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1Module I
1
INTRODUCTION TO MACRO ECONOMICS
Unit Structure:
1.0 Objectives
1.1 Introduction
1.2 Meaning of Macro Economics
1.3 Scope of Macro Economics
1.4 Summary
1.5 Questions
1.0OBJECTIVES
To study the introduction and meaning of macro economics.
To study the scope of macro economics.
To study the importance of macro economics.
1.1 INTRODUCTION
Macroeconomics is that part of econom ic theory which studies the
economy in its totality or as a whole. It studies not individual economic
units like a household, a firm or an industry but the whole economic
system. Macroeconomics is the study of aggregates and averages of the
entire economy. Such aggregates are national income, total employment,
aggregate savings and investment, aggregate demand, aggregate supply
general price level, etc.
Here, we study how these aggregates and averages of the economy
as a whole are determined and what cause s fluctuations in them. Having
understood the determinants, the aim is how to ensure the maximum level
of income and employment in a country. In short, macroeconomics is the
study of national aggregates or economy -wide aggregates. In a way it is
like study of economic forest as distinguished from trees that comprise the
forest. Main tools of its analysis are aggregate demand and aggregate
supply.
Since the subject matter of macroeconomics revolves around
determination of the level of income and employment, therefore, it is also
known as ‘Theory of Income and Employment’. These days when the
study of lakhs of individual units has become almost impossible and when
government’s participation through monetary and fiscal measures in themunotes.in
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2economy has increased ver y much, use of macro analysis has become
indispensable. Correct economic policies formulated at macro level have
made it possible to control business cycles (inflation and deflation) and as
a resultviolent booms and depressions have become things of the pa st.In a
suitably modified form, macroeconomics is the basis of all plans of
economic development of underdeveloped economies. Economists are
now confidently exploring the possibilities and ways of maintaining
economic growth and full employment. More than anything else,
macroeconomic thought has enabled us to properly organise, collect and
analyse the data about national income and coordinate international
economic policies.
The scope of macroeconomics includes the following parts:
1. Theory of national In come
2. Theory of employment
3. Theory of money
4. Theory of general price level
5. Theory of economic growth
Clearly, the study of the problem of unemployment in India
orgeneral price level or problem of balance of payment is macroeconomic
study because these relate to the economy as a whole.
1.2 MEANING OF MACRO ECONOMICS
The world Macro Economics is derived from Greek word
‘Makros’ meaning large or aggregate (Ragner Frisch).Macroeconomics
analyses the behaviour of the economy as a whole, for e.g. study
ofNational Income, General Price Level, National output, Business cycle
etc. The credit for the development of Macroeconomic approach goes to J.
M. Keynes.
Macroeconomics deals with economic affairs ‘in the large’;
itconcerns the overall dimensions of economic life. It studies thecharacter
of the forest and not only a tree like Micro economics.
Uses of Macro E conomics
Macro economic analysis helps us to get an idea of how a complex
economic system functions
It is of great significance in formulating suitable economic policies for
eg. Control of inflation, promotion of economic growth etc.
It helps us in underst anding the functioning of an economy as a whole.
It helps us in studying phenomenon of trade cycle or business cycle.
It helps us to evaluate the resources and capabilities of an economy. It
will help us to increase NI, output etc.munotes.in
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3Macro economics helps us to study the problems related to the
measurement of NI and related concepts
It helps us to analyse the problems arising from frequent changes in
the value of money. It helps us to understand the effects of inflation
and deflation.
It helps us to us e monetary, fiscal policies for the economy as a whole.
1.3 SCOPE OF MACRO ECONOMICS
Macro Economics is of much theoretical and practical importance.
Let us see what are the importance and the scope where macro economics
are being used.
1. To Understand the working of the Economy
The study of macro economics variables is requisite for
considerate the operation of the financial system. Our main economic
complexities are associated with the performance of total income,
irredundant and the normal price scale in the fiscal. These variables are
geometrically measurable in this manner facilitating the probabilities of
analysing the effects on the functioning of the economy.
2. In Economic Policies
Macro Economics is extremely useful from the view point of the
fiscal policy. Modern Governments, particularly, the underdeveloped
economies are confronted with innumerable national problems. They are
the problems of over population, inflation, balance of payments, general
under production etc. The main conscienti ousness of these governments
rests in the regulation and control of over population, general prices,
general volume of commerce, general productivity etc.
3. In General Unemployment
Redundancy is caused by deficiency of effectual demand. In order
eradicat e it, effective demand should be raised by increasing total
investment, total productivity, total income and consumption. Thus, macro
economics has special significance in studying the causes, effects and
antidotes of general redundancy.
4. In National I ncome
The study of macro economics is very significant for evaluating
the overall performance of the economy in terms of national income. This
led to the construction of the data on national income. National income
data help in anticipating the lev el of fiscal activity and to comprehend the
distribution of income among different groups of people in the economy.
5. In Economic Growth
The economics of growth is also a study in macro economics. It is
on the basis of macro economics that the resources and capabilities of anmunotes.in
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4economy are evaluated. Plans for the overall increase in national income,
productivity, employment are framed and executed so as to raise the level
of fiscal development of the economy as a whole.
6. In Monetary Problems
It is in te rms of macro economics that monetary problems can be
analysed and understood properly. Frequent changes in the value of
money, inflation or deflation, affect the economy adversely. They can be
counteracted by adopting monetary, fiscal and direct control me asures for
the economy as a whole.
7. In Business Cycle
Moreover, macro economics as an approach to fiscal problems
started after the great Depression, thus its significance falls in analysing
the grounds of fiscal variations and in providing remedies.
8. For Understanding the Behaviour of Individual Units
For understanding the performance of individual units, the study of
macro economics is imperative. Demand for individual products depends
upon aggregate demand in the economy. Unless the causes of defic iency
in aggregate demand are analysed it is not feasible to understand fully the
grounds for a fall in the demand of individual products. The reasons for
increase in costs of a specific firm or industry cannot be analysed without
knowing the average cost conditions of the whole economy. Thus, the
study of individual units is not possible without macro economics.
1.4 SUMMARY
We may conclude that macro economics enriches our knowledge
of the functioning of an economy by studying the behaviour of national
income, productivity, investment, savings and consumption. Further more,
it throws much light in solving the problems of redundancy, inflation,
economic instability and economic growth. The concept of stock and flow
are mainly used in the macro economics o r in the theory of income,
productivity and employment. Lastly, both the concepts of stock ad flow
variables are very significant in modern theories of income, interest rate,
business cycles etc.
1.5 QUESTIONS
1.What is Macro economics? Explain Nature ofmacroeconomics.
2.Explain the Scope & importance of macroeconomics.
3.Describe the limitations or drawbacks of macroeconomics.
4.Distinguish between Micro and Macro Economics.
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52
INTRODUCTION TO NATIONAL INCOME
Unit Structure:
2.0 Objectives
2.1 Introduction
2.2 Concepts of National Income: GNP, NNP, NDP, Per Capita
Income, Personal Income and Disposal Income
2.3 Methods of Measurement of National Income
2.4 Difficulties in Measurement of National Income
2.5 Circular Flow of Income
2.5.1Circular Flow of In come in Two Sector Economy
2.5.2Circular Flow of Income in Three Sector Economy
2.5.3Circular Flow of Income in Four Sector Economy
2.6 Summary
2.7 Questions
2.0OBJECTIVES
Tostudy the various concepts national income.
To study the measurement of National Income and difficulties in
measurement of National Income.
To study the circular flows of income in two, three & four sector
economy.
2.1 INTRODUCTION
Macroeconomics deals with study of aggregates. The macro
variable s are aggregate demand, Aggregate Supply, National Income,
national output, National expenditure, Inflation, unemployment,
international trade, balance of payment, fiscal and monetary policy etc.
As from above it is clear that national income is macro Var iable
and it determines total income of nation. National income can be can be
defined as total money value of final goods and services produced in a
country over a period of one year including income from abroad without
duplication.
In India since 1955, C entral Statistical organization took the
responsibility of calculation of national income in closed economy
basically when we consider two sector model the three factors are
expressed as:munotes.in
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6National Expenditure = National Product = National income or
Dividen d.
a.National Expenditure is total spending on the goods and services
produced during a given year.
b.National product is total goods and services produced during one year
and measured in money terms.
c.National income or dividend is total income earned b y factors of
production during given period of one year.
Definition:
According to A.C. Pigou , “National income is that part of objective
income of the community, including of course income derived from
abroad which can be measured in money.”
According to F isher, “The National dividend or income consists
solely of services as received by ultimate consumers, whether from
their material or from the human environments. Thus, a piano, or an
overcoat made for me this year is not a part of this year’s income, but
an addition to the capital. Only the services rendered to me during this
year by these things are income.”
According to Marshall, “The labour and capital of a country, acting
on its natural resources, produce annually a certain net aggregate of
commodities , material and immaterial, including services of all kinds
and net income due on account of foreign investments must be added
in. This is the true net annual income or revenue of the country, or the
national dividend.”
As per national income committee the national income is defined
as, "the value of commodities and services produced in an economy
during a given period, counted without duplication."
2.2 CONCEPTS OF NATIONAL INCOME
2.2.1 Gross National Product (GNP):
GDP refers to the value of final goo ds and services produced within
the country in a, particular year. GDP is different from GNP. Ap a r to f
GNP may be produced outside the country For example the money
earned by the Indians 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 ac o u n t r yw h e r e a st h eb o u n d a r i e so f
GDP are determined by the geographical limits of acountry. It is also clear
that the difference between GDP and GNP is due to the "net revenue from
abroad." If the citizens of a country are earning more from abroad than
foreigners are earning in that country, GNP exceeds GDP If the foreigners
in the country are earning more than its citizens are earning abroad, GNP
is less than GDP.munotes.in
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72.2.2 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 capita lgoods 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 fin al goods and services after providing for depreciation.
It is called national income at market prices. In other words, net national
product is the total value of final goods and services produced in the
country during a year after deducting the depreciation, plus net income from
abroad.
2.2.3 Net Domestic Product (NDP):
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 abr oad is positive, NDP will be less than NNP If the net income
from abroad is negative, NDP will be greater than NNP NDP is also
calculated either at market price or at factor cost.
National Income at Factor Cost: -means sum total of all income
earned by resource suppliers for their contribution of land, labour, capital
and entrepreneurial ability which go into the years net production.
National income at factor cost shows how much it costs society In terms of
economic resources to produce th e 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)
2.2.4 Per Capita Income (PCI):
Per Capita Income is obtained by dividing National Income by the
population.National IncomePer Capita IncomePopulation
Per Capita Income highlight the average income of the people in the
country.
2.2.5 Personal Income (P I):
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 incom et a x e s and undistributed
corporate profits are not actually received by households. In the same
manner, some incomes which are received like transfer payments are not
currently earned ex Old age pension, unemployment compensation, relief
payments interest payments etc. To get personal income from national wemunotes.in
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8must subtract from National income the three types of incomes which are
earned but not received and add incomes that are not currently earned,
Persona l income = N.I -Social Security -contributions -corporate
income taxes -undistributed corporate profit + Transfer Payments.
2.2.6 Disposable Income (DI):
The personal income which remains after payment of taxes to the
government in the form of income t ax, personal property tax etc., is
called disposable income. Disposable income = Personal Income -
Personal Taxes. An individual can decide to consume or save the
disposable income as he wishes.
2.3METHODS OF MEASUREMENT OF NATIONAL
INCOME
For measuring national income, the economy through which
people participate in economic activities, earn their livelihood, produce
goods and services and share the national products is viewed from three
different angles :
1.The national economy is considere d as an aggregate of producing units
combining 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 sell factor services to make their livelihood.
3.The national economy may also be viewed as a collection of
consuming, saving and investing units (individuals, households
and government).
4.National income may be measured by three different corresponding
methods :
A)Net product method
B)Factor -income method
C)Expenditure method
A.Net product method
It is also called the Value Added Method. It consists of three
stages : i) estimating the gross value of domestic output in the various
branches of production; ii) determining the cost of material and services
used and also the depreciation of physical assets; iii) deducting these
costs and depreciation from gross value to obtain the net value of
domestic output.
Measuring gross value : For measuring the gross value of domestic
product, output is classified under various categories and it is computed
in two alternati ve 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 GDPmunotes.in
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9on the basis thereof. If there are gaps in data, some estimates are made
thereof and gaps are filled.
Estimating cost of production : is, however a relatively more
complicated and difficult task because of non -availability of adequate
and requisite data. Countries adopting net -product method find some
ways and means to calculate the deductible cost. The costs are estimated
either in absolute terms or as an overall ratio of input to the total output.
The general practice in estimating depreciation is to follow the usual business
practice of depreciation accounting.
Following a suitable method, deductible costs including
depreciation are estimated for each sector. The cost estimates are then
deducted from the sectoral gross output to obtain the net sectoral
products. The net sectoral products are then added together. The total
thus obtained is taken to be the measure of net national products or
national income by net pr oduct method.
B.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 t e basic factors of production used
in producing the national product‖The total factor -incomes are grouped
under three categories :
i)Labour incomes : included in the national income have three components :
a) wages and salaries paid to the residents of the country including bonus
and commission and social security payments; b) supplementary labour
incomes including employer‘s contribution to soca security and
employers welfare funds and direct pension payments to retired
employees; c) supplementary labour incomes in kind, e.g. free health and
education, food and clothing, and accommodation, etc. Compensations
in kind in the form of domestic servants and other free -of-cost services
provided to the employees are included in labour inc ome. War bonuses,
pensions, service grants, are not included in labour income as they are
regarded as transfer payments. Certain other categories of income, e.g.,
incomes from incidental jobs, gratuities, tips etc., are ignored for lack of
data.
ii)Capital incomes : According to Studenski, capital incomes include
the following capital earnings
a)Dividends excluding inter -corporate dividends;
b)Undistributed before -tax profits of corporations;
c)Interest on bonds, mortgages, and savings deposits (excludi ng
interests on war bonds, and on consumer -credit)
d)Interest earned by insurance companies and credited to the insurance
policy reserves;
e)Net interest paid out by commercial banks;munotes.in
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10f)Net rents from land, building, etc., including imputed net rents on
owner -occupied dwellings;
g)Royalties;
h)Profits of government enterprises.
iii)Mixed income : include earnings from
a)Farming enterprises;
b)Sole proprietorship (not included under profit or capital income)
c) Other professions, e.g., legal and medical practices, consultancy
services, trading and transporting etc. This category also includes the
incomes of those who earn their living through various sources as
wages, rent on own property, interest on own capi tal, etc.
