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Public Finance: Meaning and Concept

of Public Finance
Meaning:
In public finance we study the finances of the Government.
Thus, public finance deals with the question how the
Government raises its resources to meet its ever-rising
expenditure. As Dalton puts it, public finance is concerned
with the income and expenditure of public authorities and
with the adjustment of one to the other.

Accordingly, effects of taxation, Government

Further, it was thought that Government budget must be

balanced. Public borrowing was recommended mainly
for production purposes. During a war, of course, public
borrowing was considered legitimate but it was thought
that the Government should repay or reduce the debt as
soon as possible.

Historical background

expenditure, public borrowing and deficit financing on

2.01 The first formal report on government finance was

the economy constitutes the subject matter of public

issued by the Dominion Bureau of Statistics (now

finance. Thus, Prof. Otto Eckstein writes Public

Finance is the study of the effects of budgets on the
economy, particularly the effect on the achievement of

Statistics Canada) for the year 1919. The report dealt

with municipal statistics for 50 municipalities with
populations over 10,000. In the preface to this report,
R.H. Coats, Dominion Statistician, wrote: " the first
essential for comparative statistics is the adoption of a

the major economic objectsgrowth, stability, equity

and efficiency.

uniform system of municipal accounting and reporting.

A memorandum outlining a system, and looking to cooperative action between the Dominion Bureau of

Further, it also deals with fiscal policies which ought to

Statistics and the provincial departments, was drawn up

in the Bureau in 1918 and submitted to the provinces. It

be adopted to achieve certain objectives such as price

was recognized, however, that the matter was complex

stability, economic growth, more equal distribution of

and far reaching in scope, and that definite action would

not be feasible without careful discussion of details,

income. Economic thinking about the role that public

finance is expected to play has changed from time to
time according to the changes in economic situation.

such as might take place at a conference of Dominion

and provincial officials."

2.02 For many years thereafter the Bureau had two goals
in the field of public finance, which it pursued

Before the Great Depression that gripped the Western

simultaneously: (i) the production of a set of consistent

industrialised countries during the thirties, the role of

and compatible series of financial and employment

public finance was considered to be raising sufficient

resources for carrying out the Government functions of
civil administration and defense from foreign countries.

statistics for all governments in Canada and (ii) the

development and implementation of a common
accounting and financial reporting system by these
governments. Developments in each are discussed
separately.

During this period, the classical economists considered

it prudent to keep expenditure to the minimum so that

2.03 The first Dominion-Provincial Conference on

Government Finance Statistics was held in 1933. It

taxing of the people is avoided as far as possible.

asked the Bureau to prepare a standard classification of

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accounts for use by the provinces. Reporting schedules

2.05 To provide comparable statistics, Statistics Canada

were devised and work on the development, revision,

has developed the FMS as the basis for its series on

and improvement of uniform classification systems and

government financial and related statistics. Indeed, the

reporting forms continued through a series of

concepts and classifications that governments rejected

Dominion-provincial meetings in 1943, 1945, 1947, 1952,

for their internal purposes are now recognized by these

1953, and a series of committee meetings during the

same governments as suitable for their external

period 1954 to 1960. The first conference on municipal

dealings. This is seen, not only in the secondary

statistics took place in 1937 and was followed by others

reporting formats referred to previously, but also in the

in 1940, 1947, 1948, 1953, 1958, and by a series of seven

selection of the FMS as the most appropriate system for

meetings during the period 1967 to 1970. Annual

the work of the Tax Structure Committee of the 1960's,

meetings on municipal statistics began in 1971.

the Tri-level Task Force on Public Finance (1974 to

Standard reporting schedules for the provinces were

1976), and above all, by its embodiment in the

issued and revised as appendices to the reports on the

successive Federal-Provincial Fiscal Arrangements

meetings. For municipal purposes, a manual of

Acts.

instructions was first issued in 1942 and subsequently

revised in 1950 and 1960. A new manual was issued in

2.06 The modern FMS began with resolutions adopted at

19701 and this version still serves as the main guide for

the 1933 Dominion-Provincial Conference on Provincial

municipal respondents.

Finance Statistics. These included agreements that

"revenue should be primarily classified by source" and

2.04 Nevertheless the goal of a uniform system of

that "expenditures should be reported on the basis of

accounting and financial reporting for all governments

the several functions of government." These resolutions

in Canada remains as elusive as ever. This is confirmed

confirmed the approach taken by the Dominion Bureau

by an examination of federal and provincial public

of Statistics in its series on municipal and provincial

accounts (PA) and municipal financial statements. Some

government finance statistics which commenced with

provinces provide supplementary tables in which the

data for 1918 and 1921 respectively.

data in their PA are recast into approximations of

the FMS framework.

2.07 Statistical systems are constructed to facilitate the

analysis of major areas of concern. Over time, the

Although the annual reports provided by municipalities

relative importance of topics changes as does the way

to provincial governments are heavily influenced by the

those topics are perceived. Consequently the

same framework, the accounting systems and records

classifications used to identify and describe the

from which they are derived remain as individual as

components of a statistical system must also change.

ever. This is not surprising given that the primary

purpose of such systems and records is to report to the

2.08 In its earliest form, prior to World War II,

government or council that its financial affairs are being

the FMS depicted provincial and local governments as

conducted in accordance with the relevant statutes and

independent entities, but federal activities were not

regulations; in addition the systems and records must

included in the system until 1953. Attention was focused

clearly relate financial activities to administrative

on current spending of own source revenues and on

responsibilities. In view of the variety in size,

departmental activities. Transactions of special purpose

organization and roles of governments in Canada, it is

agencies were reflected only to the extent of their net

doubtful that a uniform accounting system will ever be

contributions to, or receipts from, their parent

instituted.

governments. Following the conferences of the early

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1940's and the work for the Conference on

more and more as joint programs involving varying

Reconstruction, the government universe was more

degrees of participation by two and sometimes all three

clearly delineated. A number of administrative and

levels of government were initiated along with programs

special agencies were included for the first time and a

receiving most of their funding from one level of

new classification framework was introduced to provide

government with the service being delivered by another.

more detailed information on government operations. In

Not all developments, however, were in the direction of

addition, the concept of "general" revenue and

increasing co-operation. In 1965, Quebec "opted out" of

expenditures (i.e., the consolidation of current and

several joint federal-provincial programs and received

capital transactions) was introduced in keeping with the

federal income tax abatements and other fiscal

revised concept of the government universe which was

compensation in lieu of the transfers specific to these

comprised of departments and ministries; boards,

programs.

commissions and agencies performing functions similar

to those of departments; agencies engaged in

2.11 These changes in government operations and

"industrial" or "commercial" type of activities primarily

relationships resulted in a major shift in emphasis in

to service the requirements of their own governments;

the FMS. Attention was no longer focused on the

government-owned institutions such as those engaged

activities carried out by a government using its own

in education, health or welfare services or the

resourcesknown as the "net general" approach.

administration of justice; social insurance schemes of a

Instead the FMS concentrated on the total activities of a

universal nature [Canada Pension Plan (CPP) and

governmentthe "gross general" approachincluding

Quebec Pension Plan (QPP)]; public service pension

activities carried out in co-operation with or on behalf of

plans operated by governments; working capital funds.

other governments as well as contributions to other

governments to perform activities on its behalf. Thus

2.09 Over the following decades interest focused on the

the focus shifted from the activities directly attributable

development of statistical series embodying the

to a particular government (or group of governments) to

concepts of the FMS. This culminated in the publication

the total impact of that government's operations.

of a chapter on government finance in the Historical

Statistics of Canada (M.C. Urquhart, Editor, K.A.H.

