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ECONOMICS
(FOR PROVINCIAL PLANNING SERVICES OFFICERS)

Prepared by:

Sozana Gul
MSc. Economics
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MICROECONOMICS
Microeconomics is the study of individuals, households and firms' behavior in
decision making and allocation of resources. It generally applies to markets of
goods and services and deals with individual and economic issues.
Description: Microeconomic study deals with what choices people make, what
factors influence their choices and how their decisions affect the goods markets
by affecting the price, the supply and demand.

CONSUMER BEHAVIOUR
Consumer : is an economic agent who consumes final goods or services for a
consideration.
Utility: is want satisfying power of a commodity.
Total utility: It is the total satisfaction derived from consumption of given
quantity of a commodity at a given time. In other words, It is the sum total of
marginal utility.
Marginal Utility: It is the change in total utility resulting from the consumption
of an additional unit of the commodity.In other words, It is the utility derived
from each additional unit.
Mun = Tun-Tun-1
Relation between total utility and marginal utility
UNITS Mu Tu
1 10 10
2 8 18
3 6 24
4 4 28
5 2 30
6 0 30
7 -2 28
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1. when Mu diminishes but positive Tu increases at a diminishing rate.

2. when Mu is zero, Tu is maximum.
3. when Mu is negative, Tu diminishes.

LAW OF DIMINISHING MARGINAL UTILITY (MU)

In economics, the law of diminishing marginal utility states that the marginal
utility of a good or service declines as more of it is consumed by an individual.
Economic actors receive less and less satisfaction from consuming incremental
amounts of a good. For example, an individual might buy a certain type of
chocolate for a while. Soon, they may buy less and choose another type of
chocolate or buy cookies instead because the satisfaction they were initially
getting from the chocolate is diminishing.

Graphical Representation of the Law of Diminishing Marginal Utility

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Mathematical Interpretation of the Law of Diminishing Marginal Utility

KEY TAKEAWAYS
• The law of diminishing marginal utility explains that as a person
consumes an item or a product, the satisfaction (utility) that they derive
from the product wanes as they consume more and more of that product.
• Demand curves are downward-sloping in microeconomic models since
each additional unit of a good or service is put toward a less valuable
use.
• Marketers use the law of diminishing marginal utility because they want
to keep marginal utility high for products that they sell.

LAW OF EQUI-MARGINAL UTILITY

The idea of equi-marginal principle was first mentioned by H.H.Gossen
(1810-1858) of Germany. Hence it is called Gossen's second Law. Alfred
Marshall made significant refinements of this law in his 'Principles of
Economics'.
The law of equi-marginal utility explains the behaviour of a consumer when he
consumers more than one commodity. Wants are unlimited but the income which
is available to the consumers to satisfy all his wants is limited. This law explains
how the consumer spends his limited income on various commodities to get
maximum satisfaction. The law of equi-marginal utility is also known as the law
of substitution or the law of maximum satisfaction or the principle of
proportionality between prices and marginal utility.
Assumptions
1. The consumer is rational so he wants to get maximum satisfaction.
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2. The utility of each commodity is measurable.

3. The marginal utility of money remains constant.
4. The income of the consumer is given.
5. The prices of the commodities are given.
6. The law is based on the law of diminishing marginal utility.
Explanation of the law
Suppose there are two goods X and Y on which a consumer has to spend a given
income. The consumer being rational, he will try to spend his limited income on
goods X and Y to maximise his total utility or satisfaction. Only at that point the
consumer will be in equilibrium. According to the law of equi-marginal utility,
the consumer will be in equilibrium at the point where the utility derived from
the last rupee spent on each is equal.
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Limitations of the Law

The law of equi-marginal utility bristles with the following difficulties.
1. Indivisibility of Goods
The theory is weakened by the fact that many commodities like a car, a house
etc. are indivisible. In the case of indivisible goods, the law is not applicable.
2. The Marginal Utility of Money is Not Constant
The theory is based on the assumption that the marginal utility of money is
constant. But that is not really so.
3. The Measurement of Utility is not Possible
Marshall states that the price a consumer is willing to pay for a commodity is
equal to its marginal utility. But modern economists argue that, if two persons are
paying an equal price for given commodity, it does not mean that both are getting
the same level of utility. Thus utility is a subjective concept, which cannot be
measured, in quantitative terms.
4. Utilities are Interdependent
This law assumes that commodities are independent and therefore their marginal
utilities are also independent. But in real life commodities are either substitutes
or complements. Their utilities are therefore interdependent.
Importance
According to Marshall, 'the applications of this principle extend over almost
every field of economic activity.'
1. It applies to consumption
Every rational human being wants to get maximum satisfaction with his limited
means. The consumer arranges his expenditure in such a way that, M U so that
he will get maximum satisfaction.
2. It applies to production
The aim of the producer is to get maximum output with least-cost, so that his
profit will be maximum. Towards this end, he will substitute one factor for
another till he get maximum satisfaction.
4. It applies to distribution
The general theory of distribution involves the principle of substitution. In
distribution, the rewards to the various factors of production, that is their relative
shares, are determined by the principle of equi-marginal utility.
5. It Applies to Public Finance
The principle of 'Maximum Social Advantage' as enunciated by Professors Hicks
and Dalton states that, the revenue should be distributed in such a way that the
last unit of expenditure on various programmes brings equal welfare, so that
social welfare is maximised.
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CONSUMER SURPLUS
The concept of consumer surplus is derived from the law of diminishing marginal
utility. As per the law, as we purchase more of a commodity, its marginal utility
reduces. Since the price is fixed, for all units of the goods we purchase, we get
extra utility. This extra utility is consumer surplus.
Consumer Surplus
Alfred Marshall, British Economist defines consumer’s surplus as follows:
“Excess of the price that a consumer would be willing to pay rather than go
without a commodity over that which he actually pays.”
Hence, Consumer’s Surplus = The price a consumer is ready to pay – The price he
actually pays
Further, the consumer is in equilibrium when the marginal utility is equal to the
price. That is, he purchases those many numbers of units of a good at which the
marginal utility is equal to the price. Now, the price is fixed for all units. Hence,
he gets a surplus for all units except the one at the margin. This extra utility is
consumer surplus.
Let us take a look at an example of consumer surplus.
Marginal Consumer’s
No. of units Price (Rs.)
Utility Surplus
1 30 20 10
2 28 20 8
3 26 20 6
4 24 20 4

From the table above, we see that as the consumption increase from 1 to 2 units,
the marginal utility falls from 30 to 28. This diminishes further as he increases
consumption. Now,
• Marginal utility is the price the consumer is willing to pay for that
unit.
• The actual price of the unit is fixed.
Therefore, the consumer enjoys a surplus on all purchases until the sixth unit.
When he buys the sixth unit, he is in equilibrium, since the price he is willing to
pay is equal to the actual price of the unit.
Graphical Representation
The concept of consumer surplus is illustrated graphically as follows:
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In the figure, you can see that the X-axis measures the amount of commodity,
while the Y-axis measures the price and marginal utility. Further, MU represents
the marginal utility curve, sloping downwards. This indicates that as the marginal
utility falls, the consumer purchases more units of the commodity and vice-versa.
Next, if OP is the price of a unit of the commodity, the consumer is in equilibrium
only when he purchases OQ units. In other words, when marginal utility is equal
to the price OP.
Further, the Qth unit does not yield any surplus since the price and marginal utility
is equal. However, for the purchase of all units before the Qth unit, the marginal
utility is greater than the price, offering a surplus to the consumer.
In Fig. 2 above, the total utility is equal to the area under the marginal
utility curve up to point Q (ODRQ). However, for price = OP, the consumer pays
OPRQ. Hence, he derives extra utility equal to DPR which is consumer surplus.
Limitations
1. It is difficult to measure the marginal utilities of different units of a
commodity consumed by a person. Hence, the precise measurement of
consumer’s surplus is not possible.
2. For necessary goods, the marginal utilities of the first few units are
infinitely large. Hence the consumer’s surplus is infinite for such
goods.
3. The availability of substitutes also affects the consumer’s surplus.
4. Deriving the utility scale for prestigious goods like diamonds is very
difficult.
5. We cannot measure the consumer’s surplus in terms of money. This is
because the marginal utility of money changes as a consumer makes
purchases and his stock of money diminishes.

CONSUMER BEHAVIOUR ORDINAL APPROACH

A popular alternative to the marginal utility analysis of demand is the Indifference

Curve Analysis. This is based on consumer preference and believes that we
cannot quantitatively measure human satisfaction in monetary terms. This
approach assigns an order to consumer preferences rather than measure them in
terms of money. Let us take a look.
What is an Indifference Curve?
An indifference curve is a curve that represents all the combinations of goods that
give the same satisfaction to the consumer. Since all the combinations give the same
amount of satisfaction, the consumer prefers them equally. Hence the name
indifference curve.
Here is an example to understand the indifference curve better. Peter has 1 unit of
food and 12 units of clothing. Now, we ask Peter how many units of clothing is he
willing to give up in exchange for an additional unit of food so that his level of
satisfaction remains unchanged.
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Peter agrees to give up 6 units of clothing for an additional unit of food. Hence, we
have two combinations of food and clothing giving equal satisfaction to Peter as
follows:
1 unit of food and 12 units of clothing
2 units of food and 6 units of clothing
By asking him similar questions, we get various combinations as follows:

Combination Food Clothing

A 1 12

B 2 6

C 3 4

D 4 3

Graphical Representation:

The diagram shows an Indifference curve (IC). Any combination lying on this
curve gives the same level of consumer satisfaction. Another name for it is Iso-
Utility Curve.
Indifference Map
An Indifference Map is a set of Indifference Curves. It depicts the complete
picture of a consumer’s preferences. The following diagram showing an
indifference map consisting of three curves:
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We know that a consumer is indifferent among the combinations lying on the same
indifference curve. However, it is important to note that he prefers the combinations
on the higher indifference curves to those on the lower ones.
This is because a higher indifference curve implies a higher level of satisfaction.
Therefore, all combinations on IC1 offer the same satisfaction, but all combinations
on IC2 give greater satisfaction than those on IC1.
Marginal Rate of Substitution
This is the rate at which a consumer is prepared to exchange a good X for Y. If we
go back to Peter’s example above, we have the following table:

Combination Food Clothing MRS

A 1 12 –

B 2 6 6

C 3 4 2

D 4 3 1

In this example, Peter initially gives up 6 units of clothing to get an extra unit of
food. Hence, the MRS is 6. Similarly, for subsequent exchanges, the MRS is 2 and
1 respectively. Therefore, MRS of X for Y is the amount of Y whose loss can be
compensated by a unit gain of X, keeping the satisfaction the same.
Interestingly, as Peter accumulates more units of food, the MRS starts falling –
meaning he is prepared to give up fewer units of clothing for food. There are two
reasons for this:
1. As Peter gets more units of food, his intensity of desire for additional
units of food decreases.
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2. Most of the goods are imperfect substitutes for one another. If they
could substitute one another perfectly, then MRS would remain
constant.
Properties of an Indifference Curve or IC
Here are the properties of an indifference curve:
An IC slopes downwards to the right
This slope signifies that when the quantity of one commodity in combination is
increased, the amount of the other commodity reduces. This is essential for the
level of satisfaction to remain the same on an indifference curve.
An IC is always convex to the origin
From our discussion above, we understand that as Peter substitutes clothing for
food, he is willing to part with less and less clothing. This is the diminishing
marginal rate of substitution. The rate gives a convex shape to the indifference
curve. However, there are two extreme scenarios:
1. Two commodities are perfect substitutes for each other – In this case,
the indifference curve is a straight line, where MRS is constant.
2. Two goods are perfect complementary goods – An example of such
goods would be gasoline and water in a car. In such cases, the IC will
be L-shaped and convex to the origin.
Indifference curves never intersect each other
Two ICs will never intersect each other. Also, they need not be parallel to each
other either. Look at the following diagram:
A higher IC indicates a higher level of satisfaction as compared to a lower
IC
A higher IC means that a consumer prefers more goods than not.
An IC does not touch the axis
This is not possible because of our assumption that a consumer considers different
combinations of two commodities and wants both of them. If the curve touches
either of the axes, then it means that he is satisfied with only one commodity and
does not want the other, which is contrary to our assumption.

BUDGET LINE
Since a higher indifference curve represents a higher level of satisfaction, a
consumer will try to reach the highest possible IC to maximize his satisfaction. In
order to do so, he has to buy more goods and has to work under the following two
constraints:
1. He has to pay the price for the goods and
2. He has limited income, restricting the availability of money for
purchasing these goods
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As can be seen above, a budget line shows all possible combinations of two goods
that a consumer can buy within the funds available to him at the given prices of
the goods. All combinations that are within his reach lie on the budget line.
A point outside the line (point H) represents a combination beyond the financial
reach of the consumer. On the other hand, a point inside the line (point K)
represents under-spending by the consumer.
CONSUMERS EQUILIBRIUM
A consumer is in equilibrium when he derives maximum satisfaction from the
goods and is in no position to rearrange his purchases.
Assumptions
• There is a defined indifference map showing the consumer’s scale
of preferences across different combinations of two goods X and Y.
• The consumer has a fixed money income and wants to spend it
completely on the goods X and Y.
• The prices of the goods X and Y are fixed for the consumer.
• The goods are homogenous and divisible.
• The consumer acts rationally and maximizes his satisfaction.
Consumers Equilibrium
In order to display the combination of two goods X and Y, that the consumer buys
to be in equilibrium, let’s bring his indifference curves and budget line together.
We know that,
• Indifference Map – shows the consumer’s preference scale between
various combinations of two goods
• Budget Line – depicts various combinations that he can afford to buy
with his money income and prices of both the goods.
In the following figure, we depict an indifference map with 5
indifference curves – IC1, IC2, IC3, IC4, and IC5 along with the budget line PL for
good X and good Y.
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From the figure, we can see that the combinations R, S, Q, T, and H cost the same
to the consumer. In order to maximize his level of satisfaction, the consumer will
try to reach the highest indifference curve. Since we have assumed a budget
constraint, he will be forced to remain on the budget line.
So, which combination will he choose?
Let’s say that he chooses the combination R. From Fig. 1, we can see that R lies
on a lower indifference curve – IC1. He can easily afford the combinations S, Q,
or T which lie on the higher ICs. Even if he chooses the combination H, the
argument is similar since H lies on the curve IC1 too.
Next, let’s look at the combination S lying on the curve IC2. Here again, he can
reach a higher level of satisfaction within his budget by choosing the combination
Q lying on IC3 – higher indifference curve level. The argument is similar for the
combination T since T lies on the curve IC2 too.
Therefore, we are left with the combination Q.
What happens if he chooses the combination Q?
This is the best choice since Q lies on his budget line and pts puts him on the
highest possible indifference curve, IC3. While there are higher curves, IC4 and
IC5, they are beyond his budget. Therefore, he reaches the equilibrium at point Q
on curve IC3.
Notice that at this point, the budget line PL is tangential to the indifference curve
IC3. Also, in this position, the consumer buys OM quantity of X and ON quantity
of Y.
Since point Q is the tangent point, the slopes of line PL and curve IC3 are equal at
this point. Further, the slope of the indifference curve shows a marginal rate of
substitution of X for Y (MRSxy) equal to MUxMUy. Also, the slope of the price
line (PL) indicates the ratio between the prices of X and Y and is equal to PxPy.
Hence, at the equilibrium point Q,
MRSxy = MUxMUy = PxPy
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Therefore, we can say that consumers equilibrium is achieved when the price line
is tangential to the indifference curve. Or, when the marginal rate of substitution
of the goods X and Y is equal to the ratio between the prices of the two goods.

MARKET SUPPLY AND MARKET DEMAND

Law of demand:
It is our common experience that the quantity of a commodity people buy is
linked to its price. We may observe any number of markets we will always find
that price of a commodity and its demand has inverse relation. Since the inverse
relationship between price and quantity demanded is universally true, the
economists call the relation as law of demand.
“If other things do not change people buy more of a good when its price falls
and less of it when its price rise”.
This is the verbal statement of law of demand. The law can be shown in the
form of a demand schedule or a demand curve.

Demand schedule:
A demand schedule shows the quantities of a good or service which buyers
would be willing and able to purchase at various prices. When the price of P and
Q are put in a table, we get a demand schedule as shown below. The demand
schedule shows that when price Rs. 40 per kg, people buy 200 kg. of sugar.
When price starts falling the demand for sugar expands. At price Rs.20 per kg,
the quantity demanded reaches 600 kg.
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The above diagram shows the demand curve which is downward sloping. Clearly
when the price of the commodity increases from price p3 to p2, then its quantity
demand comes down from Q3 to Q2 and then to Q3 and vice versa.
Table 8.1 Individual and Market Demand
Price ($) Household 1 Demand Household 2 Demand Market Demand
1 17 10 27
3 8 3 11
5 5 2 7
7 4 1.5 5.5
In most markets, many households purchase the good or the service traded. We
need to add together all the demand curves of the individual households to
obtain the market demand curve. To see how this works, look at Table 8.1
"Individual and Market Demand" and Figure 8.2 "Market Demand". Suppose
that there are two households. Part (a) of Figure 8.2 "Market Demand" shows
their individual demand curves. Household 1 has the demand curve from Figure
8.1 "The Demand Curve of an Individual Household". Household 2 demands
fewer chocolate bars at every price. For example, at $5, household 2 buys 2 bars
per month; at $3, it buys 3 bars per month. To get the market demand, we
simply add together the demands of the two households at each price. For
example, when the price is $5, the market demand is 7 chocolate bars (5
demanded by household 1 and 2 demanded by household 2). When the price is
$3, the market demand is 11 chocolate bars (8 demanded by household 1 and 3
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demanded by household 2). When we carry out the same calculation at every
price, we get the market demand curve shown in part (b) of Figure 8.2 "Market
Demand".
Toolkit: Section 31.9 "Supply and Demand"
You can review the market demand curve in the toolkit.
Figure 8.2 Market Demand

Market demand is obtained by adding together the individual demands of all the
households in the economy.
Because the individual demand curves are downward sloping, the market
demand curve is also downward sloping: the law of demand carries across to the
market demand curve. As the price decreases, each household chooses to buy
more of the product. Thus the quantity demanded increases as the price
decreases. Although we used two households in this example, the same idea
applies if there are 200 households or 20,000 households. In principle, we could
add together the quantities demanded at each price and arrive at a market
demand curve.
• As price decreases, some households decide to enter the market; that is,
these households buy some positive quantity other than zero.
• As price decreases, households increase the quantity that they wish to
purchase.
When the price decreases, there are more buyers, and each buyer buys more.
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Theory of Supply

Supply is the quantity of goods a firm offers to sell in the market at a given price.
Now the theory of supply states that with an increase in price the number of goods
a firm wishes to supply will also increase.

Figure 8.4 Market Supply

Market supply is obtained by adding together the individual supplies of all the
firms in the economy.
In general, both mechanisms come into play. The market supply curve slopes up
for two reasons:
1. As the price increases, more firms decide to enter the market—that is,
these firms produce some positive quantity other than zero.
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2. As the price increases, firms increase the quantity that they wish to
produce.
When the price increases, there are more firms in the market, and each firm
produces more.
Equilibrium Price
The easiest thing to understand is that producers want good value for their
products and consumers are willing to spend in accordance with the utility. So
how do we satisfy both buyers and sellers? The answer is the equilibrium price.
Let us take a look.

Equilibrium Price

Equilibrium means a state of no change. Evidently, at the equilibrium price, both

buyers and sellers are in a state of no change. Technically, at this price, the
quantity demanded by the buyers is equal to the quantity supplied by the sellers.
Both market forces of demand and supply operate in harmony at the equilibrium
price.

Graphically, this is represented by the intersection of the demand and supply

curve. Further, it is also known as the market clearing price. The determination of
the market price is the central theme of microeconomics. That is why the
microeconomic theory is also known as price theory.

KEY TAKEAWAYS
• The market demand curve is obtained by adding together the
demand curves of the individual households in an economy.
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• As the price increases, household demand decreases, so market

demand is downward sloping.
• The market supply curve is obtained by adding together the
individual supply curves of all firms in an economy.
• As the price increases, the quantity supplied by every firm
increases, so market supply is upward sloping.
• A perfectly competitive market is in equilibrium at the price where
demand equals supply.

Elasticity of Demand
Elasticity of Demand, or Demand Elasticity, is the measure of change in
quantity demanded of a product in response to a change in any of the
market variables, like price, income etc. It measures the shift in demand when
other economic factors change.
In other words, the elasticity of demand is the percentage change in quantity
demanded divided by the percentage change in another economic variable.
The demand for a commodity is affected by different economic variables:
1. Price of the commodity
2. Price of related commodities
3. Income level of consumers
3 Types of Elasticity of Demand
On the basis of different factors affecting the quantity demanded for a product,
elasticity of demand is categorized into mainly three categories: Price
Elasticity of Demand (PED), Cross Elasticity of Demand (XED), and
Income Elasticity of Demand (YED).

1. Price Elasticity of Demand (PED)

Any change in the price of a commodity, whether it’s a decrease or increase,
affects the quantity demanded for a product. For example, when there is a rise in
the prices of ceiling fans, the quantity demanded goes down.
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This measure of responsiveness of quantity demanded when there is a change

in price is termed as the Price Elasticity of Demand (PED).
The mathematical formula given to calculate the Price Elasticity of Demand is:
PED = % Change in Quantity Demanded % / Change in Price

2. Income Elasticity of Demand (YED)

The income levels of consumers play an important role in the quantity
demanded for a product. This can be understood by looking at the difference in
goods sold in the rural markets versus the goods sold in metro cities.
The Income Elasticity of Demand, also represented by YED, refers to the
sensitivity of quantity demanded for a certain good to a change in real income
(the income earned by an individual after accounting for inflation) of the
consumers who buy this good, keeping all other things constant.
YED = % Change in Quantity Demanded% / Change in Income
The result obtained from this formula helps to determine whether a good is a
necessity good or a luxury good.
3. Cross Elasticity of Demand (XED)
In a market where there is an oligopoly, multiple players compete. Thus, the
quantity demanded for a product does not only depend on itself but rather, there
is an effect even when prices of other goods change.
Cross Elasticity of Demand, also represented as XED, is an economic concept
that measures the sensitiveness of quantity demanded of one good (X) when
there is a change in the price of another good (Y), and that’s why it is also
referred to as Cross-Price Elasticity of Demand.
XED = (% Change in Quantity Demanded for one good (X)%) / (Change in
Price of another Good (Y))

The result obtained for a substitute good would always come out to be positive
as whenever there is a rise in the price of a good, the demand for its substitute
rises. Whereas, the result will be negative for a complementary good.
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5 other types of Elasticity of Demand

The effect of change in economic variables is not always the same on the
quantity demanded for a product.
The demand for a product can be elastic, inelastic, or unitary, depending on the
rate of change in the demand with respect to the change in the price of a
product.
• An elastic demand is one that shows a larger fluctuation in the quantity
demanded of a product, in response to even a little change in another
economic variable. For example, if there is a hike of $0.5 in the price of a
cup of coffee, there are very high chances of a steep decline in the
quantity demanded.

• An inelastic demand is one that shows a very little fluctuation in the

quantity demanded with respect to a change in another economic
variable. An example of this can be petrol or diesel.

• Unitary elasticity is one in which the fluctuation in one variable and

quantity demanded is equal.

1. Perfectly Elastic Demand

When there is a sharp rise or fall due to a change in the price of the commodity,
it is said to be perfectly elastic demand.
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In perfectly elastic demand, even a small rise in price can result in a fall in
demand of the good to zero, whereas a small decline in the price can increase
the demand to infinity.

2. Perfectly Inelastic Demand

A perfectly inelastic demand is the one in which there is no change measured
against a price change.
The numerical value obtained from the PED formula comes out as zero for a
perfectly inelastic demand.
The demand curve for a perfectly inelastic demand is a vertical line i.e. the
slope of the curve is zero.

3. Relatively Elastic Demand

Relatively elastic demand refers to the demand when the proportionate change
in the demand is greater than the proportionate change in the price of the good.
The numerical value of relatively elastic demand ranges between one to
infinity.
In relatively elastic demand, if the price of a good increases by 25% then the
demand for the product will necessarily fall by more than 25%.
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Demand Curves

4. Relatively Inelastic Demand

In a relatively inelastic demand, the proportionate change in the quantity

demanded for a product is always less than the proportionate change in the
price.