All these three kinds of incomes added together give the measure
of national income by factor income method.
C.Expenditure Method
Also known as final product method, measures national income at
the final expenditure stages. In estimating the tot al national expenditure,
any of the two following methods are followed ;
First, all the money expenditures at market price are computed and added
up together, and Second, the value of all the products finally disposed of are
computed and added up, to arrive at the total national expenditure.
The items of expenditure which are taken into account under the
first method are
a)Private consumption expenditure;
b)Direct tax payments;
c)Payments to the non -profit making institutions and charitable
organizations like schools, hospitals, orphanages, etc.
d)Private savings.
Under the second method, the following items are considered
a)Private consumer goods and services;
b)Private investment g oods;
c)Public goods and services;
d)Net investment abroad.
The second method is more extensively used because the data
required in this method can be collected with greater ease and accuracy.
Treatment of Net Income from Abroad :
Nowadays, most economies are open in the sense that they carry
out foreign trade in goods and services and financial transactions with
the rest of the world. In the process, some nations get net income
through foreign trade while some lose their income to foreigners. The net
earnings or loss in foreign trade affects the national income. In
measuring the national income, therefore, the net result of external
transactions are adjusted to the total. Net incomes from abroad are addedmunotes.in
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11to, and net losses to the f oreigners are deducted from the total national
income arrived at through any of the above three methods.
Briefly speaking, all exports of merchandise and of services like
shipping, insurance, banking, tourism and gifts are added to the national
income. And all the imports of the corresponding items are deducted from
the value of national output to arrive at the approximate measure of
national income. To this is added the net income from foreign
investment. These adjustments for internati onal transactions are based
on the international balance of payments of the nations.
2.4DIFFICULTIES IN MEASUREMENT OF NATIONAL
INCOME
1.Changes in the general level of prices form the basis for
measuring the changes in the value of money. The concept of the
general price level is not very clear.
2.Change in the general price level does not reflect the price of each and
every commodity. All prices do* not change at the same rate. ,
3.It is difficult t os e l e c tc o m m o d i t i e ss i n c et h ep a t t e r no f
consumption is not uniform.
4There are practical difficulties in assessing weights on the
basis of their importance in consumption.
5Base year is selected arbitrarily
2.5 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 on diagram in the form
of current and cross -current in such a manner that the total money
payments equals the total money receipts in the economy.
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 ser vices. 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 flow, that is the flow of goods and services, and
2.Money flow.
Product and money flow in o pposite direction in a circular way.
The product flow consists of a) factor flow, that is flow of factor servicesmunotes.in
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12and 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 i n 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 sy stem work.
The economists, however use simplified models to explain the
circular flow of income and expenditure dividing the economy into four
sectors namely, I) Household sector, II) Business or Firms sector , III)
Government sector, and IV) Foreign se ctor. 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 household and business sectors;
II)Three -sector m odel including the household, business and
government sectors; and
III)Four-sector model including the household, business, government and
the foreign sectors.
2.5.1 Circular Flow of Income in Two Sector Economy
We begin with a simple hypothetical economy w here 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 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 secto r 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 from the business sector to
the household sector when the former buys t he 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 flows in a circular manner form the business sector to the
household sec tor and from the household sector to the business sector in
the economy.
The circular flow in a two sector economy is depicted in Fig. 1.1
where the flow of money as income payments from the 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 sectormunotes.in
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13is shown to go the 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 expenditure 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.2.1
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.
3.The business firms keep their 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 undistri buted money as reserve.
The money it receives by selling goods and services to the householdFactor income = Wages, Rent, Interest and ProfitsHousehold SectorFactor Owners and
Consumers of goodsand servicesFirms SectorFactor Users and
Producer of goods
and servicesFactor Market
Commodity Marketmunotes.in
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14sector 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 ou tflow of income or no foreign trade.
It is these assumptions that keep the flow 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.
Circular Flow of Money in a T wo Sector Economy with Saving and
Investment:
In the analysis of circular flow of income in a two secto r 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 part of their income for vario us 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 b usiness 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 money
expenditure to busine ss 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 brought 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, bus iness 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 flo w of money
with savings and investment is explained with the help of following
assumptions.
1.All the households need to deposit their savings with the financial
institutions \market.
2.There are no inter -households borrowings.
In the following figure, in t he 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.munotes.in
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15The circula r flow of money with savings and investment is shown
in the following fig. 2.2.
Flow of goods & services
Fig.2.2
Factors of production -Land, Labour, Capital & Entrepreneurship
The necessary condition for the constant flow 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 flo w. 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 neces sarily 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 planned savings, income, output and employmen t 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 equality between
planned savings and planned investment is satisfied.
2.5.2 Circular Flow of Income in Three Sector Economy
The two sector economy model consists of households and
business firms. But in a three sector economy a dditional 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 t his it requires huge amount of income.
Government receives income in the form of taxes from households andmunotes.in
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16business 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 includes 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.
Anot her 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 labeled as Government
borrowing.
In a three sector economy we have the following three economic
agents.
1.Households and business firms
2.Financial sector
3.Government
The circular flow of income in a three sector economy is shown in
the following fig. 2.3.
Wages, Salaries & Payments Purchase of goods & services
The above figure clearly shows that, income receiv ed 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.munotes.in
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17Thus, 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 th e 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 symbol ically expressed as,
Total expenditure (E) = C + I + G
Total income (Y) received is allocated to consumption (C), savings
(S) and taxes (T).
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
business firms must be less than the savings of the households. Thus
Government borrowing reduces private investment in the economy.
2.5.3 Circular Flow of I ncome in Four Sector Economy
So far the circular flow 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. When
foreigners buy goods and services produced by domestic firms, they are
exports in the circular flow of money. On the other hand, imports aremunotes.in
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18leakages from the circular flow of money. They are expendi ture incurred
by the household sector to purchase goods 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 sector
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 su ch as shipping, insurance, banking etc. for 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 sector makes payments to the fore ign sector for
imports of capital goods, machinery, raw materials, consumer goods and
services from abroad. These are the leakages from circular flow of money.
X–M
Fig.2.4
Like the business sector, modern g overnments also export and
import of goods and 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 education, 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 circular flow of money. On the other hand, the leakages
are payments made to foreigners for the purchase of goods and services.munotes.in
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19Figure 2.4 shows the circular flow of money in four sector open
economy with saving at t he right hand and taxes and imports at the left
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 th e lower
level left hand side of the figure. Further, 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 2.4 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 f oreign sector
in current s and cross -currents.
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 smoothly of there is any disturbance in its smo oth
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 consumers –The
circular flow of money establis hes 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 producers.
3.To find out the leakages in circu lar 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 contracts 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 pri ces
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
investmen t 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 circular flow of money possesses much
theoret ical and practical significance in an economy.munotes.in
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202.6 SUMMARY
1.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.
2.In the Two sector economy money fl ows in a circular manner form the
business sector to the household sector and from the household sector
to the business sector in the economy.
3.In a three sector economy we have the following three economic
agents, Households and business firm, Financial se ctor, and
Government.
4.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.
5.National income may be measured by three different corresponding
methods : Net product method, Factor -income method and Expenditure
method.
6.Measurement of National Income in India : The earliest estimate of
India‘s national income was made by Dadabhai Naor oji in 1867 -68.
7.In 1949, A National Income Committee (NIC) was appointed. In
1967, the task of estimating national income was given to the Central
statistical Organization (CSO).
2.7 QUESTIONS
1.Explain the various concepts of national income.
2.Explain the methods of measurement of national income and also
explain the difficulties in national income.
3.Explain the circular flow of income in two sector economy with
diagram.
4.Explain the circular flow of income in three sector economy with
diagram.
5.Explain the circular flow of income in four sector economy with
diagram.
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21Module 2
3
CONSUMPTION
Unit Structure:
3.0 Objectives
3.1 Introduction
3.2 Meaning of Consumption
3.3 Consumption Function
3.4 Say’s Law of Market
3.5 Theory of Effective Demand
3.6 Summary
3.7 Questions
3.0 OBJECTIVES
To study the concepts of consumption & consumption function.
To study the say’s low of market.
To study the theory of effective demand.
3.1INTRODUCTION
The consumption is the key macroeconomic concept which decides
or affects whole economy like as national income, employment, full
employment level and many more. That is why, there is need to
understand the concept of consumption in the study of macroeconomics.
3.2MEANING OF CONSUMPTION
What is Consumption?
Consump tion is the utility driven phenomena where consumption
happened of goods and services, definitely utility is acquired from it. That
is why, we stated above consumption is the utility driven act. The various
macro economists define the consumption in the ec onomy. Most important
among them is given by Prof. J. M. Keynes who defined short term
consumption function in his famous psychological consumption theory.
Relationship between Consumption and Income:
When income increases, consumption also increases; but it is not
as much as income. This important fact of consumption was focused by
Keynes who first of all evolved the concept of consumption function. Why
it happens, because whatever income increases which is not consumed all,
some were saved. So, that is the main reason behind it.munotes.in
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22Keynesian linear consumption function is as follow:
C=a+b Y
Where,
C = consumption
a = autonomous consumption
b = intercept term/ slope (coefficient of disposable income/ marginal
propensity to consume (MPC)
Y = disposable income.
Above Keynesian consumption function is explained by following figure -
3.3 CONSUMPTION FUNCTION
In Keynes theory of income and employment, we have already seen
that the volume of employment in a society depends on the level of
effective demand which in turn is determined by the aggregate demand
function. The aggregate demand is made up of 2 components i.e.
consumption expenditure and investment expenditure. Consumption
expenditure is a major component of aggregate deman d in a economy. The
consumption expenditure depends on the size of income and propensity to
consume, which is called consumption function. The marginal efficiency of
capital and the rate of interest determine investment. The Investment
multiplier expresses the relationship between the increases in investment and
increases in consumption. We will be studying the consumption function
and the investment rnultiplier in this unit.
In macro economic theory, Keynes singled out income as the main
determinant -Of consumption. The relationship is expressed in the form of a
function. The consumption function is the assumed direct relationship
between the national income level and the planned or desired
consumption expenditure. Keynes called it the propensity to consume.
Algebraically the basic relationship between consumption spending and
national income is shown as
C=f ( Y )
'C' stands for consumption function, 'Y' stands for national
income, 'f. stands fo r functional relationship.
The simplest form of relationship between income and
consumption can be expressed as follows.
C=c Y
This means that the consumption (C) is a constant proportion (c)
of income (Y)munotes.in
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23According to Keynes, at various income levels ,as c h e d u l eo f the
propensity to consume is a statement showing the functional relationship
between the level of consumption at each level of income.
TABLE: 3.2
CONSUMPTION FUNCTION
INCOME YCONSUMPTION (C)
(In crores of rupees)
200
300 220
400 300
500 380
600 540
700 620
The schedule relating to the various amounts of consumption at
different levels of income is called the consumption function, it is clear
from the above table that consumption is an increasing function of
income since both the variables Y and C move in the same direction.
Consumption function can be represented diagramatically as below.
Figure No. 3.1
In the above diagram, Y -axis measures consumption, and X axis
measures the real income. The curve 'C' represents the
consumption function (Propensity to consume). It moves upwards to
the right implying that consumption increases as income increases
However the increase in consumption C1C2 is less than the increase in
income Y1Y2That part of the income, which is not consumed is saved, SS' is
the saving. Hence the consumption function measures the amount saved
also.
Significance of Keynes Consumption Function
According to Hansen, Keynes analysis of cons umption
function is a major landmark in the history of economic doctrines. Keynes
concept of consumption function has revolutionized the entire economic
thinking in modem times.munotes.in
Page 24
24The important implications are the following.
1.Importance of Investment: Since consumption is a stable
function, Keynes concluded that employment can increase
only if the investment increases. Investment therefore is
regarded as a crucial factor determining employment in the
short run investment has to De sufficient to fill in the gap
between income and consumption if output and employment
are to be maintained.
2.Refutes the Say's Law of Market: Keynes was able to
invalidate the Say's law of market which was the basic
principle of th ec l a s s i c a lt h e o r y .K e y n e ss h o w e dt h e
consumption expenditure rises less than the rise in income.
Hence supply does not create its own demand. All that is
produced is not demanded
3. Keynes Theory explains the Trade cycle Phenomenon:
Keynes consumption function provided a satisfactory
explanation of the upward and downward swings in the trade
cycle. When the MFC is less than usual, the economy is at the
upper turning point (down turn from propensity). As
consumption falls and savings b ecome more, with increase in
income, will ultimately lead to a slump. The lower turning point
i.e. from depression to recovery is explained in terms of the
failure of people to cut down their consumption as the income
decreases.
4.MEC helps to study the nature of income propagation :-A very
important implication is the need for government interference to
remedy the problems of overproduction and unemployment.
3.4 SAY’S LAW OF MARKET
The belief of classical theory regarding the existence of full
employment in the economy is based on Say's Law put forward by a
French economist J B. Say. According to J. B. Say's law. "Supply creates its
own demand". This implies that any increase in production made
possible by the increase in the productive capacity or the stock of fixed
capital will be sold in the market. There will be no problem of lack of
demand. This appears to be a simple proposition. But it has a number of
implications.
Say's law c ontends 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 pro duction, also
creates the demand to purchase these goods. Any production process has
two effects:
1As factors are employed in production process, income is
generated in the economy on account of the payment of remuneration
to the factors of production.
2It results in the production of a certain level of output, which ismunotes.in
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25supplied in the market. According to Say's law additional output
creates additional incomes which creates an equal amount of extra
expenditure.
An e wp r o d u c t i o np r o c e s s ,b yp a y i n go u ti n c o m et oi t s
employed factors generates demand at the same time, as it adds to
supply. Thus any increase in production is followed by a matching
increase in demand.