2.12 At the same time, a comprehensive review of the

Buckley, Assistant Editor, Cambridge/Macmillan, 1965),

system's classifications was launched. Earlier reviews

and of the publication Historical Review, Financial

had been initiated by Dominion-Provincial Conferences

Statistics of Governments in Canada, 1952 to 1962

on Provincial Finance Statistics (see paragraph 2.03)

[Dominion Bureau of Statistics (DBS) (now Statistics

which appointed working parties of provincial and

Canada (StatCan)) Catalogue no. 68-503, 1966], the latter

federal officials for the purpose. On completion of the

being the principal statistics prepared for the Tax

task a new conference reviewed the work, modified it

Structure Committee. These publications, together with

where necessary and then promulgated the results. The

the annual series of FMS statistics for each level of

procedure adopted in 1965 was quite different. The

government and for consolidation of all levels, signaled

vehicle chosen was the eighth Federal-Provincial

the maturing of the FMS.

Conference on Municipal Finance Statistics held in 1966.

These Federal-Provincial conferences were held

2.10 At the same time, major changes were occurring in

annually until 1970. The working party consisted of the

the field of public finance which were to have significant

Governments Division of DBS (later Public Finance

effects on the FMS. Federal, provincial, territorial and

Division of Statistics Canada (StatCan) and now Public

local levels of government were beginning to co-operate

Institutions Division of StatCan). The first session of the

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conference assigned certain tasks to the working party.

2.15 Government finance and statistical systems

The second session reviewed the work and assigned

continued to change after the 1984 update of the FMS.

further tasks. In all, the complete review of the

With the1997 historical revision, increased harmony

classifications and of the reporting formats required

between the FMS and the Canadian System of National

seven sessions.

Accounts (CSNA) and to other statistical systems

increased. Better ways to measure the development in

2.13 The immediate results of this conference was

government finance have been achieved. Details on

embodied in "A Financial Information System for

changes implemented are presented in Appendix A. The

Municipalities" (Catalogue nos. 12-532, 12-533 and 12-

1999 revision of the manual reflects these achievements

534, 1970), which described the FMS in terms of

by presenting:

municipal finance. This manual provided the impetus for

the production, in 1972, of the publication "The

(a) The results of harmonizing

Canadian System of Government Financial Management

the CSNA and FMS concepts which has been

Statistics" (Catalogue no. 68-506, 1972, amended in 1974

implemented to eliminate differences between the two

and 1984), the first general description of the system.

systems and to simplify reconciliation with other

statistical systems.

2.14 The use of the FMS in analyzing and describing

government financial transactions continued to expand

(b) The results of implementing, throughout StatCan, the

throughout the 1970s. The continuing changes in all

entire coverage of the Canadian public sector.

aspects of government finance and in types of

government organizations created the need for a further

(c) The development in all aspects of government

updating of the FMS manual. A first draft of a revised

finance since the last revision of the manual in 1984.

edition was circulated withinStatCan as well as to

federal, provincial and territorial finance officials in

(d) The incorporation of the harmonized revenue

1980. The revision process lasted four years. At the

classification resulting from the harmonization

March 1984 meeting of the Federal-Provincial Committee

of CSNA and FMSconcepts.

on Government Statistics (in the same year the

committee was re-named "Federal-Provincial Committee
on Public Sector Statistics"), formal approval was given
to a third draft of the FMS manual. This manual was
subsequently published as "The System of Government
Financial Management Statistics" (Catalogue no. 68507).

Major relevant issues encountered during the review

process and more particularly during the 1997 historical
revision of the CSNA have been discussed at the 1996,
1997 and 1998 meetings of the Federal-Provincial
Committee on Public Sector Statistics.
Also, StatCan's experts in the field, met in 1996 and 1997
with federal government officials to discuss a number of

That latest edition included a more complete statement

topics and to assess the impact of the proposed

of the conceptual basis of the FMS and refined a number

revisions on the federal-provincial fiscal arrangements.

of definitionsnotably that of a government business

enterprise. It also expanded the classification system
used for revenue and expenditures and modified the
economic categories employed for cross classification
of expenditures.

The Concept of Functional Finance:

But under the impact of the Great Depression of thirties and
the Keynesian explanation of it, the thinking about and role
of public finance underwent a sea change. The classical
view of public finance could not meet the requirements of the
then prevailing situation.

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In order to increase aggregate effective demand and

more than the original amount of deficit financing

thereby raise the level of income and employment in the

through the process of multiplier.

country, public finance was called upon to play an active

role. During the Second World War and after, the
Western economies suffered from serious inflationary
pressures which were attributed to the excessive
aggregate demand.

Thus, after Keynesian revolution public finance

assumed a functional role of maintaining economic
stability at full employment level. Therefore, the present
view of public finance is not one of mere resourceraising for the Government but one of serving as an

So, in such inflationary conditions, the public finance

instrument for maintaining stability through

was expected to check prices through reducing

management of demand. Therefore, this present view of

aggregate demand. Thus the budget which was

public finance has been described by A.P. Lerner as one

previously meant to raise resources for limited activities

of Functional Finance.

of the Government assumed a functional role to serve

as an instrument of economic regulation.

In developing countries, public finance has to fulfill

another important role. Whereas in the developed

It came to be realised that governments taxing and

industrialised countries, the basic problem in the short

spending policies could go a long way in mitigating

run is to ensure stability at full employment level and in

economic fluctuations. Balanced budgets are no longer

the long run to ensure steady rate of economic growth,

considered sacrosanct and the governments can spend

that is, growth without fluctuations, the developing

beyond their resources without offending canons of

countries confront a more difficult problem of how to

sound finance to restore the health of the economy.

generate a higher rate of economic growth so as to

tackle the problems of poverty and unemployment.

Public borrowing and consequent increase in public

debt at the time of depression raises aggregate demand

Therefore, public finance has to play a special role of

and thereby helps in raising the level of income and

promoting economic growth in the developing countries

employment. Therefore, deficit budget and increase in

besides maintaining price stability. Further, for

public debt at such times is a thing to be welcomed.

developing countries mere economic growth is not

enough; the composition of growing output and distri-

It was further demonstrated by Keynes that deficit

financing by the Government could activise a depressed
economy by creating income and employment much

bution of additional incomes ought to be such as will

ensure removal of poverty and unemployment in the
developing countries.

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Therefore, public finance has not only to augment
resources for development and to achieve optimum
allocation of resources, but also to promote fair
distribution of income and expansion in employment
opportunities. This is the functional view of public
finance in the context of the developing countries.