For example, if the price of a good goes down by 10%, the proportionate change
in its demand will not go beyond 9.9..%, if it reaches 10% then it would be
called unitary elastic demand.

The numerical value of relatively inelastic demand always comes out as less
than 1 and the demand curve is rapidly sloping for such type of demand.
5. Unitary Elastic Demand

When the proportionate change in the quantity demanded for a product is equal
to the proportionate change in the price of the commodity, it is said to be unitary
elastic demand.

The numerical value for unitary elastic demand is equal to 1. The demand curve
for unitary elastic demand is represented as a rectangular hyperbola.
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THEORY OF FIRM
Production Function
The functional relationship between physical inputs (or factors of production) and
output is called production function. It assumed inputs as the explanatory or
independent variable and output as the dependent variable. Mathematically, we
may write this as follows:

Q = f (L,K)

Here, ‘Q’ represents the output, whereas ‘L’ and ‘K’ are the inputs, representing
labour and capital (such as machinery) respectively. Note that there may be many
other factors as well but we have assumed two-factor inputs here.

Time Period and Production Functions

The production function is differently defined in the short run and in the long run.

Those inputs that vary directly with the output are called variable factors. These
are the factors that can be changed. Variable factors exist in both, the short run
and the long run. Examples of variable factors include daily-wage labour, raw
materials, etc.
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On the other hand, those factors that cannot be varied or changed as the output
changes are called fixed factors. These factors are normally characteristic of the
short run or short period of time only. Fixed factors do not exist in the long run.

Consequently, we can define two production functions: short-run and long-run.

The short-run production function defines the relationship between one variable
factor (keeping all other factors fixed) and the output. The law of returns to a
factor explains such a production function.

For example, consider that a firm has 20 units of labour and 6 acres of land and it
initially uses one unit of labour only (variable factor) on its land (fixed factor). So,
the land-labour ratio is 6:1. Now, if the firm chooses to employ 2 units of labour,
then the land-labour ratio becomes 3:1 (6:2).

The long-run production function is different in concept from the short run
production function. Here, all factors are varied in the same proportion. The law
that is used to explain this is called the law of returns to scale. It measures by how
much proportion the output changes when inputs are changed proportionately.

Total Product, Average Product and Marginal Product

Total Product

In simple terms, we can define Total Product as the total volume or amount of
final output produced by a firm using given inputs in a given period of time.

Marginal Product

The additional output produced as a result of employing an additional unit of the

variable factor input is called the Marginal Product. Thus, we can say that
marginal product is the addition to Total Product when an extra factor input is
used.

Marginal Product = Change in Output/ Change in Input

Thus, it can also be said that Total Product is the summation of Marginal products
at different input levels.

Total Product = Ʃ Marginal Product

Average Product
 27

It is defined as the output per unit of factor inputs or the average of the total
product per unit of input and can be calculated by dividing the Total Product by
the inputs (variable factors).

Average Product = Total Product/ Units of Variable Factor Input

Relationship between Marginal Product and Total Product

The law of variable proportions is used to explain the relationship between Total
Product and Marginal Product. It states that when only one variable factor input is
allowed to increase and all other inputs are kept constant, the following can be
observed:

• When the Marginal Product (MP) increases, the Total Product is also
increasing at an increasing rate. This gives the Total product curve a
convex shape in the beginning as variable factor inputs increase. This
continues to the point where the MP curve reaches its maximum.
• When the MP declines but remains positive, the Total Product is
increasing but at a decreasing rate. Thisgiveends the Total product
curve a concave shape after the point of inflexion. This continues
until the Total product curve reaches its maximum.
• When the MP is declining and negative, the Total Product declines.
• When the MP becomes zero, Total Product reaches its maximum.

Relationship between Average Product and Marginal Product

There exists an interesting relationship between Average Product and Marginal

Product. We can summarize it as under:

• When Average Product is rising, Marginal Product lies above Average

Product.
 28

• When Average Product is declining, Marginal Product lies below

Average Product.
• At the maximum of Average Product, Marginal and Average Product
equal each other.

TP, MP, AP: Shape of the Curves

When we take a look at the figure below, the following can be noted about the
shapes of the TP, MP and AP curves.

• The TP curve first increases at an increasing rate, after which it

continues to increase but at a decreasing rate, giving the curve an S-
shape. This trend continues till TP reaches its maximum. Here, MP
=0. After the maximum, TP starts to fall or it declines.
• The MP curve also initially increases, reaches its maximum and then
declines. Note that the maximum of MP is reached at the point where
TP starts to increase at a diminishing rate. An interesting fact is that
MP can also be negative, whereas TP is always positive even when it
declines.
• The AP curve also shows a similar trend as the MP. It rises, reaches
its maximum and then falls. At the point where AP reaches its
maximum, AP = MP.
• All – TP, MP and AP curves, are inverted U-shaped.
Law of Variable Proportion

The law of variable proportions explains the peculiar shape of the TP curve. It is
based on the following assumptions:

• Only one input is variable and all other inputs are held constant.
• The proportion in which factor units are used may be changed.
 29

• The state of technology and factor prices are assumed to be constant.

• The time period is the short-run.
It states that if we increase one variable factor, keeping all other factors constant,
the TP curve first increases at an increasing rate (convex shape) and then at a
diminishing rate (concave shape) after which it starts to fall. This lends it an S-
shape till the point where TP reaches its maximum.

Stages of Production

Based on the shapes of the TP, MP and AP curves, we can identify different
stages of the production process faced by a firm.

Source: JBDON

Stage I

Called the stage of increasing returns to a factor, his stage refers to that phase in
the production process where MP is increasing and reaches its maximum point. It
is the phase where TP is increasing at an increasing rate. The stage starts from the
origin and extends till the point of inflexion – the point on the TP curve after
which TP increases at a diminishing rate

Since TP is increasing at an increasing rate in this phase, it is profitable for the

firm to continue employing more units of the variable factor to increase its
production. Hence, the firm never operates in Stage I.
 30

Stage II

This stage is called the stage of diminishing returns to a factor. It refers to the
phase where TP increases at a diminishing rate and reaches its maximum. In this
phase, MP is declining but note that it still remains positive. The stage ends where
MP = 0. Since this implies efficient utilization of the fixed factor, a firm always
operates in the second stage of production.

Stage III

This is the final phase, called the stage of negative returns to a factor, where the
TP curve starts to decline. MP in this phase becomes negative. This stage is not at
all feasible for operation for any firm as the TP starts to decline, which means that
production has surpassed the optimum level of specialization.

Returns to Scale

The long run refers to a time period where the production function is defined on
the basis of variable factors only. No fixed factors exist in the long run and all
factors become variable. Thus, the scale of production can be changed as inputs
are changed proportionately. Thus, returns to scale are defined as the change in
output as factor inputs change in the same proportion. It is a long run concept.

Types of Returns to Scale

There are three defined types of returns to scales, which include:

Increasing Returns to Scale

When the output increases more than proportionately when all the inputs increase
proportionately, it is known as increasing returns to scale. This represents a kind
of decreasing the cost to the firm. External economies of scale might be one of the
reasons behind such increase in output in increasing returns to scale. Thus, when
inputs double, output more than doubles in this case.

Decreasing Returns to Scale

When the output increases less than proportionately as all the inputs increase
proportionately, we call it decreasing returns to scale or diminishing returns to
scale. In this case, internal or external economies are normally overpowered by
internal or external diseconomies. Thus, if we double the inputs, the output will
increase but by less than double.
 31

Constant Returns to Scale

When the output increases exactly in proportion to an increase in all the inputs or
factors of production, it is called constant returns to scale. For example, if twice
the inputs are used in production, the output also doubles. Thus, constant returns
to scale are reached when internal and external economies and diseconomies
balance each other out.

A regular example of constant returns to scale is the commonly used Cobb-

Douglas Production Function (CDPF). The figure given below captures how the
production function looks like in case of increasing/decreasing and constant
returns to scale.

Source: FAO

Cobb-Douglas Production Function

As we know, a production function explains the functional relationship between

inputs (or factors of production) and the final physical output. Let us begin with a
simple form a production function first –

Q = f(L, K)

The above mathematical equation tells us that Q (output) is a function of two

inputs (assumption). These inputs are L (amount of labour) and K (hours of
capital). Basing our understanding of the function above, we can now define a
more specific production function – the Cobb Douglas Production Function.

Q = A Lβ Kα
 32

Here, Q is the output and L and K represent units of labour and capital
respectively. A is a positive constant (also called the technology coefficient). α
and β are constants lying between 0 and 1.

We can calculate the Marginal Product for the CDPF and derive interesting
results. Marginal Product captures the change in output due to an infinitesimal
change in an input. It is calculated by first-order differentiation of the CDPF.
Hence,

MPL = A β Lβ-1 Kα , and MPK = A α Lβ Kα-1

Let us now find out the implications of returns to scale on the Cobb-Douglas
production function: If we are to increase all inputs by ‘c’ amount (c is a constant),
we can judge the impact on output as under.

Q (cL, cK) = A (cL)β (cK)α = Acβ cα Lβ Kα = Acα+β Lβ Kα

Note that if α+β > 1 there will be increasing returns to scale. If α+β < 1 there will
be decreasing returns to scales. And, if α+β = 1 there will be constant returns to
scale (case of linear homogenous CDPF). Thus, depending on the nature of the
CDPF, there will be increasing, decreasing or constant returns to scale.

CONCEPT OF COSTS
Concept of Costs in terms of Treatment

1. Accounting costs

Accounting costs are those for which the entrepreneur pays direct cash for
procuring resources for production. These include costs of the price paid for raw
materials and machines, wages paid to workers, electricity charges, the cost
incurred in hiring or purchasing a building or plot, etc. Accounting costs are
treated as expenses. Chartered accountants record them in financial statements.

2. Economic costs

There are certain costs that accounting costs disregard. These include money
which the entrepreneur forgoes but would have earned had he invested his time,
efforts and investments in other ventures. For example, the entrepreneur would
have earned an income had he sold his services to others instead of working on his
own business.
 33

Concept of Costs in terms of the Nature of Expenses

1. Outlay costs

The actual expenses incurred by the entrepreneur in employing inputs are called
outlay costs. These include costs on payment of wages, rent, electricity or fuel
charges, raw materials, etc. We have to treat them are general expenses for the
business.

2. Opportunity costs

Opportunity costs are incomes from the next best alternative that is foregone when
the entrepreneur makes certain choices.

For example, the entrepreneur could have earned a salary had he worked for
others instead of spending time on his own business. These costs calculate the
missed opportunity and calculate income that we can earn by following some
other policy.

Concept of Costs in terms of Traceability

1. Direct costs

Direct costs are related to a specific process or product. They are also called
traceable costs as we can directly trace them to a particular activity, product or
process.

They can vary with changes in the activity or product. Examples of direct costs
include manufacturing costs relating to production, customer acquisition costs
pertaining to sales, etc.

2. Indirect costs

Indirect costs, or untraceable costs, are those which do not directly relate to a
specific activity or component of the business. For example, an increase in
charges of electricity or taxes payable on income. Although we cannot trace
indirect costs, they are important because they affect overall profitability.

Concept of Costs in terms of the Purpose

1. Incremental costs
 34

These costs are incurred when the business makes a policy decision. For example,
change of product line, acquisition of new customers, upgrade of machinery to
increase output are incremental costs.

2. Sunk costs

Suck costs are costs which the entrepreneur has already incurred and he cannot
recover them again now. These include money spent on advertising, conducting
research, and acquiring machinery.

Concept of Costs in terms of Payers

1. Private costs

These costs are incurred by the business in furtherance of its own objectives.
Entrepreneurs spend them for their own private and business interests. For
example, costs of manufacturing, production, sale, advertising, etc.

2. Social costs

As the name suggests, it is the society that bears social costs for private interests
and expenses of the business. These include social resources for which the firm
does not incur expenses, like atmosphere, water resources and environmental
pollution.

Concept of Costs in terms of Variability

1. Fixed costs

Fixed costs are those which do not change with the volume of output. The
business incurs them regardless of their level of production. Examples of these
include payment of rent, taxes, interest on a loan, etc.

2. Variable costs

These costs will vary depending upon the output that the business generates. Less
production will cost fewer expenses, and vice versa, the business will pay more
when its production is greater. Expenses on the purchase of raw material and
payment of wages are examples of variable costs.
 35

Short Run Cost Function

The cost function is a functional relationship between cost and output. It explains
that the cost of production varies with the level of output, given other things
remain the same (ceteris paribus). This can be mathematically written as:

C = f(X)

where C is the cost of production and X represents the level of output.

Total Fixed Cost

Fixed cost refers to the cost of fixed inputs. It does not change with the level of
output (thus, fixed). Fixed inputs include building, machinery etc. Hence the cost
of such inputs such as rent or cost of machinery constitutes fixed costs. Also
referred to as overhead costs, supplementary costs or indirect costs, these costs
remain the same irrespective of the level of output.

Hence, if we plot the Total Fixed Cost (TFC) curve against the level of output on
the horizontal axis, we get a straight line parallel to the horizontal axis. This
indicates that these costs remain the same and that they have to be incurred even if
the level of output is zero.

Total Variable Cost

The cost incurred on variable factors of production is called Total Variable Cost
(TVC). These costs vary with the level of output or production. Thus, when
production level is zero, TVC is also zero. Thus, the TVC curve begins from the
origin.

The shape of the TVC is peculiar. It is said to have an inverted-S shape. This is
because, in the initial stages of production, there is scope for efficient utilization of
fixed factor by using more of the variable factor (eg. Workers employing
machinery).

Hence, as the variable input employed increases, the productive efficiency of

variable inputs ensures that the TVC increases but at a diminishing rate. This
makes the first part of the TVC curve that is concave.

As the production continues to increase, more and more variable factor is

employed for a given amount of fixed input. The productive efficiency of each
 36

variable factor falls and it adds more to the cost of production. So the TVC
increases but now at an increasing rate. This is where the TVC curve is convex in
shape. And so the TVC curve gets an inverted-S shape.

Total Cost

Total cost (TC) refers to the sum of fixed and variable costs incurred in the short-
run. Thus, the short-run cost can be expressed as

TC = TFC + TVC

Note that in the long run, since TFC = 0, TC =TVC. Thus, we can get the shape of
the TC curve by summing over TFC and TVC curves.

Fig.1

(Source: economicsdiscussion)

The following can be noted about the TC curve:

• The TC curve is inverted-S shaped. This is because of the TVC curve.

Since the TFC curve is horizontal, the difference between the TC and
TVC curve is the same at each level of output and equals TFC. This is
explained as follows: TC – TVC = TFC
• The TFC curve is parallel to the horizontal axis while the TVC curve
is inverted-S shaped.
• Thus, the TC curve is the same shape as TVC but begins from the
point of TFC rather than the origin.
 37

• The law that explains the shape of TVC and subsequently TC is called
the law of variable proportions.
Long Run Cost Curves

The long run is different from the short run in the variability of factor inputs.
Accordingly, long-run cost curves are different from short-run cost curves. This
lesson introduces you to Long run Total, Marginal and Average costs. You will
learn the concepts, derivation of cost curves and graphical representation by
way of diagrams and solved examples.
The Concept of the Long Run

The long run refers to that time period for a firm where it can vary all the factors
of production. Thus, the long run consists of variable inputs only, and the concept
of fixed inputs does not arise. The firm can increase the size of the plant in the
long run. Thus, you can well imagine no difference between long-run variable cost
and long-run total cost, since fixed costs do not exist in the long run.

Long Run Total Costs

Long run total cost refers to the minimum cost of production. It is the least cost of
producing a given level of output. Thus, it can be less than or equal to the short
run average costs at different levels of output but never greater.

In graphically deriving the LTC curve, the minimum points of the STC curves at
different levels of output are joined. The locus of all these points gives us the LTC
curve.

Long Run Average Cost Curve

Long run average cost (LAC) can be defined as the average of the LTC curve or
the cost per unit of output in the long run. It can be calculated by the division of
LTC by the quantity of output. Graphically, LAC can be derived from the Short
run Average Cost (SAC) curves.

While the SAC curves correspond to a particular plant since the plant is fixed in
the short-run, the LAC curve depicts the scope for expansion of plant by
minimizing cost.
 38

Derivation of the LAC Curve

Note in the figure, that each SAC curve corresponds to a particular plant size. This
size is fixed but what can vary is the variable input in the short-run. In the long
run, the firm will select that plant size which can minimize costs for a given level
of output.

You can see that till the OM1 level of output it is logical for the firm to operate at
the plat size represented by SAC2. If the firm operates at the cost represented by
SAC2 when producing an output level OM2, the cost would be more.

So in the long run, the firm will produce till OM1 on SAC2. However, till an
output level represented by OM3, the firm can produce at SAC2, after which it is
profitable to produce at SAC3 if the firm wishes to minimize costs.

(Source: test.blogspot)

Thus, the choice, in the long run, is to produce at that plant size that can minimize
costs. Graphically, this gives us a LAC curve that joins the minimum points of all
possible SAC curves, as shown in the figure. Thus, the LAC curve is also called
an envelope curve or planning curve. The curve first falls, reaches a minimum and
then rises, giving it a U-shape.

We can use returns to scale to explain the shape of the LAC curve. Returns to
scale depict the change in output with respect to a change in inputs.
During Increasing Returns to Scale (IRS), the output doubles by using less than
double inputs. As a result, LTC increases less than the rise in output and LAC will
fall.

• In Constant Returns to Scale (CRS), the output doubles by doubling

the inputs and the LTC increases proportionately with the rise in
output. Thus, LAC remains constant.
 39

•In Decreasing Returns to Scale (DRS), the output doubles by using

more than double the inputs so the LTC increases more than
proportionately to the rise in output. Thus, LAC also rises. This gives
LAC its U-shape.
Long Run Marginal Cost

Long run marginal cost is defined at the additional cost of producing an extra unit
of the output in the long-run i.e. when all inputs are variable. The LMC curve is
derived by the points of tangency between LAC and SAC.

Note an important relation between LMC and SAC here. When LMC lies below
LAC, LAC is falling, while when LMC is above LAC, LAC is rising. At the point
where LMC = LAC, LAC is constant and minimum.

Concepts of Total Revenue Average Revenue and Marginal Revenue

Total Revenue

A firm sells 100 units of a particular commodity for Rs. 10 each. If you were to
calculate the amount realized by the firm, the answer is simple – Rs. 1,000 (100 x
10). This is the total revenue for the firm.

Hence, the total revenue refers to the amount of money realized by a firm on
the sale of a commodity. Total revenue is expressed as follows:

TR = P x Q … where TR – Total Revenue, P – Price, and Q – Quantity of the

commodity sold.

Average Revenue

Average revenue is simply the revenue earned per unit of the output. In simpler
words, it is the price of one unit of the output. Average revenue is expressed as
follows:

AR=TRQ
… where AR – Average Revenue, TR – Total Revenue, and Q – Quantity of the
commodity sold.
By using the formula for total revenue, we get

AR=P×QQ
 40

Or AR = P
For example, a firm sells 100 units of a commodity and realizes a total revenue of
Rs. 1,000. Therefore, its average revenue is

AR=1000100=Rs.10
Hence, the firm sells the commodity at a price of Rs. 10 per unit.

Marginal Revenue

Marginal revenue (MR) is the change in total revenue resulting from the sale of an
additional unit of a commodity.

For example, consider a firm selling 100 units of a commodity and realizing a
total revenue of Rs. 1,000. Further, it realizes a total revenue of Rs. 1,200 after
selling 101 units of the same commodity. Therefore, the marginal revenue is Rs.
200.

Marginal revenue is also defined as the rate of change of total revenue resulting
from the sale of an additional unit of a commodity.

Therefore,

MR=ΔTRΔQ
… where MR – Marginal revenue, TR – Total revenue, Q – Quantity of the
commodity sold, and Δ – the rate of change.
Further, for one unit change in output, we have

MRn = TRn – TRn-1

Where,

• TRn – the total revenue when the sales are at the rate of ‘n’ units per
period.
• TRn-1 – the total revenue when the sales are at the rate of (n-1) units
per period.
•

Producer Equilibrium
 41

Producer's equilibrium or optimisation occurs when he earns maximum

profit with optimal combination of factors. ... A profit maximisation firm
faces two choices of optimal combination of factors (inputs). Or Producer's
equilibrium refers to a situation where profits are maximised, i.e., the
difference between total revenue and total cost is maximised, or in cases
losses, the difference is minimised, so as to minimise losses.
In order to achieve this, producers first have to classify their resources into different
combinations. Each combination would provide production in different quantities.
The combination that provides the highest amount of produce at the least amount
of costs is the optimum level of production.

In order to find out producer’s equilibrium, we first need to understand isoquant

curves and iso-cost lines. These two concepts help us calculate optimum
production.

Isoquant Curves

These lines represent various input combinations which produce the same levels
of output. The producer can choose any of these combinations available to him
because their outputs are always the same. Thus, we can also call them equal–
product curves or production indifference curves.

Just like indifference curves, isoquants are also negatively-sloping and convex
in shape. They never intersect with each other. When there are more curves than
one, the curve on the right represents greater output and curves on the left show
less output.

Consider the table below. It shows four combinations, i.e. A, B, C and D, which
produce varying levels of output.

Units of Units of
Factor combinations
Labour Capital

A 5 9
 42

B 10 6

C 15 4

D 20 3

Plotting these figures on a graph provides us with this curve (Figure 1):

Source:Economicsdiscussion.net

The X-axis shows units of labour, while the Y-axis represents units of capital.
Points A, B, C and D are combinations of factors on which IQ is the level of
output, i.e. 100 units. IQ1 and IQ2 represent greater potential output.

Isocost Lines

Isocost lines represent combinations of two factors that can be bought with
different outlays. In other words, it shows how we can spend money on two
 43

different factors to produce maximum output. These lines are also called budget
lines or budget constraint lines.

Let’s assume that a farmer has Rs. 1,000 to spend on labour costs and ploughs for
farming. The cost of one such plough and wage per labourer is Rs. 100.
Considering his total outlay of Rs. 1,000, he can spend that money in the
following combinations:

Plo 1 2 3 4 5 6 7 8 9
10
ugh 0 0 0 0 0 0 0 0 0 0
00
s 0 0 0 0 0 0 0 0 0

9 8 7 6 5 4 3 2 1
Lab 10
0 0 0 0 0 0 0 0 0 0
our 00
0 0 0 0 0 0 0 0 0

The farmer, in this case, can either spend the entire sum of Rs. 1,000 on just
ploughs by buying 10 of them. Similarly, he can also spend it all on labour by
employing 10 labourers. He can even purchase both, labour and ploughs using
different combinations as shown above. The total outlay of Rs. 1,000 will remain
the same. Hence, the isocost line will remain straight as shown below:

The x-axis represents units of ploughs, and Y-axis would show units of labour.
Output levels are shown by a straight line because they remain constant.
 44

Production Equilibrium

Isoquant curves, as we learned above, show us input combinations that we can

employ to produce certain levels of output. Furthermore, isocost lines help us
determine combinations of two factors in which we can invest our outlays to
produce output. A combination of these two graphs is what gives us the optimum
production level, i.e. the producer’s equilibrium.

Using this equilibrium, the producer can determine different combinations to

increase output. He can also use this information to find ways to cut costs using
the same inputs and consequently generate more profit. We can find out the least
expensive combinations of factors by superimposing isoquant curves on isoquant
lines.

Plotting Producer’s Equilibrium

The graph below shows how we can use isoquant curve and isocost lines to
determine optimum producer’s equilibrium.

Source:Economicsdiscussion.net

In the figure shown above, the isoquant curve represents targeted output, i.e. 200
units. Icocost lines EF, GH and KP show three different combinations in which
we can utilize the total outlay of inputs, i.e. capital and labour.
 45

The isoquant curve crosses all three isocost lines on points R, M and T. These
points show how much costs we will incur in producing 200 units. All three
combinations produce the same output of 200 units, but the least costly for the
producer will be point M, where isocost line GH is tangent to the isoquant curve.

Points R and T also cross the isoquant curve and equally produce 200 units, but
they will be more expensive because they are on the higher isocost line of KP. At
point R the producer will spend more on capital, and labour will be more
expensive on point T.

Thus, point M is the producer’s equilibrium. It will produce the same output of
200 units, but will a more profitable combination as it will cost less. The producer
must, therefore, spend OC amount on capital and OL amount on labour.

