UNIT-4-MACRO ECONOMICS Dr.

Arvinder Kour

UNIT – 4- MACRO ECONOMICS

Nature and Scope of Macroeconomics, Concept of GDP, GNP, NDP, NNP, Measurement of GDP;
Economic Growth and development, Money – definition, types and function of money, Inflation –
meaning, types, causes and measure to control, concept of deflation, functions of central and
commercial bank , Sources of public revenue - direct and indirect taxes. .

Macroeconomics

The term macroeconomics was introduced by Ragnar Frisch in 1933. However, its approach to
economic problems came in the 16th and 17th centuries. As a result, this originated with mercantilists.

This branch of Economics deals with the economy as a whole or totality, including the Macro factors.
The scope of macroeconomics does not involve studying the individual units of an economy.
However, the economy studies the total and average of the entire economy. The major factors include
national income, total employment, total savings and investments, aggregate demand and supply,
and the general price level.

The scope of macroeconomics revolves around the determination of income and employment.
Therefore, it is known as the “theory of income and employment.”

Control over the inflation and deflation cycle was only possible by choosing the current economic
policies. These policies were formulated at the macro level. Moreover, governments’ participation
through monetary and fiscal measures has increased. Therefore, the use of macro analysis is
irrefutable.

So now, we understand that macroeconomics is a specialized field of Economics. It focuses on the

economy through the aggregate of the individual units to determine a large impact on the complete
nation.
All the prominent policies and measures are based on this concept. For example, the per capita
income determines the National income. This is an average of the total earnings of all the citizens in
the nation.

The following table will help you get a good understanding of the two branches of economics:

Scope of Macroeconomics

Macroeconomics is an essential field of study for economists. The scope of macroeconomics is

immense. Government, financial bodies, and researchers analyze a nation’s general national issues
and economic well-being. It mainly covers the major fundamentals of macroeconomic theories and
policies.

The Macroeconomic theories involve economic growth and development, national income, money,
international trade, employment, and general price level. In contrast, macroeconomic policies cover
fiscal and monetary policies. The study of problems like unemployment in India, the general price
level, or the disequilibrium in the balance of payment (BOP) is a part of the macroeconomic study.

The scope of macroeconomics covers numerous subject matters. Some of these are as follows:

Macroeconomic Theories
Understandably, the Government is the regulating body of a nation. It considers the various critical
aspects that directly impact the lives of the citizens. There are six theories under the scope of
macroeconomics:

1. Theory of Economic Growth and Development

The growth of an economy also comes under the study of macroeconomics. The resources and
capabilities of an economy are evaluated based on the scope of macroeconomics. It influences the
increase in national income and output at the environmental level. They have a direct impact on the
economic development of an economy.

2. Theory of Money

Macroeconomics assesses the impact of the reserve bank on the economy, the inflow and outflow of
capital, and its effects on job rates. The frequent change in the value of money caused due to inflation
and deflation has adverse effects on a nation’s economy. They can be cured by taking monetary and
fiscal policies and direct economic control measures.

3. Theory of National Income

It includes different topics related to measuring national income, including revenue, spending, and
budgeting. The macroeconomic study is vital for assessing the economy’s overall performance in
terms of national income. At the onset of the Great Depression of the 1930s, it was essential to
investigate the triggers of general overproduction and unemployment.

This led to the creation of data on national income. It helps forecast the level of economic activity and
income distribution among various citizens.

4. Theory of International Trade

It is an area of study focusing on exporting and importing products or services. In brief, it points out
the effect on the economy through cross-border commerce and customs duty.

5. Theory of Employment

This scope of macroeconomics assists in determining the level of unemployment. It also determines
the causes that lead to such conditions of unemployment. Hence, this affects the production, supply,
consumer demand, consumption, and expenditure behaviour.

6. Theory of General Price Level

This refers to studying commodity prices and how specific price rates fluctuate due to inflation or
deflation.

Macroeconomic Policies

The RBI and the Government of India function jointly to imply the macroeconomic policies for the
nation’s improvement and development. It is classified into the following two sections:

1. Fiscal policy
It is one of the effective tools of macroeconomics that helps ensure a country’s economic stability. It
refers to how the expenditure meets the deficit income, which explains itself as a form of budget
decision under the scope of macroeconomics.

2. Monetary policies

The Reserve Bank is establishing monetary policy in coordination with the Government. These
policies are the measures taken to maintain economic stability and growth by regulating the different
interest rates.

Importance of Macroeconomics

Till now we have studied the nature and scope of macroeconomics. Now let us understand the
importance of macroeconomics in multiple areas:

 Macroeconomics is a vital concept that considers the whole nation and works for the
economy’s welfare.
 It helps prevent economic fluctuations and prepare for any financial crisis or long-term
negative situations.
 The fiscal and monetary policies system depends entirely on the analysis of the widely held
macroeconomic conditions in the nation.
 Macroeconomics mainly aims to help the Government and the financial bodies maintain
economic stability in the country.
 This stream of economics gives a broader perspective of social or national issues.
 It ensures or checks the country’s economy and financial position properly.
 Analyzing macroeconomic theories and issues helps economists figure out the causes and
possible solutions to such macro-level problems.
 Dealing with various economic conditions through macroeconomic data opens the door to
growth for the country.

Macroeconomics Constraints

The scope of macroeconomics comprises a wide range of areas. However, certain constraints are
affecting the scope of macroeconomics. An economist needs to analyze the following problems while
studying macroeconomics:

 Business activities also result in societal costs like deforestation and land degradation. The
government carries out clear laws and legislation to regulate such social expenses. These
regulations serve as a barrier for business organizations.
 The economic conditions of a nation have a critical impact on the activities of every firm, either
directly or indirectly. Different economic patterns or variables affecting the industries include
the GDP, job rates and conditions, revenue, banking, and pricing policies.
 Many organizations trade in international markets. They are sensitive to the fluctuations in the
economy of other countries, exchange rates, prices, and other varied factors. Hence, such
changes may influence the economic conditions of the country. This might also end up
affecting business organizations.

Summing up
Macroeconomics is the aggregate study of the entire economy of a nation. The way of allocating
resources is determined using the principles of macroeconomics. Be it your everyday life or industrial
working areas, macroeconomics has its presence in every field. Having a dynamic nature, it deals
with the continuous changes in an economy.