Vicious Circle of Poverty

Explain the vicious circle of poverty and how does it
check the growth of capital formation in the country? or
A country is poor because it is poor
Vicious Circle of Poverty :The people in the less developed countries have low per
capita income. Having low income their rate of savings
is low. When savings are small in a country, investment
will also be low. Low investment leads to low
productivity. With low productivity level, the income is
bound to be low. People as such remain poor. In the way
vicious circle of poverty completes. Summing up, we
can say that less developed countries are poor because
they do not have sufficient capital resources for
investment. Capital has a central position for economic
development. A financially poor country is trapped in its
own poverty. A country can get rid off from poverty if its

Demand Side of Capital :The production of the poor country is low. The low
production causes low per capita income and low
purchasing power. The low purchasing power reduces
the demand for products. Due to low demand, market
will be limited. The small size of market discourages the
investment. The low production reduces the productivity
per worker. When the out put per worker is low, the per
capita income is bound to be low. So vicious circle of
poverty is complete on the demand side of capital
formation.
On the demand side vicious circle of poverty operates in
the following manner :

rate of capital formation increases than the rate of

population growth. So capital formation is the key to
economic development by demand and supply of
capital.

Supply Side of Capital :In the developed countries due to low production, per
capita income is low. The low level of income means the
capacity to save is low. The low level of savings leads to
low investment. The low rate of investment reduces the
productivity per worker. It leads to low per capita
income. The vicious circle is thus complete on

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the supply side of capital formation.
The vicious circle of supply can shown by the following
diagram :

If the under developed countries adopt the following

policies, they can remove the obstacles and can break
the vicious circle of poverty.

Main Points of Vicious Circle of Poverty :1. Poverty

1. Proper Use of Natural Resources :-

2. Low production

The developing countries can achieve rapid economic

3. Rapid population growth

growth by making the efficient use of natural resources.

4. Low per capita income

By proper use of resources we can increase the

5. Low consumption

production and per capita income of the country.

6. Limited market
7. Low savings

2. Self Reliance Policy :-

8. Lack of capital
9. Low investment
10. Low production
11. Poverty

The less developing countries should reduce their

dependence on foreign aid. The heavy reliance on
foreign aid and its repeated suspension, delay and
breach of agreements have created multiple problems.

If any country per capita income is high, then the rate of

capital formation will be high as the factors affecting the

The policy of self reliance should be followed for

financing development projects.

demand for and supply of capital formation are

favorable to economic growth.
3. Encouragement of Private Sector :A country is poor and remains poor because its human

The less developed countries should encourage the

and natural resources remain not utilized. In the less

private sector to increase the rate of investment in the

developed countries people are mostly unskilled and

country. The government has also given incentives to

technologically backward. They are illiterate and lack

the private sector to promote the rate of development in

the entrepreneurial ability. So the natural resources are

the country.

not used properly, out put remains low and poor country
remains poor because it is poor.

4. Increase in Savings :-

How you can break the vicious circle of poverty in the

under developed countries? or Describe the various
measures to remove the economic obstacles of

The government of less developed countries should

provide incentives to encourage the rate of savings in
the country. New and attractive savings schemes should
be introduced.

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The less developed countries should adopt the balance
5. Increase in Exports :-

growth strategy to remove poverty. Because investment

We should increase our exports to make our balance of

in various sectors at the same time can provide market

payment favorable. We should increase the exports of

and a source of a supply for another.

manufactured goods instead of primary commodities.

11. Introduction to Technology :6. Reduction in Imports :-

The developing countries can increase the rate of

The developing countries should produce substitutes of

development by adopting suitable advance technology

imports in side the country to save the foreign

in various sectors of the economy. But they should

exchange. Import of luxuries should be curtailed.

adopt the technology according to their requirements.

7. Development of Agriculture :-

12. Reduction in Population Growth :-

To increase the per acre yield government should

In the less developed countries high birth rate is the

expand the credit facilities to the farmers. Due to low

main cause of low per capita income. In India and

yield of wheat it has imported many times to meet the

Pakistan rate of population growth is high. effective

needs of the country.

measures should be taken to reduce the population

pressure.

8. Development of Industrial Sector :Agriculture based industries should be established in

13. Administrative Performs :-

the less developed countries. All the raw material should

The professionally qualified persons should be

be used in these industries, instead of exporting raw

appointed in the financial institutions and in the

material on lower rates.

planning sector. Corrupt and inefficient administration

should be removed.

9. Reduction in Employment :The government should increase the job opportunities

14. Monopolies Must be Discouraged :-

in the country. It will improve the saving and purchasing

The government should discourage the monopolistic

power of the people. New projects should be started to

associations and should protect the interest of the

increase the rate of employment.

consumer, Govt. should keep an eye on the prices also.

10. Balanced Growth Strategy :-

15. Denationalization :-

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All the poor countries should handed over the sick
industries to the private sector. The present government

Some of the most important differences between public

and private finance are as follows:
Before we study public finance, we may well compare it

has also decided to sell the shares of public industries

with individual or private finance.

to private sector. This policy will reduce the deficit of the

budget.

Individuals and States are similar in that they both need

resources. Both have to secure maximum results from
their resources. Both attempt to get the best out of all

16. Improve the Quality of Labour :-

items of expenditure.

Poor countries should improve the quality of labour by

providing the education and technical skill to the labour.
It will increase the efficiency of the people and the rate

There are, however, some important differences

between private and public finance. They are:
(i) An individuals income determines his expenditure,

of production.

while a States proposed expenditure determines its

income: A person cuts his coat, as they say, according

17. Political Stability :It is the basic requirement for the development of any

to the cloth he has. A Government, on the other hand,

arranges for cloth according to the length of the coat it
proposes to have. Thus, the State first decides the

country. All the poor countries should prevail peace and

political stability if they want to achieve development.

nature and scale of its expenditure and then proceeds to

find funds to meet it, an individual knows his income
and he has to plan out his expenditure accordingly. An

18. Stable Economic Policy :The poor countries should adopt the stable economic
policy. There should be no frequent changes in the

individual adjusts his expenditure to his income,

whereas the State adjusts its income to its expenditure.

(ii) A public authority can vary the amount of its income

taxation and import export policy. Because it discourage

and expenditure within limits, of course, but more easily

the rate of investment in the country.

than an individual. An individual cannot easily double

his income or halve his expenses even if he would be
better off that way. But this is not so difficult in the case

19. Effective Planning :-

of Governments.

The less developed countries can prepare the

development plans to accelerate the rate of
development in the country.

(iii) A public authority usually does not discount the

future at as high a rate as an individual. The reason is
obvious. The life of a man is counted in years and his
foresight is limned. A State is supposed to live forever.

Differences between Public and

Private Finance

Hence, future satisfactions do not appear so small

against present utilities to a State as they do to an

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individual. He always prefers a bird in hand to two in the

marginal utility in every case. But state expenditure is

bush even though the two in the bush may be fairly

done by the Finance Department in an objective manner.

certain tomorrow.

There is no such equi-marginalising of utilities.

(iv) A wise man is he who, after meeting his needs,

(x) The private individual lacks the coercive authority

saves something to lay by. Not so with a State. A State

which a government has. A government has simply to

should not ordinarily try to hoard but should repay to

pass a law and compel the citizens to pay a tax or

the people in services all that it receives in taxes. A

subscribe to a compulsory loan (i.e. compulsory

heavily surplus budget is for this reason as bad as, and

deposit), but an individual cannot do anything of the

perhaps even worse than, a heavily deficit one. The

kind.

deficit budget may propose to incur the deficit for the

promotion of mass welfare, while the surplus budget is

Importance of Public Finance

only an extra burden on the tax-payer.