In the original form Say's law was applicable to a barter
economy. In a barter economy, people produce goods either to consume
or to exchange them for other products. In the process the aggregate
demand for goods equals the aggregate supply of goods. Hence there is no
possibility of over production. Introduction of money also does not change
the basic law. Money is used only as a medium of exchange. The
classical theorists believed that money is neutral and does not influence
the real process of production a nd distribution. There is a circular flow of
money from the firm to households and from households to firms. The
firm purchases inputs for production. They pay in the form of wages,
rent, interest and profits. This becomes the income of households. The
households spend their income on goods and services produced by
firms. In this circular flow there is no saving and hoarding. All
income received is spent. In case the household saves a part of the
income, the circular flow can still be maintained if savings are equal to
investment.
If there is a divergence between saving and investment, the
equality is maintained through the flexibility of money interest. Interest
is a reward for saving. Higher the interest, more are the savings and vice -
versa. At the same t ime, lower the interest rate, higher the demand for
investment and vice -versa. If I > S rate of interest will rise. Savings will
also increase and investment will fall till the two become equal.
Assumptions of the Law
The following assumption forms the ba ckbone of Say=sl a w .
1.Optimum Allocation of Resources: -The resources are optimally
allocated in different channels of production on the basis of equality
of marginal products and proportionality.
2.Perfect Equilibrium: -Demand and supply equilibrium leads to the
fixing of commodity price and factor prices.
3.Perfect Competition: -The commodity and the factor markets have
perfect competition as the market conditions.
4.There is a free enterprise or free market economy.
5.Laissez -faire policy of the government: -There is no government
intervention in the economic field. Laissez -fair policy leads to
automatic adjustment and smooth working of the market
mechanism in the capitalist system.munotes.in
Page 26
266.Elastic Market: -The market is very wide and spread out without
limits. Theref ore as the output product increases, markets also
expand.
7.Market Automatism: -Af r e em a r k e te c o n o m ys t i m u l a t e s capital
formation. In an expanding economy, new workers and firms will
be automatically absorbed into the production channels. There is
nodisplacement 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.
9.Saving Investment Equality: -All the savings are
automatically invested. Therefore, savings is always equal to
investment. Savings investment equality is the basic condition of
equality. Interest flexibility ensures this.
10.Long term :-The economy's equilibrium 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 equal to aggregate supply. Hence there will be no
general over pr oduction in the long run. Therefore, equilibrium
can be maintained automatically at full employment level. Since over -
saving is not possible; Say’s Law implied that underemployment
equilibrium is not possible.
Interest rate flexibility and wage flexibility are the 2 factors
which ensures this equilibrium between be discussed.
1.Interest Rate Flexibility :-According to Say's law, all incomes are
spent i.e. income = expenditure. However, there may be "leakages" in the
circular flow of income & expenditure. Whatever is saved is invested in
production activities. Savings and investments tor saving. If savings exceed
investment, the rate of interest will fall. Hence investment will rise and
level of savings will fall till they are in equilibrium. Therefore, in classical
theory of employment, the rate of interest is a strategic variable, which brings
about equality between savings and investment Interest rate maintains
the equilibrium between savings and investment.
2.Wage Rate Flexibility and Employment : -According to the
classical economist, money wage cut policy can solve the problem
Involuntary employment is due to a rigid wage structure. If the wages can
be lowered, involuntary unemployment will disappear. A self -adjusting
system of wage will push the economy towards full employment stage.munotes.in
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27Figure No. 3.2
Implications of Say’s Law: -
1.Automatic Adjustment of Full Employment -A free enterprise
economy automatically reaches a stage of full employment level.
There are no obstacles to full employment General employment and
over production are impossible.
2.Self-adjusting Mechanism: -Increase in supply will ensure an
increase in demand in the process of the functioning of a free
capitalist economy There is no need for government
intervention.
3.Resource adjustmen t 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 In come. 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 good s
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.Af r e ee n t e r p r i s ee c o n o m yu n d e rL a i s s e z -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
investment.
7.Wage flexibility ensures full employment in the economy.
Criticism: -
J.M. Keynes vehemently criticized the classical theory. The
assumptions on which the classical theory is based can be criticizedmunotes.in
Page 28
28The Great Depression of 1930's has revealed the weaknesses of the
classical theory. The classical theory could not suggest a solution to the
problem of a depressed economy facing large scale unemployment.
1.Unrealistic Assumptions at Full Employment: -According to Keynes.
The basic assumption of full employment itself is unrealistic. An
economy can be in a state of equi librium. In under employment
situation also full employment equilibrium is just one possible
equilibrium condition according to Keynes.
2.Too much emphasis on Long Run: -Keynes gave
importance to the short run According to him. In the long run, we
are all dead.
3.Keynes refuted Say's Law of Markets: -According to
Keynes, the classical economists failed to examine the level of
aggregate demand. Supply may not create demand. Over production
is a possibility and reality according to Keynes. Supply can exceed
demand. Hence automatic self adjusting mechanism will not work.
4.Interest is not an equilibrating factor: -Keynes attacked the classical
theory in regard to savings and investment. Flexible interest rates
will not lead to equilibrium savings and investment. Changes in
income bring about the equilibrium between savings and investment
according to Keynes.
5.Role of money is neglected: -The classical economists considered
money as a veil. It's role is neutral. Keynes recognized the
importance of precautionary measures and speculative demand for
money He also recognized the effect of money on output, incomes,
employment.
6.Keynes attacked the Laissez faire policy of classical economists.
In the conditions -of the modern world, state intervention is
necessary to solve the problem of unemployment.
Government spending, taxation and borrowing are important
instruments to increase employment and income in an economy.
7.Wage cut policy is not practical. Due to the strong trade
unionism it is not possible to cut wage rates as suggested by the
classical economists as a remedy to employ more workers. Aw a g ec u t
may in fact lead to reduced purchasing power with workers which will
lead to reduced effective demand for products. This wi ll adversely
affect the levels of employment. Hence a general wage cut will lead
to reduced volume of employment. The workers will revolt if the
money wages are cut. This is due to money illusion.
8.The classical system will work only if there is perfect
competition. In such a case there should not be trade unionism,
wage legislation etc. But in. reality, all these factors exist. Hence
classical theory will not become applicable.munotes.in
Page 29
293.5 THEORY OF EFFECTIVE DEMAND
The principle of effective demand occupies a strategic position in
Keynes theory of employment. Effective demand manifests itself in the
total spending of the commodity on consumption and investment
goods. Total employment depends upon effective demand The refore
unemployment results from lack of effective demand. Higher the level of
effective demand, the more the level of employment in the economy.
Effective demand depends upon 2 factors -Aggregate
demand function, and aggregate supply function.
3.5.1Aggregate Demand Price and Function: -
The aggregate demand price for the output of any given
amount of employment is the total sum of money or proceeds which is
expected from the sale of the output produced .when that amount of labor is
employed. In other words, the aggregate demand price is the amount of
money, which the entrepreneurs expect to receive from the sale of output
produced at a particular level of employment. The aggregate demand
curve or function is a schedule of the proceeds expected from the sale of
the output at different levels of employment. The aggregate demand
curve slopes upwards from left to right. It means that as the level of
employment and income increase aggregate demand price also increases
With increase in income, people tend to spend a small amount of income
on consumption goods, Hence with increase in output and employment,
aggregate demand price increases at a diminishing rate The slope of the
curve diminishes will increase in employment. The figu re below depicts
an aggregate demand function.
Figure No. 3.3
Aggregate Supply Price :
The main aim of an entrepreneur in a capitalist society is to earn
profits. The producer will employ workers in such a way as to maximise
profits. Employment of labour means that some costs have to be
incurred. A certain minimum amount of proceeds will be necessary to induce
employers to provide any given amount of e mployment. The supply price
for any given quantity of commodity refers to that price at which the
seller is willing or is induced to supply that amount in the market. If themunotes.in
Page 30
30seller does not get the minimum receipts, he will reduce output and
employment. Th e aggregate supply curve or function is a schedule of the
minimum amount of proceeds required to induce entrepreneurs to provide
varying amount of employment. It shows the cost of producing a certain
level of output or the minimum receipts which must be obtained if that
level of output is to be maintained. The aggregate supply function slopes
upwards. The shape of aggregate supply function depends entirely on
technical conditions of production. It isdecided by the manner in which cost
rises in response to expansion of employment. The figure below shows the
aggregate supply function.
Figure No. 3.4
Equilibrium Level of Employment: -
The intersection o ft h ea g g r e g a t ed e m a n df u n c t i o nw i t h aggregate
supply function determines the level of income and employment. The
aggregate supply schedule represents costs involved at each possible level
of employment. The aggregate demand schedule represents the
expectation of maximum receipts of the entre preneur at each possible
level of employment. As long as receipts exceed costs, the level of
employment will go on increasing. The process will continue till receipts
become equal to cost. At the point of equilibrium, the amount of sales
proceeds which the entrepreneurs expect to receive is equal to what
they must receive in order to just appropriate their total costs.
Figure No. 3.5
munotes.in
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31The point E, where the aggregate demand curve intersects the
aggregate supply c urve is called the point of effective demand. The
equilibrium level of employment is ONF. This is not necessarily full
employment. If the level of employment is more or less than ON, the
profits will be less than maximum. ONF level of employment is the ful l
employment level in the diagram since at this level of employment the
aggregate supply curve AS is vertical in shape. Hence ON level of
employment is less than full employment. This happens because
investment demand is insufficient to fill the gap betwee n income and
consumption.
Figure No. 3.6
For reaching full employment, employment level has to be
increased. For this either the aggregate supply curve should be lowered or
aggregate demand should be increased. Increasing the aggregate supply
curve will necessitate increase in the productivity. This is a long run
problem. Keynesian theory is concerned with short run analysis. Hence
raising the aggregate demand is possible. This shifts the equilibrium
point to £1. This is the full employment equilibrium. Any expansion of
demand beyond E1willlead to inflation.
3.6 SUMMARY
The French economist J. B. Say believed that "supply creates its own
demand". This is the basic assumption in the classical theory of
employment. It implied that there will be no problem of lack of
demand. Every increase in production is followed by a matching
increase in demand.
The following are the assumptions of Say's Laws: -
a.Optimum allocation of resources
b.Perfect equilibrium
c.Perfect competition
d.Laissez faire policy
e.Elastic market
f.Market automation
g.Circular flow and Say's investment equality.
h.Long termmunotes.in
Page 32
32Flexible interest rates b ring about equilibrium between savings and
investment.
Wage rate flexibility ensures that there is no unemployment. A self
adjusting system of wage rates will push the economy towards full
employment stage.
J M. Keynes criticizes Say's law of markets on a number of grounds
like unrealistic assumptions of full employment, long run
assumption. Say's law is also criticized since it is one sided and
neglects the demand side. It is also criticized that interest does not
equalize savings and investment. Classical theory neglects the role of
money. Keynes also criticized the Lessaize faire policy of classical
economists Wage cut policy is not a practiced solution to solve
unemployment problems. Moreover the assumptions of perfect
competition are unrealistic.
Keynes consumption function is a very significant contribution to
modern macro economic theory. In order to explain the concepts of
consumption function and the multiplier theory, a study of the
fundamental Keynesian principles is important.
Keynes in his general theory, brings out the real determinants of
income and employment in a modern economy. According to him,
the economy can be in equilibrium at any level of employment. Full
employment is one of the different situations in an economy. U nder
employment equilibrium situations are more common.
Keynesian theory is demand oriented. It stresses effective demand as a
crucial factor in determining the levels of income and employment.
Keynes gave importance to short run equilibrium. He assumed that the
amount of capital, population, technology etc. do not change in the
short run. Therefore, in the short run, the income and output depends
upon the volume of employment. The levels of employment depend
upon effective demand, which depends upon aggr egate spending.
Effective demand manifests itself in the total spending of the
community on the consumption and investment goods.
Total employment depends on effective demand and unemployment is
due to lack of effective demand.
Two Factors determine effec tive demand -Aggregate demand function
and aggregate supply function. The intersection of aggregate demand
function and aggregate supply function determines the level of income
and employment. This point is known as the effective demand. The
equilibrium r eached thus need not be the full employment equilibrium
point. For reaching full employment equilibrium aggregate demand
should increase.
The aggregate demand is made up of two components -consumption
expenditure and investment expenditure. Consumption ex penditure is
an important component of the total expenditure. Consumption
expenditure depends on the size of income and propensity to consume,
which is called the consumption function C = f(Y)
Keynes considered two technical attributes 1) APC 2) MPC APC =
∆C/∆Ya n dM P C=C /Ymunotes.in
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333.7QUESTIONS
1.What is the meaning of consumption? Explain the relationship
between the consumption and income.
2.Explain say’s Law of Demand in detail.
3.Explain the theory of effective demand in detail.
munotes.in
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344
INVESTMENT
Unit Structure:
4.0 Objectives
4.1 Introduction
4.2 Meaning of Investment
4.3 Investment Function
4.4 Marginal Efficiency of Capital and Rate of Interest
4.5 Investment Multiplier
4.6 Summary
4.7 Questions
4.0 OBJECTIVES
To study the concepts of investment & investments function.
To study the investment multiplier.
To study the concepts of marginal efficiency of capital & interest rate.
4.1 Introduction
In modern macroeconomic analysis, the term investment
refers to real investment.
A firm invests when it uses steel or other material to build plant or
when new machines are purchased. This is real investment. When a
person buys shares or deposits money in the money in the bank, it tends to
be financial inves tment.
Investment leads to the production of new capital goods -plant and
equipment. Capital formation takes place if the newly produced capital goods
leads to a net addition to the given stocks of capital assets over and
above their replacement requirement (depreciation).
Investment may be either gross investment or net investment.
Gross investment is defined as a flow of expenditure or new fixed capita!
assets or an addition to inventories over a given pe riod of time. Since
we are not considering inventories, gross investment means the
investment expenditure on fixed capital. A part of the new capital will be
needed simply to replace the depreciated capital stock This must be
deducted to find out the net a ddition to the existing capital stock
Therefore, Net investment = Gross investment Depreciation of Fixed Capitalmunotes.in
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35investment can also be classified into autonomous investment and induced
investment. Autonomous investment does not change with the changes in
income i.e. it is independent of income. It takes place in construction of
roads, building etc.