TYPES OF MARKET STRUCTURES

We can characterize market structures based on the competition levels and the
nature of these markets. Let us study the four basic types of market structures.

Types of Market Structures

There are other determinants of market structures such as the nature of the goods
and products, the number of sellers, number of consumers, the nature of the
product or service, economies of scale etc. We will discuss the four basic types of
market structures in any economy.

1] Perfect Competition

In a perfect competition market structure, there are a large number of buyers and
sellers. All the sellers of the market are small sellers in competition with each
other. There is no one big seller with any significant influence on the market. So
all the firms in such a market are price takers.
 46

There are certain assumptions when discussing the perfect competition. This is the
reason a perfect competition market is pretty much a theoretical concept.
These assumptions are as follows,

• The products on the market are homogeneous, i.e. they are completely
identical
• All firms only have the motive of profit maximization
• There is free entry and exit from the market, i.e. there are no barriers
• And there is no concept of consumer preference

2] Monopolistic Competition

This is a more realistic scenario that actually occurs in the real world. In
monopolistic competition, there are still a large number of buyers as well as
sellers. But they all do not sell homogeneous products. The products are similar
but all sellers sell slightly differentiated products.

Now the consumers have the preference of choosing one product over another.
The sellers can also charge a marginally higher price since they may enjoy some
market power. So the sellers become the price setters to a certain extent.

For example, the market for cereals is a monopolistic competition. The products
are all similar but slightly differentiated in terms of taste and flavours. Another
such example is toothpaste.

3] Oligopoly

In an oligopoly, there are only a few firms in the market. While there is no clarity
about the number of firms, 3-5 dominant firms are considered the norm. So in the
case of an oligopoly, the buyers are far greater than the sellers.

The firms in this case either compete with another to collaborate together, They
use their market influence to set the prices and in turn maximize their profits. So
the consumers become the price takers. In an oligopoly, there are various barriers
to entry in the market, and new firms find it difficult to establish themselves.

4] Monopoly

In a monopoly type of market structure, there is only one seller, so a single firm
will control the entire market. It can set any price it wishes since it has all the
 47

market power. Consumers do not have any alternative and must pay the price set
by the seller.

Monopolies are extremely undesirable. Here the consumer loose all their power
and market forces become irrelevant. However, a pure monopoly is very rare in
reality.
 48

'MACROECONOMICS'
Definition: Macroeconomics is the branch of economics that studies the behavior
and performance of an economy as a whole. It focuses on the aggregate changes
in the economy such as unemployment, growth rate, gross domestic product and
inflation.
The topics studied in macroeconomics include:

• GDP
• Price levels
• Inflation rates
• Political economy
• Unemployment rates
• Finance development
• Fiscal and monetary policies
• National and international trade
• Government savings and investments

National Income: Definition, Concepts and Methods of Measuring National

Income

National Income: Definition, Concepts and Methods of Measuring National

Income!
Introduction:
National income means the total value of goods and services produced annually
in a country.

In other words, the total amount of income accruing to a country from economic
activities in a year’s time is known as national income. It includes payments
made to all resources in the form of wages, interest, rent and profits.

1. Definitions of National Income:

The definitions of national income can be grouped into two classes: One, the
traditional definitions advanced by Marshall, Pigou and Fisher; and two,
modern definitions.
 49

The Marshallian Definition:

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. This is the true net
annual income or revenue of the country or national dividend.”

The Pigouvian Definition:

A.C. Pigou has in his definition of national income included that income which
can be measured in terms of money. In the words of 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.”

Fisher’s Definition:
Fisher adopted ‘consumption’ as the criterion of national income whereas
Marshall and Pigou regarded it to be production. According to Fisher, “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.”

Modern Definitions:
From the modern point of view, Simon Kuznets has defined national income as
“the net output of commodities and services flowing during the year from the
country’s productive system in the hands of the ultimate consumers.”

2. Concepts of National Income:

There are a number of concepts pertaining to national income and methods of
measurement relating to them.
 50

(A) Gross Domestic Product (GDP):

GDP is the total value of goods and services produced within the country during
a year. This is calculated at market prices and is known as GDP at market
prices.

There are three different ways to measure GDP:

Product Method, Income Method and Expenditure Method.

These three methods of calculating GDP yield the same result because National
Product = National Income = National Expenditure.

1. The Product Method:

In this method, the value of all goods and services produced in different
industries during the year is added up. This is also known as the value added
method to GDP or GDP at factor cost by industry of origin.

2. The Income Method:

The people of a country who produce GDP during a year receive incomes from
their work. Thus GDP by income method is the sum of all factor incomes:
Wages and Salaries (compensation of employees) + Rent + Interest + Profit.

3. Expenditure Method:
This method focuses on goods and services produced within the country during
one year.

(1) Consumer expenditure on services and durable and non-durable goods (C),
(2) Investment in fixed capital such as residential and non-residential building,
machinery, and inventories (I), (3) Government expenditure on final goods and
services (G), (4) Export of goods and services produced by the people of
country (X), (5) Less imports (M).
 51

Thus GDP by expenditure method at market prices = C+ I + G + (X – M),

where (X-M) is net export which can be positive or negative.

(B) GDP at Factor Cost:

GDP at factor cost is the sum of net value added by all producers within the
country. Since the net value added gets distributed as income to the owners of
factors of production, GDP is the sum of domestic factor incomes and fixed
capital consumption (or depreciation).

Thus GDP at Factor Cost = Net value added + Depreciation.

(C) Net Domestic Product (NDP):

NDP is the value of net output of the economy during the year. Some of the
country’s capital equipment wears out or becomes obsolete each year during the
production process. The value of this capital consumption is some percentage of
gross investment which is deducted from GDP. Thus Net Domestic Product =
GDP at Factor Cost – Depreciation.

(D) Nominal and Real GDP:

When GDP is measured on the basis of current price, it is called GDP at current
prices or nominal GDP. On the other hand, when GDP is calculated on the basis
of fixed prices in some year, it is called GDP at constant prices or real GDP.

Nominal GDP is the value of goods and services produced in a year and
measured in terms of rupees (money) at current (market) prices.

To find out the real GDP, a base year is chosen when the general price level is
normal, i.e., it is neither too high nor too low. The prices are set to 100 (or 1) in
the base year.

Suppose 1990-91 is the base year and GDP for 1999-2000 is Rs. 6, 00,000
crores and the price index for this year is 300.
 52

Thus, Real GDP for 1999-2000 = Rs. 6, 00,000 x 100/300 = Rs. 2, 00,000
crores

(E) GDP Deflator:

GDP deflator is an index of price changes of goods and services included in
GDP. It is a price index which is calculated by dividing the nominal GDP in a
given year by the real GDP for the same year and multiplying it by 100. Thus,

It shows that at constant prices (1993-94), GDP in 1997-98 increased by

135.9% due to inflation (or rise in prices) from Rs. 1049.2 thousand crores in
1993-94 to Rs. 1426.7 thousand crores in 1997-98.

(F) Gross National Product (GNP):

GNP is the total measure of the flow of goods and services at market value
resulting from current production during a year in a country, including net
income from abroad.

GNP includes four types of final goods and services:

(1) Consumers’ goods and services to satisfy the immediate wants of the people;

(2) Gross private domestic investment in capital goods consisting of fixed

capital formation, residential construction and inventories of finished and
unfinished goods;

(3) Goods and services produced by the government; and

(4) Net exports of goods and services, i.e., the difference between value of
exports and imports of goods and services, known as net income from abroad.

Three Approaches to GNP:

 53

Three approaches are employed for this purpose. One, the income method to
GNP; two, the expenditure method to GNP and three, the value added method
to GNP. Since gross income equals gross expenditure, GNP estimated by all
these methods would be the same with appropriate adjustments.

1. Income Method to GNP:

The income method to GNP consists of the remuneration paid in terms of
money to the factors of production annually in a country.

Thus GNP is the sum total of the following items:

(i) Wages and salaries:
Under this head are included all forms of wages and salaries earned through
productive activities by workers and entrepreneurs. It includes all sums received
or deposited during a year by way of all types of contributions like overtime,
commission, provident fund, insurance, etc.

(ii) Rents:
Total rent includes the rents of land, shop, house, factory, etc. and the estimated
rents of all such assets as are used by the owners themselves.

(iii) Interest:
Under interest comes the income by way of interest received by the individual
of a country from different sources.

(iv) Dividends:
Dividends earned by the shareholders from companies are included in the GNP.

(v) Undistributed corporate profits:

Profits which are not distributed by companies and are retained by them are
included in the GNP.

(vi) Mixed incomes:

 54

These include profits of unincorporated business, self-employed persons and

partnerships. They form part of GNP.

(vii) Direct taxes:

Taxes levied on individuals, corporations and other businesses are included in
the GNP.

(viii) Indirect taxes:

The government levies a number of indirect taxes, like excise duties and sales
tax.

These taxes are included in the price of commodities. But revenue from these
goes to the government treasury and not to the factors of production. Therefore,
the income due to such taxes is added to the GNP.

(ix) Depreciation:
Every corporation makes allowance for expenditure on wearing out and
depreciation of machines, plants and other capital equipment. Since this sum
also is not a part of the income received by the factors of production, it is,
therefore, also included in the GNP.

(x) Net income earned from abroad:

This is the difference between the value of exports of goods and services and
the value of imports of goods and services. If this difference is positive, it is
added to the GNP and if it is negative, it is deducted from the GNP.

Thus GNP according to the Income Method = Wages and Salaries + Rents +
Interest + Dividends + Undistributed Corporate Profits + Mixed Income +
Direct Taxes + Indirect Taxes + Depreciation + Net Income from abroad.

2. Expenditure Method to GNP:

 55

From the expenditure view point, GNP is the sum total of expenditure incurred
on goods and services during one year in a country.

It includes the following items:

(i) Private consumption expenditure:
It includes all types of expenditure on personal consumption by the individuals
of a country. It comprises expenses on durable goods like watch, bicycle, radio,
etc., expenditure on single-used consumers’ goods like milk, bread, ghee,
clothes, etc., as also the expenditure incurred on services of all kinds like fees
for school, doctor, lawyer and transport. All these are taken as final goods.

(ii) Gross domestic private investment:

Under this comes the expenditure incurred by private enterprise on new
investment and on replacement of old capital. It includes expenditure on house
construction, factory- buildings, and all types of machinery, plants and capital
equipment.

(iii) Net foreign investment:

It means the difference between exports and imports or export surplus.
Therefore, the difference of value between exports (X) and imports (M),
whether positive or negative, is included in the GNP.

(iv) Government expenditure on goods and services:

The expenditure incurred by the government on goods and services is a part of
the GNP. Central, state or local governments spend a lot on their employees,
police and army. To run the offices, the governments have also to spend on
contingencies which include paper, pen, pencil and various types of stationery,
cloth, furniture, cars, etc.

Thus GNP according to the Expenditure Method=Private Consumption

Expenditure (C) + Gross Domestic Private Investment (I) + Net Foreign
 56

Investment (X-M) + Government Expenditure on Goods and Services (G) = C+

I + (X-M) + G.

3. Value Added Method to GNP:

Another method of measuring GNP is by value added. In calculating GNP, the
money value of final goods and services produced at current prices during a
year is taken into account. This is one of the ways to avoid double counting. But
it is difficult to distinguish properly between a final product and an intermediate
product.

(G) GNP at Market Prices:

When we multiply the total output produced in one year by their market prices
prevalent during that year in a country, we get the Gross National Product at
market prices. Thus GNP at market prices means the gross value of final goods
and services produced annually in a country plus net income from abroad. It
includes the gross value of output of all items from (1) to (4) mentioned under
GNP. GNP at Market Prices = GDP at Market Prices + Net Income from
Abroad.

(H) GNP at Factor Cost:

GNP at factor cost is the sum of the money value of the income produced by
and accruing to the various factors of production in one year in a country. It
includes all items mentioned above under income method to GNP less indirect
taxes.

GNP at Factor Cost = GNP at Market Prices – Indirect Taxes + Subsidies.

(I) Net National Product (NNP):

NNP includes the value of total output of consumption goods and investment
goods. But the process of production uses up a certain amount of fixed capital.
Some fixed equipment wears out, its other components are damaged or
destroyed, and still others are rendered obsolete through technological changes.
 57

So NNP = GNP—Depreciation.

(J) NNP at Market Prices:

Net National Product at market prices is the net value of final goods and
services evaluated at market prices in the course of one year in a country. If we
deduct depreciation from GNP at market prices, we get NNP at market prices.
So NNP at Market Prices = GNP at Market Prices—Depreciation.

(K) NNP at Factor Cost:

Net National Product at factor cost is the net output evaluated at factor prices. It
includes income earned by factors of production through participation in the
production process such as wages and salaries, rents, profits, etc. It is also called
National Income. This measure differs from NNP at market prices in that
indirect taxes are deducted and subsidies are added to NNP at market prices in
order to arrive at NNP at factor cost. Thus

NNP at Factor Cost = NNP at Market Prices – Indirect taxes+ Subsidies

= GNP at Market Prices – Depreciation – Indirect taxes + Subsidies.

= National Income.

(L) Domestic Income:

Income generated (or earned) by factors of production within the country from
its own resources is called domestic income or domestic product.

Domestic income includes:

(i) Wages and salaries, (ii) rents, including imputed house rents, (iii) interest,
(iv) dividends, (v) undistributed corporate profits, including surpluses of public
undertakings, (vi) mixed incomes consisting of profits of unincorporated firms,
self- employed persons, partnerships, etc., and (vii) direct taxes.
 58

(M) Private Income:

Private income is income obtained by private individuals from any source,
productive or otherwise, and the retained income of corporations. It can be
arrived at from NNP at Factor Cost by making certain additions and deductions.

The additions include transfer payments such as pensions, unemployment

allowances, sickness and other social security benefits, gifts and remittances
from abroad, windfall gains from lotteries or from horse racing, and interest on
public debt. The deductions include income from government departments as
well as surpluses from public undertakings, and employees’ contribution to
social security schemes like provident funds, life insurance, etc.

Thus Private Income = National Income (or NNP at Factor Cost) + Transfer
Payments + Interest on Public Debt — Social Security — Profits and Surpluses
of Public Undertakings.

(N) Personal Income:

Personal income is the total income received by the individuals of a country
from all sources before payment of direct taxes in one year.

Personal Income = National Income – Undistributed Corporate Profits – Profit

Taxes – Social Security Contribution + Transfer Payments + Interest on Public
Debt.

Personal income differs from private income in that it is less than the latter
because it excludes undistributed corporate profits.

Thus Personal Income = Private Income – Undistributed Corporate Profits –

Profit Taxes.

(O) Disposable Income:

Disposable income or personal disposable income means the actual income
which can be spent on consumption by individuals and families. The whole of
 59

the personal income cannot be spent on consumption, because it is the income

that accrues before direct taxes have actually been paid. Therefore, in order to
obtain disposable income, direct taxes are deducted from personal income. Thus
Disposable Income=Personal Income – Direct Taxes.

Disposable Income = Consumption Expenditure + Savings.

(Q) Per Capita Income:

The average income of the people of a country in a particular year is called Per
Capita Income for that year. This concept also refers to the measurement of
income at current prices and at constant prices. For instance, in order to find out
the per capita income for 2001, at current prices, the national income of a
country is divided by the population of the country in that year.

Similarly, for the purpose of arriving at the Real Per Capita Income, this very
formula is used.

3. Methods of Measuring National Income:

There are four methods of measuring national income. Which method is to be
used depends on the availability of data in a country and the purpose in hand.

(1) Product Method:

According to this method, the total value of final goods and services produced
in a country during a year is calculated at market prices. To find out the GNP,
the data of all productive activities, such as agricultural products, wood received
from forests, minerals received from mines, commodities produced by
industries, the contributions to production made by transport, communications,
insurance companies, lawyers, doctors, teachers, etc. are collected and assessed
 60

at market prices. Only the final goods and services are included and the
intermediary goods and services are left out.

(2) Income Method:

According to this method, the net income payments received by all citizens of a
country in a particular year are added up, i.e., net incomes that accrue to all
factors of production by way of net rents, net wages, net interest and net profits
are all added together but incomes received in the form of transfer payments are
not included in it. The data pertaining to income are obtained from different
sources, for instance, from income tax department in respect of high income
groups and in case of workers from their wage bills.

(3) Expenditure Method:

According to this method, the total expenditure incurred by the society in a
particular year is added together and includes personal consumption
expenditure, net domestic investment, government expenditure on goods and
services, and net foreign investment. This concept is based on the assumption
that national income equals national expenditure.

(4) Value Added Method:

Another method of measuring national income is the value added by industries.
The difference between the value of material outputs and inputs at each stage of
production is the value added. If all such differences are added up for all
industries in the economy, we arrive at the gross domestic product.

4. Difficulties or Limitations in Measuring National Income:

There are many conceptual and statistical problems involved in measuring
national income by the income method, product method, and expenditure
method.

We discuss them separately in the light of the three methods:

 61

(A) Problems in Income Method:

The following problems arise in the computation of National Income by
income method:
1. Owner-occupied Houses:
A person who rents a house to another earns rental income, but if he occupies
the house himself, will the services of the house-owner be included in national
income. The services of the owner-occupied house are included in national
income as if the owner sells to himself as a tenant its services.

2. Self-employed Persons:
Another problem arises with regard to the income of self-employed persons. In
their case, it is very difficult to find out the different inputs provided by the
owner himself. He might be contributing his capital, land, labour and his
abilities in the business. But it is not possible to estimate the value of each
factor input to production. So he gets a mixed income consisting of interest,
rent, wage and profits for his factor services. This is included in national
income.

3. Goods meant for Self-consumption:

In under-developed countries like India, farmers keep a large portion of food
and other goods produced on the farm for self-consumption. The problem is
whether that part of the produce which is not sold in the market can be included
in national income or not. If the farmer were to sell his entire produce in the
market, he will have to buy what he needs for self-consumption out of his
money income. If, instead he keeps some produce for his self-consumption, it
has money value which must be included in national income.

4. Wages and Salaries paid in Kind:

Another problem arises with regard to wages and salaries paid in kind to the
employees in the form of free food, lodging, dress and other amenities.
Payments in kind by employers are included in national income. This is because
 62

the employees would have received money income equal to the value of free
food, lodging, etc. from the employer and spent the same in paying for food,
lodging, etc.

(B) Problems in Product Method:

The following problems arise in the computation of national income by
product method:
1. Services of Housewives:
The estimation of the unpaid services of the housewife in the national income
presents a serious difficulty. A housewife renders a number of useful services
like preparation of meals, serving, tailoring, mending, washing, cleaning,
bringing up children, etc.

2. Intermediate and Final Goods:

The greatest difficulty in estimating national income by product method is the
failure to distinguish properly between intermediate and final goods. There is
always the possibility of including a good or service more than once, whereas
only final goods are included in national income estimates. This leads to the
problem of double counting which leads to the overestimation of national
income.

3. Second-hand Goods and Assets:

Another problem arises with regard to the sale and purchase of second-hand
goods and assets. We find that old scooters, cars, houses, machinery, etc. are
transacted daily in the country. But they are not included in national income
because they were counted in the national product in the year they were
manufactured.

4. Illegal Activities:
Income earned through illegal activities like gambling, smuggling, illicit
extraction of wine, etc. is not included in national income. Such activities have
 63

value and satisfy the wants of the people but they are not considered productive
from the point of view of society.

5. Consumers’ Service:
There are a number of persons in society who render services to consumers but
they do not produce anything tangible. They are the actors, dancers, doctors,
singers, teachers, musicians, lawyers, barbers, etc. The problem arises about the
inclusion of their services in national income since they do not produce tangible
commodities. But as they satisfy human wants and receive payments for their
services, their services are included as final goods in estimating national
income.

9. Price Changes:
National income by product method is measured by the value of final goods and
services at current market prices. But prices do not remain stable. They rise or
fall. When the price level rises, the national income also rises, though the
national production might have fallen.

(C) Problems in Expenditure Method:

The following problems arise in the calculation of national income by
expenditure method:
(1) Government Services:
In calculating national income by, expenditure method, the problem of
estimating government services arises. Government provides a number of
services, such as police and military services, administrative and legal services.
Should expenditure on government services be included in national income?

(2) Transfer Payments:

There arises the problem of including transfer payments in national income.
Government makes payments in the form of pensions, unemployment
allowance, subsidies, interest on national debt, etc. These are government
 64

expenditures but they are not included in national income because they are paid
without adding anything to the production process during the current year.

(3) Durable-use Consumers’ Goods:

Durable-use consumers’ goods also pose a problem. Such durable-use
consumers’ goods as scooters, cars, fans, TVs, furniture’s, etc. are bought in one
year but they are used for a number of years. Should they be included under
investment expenditure or consumption expenditure in national income
estimates? The expenditure on them is regarded as final consumption
expenditure because it is not possible to measure their used up value for the
subsequent years.

(4) Public Expenditure:

Government spends on police, military, administrative and legal services, parks,
street lighting, irrigation, museums, education, public health, roads, canals,
buildings, etc. The problem is to find out which expenditure is consumption
expenditure and which investment expenditure is.

5. Importance of National Income Analysis:

The national income data have the following importance:

1. For the Economy:
National income data are of great importance for the economy of a country.
These days the national income data are regarded as accounts of the economy,
which are known as social accounts. These refer to net national income and net
national expenditure, which ultimately equal each other.

2. National Policies:
National income data form the basis of national policies such as employment
policy, because these figures enable us to know the direction in which the
 65

industrial output, investment and savings, etc. change, and proper measures can
be adopted to bring the economy to the right path.

3. Economic Planning:
In the present age of planning, the national data are of great importance. For
economic planning, it is essential that the data pertaining to a country’s gross
income, output, saving and consumption from different sources should be
available. Without these, planning is not possible.

4. Economic Models:
The economists propound short-run as well as long-run economic models or
long-run investment models in which the national income data are very widely
used.

5. Research:
The national income data are also made use of by the research scholars of
economics. They make use of the various data of the country’s input, output,
income, saving, consumption, investment, employment, etc., which are obtained
from social accounts.

6. Per Capita Income:

National income data are significant for a country’s per capita income which
reflects the economic welfare of the country. The higher the per capita income,
the higher the economic welfare of the country.

7. Distribution of Income:
National income statistics enable us to know about the distribution of income in
the country. From the data pertaining to wages, rent, interest and profits, we
learn of the disparities in the incomes of different sections of the society.
Similarly, the regional distribution of income is revealed.
 66

Consumption Function and Multiplier

The consumption function, or Keynesian consumption function, is an economic

formula that represents the functional relationship between total consumption and
gross national income. It was introduced by British economist John Maynard
Keynes, who argued the function could be used to track and predict total
aggregate consumption expenditures.

Calculating the Consumption Function

The consumption function is represented as:

C = A + MD

where:C=consumer spendingA=autonomous consumptionM=marginal propens

ity to consumeD=real disposable income
The Consumption Function The consumption function is an equation describing
how a household’s level of consumption varies with its disposable income. In
order to fully understand the consumption function, we need to understand a few
ideas about household income and how they choose to use that income.

A household’s disposable income is their income after net taxes

Out of each additional dollar a household earns, they can choose to either save
or consume it.
The fraction of each dollar that a household chooses to consume is referred to as
the marginal
propensity to consume. The fraction of each dollar that a household chooses to
save is the marginal propensity to save.
 67

For simplicity, assume that taxes are lump sum, i.e. tax is constant regardless of
income earned, or earned in addition, this means that out of each additional
dollar earned, you must either spend or save the entire dollar. As a result the
MPC and MPS must always add up to equal 1.

What happens when your disposable income is zero? You must still consume in
order to survive (food, clothes, etc.). This amount that you consume when your
income is zero is called autonomous consumption. With this, we are ready to
derive the consumption function:

Example 2. When David has no income, he spends $500. If his income

increases to $2000, he spends $1900. What is his consumption function?
The Aggregate Expenditure Model
The aggregate expenditure (or income-expenditure) model is a macroeconomic
model that
focuses on the relationship between total spending and real GDP, assuming the
price level is
constant. To fully investigate this model we first need to define the aggregate
expenditure
function.