With the shift in the paradigm of the society, moving

from a police state to a welfare state, the importance
of public finance has changed considerably. The
importance of public finance could be view from the
following
angle.

(v) There is no fixed period of time over which an

individual balances his budget. State budgets are
-generally made for one year. But the income and
expenditure of an individual are continuous and cover

1.

the whole period of his life.

(vi) The individual finance is kept a secret, whereas the

2.

State finance is made public. The budget is published

and every citizen is welcome to scrutinize it and
comment on it. An individual will not let anybody have a
peep into his financial position.

3.

(vii) A State can raise an internal loan; an individual

cannot. Nobody can borrow from himself. But a State
can borrow from its own citizens.

4.

(viii) The State can issue paper currency in order to

meet its expenditure. But no such course is open to a
private individual.

(ix) No Equi-marginalising of utilities. An individual tries

to maximize satisfaction from his income by distributing
his expenditure in such a manner as to have equi-

5.

Taxation: The consumption of cigarette,

alcohol, opium and other commodities that fall within
that general category need to be discouraged. The
governments often levy taxes to discourage the
consumption of these harmful commodities.
Protection of Infant Industries: If the infant and
newly started firm or industries in developing nations
are allowed to struggle with foreign firms especially
from those technologically advanced countries, they
may not survive due to many reason and factors. These
industries need protection and government often levies
duties in order to protect them.
Provision Public Goods: Governments provide
public good, the government-financed items and
services such as roads, military forces, lighthouses, and
streetlights. Private citizens even the wealthy ones
would not voluntarily pay for these services, and
therefore businesses have no incentive to produce
them.
Side Effects of a Market Economy: Public
finance also enables governments to correct or offset
undesirable side effects of a market economy. These
side effects are called spillovers or externalities.
Example: households and industries may generate
pollution and release it into the environment without
considering the adverse effect pollution has on others.
Pollution is a spillover because it affects people who are
not responsible for it. To correct a spillover,
governments can encourage or restrict certain activities.
For example, governments can sponsor recycling
programs to encourage less pollution, pass laws that
restrict pollution, or impose charges or taxes on
activities that cause pollution.
Redistribute
of
Income: Governments
redistribute income by collecting taxes from their
wealthier citizens to provide resources for their needy

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ones. The taxes fund programs that help support people
with low incomes.
6.
Equity: Public finance plays a great role in
eliminating or reducing the inequalities of income and
wealth in a capitalist economy. This is achievable by
transferring the purchasing power from the rich to the
poor. When governments impose progressive taxes on
the richer members of the society and provides various
facilities such as subsided food, housing, free medical
aid and education to the less privilege members of the
society, that is what is called equity. Public finance
provides government programs that moderate the
incomes of the wealthy and the poor. These programs
include social security, welfare, and other social
programs. For example, some elderly people or people
with disabilities require financial assistance because
they cannot work.
7.
Subsidies and grants: In modern times,
subsidies and grants are inevitable for producing
essential goods and services meant for the masses. It
has a prominent place in the governmental expenditure
of developing countries. Subsidy on fuel, transportation
could seen in Nigeria.
8.
Optimum utilization of resources: The natural
resources developing countries are underutilized or
overutilised. The proper utilization of natural resources
is imperative not only for the present generation, but
also for the unborn generations. The state can direct the
flow of production, consumption and distribution in the
economy by framing a suitable budget policy.
9.
Economic planning: Government usually have
rolling plans for more than a year, a times the
implementation of say five year plan tends to require a
huge fund. Thus, government need to combine
resources, taxation and public borrowing effectively.
10.
Providing employment opportunities: The
government has to spend huge amount of public
expenditure to provide the purchasing power to the
general masses and reduce the problem of
unemployment in the economy. The SURE-P of the
federal government of the Nigeria is a move in that
direction.
11.
Market Failures: These are the market
inadequacies or private sector of the economy fails to
address and fail to satisfy all the needs of the society.
Often market fails in providing the societys desired set
of goods and services and the distribution of income
and poverty. It also fails in achieving stability in
employment and prices.

Mixed Economic System'

A mixed economic system is an economic system that
features characteristics of both capitalism and
socialism. A mixed economic system protects private
property and allows a level of economic freedom in the
use of capital, but also allows for governments to
interfere in economic activities in order to achieve social
aims. According to neoclassical theory, mixed
economies are less efficient than pure free markets, but
proponents of government interventions argue that the
base conditions such as equal information and rational
market participants cannot be achieved in practical
application.
!--break--Most modern economies feature a synthesis of
two or more economic systems, with economies falling
at some point along a continuum. The

public sector works alongside the private sector, but

may compete for the same limited resources. Mixed
economic systems do not block the private sector from
profit-seeking, but do monitor profit levels and may
nationalize companies that are deemed impediments to
the public good. The United States is mostly a free
market economy, but it incorporates elements such as
protection for agriculture and manufacturing by through
trade restrictions and subsidies. This makes the United
States a mixed economy by definition.

Main Principles of Public

Expenditure and implications.
The main principles or canons which should govern
public expenditure as follows:
1.
The principle of Maximum Social Advantage: The
government expenditure should be incurred in such a
way that it should give benefit to the community as a
whole. The aim of the public expenditure is the
provision of maximum social advantage. If one section
of the society or one particular group receives benefit of
the public expenditure at the expense of the society as a
whole, then that expenditure cannot be justified in any
way, because it does not result in the greatest good to
the public in general. So we can say that the public
expenditure should secure the maximum social
advantage.
2.
The Principle of Economy: The principle of
economy requires that government should spend
money in such a manner that all wasteful expenditure is
avoided. Economy does not mean miserliness or
niggardliness. By economy we mean that public
expenditure should be increased without any
extravagance and duplication. If the hard earned money
of the people, collected through taxes, is thoughtlessly
spent the public expenditure will not confirm to the
canon of economy.
3.
Principe of Sanction: According to the principle
all public expenditure should be incurred by getting
prior sanction from the competent authority. The
sanction is necessary because it helps in a voiding
waste, extravagance, and overlapping of public money.
Moreover, prior approval of the public expenditure
makes it easy for the audit department to scrutinize the
different items of expenditure and see whether the
money has not been overspent or misappropriated.
4.
Principle of Balanced Budgets: Every
government must try to keep its budgets well balanced.
There should be neither ever recurring surpluses nor
deficits in the budgets. Ever recurring surpluses are not
desired because it shows that people are unnecessarily
heavily taxed. If expenditure exceeds revenue every
year, then that too is not a healthy sign because this is
considered to be the sign of financial weakness of the
country. The government therefore must try to live with
in its own means.
5.
The Principle of Elasticity: The principle of
elasticity requires that public expenditure should not in
any way be rigidly fixed for all times. It should be rather
fairly elastic. The public authorities should be in a

12 | P a g e
position to vary the expenditure as the situation
demands. During the period of depression, it should be
possible for the government to increase the expenditure
so that economy is lifted from low level of employment.
During boom period, the state should be in a position to
curtail the expenditure without causing any distress to
the people.
6.
No Unhealthy Effect on Production and
Distribution: The public expenditure should be arranged
in such a way that it should not have adverse effect on
production or distribution in the country. Public
expenditure should aim at stimulating production and
reducing inequalities of wealth distribution. If due to
unwise public spending wealth gets concentrated in a
few hands, then its purpose is not served. The money
really goes waste then.

rises faster than the latter. Hence, the income elasticity

of public expenditure (IEPE) for the U.S.A. was 4.8 for
the period 1890-1963 and 4.5 for the U.K. in 1890-1955.