There is a great importance of macroeconomics in the financial model of a country. It helps the
government to curate solutions to various economic problems. It plays a vital role in attaining the
economic stability of a country.

The scope of macroeconomics is extensive. It exerts influence on both individuals as well as the
government’s economic frameworks.

Macroeconomics also serves as the foundation of many economic policies. It lays the basis of a
regional decision-making mechanism in a nation. It throws light on how the economy of a country
works.
However, the policies underpinned by this concept usually have an outspread impact. It requires an
observational, logical, and incredible approach.

Gross Domestic Product (GDP)

One of the main ideas that economist John Maynard Keynes introduced is the idea that the number
one driver of the economy is demand. If we can measure the economy in terms of what everyone
spends, then we can estimate the level of production in our economy. We measure the economy
using GDP.

GDP stands for gross domestic product. It's the official measure of the total output of goods and
services in the economy. The definition of GDP is as follows: it is the total market value of all final
goods and services produced during a given time period within a nation's domestic borders.

The word 'domestic' (in 'gross domestic product') means that we're only counting things that are
produced within our domestic borders, whether they are produced by Americans or by foreigners. It
doesn't matter. Nothing that is produced outside of our domestic borders gets counted in the GDP.

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 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 – Depreciation.

Gross National Product (GNP):

Gross national product (GNP) is an estimate of total value of all the final products and services
produced in a given period by the means of production owned by a country's residents. GNP is
commonly calculated by taking the sum of personal consumption expenditures, private domestic
investment, government expenditure, net exports, and any income earned by residents from overseas
investments, minus income earned within the domestic economy by foreign residents. Net exports
represent the difference between what a country exports minus any imports of goods and services.

GNP is related to another important economic measure called gross domestic product (GDP), which
takes into account all output produced within a country's borders regardless of who owns the means
of production. GNP starts with GDP, adds residents' investment income from overseas investments,
and subtracts foreign residents' investment income earned within a country.

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.

 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.

All this process is termed depreciation or capital consumption allowance. In order to arrive at NNP, we
deduct depreciation from GNP. The word ‘net’ refers to the exclusion of that part of total output which
represents depreciation. So NNP = GNP—Depreciation.

 Estimation of GDP:

There are three methods of estimating 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. The following items are included in India in this: agriculture and allied services; mining;
manufacturing, construction, electricity, gas and water supply; transport, communication and trade;
banking and insurance, real estates and ownership of dwellings and business services; and public
administration and defense and other services (or government services). In other words, it is the sum
of gross value added.

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.

GDP by expenditure method includes:

(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). That part of consumption, investment and government expenditure which is
spent on imports is subtracted from GDP. Similarly, any imported component, such as raw materials,
which is used in the manufacture of export goods, is also excluded.

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.

 GDP at Factor Cost and at Market Price:

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.

GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies.

GDP at factor cost includes:

(i) Compensation of employees i.e., wages, salaries, etc.

(ii) Operating surplus which is the business profit of both incorporated and unincorporated firms.

(iii) Mixed Income of Self- employed.

GDP at Market Price:

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 Domestic Product at market prices. Thus GDP at market prices
means the gross value of final goods and services produced annually in a country.

Conceptually, GDP at factor cost and GDP at market price must be identical/This is because the
factor cost (payments to factors) of producing goods must equal the final value of goods and services
at market prices. However, the market value of goods and services is different from the earnings of
the factors of production.

In GDP at market price are included indirect taxes and are excluded subsidies by the government.
Therefore, in order to arrive at GDP at factor cost, indirect taxes are subtracted and subsidies are
added to GDP at market price.

 GDP at Current and Constant Price:

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. In comparing one year with another, we are faced with the
problem that the rupee is not a stable measure of purchasing power. GDP may rise a great deal in a
year, not because the economy has been growing rapidly but because of rise in prices (or inflation).
On the contrary, GDP may increase as a result of fall in prices in a year but actually it may be less as
compared to the last year. In both cases, GDP does not show the real state of the economy. To rectify
the underestimation and overestimation of GDP, we need a measure that adjusts for rising and falling
prices.

This can be done by measuring GDP at constant prices which is called real GDP. 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.

ECONOMIC GROWTH

“Economic growth is an increase in the capacity of an economy to produce goods and services,
compared from one period of time to another.” It can be measured in nominal or real terms, the latter
of which is adjusted for inflation.

Economic growth can be defined as, “An increase in the capacity of an economy to produce goods
and services within a specific period of time.”

Following are some of the important factors that affect the economic growth of a country:

(a) Human Resource:

Refers to one of the most important determinant of economic growth of a country. The quality and
quantity of available human resource can directly affect the growth of an economy. The quality of
human resource is dependent on its skills, creative abilities, training, and education. If the human
resource of a country is well skilled and trained then the output would also be of high quality.

(b) Natural Resources:

Affect the economic growth of a country to a large extent. Natural resources involve resources that
are produced by nature either on the land or beneath the land. The resources on land include plants,
water resources and landscape. The resources beneath the land or underground resources include
oil, natural gas, metals, non-metals, and minerals. The natural resources of a country depend on the
climatic and environmental conditions. Countries having plenty of natural resources enjoy good
growth than countries with small amount of natural resources.

(c) Capital Formation:

Involves land, building, machinery, power, transportation, and medium of communication. Producing
and acquiring all these manmade products is termed as capital formation. Capital formation increases
the availability of capital per worker, which further increases capital/labor ratio. Consequently, the
productivity of labor increases, which ultimately results in the increase in output and growth of the
economy.

(d) Technological Development:

Refers to one of the important factors that affect the growth of an economy. Technology involves
application of scientific methods and production techniques. In other words, technology can be
defined as nature and type of technical instruments used by a certain amount of labor. Technological
development helps in increasing productivity with the limited amount of resources. Countries that
have worked in the field of technological development grow rapidly as compared to countries that
have less focus on technological development.

(e) Social and Political Factors:

Play a crucial role in economic growth of a country. Social factors involve customs, traditions, values
and beliefs, which contribute to the growth of an economy to a considerable extent.
For example, a society with conventional beliefs and superstitions resists the adoption of modern
ways of living. In such a case, achieving becomes difficult. Apart from this, political factors, such as
participation of government in formulating and implementing various policies, have a major part in
economic growth.

ECONOMIC DEVELOPMENT

1. Prof. Meier and Baldwin

According to Prof. Meier and Baldwin; "Economic development is a process whereby an economy's
real national income increases over a long period of time".