Remember when dealing with this formula that C here is referring to the
consumption function. Also of note is a new term, which in this model
refers to planned investment. Planned investment refers to the investment
spending businesses intend to carry out in a given time period. In this chapter it
 68

is given, but in general (and as we will see in later chapters), it is a function if

the interest rate, r. Missing in this equation is unplanned investment, which
refers to unplanned changes to inventories firms make during a given time
period. Actual investment spending, then, is the sum of these two

Aggregate Expenditure Model Equilibrium

In the previous section we described how aggregate expenditures plus
unplanned investment
equals GDP. What are the implications of this for the economy? For instance, if
aggregate
expenditures are larger than GDP, this means that unplanned inventories must
be negative in
order for this formula to hold. However, if this is true, that means that there are
unexpected
decreases in inventories. How are firms going to respond to this? By increasing
production to
meet this demand for expenditures, by producing more goods though, this leads
to an increase in GDP, which in turn leads to a decrease in GDP. We can
summarize the logic as follows:

Therefore, the only time when GDP is not changing is when aggregate
expenditures are equal to GDP. This is what we call the macroeconomic
equilibrium of this model:
Macroeconomic equilibrium

We can illustrate these ideas graphically. If we place the function AE = Y on the

graph containing the aggregate expenditures function, it represents all of the
possible equilibrium points in the economy. The macroeconomic equilibrium is
 69

thus the point where the aggregate expenditures function intersects with this
line, often referred to as the 45° line.
Note however that the macroeconomic equilibrium here does not correspond to
the economy
being at full employment. In fact, it is possible for the economy to be in
equilibrium, but be
below full employment GDP, in which case we are in a recession, or above full
employment
GDP, in which case we are in a boom. In these cases we cannot get to full
employment by
moving along the current aggregate expenditures line. Instead we have to shift
the aggregate
expenditures function.
The Multiplier and Shifting the Aggregate Expenditures Function
The multiplier effect describes how changes in autonomous expenditures lead to
changes in real GDP. This is best illustrated with an example:
In general, the multiplier can be described with the following formula:

Tutorial: Determining how spending needs to change to reach full employment

GDP
Step 1: Determine the MPC (if applicable)
You may not always be given the MPC to use for the multiplier. If not use the
information in the question to determine the MPC
Step 2: Determine Δ𝑌
The change in GDP in these questions can be defined as follows:

A) What is the equilibrium level of real GDP?

B) What is the MPC?
C) If potential GDP is $7000 billion, is the economy at full employment? If not,
what is the
condition of the economy?
D) If the economy is not at full employment, by how much should government
spending
 70

increase so that the economy can move to the full employment level of GDP?
Practice Questions
1. On the 45-degree line diagram, for points that lie above 45-degree line,
a) planned aggregate expenditure is greater than GDP.
b) planned aggregate expenditure is equal to GDP.
c) planned aggregate expenditure is less than GDP.
d) planned aggregate expenditure is less than aggregate income.
2. How does a decrease in government spending affect the aggregate
expenditure line?
a) It shifts the aggregate expenditure line downward.
b) It increases the slope of the aggregate expenditure line.
c) It shifts the aggregate expenditure line upward.
d) It decreases the slope of the aggregate expenditure line.
3. (Refer to the image to the left). Suppose
that the level of GDP associated with point N
is potential GDP. If the U.S. economy is
currently at point K,
a) Firms are operating above capacity.
b) The economy is at full employment.
c) The economy is in recession.
d) The level of unemployment is equal to the
natural rate.
 71

9. Suppose potential GDP is 4000. Is this market operating at full employment?

a) Yes, the market is at full employment
b) No, the market is in recession
c) No, the market is in expansion
d) Not enough information
10. If the government wanted to reach full employment, how much would it
need to spend to
achieve this goal?
a) 0 b) -450 c) 600 d) 1500
11. If the MPC is 0.95, then a $10 million increase in disposable income will
a) increase consumption by $200 million.
b) increase consumption by $9.5 million.
c) increase consumption by $105 million.
d) decrease consumption by $950 million.
12. If an increase in autonomous expenditure of $10 million results in a $50
million increase in
equilibrium real GDP, then the MPC is:
a) 0.5 b) 0.75 c) 0.8 d) 0.9
13. If the consumption function is defined as C = 5500 + 0.9Y, what is the value
of the
multiplier?
a) 0.1 b) 0.9 c) 9 d) 10
Answer:
1. a) 2. a) 3. c) 4. d) 5. c) 6. a) 7. d)
8. a) 9. b) 10. c) 11. b) 12. c) 13. d)
Determination of Equilibrium Level of Income and output.

Determination of Equilibrium Level of Income!

 72

According to the Keynesian Theory, equilibrium condition is generally stated in

terms of aggregate demand (AD) and aggregate supply (AS). An economy is in
equilibrium when aggregate demand for goods and services is equal to
aggregate supply during a period of time.

So, equilibrium is achieved when:

AD = AS … (1)

We know, AD is the sum total of Consumption (C) and Investment (I):

AD = C + I … (2)

Also, AS is the sum total of consumption (C) and saving (S):

AS = C + S … (3)

Substituting (2) and (3) in (1), we get:

C+S=C+I

Or, S = I

It means, according to Keynes, there are Two Approaches for determining the
equilibrium level of income and employment in the economy:

It must be noted that Equilibrium level of income and employment can also be
determined according to ‘Classical Theory’. However, the scope of syllabus is
limited to the Keynesian theory.

Two Approaches for Determination of Equilibrium Level:

The two approaches to determine equilibrium level of income, output and
employment in the economy are:
1. Aggregate Demand-Aggregate Supply Approach (AD-AS Approach)
 73

2. Saving-Investment Approach (S-I Approach)

It must be kept in mind that AD, AS, Saving and Investment are all planned or
ex- ante variables.

Assumptions:
Before we proceed further, let us first state the various assumptions made
in determination of equilibrium output:
(i) The determination of equilibrium output is to be studied in the context of
two-sector model (households and firms). It means, it is assumed that there is no
government and foreign sector.

(ii) It is assumed that investment expenditure is autonomous, i.e. investments

are not influenced by level of income.

(iii) Price level is assumed to remain constant.

(iv) Equilibrium output is to be determined in context of short-run.

Aggregate Demand-Aggregate Supply Approach (AD-AS Approach):

According to the Keynesian theory, the equilibrium level of income in an
economy is determined when aggregate demand, represented by C + I curve is
equal to the total output (Aggregate Supply or AS).

Aggregate demand comprises of two components:

1. Consumption expenditure CC):
It varies directly with the level of income, i.e. consumption rises with increase
in income.

2. Investment expenditure (I):

It is assumed to be independent of the level of income, i.e. investment
expenditure is autonomous. So, AD curve is represented by (C + I) curve in the
income determination analysis. Aggregate supply is the total output of goods
 74

and services of the national income. It is depicted by a 45° line. Since the
income received is either consumed or saved, the

AS curve is represented by the (C + S) curve.

The determination of equilibrium level of income can be better understood

with the help of the following schedule and diagram:
Table 8.1 Equilibrium by AD and AS Approach:

Employme Incom Consumptio Savin Investme A AS Remarks

nt (Lakhs) e (V) n (C) g (S) nt (I) D C
C +
+l S

0 0 40 -40 40 80 0 AD > AS

10 100 120 -20 40 16 10 AD > AS

0 0
20 200 200 0 40 AD > AS
24 20
30 300 280 20 40 AD > AS
0 0

32 30
0 0

40 400 360 40 40 40 40 Equilibriu

0 0 m
(AD=AS)

50 500 440 60 40 48 50 AD < AS

0 0
60 600 520 80 40 AD < AS
 75

56 60
0 0

Amount in Rs crores

In Fig. 8.1, the AD or (C +1) curve shows the desired level of expenditure by
consumers and firms corresponding to each level of output. The economy is in
equilibrium at point ‘E’ where (C + I) curve intersects the 45° line.

1. ‘E’ is the equilibrium point because at this point, the level of desired
spending on consumption and investment exactly equals the level of total
output.

2. OY is the equilibrium level of output corresponding to point E.

3. In Table 8.1, the equilibrium level of income is Rs 400 crores, when AD (or
C +1) = AS = Rs 400 crores.

4. It is a situation of ‘Effective Demand’. Effective demand refers to that level

of AD which becomes ‘effective’ because it is equal to AS.
 76

If there is any deviation from the equilibrium level of output, i.e. when planned
spending (AD) is not equal to planned output (AS), then a process of
readjustment will start in the economy and the output will tend to adjust up or
down until AD and AS are equal again.

When planned spending (AD) is more than planned output (AS), then (C + I)
curve lies above the 45° line. It means that consumers and firms together would
be buying more goods than firms are willing to produce. As a result, the planned
inventory would fall below the desired level.

To bring the inventory back to the desired level, firms would resort to increase
in employment and output until the economy is back at output level OY, where
AD becomes equal to AS and there is no further tendency to change.

When AD is less than AS:

When AD < AS, then (C +1) curve lies below the 45° line. It means that
consumers and firms together would be buying less goods than firms are willing
to produce. As a result, the planned inventory would rise. To clear the unwanted
increase in inventory, firms plan to decrease the employment and output until
the economy is back at output level OY, where AD becomes equal to AS and
there is no further tendency to change.

It must be noted that equilibrium level may or may not be at the level of full
employment, i.e. equilibrium is possible even at a level lower than the full
employment level.

For instance, in Table 8.1, employment level is 40 lakhs corresponding to

equilibrium income of Rs 400 crores. It is not the full employment level since
employment increases even after the equilibrium level.
 77

Saving-Investment Approach (S-l Approach):

According to this approach, the equilibrium level of income is determined at a
level, when planned saving (S) is equal to planned investment (I).

Let us understand this with the help of following schedule and diagram:
Table 8.2 Equilibrium by Saving and Investment Approach
Amount in Rs crores

Income (Y) Consumption (C) Saving (S) Investment (I) Remarks

0 40 -40 40 S<1

100 120 -20 40 S<1

200 200 0 40 S<1

300 280 20 40 S<1

400 360 40 40 Equilibrium

(S=1)

500 440 60 40 S>1

600 520 80 40 S>1

In Fig 8.2, Investment curve (I) is parallel to the X-axis because of the
autonomous character of investments. The Saving curve (S) slopes upwards
showing that as income rises, saving also rises.

1. The economy is in equilibrium at point ‘E’ where saving and investment

curves intersect each other.

2. At point ‘E’, ex-ante saving is equal to ex-ante investment.

 78

3. OY is the equilibrium level of output corresponding to point E.

4. In Table 8.2, the equilibrium level of income is Rs 400 crores, when planned
saving – planned investment = RS 400 crores.

If there is any deviation from the equilibrium level of income, i.e., if planned
saving is not equal to the planned investment, then a process of readjustment
will start which will bring the economy back to the equilibrium level.

When saving is more than Investment:

If planned saving is more than planned investment, i.e. after point ‘E’ in Fig.
8.2, it means that households are not consuming as much as the firms expected
them to. As a result, the inventory rises above the desired level. To clear the
unwanted increase in inventory, firms would plan to reduce the production till
saving and investment become equal to each other.
When saving is less than Investment:
If planned saving is less than planned investment, i.e. before point ‘E’ in Fig.
8.2, it means that households are consuming more and saving less than what the
firms expected them to. As a result, planned inventory would fall below the
desired level. To bring the inventory back to the desired level, firms would plan
to increase the production till saving and investment become equal to each
other.
 79

What is inflation and how it works?

Inflation is an economic indicator that indicates the rate of rising prices of
goods and services in the economy. Ultimately it shows the decrease in the
buying power of the rupee. It is measured as a percentage.
This percentage indicates the increase or decrease from the previous period.
Inflation can be a cause of concern as the value of money keeps decreasing as
inflation rises.
Different types of inflation
Inflation means a sustained increase in the general price level. The main two
types of inflation are

1. Demand-pull inflation – this occurs when the economy grows

quickly and starts to ‘overheat’ – Aggregate demand (AD) will be
increasing faster than aggregate supply (LRAS).
2. Cost-push inflation – this occurs when there is a rise in the price of
raw materials, higher taxes, e.t.c
We can also categorise inflation by how fast the price increases are, such as:

• Disinflation – a falling rate of inflation

• Creeping inflation – low, but consistently creeping up.
• Walking/moderate inflation – (2-10%)
• Running inflation (10-20%)
 80

Demand Pull Inflation

This is when the aggregate demand in an economy exceeds the aggregate supply.
This increase in the aggregate demand might occur due to an increase in the
money supply or income or the level of public expenditure.

This concept is associated with full employment when altering the supply is not
possible. Take a look at the graph below:

In the graph above, SS is the aggregate supply curve and DD is the aggregate
demand curve. Further,

• Op is the equilibrium price

• Oq is the equilibrium output
 81

Exogenous causes shift the demand curve to the right to D1D1. Therefore, at the
current price (Op), the demand increases by qq2. However, the supply is Oq.

Hence, the excess demand for qq2 puts pressure on the price, increasing it to Op1.
Therefore, there is a new equilibrium at this price, where demand equals supply.
As you can see, the excess demand is eliminated as follows:

• The price rises which leads to a fall in demand and a rise in supply.

Cost-Push Inflation

Supply can also cause inflationary pressure. If the aggregate demand remains
unchanged but the aggregate supply falls due to exogenous causes, then the price
level increases. Take a look at the graph below:

In the graph above, the equilibrium price is Op and the equilibrium output is Oq.
If the aggregate supply falls, then the supply curve SS shifts left to reach S1S1.

Now, at the price Op, the demand is Oq but the supply is Oq2 which is lesser than
Oq. Therefore, the prices are pushed high till a new equilibrium is reached at Op1.

At this point, there is no excess demand. Hence, you can see that inflation is a
self-limiting phenomenon.
 82

Open Inflation

This is the simplest form of inflation where the price level rises continuously and
is visible to people. You can see the annual rate of increase in the price level.

Repressed Inflation

Let’s say that there is excess demand in an economy. Typically, this leads to an
increase in price.

However, the Government can take some repressive measures like

price control, rationing, etc. to prevent the excess demand from increasing
the prices.

Hyper-Inflation

In hyperinflation, the price level increases at a rapid rate. In fact, you can expect
prices to increase every hour. Usually, this leads to the demonetization of an
economy.

Creeping and Moderate Inflation

• Creeping – In this case, the price level increases very slowly over an
extended period of time.
• Moderate – In this case, the rise in the price level is neither too fast
nor too slow – it is moderate.

True Inflation

This takes place after the full employment of all the factor inputs of an economy.
When there is full employment, the national output becomes perfectly inelastic.
Therefore, more money simply implies higher prices and not more output.

Semi-Inflation

Even before full employment, an economy might face inflationary pressure due to
bottlenecks from certain sectors of the economy.
 83

Types of inflation by rate of increase

Creeping inflation (1-4%)

When the rate of inflation slowly increases over time. For example, the inflation
rate rises from 2% to 3%, to 4% a year. Creeping inflation may not be
immediately noticeable, but if the creeping rate of inflation continues, it can
become an increasing problem.

Walking inflation (2-10%)

When inflation is in single digits – less than 10%. At this rate – inflation is not a
major problem, but when it rises over 4%, Central Banks will be increasingly
concerned. Walking inflation may simply be referred to as moderate inflation.

Running inflation (10-20%)

When inflation starts to rise at a significant rate. It is usually defined as a rate

between 10% and 20% a year. At this rate, inflation is imposing significant
costs on the economy and could easily start to creep higher.

Galloping inflation (20%-1000%)

This is an inflation rate of between 20% up to 1000%. At this rapid rate of price
increases, inflation is a serious problem and will be challenging to bring under
control. Some definitions of galloping inflation may be between 20% and
100%. There is no universally agreed definition, but hyperinflation usually
implies over 1,000% a year.

Hyperinflation (> 1000%)

This is reserved for extreme forms of inflation – usually over 1,000% though
there is no specific definition. Hyperinflation usually involves prices changing
so fast, that it becomes a daily occurrence, and under hyperinflation, the value
of money will rapidly decline.

• Shrinkflation – when the price stays the same, but firms reduce the
size of the good – effectively a price increase.
• Disinflation – a fall in the inflation rate. It means prices are
increasing at a slower rate.
• Deflation – a fall in prices – a negative inflation rate.
Causes of inflation

Monetary Policy: It determines the supply of currency in the market. Excess

supply of money leads to inflation. Hence decreasing the value of the currency.
 84

Fiscal Policy: It monitors the borrowing and spending of the economy. Higher
borrowings (debt), result in increased taxes and additional currency printing to
repay the debt.
Demand-pull Inflation: Increases in prices due to the gap between the demand
(higher) and supply (lower).
Cost-push Inflation: Higher prices of goods and services due to increased cost
of production.
Exchange Rates: Exposure to foreign markets are based on the dollar value.
Fluctuations in the exchange rate have an impact on the rate of inflation.
How do we prevent inflation?
To prevent inflation, the primary strategy is to change the monetary policy by
adjusting the interest rates. Higher interest rates decrease the demand in the
economy. This results in lower economic growth and therefore, lower inflation.
Other ways to prevent inflation are:
Controlling the money supply can also help in preventing inflation.
Higher Income Tax rate can reduce the spending, and hence resulting in lesser
demand and inflationary pressures.
Introducing policies to increase the efficiency and competitiveness of the
economy helps in reducing the long term costs.
What are the effects of a rise in the inflation rate?
A rise in an inflation rate can cause more than a fall in purchase power.

• Inflation could lead to economic growth as it can be a sign of rising

demand.
• Inflation could further lead to an increase in costs due to workers demand
to increase wages to meet inflation. This might increase unemployment as
companies will have to lay off workers to keep up with the costs.
• Domestic products might become less competitive if inflation within the
country is higher. It can weaken the currency of the country.
 85

MONEY & BANKING

What Is Money?
Money is an economic unit that functions as a generally recognized medium of
exchange for transactional purposes in an economy. Money provides the
service of reducing transaction cost, namely the double coincidence of wants.
Functions of Money
Medium of exchange. Money's most important function is as a medium of
exchange to facilitate transactions. Without money, all transactions would have
to be conducted by barter, which involves direct exchange of one good or
service for another.
Store of value. In order to be a medium of exchange, money must hold its value
over time; that is, it must be a store of value. If money could not be stored for
some period of time and still remain valuable in exchange, it would not solve
the double coincidence of wants problem and therefore would not be adopted as
a medium of exchange. As a store of value, money is not unique; many other
stores of value exist, such as land, works of art, and even baseball cards and
stamps. Money may not even be the best store of value because it depreciates
with inflation. However, money is more liquid than most other stores of value
because as a medium of exchange, it is readily accepted everywhere.
Furthermore, money is an easily transported store of value that is available in a
number of convenient denominations.
Unit of account. Money also functions as a unit of account, providing
a common measure of the value of goods and services being exchanged.
Knowing the value or price of a good, in terms of money, enables both the
supplier and the purchaser of the good to make decisions about how much of the
good to supply and how much of the good to purchase.

Quantity Theory of Money

What Is the Quantity Theory of Money?
The quantity theory of money is a theory that variations in price relate to
variations in the money supply. It is most commonly expressed and taught
using the equation of exchange and is a key foundation of the economic theory
of monetarism.
Understanding the Quantity Theory of Money
Definition: Quantity theory of money states that money supply and price level
in an economy are in direct proportion to one another. When there is a change
in the supply of money, there is a proportional change in the price level and
vice-versa.

It is supported and calculated by using the Fisher Equation on Quantity Theory

of Money.

M*V= P*T
 86

where,

M = Money supply

V = Velocity of money

P = Price level

T = volume of the transactions

Description: The theory is accepted by most economists per se. However,

Keynesian economists and economists from the Monetarist School of
Economics have criticized the theory.

According to them, the theory fails in the short run when the prices are sticky.
Moreover, it has been proved that velocity of money doesn't remain constant
over time. Despite all this, the theory is very well respected and is h
Generally speaking, the quantity theory of money explains how increases in the
quantity of money tends to create inflation, and vice versa. In the original
theory, V was assumed to be constant and T is assumed to be stable with
respect to M, so that a change in M directly impacts P. In other words, if the
money supply increases then the average price level will tend to rise in
proportion (and vice versa), with little effect on real economic activity.
For example, if the Federal Reserve (Fed) or European Central Bank (ECB)
doubled the supply of money in the economy, the long-run prices in the
economy would tend to increase dramatically. This is because more money
circulating in an economy would equal more demand and spending by
consumers, driving prices up.
Criticism of Fisher's Quantity Theory of Money
Economists disagree about how quickly and how proportionately prices adjust
after a change in the quantity of money, and about how stable V and T actually
are with respect to time and to M.

MODERN QUANTITY THEORIES OF MONEY: FROM FISHER TO

CAMBRIDGE

Most economic historians who give some weight to monetary forces in

European economic history usually employ some variant of the so-
called Quantity Theory of Money. Even in the current economic history
literature, the version most commonly used is the Fisher Identity, devised by the
Yale economist Irving Fisher (1867-1947) in his book The Purchasing Power of
Money (revised edn. 1911). For that reason we cannot avoid it, even though
most economists today are reluctant to use it without significant modification.
 87

1. The Fisher Identity, or The Equation of Exchange: M.V = P.T

M = stock of money in coin, notes, bank deposits ('high-powered')
V = the velocity of circulation; the rate at which a unit of money circulates in
effecting transactions in course of one year; the average number of times it
'turns over'
P = some measure of the price level; e.g. Consumer Price Index
T = the total volume of monetary transactions that take place in the economy
during the course of that same year.
a) This is more of an identity () or tautology than it is a causal equation: it
simply states that total spending, in terms of the money stock multiplied by the
rate of its turnover or circulation, necessarily equals total spending in terms of
the total volume of monetary transactions multiplied by the current price index.
The two values on each side of the sign are necessarily identical.
b) Problems with the Fisher Identity:
i) M and P, it has been argued, are extremely difficult to estimate or calculate.
For the medieval, early modern, modern, and present day eras this is a form of
nitpicking that in no way invalidates the model. Good proxies can be provided
for most of these eras, certainly good enough to indicate general movements of
both prices and monetary stocks. The other two objections are far more
important.
ii) T really is quite impossible to calculate for any period or even to
comprehend. That is, even if we could attach a numerical value to T, it would be
rather meaningless: T = the total volume of all transactions in the economy,
both intermediate and final, from raw materials to fully manufactured products
along with all services. How can we resolve the problem of multiple counting?
How can we add up all the transactions involving so many different
commodities and services: with what common denominator? Adding together
apples and oranges (as pieces of fruit) is a very simple task by comparison.
iii) V, as a measure of the velocity of circulation or turnover of money, is not in
fact an independent variable, but rather a residual one, which has to be
calculated algebraically by first knowing the other three. Thus we can calculate
V only by this formula: V = (P.T)/M
2. The Cambridge Cash Balances Equation: M = k.P.T
This is a lesser-known rival to the Fisher Identity that emerged during the 1920s
at Cambridge, with a formula that resolved at least the problems concerning
Velocity:
a) Its originators at Cambridge (especially A.C. Pigou) asked two principal
questions:
(1) how much 'high-powered' money (usually called M1), do people currently
wish to hold in the form of cash balances (money held in coin, notes, bank
deposits), rather than being spent or invested?
(2) What, therefore, is the ratio of those cash balances to the total money value
of all transactions in the economy?
 88

b) That ratio is indicated by the letter k; and this form of the Quantity equation
now becomes: M = k(P.T). The letter k thus indicates the proportion of the total
value of all monetary transactions that the public chooses to hold in cash
balances; and thus it tells us the necessary amount of M that is required for that
level of P.T (total spending). Note that P times T again equals the total
monetary value of all transactions; and thus suffers from the same problems of
estimating the value of T, as indicated above for the Fisher Identity.
c) Liquidity Preference: a concept further developed by Keynes, who asked a
fundamental question. Why do people wish to hold cash balances, instead of
immediately spending or investing that money? He suggested three motivations.
(1) transactions motive: people hold a stock of ready cash in order to meet
their day to day needs in buying goods and paying for services, etc. This is
deemed to be the major need for holding ready cash.
(2) precautionary motive: to have ready cash on hand in order to meet some
unforseen emergency, as a contingency fund for future needs.
(3) speculative motive: to have ready cash to take immediate advantage of
some special investment opportunity -- a cash fund to speculate with.
d) Cash Balances and Opportunity Cost:

What is the cost of holding these cash balances? The true cost is
the opportunity cost: i.e. the interest or other investment income foregone by
not investing those balances. Consequently, we should find that cash balances
are to some extent interest-sensitive, and vary with interest rates. That is, the
proportion of national income held in cash balances (k) should fall as real
interest rates rise, because rising interest rates will increase the opportunity cost
of holding those balances; and conversely that proportion k held in cash
balances should rise with falling real interest rates.

e) Note that mathematically, the Fisher and Cambridge Cash Balances

equations are related: k is the reciprocal of V; V is the reciprocal of k

f) What is the difference between k and V?