2. Welfare State Ideology and Wagners Law:

The modern State is a welfare state. It aims at promoting

the economic, political, and social well-being of its
citizens. It makes every effort to improve the living

Main Causes of Growth of Public

Expenditures

standard of the common people. For this purpose, it has

to undertake may functions and services never
visualised before.

Some of the main causes of public expenditure growth

Even in an avowedly capitalistic economy, there has
are: 1. Income Elasticity and Increase in Per Capita
been increasing State intervention through legislative
Income 2. Welfare State Ideology and Wagners Law 3.
and administrative measures for augmenting production
Effects of War and the Need for Defence 4. Resource
and improving distribution. Many wants which were
Mobilisation and Ability to Finance 5. Inflation 6. The
formerly satisfied individually by private means are now
Role of Democracy and Socialism 7. The Urbanisation
satisfied collectively through public expenditure.
Effect 8. The Rural Development Effect 9. The
Population Effect 10. The Growth of Transport and
Communication 11. The Planning Effect.

1. Income Elasticity and Increase in Per Capita Income:

In the classical era, the State was assumed to have a

very limited function under the laissez faire policy. The
functions of the State were restricted to justice, police,
and army.

According to Musgrave, a rising share of public

expenditure in national income is associated with a rise
in per capita income.

Today, however, the role of the State has changed under

the welfare criterion and there is a persistent trend
towards an extensive and intensive increase in the scale

Thus, an increase in per capita income over a period of

of governmental performance. Apart from performing

time may cause a relative rise in public expenditure.

old functions more efficiently and on a larger scale, a

This is because the demand for public goods tends to

modern State constantly undertakes new functions and

expand with the rise in per capita income. Usually, it

added responsibilities day by day.

13 | P a g e
It now embraces many new ideas such as social

In Wagners opinion, the pressure for social progress

insurance, unemployment relief, and provisions for

may be regarded as the root cause of the relative growth

underprivileged classes. In order to reduce inequalities

of public expenditure in modern times.

of income, the State has to spend a large sum on free

and cheap medical aid, subsidised food and housing,
free education. Especially in underdeveloped countries
such as India, the State expenditure on these social
services is rising fast.

Due to the pressure of social progress under the welfare

state theory, in addition to the maintenance of law and
order, government participation in the economic field for
the provision of some goods, such as communication,
education, medical facilities, etc. was necessitated. In

In India, for instance, expenditure on social service is

short, the Wagner hypothesis states that in a welfare

rising fast. In India, for instance, expenditure on social

state, as the economy expands, public expenditure will

services has gone up from Rs. 419 crores in the First

also tend to increase persistently.

Plan to Rs. 2,772 crores in the Fourth Plan. In the

3. Effects of War and the Need for Defence:
Seventh Plan, it was envisaged to be Rs. 29,350 crores.
The tremendous growth in public expenditure may also
Fundamentally, public expenditure in modern times
be attributed to wars and threats of war in modern
shows an increasing trend on account of the evertimes. In the Second World War, countries like England
increasing scale of State activity. This tendency, in
incurred heavy war expenditures, amounting to 15
economic literature, is known as Wagners law of
million per day. Wars and threats of war and the
increasing expansion of State activities.
consequent defence needs compel governments to
Adolf Wagner, a German fiscal theorist of the nineteenth

spend more and more on the production of war goods.

century, propounded this theory according to which

Due to the invention of nuclear weapons, there is always
there is a persistent tendency towards an increase in the
the danger of foreign aggression. International political
expenses and functions of the State, that is, there is a
situation is uncertain and insecure. Modern States are
functional relationship between State activities and the
already facing a cold war. As such, every nation has to
relative growth of public expenditure owing to the
prepare itself for strong defence.
social progress which is to be realised through State
participation in economic fields. Indeed, the welfare

The defence expenditure is thus continuously rising. It

aspect of government activity is appropriately described

contains expenditure on war materials, maintenance and

by Wagner as, the pressure for social progress.

growth of armed forces, naval and air wings, expenses

14 | P a g e
on the development of military art and practice,

6. The Role of Democracy and Socialism:

pensions to retired war personnel, interests on war debt,

The recent growth of democracy and socialism
cost of rehabilitation, etc.
everywhere in the world has caused public expenditure
Peacock and Wiseman have referred to the

to increase very much. A democratic structure of

displacement effect in the post-war period when higher

government is inevitably more expensive than a

taxes and higher revenue collection drive of the war

totalitarian government. In India, democracy has

period are continued by the government, finding them

certainly become a costly affair. Expenditure on

easy and attractive. The displacement effect may further

elections and bye-elections is increasing.

be supplemented by a scale hypothesis, i.e., adoption

The number of ministries and executive offices has also
of new social welfare schemes by the government on a
been increasing. Further, the ruling party has to fulfill its
permanent basis.
promises and launch upon new policies and
4. Resource Mobilisation and Ability to Finance:

programmes to achieve socialist objectives, in order to

create a favourable image in the public. This also

When the government innovates more and more

methods of taxation and resource mobilisation, its

requires increasing State expenses in order to provide

new amenities and opportunities to the people at large.

ability to finance public expenditure increases and the

size of public expenditure grows. Public sector outlays

7. The Urbanisation Effect:

could be increased by more taxation yields, public debt,

The spread of urbanisation is an important factor
foreign aid and deficit financing.
leading to the relative growth of public expenditure in
5. Inflation:

modern times. With the growth of urban areas, there has

been an increasing tendency of expenditure on civil

With the rising prices, the government has to keep on

administration.

increasing public expenditure to carry out its functions

and maintain the supply of public goods intact. During

Expenses on water supply, electricity, provision of

inflation, the government has to pay additional DA to its

transport, maintenance of roads, schools and colleges,

employees which obviously call for an extra burden on

traffic controls, public health, parks and libraries,

public expenditure.

playgrounds, etc. have increased enormously these

days. Likewise, the expenditure on courts, prisons etc.
is increasing, especially in the urban sector.

15 | P a g e
8. The Rural Development Effect:

constructing new railway lines, new roads, national

highways, bridges and even canals to connect the

In an underdeveloped country, the government has also

different areas with a smooth transport system as a
to spend more and more for rural development. It has to
precondition of growth.
undertake schemes like community development
projects and other social measures.

11. The Planning Effect:

9. The Population Effect:

In a less developed economy, the government adopts

economic planning for the development of the country.