2. Prof. Colin Clark

"Economic progress can be defined simply as an improvement in economic welfare."

"Economic development is a continuous process which has to be extended over a long period of time
so as to break the vicious circle of poverty and lead a country to a stage of self-sustaining growth or to
Self-generating economy".

Factors that Influence the Economic Development of a Country

There are mainly two types of determinants (factors) which influence the economic development of a
country.

A) Economic Factors in Economic Development:

1) Capital Formation:

The strategic role of capital in raising the level of production has traditionally been acknowledged in
economics. It is now universally admitted that a country which wants to accelerate the pace of growth,
has choice but to save a high ratio-of its income, with the objective of raising the level of investment.
Great reliance on foreign aid is highly risky, and thus has to be avoided. Economists rightly assert that
lack of capital is the principal obstacle to growth and no developmental plan will succeed unless
adequate supply of capital is forthcoming.

2) Natural Resources:

The principal factor affecting the development of an economy is the natural resources. Among the
natural resources, the land area and the quality of the soil, forest wealth, good river system, minerals
and oil-resources, good and bracing climate, etc., are included. For economic growth, the existence of
natural resources in abundance is essential. A country deficient in natural resources may not be in a
position to develop rapidly. In fact, natural resources are a necessary condition for economic growth
but not a sufficient one. Japan and India are the two contradictory examples.

3) Marketable Surplus of Agriculture:

Increase in agricultural production accompanied by a rise in productivity is important from the point of
view of the development of a country. But what is more important is that the marketable surplus of
agriculture increases. The term ‘marketable surplus’ refers to the excess of output in the agricultural
sector over and above what is required to allow the rural population to subsist.

The importance of the marketable surplus in a developing economy emanates from the fact that the
urban industrial population subsists on it. With the development of an economy, the ratio of the urban
population increases and increasing demands are made on agriculture for food grains. These
demands must be met adequately; otherwise the consequent scarcity of food in urban areas will
arrest growth.

4) Economic System:

The economic system and the historical setting of a country also decide the development prospects to
a great extent. There was a time when a country could have a laissez faire economy and yet face no
difficulty in making economic progress. In today’s entirely different world situation, a country would
find it difficult to grow along the England’s path of development.

B) Non-Economic Factors in Economic Development:

1) Human Resources:

Human resources are an important factor in economic development. Man provides labour power for
production and if in a country labour is efficient and skilled, its capacity to contribute to growth will
decidedly be high. The productivity of illiterate, unskilled, disease ridden and superstitious people is
generally low and they do not provide any hope to developmental work in a country. But in case
human resources remain either unutilized or the manpower management remains defective, the same
people who could have made a positive contribution to growth activity prove to be a burden on the
economy.

2) Technical Know-How and General Education:

It has never been, doubted that the level of technical know-how has a direct bearing on the pace of
development. As the scientific and technological knowledge advances, man discovers more and more
sophisticated techniques of production which steadily raise the productivity levels.

Schumpeter was deeply impressed by the innovations done by the entrepreneurs, and he attributed
much of the capitalist development to this role of the entrepreneurial class. Since technology has now
become highly sophisticated, still greater attention has to be given to Research and Development for
further advancement. Under assumptions of a linear homogeneous production function and a neutral
technical change which does not affect the rate of substitution between capital and labour, Robert M.
Solow has observed that the contribution of education to the increase in output per man hour in the
United States between 1909 and 1949 was more than that of any other factor.

3) Political Freedom:

Looking to the world history of modern times one learns that the processes of development and
underdevelopment are interlinked and it is wrong to view them in isolation. We all know that the
under-development of India, Pakistan, Bangladesh, Sri Lanka, Malaysia, Kenya and a few other
countries, which were in the past British colonies, was linked with the development of England.
England recklessly exploited them and appropriated a large portion of their economic surplus.

4) Social Organisation:

Mass participation in development programs is a pre-condition for accelerating the growth process.
However, people show interest in the development activity only when they feel that the fruits of growth
will be fairly distributed. Experiences from a number of countries suggest that whenever the defective
social organisation allows some elite groups to appropriate the benefits of growth, the general mass
of people develop apathy towards State’s development programs. Under the circumstances, it is futile
to hope that masses will participate in the development projects undertaken by the State.

5) Corruption:

Corruption is an obstacle in developing countries at various levels and it operates as a negative factor
in their growth process. Until and unless these countries root-out corruption in their administrative
system, it is most natural that the capitalists, traders and other powerful economic classes will
continue to exploit national resources in their personal interests.

6) Desire to Develop:

Development activity is not a mechanical process. The pace of economic growth in any country
depends to a great extent on people’s desire to develop. If in some country level of consciousness is
low and the general mass of people has accepted poverty as its fate, then there will be little hope for
development. According to Richard T. Gill, “The point is that economic development is not a
mechanical process; it is not a simple adding- up of assorted factors. Ultimately, it is a human
enterprise. And like all human enterprises, its outcome will depend finally on the skill, quality and
attitudes of the men who undertake”.

Definition and Functions of Money

In order to understand the fundamentals of economics, it is imperative to have a good understanding of

money. In this article, we will look at the definition of money from an economics perspective and also the
various functions of money.

Definition of Money

Money, in simple terms, is a medium of exchange. It is instrumental in the exchange of goods and/or
services.

Further, money is the most liquid assets among all our assets. It also has general acceptability as a
means of payment along with its liquid nature.

Usually, the Central Bank or Government of a country creates and issues money. Also called cash
money, this is a legal tender and hence there is a legal compulsion on citizens to accept it.

Functions of Money

There are many static and dynamic functions of money as follows:

Static Functions of Money

These functions are:

  A medium of Exchange – In an exchange economy, money plays an intermediary role. It makes
the exchange system smooth and convenient.

 A measure of Value – The value of a product or service is determined on the basis of the money
needed for its possession. This helps in making the exchange a mutually profitable activity.

 The Standard of Deferred Payments – Money plays an important role in lending and borrowing.
Money is taken as a loan and repaid after a time-gap.

 Store of Value – You can store the purchasing power of money and keep a part of it for future
use – monetary savings. You can use your current income for current consumption as well as
future consumption through savings.

Dynamic Functions of Money:

These functions are:

 Money can activate idle resources and put them into productive channels.

 Therefore, it helps in increasing output, employment, and also income levels.

 Further, it helps in converting savings into investments.