Why is k a more useful variable than V? Because k is much more 'predictable;'

and conceptually k is an 'active' variable -- i.e. we should be able to predict
roughly what proportion of total national expenditures people wish to hold in
cash balances. But V, on the contrary, is a passive (i.e. resulting from) or
'residual' variable, calculated as noted only by first knowing M, P, and T. Thus
one might say that k (cash balances) is a predictive measure of velocity,
while V measures only resulting velocity.

3. The Basic Suppositions Concerning the Older Quantity Theories of

Money
a) The Demand for Money is chiefly a TRANSACTIONS DEMAND:
 89

b) The Transactions Demand for Money will be proportional to the

aggregate value of transactions (i.e. k as proportion of P.T); and this
proportion will not vary in the short run;
c) The Supply of money is exogenously determined, determined
independently of the economy (by some external authority or events).
d) Full Employment prevails: so that any increase in aggregate demand will
not increase the volume of output or transactions (T);
e) Those with excess money will spend it on goods and services; those with
insufficient supply of money will cut their expenditures on goods and services.
f) The Transactions Velocity of Money is, at least in the short run, very
stable.

METHODS AND PRINCIPLES OF NOTE ISSUE

The principles of note issue are classified into two classes. One opinion says
that complete conversion of notes into gold bars is known as the “Currency
Principle”. The second advocates the elasticity in the supply of money
according to the needs of trade and commerce, known as “Banking Principle”.
These two theories are discussed below in detail:-
Principles of Note Issue
Currency Principle
According to these principles of note issue, notes are issued against gold
reserve. The paper money is an reasonable substitute for metallic money. The
paper money should have backing hundred percent of gold reserve. If there is
lack of gold reserve against paper money. People will lose confidence in such
notes. Hence, notes issued should be limited to the limit and quantity of notes
issued will automatically expand or contract according to the inflow and
outflow of gold into and out of the country concerned. The advantages claimed
for this principal is that there is full care and protection to the paper currency.
Moreover, excess issuance of currency in this principle is no danger. In this
case, issue of currency depends on the availability of gold.
Banking Principle
Under banking principles of note issue, there is no requirement for backing of
paper money by law. Notes issued should entirely on the discretion and
necessity of the bank and trade. Bank will sustain sufficient reserve to honor the
notes in their own interest. Under this principal, the surplus money should be
routinely offered for cash payment, if there is an excess of notes issued and thus
the appropriate ratio will be sustain between gold reserve and supply of money.
This system is faced with the danger of over issue and as a result public
confidence is lacking in this system.
After reading the above mentioned principles of note issue, now we can easily
arrive at a conclusion that both these systems of note issue are defective. One
 90

scarifies elasticity and other security. These days, a certain percentage of notes
issued by the central bank backed by gold or silver.
Methods of Note Issue
Notes are issued in almost all the countries according to the “Banking
Principal”, but the reserve varies from country to country. According to the
reserve, several countries methods of note issued have been evolved which are
as under;
• Fixed Fiduciary System
• Maximum Fiduciary System
• Proportional Reserve System
• The Minimum Reserve System
1. Fixed Fiduciary System
Under this method of note issue, central bank of the country is allowed to issue
currency notes of a specified amount without presenting gold and silver to cover
it. Once this limit is reached, additional amount of notes can be issued by
hundred percent backed by gold. The advantages claimed for this method is that
it gives elasticity in the money supply. It also grant maximum care due to the
excess issuance of notes of the “Fiduciary Limit” except they are sheltered by
hundred percent of gold. The possibility of inflation is effectively checked.
However, this system is objected on the ground that judiciary limit is open to
change by amendment in the Act and is raised will lose the confidence of the
people.
2. Maximum Fiduciary System
According to this method of note issue, the fiduciary system’s limit is fixed
above the normal requirements of the country. Beyond the maximum no note is
issued without legal sanction. This system is defective in the sense that, if the
limit is too low, the currency system becomes inelastic and if the limit is too
high, there is danger of over issue of notes.
3. Proportional Reserve System
Under this method of note issue, the central bank is mandatory by law to
maintain a permanent percentage from 25% to 40% adjacent to issuance of
notes. It is often called percentage system. The remainder of the notes is to be
covered by trade bills and government securities. This system is easily operated
and it gives needed elasticity to the currency note system. But the system is
uneconomic as huge amount of gold is kept idle as reserve. Moreover, the value
of money is not stable, but this system is elastic up to a certain limit.
4. Minimum Reserve System
Under this method of note issue, the reserve limit is permanently fixed and the
volume of the notes has no connection with the amount of the reserve. To meet
the ever- increasing demand for currency, government can issue notes up to any
amount against the reserve but it is faced with the danger of the inflation.
Methods of issuing of notes in Pakistan
1. 1. Methods of Issuing of Notes in Pakistan
 91

2. 2. There are different methods of money notes issuing adopted by

different countries of the world at different times. The most important of
them are:- 1. Fixed Fiduciary System. 2. Proportional Reserve System. 3.
Minimum Reserve System. Methods of Note Issue
3. 3. Fixed Fiduciary System :- Under fixed fiduciary system, the
government fixes a fixed amount of notes without keeping any metallic
reserve. But this portion of currency must be backed by government
securities, which is called fiduciary Limit. The notes issued other than
fiduciary limit must be fully backed by gold or silver reserves. This
system was introduced in England in1844 in the Bank charter Act of
1844. Norway and Japan also adopted this method . This system acted as
a brake on the undue expansion of currency and credit in the time of
prosperity. This system also provides security for the convertibility of
notes
4. 4. Proportional Reserve System:- Under this system the central bank is
required to keep only ascertain percentage of notes issued in the form of
gold or silver. The reserve proportion is usually from 30% to 40%. It
means a central bank can issue PKR-100 note after keeping gold silver
valuing PKR. 30 or 40. This method of currency regulation is the most
affordable system of the present time and is widely used in many
countries. It was first of all adopted by Germany in1876 and followed
with modifications by U.S.A in 1914.
5. 5. Minimum Reserve System:- Fixed minimum reserve system allows the
central bank to keep only a fixed amount of reserve against whatever the
amount of note issue. The reserve is in the form of gold, silver and-
foreign exchange or in the form of any of these types of things. This
method -is being used in Pakistan after December 1965. India is also
applying it since 1957.South Africa has adopted it in 1930. Holland has
been issuing notes under this method for many years.
6. 6. Method Of Note Issue Adopted In Pakistan:- Pakistan has used
proportional reserve system up to December 1965. Under this method
30% was to be kept as reserve in the form of gold coin, gold, silver
bullion and approved foreign exchange. The balance was covered by
rupee coin and government security After 1965. State Bank of Pakistan
adopted fixed minimum reserve system Under this system the bank has to
keep only legally fixed amount of minimum reserve in gold, or silver.
Moreover the government in consultation with the State Bank can alter it.
(best answer)
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CREDIT CREATION

1. Bank as a business institution – Bank is a business institution which tries to

maximize profits through loans and advances from the deposits.
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2. Bank Deposits – Bank deposits form the basis for credit creation and are of
two types:
a) Primary Deposits – A bank accepts cash from the customer and opens a
deposit in his name. This is a primary deposit. This does not mean credit
creation. These deposits simply convert currency money into deposit money.
However, these deposits form the basis for the creation of credit.
b) Secondary or Derivative Deposits – A bank grants loans and advances and
instead of giving cash to the borrower, opens a deposit account in his name.
This is the secondary or derivative deposit. Every loan crates a deposit. The
creation of a derivative deposit means the creation of credit.
3. Cash Reserve Ratio (CRR) – Banks know that all depositors will not
withdrawal deposits at the same time. Therefore, they keep a fraction of the
total deposits for meeting the cash demand of the depositors and lend the
remaining excess deposits. CRR is the percentage of total deposits which the
banks must hold in cash reserves for meeting the depositors’ demand for cash.
4. Excess Reserves – The reserves over and above the cash reserves are the
excess reserves. These reserves are used for loans and credit creation.
5. Credit Multiplier – Given a certain amount of cash, a bank can create
multiple times credit. In the process of multiple credit creation, the total amount
of derivative deposits That a bank creates is a multiple of the initial cash
reserves.
Q. What is Credit Creation?
Credit creation is the expansion of deposits. And, banks can expand their
demand deposits as a multiple of their cash reserves because demand deposits
serve as the principal medium of exchange. Credit creation separates a bank
from other financial institutions. ( For 1 Mark)
Demand deposits are an important constituent of money supply and the
expansionofdemand deposits means the expansion of money supply. The entire
structure of bankingisbased on credit. Credit basically means getting the
purchasing power nowandpromisingtopay at some time in the future. Bank
credit means bank loans and advances.
A bank keeps a certain part of its deposits as a minimum reserve to meet the
demands of its depositors and lends out the remaining to earn income. The loan
is credited to the account of the borrower. Every bank loan creates an equivalent
deposit in the bank. Therefore, credit creation means expansion of bank
deposits.
The two most important aspects of credit creation are:
1. Liquidity – The bank must pay cash to its depositors when they exercise their
right to demand cash against their deposits.
2. Profitability – Banks are profit-driven enterprises. Therefore, a bank must
grant loans in a manner which earns higher interest than what it pays on its
deposits.
Q. How do banks create credit?
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Credit creation is the expansion of deposits .The bank’s credit creation process
is based on the assumption that during any time interval, only a fraction of its
customers genuinely need cash. Also, the bank assumes that all its customers
would not turn up demanding cash against their deposits at one point in time.
There are two ways of analyzing the credit creation process:
a) Credit creation by a single bank
b) Credit creation by the banking system as a whole Credit creation by a single
bank In a single bank system, one bank operates all the cash deposits and
claques. The process of creating credit is explained with the hypothetical
example below:

Let’s assume that the bank requires to maintain a CRR of 20 percent.

• If a person (person A) deposits 1,000 rupees with the bank, then the
bankkeepsonly200 rupees in the cash reserve and lends the remaining 800 to
another person(personB). They open a credit account in the borrower’s name for
the same.
• Similarly, the bank keeps 20 percent of Rs. 800 (i.e. Rs. 160) and advances
the remaining Rs. 640 to person C.
• Further, the bank keeps 20 percent of Rs. 640 (i.e. Rs. 128) and advances the
remaining Rs. 512 to person D. This process continues until the initial primary
deposit of Rs. 1,000 and the initial additional reserves of Rs. 800 lead to
additional or derivative deposits of Rs. 4,000 (800+640+512+….). Adding the
initial deposits, we get total deposits of Rs. 5,000. In this case, the credit
multiplier is 5 (reciprocal of the CRR) and the credit creation is five times the
initial excess reserves of Rs. 800.
Multiple Credit Creation by the Banking System The banking system has many
banks in it and it cannot grant loans in excess of the cash it creates. When a
bank creates a derivative deposit, it loses cash to other banks. The loss of
deposit of one bank is the gain of deposit for some other bank. This transfer of
cash within the banking system creates primary deposits and increases the
possibility for further creation of derivative deposits. Here is an illustration to
explain this process better:
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As explained above, the initial deposit of Rs. 1,000 with bank A leads to a
creation of total deposits of Rs. 5,000.
Q. What are the limitations of Credit Creation?
Ans: Credit creation is the expansion of deposits . There are specific limitations
on the power to create deposits. While banks would prefer an unlimited capacity
for creating credit to increase profits, there are many limitations. These
limitations make the process of creating credit non-profitable. Therefore, a bank
continues to create additional credit as long as:
a) There is a negligible chance of the loans turning into bad debts
b) The interest rate that banks charge on loans and advances is greater than the
interest that the bank gives to depositors for the money deposited in the bank.
Various draw backs are:
1. Cash Reserve Ratio: The credit creation power of banks depends upon the
amount of cash they possess. The larger the cash, the larger the amount of credit
that can be created by banks. Thus, the bank’s power of creating credit is
limited by the cash it possesses.
2.Availability of Adequate and Proper Securities: If proper securities are not
available with the public, a bank cannot create credit. As Crowther has
written—”the bank does not create money out of thin air, it transmutes other
forms of wealth into money.”
3. Keeping of Reserve with the Central Bank: Every affiliated and attached
bank has to keep certain reserves with the Central Bank of the country. The
Central Bank keeps on changing the percentages of these reserves from time to
time. When the Central Bank increases the percentages of these reserves, then
the power of the commercial banks to create credit is reduced in the same
proportion.
4. Banking Habits of the People:The banking habits of the people are an
important factor which governs the power of credit creation on the part of
banks. If people are not in the habit of using cheques, the grant of loans will
lead to the withdrawal of cash from the credit creation stream of the banking
system. This reduces the power of banks to create credit to the desired level.
5. Volume of Currency in Circulation: Volume of currency in circulation is an
important factor of creation of credit. If the primary deposits are large, then the
derivative deposits created on their basis will also be large. But the volume of
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primary deposits is closely connected with the actual volume of currency in

circulation.
6. If heavy with-drawl of Cash by the Borrowers: If the borrowers will
withdraw money in cash, then the balance of deposits will be disturbed. With
the withdrawal of cash, the excess reserves of the banks are automatically
reduced. This reduces the power of credit creation.
7. Existence of Cash Transactions in the Economy: This system of doing
transaction sets another limitation on the power of the banks to create credit. In
under-developed area most of the transactions have to be effected in cash. This
puts a question as to what extent banks power to create credit is reduced.
8. Economic Conditions of Trade and Business: Banks cannot continue to
create credit limitlessly. Their power to create credit depends upon the
economic climate present in the country. If there are boom times, there is a
greater scope of profitable investment and thus greater demand for bank loans
on the part of businessmen.
9. If Good Collateral Securities are not Available: We are aware that every loan
made by the bank must be backed by some valuable security like stocks, shares,
bills and bonds etc. If these collateral securities are not available in sufficient
number the banks cannot expand their lending activities and consequently
cannot expand credit in the economy.
10. It is Essential to Maintain Statutory Liquidity Ratio: The Commercial Banks
under law are required to maintain a second line of defence in the form of the
liquid assets. In India it has become essential to keep 34% of the assets in liquid
forms. The liquid assets have been considered as government bonds and
securities, treasury bills and other approved securities which can be en-cashed
quite easily in emergency. Such restrictions reduce the lendable resources with
the banks and curtail their power to create credit to that extent.
11. If the Behaviour of Other Banks is Not Co-operative: If some of the banks
do not advance loans to the extent required of the banking system, the chain of
credit expansion will be broken. The effect will be that the banking system will
not operate properly. Q. How CRR affects credit creation? If the Cash Reserve
Ratio (CRR) is increased by the RBI, its impact on the expansion of credit
creation will be to decrease it. In short, credit creation is the reciprocal of the
CRR.
FUNCTIONS OF THE CENTRAL BANK

Central bank is regarded as an apex financial institution in the banking system.

It is considered as an integral part of the economic and financial system of a
nation. The central bank functions as an independent authority and is
responsible for controlling, regulating and stabilising the monetary and banking
structure of the country.
The functions of a central bank can be discussed as follows:
1. Currency regulator or bank of issue
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2. Bank to the government

3. Custodian of Cash reserves
4. Custodian of International currency
5. Lender of last resort
6. Clearing house for transfer and settlement
7. Controller of credit
8. Protecting depositors interests
The above mentioned functions will be discussed in detail in the following
lines.
Currency regulator or bank of issue: Central banks possess the exclusive
right to manufacture notes in an economy. All the central banks across the
world are involved in issuing notes to the economy.
This is one of the most important functions of the central bank in an economy
and due to this the central bank is also known as the bank of issue.
Earlier all the banks were allowed to publish their own notes which resulted in a
disorganised economy. To avoid this situation the government around the world
authorised the central banks to function as the issuer of currency, which resulted
in uniformity in circulation and balanced supply of money in the economy.
Bank to the government: One of the important functions of the central bank is
to act as the bank to the government. The central bank accepts deposits and
issues funds to the government. It is also involved in making and receiving
payments for the government. Central banks also offer short term loans to the
government in order to recover from bad phases in the economy.
In addition to being the bank to the government, it acts as an advisor and agent
of the government by providing advice to the government in areas of economic
policy, capital market, money market and loans from the government.
In addition to that, the central bank is instrumental in formulation of monetary
and fiscal policies that help in regulation of money in the market and controlling
inflation.
Custodian of Cash reserves: It is a practice of the commercial banks of a
country to keep a part of their cash balances in the form of deposits with the
central bank. The commercial banks can draw that balance when the
requirement for cash is high and pay back the same when there is less
requirement of cash.
It is for this reason that the central bank is regarded as the banker’s bank.
Central bank also plays an important role in the credit creation policy of
commercial banks.
Custodian of International currency: An important function of the central
bank is to maintain a minimum balance of foreign currency. The purpose of
maintaining such a balance is to manage sudden or emergency requirements of
foreign reserves and also to overcome any adverse deficits of balance of
payments.
Lender of last resort: The central bank acts as a lender of last resort by
providing money to its member banks in times of cash crunch. It performs this
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function by providing loans against securities, treasury bills and also by

rediscounting bills.
This is regarded as one of the most crucial functions of the central bank wherein
it helps in protecting the financial structure of the economy from collapsing.
Clearing house for transfer and settlement: Central bank acts as a clearing
house of the commercial banks and helps in settling of mutual indebtedness of
the commercial banks. In a clearing house, the representatives of different banks
meet and settle the inter bank payments.
Controller of credit: Central banks also function as the controller of credit in
the economy. It happens that commercial banks create a lot of credit in the
economy that increases the inflation.
The central bank controls the way credit creation by commercial banks is done
by engaging in open market operations or bringing about a change in the CRR
to control the process of credit creation by commercial banks.
Protecting depositors interests: Central bank also needs to keep an eye on the
functioning of the commercial banks in order to protect the interests of
depositors.

METHODS OF CREDIT CONTROL USED BY CENTRAL BANK

The following points highlight the two categories of methods of credit
control by central bank.
The two categories are:
I. Quantitative or General Methods
II. Qualitative or Selective Methods.

Category # I. Quantitative or General Methods:

1. Bank Rate Policy:
The bank rate is the rate at which the Central Bank of a country is prepared to
re-discount the first class securities.
It means the bank is prepared to advance loans on approved securities to its
member banks.
As the Central Bank is only the lender of the last resort the bank rate is normally
higher than the market rate.
For example:
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If the Central Bank wants to control credit, it will raise the bank rate. As a
result, the market rate and other lending rates in the money-market will go up.
Borrowing will be discouraged. The raising of bank rate will lead to contraction
of credit.
Similarly, a fall in bank rate mil lowers the lending rates in the money market
which in turn will stimulate commercial and industrial activity, for which more
credit will be required from the banks. Thus, there will be expansion of the
volume of bank Credit.
2. Open Market Operations:
This method of credit control is used in two senses:
(i) In the narrow sense, and
(ii) In broad sense.
In narrow sense—the Central Bank starts the purchase and sale of Government
securities in the money market. But in the Broad Sense—the Central Bank
purchases and sale not only Government securities but also of other proper and
eligible securities like bills and securities of private concerns. When the banks
and the private individuals purchase these securities they have to make
payments for these securities to the Central Bank.
This gives result in the fall in the cash reserves of the Commercial Banks, which
in turn reduces the ability of create credit. Through this way of working the
Central Bank is able to exercise a check on the expansion of credit.
Further, if there is deflationary situation and the Commercial Banks are not
creating as much credit as is desirable in the interest of the economy. Then in
such situation the Central Bank will start purchasing securities in the open
market from Commercial Banks and private individuals.
With this activity the cash will now move from the Central Bank to the
Commercial Banks. With this increased cash reserves the Commercial Banks
will be in a position to create more credit with the result that the volume of bank
credit will expand in the economy.
3. Variable Cash Reserve Ratio:
Under this system the Central Bank controls credit by changing the Cash
Reserves Ratio. For example—If the Commercial Banks have excessive cash
reserves on the basis of which they are creating too much of credit which is
harmful for the larger interest of the economy. So it will raise the cash reserve
ratio which the Commercial Banks are required to maintain with the Central
Bank.
This activity of the Central Bank will force the Commercial Banks to curtail the
creation of credit in the economy. In this way by raising the cash reserve ratio of
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the Commercial Banks the Central Bank will be able to put an effective check
on the inflationary expansion of credit in the economy.
Similarly, when the Central Bank desires that the Commercial Banks should
increase the volume of credit in order to bring about an economic revival in the
country. The Central Bank will lower down the Cash Reserve ratio with a view
to expand the cash reserves of the Commercial Banks.
With this, the Commercial Banks will now be in a position to create more credit
than what they were doing before. Thus, by varying the cash reserve ratio, the
Central Bank can influence the creation of credit.
Which is Superior?
Either variable cash reserve ratio or open market operations:
From the analysis and discussions made above of these two methods of credit, it
can be said that the variable cash reserve ratio method is superior to open
market operations on the following grounds:
(1) Open market operations is time consuming procedure while cash reserves
ratio produces immediate effect in the economy.
(2) Open market operations can work successfully only where securities market
in a country are well organised and well developed.
While Cash Reserve Ratio does not require such type of securities market for
the successful implementation.
(3) Open market operations will be successful where marginal adjustments in
cash reserve are required.
But the variable cash reserve ratio method is more effective when the
commercial banks happen to have excessive cash reserves with them.
These two methods are not rival, but they are complementary to each other.
Category # II. Qualitative or Selective Method of Credit Control:
The qualitative or the selective methods are directed towards the diversion of
credit into particular uses or channels in the economy. Their objective is mainly
to control and regulate the flow of credit into particular industries or businesses.
The following are the important methods of credit control under selective
method:
1. Rationing of Credit.
2. Direct Action.
3. Moral Persuasion.
4. Method of Publicity.
5. Regulation of Consumer’s Credit.
6. Regulating the Marginal Requirements on Security Loans.
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1. Rationing of Credit:
Under this method the credit is rationed by limiting the amount available to
each applicant. The Central Bank puts restrictions on demands for
accommodations made upon it during times of monetary stringency.
In this the Central Bank discourages the granting of loans to stock exchanges by
refusing to re-discount the papers of the bank which have extended liberal loans
to the speculators. This is an important method of credit control and this policy
has been adopted by a number of countries like Russia and Germany.
2. Direct Action:
Under this method if the Commercial Banks do not follow the policy of the
Central Bank, then the Central Bank has the only recourse to direct action. This
method can be used to enforce both quantitatively and qualitatively credit
controls by the Central Banks. This method is not used in isolation; it is used as
a supplement to other methods of credit control.
Direct action may take the form either of a refusal on the part of the Central
Bank to re-discount for banks whose credit policy is regarded as being
inconsistent with the maintenance of sound credit conditions. Even then the
Commercial Banks do not fall in line, the Central Bank has the constitutional
power to order for their closure.
This method can be successful only when the Central Bank is powerful enough
and has cordial relations with the Commercial Banks. Mostly such
circumstances are rare when the Central Bank is forced to resist to such
measures.
3. Moral Persuasion:
This method is frequently adopted by the Central Bank to exercise control over
the Commercial Banks. Under this method Central Bank gives advice, then
request and persuasion to the Commercial Banks to co-operate with the Central
Bank is implementing its credit policies.
If the Commercial Banks do not follow or do not abide by the advice or request
of the Central Bank no gross action is taken against them. The Central Bank
merely was its moral influence and pressure with the Commercial Banks to
prevail upon them to accept and follow the policies.
4. Method of Publicity:
In modern times, Central Bank in order to make their policies successful, take
the course of the medium of publicity. A policy can be effectively successful
only when an effective public opinion is created in its favour.
Its officials through news-papers, journals, conferences and seminar’s present a
correct picture of the economic conditions of the country before the public and
give a prospective economic policies. In developed countries Commercial
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Banks automatically change their credit creation policy. But in developing

countries Commercial Banks being lured by regional gains. Even the Reserve
Bank of India follows this policy.
5. Regulation of Consumer’s Credit:
Under this method consumers are given credit in a little quantity and this period
is fixed for 18 months; consequently credit creation expanded within the limit.
This method was originally adopted by the U.S.A. as a protective and defensive
measure, there after it has been used and adopted by various other countries.
6. Changes in the Marginal Requirements on Security Loans:
This system is mostly followed in U.S.A. Under this system, the Board of
Governors of the Federal Reserve System has been given the power to prescribe
margin requirements for the purpose of preventing an excessive use of credit for
stock exchange speculation.
This system is specially intended to help the Central Bank in controlling the
volume of credit used for speculation in securities under the Securities
Exchange Act, 1934.