A high growth of population naturally calls for increase

In a planned economy, thus, when the public sector is
in the expenses as all State functions are to be
expanding its role, public expenditure obviously shows
performed more extensively. Rising population also
an increasing trend.
poses various problems in poor countries.
In India, for instance, the public sector outlay during the
The State will have the added responsibility of solving
First Five Year Plan was just Rs. 1,960 crores, which is
such problems as food, unemployment, housing and
now estimated at Rs. 2, 47,865 crores during the Eighth
sanitation. Further, overpopulated countries like India
Plan period (1992-97).
will have to check the population growth. The State has,
therefore, to spend more and more on family planning

Effects of Public Expenditure in an

Economy

campaigns every year.

Introduction
10. The Growth of Transport and Communication:

Public expenditure is one of the important subject

matters of public finance. It deals with various

With the expansion of trade and commerce, the State

expenditures of an authority. Before the Keynesian

revolution of 1930s, in economics, public expenditure

has to provide and maintain a quick and efficient

played very limited role in public finance. Because, most

transport system. Transport being a public utility, the

of the economists of that time were believed in the free

competition or the so called laissez-faire. Therefore the

State has to provide it cheaply also. Hence, railway and

passenger transport is nationalised.

solutions for economic problems were dealt by market.

But the world witnessed great depression in 1930s,
which later impacted in the raise of macroeconomics.
From the Keynesian revolution onwards, public

Government has, therefore, to run transport services

even at a loss. This obviously calls for a high
expenditure for maintenance and expansion. Further,
the government in a poor country has to spend a lot on

expenditure has played a very crucial role in the growth

and development of any economy. In fact, since the
increasing trend of public expenditure, it has wide
effects in the economy. Here this hub is provided some
of the major effects of public expenditure.

16 | P a g e
Broadly the effects of public expenditure can be

Public expenditure has wide effects on the distribution

discussed under the following four heads.

function of an economy. Here the effect is the

distribution of the public expenditure in to various fields

i) Effects on production
ii) Effects on distribution

or economic groups. The core aim behind the effect on

distribution is that to reduce the inequality. As like in the
case of tax (public revenue), public expenditure may be

iii) Effects on growth and development, and

iv) Effects on economic stability.
Each of these effects is briefly explained below.
i) Effects on production
Public expenditure has a wide effect on the production

in any of the following three modes based on the ability

to receive.
a) Progressive public expenditure
b) Regressive public expenditure, and
c) Proportional public expenditure.

aspects of an economy. It can able to control the level of

a) Progressive public expenditure: Progressive public

production indirectly. Public expenditure denotes the

expenditure is very essential for any economy to bring

support of the authority towards its economy.

economic equality. It aims more flow of income to the

Public expenditure can influence the ability to work,

save and invest. And also the willingness to work, save

poor class like providing subsidies, social insurance,

special schemes etc.

and invest. This is because a sufficient amount of public

b) Regressive public expenditure: It is not good for any

expenditure will ensure the production activities. For

economy to bring economic equality. Here the flow of

instance, governments public expenditure on

income is concentrated to the richer class. This will

developing basic infrastructural facilities will create the

widen the gulf between two classes and by inequality in

ability and willingness to work. This means that, public

the society.

expenditure can create employment opportunities.

Therefore, income of the people will increase. It will
gradually create a tendency among people to save. This
saving will convert in to investment. That means more
growth of the economy.

c) Proportional public expenditure: Here the flow of

income is based on the proportion of income or wealth
held by the people. This method never helps to bring
any improvements in the society.

Similarly public expenditure can able to control the

resources in to various uses and locations. By

iii) Effects on growth and development

understanding the requirements of the economy,

government can take reasonable policies to improve

Today, there are many discussions all over the world on

backward locations and efficient utilization of the

the topic economics of growth and development. Public

resources. In fact, public expenditure plays a vital role

expenditure is one of the crucial tools of determining

on production aspects like resource utilization and

the speed of economic growth and development. By

economic contribution of various sectors and locations.

trying to achieve economic growth and development,

public expenditure creates wide effects on the

There are some direct effects also by the public

expenditure. Sometimes government starts industrial
activities, projects, schemes etc. which will directly
generate employment opportunities, more income,

improvements in infrastructural facilities, increasing of

social overheads, maximum social advantage, welfare,
safety, security, reducing inequalities, improvements in
the standard of living etc.

effective demand, and mass production and so on,

finally economic growth and development.
ii) Effects on distribution

iv) Effects on economic stability

17 | P a g e
Attaining economic growth and development and

expenditure refers to expenses Incurred by public

maintaining its stability are the two main aims of any

authorities central, state and local on its various

economy. Economic stability can be achieved only by

activities. The activities of public authorities Include the

eliminating the barriers of growth. Public expenditure

primary activities as the civil administration and defense

has a big deal in bringing economic stability. Therefore,

of the country etc.

sustainability is the most noted point. Simply, economic

stability is a condition of an economy where there is no
inflation, deflation, unemployment, flexible exchange
rate etc.

(2) Canons of Economy:

The

canon

of

economy

suggests

that

as

canons

the

State

of

public

To cure inflation government must follow surplus

expenditure,

should

be

budget policy by reducing its public expenditure. On

economical in spending. It implies two things, Firstly;

contrary, government must follow deficit budget policy

the Government should not spend more than the

during deflation by expanding public expenditure. This

amount required to be spent on particular item of

is simply because public expenditure can simply adjust

expenditure. Secondly, The State should spend money

the volume of money in the economy.

in such a way that might develop the productive

capacity of the community as much as possible. The

Conclusion

first consideration has reference to the present while

Public expenditure has playing an unavoidable role in

second consideration has reference to the future. The

the present economic systems. Now, it using as a best

main aim of the canon is to avoid the wastage and

tool for bring the economic stability, achieving

extravagance of any kind. In this reference, it is

economic growth, reducing unemployment, inequality

etc. In short, public expenditure creates a wide and
numerous effects in an economy in its various
components like production, distribution, utilization of
resources and so on.

necessary to check duplication of expenditure. In this

connection, the Government should see that the
expenditure should not produce , any adverse effect on
production and on the will and the power of the people
to sue .

(3) Canons of Sanction:

5 Canons of Public Expenditure |

Principles of Public Expenditure
Public expenditure There are 5 canons of public
expenditure which are presented for you one by
one.Generally, government expenditure on public
activities is much higher than the revenue collected
through various sources. The deficit is made lip of
public debts and other sources.5 canons of public
expenditure are:

What it implies is that the Government, before incurring

any expenditure on any item should obtain the proper
sanction and approval of the competent authority.
Without its approval, the Government department
cannot incur any expenditure or any expenditure
beyond the specified limit. In a democratic country,
competent authority is the legislature. The government
presents its budget before the legislature and gets
approval and only then the government departments
can incur expenditure.

(1) Canons of Maximum Social Benefit:

(4) Canons of Surplus or Balanced Budget:
The principle of maximum social benefit, as canons of
public expenditure, implies that the Government should
plan its expenditure in a manner as to promote the
greatest

good

of

the

greatest

number.

Public

According to this canons of public expenditure, the

state must avoid resort to deficit financing as far as
possible. The classical economists always preferred

18 | P a g e
surplus budget just like an ordinary citizen. But in
modern time, balanced budget (no deficit no surplus
budget) is preferred. It implies that the balanced
expenditure must be balanced to public revenue. The
policy of deficit financing is not tenable for long.
Surplus budget also cannot find favor because it implies
that the government is spending much less than what it
should. The tax payers will realize a burden in paying
tax. So, the government should prepare a balanced
budget.