 The creation of new money governments of modern economies can spend more than what they
earn.

Different Types of Money :

There are several kinds of money varying in liability and strength. The society has modified the money
at different times and in this way several types of money are introduced. When there was ample
availability of metals, metal money came into existence later it was substituted by the paper money.
At different times, several commodities were used as the medium of exchange. So, it can be said that
according to the needs and availability of means, the kinds of money has changed.

There are 4 major types of Money :

 Commodity Money
 Fiat Money
 Fiduciary Money
 Commercial Bank Money

Commodity Money
It is the simplest kind of money which is used in barter system where the valuable resources fulfil the
functions of money. The value of this kind of money comes from the value of resource used for the
purpose. It is only limited by the scarcity of the resources. Value of this kind of money involves the
parties associated with the exchange process. This money has intrinsic value.
Whenever any commodity is used for the exchange purpose, the commodity becomes equivalent to
the money and is called commodity money. There are certain types of commodity, which are used as
the commodity money. Among these, there are several precious metals like gold, silver, copper and
many more. Again, in many parts of the world, seashells (also known as cowrie shells), tobacco and
many other items were in use as a type of money & medium of exchange.
Ex: gold coins, beads, shells, pearls, stones, tea, sugar, metal.
Fiat Money
Fiat currency is the kind of money which don’t have any intrinsic value and it can’t convert into a
valuable resource. The value of fiat money is determined by government order which makes it a legal
instrument for all transaction purposes. The fiat money needs to be controlled as it may affect entire
economy of a country if it is misused. Today Fiat money is the basis of all the modern money system.
The real value of fiat money is determined by the market forces of demand and supply.
Ex: Paper money, Coins.

Fiduciary Money
Today’s monetary system is highly fiduciary. Whenever any bank assures the customers to pay in
different types of money and when the customer can sell the promise or transfer it to somebody else,
it is called the fiduciary money. Fiduciary money is generally paid in gold, silver or paper money.
There are cheques and banknotes, which are the examples of fiduciary money because both are
some kind of token which are used as money and carry the same value.

Commercial Bank Money

Commercial Bank money or demand deposits are claims against financial institutions that can be
used for the purchase of goods and services. A demand deposit account is an account from which
funds can be withdrawn at any time by cheque or cash withdrawal without giving the bank or financial
institution any prior notice. Banks have the legal obligation to return funds held in demand deposits
immediately upon demand (or ‘at call’). Demand deposit withdrawals can be performed in person, via
cheques or bank drafts, using automatic teller machines (ATMs), or through online banking.

Other types of Money:

There are also various other types of money like the credit money, electronic money, coin and paper
money, Fractional money and Representative money as discussed below :
Fractional Money
It is a hybrid type of money which is partly backed by a commodity and has a fiat money transaction
purpose. If the commodity loses its value then Fractional money converts into Fiat money.
Representative money
It represents a claim on commodity and it can be redeemed for that commodity at a bank. It is a token
or paper money that can be exchanged for a fixed quantity of a commodity. Its value depends on the
commodity it backs.
Coins
Metals of particular weight are stamped into coins. There are various precious metals like gold, silver,
bronze, copper whose coins are already used in human history. The minting of coins is controlled by
the state government or ministry of finance.
Paper Money
Paper money doesn’t have any intrinsic value, as a fiat money, it is approved by Central Financial
Institution or Government order to be treated as legal tender through which value exchange can
happen. They print the paper money according to the requirements which are tightly controlled as it
can affect the economy of the country.

Inflation: Meaning, types, causes and consequences, measures to control inflation

1. Meaning of Inflation:
Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds
available goods and services.

Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price
of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the
general level or average of prices’. In other words, inflation reduces the purchasing power of money.
A unit of money now buys less.

In economics, inflation is a sustained increase in the general price level of goods and services in an
economy over a period of time. When the price level rises, each unit of currency buys fewer goods
and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money –
a loss of real value in the medium of exchange and unit of account within the economy.A chief
measure of price inflation is the inflation rate, the annualized percentage change in a general price
index,

Types of Inflation:

1. Demand-pull inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such
inflation is called demand-pull inflation. But why does aggregate demand rise? Classical economists
attribute this rise in aggregate demand to money supply. If the supply of money in an economy
exceeds the available goods and services, DPI appears. It has been described by Coulborn as a
situation of “too much money chasing too few goods.”

In this type of inflationprices increase results from an excess of demand over supply for the economy
as a whole. Demand inflation occurs when supply cannot expand any more to meet demand; that is,
when critical production factors are being fully utilized, also called Demand inflation.

2. Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of
inflation is known as cost-push inflation (henceforth CPI). Cost of production may rise due to an
increase in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since
wage rate is not completely market-determined. Higher wage means high cost of production. Prices of
commodities are thereby increased.

This type of inflation occurs when general price levels rise owing to rising input costs. In general,
there are three factors that could contribute to Cost-Push inflation: rising wages increases in
corporate taxes, and imported inflation. [Imported raw or partly-finished goods may
become expensive due to rise in international costs or as a result of depreciation of local currency]

Causes of Inflation:

A. Demand factors causes to inflation:

1. Increase in public expenditure: Increase public expenditure causes to increase investment
from government side which create number of employment opportunities in the economy and
as the rate of employment generation increases it generates income in the economy, money
flow in the hand of common individuals which create demand and prices rises in the economy.
 2. Deficit financing: Deficit financing is known as when government expenditure increase with
respect to government expenditure, because of what money supply increases in an economy
which create inflationary situation.
3. Increase in export: Increase in export creates less supply of goods and services for those
goods which going to export and lack of supply in the home market become reason to
increase the level of prices.
4. Speculation: Speculation creates excess of money supply in the economy because of people
increase their demand and inflation arises in the economy.
5. Rapid growth of population: (Explain at your side)
6. Increase in salaries: (Explain at your side)

B. Supply factors causes to inflation:

1. Unfavorable agriculture production: If the agriculture production is not favorable in
particular year it create shortage of supply of various good, if supply of goods decreases
prices increases.
2. Price policy of the government: If price policy of the government is favorable than supply
increase and if not favorable than supply decrease and if supply decrease prices tends to
increases.
3. Decrease in import: Decrease in import decreases the supply of imported good and thereby
prices of imported goods increases.
4. Deficiency of factors of production: The factors of production used in production process
are not enough efficient than it directly affect level of production and thereby supply decrease
and prices increases.
5. Insufficient growth of Industrial sector: If the growth of industrial sector is not sufficient
than it decrease supply of manufacturing goods and prices increases.