WHAT IS THE THEORY OF LIQUIDITY PREFERENCE?

Liquidity preference according to macroeconomic theory is the demand for

money taken into account as liquidity. It shows the relationship between the
interest rate and the quantity of money the public wishes to hold. The Liquidity
Preference Theory states that the interest rate is the price for money. In simple
terms, this means that when money is demanded, it is not because one wants to
borrow money but money is demanded due to one's desire to remain liquid. The
theory suggests that cash is the most accepted liquid asset and more liquid
investments are easily cashed in for their full value.
The Liquidity Preference Theory says that the demand for money is not to
borrow money but the desire to remain liquid. In other words, the interest rate is
the ‘price’ for money.
John Maynard Keynes created the Liquidity Preference Theory in to explain the
role of the interest rate by the supply and demand for money. According to
Keynes, the demand for money is split up into three types – Transactionary,
Precautionary and Speculative.
He also said that money is the most liquid asset and the more quickly an asset
can be converted into cash, the more liquid it is.
Three Motives for Liquidity
1. Transactionary Demand
People prefer to be liquid for day-to-day expenses. The amount of liquidity
desired depends on the level of income, the higher the income, the more money
is required for increased spending. This is called transactionary demand.
2. Precautionary Demand
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Precautionary demand is the demand for liquidity to cover unforeseen

expenditures such as an accident or health emergency. The demand for this type
of money increases as the income level increases.
3. Speculative Demand
Speculative demand is the demand to take advantage of future changes in the
interest rate or bond prices. According to Keynes, the higher the rate of interest,
the lower the speculative demand for money. And the lower the rate of interest,
the higher the speculative demand for money.

Keynesian Liquidity Preference Theory

An increase in Money Supply leads to a fall in Interest Rates (the Liquidity
Preference Theory denoted by R). This, in turn, leads to higher Investment
(Theory of Investment denoted by I) which then results in higher Income (Y)
via the Multiplier Effect.
↑MS → ↓R → ↑I → ↑Y (via the multiplier) and ↑Price
Monetarist Liquidity Preference Theory
An increase in the money supply leads to, temporarily, higher income levels and
employment but in the long run, this only increases the rate of inflation.
↑MS → (temporarily ↑Y + employment) but in the long run → ↑Price
The economy returns to the Natural Rate of Unemployment
Another Answer:
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What is the Theory of Liquidity Preference?

The Theory of Liquidity Preference states that agents in financial markets
demonstrate a preference for liquidity. Formally, if U(Asset A) > U(Asset B)
and rA = rB, then L(Asset A) > L(Asset B), where:
• U(Asset A) is an investor’s utility from holding asset A
• U(Asset B) is an investor’s utility from holding asset B
• rA is the return generated by asset A
• rB is the return generated by asset B
• L(Asset A) is the liquidity of Asset A
• L(Asset B) is the liquidity of Asset B

Under the Theory of Liquidity Preference, an investor faced with two assets
offering the same rate of return will always choose the more liquid asset. The
term liquidity preference was introduced by English economist John Maynard
Keynes in his 1936 book, “The General Theory of Employment, Interest, and
Money.” Keynes called the aggregate demand for money in the economy
liquidity preference.

The Keynesian Monetary Theory and the LM Curve

According to Keynes General Theory, the short-term interest rate is determined
by the supply and demand for money. Holding money is the opportunity cost of
not investing that money in short-term bonds. The demand for money is a
function of the short-term interest rate and is known as the liquidity preference
function.
Money supply is usually a fixed quantity set by a central banking authority.
L(r,Y) is a liquidity preference function if and if , where r is the short-term
interest rate and Y is the level of output in the economy.
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Formally, the liquidity money (LM) curve is the locus of points in Output –
Interest Rate space such that the money market is in equilibrium.
Alternatively, we can say that the LM curve maps changes in money demand or
supply to changes in the short-term interest rate.
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The Theory of Liquidity Preference and an Upward Sloping Yield Curve

According to the Theory of Liquidity Preference, the short-term interest rate in
an economy is determined by the supply and demand for the most liquid asset in
the economy – money. The concept, when extended to the bond market, gives a
clear explanation for the upward sloping yield curve. Since investors strictly
prefer liquidity, in order to persuade investors to buy long-term bonds over
short-term bonds, the return offered by long-term bonds must be greater than
the return offered by short-term bonds.
Formally, if U(Asset A) > U(Asset B), and L(Asset A) > L(Asset B), then
rA > rB. The difference in interest rates is known as the liquidity premium or the
term premium. A commonly used measure of the term premium is the 10-2
spread.
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PUBLIC FINANCE
Public finance is the study of the role of the government in the economy. It is
the branch of economics that assesses the government revenue and government
expenditure of the public authorities and the adjustment of one or the other to
achieve desirable effects and avoid undesirable ones.

Components of Public Finance

The main components of public finance include activities related to
collecting revenue, making expenditures to support society, and implementing a
financing strategy (such as issuing government debt). The main components
include:
Tax collection
Tax collection is the main revenue source for governments. Examples of taxes
collected by governments include sales tax, income tax (a type of progressive
tax), estate tax, and property tax. Other types of revenue in this category include
duties and tariffs on imports and revenue from any type of public services that
are not free.
Budget
The budget is a plan of what the government intends to have as expenditures in
a fiscal year. In the U.S., for example, the president submits to Congress a
budget request, the House and Senate create bills for specific aspects of the
budget, and then the President signs them into law. Read a copy of 2017 Budget
of the U.S. government, as published by the Office of Management and Budget.
Expenditures
Expenditures are everything that a government actually spends money on, such
as social programs, education, and infrastructure. Much of the government’s
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spending is a form of income or wealth redistribution, which is aimed at

benefiting society as a whole. The actual expenditures may be greater than or
less than the budget.
Deficit/Surplus
If the government spends more then it collects in revenue there is a deficit in
that year. If the government has less expenditures than it collects in taxes, there
is a surplus.
National Debt
If the government has a deficit (spending is greater than revenue), it will fund
the difference by borrowing money and issuing national debt. The U.S.
Treasury is responsible for issuing debt, and when there is a deficit, the Office
of Debt Management (ODM) will make the decision to sell government
securities to investors.

WHAT ARE GOVERNMENT EXPENDITURES?

Definition: Government expenditure refers to the purchase of goods and
services, which include public consumption and public investment, and transfer
payments consisting of income transfers (pensions, social benefits) and capital
transfer.
What is the definition of government expenditures? A government spends
money towards the supply of goods and services that are not provided by the
private sector but are important for the nation’s welfare. Government spending
goes to the nation’s defense, infrastructure, health and welfare benefits.

SOURCES OF GOVERNMENT SPENDING/EXPENDITURE

Government spending is financed primarily through two sources:

1. Tax collections by the government

• Direct taxes
• Indirect taxes

2. Government borrowing
• Borrowing money from its own citizens
• Borrowing money from foreigners
Purposes of Government Spending
• To supply goods and services that are not supplied by the private sector,
such as defense, roads, and bridges; merit goods such as hospitals and
schools, and welfare payments and benefits including unemployment and
disability benefits.
• To achieve improvements in the supply-side of the macro-economy, such
as spending on education and training to improve labor productivity.
• To provide subsidies to industries that may need financial support for
either their operation or expansion. The private sector is not able to meet
such financial requirements and, hence, the public sector plays a crucial
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part in lending necessary support. For example, transport infrastructure

projects do not attract private finance unless the government provides
expenditures for the industry.
• To help redistribute income and promote social welfare.

Types of Spending

1. Current spending
They are for the short term and include expenditure on wages and raw materials.

2. Capital spending
They are for the long term and do not need to be renewed each year. Also called
“social capital,” they include spending on physical assets like roads, bridges,
hospital buildings, and equipment.

Government Borrowings
The government primarily funds its spending on the economy through tax
revenues it earns. However, when revenue is insufficient to pay for
expenditures, it resorts to borrowing. Borrowing can be short-term/long-term
and involves selling government bonds/bills. Treasury bills are also issued into
the money markets to help raise short-term cash.
Sources of Government Revenue:
The following points highlight the nine main sources of government revenue.
The sources are: 1. Tax 2. Rates 3. Fees 4. Licence Fee 5. Surplus of the public
sector units 6. Fine and penalties 7. Gifts and grants 8. Printing of paper money
9. Borrowings.

Source # 1. Tax:
A tax is a compulsory levy imposed by a public authority against which tax
payers cannot claim anything. It is not imposed as a penalty for only legal
offence. The essence of a tax, as distinguished from other charges by the
government, is the absence of a direct quid pro quo (i.e., exchange of favour)
between the tax payer and the public authority.

Tax has three important features:

(i) It is a compulsory contribution, to the state from the citizen. Anyone refusing
to pay tax is punished under law. Nobody can object to taxation on the ground
that he is not getting the benefit of certain state services,

(ii) It is the personal obligation of the individual to pay taxes under all
circumstances,
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(iii) There is no direct relationship between benefit and tax payment.

Source # 2. Rates:
Rates refer to local taxation, i.e., taxation levied by (or for) local rather than
central government. Normally rates are proportional to the estimated rentable
value of business and domestic properties. Rates are often criticised as being
unrelated to income.

Source # 3. Fees:
Fee is a payment to defray the cost of each recurring service undertaken by the
government, primarily in the public interest.

Source # 4. Licence fee:

A licence fee is paid in those instances in which the government authority is
invoked simply to confer a permission or a privilege.

Source # 5. Surplus of the public sector units:

The government acts like a business- person and the public acts like its
customers. The government may either sell goods or render services like train,
city bus, electricity, transport, posts and telegraphs, water supply, etc. The
government also earns revenue from the production of commodities like steel,
oil, life-saving drugs, etc.

Source # 6. Fine and penalties:

They are the charges imposed on persons as a punishment for contravention of a
law. The main purpose of these is not to raise revenue from the public but to
force them to follow law and order of the country.

Source # 7. Gifts and grants:

Gifts are voluntary contribution from private individuals or non-government
donors to the government fund for specific purposes such as relief fund, defence
fund during war or an emergency. However, this source provides a small
portion of government revenue.

Source # 8. Printing of paper money:

It is another source of revenue of the government. It is a method of creating
extra resources. This method is normally avoided because if once this method of
financing is started, it becomes difficult to stop it.
 110

Source # 9. Borrowings:
Borrowings from the public is another source of government revenue. It
includes loans from the public in the form of deposits, bonds, etc. and also from
the foreign agencies and organisations.

WHAT ARE TAXES?

Taxes are mandatory contributions levied on individuals or corporations by a
government entity—whether local, regional, or national. Tax revenues finance
government activities, including public works and services such as roads and
schools, or programs such as Social Security and Medicare.

The Three Basic Tax Types

Most taxes can be divided into three buckets: taxes on what you earn, taxes on
what you buy, and taxes on what you own.
Taxes on What You Earn

Individual Income Taxes

An individual income tax (or personal income tax) is levied on the wages,
salaries, investments, or other forms of income an individual or household
earns.

Many individual income taxes are “progressive,” meaning tax rates increase as a
taxpayer’s income increases, resulting in higher-earners paying a larger share of
income taxes than lower-earners.

Corporate Income Taxes

A corporate income tax (CIT) is levied by federal and state governments on

business profits, which are revenues (what a business makes in sales) minus
costs (the cost of doing business).

Payroll Taxes

Payroll taxes are taxes paid on the wages and salaries of employees to finance
social insurance programs. Most taxpayers will be familiar with payroll taxes
from looking at their paystub at the end of each pay period, where the amount of
payroll tax withheld by their employer from their income is clearly listed.

Capital Gains Taxes

Capital assets generally include everything owned and used for personal
purposes, pleasure, or investment, including stocks, bonds, homes, cars,
jewelry, and art. Whenever one of those assets increases in value—e.g., when
 111

the price of a stock you own goes up—the result is what’s called a “capital
gain.”

Taxes on What You Buy

Sales Taxes

Sales taxes are a form of consumption tax levied on retail sales of goods and
services. If you live in the U.S., you are likely familiar with the sales tax from
having seen it printed at the bottom of store receipts.

Gross Receipts Taxes

Gross receipts taxes (GRTs) are applied to a company’s gross sales, regardless
of profitability and without deductions for business expenses. This is a key
difference from other taxes businesses pay, such as those based on profits or net
income, like a corporate income tax, or final consumption, like a well-
constructed sales tax.

Value-Added Taxes

A Value-Added Tax (VAT) is a consumption tax assessed on the value added in

each production stage of a good or service.

Each business along the production chain is required to pay a VAT on the value
of the produced good/service at that stage, with the VAT previously paid for
that good/service being deductible at each step.

The final consumer, however, pays the VAT without being able to deduct the
previously paid VAT, making it a tax on final consumption. This system
ensures that only final consumption can be taxed under a VAT, avoiding tax
pyramiding.

Excise Taxes

Excise taxes are taxes imposed on a specific good or activity, usually in addition
to a broad consumption tax, and comprise a relatively small and volatile share
of total tax collections. Common examples of excise taxes include those on
cigarettes, alcohol, soda, gasoline, and betting.

Taxes on Things You Own

Property Taxes
 112

Property taxes are primarily levied on immovable property like land and
buildings and are an essential source of revenue for state and local governments
in Pakistan.

Tangible Personal Property (TPP) Taxes

Tangible personal property (TPP) is property that can be moved or touched,

such as business equipment, machinery, inventory, furniture, and automobiles.

Estate and Inheritance Taxes

Both estate and inheritance taxes are imposed on the value of an individual’s
property at the time of their death. While estate taxes are paid by the estate
itself, before assets are distributed to heirs, inheritance taxes are paid by those
who inherit property. Both taxes are usually paired with a “gift tax” so that they
cannot be avoided by transferring the property prior to death.

Wealth Taxes

Wealth taxes are typically imposed annually on an individual’s net wealth (total
assets, minus any debts owed) above a certain threshold.

For example, a person with $2.5 million in wealth and $500,000 in debt would
have a net wealth of $2 million. If a wealth tax applies to all wealth above $1
million, then under a 5 percent wealth tax the individual would owe $50,000 in
taxes.

Incidence of different taxes

Taxes are not always borne by the people who pay them in the first
instance. They are often shifted to other people. Tax incidence means the final
placing of a tax. Incidence is on the person who ultimately bears the money
burden of tax. According to the modern theory, incidence means the changes
brought about in income distribution by changes in the budgetary policy.

Impact and Incidence: The impact of a tax is on the person who pays it in the
first instance and the incidence is on the one who finally bears it. Therefore, the
incidence is on the final consumers.

Incidence and Effects: The effect of a tax refers incidental results of the
tax. There are several consequences of imposition of tax, for example,
decreased demand.

Money Burden and the Real Burden: The money burden of a tax is represented
by the total amount of money received by the treasury. For example, the
consumer has to spend Rs. 50 more on sugar monthly, it is the money burden
 113

that he has to bear. But if he has to reduce his consumption of sugar it means
there is a reduction in economic welfare. This inconvenience, pinching,
sacrifice or in short the loss of economic welfare is the real burden of tax.

THEORIES OF TAX SHIFTING AND INCIDENCE

1. Earlier Theories: The earlier theories may be classified into:

(a) Concentration or Surplus theory: According to

concentration theory, each tax tends to concentrate on a particular
class of people who happen to enjoy surplus from their products.

(b) Diversion or Diffusion theory: The diffusion theory states

that the tax eventually got diffused in the entire society. That is,
the final placing of tax is not one but multiple. The process of
diffusion took place through shifting or through process of
exchange.

2. Modern Theory: According to modern theory, the concentration and

diffusion theories are partially true. Actually there are both concentration
and diffusion of taxes according to the conditions present. The modern
theory seeks to analyse the conditions which bring about concentration or
diffusion.

Factors determining Tax Incidence

(a) Elasticity: While considering incidence we consider both elasticity of

demand and elasticity of supply. If the demand for the commodity taxed is
elastic, the tax will tend to be shifted to the producer but in case of inelastic
demand, it will be largely borne by the consumer. In case of elastic supply, the
burden will tend to be on the purchaser and in the case of inelastic supply on the
producer.

(b) Price: Since shifting of the tax burden can only take place through a
change in price, price is a very important factor. If the tax leaves the price
unchanged, the tax does not shift.

(c) Time: In short run, the producer cannot make any adjustment in plant
and equipment. If, therefore, demand falls on account of price rise resulting
from the tax, he may not be able to reduce supply and may have to bear the tax
to some extent. In the long run, however, full adjustment can be made and tax
shifted to the consumer.

(d) Cost: Tax raises the price; rise in price reduces demand and reduced
demand results in the reduction of output. A change in the scale of production
 114

affects cost and the effect will vary according as the industry is decreasing,
increasing or constant costs industry. For instance, if the industry is subject to
decreasing cost, a reduction in the scale of production will raise the cost and
hence price, shifting the burden of the tax to the consumer.

(e) Nature of tax: The incidence of taxation will definitely depend on the
nature of tax. For example, an indirect tax’s burden is fall on the consumer.

(f) Market form: Another factor determining the incidence of taxation is

the market form. Under perfect competition, no single producer or single
purchaser can affect the price; hence shifting of tax in either direction is out of
the question. But under monopoly, a producer is in a position to influence price
and hence shift the tax.

Distinction between Direct and Indirect Taxes

A direct tax is not intended to be shifted, whereas an indirect tax is so intended.

Taxes on commodities are generally called indirect taxes as they completely or

partially shifted consumers. But it should be remembered that all the commodity
taxes are not indirect taxes. A tax is said to be indirect if its burden is shifted
finally to the consumer.

Direct tax is the tax in which the commodity is taxed by the government, yet its
price remains unaffected or changed. In this case the tax is not shifted to
consumer and the tax will be called direct tax. If the tax is shifted, the tax is
indirect, otherwise indirect.

Merits and Demerits of Direct and Indirect Taxes

Merits of Direct Tax:

1. Equitable, i.e., the principle of progression is applied

2. Economical, i.e., the cost of collection is small
3. Certain, i.e., the direct tax can be calculated with a fair degree of
precision
4. High degree of elasticity, i.e., the direct tax can be raised much easily
5. Civic consciousness, direct tax creates civic consciousness among tax-
payers
6. Reduction of inequalities, i.e., the objective of direct tax is to reduce
economic inequalities by taxing higher income earners at progressive tax
rates.

Demerits of Direct Tax:

 115

1. Inconvenient: for the tax payer to pay and file the income tax return
2. Unpopular tax system
3. Tax evasion is common
4. Unarbitrary tax rates

Merits of Indirect Tax:

1. Convenient: for the tax payer to pay and it requires no filing of returns
2. No tax evasion
3. Unified tax rate
4. Beneficial social effects (in case of harmful drugs and intoxicants)
5. Capital formation
6. Re-allocation of resources
7. Wide coverage

Demerits of Indirect Tax:

1. Uncertain
2. Regressive
3. No civic consciousness
4. Inflationary
5. Loss of economic welfare

Incidence of Some Taxes

Taxes on Personal Income:

1. Income tax, super tax and excess profit tax are all direct taxes and
generally cannot be shifted.
2. However, the business is in a strong position and can shift a part of his
tax burden to his customers. But this situation is rarely present and the
income tax payer must bear the burden of tax.
3. If the income tax is extremely heavy, it may discourage saving and
investment. However, it will mainly depend on whether the tax falls on
average income or marginal income, the effects would be adverse. If the
increase in tax is fall on marginal income, it will mean a positive
discouragement to the earning of that income.

Corporate Tax:

1. Corporate tax discourages investment, level of national income and

employment.
 116

2. A corporation tax, by reducing the earnings of the existing firms,

discourages the entry of new firms into the industry which may result in a
monopoly or a semi-monopoly for the existing firms with all the
attendant evils.

3. A part of corporate tax may be shifted to the buyers through a price rise.

Tax on Profits:

1. Some economists are not of the view that the tax on profit should be
shifted to buyers. It should be borne by the seller who pays it.

2. The second view does not subscribe with the above approach. It is
argued that normal profit is a part of the cost and when the entrepreneur is
able to influence the price, the tax is generally shifted to the consumer.

3. However, the tax on profit in the form of a licence duty will be borne by
the producer.

Wealth Tax:

1. Wealth tax is imposed on value of a person’s stock of wealth

2. By enabling the government not to raise the income tax rates too high, the
wealth tax encourages investment in modern industries

3. Another obvious effect of wealth tax is the reduction of economic

inequalities by reducing the size of inherited wealth

Property Tax:

1. The wealth tax is imposed on the net worth of the individual. Whereas,
the property tax is levied on the gross amount of assets’ value

2. There is no shifting of tax and the incidence is on the person on whom the
tax is levied. However, the tax on productive property may be shifted to
consumers.

Land Taxation:

1. The value of land depends on two sets of factors:

(a) Natural factors like the fertility of the soil, the situation of the
land, some other natural conditions, and
 117

(b) Investment of capital in drainage schemes, anti-erosion measures,

irrigation facilities and other measures necessary to increase and
sustain productivity

2. The tax on the first set is a tax on economic rent and has a tendency to
fall on the owners

3. But when the owner can vary his investment when the tax increases, he
can shift the tax burden to the consumer.

Tax on Buildings:

1. If the tax is imposed on the owner, he will try to raise the house rent and
thus shift the tax to the occupier or tenant. But he cannot do this during
the currency of the lease.

2. A heavy tax will check building activity and the remuneration of the
builder and of other people engaged in the trade may fall

3. The tax may fall partly on the owner, partly on the builder and partly on
the occupier

Death Duty:

1. Death duty may take two forms, i.e., Estate Duty and Succession Duty

2. The Estate Duty is levied on the total value of the estate (i.e., movable
and immovable property) left by the deceased irrespective of the
relationship of the successor

3. The succession duty varies with the relationship of the beneficiary to the
deceased. It takes into consideration individual share of the successor
and not the total value as in the estate duty.

Tax on Monopoly:

1. The monopoly tax may be:

(a) Independent of the output of the monopolised product, or

(b) It may vary with the output, i.e., increase or decrease with the
output

2. When the tax is independent of the quantity produced, it may either be

lump sum tax on the monopolist or a percentage of the monopoly net
revenue (profits). In both cases it will be borne by the monopolist and he
 118

cannot shift the same to the consumer, because the monopolist is already
on a price with maximum beyond which his profit will decline

3. In the second case, the price of the commodity or incidence of taxation

will depend on the elasticities of supply and demand, and the influence of
laws of returns.

4. Taxing of the commodity, therefore raises the price which will tend to
reduce the demand

5. If, however, the demand is inelastic, it cannot be appreciably reduced and

the tax will be borne by the consumer.

6. If the demand is elastic, the consumers may buy less when the tax has
raised the price. Instead of facing a decline in demand the monopolist
may reduce the price and decide to bear the tax himself.

Commodity Tax:

1. Taxes on commodities may take several forms:

(a) Tax on manufacture or production of a commodity called excise

duties,

(b) Tax on sale of a particular commodity known as sales tax, and

(c) Import or export of commodities known as custom duties.

2. The commodity tax is tended to be shifted to the consumer and from

consumer to the producer

3. Tax on production tends to raise the prise and will therefore be normally
borne by the consumer

4. But the consumption tax is likely to check consumption and tends to be

shifted backward to the producer.

5. Therefore, the tax on commodity will be partly borne by the producer and
partly borne by the consumer

6. The portions of commodity tax to be borne by the producer and consumer

depends on the degree of elasticity of demand and supply:

Elasticity Incidence
Elastic demand More tax burden on the supplier /
producer
 119

Inelastic More tax burden on the buyer / consumer

demand
Elastic supply More tax burden on the buyer / consumer
Inelastic supply More tax burden on the supplier /
producer

7. As a rule, the consumer bears a smaller part of the tax when the demand
is more elastic than the supply

8. This may happen that the price may not rise at all. This is because the
consumers have been able to discover an untaxed supply of the
commodity or substitute. In this case, the tax burden will fall on the
producer.