Autonomous investment depends on population growth and
technical progress than on the level of income. Most of the
investment activity of the government is autonomous in nature Induced
investment changes with changes in income,
4.2MEANING OF INVESTMENT
Investment is the important concept in macro economics which
implies the situation of national income, employment and capital
formation in country. It means, investment is the key economic variable in
the development of country.
Definition of Investment:
The investment means to addition in the stock of capital or c reation
of new capital such as plant, machine, and transportation vehicle, new
factories and so on which creates employment and income in the
economy. Just holding financial asset is not real investment like holding
shares, holding bonds etc. This type of investment is merely called
financial investment. It may or may not create income and employment.
Therefore, creation of physical capital in the economy, it is called real
investment.
Types of Investment:
There are mainly two types of investment which dis cussed as
below -
1. Autonomous Investment
2. Induced Investment
1.Autonomous Investment:
After the Keynesian analysis two types of investment
distinguished, these are autonomous investment and induced investment.
The autonomous investment is the investme nt which does not change with
the change in income level. It means, the autonomous investment is
independent from income.
J. M. Keynes explained that the level of investment is depends
upon marginal efficiency of capital (MEC) and rate of interest. He sta tes
that change in income level will not affects investment. Therefore, the
concept of autonomous investment of Keynes is mainly based on short
term analysis or short run problems. He said, income effects investment in
the long run.
The autonomous investm ent explained with the help of below
figure.munotes.in
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36Figure No. 4.1
Autonomous Investment
In the above figure, X axis represents national income and Y axis
represents investment I AIA’ indicated autonomous investment. The
autonomous investment takes place houses, road constructions, public
undertakings and other types of public infrastructure development which
are necessities, not depends on income. That is why, the autonomous
investment curve is horizontal to X axis. It implies with the increase in
income or change in income; autonomous investment does not change.
2. Induced Investment:
The induced investment is the investment which changes with changes in
the level of income. The high level of i ncome, the higher the consumption
level, consumption will lead to increase in demand and increase in demand
will promote to industry to produce more which will increase the
investment level in economy due to increase in profit expectations of
investors.
The induced investment we can explain with the help of diagram which
discussed in the below diagram -
Figure No. 4.2
Induced Investment
munotes.in
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37In the above figure 8.7, Y axis represents investment and X axis
represents national income. Id Id represents induced investment curve
which is upward sloping. It implies that with increase in income,
investment also increases. It means that there is positive relation between
national income and investment.
4.3 Investment Functio n
Investment function refers to inducement to invest or investment demand.
According to the classical economists, investment demand is a
decreasing function of the rate of interest.
I=f( i )
where I = Investment
(i) = rate of interest
According to Keynes, the volume of investment depends upon two
factors, 1) The marginal efficiency of capital and 2)The rate of interest.
The marginal efficiency of capital is called the expected rate of profit.
4.4 MARGINAL EFFICIENCY OF CAPITAL AND RAT E
OF INTEREST
MEC is expressed as a ratio and compared to the rate of interest.
There is a comparison between the expected rate of profit and the rate of
interest. In effect it is a comparison between the supply price of an asset
and its demand price. Keynes makes a distinction between the demand
price and the supply price of a capital asset. The demand price of an
asset is defined as the sum of the expected future yields discounted at
the current rate of interest. We have already seen that supply price = the
sum of prospective yields discounted by the MEC.
In symbolic terms, demand price of an asset can be put as follows.
DP = demand price, Q1, Q2, Q3,...Qn = the prospective yield or
annuities, i = current rate of interest.
For Example, the market value of an asset., which promises to yield
Rs. 1600 at the end of one year and Rs. 1210 at the end of 2 years will be
estimate d at higher than Rs 2000, when the interest rate is less than 10%.
If the market rate of interest is 5% the present value of capital asset will
be
= 1047.62 + 1097
1
= 2144.62
This is the demand price of a capital asset.munotes.in
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38The effect of the relative positions of demand and supply on the
behaviour of investor in taking decisions will be as follows
1)When MEC = interest rate, SP = DP -neutral
2)If MEC > DP > SP -favourable
3)When MEC < DP < SP –unfavourable
The two strategic variables in investment decisions are the MEC and
the rate of interest. MEC of an asset falls as I in that asset increases. The
reasons are,
1 The prospective yield of that asset will fall as more units are produced.
More production will lead to the units competing with each other
to meet the demand for the product.
2T h es u p p l yp r i c eo ft h ea s s e tw i l lr i s ea sm o r eo ft h ea s s e t s are
produced. Investment will be in equilibrium when MEC becomes
equal to the given current rate of interest. This is given by the
following diagram
Figure 4.3
At i1 rate of interest investment is OM1 . At this level of
investment, MEC = i1 . If the rate of interest falls to i2, investment will
rise to OM2. However change in profit expectation can shift the MEC curve
also.
Figure 4.4munotes.in
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39This is shown by the above diagram. Due to rise in profit
expectation, MEC curve shifts to MEC1. As a result investment also
increases to i2. MEC is the prime factor in determining investment, since
rate of interest is rather rigid during the short period.
Factors Affecting MEC :
A number of short run and long run factors affect the marginal
efficiency of capital.
Short run Factors:
1.Expectation about demand, price and cost of Production: It there
is an expectation of demand to increase and hence prices to rise,
a high MEC leads to increased investment and vice versa
2.Business Optimism and Pessimism: If the atmosphere is one of
optimism , entrepreneurs will estimate MEC to be high.
3.Changes in Income: Unexpected windfall gains suddenly
increases income levels. This will induce an increase in MEC.
4.An increase in the propensity to consume will raise the MEC and
vice-versa: Increased demand for consumption goods will induce the
demand for capital goods
Long Run Factors :
1.Population Growth: Increase in population leads to increase in demand.
MEC will increase as a result.
2.Technological Advancement: Improvement and growth of new
technology leads to new products, new markets etc .This will have a
favourable impact on the MEC .
3.Development of Infrastructure : Developing the infrastructure
also has a positive -impact on the MEC in the long run.
4.5 INVESTMENT MULTIPLIER
The theory of multiplier was first developed by Prof. R.F. Kahn in
1931. It explains th e effects of initial increase in investment on aggregate
employment. Kahn’s multiplier was thus known as ‘employment
multiplier.’
J.M. Keynes used the concept of multiplier to analyze the effects
of change in investment on income via changes in consumpt ion
expenditure. Thus this multiplier came to be known as the investment
multiplier. It may be defined as “the ratio of the change in income to the
change in investment.” It is symbolically expressed as, K = ΔY/ ΔI.
Where K = Stands for Multiplier, ΔY = change in income and ΔI= change
in investment.
In an economy, when there is a small increase in investment, there
would be multiplier increase in national income. For example, if the
investment is increased by Rs. 4 cro. and if as a result, the national incomemunotes.in
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40increases by Rs. 20 cro. the value of ‘K’ (multiplier) will be 5. In other
words, investment multiplier points out that, national income will rise
much more than the initial i ncrease in investment. A part of this additional
income is spent on consumption goods. Since, one man’s expenditure is
another man’s income. The consumption expenditure of the people at the
first round would become income of the people at the second round and so
on.
Graphical Presentation -
The multiplier is depends upon the marginal propensity to
consume (MPC). If the MPC is higher, the size of multiplier would be
higher and vice versa. The concept of multiplier can be explained with the
help of followin g diagram.
Y
Consumption
Expenditure, N
Savings &
Investment E 2 C+I 1
} ΔI
C+I
E1
ΔY
450
OY 1 Y2 X
Fig.4.5
In the above diagram, OX axis represents income and OY axis
represents investment, consumption expenditure and savings. 450line is
known as consumption line. C+I is the initial investment curve which
intersects ON line at E 1point .When the investment is C+I the national
income is OY 1. When there is an increase in investment from C+I to C+I 1
the national income would rise fro mO Y 1to OY 2.
Working of the Multiplier -
The working of ‘K’ is explained as under. The following table
shows how there would be a multiplication in income according to income
propagation assuming that MPC is half or 50% of the income with the
initial i nvestment of Rs. 200 crores.munotes.in
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41Rounds Initial investment ΔY ΔC ΔS
1st200 cro. 200 100 100
2nd100 50 50
3rd50 25 25
4th25 12.50 12.50
5th12.50 6.25 6.25
6th6.25 …. ….
Finally 200 400 200 200
The above table shows that the initial investment of Rs. 200 crores
is the income of the people. Out of 200 crores 50% i.e. Rs. 100 crores is
spent on consumption and remaining amount of Rs. 100 crores is saved.
The consumption expenditure of the people at the first round would
become income of the people at the second round. Again out of Rs. 100
croresRs. 50 crores is spent on consumption and remaining Rs. 50 crores
is saved. The consumption expenditure of the people at the second round
would become income of the people at the third round. Again 50% of the
income is spent on consumption and remaining 50% is saved. This process
will go on and on till the initial income of Rs. 200 crores would not
become zero.
Calculation of the Multiplier -
The value of ‘ K’ or multiplier is equal to reciprocal of 1 -MPC. It
is symbolically expressed as, K =
or K =
If MPC is 4/5 then,
K=
K=
, K = 5. The value of ‘K’ will be 5.
The following table would indicate the different values of ‘K’ at different
MPC figures.
MPC MPS Value of ‘K’
0 1 1
1/2 1/2 2
2/3 1/3 3
3/4 1/4 4
4/5 1/5 5
1/3 2/3 1
3/5 2/5 2
munotes.in
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428/9 1/9 9
9/10 1/10 10
99/100 1/100 100
1 0 Infinity
So from this schedule it is clear that larger the MPC the greater
would be the value of ‘K’ and vice versa.
Reverse working of the Multiplier -
So far, we have described the working of the multiplier in the
forward direction. But the multiplie r may work in the reverse or backward
direction also. It means that a decrease in investment causes a multiple
decrease in aggregate income. For example, if investment decreases by Rs.
10 cro., it will reduce the income by an equal amount. If MPC is half,
consumption expenditure will fall by Rs. 5 cro. Thus reduction in
investment leads to the reverse operation of the multiplier which causes a
decrease in aggregate income. This is shown in the following figure with
the help of saving and investment curves.
Y S
Saving & E I
Investment
ΔI E1 I1
S
ΔY
O Income Y 1 YX
Fig.4.6
In the above diagr am horizontal straight line is autonomous
investment curve. SS curve is the saving curve. The I curve is the original
investment curve which intersects SS saving curve at E point. At this point
the equilibrium level of income is OY. When the investment dec reases the
original investment curve I shift downwards to the I 1.The new investment
curve I 1intersects the SS saving curve at E 1point. At this equilibrium
point the level of income decreases from OY to OY 1.The fall in income
(ΔY) is a multiple of decline in investment (ΔI).
Thus in a community with lower MPC, the initial decline in
investment will have greater adverse effect on the level of income and
employment. However, MPC is less than one but g reater than zero. This
implies that people neither spend the full amount of extra income normunotes.in
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43reduce consumption by the full decrement of income. Hence income and
employment cannot continue to decline till to zero. This otherwise, reverse
working of the mul tiplier would imply a complete collapse of the
economy.
Assumptions -
The concept of multiplier is based on the following assumption.
1.The value of multiplier depends upon increase in investment.
2.It is assumed that the increase in investment has not further indirect
effects on investment.
3.The calculation of multiplier depends on the assumption of a closed
economy.
4.The MPC is constant.
5.There exists unemployment in the economy.
6.There is absence of multiplier period.
7.Keynes has assu med that, change in investment is of autonomous and
not induced type.
8.It is assumed that the consumer goods are regularly made available.
Leakages in Multiplier Process –
The size or value of multiplier is reduced by the leakages in
income stream on account of the following factors.
1. Savings -In actual life the people does not spend the entire increase in
income on consumer goods. On the contrary they save a part of it. The
saved portion of increased income does not get converted in
investment. T his limits the value of ‘K’. Thus higher the propensity to
save of the people lower shall be the value of ‘K’.
2.Repayment of old debts –The income recipients may repay their old
debts to lenders instead of spending their income on consumer goods.
The v alue of ‘K’ is reduced if lenders who receive this money from the
borrowers do not spend it.
3.Accumulation of idle cash deposits -A part of increased income may
be saved in the form of idle bank deposit instead of spending their
income on consumer good s. The value of ‘K’ is reduced if the bankers
who receive this money do not spend on consumer goods.
4. Purchase of old assets –The income recipients may buy old assets such
as shares and securities from the people who may not increase their
consumption. This will reduce value of ‘K’.
5. Excess of import –The import of foreign goods may be increase this
will not help the domestic employment. This is because money is spent
on foreign goods resulting in a net outflow of funds to foreign
countries. This wou ld reduce value of ‘K’.
6. Inflation –The rise in prices would reduce additional money
expenditure even to buy same amount of goods and services. Hence
actual consumption may not increase. This will reduce value of ‘K’.
7. High taxes –High rate of taxes may lead to decline in consumption
expenditure and the value of ‘K’.munotes.in
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44Limitations -
1. Availability of consumer goods –The theory assumes that multiplier
depends upon the availability of consumer goods. The shortage of
consumer goods will not increase the consumption expenditure.
Ultimately it will reduce the magnitude of multiplier.
2. Full employment level –The multiplier works in the economy where
the level of income is low and unemployment is high. Once the
economy reaches the level of full employment the multiplier fails to
work. At this level any increase in investment will not increase
aggregate output and employment. This will limit the value of ‘K’.
3. Multiplier period –According to Keynes, when income of the people
increases they spend a part o f it on consumption and remaining amount
is saved. But in reality there is time gap between the receipt of
increased income and the expenditure on consumption. This time gap
is called as multiplier period. The value of multiplier depends upon the
multiplie r period of the time gap. Longer the time gap, the smaller will
be the value of ‘K’ and the smaller the time gap, the larger will be the
value of ‘K’.
4. Availability of resources –The concept of multiplier depends on the
availability of resources for the production of consumer goods. But the
shortage of resources will adversely affect the working of the
multiplier and thus it will reduce the value of multiplier.