Measures to Control Inflation

We have studied above that inflation is caused by the failure of aggregate supply to equal the
increase in aggregate demand. Inflation can, therefore, be controlled by increasing the supplies and
reducing money incomes in order to control aggregate demand.

The various methods are usually grouped under three heads:

Monetary measures, fiscal measures and other measures.

1. Monetary Measures:

Monetary measures aim at reducing money incomes.

(a) Credit Control:

One of the important monetary measures is monetary policy. The central bank of the country adopts a
number of methods to control the quantity and quality of credit. For this purpose, it raises the bank
rates, sells securities in the open market, raises the reserved ratio, and adopts a number of selective
credit control measures, such as raising margin requirements and regulating consumer credit.

Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors.
Monetary policy can only be helpful in controlling inflation due to demand-pull factors.

(b) Demonetization of Currency:

However, one of the monetary measures is to demonetize currency of higher denominations. Such a
measure is usually adopted when there is abundance of black money in the country.
(c) Issue of New Currency:

The most extreme monetary measure is the issue of new currency in place of the old currency. Under
this system, one new note is exchanged for a number of notes of the old currency. The value of bank
deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of
notes and there is hyperinflation in the country. It is a very effective measure. But is inequitable for it
hurts the small depositors the most.

2. Fiscal Measures:

Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by

fiscal measures. Fiscal measures are highly effective for controlling government expenditure,
personal consumption expenditure, and private and public investment.

The principal fiscal measures are the following:

(a) Reduction in Unnecessary Expenditure:

The government should reduce unnecessary expenditure on non-development activities in order to

curb inflation. This will also put a check on private expenditure which is dependent upon government
demand for goods and services. But it is not easy to cut government expenditure. Though economy
measures are always welcome but it becomes difficult to distinguish between essential and non-
essential expenditure. Therefore, this measure should be supplemented by taxation.

(b) Increase in rate of direct taxes:

To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes
should be raised and even new taxes should be levied, but the rates of taxes should not be so high as
to discourage saving, investment and production. Rather, the tax system should provide larger
incentives to those who save, invest and produce more.

Further, to bring more revenue into the tax-net, the government should penalise the tax evaders by
imposing heavy fines. Such measures are bound to be effective in controlling inflation. To increase
the supply of goods within the country, the government should reduce import duties and increase
export duties.

(c) Increase in Savings:

Another measure is to increase savings on the part of the people. This will tend to reduce disposable
income with the people, and hence personal consumption expenditure. But due to the rising cost of
living, people are not in a position to save much voluntarily. Keynes, therefore, advocated compulsory
savings or what he called ‘deferred payment’ where the saver gets his money back after some years.

For this purpose, the government should float public loans carrying high rates of interest, start saving
schemes with prize money, or lottery for long periods, etc. It should also introduce compulsory
provident fund, provident fund-cum-pension schemes, etc. compulsorily. All such measures to
increase savings are likely to be effective in controlling inflation.

(d) Surplus Budgets:

An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government
should give up deficit financing and instead have surplus budgets. It means collecting more in
revenues and spending less.

(e) Public borrowing/debt:

At the same time, it should stop repayment of public debt and postpone it to some future date till
inflationary pressures are controlled within the economy. Instead, the government should borrow
more to reduce money supply with the public.

Like the monetary measures, fiscal measures alone cannot help in controlling inflation. They should
be supplemented by monetary, non-monetary and non-fiscal measures.

3. Other Measures:

The other types of measures are those which aim at increasing aggregate supply and reducing
aggregate demand directly:

(a) To Increase Production:

The following measures should be adopted to increase production:

(i) One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.

(ii) If there is need, raw materials for such products may be imported on preferential basis to increase
the production of essential commodities.

(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be
maintained through agreements with trade unions, binding them not to resort to strikes for some time.

(iv)The policy of rationalization of industries should be adopted as a long-term measure.

Rationalisation increases productivity and production of industries through the use of brain, brawn and
bullion.

(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc.
should be provided to different consumer goods sectors to increase production.

(b) Rational Wage Policy:

Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there
is a wage-price spiral. To control this, the government should freeze wages, incomes, profits,
dividends, bonus, etc. But such a drastic measure can only be adopted for a short period and by
antagonising both workers and industrialists. Therefore, the best course is to link increase in wages to
increase in productivity. This will have a dual effect. It will control wages and at the same time
increase productivity, and hence increase production of goods in the economy.

(c) Price Control:

Price control and rationing is another measure of direct control to check inflation. Price control means
fixing an upper limit for the prices of essential consumer goods. They are the maximum prices fixed
by law and anybody charging more than these prices is punished by law. But it is difficult to administer
price control.

(d) Rationing:

Rationing aims at distributing consumption of scarce goods so as to make them available to a large
number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene
oil, etc. It is meant to stabilise the prices of necessaries and assure distributive justice. But it is very
inconvenient for consumers because it leads to queues, artificial shortages, corruption and black
marketing. Keynes did not favour rationing for it “involves a great deal of waste, both of resources and
of employment.”
What is Deflation? :

Deflation is the opposite of inflation. Deflation refers to situation, where there is decline in general
price levels. Thus, deflation occurs when the inflation rate falls below 0% (or it is negative inflation
rate). Deflation increases the real value of money and allows one to buy more goods with the same
amount of money over time. Deflation can occur owing to reduction in the supply of money or
credit. Deflation can also occur due to direct contractions in spending, either in the form of a
reduction in government spending, personal spending or investment spending. Deflation has often
had the side effect of increasing unemployment in an economy, since the process often leads to a
lower level of demand in the economy.

Functions of a Central Bank

A central bank performs the following functions, as given by De Kock and accepted by the majority of
economists.

1. Regulator of Currency:

The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it circulate
as legal tender money. It has its issue department which issues notes and coins to commercial banks.
Coins are manufactured in the government mint but they are put into circulation through the central
bank.

Central banks have been following different methods of note issue in different countries. The central
bank is required by law to keep a certain amount of gold and foreign securities against the issue of
notes. In some countries, the amount of gold and foreign securities bears a fixed proportion, between
25 to 40 per cent of the total notes issued.