External loan is that which is raised from

international money markets, foreign
governments, and from international agencies
like International Monetary Fund. When a state
is in need of money, it tries to get as much loan
as it can from other states. The foreign
governments do not advance loans without a
limit. They minutely study the budgetary
position of the borrowing country, the taxbearing capacity of the nation, the per-capita
income of the people and the purpose for
which the loan is desired. If the position of the
budget is sound and the taxable capacity of
the nation is high, then a foreign government
may advance sizable loan to the borrowing
country.

(5) Canons of Flexibility or Elasticity:

Flexibility must be there in public expenditure. It implies

that the expenditure may be expended or contracted
according to the call of the time. At a time of crisis, the
expenditure should be cut down because the income of
the government is expected to be short at such a time.
The principles or 5 canons of public expenditure should
be followed by the government which taking up the
project. Sanctioning authority should think well before
sanctioning a budget.

Public Debt
Public debt refers to borrowing by a government from
within the country or from abroad, from private
individuals or association of individuals or from banking
and NBFIs.

Classification of Public Debt

(a) Internal and External: When a state finds
that it is not possible to obtain further money
by taxation, it resorts to borrowing from
citizens and financial institutions within the
country. This is internal borrowing. The state
may accumulate funds by raising short-term
loans or long-term loans or by both. If the state
is passing through a very critical period, then
it can borrow all the money which the nation
saves. In that case trade and industry will
suffer a lot because no money is left to finance
them. In the normal period, however, the state
can borrow only surplus funds which are left
with the businessmen after meeting all the
needs of the business.

(b) Productive and Unproductive: The debt

that is expected to create assets which will
yield income sufficient to pay the principal
amount and the interest on it, is known as
productive debt. In other words, they are
expected pay their way; they are selfliquidating. J.L. Hanson has referred such a
debt as reproductive debt.
On the other hand, unproductive debt is the
debt that is raised for financing unproductive
assets or heavy unproductive
expenditures. Such a debt is a deadweight
debt. Debt invested on wars or prevention of
war is a deadweight debt.
(c) Short-term and Long-term: The loans that
are repayable within a period of one year, they
are termed as short-term loans and if they are
taken for more than one year, they are referred
to as long-term loans. Following are the
reasons for raising short-term loans:
1.
If, at any time, the expenditure
of the government exceeds the
revenue, then she takes recourse to
short-term borrowing.
2.
If, at any time, the rate of
interest in the market is very high
and the government is in need of
large fund to finance her various
projects, then it raises loan for a
short-period of time only and waits
till the prevailing high rate of interest
comes down.
3.
The commercial banks find a
very safe and profitable opportunity
to invest their surplus funds in the
government short-term loans.

19 | P a g e
If the government is in need of large funds and
the short-term loans are not enough, then she
takes recourse to long-term borrowing. Longterm loans entail following advantages:
1.
Long-term loan provides an
opportunity to the state in undertaking
large projects like construction of canals,
hydroelectric projects, buildings,
highways, etc. As these loans are not to
be repaid at a short notice, so the
government safely spends them on
productive projects.
2.
Long-term loans are also
unavoidable for strengthening countrys
defence.
3.
Long-term loans provide good
opportunity for commercial banks and
insurance companies to invest their
surplus funds. As the rate of interest on
long-term loans is higher than on the
short-term loans.
4.
Long-term loans can be repaid by
the government by the time which is
favourable or convenient to her. She can
also convert these loans at a lower rate of
interest later on.
5.
If at any time, the rate of interest is
low, the government can contract a longterm loan and with the amount thus raised
some public work programmes at lower
cost.

central bank. In Pakistan, the Government

issues what are called Treasury Bills which
are repayable within one year.
2.

To reduce depression in the economy and

financing public works programme.

3.

To curb inflation by withdrawing the

purchasing power from the public.

4.

Financing economic development esp. in

under-developed countries.

5.

Financing the public sector for expanding and

strengthening the public enterprises.

6.

War, arms and ammunition financing.

Methods of Debt Redemption

1.

Utilisation of surplus revenue: This is an old

method and badly out of tune with the modern
conditions. Budget surplus is not a common
phenomenon. Even when there is a surplus, it
cannot be used for making any substantial
reduction in the public debt.

2.

Purchase of government bonds: The

government may buy her own stocks in the
market, thus wiping off its obligation to that
extent. This may be done by the application of
surplus revenues or by borrowing at low rates,
if the conditions are favourable.

3.

Terminable annuities: When it is intended

completely to wipe off a permanent debt, it
may be arranged to pay the creditors a certain
fixed amount for a number of years. These
annual payments are called annuities. It will
appear that, during the time these annuities
are being paid, there will be much greater
strain on the government finances than when
only interest has to be paid.

4.

Conversion of high-interest-rated loans to lowinterest-rated loans: A government may have

borrowed when the rate of interest was
high. Now, if the rate of interest falls, it can
convert a high-rated loan into a low-rated one.

5.

Sinking fund: This is the most important

method. A fund is created for the repayment of
every loan by setting aside a certain amount
every year out of the current revenue. The
sum to be set aside is so calculated that over a
certain period, the total sum accumulated,
together with the interest thereon, is enough to
pay off the loan.

Causes of Increase in Public

Debt
1.
War or war-preparedness,
including nuclear programmes
2.
To cover the budget
deficits on current account
3.
schemes

To undertake public welfare

4.

Urge for economic growth

5.
Inefficiencies of public
organisations and corruption

Burden of Public Debt

Purposes of Public Debt
1.

Bringing gap between revenue and

expenditure through temporary loans from

If the debt is taken for productive purposes, for e.g., for

irrigation, transportation, railway, roads, information
technology, human skill development, etc., it will not

20 | P a g e
mean any burden. Infact, they will confer a benefit. But
if the debt is unproductive it will impose both money
burden and real burden on the economy.

6.

Public has become a powerful tool of

developmental monetary policy

7.

There are two ways in which the governments

of under-developed countries raise resources
through public loans:

(a) Burden of internal debt: Internal debt involves a

series of transfers of wealth within the country, i.e., from
lender to government and then later on at the time of
redemption from government to lender. Money is thus
transferred from one section of the community to other
sections. In this case the money burden on the
economy is zero.
But there may be real burden on the community. In
order to repay the interest and the principal amount of
the debt, the government has to levy taxes. What the
taxpayers pay the lenders receive. The lenders are
generally rich people and tax burden is fall on poor
especially in the case of indirect taxes. The net result
may be that the wealth is transferred from poor to
rich. This is the loss of economic welfare.
(b) Burden of external debt: External debt also involves
a series of transfer of wealth from the foreign lender to
the borrowing country, and when it is repaid the transfer
is in the opposite direction. As the borrowing country
paid interest to the foreign lenders, a direct money
burden is fall on the whole community.
The community is also suffered from real burden of
external debts. Government has to cover the amount of
interest to be paid to the foreign lender by heavily taxing
the income of the community. As a result the
production, consumption and distribution of income is
badly affected. Moreover, the foreign lender has direct
involvement in the economic activities of the country.

8.

Taxation should cover at least current

expenditure on normal government services
and borrowing should resort to finance
government expenditure which results in
creation of capital assets.