4.6 SUMMARY
1.The theory of multiplier was first developed by Prof. R.F. Kahn in
1931. It expl ains the effects of initial increase in investment on
aggregate employment. Kahn’s multiplier was thus known as
‘employment multiplier.’
2.J.M. Keynes used the concept of multiplier to analyze the effects of
change in investment on income via changes in con sumption
expenditure. Thus this multiplier came to be known as the investment
multiplier. It may be defined as “the ratio of the change in income to
the change in investment.” It is symbolically expressed as, K = ΔY/
ΔI.
4.7 QUESTIONS
1.What is Investme nt? Explain the types of investment with the help of
diagram.
2.Explain the concept of Investment multiplier.
3.Explain the calculation and leakages of investment multiplier.
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45Module 3
5
SUPPLY OF MONEY
Unit Structure:
5.0 Objectives
5.1 Introduction
5.2 Supply of Money
5.3 Determinants of Money Supply
5.4 Velocity of Circulation of Money
5.5 RBI’s Approaches to Measurement of Money Supply
5.6 Summary
5.7 Questions
5.8 References
5.0 OBJECTIVES
Tounderstand the concept of money and supply of money
To know the determinants of money supply.
To know about the concept velocity of circulation of money.
To understand the RBI’s approaches to measurement of money supply.
5.1INTRODUCTION
Due to the difficulties of the barter system, money came into
existence. Initially, we use metallic money, which was replaced by the
paper money over a period of time. Today there are a wide variety of
assets, which are used as money or near money. Before explaining what
constitutes money, we will try to understand s ome of the important
definitions, of money and then functions of money
Definition of money :
Different economists have defined money differently. Some of
them focus on the exchange function of money while some others
consider the general acceptability of money as a medium of exchange.
Following are some of the important definitions of money -
Crowther Money can be anything that is generally acceptable as
am e a n so fe x c h a n g ea n dt h a ta tt h es a m et i m ea c tam e a s u r e and store
of Value.munotes.in
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46Marshal lMoney constitutes ail those things, which are at any
time and space generally accepted without doubt or special enquiry as a
means of purchasing commodities and services and of defraying
expenses.
Robertson Money is anything, which is widely accepted in
payments for goods or in discharge of other kinds of business obligations
Walker Money is what money does.
From the above definitions, we may enlist following features of money:
1Money must have a general acceptability.
2.Money should act as a medium of exchange in buying and selling
operations
Money should be capable of storing the value for the future
Functions of Money:
Money performs following important functions: -
1. Medium of Exchange: Perhaps the most important fu nction of
money is to serve as a medium of exchange in buying and selling goods.
Under barter system, exchange required finding of two people wanting
each other's goods, (double coincidence of wants) The existence of money
has eliminated such requirement a nd the exchange transactions have
become very simple. A man having wheat can sell it for money and buy
anything that he wants with that money. He does not have to find a man
having the commodity of his need.
2. Measure of Value: Money serves as a common m easure of value
for all the commodities and service's. The value of every commodity can
be expressed in terms of money. This simplifies the exchange transactions
of all the commodities on one hand, and helps to compare the values of
different commodities, on the other hand. For example, it is very easy to
compare the values of say Radio and a Cassette player once we express
them it terms of money. We can easily conclude that the cassette player of
Rs 4500 is more valuable than a Radio of Rs.2300.
3 Store o f Value: In the absence of money, it would be difficult to store
the value for the future Money makes it very convenient to store the value
for the future Money does not require more space, it is durable and is
readily exchangeable with the other commoditi es and services whenever
required.
4S t a n d a r do fD e f e r r e dP a y m e n t s : Money also performs one more
important function of the modem times. With the invention of
money, it is possible to express future payments in terms of money. A
borrower borrows some amoun t of money today and assures to repay
the same with some interest in future. All the credit transactions
related to trade and commerce of modem economy are based on
this function of money.munotes.in
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475.Other functions: Apart from the above -mentioned important functions
of money, there are some other ways in which money helps the
modem economies. It facilitates the distribution of National
income among different factors of production in the form of the
rewards for the services rendered by them. Thus, the labour class gets
wages, the capitalists get interest, the landowners get rent and the
entrepreneurs get profits in the form of money.
5.2 SUPPLY OF MONEY
Money supply refers to the stock of money available for the
spending purpose which is held by the people o f a country. The money
may be available in the various forms.
1Coins and notes which are issued by the government and the central
bank of the country and which are in circulation. This portion of
money supply is known as legal tender.
2.Demand deposits with the commercial banks, which are withdrawable
at any time. To withdraw the demand deposits the customers need
not give a prior notice to the bank.
Time deposits and other kinds of less liquid assets also may
be included in the concepts of the money supply. These concepts
will be analyzed in the latter part of the study material.
From the concept of money supply, some types of financial
assets are excluded These are. –
1That part of currency notes and coins which lies with the
commercial banks and with the central bank as reserves. This is
because this part of money is not included m circulation.
2The monetary gold held by the central bank of the country does
not get circulated in the economy It becomes apart of international
money So it is excluded from the concept of money supply.
3All those cash balances held either by the banks or by the government
of which are in the treasury of a country are also excluded from the
concept of money supply. This is because, they are kept for the
administrative and non -commercial activities and are not
circulated in the economy.
In short, m its very narrow sense, money supply is defined as the
money available with the public in the form of currency (notes and
coins) and the demand deposits with the banks.
5.3 DETERMINANTS OF MONEY SUPPLY
The total money supply in the economy depends upon various
factors. They are called as the determinants of money supply. Following is
a brief analysis of the factors on which money supply depends.munotes.in
Page 48
481)Reserve or high powered money.
High powered or Reserve money (H) is a base of money supply.
It includes only the currency (C). cash reserves of the banks (R) and
other deposits with the RBI (OD)
H=C+R+O DH i g hp o w e r e dm o n e yi sam a j o rd e t e r m i n a n t of
money supply in the economy
2)Money Multiplier:
The high powered money along with the money multiplier determine
the total supply of money. Money multiplier depends upon the
people's preference to hold cash If more cash is held by the people,
banks will have less cash, their credit creation capacity will be low
So availability of money in the economy will also be low. The
value of money multiplier will also depend upon the reserve
requirements. The commercial banks have to keep certain % of their
deposits with the Central bank. Their credit creation capacity
decreases due to this and hence the supply of money, in the ec onomy
also gets reduced. Thus higher the value of money multiplier, higher
will be the money supply and vice versa.
3)Community's choice :
Total money supply also depends upon the choice of
community -whether to hold money in terms of cash or in terms
of deposits of commercial banks. If the community holds larger part
of money m cash, it that money does not enter into the credit creation
process. But if the community keeps their money in the banks and
make transactions by cheques more money will b eh e l d
by the banks which can be circulated in the economy through of credit
creation process.
4)Velocity of circulation (v):
The number of times money changes hands or the velocity of money
is an important determinant of money supply. The Higher the
velocity of money, the more will be the supply of money and vice
versa.
5)Fiscal and monetary policy :
Fiscal policy is the policy which influences economy through
taxation, public expenditure, public debt and deficit financing. The
decisions of the fiscal authorities also have an influence on the
supply of money. Increase in public expenditure or reduction in the
rates of taxes or deficit financing may increase the supply of money.
On the other hand, introduction of new taxes, and fall in the
government expenditure will reduce the total money supply in the
economy.
Monetary policy of the Central Bank is also an important determinant
of money supply A cheap money policy by the central bank
increases the availability of mon ey in the economy and a
restrictive money policy reduces the total money supply (discussed
in detail in the next unit.)munotes.in
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496)Liquidity Preference :
Liquidity preference is the desire of people, to hold money in cash.
More the liquidity preference, less is the money available for
circulation and less will be total money supply.
5.4 VELOCITY OF CIRCULATION OF MONEY
The velocity of money is the number of times money Changes
hands during a given period of time, generally one year The money supply
in the economy is greatly affected by the velocity of money in
circulation. The more the velocity of the money, more is the money
supply in the economy. The velocity or speed of money depends upon
many factors.
(1)Regularity of Income
In a Community, if people are receiving income quite regularly
and at a regular interval, the velocity of money is quite high. The people
would spend money frequently as they receive the money regularly. In the
community where people receive their income irregularly, the velocity of
money will be less because the people will tend to hold more cash than
spending it.
(2)Liquidity preference
The liquidity preference means the desire of people to hold cash.
If people want to hold more money in cash or they have more liquidity
preference, less will be the velocity of money.
(3)Savings
The more the savings or less the consumption's, the lower is the
velocity of money in circulation More money saved means people hold
more money in cash and do not spend. This reduces the movement of
money .in the circulation.
(4)Development of banking and financial institutions in a
country with more banking and financial institutions, money
changes hands quite frequently. People's savings are mobilised more
quickly by the bankin g and financial institution. This increases the
velocity of money in circulation.
(5)Trade Cycles
The velocity of money also Changes in accordance with the phases
of the trade Cycle. During prosperity, the volume of transactions is more,
money Changes hands more quickly. This increases the degree of
velocity of money. On the other hand, during the depression situation
or in deflation, the volume of transactions is quite less. This reduces
the degree of velocity of moneymunotes.in
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50(6)Level of income
The velocity of money is quite high among the low income
groups people. This is because they have to spend most of their
incomes on the immediate' needs. This is not so with high income groups.
This group can withhold their consumption as many of their wan ts are
satisfied. As a result the velocity of money in circulation may be low.
5.5 RBI’S APPROACHES TO MEASUREMENT 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.In1964 -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. Thi s 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 th e 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
(M1) and broad money (M 3). Narrow money excludes time deposits
because they are not liquid and are income earning assets while broad
money includes 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 2and M 4measures of money supply include
post office savings and other dep osits with the post offices.
The third working group on money supply recommended the
following measures of monetary aggregates through their report
submitted in 1998:
1.M0=Currency in circulation + Bankers’ deposits with the RBI +
Other deposits wit h the RBI. (M 0is compiled on weekly basis).
2. M 1=Currency with the public + Demand deposits with the banking
System + Other deposits with the RBI = Currency with themunotes.in
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51public + 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 Deposits [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 +
Certificates Of Deposits 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
Contractual maturity of over one year with the ban king system
+Call borrowings from Non -depository financial corporations by
the Banking system. (M 1,M2&M 3are 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 instit utions and
refinancing Institutions (FIs) + Term borrowing by FIs + Certificates of
Deposits issued by FIs.
3.L3=L2+ Public deposits of Non -banking Financial Companies.
(L3is compiled on quarterly basis).
5.6 SUMMARY
Money is considered as a mediu m of exchange.
Over the years money has performed many more functions than
just being an exchange medium.
Money supply is the total stock of money circulated in the
economy. It is a stock as well as flow concept.
There are two different views regardin gt h ec o n s t i t u e n t so f money
supply -traditional or narrow and modern or broad.
As per the recommendations of the RBI‘s Working Groupmunotes.in
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521998, the revised measures of money supply are M1, M2 and
M3.
Total money supply in the economy depends upon many factors
which are called as the determinants of money supply.
The velocity of circulation of money is the average number of times
money changes hands during a given period of time, generally a
year.
5.7QUESTIONS
1.What is the meaning of money? What are the main functions of
money?
2.Explain the concept of money supply.
3.What are the determinants of money supply?
4.Explain the concept of velocity of circulation of money.
5.Explain the RBI’s Approaches to measurement of money supply.
munotes.in
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536
DEMAND FOR MONEY
Unit Structure:
6.0 Objectives
6.1 Introduction
6.2 Keynesian Approach to Demand for Money
6.3 Classical Approach to Demand for Money
6.4 Friedman’s Approach to Demand for Money
6.5 Summary
6.6 Questions
6.0OBJECTIVES
To understand the Keynesian Approach to Demand for money.
To understand the Classical approach to demand for money.
To understand the Friedman’s approach to demand for money.
6.1INTRODUCTION
Money is defined in Economics as ‘anything that is generally
accepted in payment for goods and services as a medium of exchange.’
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 p ayments for the services
obtained from the factors of production, wealth is a stock of accumulated
purchasing power. While income is a flow variable that is measured over
a given period of 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 the 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 pri ces. 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 class ified 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. Precio us metals like silver, gold,
platinum etc are liquid real assets. Artwork, machinery and real estate are
the examples of less liquid real assets. The liquidity of an asset is
determined by the following factors:munotes.in
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541.Existence of a well established market in which the asset can be
quickly sold.
2.Size of transaction costs (brokers 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 purchasing 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 o f potato vada and with that money I could
have arranged a potato vada party for 100 students. (The value of money:
Vm= 1/P, where ‘P’ stands for price level.
6.2KEYNESIAN APPROACH TO 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
precautiona ry motive and the speculative motive. The speculative
motive of demand for money is a special contribution of Keynes.
(i)The transaction motive :
It refers to the transaction demand for money as a medium of exchange for
carrying on current trade and business transactions.
Money is demanded for transaction purposes since it is received at
discrete intervals of time and expenditure goes on continuously. Keynes
classified the transactions motive into (a) income motive and (b) business
motive.
(a) The i ncome 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 month. But expenditure
goes on throughout all the tim e. To meet day-to-day expenditure a part
of the income has to be held in the form of liquid cash. The following
factors decide the amount of money held by people:
(i) Level of Income As the level of income increases, the transaction
demand for money of the individual will increase and vice versa.
(ii) Tune Interval: The longer the time interval between the receipt
of income and expenditure, the higher the amount of money held by
people for transaction purposes.
(iii) The stan dard of Living : The higher standard of living, the larger
the amount of money held and vice versa.munotes.in
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55(b) The business Motive :
The businessmen and the firms also hold cash balance in order
to bridge the interval between the time of incurring business costs o r
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 u pon 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 6.1
In the above figure, dd is rising indicating that, with the increase in national
income, the demand for money for transaction purposes also rises,
(ii)The Precautionary Motive :
Besides the money kept also for transaction purposes, people hold
additional am ount of money to meet unexpected or unforeseen
contingencies, emergencies or unexpected events. Money held for such
precautions is known as precautionary motive. The accessibility of
individuals and firms to the credit market determines the amount of
money held for this purpose. If borrowing is easy or the assets of the
people can be easily connected into cash, the amount of money held for
this motive will be very low and vice versa. Uncertainty regarding
future will make individuals and firms keep aside money for precaution
purposes. The precautionary motive of demand for money depends onmunotes.in
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56the income level ie. L = f(y), where 'Lp‘stands for precautionary motive,
Taf u n c t i o no fa n d y, the level of income,
(iii)Speculative motive :
People hold mon ey as a store of wealth or liquid asset for investment
and lending, with a view to make speculative gains. People speculate
about the future prices of bonds or securities or future interest rates.