DD and SS intersect at point P and MP is the price determined. Now suppose a

sales tax per unit is levied. As a result the supply curve of the commodity will
rise upward equal to the tax per unit. The new supply curve will be S’S’. The
distance between the two supply curves represents the tax per unit of the
commodity. S’S’ cuts the demand curve DD at Q and, therefore, now TQ is the
price determined which is higher than the old price PM by RQ. Hence RQ is
the burden of tax borne by the consumer even though the tax per unit is
LQ. Therefore, RL (LQ – QR) is the burden of the tax borne by the seller or he
has RL price less than before (PM being the first price).

10.Therefore the commodity tax is distributed between the buyers and sellers
according to the ratio of elasticities of demand and supply:

RL = Burden of the tax on the seller (producer) .

RQ Burden of the tax on the buyer (consumer)
 120

Ed = Proportionate decrease in quantity demanded

Proportionate increase in price

---------------------------------- (i)

Es = Proportionate decrease in quantity supplied

Proportionate decrease in price

------------------------------------- (ii)

= Elasticity of Demand (Ed)

Elasticity of Supply (Es)

11.In the above equation, RL is the burden of the tax on the seller and RQ is
the burden of tax on the buyers. Hence:

RL = Burden of tax on the seller

RQ = Burden of tax on the buyer
= Elasticity of demand (Ed)
Elasticity of supply (Es)
 121

Sales Tax:

1. The sales tax is levied on the turnover, profits or no profits. It covers a

wide variety of commodities.

2. The sales tax may make heavy inroads into profits which may lead to
retrenchment in the staff and management, restrict enterprise and
employment and hamper utilisation of resources.

3. Thus, its incidence may fall upon employees, management and landlords.

Import Duties and Export Duties:

1. Import Duties are generally borne by the home consumer

2. If the demand for the imported product is elastic and the supply is
inelastic and the foreign producer has no alternative market, then in such
a case the burden of tax may be shifted to foreign seller. This situation is
rarely present.

3. Export duty is borne by the exporter. The price in the world market is
fixed and no individual exporter is in a position to influence the world
price.

4. There are certain exceptional situations in which the purchaser may bear
the burden of export duty. For example, the supplier or the producer has
the monopoly of the supply of a commodity.

Effects of Taxation on Production, Consumption and Distribution

Effects on Production:

1. Production is affected by taxes in two ways:

(a) By affecting the ability to work, save and invest

(b) By affecting the desire to work, save and invest

2. A tax on necessaries of life, will obviously affect the workers’

productivity and hence reduce production. A heavy tax on income tends
to reduce the ability to save and invest on part of individuals. A decrease
in investment is bound to affect adversely the level of output in the
country
 122

3. Normally taxation induces people to work harder, earn more, save more
and invest more to increase their income and enjoy the same income after
tax

4. Some taxes has no adverse effects, for e.g., import duties, tax on
monopolists, etc.

5. High marginal rates of income tax are likely to affect adversely the tax
payers’ desire to work, save and invest

6. The reaction varies from individual to individual. It depends on the

individual’s elasticity of demand for income. When it is fairly elastic, the
tax will lessen his desire to work and save

7. Entrepreneurs may avoid the production of goods which are taxed. There
is likely to be a diversion of resources from some sectors of economy to
others

Effects on Income Distribution:

1. The effects of taxes on income distribution depends on the type of taxes

and rates of taxes

2. Taxation of goods of mass consumption is regressive and redistributes

incomes in favour of rich.

3. But if such commodities are exempted and luxuries are taxed, and the
taxation is made progressive, then the income will be redistributed in
favour of poor.

Effects on Consumption:

1. By imposing tax on a consumable good which is injurious to health, its

consumption can be checked.

2. Similarly the tax on luxury goods can decrease their consumption and
resources diverted to the production of mass consumption

PUBLIC DEBT

Public debt is the total amount, including total liabilities, borrowed by the
government to meet its development budget. Public debt is an important source
of resources for a government to finance public spending and fill holes in the
budget. Public debt as a percentage of GDP is usually used as an indicator of the
ability of a government to meet its future obligations.
 123

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The State generally borrows from the people to meet three kinds of
expenditure:
(a) to meet budget deficit,

(b) to meet the expenses of war and other extraordinary situations and

(c) to finance development activity.

(a) Public Debt to Meet Budget Deficit:

It is not always proper to effect a change in the tax system whenever the public
expenditure exceeds the public revenue. It is to be seen whether the transaction
is casual or regular. If the budget deficit is casual, then it is proper to raise loans
to meet the deficit. But if the deficit happens to be a regular feature every year,
then the proper course for the State would be to raise further revenue by
taxation or reduce its expenditure.

(b) Public Debt to Meet Emergencies like War:

In many countries, the existing public debt is, to a great extent, on account of
war expenses. Especially after World War II, this type of public debt had
considerably increased. A large portion of public debt in India has been incurred
to defray the expenses of the last war.

(c) Public Debt for Development Purposes:

During British rule in India public debt had to be raised to construct railways,
irrigation projects and other works. In the post-independence era, the
government borrows from the public to meet the costs of development work
under the Five Year Plans and other projects. As a result the volume of public
debt is increasing day by day.

METHODS OF REPAYMENT OF DEBT

The following points highlight top nine methods used for the redemption of
public debt. The methods are: 1. Refunding 2. Use of Budgetary Surplus 3.
Terminal Annuity 4. Sinking Fund 5. Debt Conversion 6. Statutory Reduction in
the Rate of Interest 7. Additional Taxation 8. Capital Levy 9. Using Trade
Surplus.
 124

Method # 1. Refunding:
The government often issues new bonds for raising new loans in order to pay-
off the matured loans (i.e., an old debt). Thus, the government takes a fresh loan
in order to repay an old debt. When the government uses this method of
refunding there is no liquidation of the money burden of the public debt.
Instead, the debt-servicing (i.e., repayment of the interest along with the
principal) burden gets accumulated on account of the postponement of the debt-
repayment to some future date.

Method # 2. Use of Budgetary Surplus:

Sometimes, a government is able to generate a surplus in the budget. In such a
situation, the government is left with two options. It can either reduce taxes or
repay some of its old debt. In general, the government makes use of the
budgetary surplus to buy back from the market (the people) its own bonds and
securities. As a result, there is an automatic liquidation of the debt liability of
the government.

Method # 3. Terminal Annuity:

In some countries, the government follows the practice of paying-off the debt
on the basis of terminal annuity. By using this method, the government pays-off
its debt (which includes both interest and the principal) in equal annual
instalments.

This method often finds favour with the planners and policymakers in
developing countries like India because it leads to a fall in the burden of public
debt every year. The government is not required to repay the entire debt at a
time (i.e., it is not required to make one huge lump-sum payment in order to
repay the debt).

Method # 4. Sinking Fund:

Sometimes, this government of a country establishes a separate fund known as
the ‘Sinking Fund’ for the purpose of repaying its debt. Under this system, the
government goes on crediting a fixed amount of money to this fund every year.

By the time the debt matures, sufficient money gets accumulated in the fund so
as to enable the government to repay the debt along with interest. In general,
there are, in fact, two alternative ways of crediting sums to this fund.

The usual procedure is to deposit a certain (fixed) percentage of its annual

income to the fund. A preferable alternative for the government is to raise a new
 125

loan and credit the proceeds to the sinking fund. However, some economists do
not treat the second method with favour. For example, Dalton has opined that it
is in the Tightness of thing to accumulate a sinking fund out of the current
revenue of the government, not out of new loans.

Modern economists like J.F. Due, Richard Musgrave and others look at this
sinking fund method as a systematic method of debt repayment. Under this
system the-burden of debt is spread evenly over an extended period of time (10
– 15 years). Furthermore, this normal method adds to the creditworthiness of the
government. Critics, however, argue that this method is a slow process of debt
repayment.

Method # 5. Debt Conversion:

Sometimes, a high interest debt is converted into a low-interest one. The
question here is: when is this possible? Let us suppose the government contracts
the debt when the existing rate of interest is quite high. But after some time the
market rate of interest may fall.

This gives the government an opportunity to convert its high-interest debt into a
low-interest one. And, the government is enabled to reduce the burden of public
debt. If the interest burden of public debt falls the government is not required to
raise huge revenue through taxes to service the debt.

Instead, the government can reduce taxes and provide relief to the taxpayers in
the event of a fall in the rate of interest payable on public debt. Since most
taxpayers are poor people and bondholders are rich, such debt conversion is
likely to improve the pattern of income distribution. If this happens there is an
automatic reduction in the degree of inequality in the distribution of income.

Method # 6. Statutory Reduction in the Rate of Interest:

Sometimes, the government passes ordinances to reduce the rate of interest
payable on its debt. This happens when the government suffers from financial
crisis and when there is a huge deficit in its budget. There are so many instances
of such compulsory reduction in the rate of interest. However, this practice is
not followed under normal circumstances. Instead, the government is forced to
adopt this method of debt management (repayment) only when the situation so
demands.
 126

Method # 7. Additional Taxation:

Sometimes, the government imposes additional taxes on people to pay interest
on public debt. By levying new taxes, both direct and indirect, the government
can collect the necessary revenue so as to be able to pay-off its old debt.

However, this method is often criticised on the ground that it creates inequality
in the distribution of income by redistribution (transferring) income from
taxpayers to the bondholders. This is why it is said that if income-tax revenue is
used to pay interest on public debt there is a net burden on the community.

Method # 8. Capital Levy:

In times of war or emergency most governments follow the usual practice of
repaying its debt by imposing a capital levy on its citizens. Keynes also agreed
to this method when he discussed the different methods of paying for a war. A
capital levy is just like a wealth tax inasmuch as it is imposed on capital assets.

This method serves a two-fold purpose:

(1) Prima facie, it enables to the government to repay its wartime debt by
collecting additional tax revenues from the rich people (i.e., people who have
huge private property and wealth);

(2) Secondly, such capital levy, imposed at progressive rates in capital assets,
also helps reduce the degree of inequality in the distribution of income and
wealth.

Method # 9. Using Trade Surplus:

The methods discussed above are used to repay internal debt. However, when
the government borrows from other countries, it has to service the debt in
foreign exchange. The burden of country’s external debt is measured by its
debt-service ratio, which is a country’s repayment obligations of principal and
interest for a particular year on its external debt as a percentage of its exports of
goods and services (i.e., its current receipts) in that year.

An external debt is usually repaid in foreign currencies or gold. If a country is

unable to repay the debt it has to export goods abroad. For this, it has to
generate an export surplus, i.e., it has to raise exports and reduce imports and
make net export or the balance of trade favourable.

If a country is able to generate export surplus or balance of trade surplus there

will be net inflow of foreign exchange into the country. This will enable the
debtor country to repay its external (foreign) trade.
 127

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DEFICIT FINANCING

Deficit financing means generating funds to finance the deficit which results
from excess of expenditure over revenue. The gap being covered by borrowing
from the public by the sale of bonds or by printing new money.

Why we need deficit financing

For developing countries like India, higher economic growth is a priority. A
higher economic growth requires finances. With the private sector being shy of
making huge expenditure, the responsibility of drawing financial reresources
rests on the government.

Often both the tax and non-tax revenues fail to mobilize enough resources just
through taxes. The deficit is often funded through borrowings or printing new
currency notes.
What are the pitfalls of deficit financing
Printing new currency notes increases the flow of money in the economy. This
leads to increase in inflationary pressures which leads to rise of prices of goods
and services in the country. Deficit financing is inherently inflationary. Since
deficit financing raises aggregate expenditure and, hence, increases aggregate
demand, the danger of inflation looms large.
What are the effects on investment?
Deficit financing effects investment adversely. When there is inflation in the
economy employees demand higher wages to survive. If their demands are
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accepted it increases the cost of production which de-motivates the investors.

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INTERNATIONAL TRADE
If you can walk into a supermarket and find Costa Rican bananas, Brazilian
coffee, and a bottle of South African wine, you're experiencing the impacts of
international trade.

International trade allows countries to expand their markets and access goods
and services that otherwise may not have been available domestically. As a
result of international trade, the market is more competitive. This ultimately
results in more competitive pricing and brings a cheaper product home to the
consumer.

international trade, economic transactions that are made between countries.

Among the items commonly traded are consumer goods, such as television sets
and clothing; capital goods, such as machinery; and raw materials and food.
Other transactions involve services, such as travel services and payments for
foreign patents.
THEORY OF COMPARATIVE COST
What is a Comparative Advantage?
In economics, a comparative advantage occurs when a country can produce a
good or service at a lower opportunity cost than another country. The theory of
comparative advantage is attributed to political economist David Ricardo, who
wrote the book Principles of Political Economy and Taxation (1817).
Ricardo used the theory of comparative advantage to argue against Great
Britain’s protectionist Corn Laws, which restricted the import of wheat from
1815 to 1846. In arguing for free trade, the political economist stated that
countries were better off specializing in what they enjoy a comparative
advantage in and importing the goods in which they lack a comparative
advantage.
What is an Opportunity Cost?
To understand the theory behind a comparative advantage, it is crucial to
understand the idea of an opportunity cost. An opportunity cost is the foregone
benefits from choosing one alternative over others.
For example, a laborer can use one hour of work to produce either 1 cloth or 3
wines. We can think of opportunity cost as follows: What is the forgone benefit
from choosing to produce one cloth or one wine?
Therefore:
• By producing one cloth, the opportunity cost is 3 wines.
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• By producing one wine, the opportunity cost is ⅓ cloth.

Comparative Advantage and Free Trade
Comparative advantage is a key principle in international trade and forms the
basis of why free trade is beneficial to countries. The theory of comparative
advantage shows that even if a country enjoys an absolute advantage in the
production of goods, trade can still be beneficial to both trading partners.
Practical Example: Comparative Advantage
Consider two countries (France and the United States) that use labor as an input
to produce two goods: wine and cloth.
In France, one hour of a worker’s labor can produce either 5 cloths or 10 wines.
In the US, one hour of a worker’s labor can produce either 20 cloths or 20
wines.
The information provided is illustrated as follows:

It is important to note that the United States enjoys an absolute advantage in the
production of cloth and wine. With one labor hour, a worker can produce either
20 cloths or 20 wines in the United States compared to France’s 5 cloths or 10
wines.
The United States enjoys an absolute advantage in the production of cloth and
wine.
To determine the comparative advantages of France and the United States, we
must first determine the opportunity cost for each output:
France:
Opportunity cost of 1 cloth = 2 wine
Opportunity cost of 1 wine = ½ cloth
The United States:
Opportunity cost of 1 cloth = 1 wine
Opportunity cost of 1 wine = 1 cloth
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When comparing the opportunity cost of 1 cloth for both France and the United
States, we can see that the opportunity cost of cloth is lower in the United
States. Therefore, the United States enjoys a comparative advantage in the
production of cloth.
Additionally, when comparing the opportunity cost of 1 wine for France and the
United States, we can see that the opportunity cost of wine is lower in France.
Therefore, France enjoys a comparative advantage in the production of wine.
Comparative Advantage and its Benefits in Free Trade
How does identifying each country’s comparative advantage aid in
understanding its benefits in free trade?
First, let’s assume that the maximum amount of labor hours is 100 hours.
In France:
If all labor hours went into wine, 1,000 barrels of wine could be produced.
If all labor hours went into cloth, 500 pieces of cloth could be produced.
In the United States:
If all labor hours went into wine, 2,000 barrels of wine could be produced.
If all labor hours went into cloth, 2,000 pieces of cloth could be produced.
Following Ricardo’s theory of comparative advantage in free trade, if each
country specializes in what they enjoy a comparative advantage in and imports
the other good, they will be better off. Recall that:
France enjoys a comparative advantage in wine.
The United States enjoys a comparative advantage in cloth.
In France, the country specializes in wine and produces 1,000 barrels. Recall
that the opportunity cost of 1 barrel of wine in the United States is 1 piece of
cloth. Therefore, the United States would be open to accepting a trade of 1 wine
for up to 1 piece of cloth.
The potential gains from trade for Europe by specializing in wine is represented
by the arrow:
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In the United States, the country specializes in cloth and produces 2,000 pieces.
Recall that the opportunity cost of 1 piece of cloth in France is 2 barrels of
wine. Therefore, France would be open to accepting a trade of 1 cloth for up to
2 barrels of wine.

The potential gains from trade for the United States by specializing in cloth is
represented by the arrow:

Therefore, using the theory of comparative advantage, a country that

specializes in their comparative advantage in free trade is able to realize higher
output gains by exporting the good in which they enjoy a comparative
advantage and importing the good in which they suffer a comparative
disadvantage.
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ARGUMENTS FOR AND AGAINST PROTECTION | TRADE

Arguments for Protection:
The economists at different times put forward different arguments to justify he
policy of protection. Some of the arguments are, however, proved to be
fallacious and so cannot be accepted. There are some other arguments which
prove to be good and so these are widely accepted.

We may discuss both types of arguments for protection:

1. Infant Industries:
Many developing countries, like India, Pakistan, Sri Lanka and Bangladesh
have the conditions necessary to compete successfully in the international
market, but they lack experience and expertise which take time to acquire.

The infant industry argument suggests that new industries should be given
temporary protection in order to enable them to build up this experience. This
argument applies where the industry is small and young, and where costs are
high but fall as the industry grows.

According to this argument, there are some industries in which a country would
really have comparative advantages if and only if it could get them started. If
faced with foreign competition, such infant (young and growing) industries
would not be able to pass the initial period of experiment and financial stresses.

But given protection for a short period, they can be expected to develop
economies of mass production and they would ultimately be able to face foreign
competition without protection. So, at the infant stage such industries should be
protected for a period till they can face competition independently.

The central idea of this argument is embodied in the saying- Nurse the baby,
protect the child, and free the adult’. This argument s now widely accepted in
India as a good ground of protection for a temporary period for promoting home
industries at the early stages.

Critics, however, argue that most infant industries never grow up- that they
continue to demand protection; so their customers continue to pay high prices.
Once protection is given to such industries, it is a practice (mainly for political
reasons), to remove it.
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2. Diversification of Industries Argument:

A policy of production is also advocated to diversify a developing country’s
industrial structure. A country cannot rely on one or a few industries only; it is
necessary that a large number of industries of diverse varieties develop in the
long run. This strategy will reduce the risk of losing foreign markets; for, in
case of failure to export one commodity, other goods may be exported.

3. Employment Protection:
The dynamics of the world economy mean that at any time some industries will
be in decline. If those industries were responsible for a significant amount of
employment in a country in the past, their decline would cause problems of
regional unemployment. There s justification for a country to protect a
contracting industry to slow down its rate of decline so that time is given for
people to find jobs elsewhere in the economy.

4. Employment Creation:
Protection to home industries may create employment opportunities in the
country, and thus reduce the magnitude of unemployment. But this argument is
also fallacious; for protection may create employment in some home industries,
but by reducing imports it reduces employment opportunities in the foreign
countries.

So, such a beggar-my-neighbour high-tariff policy might create employment in

the short run only before other nations retaliate. Protection can of course
increase employment in another way. By improving the balance of trade it can
increase employment and income provided the other countries do no retaliate.
But even this argument is not convincing as protection cannot maintain high
employment indefinitely through export surplus.

5. Balance of Trade:
Some countries experience imbalance in their trade with the rest of the world. If
they are importing too many goods they may correct a temporary problem by
imposing tariffs on imports. A suitable tariff policy can create and maintain a
favourable balance of trade.

The restrictions on imports for the purpose of protection will create a surplus in
the balance of trade of the country. But this argument is wrong. If all countries
simultaneously follow this policy, none would find foreign buyers for the sale
of goods and so none would gain. However, Sir Arthur Lewis has put forward a
counter argument here.
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As he says: “National income cannot be increased by adding imports, since

this would result only in diverting resources to the production of articles of
domestic consumption, thereby with drawing them from the most
profitable export markets. Nor can domestic employment be increased by
reducing imports because this would reduce exports to the same extent”.
6. Dumping to Reflect Low Marginal Cost of Production:
Dumping is a problem which confronts many countries. It is an example of
price discrimination at the international level. By following the practice of
dumping foreign sellers try to capture the home market by selling their goods at
low prices.

Protection of home industries is necessary to resist such a policy. It refers to the

selling of products on overseas markets at prices below those prevailing on
domestic markets. The danger here is that the dumping of products could cause
prices to drop drastically.

This could benefit the consumers in the short run. But, in the long run, domestic
producers could be forced out of business making room for the foreign suppliers
in the future. Producers may be off-loading products on foreign markets to keep
prices up in their home markets. The price of a Japanese camera, for example, is
higher in Tokyo than in New York. Therefore, the effects of dumping are
undesirable and, if it can be detected, some protection against its adverse effects
is justified.

7. Improving the Terms of Trade:

Countries can improve their position when they are the sole (or dominant) buyer
of a commodity. This is rare, but if American importers of tea agreed with one
another to restrict imports’ then the world price would fall. Of course, this
would lower the incomes received by the producers of tea and so might be
thought undesirable as they are mostly poor countries.

8. Retaliation:
Protecting an industry as a retaliation for protection introduced by other
countries is questionable. It was used by the USA when it felt that the European
Union was using hidden subsidies to lower the price of steel exported to the
USA.

9. Unfair Foreign Competition:

Often countries follow a policy of protectionism against unfair foreign
competition. ‘Unfair’ competition can take a variety of forms. Sometimes,
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foreign governments can subsidise their export industries. This means that
domestic industries cannot compete fairly.

Similarly, foreign firms may ‘dump’ their products overseas, either because
they cannot be sold on their domestic market, or in order to destroy competitor.
They could then increase their prices and make large profit Countries also
require protection against low-cost imports.

It is often argued that declining industries need a period of protection in order to

allow the decline to take place gradually, so that workers can retrain as new
industries develop. A variation of this approach says that industries in high
wage countries should have protection against goods made by low-paid labour.

This, of course, denies the advantages of comparative advantage which derive

from lower- costs. Instead, the argument is that if foreign firms pay low wages,
this is a form of unfair competition and domestic firms should be protected.
This would safeguard the position of domestic workers Critics, however, argue
that this would, in fact, reduce the wages of workers in poor countries and make
consumers of rich countries pay higher prices.

Protecting an industry against ‘unfair’ competition is also questionable

countries often will claim that competition is unfair when, in fact, a country
may just be using its comparative advantage to lower costs.

This argument is used against some of the low-wage economies and the difficult
issue is to decide whether wages are low due to the abundance of labour as a
factor of production or whether exploitation is present. If the latter is the case,
protection may not be the answer to the problem.

Fallacious Arguments:
The following arguments for protection are found to be fallacious:
1. Keeping Money at Home Argument:
According to Abraham Lincon, protection prevents the purchase of foreign
goods and thereby keeps money at home. But this argument loses much of its
weight when we observe that owing to protection the people of the country are
to pay higher prices for home-produced goods.

2. Home Market Argument:

It is argued by Henry Clay and other American protectionists that the restriction
on the imports of foreign goods will create a wide domestic market for the
products of the home industries. But this argument is also fallacious because
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protection, by curtailing imports, will reduce exports’ too. It is true that home
industries will lose the foreign markets if the same policy is pursued by
foreigners.

3. National Defence Argument:

Industries which are essential for the defence (e.g., arms and ammunitions,
military equipment, etc.) of the country are to be protected to preserve the
national independence of a country. The policy of discriminating protection as
adopted in India also in 1949-50 prescribed protection for defence industries at
any cost.

4. National Self-Sufficiency Argument:

Protection is also advocated to attain self-sufficiency in essential goods. The
industries which are essential for national self-sufficiency are to be protected.
This is really a convincing argument for protection in developing countries like
India. In fact, national interest is the sole criterion for granting protection to
industries in such countries.

Arguments Against Protection:

The policy of protection is also criticised on various grounds:
(a) It creates obstacles or barriers to free multinational trade. Due to high tariffs
imposed by other countries, a country is not allowed to produce goods in which
it has cost advantages. So, protection reduces world production and con-
sumption of internationally traded goods,

(b) Owing to higher tariff on imports, the consumers are compelled to buy home
goods, often of inferior quality and often at higher prices,

(c) Protection gives shelter to weak home industries. If it is permanent, home

industries would not get any incentive to compete freely with their foreign
counterparts. There would be need for continuation of protection for an
indefinite period,

(d) Protection may lead to trade wars and international conflicts among trading
nations,

(e) Protection give rise to such abuse as ‘wire-pulling’ in political quarters,

vested interest in the protected sector, etc.