In other countries, a minimum fixed amount of gold and foreign currencies is required to be kept
against note issue by the central bank. This system is operative in India whereby the Reserve Bank of
India is required to keep Rs 115 crores in gold and Rs 85 crores in foreign securities. There is no limit
to the issue of notes after keeping this minimum amount of Rs 200 crores in gold and foreign
securities.

The monopoly of issuing notes vested in the central bank ensures uniformity in the notes issued
which helps in facilitating exchange and trade within the country. It brings stability in the monetary
system and creates confidence among the public. The central bank can restrict or expand the supply
of cash according to the requirements of the economy. Thus it provides elasticity to the monetary
system. By having a monopoly of note issue, the central bank also controls the banking system by
being the ultimate source of cash. Last but not the least, by entrusting the monopoly of note issue to
the central bank, the government is able to earn profits from printing notes whose cost is very low as
compared with their face value.

2. Banker, Fiscal Agent and Adviser to the Government:

Central banks everywhere act as bankers, fiscal agents and advisers to their respective governments.
As banker to the government, the central bank keeps the deposits of the central and state
governments and makes payments on behalf of governments. But it does not pay interest on
governments deposits. It buys and sells foreign currencies on behalf of the government.

It keeps the stock of gold of the government. Thus it is the custodian of government money and
wealth. As a fiscal agent, the central bank makes short-term loans to the government for a period not
exceeding 90 days. It floats loans, pays interest on them, and finally repays them on behalf of the
government. Thus it manages the entire public debt. The central bank also advises the government
on such economic and money matters as controlling inflation or deflation, devaluation or revaluation
of the currency, deficit financing, balance of payments, etc. As pointed out by De Kock, “Central
banks everywhere operate as bankers to the state not only because it may be more convenient and
economical to the state, but also because of the intimate connection between public finance and
monetary affairs.”

3. Custodian of Cash Reserves of Commercial Banks:

Commercial banks are required by law to keep reserves equal to a certain percentage of both time
and demand deposits liabilities with the central banks. It is on the basis of these reserves that the
central bank transfers funds from one bank to another to facilitate the clearing of cheques.

Thus the central bank acts as the custodian of the cash reserves of commercial banks and helps in
facilitating their transactions. There are many advantages of keeping the cash reserves of the
commercial banks with the central bank, according to De Kock.

In the first place, the centralization of cash reserves in the central bank is a source of great strength to
the banking system of a country. Secondly, centralized cash reserves can serve as the basis of a
large and more elastic credit structure than if the same amount were scattered among the individual
banks.

Thirdly, centralized cash reserves can be utilized fully and most effectively during periods of seasonal
strains and in financial crises or emergencies. Fourthly, by varying these cash reserves the central
bank can control the credit creation by commercial banks. Lastly, the central bank can provide
additional funds on a temporary and short term basis to commercial banks to overcome their financial
difficulties.

It holds these rates within narrow limits in keeping with its obligations as a member of the International
Monetary Fund and tries to bring stability in foreign exchange rates. Further, it manages exchange
control operations by supplying foreign currencies to importers and persons visiting foreign countries
on business, studies, etc. in keeping with the rules laid down by the government.

5. Lender of the Last Resort:

De Kock regards this function as a sine qua non of central banking. By granting accommodation in the
form of re-discounts and collateral advances to commercial banks, bill brokers and dealers, or other
financial institutions, the central bank acts as the lender of the last resort.

The central bank lends to such institutions in order to help them in times of stress so as to save the
financial structure of the country from collapse. It acts as lender of the last resort through discount
house on the basis of treasury bills, government securities and bonds at “the front door”.

The other method is to give temporary accommodation to the commercial banks or discount houses
directly through the “back door”. The difference between the two methods is that lending at the front
door is at the bank rate and in the second case at the market rate. Thus the central bank as lender of
the last resort is a big source of cash and also influences prices and market rates.

6. Clearing House for Transfer and Settlement:

As bankers’ bank, the central bank acts as a clearing house for transfer and settlement of mutual
claims of commercial banks. Since the central bank holds reserves of commercial banks, it transfers
funds from one bank to other banks to facilitate clearing of cheques. This is done by making transfer
entries in their accounts on the principle of book-keeping. To transfer and settle claims of one bank
upon others, the central bank operates a separate department in big cities and trade centres. This
department is known as the “clearing house” and it renders the service free to commercial banks.

When the central bank acts as a clearing agency, it is time-saving and convenient for the commercial
banks to settle their claims at one place. It also economize the use of money. “It is not only a means
of economizing cash and capital but is also a means of testing at any time the degree of liquidity
which the community is maintaining.”

7. Controller of Credit:

The most important function of the central bank is to control the credit creation power of commercial
bank in order to control inflationary and deflationary pressures within this economy. For this purpose,
it adopts quantitative methods and qualitative methods. Quantitative methods aim at controlling the
cost and quantity of credit by adopting bank rate policy, open market operations, and by variations in
reserve ratios of commercial banks.

Qualitative methods control the use and direction of credit. These involve selective credit controls and
direct action. By adopting such methods, the central bank tries to influence and control credit creation
by commercial banks in order to stabilize economic activity in the country.

Besides the above noted functions, the central banks in a number of developing countries have been
entrusted with the responsibility of developing a strong banking system to meet the expanding
requirements of agriculture, industry, trade and commerce.

Accordingly, the central banks possess some additional powers of supervision and control over the
commercial banks. They are the issuing of licences; the regulation of branch expansion; to see that
every bank maintains the minimum paid up capital and reserves as provided by law; inspecting or
auditing the accounts of banks; to approve the appointment of chairmen and directors of such banks
in accordance with the rules and qualifications; to control and recommend merger of weak banks in
order to avoid their failures and to protect the interest of depositors; to recommend nationalisation of
certain banks to the government in public interest; to publish periodical reports relating to different
aspects of monetary and economic policies for the benefit of banks and the public; and to engage in
research and train banking personnel etc..

Commercial Banks

Primary and Secondary Functions of Commercial Banks

(1) Primary Function:

1. Accepting Deposits:

It is the most important function of commercial banks.

They accept deposits in several forms according to requirements of different sections of the society.

The main kinds of deposits are:

(i) Current Account Deposits or Demand Deposits:

These deposits refer to those deposits which are repayable by the banks on demand:

1. Such deposits are generally maintained by businessmen with the intention of making transactions
with such deposits.

2. They can be drawn upon by a cheque without any restriction.

3. Banks do not pay any interest on these accounts. Rather, banks impose service charges for
running these accounts.

(ii) Fixed Deposits or Time Deposits:

Fixed deposits refer to those deposits, in which the amount is deposited with the bank for a fixed
period of time.