People prefer to hold securities where prices are expected to rise in future
and vice -versa. People make capital gains from speculative about the
prices of bond or securities or future interest rates. According to
Keynes. the speculations motive is the desire to earn profit by knowing
better than the market what the future will bring forth The individuals
have to choose between holding money or other assets Uncertainly
regarding the behaviour 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 rat e is expected to rise, or the prices of bonds to fall,
people sell the bonds or assets and hold more cash. The people will
buy the bonds when their prices actually fall In the other hand, if the
people expect the rate of interest to fall, or prices of bond st or i s e ,
people will buy bonds whose prices are expected to go up. This leads to a
fall in liquidity preference. This shows that speculative demand for money
is interest elastic. –
L=f ( i )w h e r e .L 2i st h ed e m a n df o rm o n e yf o rs p e c u l a t i v ep u r p o s e , (i)
the rate of interest
Liquidity preference (Speculative demand for money)
Figure 6.2
The above figure shows the inverse relation between the rate of
interest and the speculative demand for money. It slopes downwards from
left to right indicating that when the rate of interest is high, the demand
for money is low and vice versa.munotes.in
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576.3CLASSICAL APPROACH TO DEMAND FOR
MONEY
The classical economists emphasized the medium of
exchange function of money According to the classical economists like J.S.
Mill. David Hume and Irving Fisher, the demand for money arises since
money facilitates the exchange of real goods and services among
individuals. Hence money is demanded for buying and selling goods and
services or for spending over a period of time The classical economists
believed that the demand for money depends on objective factors like
the volume of exchange transactions of goods and services produced and
supplied during a give n period of time, the amount of money needed to
buy the goods and services and by the velocity of circulation. Since the
volume of goods and services changes from time to time, the demand for
money also changes The classical approach to the demand for mone yc a n
be grouped into the Fishers cash --Transactions Approach and the
Cambridge economists' cash -Balances approach.
The Fisher’s Approach to Demand for Money:
Irving Fisher's Equation of Exchange is one of the most prominent
explanations which analyse the demand for money. According to Fisher,
the demand for money means the amount of money to be held to
undertake a given volume of transactions over ap e r i o do ft i m e .F i s h e r ' s
equation of exchange is given as MV = PT, where M is the money
supply, V the transaction velocity, T transactions and 'P‘the price level.
'PT' in the equation represents the demand for money and MV stands for
the supply of money. The demand for money (Md) is equal to .I tm e a n s
that the demand for money is equal to 'P' multiplied by 'T' over a period
of time and divided by V The demand for money depends on the
amount of money which people have to hold in order to carry on a volume
oftransacti ons 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. Since the demand for money (Md) is equal 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 demand for money changes in proportion to the changes in
the price level. V also dete rmines the demand for money.
6.4FRIEDMAN’S APPROACH TO 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.munotes.in
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58Friedman Classifies the holders of money into (a) ultimate wealth
holders (b) business enterprises His theory is relevant to the ultimate
wealth holders
Friedman has given a very broad concept of wealth which
includes all sources of income or services. According to Friedman, the
demand for money is a demand for capital asset since money like
capital assets provides services and returns. Bonds are monetary
assets in which the people can hold their wealth and enjoy fixed interest
income. The return on bonds is the sum of the coupon rate of interest and
the anticipated capi tal gains or losses due to the expected change in the
market rates of the interest People can also hold their wealth in the form
of equity shares and enjoy returns in the form of dividend income and
capital gains or losses Milton Friedman gave his demand function in the
following manner
Md = f (w. h. rmrb , 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, rm, rb, re, PP, u)
Where. Md= demand for real money balances.
w =wealth of the individual
h =t h ep r o p o r t i o no fh u m a nw e a l t ht ot h et o t a lw e a l t hh e l db y
the individuals
rm =t h er a t eo fr e t u r no nm o n e yo ri n t e r e s t
rb = the rate of interest on bonds
re = the rate of return on equity shares
p = the price levelPchange in the price level
u = Institutiona l factors.
The simplified version of Friedrnan's demand function for money can
be written as,
Md =f( r ,Y p ,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 wealthmunotes.in
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59(2)Friedrnan's theory does not consider unstable elements like the
Keynes speculative demand for money
(3) Friedman did not consider the possibility of a liquidity trap
situation.
6.5SUMMARY
1.The demand for money is a derived demand, since it is demanded
for the functions that it performs. Broadly speaking the different
approaches to the demand for money are (i) The classical approach
(ii) The Neo -Classical approach (i)i) The Keynesian approach
(iv) The Modern Approach
2.According to the classical view of demand for money or the Fishers'
version, money is demanded for transaction purposes. Fisher
explains the transaction demand for money in the following form
MV = PT
Md = PT/V
It means that the demand for money is the product of the
volume oftransaction (T) over a period of time multiplied by the
average price level (P) and divided by the velocity (V).
3.Fisher assumes V and T1to remain constant during the short period.
Hence, the demand for money varies with changes in 'P'. The
Cambridge economists gave importance to the store of value
function of money. According to the neo -classical or Cambridge
economists, the demand for money is the amount of money people
desire to hold. The demand for money can be expressed as Md =
KPY. The demand for money is a constant proportion (K) of y.
Wherever there is a change in the price level or in the real national
income, the demand for money also changes in equal proportion.
4.According to Keynes' view on the demand for money there are three
motives of demanding income i.e. Transactionary, precautionary and
speculative motive. The transaction andprecautionary motives of
demand for money depend on the level of income whereas the
speculative demand depends on the rate of interest. The
speculative motive is a negative function of the rate of interes t.
When the price of bonds is low or the rate of interest is high, people
prefer bonds to liquidity and as the prices of bonds rises, people
prefer liquidity to bonds.
5.When the rate of interest is very low, i.e., below the acceptable
minimum people prefer to hold cash balances. This Situation is known
as the 'Liquidity Trap.' The total demand for money according to
Keynes is L = L (y) + L (r)
6.According to Milton Friedman there are four determinants of deman d
for money (i) the level of prices (ii) the level of real income andmunotes.in
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60output (iii) the rate of interest (iv) the rate of change in general
price level. Friedman presented a broad picture of wealth which
includes all sources of incomes or services.
6.6QUESTIONS
1.Explain the Keynesian approach to demand for money.
2.Explain the classical approach to demand for money.
3.Explain the Friedman’s approach to demand for money.
munotes.in
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61Module 4
7
COMMERCIAL BANKING
Unit Structure:
7.0 Objectives
7.1 Introduction
7.2 Meaning of Commercial Bank
7.3 Functions of Commercial Bank
7.4 Multiple Credit Creation
7.5 Development of Commercial Banking Sector Since 1990 -91
7.6 Summary
7.7 Questions
7.0OBJECTIVES
To know the meaning of commercial Bank.
To know the functions of commercial bank.
To know the concept of multiple credit creation.
To know the balance sheet of commercial bank.
To study the development of commercial banking sector since 1990 -91
7.1INTRODUCTION
According to the Banking Regu lation Act 1949, banking is defined
as“accepting for the purpose of lending or investment of deposits of
money from the public repayable on demand or otherwise and can be
withdrawn by check, draft, and order or otherwise”. A commercial
bank is therefor e a financial institution which deals in money or credit. It
accepts cash deposits from the public and lends the deposits to borrowers
in the form of loans and advances against collateral securities and makes
profits. The difference between the deposit ra tes and lending rates is
known as the interest spread. Interest spread constitutes the major part of
the profits of a commercial bank. The deposits in a commercial bank are
used to settle debts through the instrument of check. According to RS
Sayers, “ Banks are institutions whose debts usually referred to as bank
deposits –are commonly accepted in final settlement of other people’s
debts.” Sayers’ definition highlights the credit creating abilities of
commercial banks which is central to any commercial bank also a
distinguishing feature from other financial institutions like term lending
financial institutions, investment banks, insurance firms etc.munotes.in
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627.2MEANING OF COMMERCIAL BANK
There are various types of banks like the commercial banks, co-
operative banks, agricultural banks, industrial banks, etc. Each of them
are established with some specialized purpose For example, the
foreign exchange banks is specialized in the provision of the foreign
currency, the industrial banks deal with the su pply of credit to the industrial
sector, etc
Commercial bank can be defined as a joint stock company which deals
with the money by accepting deposits from the people and by lending
money to the entrepreneurs for various activities. The commercial banks
act as a link between the savers and the investors. The people having
surplus money may not be interested in the investment, while the people
who wish to invest the money may not have surplus funds. These two
types of people have to be brought together or at least the surplus funds
of the people are to made available to the investors The commercial banks
are the important institutions undertaking the task of encouraging the
people to save their surplus funds in the form of the bank deposits by
paying them int erest on their savings and then to circulate' these funds
among the investors and charging interest rate from them In the process,
the commercial banks make profits.
The commercial banks can not print the notes. The printing of
money is an exclusive right to the central bank of the country. But the
commercial banks are the profit earning institutions. They play an
important role in the creation of credit in the economy by reutilizing
the existing deposits of their customers. Thus, the commercial banks are
not only the traders of money but they are also the creators of credit. In
the further discussion we will try to understand how this is done.
7.3FUNCTIONS OF COMMERCIAL BANK
The functions of the commercial banks may be subdivided into two
categories
A) Banking Functions
B) Non-banking or Subsidiary functions
7.2.1 Banking functions of the commercial banks
I)Accepting deposits -
The commercial banks accept deposits from the people and pay
them the interest rate on their deposits. The rate of interest vanes in
accordance with the amount of deposits and the duration for which the
deposits are kept with the bank. There are various kinds of deposits.
AD e m a n dd e p o s i t s -These are withdrawals at any time or whenever
the depositor demands Either a very low interest rate is paid on such
deposits or no interest is -paid A depositor can withdraw any number ofmunotes.in
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63times from his demand deposit account There are generally no restrictions
on the withdrawals
BS a v i n gb a n kd e p o s i t s -These deposits are generally opened by the
salaried people An account can be opened with a small sum of money. A
very little interest rate is paid on these accounts
CF i x e do rT i m ed e p o s i t s -Under these deposits, money is kept
for a certain fixed period of time, say, a year, three months, five years,
etc. These deposits can earn more interest rate and, the fixed deposits are
the important way in which the people keep their savings. There is a
restriction in the number of wi thdrawals from the time deposits and if
these, deposits are withdrawn before the expiry of the time, the depositor
hasto pay a penalty.
D Recurring deposits : Here a depositor is supposed to save a certain
amount in his recurring deposit account every month or every year
The purpose of these deposits is mainly to inculcate the saving
habits among the people. These deposits also earn a reasonably high
rate of interest.
ii)Giving loans:
The commercial banks are the important financial institutions So
they mobilize the money from the saving agents and lend these to the
customers who want to borrow the money for productive purposes. The
commercial banks generally lend money for short or medium term. They
.lend money to various productive sectors like industry, trade, commerce,
tourism, export and import activities and also to the agricultural sector
While lending money to the customers, the commercial banks have to
follow the rules and regul ations fixed by the central bank of the country,
they can lend money in accordance with their deposits, they also have to
keep some amount of their deposits as reserves .This means that they
cannot lend 100% of their deposits but have to maintain a part of their
deposits in the liquid form. We will study more about the credit creation
capacity of the commercial banks later in the following discussion. The
commercial banks give loans in various forms –
a.Call loans -These are the loans which are given for av e r y
short period of time i.e. 24 hours. They are generally given to
the stock brokers and agents.
b.Bill of Exchange -The bill of exchange is used in the
business payments. Here the person who is supposed to
make payments (debtor) gives a written promise to the person
to whom the money is to be paid (creditor) to make payment in
a particular. . time period say, between one month and three
months. The creditor can immediately discount these bills from
the comme rcial banks. That means the creditor can take -,t h i s
written promise to the commercial bank, get cash in exchange but
pay some amount as a discounting rate. The creditor gets themunotes.in
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64cash immediately but he has to accept a slightly less amount
than what the discount bill is meant for.
C.Overdraft facility -The commercial banks also allow their regular
depositors to withdraw more money than what they have in their
account. Some interest rate is charged only on the amount which is
over and above the actual depos its of the borrower in the bank.
D.Loans -The commercial banks provide direct loans to the customers
who have a sound investment project and acapacity to pay back the
loans. The commercial banks even cam money by, charging rate of
interest on these loans
7.2.2 Non -banking Functions of the commercial banks
i) Agency services -The commercial banks act as agents of their
customers and they perform various services for them. They may
collect cheques on behalf of them, they may sell and purchase
securities and other financial assets, they may carry correspondence
on behalf of their customers.
it) Collection -The commercial banks also collect cheques, drafts,
dividends, bills and other type of receipts of their customers The
banks may charge some service char ges for providing these services
but the customers get a lot of help from the commercial banks in
speedy provision of these services.
iii)Payments -With a request from the customers, the
commercial banks can also make certain payments on behalf of the
custom ers. They can pay the insurance premium, rents, taxes,
electricity bills, telephone bills, etc if they are instructed to do so
by their customers.
iv)Utility services -The commercial banks provide many utility
services like underwriting facilities, locker facilities, draft facility,
foreign exchange dealings, guarantor, etc.
v}Publication of data and other statistical information -The
commercial banks may also be engaged inthe collection and
publication of st atistical information regarding the important
financial indicators.
7.4 MULTIPLE CREDIT CREATION
The commercial banks, as we have seen earlier, are the profit earning
institutions. They have to utilize the deposits kept by the people with
them, convert these deposits into the advances and then earn the rate of
return on these loans. The process by which the commercial banks turn their
primary deposits into the secondary or active deposits and earn profit is
called a process of m ultiple credit creation. In this part of the unit, we will
first understand all the concepts related to the credit creation process and
then we will actually learn how the banks can create money out of the
existing deposits.munotes.in
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65The money accepted by the banks from its depositors in the form of
cheque or cash is called as the primary deposits. These deposits, are
passive in nature.