Conclusion:
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Although protection has some disadvantages, the developing countries like

India can follow the policy of protection at the early stages of industrial
revaluation. The ultimate object should be to accelerate the rate of economic
growth and the pace of development.

According to Alan S. Blinder, the case against protectionism, described as a

negative-sum game, where the losing consumers lose more than the winning
protected producers win, involves even more problems. There are four other
problems with trade restrictions.

First, protectionism allows high-cost producers that would otherwise fail to

survive. Second, trade restrictions have a habit of affecting other industries. For
example, automobiles need protection because the ball bearings, steel and
textiles that provide inputs to automobiles are protected.

Third, foreign nations often retaliate against protectionism. Tit-for-tat is the

modus operandi in international trade: Country A raises barriers on product X
because Country B did it to product Y. Fourth, trade restrictions are not really
job-saving or job-creating, but job-swapping.

Protectionism raises the exchange rate, hurting exports in unprotected

industries. Because in the long run the value of exports must be equal to the
value of imports, we end up exchanging the products of inefficient unprotected
industries for those inefficient protected industries.

BALANCE OF PAYMENT

Balance Of Payment (BOP) is a statement which records all the monetary

transactions made between residents of a country and the rest of the world during
any given period. This statement includes all the transactions made by/to
individuals, corporates and the government and helps in monitoring the flow of
funds to develop the economy.

A BOP statement of a country indicates whether the country has a surplus or a

deficit of funds i.e when a country’s export is more than its import, its BOP is
said to be in surplus. On the other hand, the BOP deficit indicates that a country’s
imports are more than its exports.

Why is Balance of Payment (BOP) vital for a country?

A country’s BOP is vital for the following reasons:

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The BOP of a country reveals its financial and economic status.

A BOP statement can be used as an indicator to determine whether the

country’s currency value is appreciating or depreciating.

The BOP statement helps the Government to decide on fiscal and trade policies.

It provides important information to analyze and understand the economic

dealings of a country with other countries.

Elements of a Balance of Payment

There are three components of balance of payment viz current account, capital
account, and financial account. The total of the current account must balance
with the total of capital and financial accounts in ideal situations.

Current Account

The current account is used to monitor the inflow and outflow of goods and
services between countries. This account covers all the receipts and payments
made with respect to raw materials and manufactured goods.

It also includes receipts from engineering, tourism, transportation, business

services, stocks, and royalties from patents and copyrights. When all the goods
and services are combined, together they make up to a country’s Balance Of
Trade (BOT).

There are various categories of trade and transfers which happen across
countries. It could be visible or invisible trading, unilateral transfers or other
payments/receipts. Trading in goods between countries are referred to as visible
items and import/export of services (banking, information technology etc) are
referred to as invisible items.
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Unilateral transfers refer to money sent as gifts or donations to residents of

foreign countries. This can also be personal transfers like – money sent by
relatives to their family located in another country.

Capital Account

All capital transactions between the countries are monitored through the capital
account. Capital transactions include the purchase and sale of assets (non-
financial) like land and properties.

The capital account also includes the flow of taxes, purchase and sale of fixed
assets etc by migrants moving out/into a different country. The deficit or surplus
in the current account is managed through the finance from the capital account
and vice versa. There are 3 major elements of a capital account:

Loans and borrowings – It includes all types of loans from both the private
and public sectors located in foreign countries.

Investments – These are funds invested in the corporate stocks by non-

residents.

Foreign exchange reserves – Foreign exchange reserves held by the central

bank of a country to monitor and control the exchange rate does impact the
capital account.

Financial Account

The flow of funds from and to foreign countries through various investments in
real estates, business ventures, foreign direct investments etc is monitored
through the financial account. This account measures the changes in the foreign
ownership of domestic assets and domestic ownership of foreign assets. On
analyzing these changes, it can be understood if the country is selling or acquiring
more assets (like gold, stocks, equity etc).

Illustration

If for the year 2018 the value of exported goods from India is Rs. 80 lakh and the
value of imported items to India is 100 lakh, then India has a trade deficit of Rs.
20 lakh for the year 2018. The BOP statement acts as an economic indicator to
identify the trade deficit or surplus situation of a country. Analyzing and
understanding the BOP of a country goes beyond just deducting the outflows of
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funds from inflows. As mentioned above, there are various components of BOP
and fluctuations in these accounts which provide a clear indication about which
sector of the economy needs to be developed.

INTERNATIONAL LIQUIDITY

Meaning of International Liquidity:

International liquidity is defined as the aggregate stock of internally acceptable
assets held by the central bank to settle a deficit in a country’s balance of
payments. In other words, international liquidity provides a measure of a
country’s ability to finance its deficit in balance of payments without resorting to
adjustment measures. Shortage of liquidity hampers the expansion of global trade
and its surplus leads to global inflationary pressures.

International liquidity is generally used as a synonym for international reserves.

Such reserves include a country’s official gold stock holdings, its convertible
foreign currencies, SDRs, and its net reserve position in the IMF. Economists like
Heller and McKinnon use a broader definition of international liquidity to include
international borrowings, commercial credit operations, and the international
financial structure in a country’s reserves.

This definition implies international availability of liquidity and the possibility of

obtaining credit from financial institutions operating in international financial
markets. Thus, in the broader sense, international liquidity includes private as
well as official holdings of international liquidity assets.

In the literature on international liquidity distinction is made between owned and

borrowed reserves, and between conditional and unconditional reserves. Foreign
exchange surplus, after meeting all current and capital account obligations of the
country with the rest of the world, are “owned” reserves.
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Similarly, the official gold stock of a country constitutes its owned reserves.
Capital imports in the form of borrowings from abroad and direct investments by
foreign countries constitute borrowed reserves. Both owned and borrowed
reserves are the source of international liquidity.

Unconditional international liquidity consists of a country’s official gold stock,

holdings of its foreign currencies and SDRs, its net position in the IMF, and
private holding of international assets. In all such cases, liquidity assets are
available to the country without any conditions or restrictions on their use. But in
the case of borrowed reserves, the lender country may impose conditions or
restrictions on the use of liquid assets by the borrowing country.

Many international financial institutions provide funds on conditional basis for

specific projects and on specified repayment provisions. All these are cases of
conditional liquidity. This is done to avoid the misuse of liquidity by the
borrowing country.

Need and Problem of International Liquidity:

The (need or) problem of international liquidity arises because the demand for
international liquidity is rising more than its supply, thereby implying shortage of
international liquidity.

The principal causes for the shortage of international liquidity are the
following:
1. BOP Deficits:
There have been increasing BOP deficits of the majority of countries in the world.
In particular, after the opening of LDCs to world markets, these countries have
been facing persistent BOP deficits. Too much dependence on exports has
exposed these economies to international fluctuations in the demand for and
prices of their products.
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They have become unstable due to international cyclical instability. On the other
hand, their import requirements have been on the increase in order to develop. As
a result, they are faced with foreign exchange constraints. This has necessitated
larger inflow of aid and foreign investment.

Consequently, debt serving and interest on debt have risen and payments of
dividends, profits and royalties on private direct foreign investment have grown,
thereby leading to decline in the net inflow of foreign capital. All these have led
to further shortage of foreign exchange reserves.

2. High Tariff Barriers:

The exports of LDCs to developed countries have not been increasing, thereby
adversely affecting their export earnings. One of the reasons for the non-
expansion of their exports has been high tariff barriers imposed by the developed
countries on their exports, especially by their regional groups like the EEC.

At the same time, the LDCs are trying to cut down their essential imports from
the developed countries by means of exchange controls, high tariffs, import
quotas and similar protectionist devices in order to conserve foreign exchange.
This has adversely affected their development process.

3. Attitude of Developed Countries:

The majority of developed countries have surplus in their balance of payments.
They are creditors of LDCs and do not take any interest in getting rid of their
surplus so as to increase international liquidity.

4. Unequal Distribution of International Reserves:

The distribution of international reserves is biased and favours the developed
countries. It is primarily based on their quotas in the IMF. Whenever the IMF
quotas are revised, the larger share goes to the developed countries. It is the
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developing countries whose need for international liquidity is far greater which
suffer from its shortage.

Measures to Solve the Problem of International Liquidity:

The following measures have been suggested to solve the problem of
international liquidity:
1. Promoting Export Expansion:
Developing countries should reduce BOP deficit by promoting export expansion.
The choice lies in concentrating the expansion of primary or secondary products
or both. The expansion of secondary products requires import substitution for
export expansion. These policies will earn them foreign exchange.

2. Limiting Exports:
They should ban non-essential consumer goods, and limit imports of specific
goods by selective tariffs, physical quotas, etc. This policy will enable them to
conserve foreign exchange.

3. Changing Official Exchange Rate:

A developing country can change its official exchange rate by devaluing its
currency so that its export prices are lowered and import prices are increased.
This will help in earning foreign exchange.

4. Restrictive Monetary-Fiscal Policies:

By following restrictive monetary and fiscal policies, a developing country can
reduce domestic demand for products which will lower import prices, reduce
inflationary pressures and BOP deficit.

5. Reduction in BOP Surplus:

The majority of developed countries have BOP surplus which they should
reduce by:
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(a) Accepting the national currencies of developing countries for payments;

(b) Removal of trade barriers to the products of developing countries; and

(c) Accepting products of developing countries in exchange for their products, as

was done by the erstwhile USSR.

6. Expanding International Reserves:

The IMF should expand international reserves by fresh allocation of larger quotas
to member countries. In particular, all new issues of SDRs should be distributed
to developing countries so that they may pay then to developed countries to solve
their foreign exchange problem.

IMF and International Liquidity:

There was no problem of international liquidity prior to 1970. This was because
under the Bretton Woods Agreement the exchange rates of countries were fixed
in terms of gold or the US dollar at $ 35 per ounce of gold. Member countries
were forbidden to impose restrictions on payments and trade, except for a
transitional period. They were allowed to hold their monetary reserves partly gold
and partly in dollars and sterling.

These reserves were meant to incur temporary deficits by member countries while
keeping their exchange rates stable. The IMF insisted on expenditure reducing
policies and devaluation to correct deficit in balance of payments.

“Therefore, apart from ad hoc loans made by the IMF, the growth in liquidity
needed to finance the expansion of world trade had to be found in liquidity needed
to finance the expansion of world trade had to be found in the expansion of gold
and the supply of dollar and sterling. But the physical supply of gold is virtually
limited to the output of the mines in South Africa and the Soviet Union.”
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Since the dollar acted as a medium of exchange, a unit of account and a store of
value of the IMF system, every country wanted to increase its reserves of dollar
which led to dollar holdings to a greater extent than needed. Consequently, the
US gold stock continued to decline and the US balance of payments continued to
deteriorate. Robert Triffin warned in 1959 that the demand for world liquidity
was growing faster than the supply because the incremental supply of gold was
increasing little. Since the dollar was convertible into gold, the supply of US
dollars would be inadequate in relation to the liquidity needs of countries.

This might introduce trade barriers by countries in order to have balance of

payments surpluses and build up reserves. Thus, according to Triffin, a growing
liquidity shortage would generate strong contractionary forces that would
threaten the expansion of the world economy and lead to a world recession of the
1931 type.

A crisis of confidence had already erupted. The pound had been devalued in
November 1967. There was no control over the world gold market with the
appearance of a separate price in the open market. On 15 August, 1970, the United
States suspended the conversion of dollars into gold and refused to intervene in
the foreign exchange markets to maintain exchange rate stability.

The ‘Group of Ten’ industrial countries met at the Smithsonian Institute in

Washington in December 1971 and agreed to the realignment of major currencies
by devaluing the dollar by 10 per cent and revaluing their currencies. The
Smithsonian Agreement broke down following the US dollar devaluation of
February 1973 again and in March 1973 a number of countries had floating
exchange rates and the EEC countries had a “joint float” of their currencies.
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The Jamaica Agreement of January 1976 formalized the regime of floating

exchange rates. By the Second Amendment of the IMF Charter in 1978, the
member countries are not expected to maintain and establish par values with gold
or dollar. The Fund has no control over the exchange rate adjustment policies of
the member countries. The system of flexible exchange rates has tended to reduce
the need for more reserves.

Role of the IMF In Increasing World Liquidity:

The IMF is an international monetary institution which is the principal source of
supply of world liquidity to its 182 members. Over the years, it has adopted the
following measures to increase international liquidity.

SDRs. In early 1970, it introduced a scheme for the creation and issue of Special
Drawing Rights (SDRs) as unconditional reserve assets to influence the level of
world reserves and to solve the problem of international liquidity. There are SDR
146 billion in the Fund’s General Account.

The Fund also creates SDRs and allocates them to members in proportion of their
quotas. For this purpose, the Fund has established the Special Drawing Account.
As the international monetary asset, SDRs are held in the international reserves
of central banks and governments to finance improve international liquidity so as
to correct fundamental disequilibria in the balance of payments of Fund members.
The participants in the SDR scheme receive SDRs under “transactions with
designation” and “transactions by agreement” unconditionally. The IMF acts as
a clearing house in these transactions. Since 1981 there are 21.4 billion SDRs in
the Fund.

Quotas:
The bulk of Fund’s financial resources comes from quota subscriptions of
member countries. To meet the global demand for liquidity, it has been increasing
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quotas of members every four years under the General Review of Quotas. As a
result, it increased the member quotas from 7.6 billion in 1947 to SDR 212 billion
in 1998.

Selling Gold:
It increases its funds by selling gold to members.

Borrowings:
It borrows from governments, central banks or private institutions of
industrialised countries, the Bank for International Settlements, and even from
OPEC countries, like Saudi Arabia.

Reserve Tranche:
The Fund has a variety of facilities for lending its resources to member countries.
Lending by the Fund is linked to temporary assistance to member in financing
disequilibrium in their balance of payments on current account. If a member has
less currency with the Fund than its quota, the difference is called gold or reserve
tranche.

It can draw up to 25 per cent on its reserve tranche automatically upon

representation to the Fund for its balance of payments needs. It is not charged any
interest on such drawings, but is required to repay within a period of three to five
years.

Credit Tranche:
A member can draw further from balance quota in 4 instalments upon 100 per
cent of its quota from credit tranche annually. Drawings from credit tranche are
conditional because the members have to satisfy the Fund of adopting a viable
programme to ensure financial stability.
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To meet the severe balance of payments problems, the Fund has been gradually
raising the limit of borrowings by its members over the years under the credit
tranche. Now members can draw up to the equivalent of 300 per cent of their new
quotas on the total net use of the Fund’s resources. The limits exclude drawings
from CCFF, BSAF, SAF, STF and ESAF. The purchases are made under stand-
by arrangements rather than directly.

New Credit Facilities:

Since the 1960s, the Fund has created several new credit facilities for its
members. Loans from these facilities are separate from tranches and are available
for a longer period. These are : BSFF (Buffer Stock Financing Facility), EFF
(Extended Fund Facility), SFF (Supplementary Financing Facility), SAF
(Structural Adjustment Facility), ESAF (Enhanced Structural Adjustment
Facility), CCFF (Compensatory and Contingency Financing Facility), STF
(Systematic Transformation Facility), ESAL (Emergency Structural Adjustment
Loans) and CCL (Contingency Credit Line).1 These facilities provide for
members annual access to Fund resources up to 150% of their quotas or up to
450% over a three year period.
IDA Replenishments:
Another important source for increasing world liquidity is the IDA
Replenishments to the poor developing countries for three years by the
developing countries. In recent years, IDA-9 Replenishment gave $ 15.55 billion
in 1990, IDA-10 gave $ 18 billion in 1993, and IDA-11 gave 22 billion in 1996
for three years.

Criticisms of IMF:
The various Fund schemes for increasing global liquidity have been criticised for
favouring the developed countries. They are inequitable which have tended to
mark unfair distribution of international liquidity. For instance, the allocation of
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SDRs to participating countries is proportional to their quotas. In this sense, the

allocation of SDRs to developing countries is too low as compared to their needs.
Low allocation of SDRs reduces the borrowing capacity of such countries.

Moreover, the SDR scheme does not link the creation of international reserves in
the form of SDRs with the need for development finance on the part of developing
countries. The need for liquidity on the part of developing country is great.
Therefore, there is need to create more SDRs with fair distribution so that more
unconditional liquidity is made available for the greater needs of developing
countries.

Unfortunately, due to the rigid attitude of the United States and some other
developed countries, the Fund has not been able to resume allocation of SDRs
from January 1982, despite the repeated pleas of the developing countries over
these years.

So the Fund has failed in its objective of increasing international liquidity through
SDRs. Consequently, faced with a recession, an inadequate flow of concessional
aid and falling prices of commodities and raw materials, developing countries
have been facing severe balance of payments and debt problems. To solve this
problem, there is urgent need for fresh allocation of SDRs which should be
distributed only to developing countries.

INTERNATIONAL FINANCIAL INSTITUTIONS

At the Bretton Woods Conference in 1944 it was decided to establish a new

monetary order that would expand international trade, promote international
capital flows and contribute to monetary stability. The IMF and the World Bank
were borne out of this Conference of the end of World War II. The World Bank
was established to help the restoration of economies disrupted by War by
facilitating the investment of capital for productive purposes and to promote the
long-range balanced growth of international trade. On the other hand, the IMF is
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primarily a supervisory institution for coordinating the efforts of member

countries to achieve greater cooperation in the formulation of economic
policies. It helps to promote exchange 1stability and orderly exchange relations
among its member countries. It is in this context that the present chapter reviews
the purpose and working of some of the international financial institutions and
the contributions made by them in promoting economic and social progress in
developing countries by helping raise standards of living and productivity to the
point of which development becomes self-sustaining.

THE WORLD BANK The World Bank group is a multinational financial

institution established at the end of World War II (1944) to help provide long-
term capital for the reconstruction and development of member countries. The
group is important to multinational corporations because it provides much of the
planning and financing for economic development projects involving billions of
dollars for which private businesses can act as contractors and suppliers of
goods and engineering related services.

The purpose for the setting up of the Bank are

• To assist in the reconstruction and development of territories of members by

facilitating the investment of capital for productive purposes, including the
restoration of economies destroyed or disrupted by war, the reconversion of
productive facilities to peacetime needs and encouragement of the development
or productive facilities and resources in less developed countries.

• To promote private foreign investment by means of guarantees or participation

in loans and other investments made by private investors; and when private
capital is not available on reasonable terms, to supplement private investment
by providing, on suitable conditions, finance for productive purposes out of its
own capital, funds raised by it and its other resources.

• To promote the long-range balanced growth of international trade and the

maintenance of equilibrium in balance of payments by encouraging
international investment for the development of the productive resources of
members, thereby assisting in raising productivity, the standard of living and
condition of labour in their territories.

• To arrange the loans made or guaranteed by it in relation to international loans

through other channels so that the more useful and urgent projects, large and
small alike, can be dealt with first.
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To conduct its operations with due regard to the effect of international

investment on business conditions in the territories of members and, in the
immediate post-war years, to assist in bringing about a smooth transition from a
wartime to a peacetime economy.

The World Bank is the International Bank for Reconstruction and Development
(IBRD) and the International Development Association (IDA). The IBRD has
two affiliates, the International Finance Corporation (IFC) and the Multilateral
Investment Guarantee Agency (MIGA). The Bank, the IFC and e MIGA are
sometimes referred to as the “World Bank Group”.

15.4 INTERNATIONAL MONETARY FUND

The International Monetary Fund (IMF) came into official existence on

December 27, 1945, when 29 countries signed its Articles of Agreement (its
Charter) agreed at a conference held in Bretton Woods, New Hampshire, USA.
IMF is a cooperative institution that 182 countries have voluntarily joined
because they see the advantage of consulting with one another on this forum to
maintain a stable system of buying and selling their currencies so that payments
in foreign currency can take place between countries smoothly and without
delay. Its policies and activities are guided by its Charter known as the Articles
of Agreement. IMF lends money to members having trouble meeting financial
obligations to other members, but only on the condition that they undertake
economic reforms to eliminate these difficulties for their own good and that of
the entire membership. Contrary to widespread perception, the IMF has no
effective authority over the domestic economic policies of its members. What
authority the IMF does possess is confined to requiring the member to disclose
information on its monetary and fiscal policies and to avoid, as far as possible,
putting restrictions on exchange of domestic for foreign currency and on
making payments to other members. There are several major accomplishments
to the credit of the International Monetary System. For example, it

• sustained a rapidly increasing volume of trade and investment;

• displayed flexibility in adapting to changes in international commerce;

• proved to be efficient (even when there were decreasing percentages of

reserves to trade);

• proved to be hardy (it survived a number of pre-1971 crises, speculative and

otherwise, and the down-and-up swings of several business cycles);
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• allowed for a growing degree or international cooperation;

• established a capacity to accommodate reforms and improvements. To an

extent, the fund served as an international central bank to help countries during
periods of temporary balance of payments difficulties by protecting their rates
of exchange. Because of that countries did not need to resort to exchange
controls and other barriers to restrict world trade.

Statutory purposes

The purposes of the International Monetary Fund are:

• To promote international monetary cooperation through a permanent

institution that provides the machinery for consultation and collaboration on
international monetary problems.

• To facilitate the expansion and balanced growth of international trade and to

contribute, thereby, to the promotion and maintenance of high levels of
employment and real income and to the development of the productive
resources of all members as primary objectives of economic policy.

• To promote exchange stability, to maintain orderly exchange arrangements

among members and to avoid competitive exchange depreciation.

• To assist in the establishment of a multilateral system of payments in respect

of current transactions between members and in the elimination of foreign
exchange restrictions which hamper the growth of world trade.

• To give confidence to members by making the general resources of the Fund

temporarily available to them under adequate safeguards, thus providing them
with opportunity to correct maladjustment in their balance of payments without
resorting to measures destructive to national or international prosperity.

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

15.5 SDRs

As time passed, it became evident that the Fund’s resources for providing short-
term accommodation to countries in monetary difficulties were not sufficient.
To resolve the situation, the Fund, after much debate and long deliberations,
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created new drawing rights in 1969. Special Drawing Rights (SDRs), sometimes
called paper gold, are special account entries on the IMF books designed to
provide additional liquidity to support growing world commerce. Although
SDRs are a form of money not convertible to gold, their gold value is
guaranteed, which helps to ensure their acceptability. Initially, SDRs worth $9.5
billion were created.

Participant nations may use SDRs as a source of currency in a spot transaction,

as a loan for clearing a financial obligation, as a security for a loan, as a Swap
against currency, or in a forward exchange operation. A nation with a balance of
payments need may use its SDRs to obtain usable currency from another nation
designated by the fund. A participant also may use SDRs to make payments to
the Fund, such as repurchases. The Fund itself may transfer SDRs to a
participant for various purposes including the transfer of SDRs instead of
currency to a member using the Fund’s resources.

Services

Besides supervising the international monetary system and providing financial

support to member countries, the IMF assists its members by:

• Providing technical assistance in certain areas of its competence.

• Running an educational institute in Washington and offering training courses

abroad.

• Issuing wide variety of publications containing valuable information and

statistics that are useful not only to the member countries but also to banks,
research institutes, university and the media.

15.6 ASIAN DEVELOPMENT BANK (ADB)

The Asian Development Bank is a multilateral developmental finance

institution founded in 1966 by 31 member governments to promote social and
economic progress of Asian and the Pacific region. The Bank gives special
attention to the needs of smaller or less developed countries and gives priority
to regional/non-regional national programmes.

In early 1960, the United National Economic Commission for Asia and Far
East (UNECAFE) estimated that Asia and the Pacific region had an annual
deficit of US $ one billion. The ADB was formed to fill this gap. The inaugural
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meeting was held in Tokyo and the newly named bank was installed in Manila
(Philippines). The first President was Mr. Wanatanade and during his initial
years the bank conducted regional surveys to develop a fuller understanding of
the social and economic conditions of the Developing Member Countries
(DMC).

The Bank’s principal functions are

• To extend loans and equity investments for the economic and social
development of its Developing Member Countries (DMCS);

• To provide technical assistance for the preparation and execution of

development projects and programmes and for advisory services;

• To promote and facilitate investment of public and private capital for

development purposes; and

• To respond to requests for assistance in coordinating development policies and

plans of its DMCs.

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