1. Such deposits do not enjoy cheque-able facility.

2. These deposits carry a high rate of interest.

(iii) Saving Deposits:

These deposits combine features of both current account deposits and fixed deposits:

1. The depositors are given cheque facility to withdraw money from their account. But, some
restrictions are imposed on number and amount of withdrawals, in order to discourage frequent use of
saving deposits.

2. They carry a rate of interest which is less than interest rate on fixed deposits.

(iv) Recurring Deposits: Recurring deposits arerepeated in nature respect to particular time period.

2. Advancing of Loans:

The deposits received by banks are not allowed to remain idle. So, after keeping certain cash
reserves, the balance is given to needy borrowers and interest is charged from them, which is the
main source of income for these banks.

Different types of loans and advances made by Commercial banks are:

(i) Cash Credit:

Cash credit refers to a loan given to the borrower against his current assets like shares, stocks,
bonds, etc. A credit limit is sanctioned and the amount is credited in his account. The borrower may
withdraw any amount within his credit limit and interest is charged on the amount actually withdrawn.

(ii) Demand Loans:

Demand loans refer to those loans which can be recalled on demand by the bank at any time. The
entire sum of demand loan is credited to the account and interest is payable on the entire sum.

(iii) Short-term Loans:

They are given as personal loans against some collateral security. The money is credited to the
account of borrower and the borrower can withdraw money from his account and interest is payable
on the entire sum of loan granted.

(2) Secondary Functions:

1. Agency Functions:

Commercial banks also perform certain agency functions for their customers. For these services,
banks charge some commission from their clients.

Some of the agency functions are:

(i) Transfer of Funds:

Banks provide the facility of economical and easy remittance of funds from place-to-place with the
help of instruments like demand drafts, mail transfers, etc.

(ii) Collection and Payment of Various Items:

Commercial banks collect cheques, bills,’ interest, dividends, subscriptions, rents and other periodical
receipts on behalf of their customers and also make payments of taxes, insurance premium, etc. on
standing instructions of their clients.

(iii) Purchase and Sale of Foreign Exchange:

Some commercial banks are authorized by the central bank to deal in foreign exchange. They buy
and sell foreign exchange on behalf of their customers and help in promoting international trade.

(iv) Purchase and Sale of Securities:

Commercial banks buy and sell stocks and shares of private companies as well as government
securities on behalf of their customers.

(v) Income Tax Consultancy:

They also give advice to their customers on matters relating to income tax and even prepare their
income tax returns.

(vi) Trustee and Executor:

Commercial banks preserve the wills of their customers as trustees and execute them after their
death as executors.

(vii) Letters of Reference:

They give information about the economic position of their customers to traders and provide the
similar information about other traders to their customers.

4. General Utility Functions:

Commercial banks render some general utility services like:

(i) Locker Facility:

Commercial banks provide facility of safety vaults or lockers to keep valuable articles of customers in
safe custody.

(ii) Traveller’s Cheques:

Commercial banks issue traveler’s cheques to their customers to avoid risk of taking cash during their
journey.

(iii) Letter of Credit:

They also issue letters of credit to their customers to certify their creditworthiness.

(iv) Collection of Statistics:

Banks collect and publish statistics relating to trade, commerce and industry. Hence, they advice
customers on financial matters. Commercial banks receive deposits from the public and use these
deposits to give loans. However, loans offered are many times more than the deposits received by
banks. This function of banks is known as ‘Money Creation’.

SOURCES OF PUBLIC REVENUE

Introduction & Meaning of Public Revenue ↓

Governments need to perform various functions in the field of political, social & economic activities to
maximize social and economic welfare. In order to perform these duties and functions government
require large amount of resources. These resources are called Public Revenues.

The income of the government through all sources is called public income or public revenue.

Public revenue consists of taxes, revenue from administrative activities like fines, fees, gifts & grants.
Public revenue can be classified into two types.

 Tax Revenue ↓

A fund raised through the various taxes is referred to as tax revenue. Taxes are compulsory
contributions imposed by the government on its citizens to meet its general expenses, without any
corresponding benefits to the tax payer.

Seligman defines a tax thus: “A tax is a compulsory contribution from a person to the government
to defray the expenses incurred in the common interest of all, without reference to specific benefits
conferred.

Taxes are the first and foremost sources of public revenue. Taxes collected by Government are
used to provide common benefits to all mostly in form of public welfare services. Taxes do not
guarantee any direct benefit for person who pays the tax.

The government collects tax revenue by way of direct & indirect taxes. Direct taxes includes;
Corporate tax; personal income tax capital gain tax and wealth tax. Indirect taxes include custom
duty, central excise duty, and VAT and service tax.

Taxes constitute a significant part of public revenue in modern public finance. Taxes have macro-
economic effects. Taxation can affect the size and mode of consumption, pattern of production and
distribution of income and wealth.

Progressive taxes can help in reducing inequalities of income and wealth by lowering the high income
group’s disposable income. By disposable income is meant the income left in the hands of the tax
payer for disbursement after tax payment. Taxes imply a forced saving in a developing economy.
Thus, taxes constitute an important source of development finance.

 Non-Tax Revenue ↓

The revenue obtained by the government from sources other than tax is called Non-Tax Revenue.
The sources of non-tax revenue are:-

1. Fees

Fees are another important source of revenue for the government. A fee is charged by public
authorities for rendering a service to the citizens. Unlike tax, there is no compulsion involved in case
of fees. The government provides certain services and charges certain fees for them. For example,
fees are charged for issuing of passports, driving licenses, etc.

2. Fines or Penalties
Fines or penalties are imposed as a form of punishment for breach of law or non-fulfillment or certain
conditions or for failure to observe some regulations. But while taxes are generally imposed to collect
revenue. Fines are imposed as a form of punishment or to prevent people from breaking the law.
They are not expected to be a major source of revenue to the government.

3. Surplus from Public Enterprises

The Government also gets revenue by way of surplus from public enterprises. In India, the
Government has set up several public sector enterprises to provide public goods and services. Some
of the public sector enterprises do make a good amount of profits. The profits or dividends which the
government gets can be utilized for public expenditure.

