to allocate
public sector resources, th e government directly invests in public
sector undertakings like the railways, or public enterprises like oil
refineries, fertilizer plants or in transport and other infrastructure.
Resources are also diverted from undesirable sectors by levying higher
indirect taxes and withdrawal of subsidies. All these can be done
through budgetary provisions.
2. Reduction of Poverty and Income Inequalities :The public budget is
an instrument of reducing income inequality through progressive
taxation, provision of social s ecurity benefits, subsidies on food,
housing and education, provision of merit goods. In most developing
economies, the government directly attacks poverty through poverty
alleviation programmes. The public budget allocates funds for such
expenditures. All these budgetary provisions are absolutely necessary
to redistribute income and wealth and reduce inequality.
3. Economic growth : Growth of the GDP results in more production
and employment generation. Therefore, every nation tries to ensure a
healthy rate of growth of the GDP as well as achieve balanced growth
that benefits all sectors. The public budget can be used to achieve
these objectives. Economic growth can be achieved through (a)
mobilization of savings; (b) investment and capital formation; and (c)
maintaining high level of effective demand. All these can be
influenced by the budget. Tax incentives given to the people can munotes.in

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184 encourage them to save. Investments and capital formation are
encouraged through business tax incentives, subsidies and governmen t
infrastructure spending. High level of effective demand is maintained
by keeping direct tax rates low, better distribution of income through
progressive taxation and subsidies, and social security expenditure and
following contra -cyclical fiscal policy. All these can influence the
growth rate of the GDP.
4. Economic Stability : Most economies experience fluctuations in the
form of business cycles. Such fluctuations cause inflation recession
and unemployment. To protect the economy from the adverse effects
of the fluctuations and maintain stability in the economy, the budget
can play an important role, particularly in a recession or depression.
During recession, the automatic stabilizer in the fiscal system results in
reeducation in tax collection and increase in social security
expenditure. Besides, the government uses discretionary fiscal policy,
like spending to create jobs. All these make the budget a deficit
budget. On the other hand a surplus budget is followed during
inflation. However, inflation can be better tackled with monetary
policy than with fiscal policy. In order to ensure long term price
stability, the government makes provisions in the budget to encourage
production, like investment in agriculture through irrigation projects to
increase food pr oduction and reduce food prices.
5. Management of Public Enterprises : Many developing economies
have adopted the mixed economy system, where the government
sector and the private sector both produce goods and services for the
market. The objective of setting up public sector enterprises is to
generate jobs, prevent private monopolies and provide people with
essential goods and service at low prices. In order to maintain the
public sector, regular budgetary provisions have to be made. Such
provisions include r aising taxes to make investments in public sector,
as well as selling off unsustainable public sector enterprises through
the process of disinvestment. All these budgetary provisions have an
impact on the budget deficit and surplus.
6. Employment Generation : The budget is used to directly generate
employment through government programmes, like the MNREGA in
India, or by budgetary support to sectors like MSME and agriculture
that generate large scale employment. Every year the government has
to make budgetary provisions for employment generation programmes.
In developed economies, the budget is used to maintain high level of
effective demand in order to maintain high employment level.


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Public Budget, Deficit and FRBM ACT 2003
185 12.2 TYPES OF PUBLIC BUDGET
The important types of public budgets are explai ned below.
1. Balanced and Unbalanced Budget : In a balanced budget the
revenues are equal to expenditures. It has neither a budget deficit nor
budget surplus. In the unbalanced budget, revenues and expenditures
are not equal. When the revenues are greater th an expenditure, we
have surplus budget. On the other hand, when expenditure exceed
revenues, there is a deficit budget.
2. Zero based Budget and Traditional Budget : In the traditional
budget changes over the past years are to be justified, based on the
assumption that the baseline is automatically approved. In the
traditional budgets, incremental approach is used. Thus the
programmes and projects of previous years are automatically
continued and funded.
In zero based budget, every item of the budget must be approved,
rather than only changes. In zero based budget every item has to be re -
evaluated thoroughly starting from the zero base. In a zero based
budget all expenses must be justified for each new year. The needs and
costs of every function of the governm ent department are taken into
consideration for the next year’s budget. It is used when resources are
limited.
3. Performance and Programme Budget : Performance budget takes
into account the end result or the performance of the programme or
activity and thus ensures cost effective and efficient planning. It relies
on three aspects, such as, understanding of the final outcome, the
strategies formulated to reach those final outcomes and the specific
activities that are to be carried out to achieve those outcomes . Since it
involves a very detailed and objective analysis, this budgeting process
is very result oriented and its approach. This type of budget is mostly
used by the organizations and ministries involved in the developmental
activities.
Programme budget is somewhat similar to performance budget. But,
the programme budget is different in considering the programme as a
unit. In this the major functions of the government is divided into
specific programmes, activities and projects. The funds are allocated
according to the achievements expected from each programme over a
specific period. The emphasis is on the size of the programme, its
implementation, costs involved and benefits expected from the
programme. Thus this can be narrower than the performance budge t.
4. Multiple and Unified Budget : Multiple budget is where the budget is
divided into parts in such a way that each part highlights the
specialized functions of the government showing their budgets. For munotes.in

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Business Economics
186 example, the Indian government presented the Railway b udget and the
Union budget separately.
Unified budget includes receipts from all sources and outlays for all
programmes of the government. It is the most comprehensive measure
of the government’s annual finances. Unified budget is a single
measure of the f iscal status of the government, based on the sum of all
government activities. When many fund groups are consolidated to
display budget totals, interfund transactions are deducted to avoid
double counting. Now the Indian government has merged the railway
budget with the general budget.
5. Legislative and Executive Budget : Legislative budget is prepared by
the legislature directly or with the help of committees. A legislature
consists of elected representatives of the government. It is a decision
making organ ization that has the power to enact, amend and repeal
laws. The executive budget is prepared by the executive wing of the
government. The executive is responsible to the implementations of
the budget proposals prepared by the legislatures and executives.
6. Revenue Budget and Capital Budget : Budget is also classified into
revenue and capital budget.
The revenue budget covers those items which are of recurring in
nature. The revenue budget shows both revenue receipts and revenue
expenditures.
Revenue receipts consist of tax revenue and non -tax revenue. The two
components of tax revenue are (i) revenue from direct taxes, and (ii)
revenue from indirect taxes. Non tax revenue consists of interest and
dividend on investments made by the government, fees, and other
receipts for services rendered by the government.
Revenue expenditure is expenditure on maintaining existing level of
public services. Such expenditures do not create any capital asset but help
to maintain the existing assets. Revenue expenditure should i deally be met
through revenue receipts and not through borrowings.
Capital budget consists of capital receipts and capital expenditures. The
capital budget covers those items which are concerned with acquiring and
disposal of capital assets. The purpose of capital expenditure is the
expansion of present level of public services.
Capital receipts include funds received by the government in the form of
market borrowings, small savings, provident funds, recovery of loans,
external loans and disinvestment recei pts and any other receipts from sale
of government assets.
Capital expenditure includes repayment of debts and all expenditure
incurred on creation of capital assets, like roads, railroads, irrigation and munotes.in