With the help of the primary deposits, the commercial banks can
advance loans of different types. T hese are called as the secondary or
derivative deposits. These deposits are active in nature and it is these
deposits that bring out the profitability to the commercial bank.
The process of multiple credit creation can be explained with the
help of follow ing assumptions : -
1 There are many banks operating in the economy.
2 People deposit money with the bank
3 There is a sufficient demand for the bank loans
4. The banks keep a part of their deposits in terms of cash
reserves which are legally fixed by the central bank.
Suppose Bank A receives Rs. 20.000 as the primary deposits (money
deposited by a customer in the bank). Suppose the banks are required to
keep 20% as a reserve requirement prescribed by the central ban kT h e
balance sheet of the bank A will look something like this
Assets Liabilities
Fresh deposits 20.000 Fresh cash 20.000
Total 20,000 Total 20,000
Now suppose that Bank A wants to advance loans, it has to keep
20% of its deposits as a cash reserve requirement The remaining
amount can be given as loans. Now the balance sheet will look as
follows :
Assets Liabilities
Reserves 4,000 Deposits 20.000
Loans 16,000
Total 20.000 Total 20.000
Now if Bank A gives loans worth Rs 16.000, the total money supply
in the economy also has increased by 16.000/ -Ap e r s o n who borrows Rs
16,000 may make his payments by cheque which may be deposited in Bank
B. The balance sheet of Bank B will look something like this : -munotes.in
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66Balance sheet of Bank B
Assets Liabilities
Reserves 3.200 Deposit 16,000
Loans 12,800
Total 16,000 Total 16,000
So now Rs. 12,800 are added into the money supply. This process
continues and from the primary deposits of Rs. 20,000 many times
more secondary deposits are created which is called as the process of
multiple credit creation.
Following table briefly explains the process of multiple credit
creation in a given pe riod of time.
Banks Primary
DepositsLoans Reserves
A 20000 .16000 4000
B ' 16000 12800 3200
C 12800 10240 2560
D 10240 8192 2048
E 8192 6553.60 16.38.40
F -
G -
H , .
etc Etc Etc
Total of the banking system 100000 80000 20000
Thus, at the end of the process of multiple credit creation, the
primary deposits increase by 5 time and become worth Rs. 1,00,000;
the loans given to the investors are worth Rs. 80.000/ -and the reserves
with the central bank are Rs. 20.000/ -which is 20% of the total deposits.
The value of multiplier is 5 in the above example and hence the
secondary deposits are 5 time more than the primary deposits.
The value of multiplier (k) is found out with the help of
following formula.
Where
K-multiplier
R-reserve ratio
In the above example R = 20%
Kmunotes.in
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672%
Value of multiplier is K = 5.
7.4.1 Limitations to the credit creation process of commercial banks
Though the commercial banks can create credit with the help of the deposits,
their capacity to create credit is limited by many factors. They can not
expand credit indiscriminately. Following are some of the limitations on
the credit expansion capacity of the commercial banks
(1)Cash Reserve Ratio
The commercial banks can expend the credit with the help of cash in
their hands. A part of cash with the commercial banks has toe kept
with the central bank. Higher this part (CRR), lower is the capacity
of commercial banks to expand credit.
(2)Amount of Primary Deposits
The commercial banks can not print notes. They have to depend
totally on the deposits kept with them their customers. These are the
primary deposits. More the volume of these deposits, grater is the
credit expansion and vice vers a.
(3)Caution
The banks have to keep certain amount of deposits in cash to meet the
regular demand by customers. Sometimes, to gain confidence of the
public, the commercial banks may keep a larger amount of
deposits in terms of cash than legal requirement. This limits their
capacity to expand credit.
(4)Policy of the Central bank
The central bank may influence the credit creation capacity of the
commercial banks. It may either follow cheap money policy to
enforce commercial banks to expand credit or it may follow dear
money policy to make commercial banks restrict their credit
creation capacity.
(5)Banking habits of the people
In a community where the people make their transactions more with the
help of cheques than cash, the commercial banks can expand credit more
rapidly. This is because they do not have to maintain more cash reserves
in this situation and can use a large amount of primary deposits for credit
creation. But exactly opposite will be the case, if the people of a
community have more preference towards making cash transactions.
7.5DEVELOPMENT OF COMMERCIAL BANKING
SECTOR SINCE 1990 -91
Indian commercial banking sector has seen spectacular expansion
in number of branches, volume of deposits, credit created and other
parameters. However, this progress was no without its problems. We shall
now examine the impact of reforms on the commercial banks.munotes.in
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68The number of branches of increased from 60,220 in March 1991
to 1,05,752 by March, 2013. This shows an impressive performance.
However, the percentage of rural branches declined from 58.5 to 37.2
percent of the total during this period. Thus, there is a clear indication that
the banks are now more focused on profits and seem to have given up the
objective of providing services in un-banked areas. The new private sector
banks and foreign banks have a clear urban and metropolitan orientation.
As these banks increase both in terms of number of branches and business,
the semi -urban and rural population may be deprived of the banking
services.
The following table shows the progress of commercial banking in
India after 1991 in terms of the ownership by different groups.
Year 1991 2012
Scheduled Commercial Banks 104 84
State Bank Group 8 7
Nationalised Banks 20 19
Old Private Sector Banks 25 15
New Private Sector Banks 9 7
Foreign Banks 42 36
Source: RBI: Report on Trend and Progress of Banking in India (various
issues).
The above table shows a decline in the number of Scheduled
Commercial Banks (SCBs) declined after 1991. This is due to the mergers
of both the public sector and private sector banks to improve the
operational efficiency.
The SCBs in India posted a healthy deposit growth with the
introduction of the economic reforms in 1991. The aggregate deposits and
credit by the SCBs during selected years are shown in Table
Deposits and Credit by SCBs during selected years (`. Cr.) :
Year End of
March,
1991End of
March,
1995End of
March,
2001End of
March,
2006End of
March,2009End of
March,
2012
Aggregate
Deposits2,30,758 4,33,819 9,62,618 21,09,049 38,34,110 59,09,082
Total
Bank
Credit1,25,592 2,54,015 5,11,434 15,07,077 7,15,724 46,11,852
Credit -
Deposit
Ratio54.5 58.5 53.1 71.5 72.4 78.0munotes.in
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69Source: RBI: Handbook of Statistics relating to Indian Economy, 2009.
The credit -deposit ratio is another important indicator of the
efficiency of the banking sector, prior to the introduction of the reforms in
the banking sector; most of the funds of the SCBs were used by the
government under the Statutory Liquidity Ratio (SLR) regulations. After
1998, this ratio impro ved with the freeing of funds that were earlier
committed to SLR.
The net profits of the SCBs improved from `4,504 crore in 1996 -
07 to `52,771 crore in 2008 -09. The Public Sector Banks (PSBs)
accounted for nearly half of the total profits. Table shows th e profit ratios
of different groups of SCBs during 1996 -97 and 2011 -12.
Net Profits to Total Advances Ratios of SCBs (1997 -2012)
Bank Group March 31, 1997 March 31, 2012
Public Sector Banks 0.57 0.88
Nationalised Banks 0.41 0.88
SBI Group 0.41 0.89
Old Private Sector Banks 0.84 1.20
New Private Sector Banks 0.73 1.63
Foreign Banks 1.19 1.76
All Scheduled Commercial Banks 0.67 1.08
Source: RBI: Report on Trend and Progress of Banking in India (various
issues).
From the above table we can see that the profits of the SCBs show
a definite improvement after the introduction of the economic reforms and
allowing the interest rates to move according to the market conditions. The
most important fact to be noted is the improvement in the profits of the
PSBs. They nearly doubled across all the groups of SCBs.
An important indicator of the performance of a commercial bank is
the net profit to the total assets. In this case, we observe that the profit
ratio does not snow a clear cut upward trend across t he SCBs. Only the
new private sector banks posted an improvement. The decline the net
profits ratio during 2008 -09 is attributable partly to the global slowdown
in 2007 and 2008. Table shows the net profit to total assets ratios of the
SCBs during 1991 -2012.munotes.in
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70Net Interest Income to Total Assets Ratio of SCBs in India (1992 -
2012) :
Year 1992 2002 2009 2012
Scheduled Commercial Banks 10.27 8.26 7.4 8.9
State Bank Group 3.8 8.62 7.0 9.5
Nationalised Banks 2.86 8.78 7.4 9.6
Old Private Sector Banks 5.7 9.36 8.1 9.5
New Private Sector Banks N.A. 8.56 8.9 10.5
Foreign Banks 11.61 8.26 6.8 9.5
Source: RBI: Report on Trend and Progress of Banking in India (various
issues).
An important facet of the economic liberalisation is improvement
in the non performing assets (NPAs) of the commercial banks. These loans
hold up liquidity and hamper the ability to generate credit. In this
direction, the RBI initiated measures like loan s yndication and debt
recovery tribunals (DRTs) to improve the asset quality of the SCBs. As a
result of these efforts, there is a significant improvement in the
performance of the banks in India. Table 17.5 shows the NPAs of the
SCBs during selected years. From the table we can that the NPAs as
percentage of both total advances and total assets registered a decline
during 1995 -96 and 2006 -07. However, following the global financial
crisis in 2007 and 2008, the NPAs registered a marginal increase in
nominal t erms from `53,097 crore in 2005 -06 to `56,435 crore and
`68,973 crore in gross terms and to `24,734 crore and `31,424 crore
during 2007 -08 and 2008 -09. However, due to better asset management by
the commercial banks and larger provisioning, the net NPAs as percent of
net advances came down. The NPA position of the new private banks and
foreign banks worsened. This could possibly due to the fact that these
banks cater to the clients in the corporate sector and in services sector. The
PSBs performed relativel y better with 16 percent increase in their NPAs
during 2007 -09 compared to the doubling of the NPAs of the new private
and foreign banks during this period.
Gross and Net NPAs of Commercial Banks in India (1996 -97 to 2011 -
12) (in `crore)
Year 1996 -97 2001 -02 2005 -06 2010 -11
Type
of
BankGross
NPAs to
Gross
Advance
sNet
NPAs to
Net
Advance
sGrossNPAs toGrossAdvancesNet
NPAs to
Net
Advanc
esGross
NPAs to
Gross
Advance
sNetNPAs toNet
Advanc
esGrossNPAs toGross
Advanc
esNetNPAs toNet
Advanc
es
All
SCBs47,300
(15.7)22,340
(8.1)70,861
(10.4)35,554
(5.5)51,097
(3.3)81,543
(1.2)97,922
(2.4)41,813
(1.1)
Public
Sector (17.8) (9.2) (11.1) (5.8) (3.6) (1.3) (2.3) (1.1)munotes.in
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71Banks
Old
Private
Sector
Banks(10.7) (6.6) (11.0) (5.8) (3.6) (1.3) (2.3) (1.1)
New
Private
Sector
Banks(2.6) (2.0) (8.9) (4.9) (1.7) (0.8) (2.3) (0.6)
Foreig
n
Banks(4.3) (1.9) (5.4) (1.9) (0.96) (0.43) (2.5) (0.7)
Figures in the parentheses show the percentage values.
Source: Reserve Bank of India: Report on Trend and Progress of Banking
in India (various issues).
Another important indicator of a commercial bank’s performance
is the Risk -weighted Capital to Asset Ratio (RCAR). This is also
popularly known as the capital adequacy ratio. This ratio indicates the
provisioning for assets of the commercial banks in terms of the risk of
default specific to a particular asset of the banking system. These are also
known as prudential norms, the asset management of a commercial bank.
The RBI has initi ated measures to improve the capital base of the
commercial banks in India to prepare them adequately for the risk that is
contingent on assets of a commercial bank in a globalising economy. As a
part of this, the government took initiatives to recapitalis e the PSBs. As a
result of these initiatives on the part of the RBI and government, the
RACR of SCBs improved significantly. In 1995 -96, 42 SCBs achieved a
RACR of 10 percent or more and 33 banks had a RCAR of 8 to 10
percent. The average of all SCBs was 8 .7 percent in that year. By 2000 -01,
this ratio improved to an average of 11.1 percent for all SCBs. Only 2
banks had an RCAR of less than 9 percent. 84 of them achieved a capital
adequacy ratio of more than 10 percent and 12 banks had between 8 to 10
percent.
The RBI observed in its Report for 2008 -09 that, “one significant
aspect is that unlike other countries where the adverse loop operated from
the financial to real sector, in India the banking sector has got an impact
from the real sector. Secondly, the fact that so far, financial sector reforms
have been calibrated with a progressive integration into the world
economy has paid us rich dividends. A key consideration in the choice of
pace and sequencing has been the management of volatility in financia l
markets and implications for the conduct of monetary operations. The
nuanced approach to financial sector reform has served India well with an
accent on conscious gradualism in the implementation of coordinated and
sequenced moves on several fronts. What have been ensured are
appropriate safeguards to ensure stability, while taking account of themunotes.in
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72prevailing governance standards, risk management systems and incentive
frameworks in financial institutions in the country. Overall, these
progressive but cautio us policies have contributed to efficiency of the
financial system while sustaining the growth momentum in an
environment of macroeconomic and financial stability. The policy
challenge is to continue to ensure financial stability in India during this
perio d of international financial turbulence, while achieving high growth
with price stability”.
Thus, after the introduction of the banking sector reforms in 1991,
the commercial banks in India were resilient enough to face the global
financial crises that were experienced in 1998, 2007 and 2008.
7.6SUMMARY
The commercial banks are -the oldest in stitutions dealing with lending
and borrowing of funds.
They perform two main functions of accepting deposits and lending
money.
The financial development of a country depends upon the
expansion of commercial banks.
The commercial banks create the secondary or derivative deposits
with the help of multiple credit creation process.
There are many limitations to the process of multiple credit
creation.
A role of the public sector in commercial banking has been greatly
enhanced through progressive nationalisation of banks. As a result of
nationalisation, the public sector banks occupy a dominant place in
commercial banking in India.