4. Special assessment of betterment levy

It is a kind of special charge levied on certain members of the community who are beneficiaries of
certain government activities or public projects. For example, due to a public park in a locality or due
to the construction of a road, people in that locality may experience an appreciation in the value of
their property or land. Thus, due to public expenditure, some people may experience 'unearned
increments' in their asset holding. Betterment levy is like a tax because it is a compulsory payment..

5. Grants and Gifts

Gifts are Voluntary contributions by individuals or institutions to the government. Gifts are significant
source of revenue during war and emergency.

A grant from one government to another is an important source of revenue in the modern days. The
government at the Centre provides grants to State governments and the State governments provide
grants to the local government to carry out their functions.

Grants from foreign countries are known as Foreign Aid. Developing countries receive military aid,
food aid, technological aid, etc. from developed countries.

6. Deficit Financing

Deficit means an excess of public expenditure over public revenue. This excess may be met by
borrowings from the market, borrowings from abroad, by the central bank creating currency. In case
of borrowing from abroad, there cannot be compulsion for the lenders, but in case of internal
borrowings there may be compulsion. The government may force various individuals, firms and
institutions to lend to it at a much lower rate than the market would have offered.

TAXATION

A compulsory contribution to state revenue, levied by the government on workers' income and
business profits, or added to the cost of some goods, services, and transactions.

An involuntary fee levied on corporations or individuals that is enforced by a level of government in

order to finance government activities.

The main characteristic features of a tax are as follows:

1. A tax is a compulsory payment made to the government. People on whom a tax is imposed
must pay the tax. Refusal to pay the tax is a punishable offence.
2. The tax payer cannot claim any specific benefit in return for the payment of a tax.
3. Every tax involves some sacrifice on part of the tax payer.
4. A tax is not levied as a fine or penalty for breaking law.
5. A tax is payable regularly and periodically as determined by the taxing authority.
 6. A tax is levied to meet public spending incurred by the government in the general interest of
the nation. It is a payment for an indirect service to be made by the government to the
community as a whole.

Principles / cannons of taxes:-

1. Canon of equality:
This canon obeys the principle of equality and justice. This is the most important canon of taxation.
The canon of equality does not mean that every tax payer should pay the same sum. That would be
fairly injustice. Nor it means that they should pay at the same rate. This canon mean the equality of
sacrifice, i.e. tax should be imposed according to the ability of the tax payer, higher the income higher
the rate, lower the income lower the rate of tax.

2. Canon of certainty:
The tax which each individual is bound to pay ought to be certain and not absolute. The time of
payment, the way of payment, the amount to be paid all to be clear and plain to the tax payers. These
will discourage corruption and evasion of taxes.

3. Canon of convenience:
Every tax necessary to be levied at the time or in the manner, which is most likely to be convenient for
the contributor pay it.

In other word a tax should levied at a time when certain revenue has been expected by the tax payer
e.g. when a farmer reap out their crops on that time agriculture tax should be imposed, because is the
most convenient time for the agriculture tax payer.

4. Canon of economy:
A tax should be collected by the minimum possible cost. A tax is economical if its cost of collection is
small if government appoint highly salaried staff and absorb major portion of the tax, the tax will be
considered as uneconomical. According to smith.

“Every tax is to be as imposing as both to take out and keep out of the pocket of the people on little
cost”.

5. Canon of productivity:
This canon indicates that a tax when levied should produce important revenue to the government. If a
few taxes imposed field a significant fund for the state then they should be preferred over a large
number of small taxes while produce less revenue and are expensive in collection.

6. Canon elasticity:
According to their canon a tax should be elastic, do that changes can be easily made. According to
the need of the state. Whenever the government is in need for more funds then it should make
changes in the structure of taxation for collection of more funds.

7. Canon of simplicity:
According to this canon a tax system should be fairly simple, plain for the tax payer. If it is
complicated and difficult then will lead to corruption.

Direct Tax

A direct tax is a tax paid by a person on whom it is legally imposed. In direct tax, the person paying
and bearing tax is the same. It is the tax on income and property. Examples of direct taxes are:

Advantages / merits of Direct Tax

1. Follows the principle of equality: Direct tax is equitable as it is imposed on person as per
the property or income.
 2. Follows the principle of certainty: Time, procedure and amount of tax paid to be paid are
known with certainty.
3. Follows the principle of elasticity: Direct tax is elastic. The government can change tax rate
with the change in the level of property or income.
4. Increase the civic consciousness: Direct tax enhances the consciousness of the citizens.
Taxpayers feel burden of tax and so they can insist the government to spend their
contributions for the welfare of the community.

Disadvantages / demerits of Direct Tax

1. Unpopular type of tax: Direct tax gives mental pinch to the taxpayers as they have to curtail
their income to pay to the government.
2. Not follows the principle if convenience: Taxpayers feel inconvenience as the government
imposes tax progressively.
3. Helps to tax evasion: Tendency to evade tax may increase to avoid tax burden.
4. Not follows the principle of economy: It is expensive for the government to collect tax
individually.
5. Not follows the principle of productivity:

Indirect Tax
An indirect tax is a tax imposed on one person but partly or wholly paid by another. In indirect tax, the
person paying and bearing tax is different. Examples of indirect taxes are:

Advantages / merits of Indirect Tax

1. Follows the principle if convenience: Indirect tax is convenient as the taxpayer does not
have to pay a lump sum amount for tax.
2. Mass participation: There is mass participation. Each and every person getting goods or
services has to pay tax.
3. Avoid tax evasion: There is a less chance of tax evasion as the taxpayers pay the tax
collected from consumers.
4. Socially benefited: The government can check on the consumption of harmful goods by
imposing higher taxes.
5. Follows the principle of economy: cost of collection is less.
6. Follows the principle of productivity: By collecting indirect tax government able to
generate more revenue.

Disadvantages / demerits of Indirect Tax

1. Not follows the principle of certainty: Indirect tax is uncertain. As demand fluctuates, tax
will also fluctuate.
2. Not follows the principle of equality: It is regretful as the tax burden to the rich and poor is
same.

3. Create inflation: Indirect tax has bad effect on consumption, production and employment.
Higher taxes will reduce all of them.
4. Not follows the principle of simplicity: Most of the taxes are included in the price of goods
or services. As result, taxpayers do not know how much tax they are paying to the
government.
5. Not follows the principle of elasticity: As increase in tax creates the inflation and decrease
in tax causes to decrease the profit of producers.