7.7QUESTIONS
1.What is the meaning of commerci al bank? Explain the functions of
commercial bank.
2.Explain the concept of multiple credit creation.
3.Explain the development of commercial banking sector since 1991.
munotes.in
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738
CENTRAL BANKING
Unit Structure:
8.0 Objectives
8.1 Introduction
8.2 Meaning of Central Bank
8.3 Functions of Central Bank
8.3.1Traditional Functions of Central Bank
8.3.2Developmental Functions of Central Bank
8.3.3Promotional Functions of Central Bank
8.4 Summary
8.5 Questions
8.0OBJECTIVES
To know the meaning of central bank.
To understand the measure functions of central bank.
8.1 INTRODUCTION
In the modern times, the central bank is the most important
institution in the financial structure of an economy. It is the agent of the
government and through the central bank the po licies of the government
regarding monetary and fiscal issues are implemented. The activities of a
central bank play very important role in the proper functioning of
economy and in the fiscal functions of the government.
The Riksbank in Sweden was establi shed in the year 1668 which
was example*of early central banks. The Bank of England was established
in 1694 which became a full -fledged central bank in 1844. The Bank of
England happened to be the first Central Bank in the history of central
banking on the guidelines of which many other central banks were
established. So the history of central bank coincides with the development
of Bank of England. 6y the end of 19th Century, almost every European
country had a central bank Today every independent country h as a Central
bank. Many of these central banks were established after 1940.
8.2 MEANING OF CENTRAL BANK
The definition of the Central bank is derived from its functions.
Since the functions of central bank are various, it is difficult to definemunotes.in
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74central bank in the exact manner. Following are some of the important
definitions:
De Cock : Ac e n t r a lb a n ki sab a n kw h i c hc o n s t i t u t e st h e apex of
the monetary and banking structure of its country.
D.C. Rowan : The central bank is an institution which is often but
not always owned by the state, which has an overriding
duty of conducting the Monetary Policy of the
government
Vera Smith : The banking system in which a single bank has either a
complete or residuary monopoly in the note issue is
called a central banking system.
Thus different economists have defined Central banking
differently taking into consideration the functions to be performed by the
central bank. From the definitions of the central bank we may understand
the functions of central bank as follows:
-Regulation of currency according to the requirement of business. -
Keeping the cash reserve of commercial banks.
-Performing general banking and agency function sf o rt h e
government.
-Management of the stock of foreign exchange for the country.
-Granting loans or credit to the commercial banks and other
financial institutions as per the need.
-Settling the balance between the different banks in the country.
-Supervising the activities of commercial banks and other financial
institutions.
-Controlling credit flow in the economy in accordance with the
needs of business.
8.3FUNCTIONS OF CENTRAL BANK
The functions of a central bank can be studied under two heads : -
I]Traditional Functions
II]Development Functions
III]Promotional Functions.
8.3.1 Traditional Functions of Central Bank
1) Bank of Issue : -
Issuing of Currency notes is the sole responsibility of the government of
any bank and on behalf of government the central bank issues currency
notes. Earlier, each bank was allowed to issue currency note. But over
the years, the entire responsibility was given to the central bank. So note
issuing is one of the mos timportant functions of the central bank. The
monopoly of note issue was given to the central bank because of the
following reasons :munotes.in
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75-to control the excessive credit expansion i.e. to control the supply
of money in the economy
-To bring about confidenc ea n du n i f o r m i t yw i t hr e g a r dt o
currency notes.
-For proper supervision and control over the entire activity of note
issuing and circulation.
-To solve the problems related to monetary management single handed.
-To give a special power to the centra lb a n ks ot h a ti ts t a n d s
different from the other banks.
2) Government's banker:
The central bank acts as a banker, adviser and agent to the
government of that country.
As a Banker the Central Bank does regular banking jobs for the
government. It accepts deposits in terms of cash, cheques or drafts for
different levels of government central, state and local. It becomes the
depositor of the government money It also gives loans to the government
whenever needed. It accepts the tax on behalf of government The
temporary loans are adjusted against the tax receipts. The
management of treasury bills is .done through the central bank. It also
controls and manager foreign exchange affairs for the government Thus,
it provides those services to the government that commercial banks
would provide to their customers. So it is called the banker to the
government
As an adviser to the government, a central bank undertakes surveys
in the economy and guides the government to act in a particular way to
solve country's -financial problems. It gives advice to the government on
monetary, matters, money markets and capital markets. The government
may also seek an advice from the central bank on the issues related to
balance of payments, deficit financing, foreign exchange reserves, etc
As an agent to the government, a central bank has to perform many
activities. It has to execute the Monetary Policy of the Government, it
has to manage public debt, deal with the government securities,
represent the government on the issues regarding international finance
and foreign exchange, deficit financing.
3)Banker's Bank :
The.' central bank acts as an agent not only for the
government but also for the other commercial banks of the country. It is
the apex of the entire financial structure and the banking institutions. So it
is the head of all the banks and hence it controls and supervises the
activities of all these institutions. Under this role of the central bank
following activities are done : -
a)The central bank accepts and keeps cash reserve of the
commercial banks.munotes.in
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76b)The central bank discounts bills of commercial banks to make
credit available to them whenever they need.
c) The central bank is considered to be the lender of last resort for
the commercial banks because it is the ultimate source of credit or
financial assistance to the banks.
d)The central bank acts as a clearing agency for the commercial banks.
Each commercial bank keeps a minimum stipulated amount of cash
reserves with the central bank. So all the claims of that
commercial bank with the central bank are cleared through these
reserves.
e)Inter -bank transactions are also settled down through the central
bank. So a ll the financial transactions of the member banks or
commercial banks between each other are facilitated through the
central bank. This helps in clearing the claims without actually
using the cash.
4) Controller of Credit:
The central bank being an apex of all financial and banking
institutions has to control the credit flow in the economy. This is essential
to maintain stability in the economy Controlling of credit means to make
money available in a large quantity when the economy needs it and vice
versa. F or example during -the boom period, when more funds are
demanded, the central bank should be in a position to make funds
available. During the slack season, when funds are not demanded in the
larger quantity, acentral bank should be in a position to reduce their
supply. This is needed for maintaining economic stability.
As a controller of credit, the central bank of a country controls and
manages the direction use and volume of credit in the economy.
(A detail analysis of credit contro li sd o n ei nt h en e x t unit). This is done
with the help of many instruments like bank rate, open market operations,
variable reserve ratio, selective credit control measures, etc.
5)Custodian of foreign exchange reserves.
The exchange rate stability is one of the important objectives of
any country. To achieve this objective, it is necessary to regulate and
manage the foreign exchange reserves of a country in the best possible way.
The central bank of a country also has a responsibility of maintaining
foreign exchange reserves. Under the gold standard system, the central
bank was supposed to maintain stable exchange rate by increasing or
decreasing the money supply in the economy Even after the breakdown
of gold standard, t hecentral bank is supposed to control the buying and
selling of foreign currency and all other matters related to foreign
exchange transactions. The gold reserves & foreign exchange reserves
arekept as a basis for issuing notes by the central bank by mai ntaining
and controlling the foreign exchange reserves.
All those are the traditional functions of the central
bank/Central bank of any country -whether a developed or anmunotes.in
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77underdeveloped country. Apart from these regular functions, the central
bank of a d eveloping country has to perform certain additional functions.
Due to the slow pace of development of many sectors in the economy, a
central bank of such countries has to perform some typical functions
which are known as promotional functions of the centra l bank.
8.3.2 Developmental Functions of Central Bank
The introduction of Five Year Plans in 1951 led to the RBI to
adopt development banking. The following are the important development
function that the RBI adopted to create efficient machinery for prov iding
finance needed for economic development. It also created institutions that
will ensure adequate flow of funds for different productive sectors of the
economy.
1)Establishment of Financial Institutions: RBI was actively involved in
the setting up of development finance institutions like the Industrial
Finance Corporation of India (IFCI), Industrial Development Bank of
India (IDBI), National Bank for Agriculture and Rural Development
(NABARD), Unit Trust of India (UTI), Small Industries Development
Bank of India (SIDBI), State Finance Corporations (SFCs) and
Deposit Insurance Corporation (DIC). These institutions played an
active role in channelising resources to flo w into the productive sectors
of the economy.
2)Supervision of Commercial Banks: The Reserve Bank of India Act,
1934 and Banking Companies Act, 1949 give the RBI authority on
licensing and inspecting of commercial banks operating in India. It is
empowered to lay the guidelines for lending policies, amalgamation
and mergers of weak banks. It sought to restrict the detrimental control
exercised by particular groups of persons on banks. It also played an
important role in the consolidation of the State Bank o f India group. It
played an active role in strengthening the co -operative credit system.
With the introduction of the banking sector reforms, RBI sought to
promote efficiency and competition in the banking sector. It has also
introduced autonomy with accou ntability, effective risk management
systems, operational flexibility, and information systems. It
campaigned effectively for the introduction of prudential norms in the
banking sector and improving the profitability of the banks. India
happens to be one o f the few LDCs to fully implement the Basle I
norms on banking like the CRAR, bank capitalisation regulations. Due
to the statutory audit and inspection system evolved by the RBI, Indian
banking system remained free from major crisis.
3)Expansion of Banki ng Services: RBI used its regulatory authority to
ensure the geographical spread of the banking services. Branch
expansion regulations ensured that the rural economy is integrated
with the national economy and credit is channelised into the priority
sector s. As the branch expansion regulations were found to be
detrimental to the effective functioning of the banks, the RBI relaxed
these norms following the recommendations of the Narasimhammunotes.in
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78Committee. It also liberalised the norms regarding the setting -up of
ATMs.
4)Credit Policy Initiatives: The Reserve Bank played an active role in
promoting credit to the priority sectors. In addition to stipulating
annual lending targets, it introduced the Lead Bank Scheme in 1969.
For each district in the country credit targets were set, beneficiaries
identified for the provision of productive credit to the needy. It also
provided for concessional credit to the exporters on both, pre -and
post-shipment basis. The RBI played an important role in the setting -
up of the Regi onal Rural Banks (RRBs). It provided liberal re -
financing facilities in addition to providing managerial assistance.
Because of these initiatives, credit flows for agriculture, exports and
small -scale units improved significantly. In 1971, meet the risk of
default in payments of interest and principal for commercial banks the
RBI set -up the Credit Guarantee Corporation of India to. Despite the
Narasimham Committee’s recommendations to abandon the priority
sector lending targets, RBI continues with them.
5)Interest Policy: An important policy imperative in a developing
country is to ensure adequate credit at reasonable interest rates. The
differential interest rate (DRI) scheme became an important policy
plank of the RBI since 1969. This scheme provided for concessional
interest rates on priority sector operations. It also sought to regulate
interest rate on deposits and lending operations of the commercial
banks so that the cost of borrowing to the government is kept at the
minimum. However, starting in 199 1, the Reserve Bank liberalised the
interest rates. Now RBI allows commercial banks to decide on their
own deposit and lending rates. This greatly enhanced the market
efficiency in reflecting the relative risk of each asset.
8.3.3 Promotional Functions of Central Bank
Through the promotional functions, the central banks of
developing countries help the governments to achieve the
objectives of economic development and dynamic growth of a country.
Since the central banks in the developing countries were established very late
in 1940s and 1950s and since these countries have aimed at rapid economic
development, the central banks also have been one of the instruments to
achieve this objective. Following is a brief analysis of promotional
functions of the centra lbank :
1)Expansion of banking system.
The developing countries have slow expansion of their banking
sector. The rural areas do not have adequate banking facilities. The
central bank of such countries has to play an important role to expand
the banking sector. Generally, the commercial banks are not interested in
providing credit to the agricultural sector and small scale industrial sector.
By making it compulsory to direct a part of credit towards rural areas, the
central bank can make the commercial banks to play an important role.munotes.in
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792)Establishment of New Financial institutions.
The industrial sector of the developing countries needs financial -
resources. To ensure adequate credit to these sectors, the central bank ta kes
initiative to start new financial institutions. For example, the RBI played an
important role in establishing financial institutions like IDBI, NABARD,
LIC, etc., which are now actively involved in providing loan facilities to the
industrial sector.
3)Development of money and capital market.
Am o n e ym a r k e ti sap l a c ew h e r et h es h o r tt e r ml o a n sa r e given. A
capital market is a place where long term loans are given. The money and
capital market function with different types of financial institutions. In
the developing countries, the central bank plays an important role in
establishment and development of such institutions. The central bank also
monitors the development of these markets. It makes available various
credit instruments because of which lending and borrowing of money is
facilitated.
4)Promote Investment:
With the help of appropriate monetary policies, the central bank
encourages savings from the people and make the funds available for the
investors. By adopting the differential interest rate pol icy, the central bank
promotes the development of priority sectors in the economy. For
example; the RBI insists on charging low interest rate on the loans
provided to the small scale industries, export sector, agriculture and other
priority sectors. By making it legally compulsory to do so, the RBI
makes the commercial banks to follow a policy of different interest rates
to different sectors.
8.4 SUMMARY
In this unit we have focused on the funct ions of a central bank in both
developed and developing countries. We may conclude with the help of
following points.
a)The central bank is the apex institution in the entire financial
structure
b)The concept of central bank is defined in many ways
depending upon its functions.
c)The primary or traditional functions of the central bank include the
right to note issue, controlling of credit, acting as
government's agent, bankers' bank and custodian of foreign
exchange reserves.
d)The promotional functions of a central bank are important particularly
in the developing countries where the central bank has to take
important steps to develop different sectors in the economy.
e)The monetary Policy is an important instrument in the hands of central
banks to control credit flow in the economy.
f)Many macro -economic objectives like economic growth, price stability,munotes.in
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80exchange ratio stability, etc. can be achieved through monetary Policy.
g)There are conflicts among various objectives of monetary Policy.
h)Bank rate policy, open market operations and variable reserve
requirements are the general or quantitative credit control measures.
i)Selective or qualitative credit controls aim at restricting and
directing the use of credit,
j)Through the credit control techniques, the central bank
enforces the economic objectives on the activities of commercial
banks.
8.5 QUESTIONS
1.Explain the meaning of Central Bank.
2.What are the functions of Central Bank?
munotes.in