2.

Public borrowing for financing productive

investment generates additional productive
capacity in the economy

3.

It is used as an instrument to mobilise

resources which would otherwise hoarded in
real estate or jewellery

4.

It provides the people opportunities to hold

their wealth in the form of safe and stable
income-yielding assets, i.e., government
bonds

5.

The management of public debt is used as a

method to influence the structure of interest
rates.

Market borrowing, i.e., sales to the

public of government bonds (longterm) and treasury bills (short-term)
in the capital market

2.

Non-market borrowing, i.e., issue to

the public of debt which is not
negotiable and is not exchange in the
capital market, for e.g., National
Saving Certificates

There are two forms of loans, i.e., voluntary

and forced loans. Forced loans or compulsory
borrowing is a compromise between taxation
and borrowing. Like a tax it is a compulsory
contribution to the government but like a loan,
it is to be repaid with interest.

Difficulties of Public Borrowings in UDCs

1.

In UDCs there are no or very small organised

capital and money markets. The resources are
too inadequate to fulfil the capital needs of the
economy.

2.

Resources are hoarded in non-productive

sections of the economy, for e.g., real estate
jewellery.

3.

The savings in rural areas cannot be mobilised

effectively because rural incomes do not move
through monetary channels

4.

The response to government securities is also

poor because of rising prices.

Role of Public Borrowing in a Developing Economy

1.

1.

Effects of Public Debt on Production, Consumption,

Distribution and Level of Income and Employment
1.

Effects on Production: Public debts are raised

to finance productive enterprises of various
kinds, e.g., steel works, cement, multipurpose
projects, construction of ships, railway lines
and highways, heavy electrical and
engineering works, mining, oil refining, etc.

2.

Effects on Consumption: When people

subscribe to government loans, they generally
have to curtail consumption. Since investment
of funds raised by borrowing raises the level of
employment and as a result raises the level of
consumption.

3.

Effects on Distribution: Public loans transfer

money from rich to government. The fiscal
operations of the government are to benefit the
poor primarily. The incomes of the poor

21 | P a g e
increase directly through increased
employment or it benefits them in directly
through the enlargement of social services.
4.

Effects on the Level of Income and

Employment: In modern times, public
borrowing is resorted to in order to raise funds
for financing agriculture, industry, mining,
transportation, communication, etc. It
increases employment opportunities, the level
of income and standard of living.

Hicks Classification of Public Debts

1.

2.

3.

Deadweight Debt: Deadweight debt is one

which is not covered by any real assets. In the
words of Hicks: Deadweight is that which is
incurred in consequences of expenditures
which in no way increase the productive power
of the community, yielding neither money
revenue nor a future flow or utilities. The loan
raised during war period is a deadweight debt
because for such debts no real assets exist to
balance them.

Fiscal Policy
What is Fiscal Policy?
Fiscal policy is the process of shaping government
taxation and government spending so as to achieve
certain objectives. According to Prof. Samuelson, by a
positive fiscal policy we mean the process of shaping
public taxation and public expenditure in order to:
(i)
To help dampen down the swings
of a business cycle, and
(ii)
To contribute towards the
maintenance of a growing high
employment economy free from excessive
inflation or deflation.

Passive Debt: Sometimes government raises

loans for spending on such projects which
neither yield money income nor help in raising
the productivity of the country. They simply
provide enjoyments to the citizens such as
public parks, museums, public buildings, etc.

Classical View vs. Keynesian View:

Active Debt: Active debt is one which is spent

on those projects that directly help in yielding
money income and increasing the productive
power of the community.

1. Classical View: Classical economics, the prevailing

economic theory prior to the Great Depression,
hypothesizes that market economies are inherently
stable. In particular, actual GDP automatically adjusts to
the economy's productive capacity, called potential
GDP. Economic capacity is determined by the quantity
and quality of resources available (e.g., labour, capital
and natural resources). If resource prices are flexible,
they will adjust until resources are fully employed and
the economy is operating at economic capacity. If
resources are under-employed, their prices will
fall. Production becomes more profitable as resource
prices fall, encouraging firms to expand output. GDP
expands until under-employment is
eliminated. Conversely, prices will increase for overemployed resources, reducing profits, decreasing
production and eliminating over-employment.

Hansons Classification of Public Debt

J.L. Hanson has classified public debt into four main
classes:
1.

Reproductive Debt: When a debt has assets to

balance it, it is called reproductive debt. For
instance, if a state borrows money for
spending it on the construction of canals,
railways, factories, etc, it is then able to repay
the loan from these self-liquidating projects.

2.

Deadweight Debt: A debt which is not covered

by any real assets is called deadweight
debt. Debt invested on wars or prevention of
war is a deadweight debt.

3.

Funded Debt: Funded debts are long-term

debts. The government continues paying the
annual interest on such loans but makes no
promise to pay the principal sum to the lender
on any specified date. The examples of funded
debts are long-term government stocks, war
loans and console.

4.

Floating or Unfunded Debt: Floating or

unfunded debt comprises of short-term
loans. It is payable to the lender with interest
on or before a fixed date.

There are two views regarding the policies adopted by

the government in order to operate the economy
Classical View and Keynesian View.

With sufficient resource price flexibility, the economy

will adjust to full employment relatively quickly. In this
case, counter-cyclical fiscal policy is unnecessary in the
short run and counterproductive in the long run. If
resource price flexibility stabilizes the economy
relatively quickly, fiscal policy is unnecessary in the
short run. Furthermore, the economy cannot
accommodate the increased aggregate demand after
returning to full employment, assuming potential GDP is
unaffected by expansionary fiscal policy. Thus,
expansionary fiscal policy increases prices in the long
run, rather than GDP. As a result, Classical economists
believe that the Federal Government should maintain a

22 | P a g e
balanced budget; flexible resource prices stabilize the
economy at full employment.
2. Keynesian View: John Maynard Keynes formalized a
theory linking fiscal policy and economic performance
in his book General Theory of Employment, Interest,
and Money in 1036. He believed that Classical
economic theory was inconsistent with the Great
Depression that the U.S. and world economies
experienced in the 1930s. Even though the U.S.
unemployment rate reached 25% in 1933, flexible
resource prices failed to restore full employment.
Keynes offered two explanations for the Great
Depression: sticky prices and pessimistic
expectations. Keynes hypothesized that resource and
product prices are sticky rather than flexible,
particularly with respect to price decreases (i.e., a
horizontal AS curve, at least in the short run). Sticky
prices are slow to decrease as unemployment
increases. Furthermore, if producers and consumers
have pessimistic expectations, price decreases might
not stimulate increased production. Lower resource
prices will only increase output if producers expect to
sell the extra output. If consumers are pessimistic
about future economic conditions, they will not
consume more as prices fall; accordingly, business will
not increase output. Thus, falling prices might not
stimulate business investment and production.
Keynes believed that prices were sticky and
expectations pessimistic during the Great
Depression. Under these conditions, the economy can
experience prolonged high unemployment
rates. Keynes advocated counter-cyclical fiscal policy
to supplement private spending and stabilize the
economy. He felt that the potentially prolonged
unemployment during an economic contraction imposes
unacceptable social and personal costs. He supported
counter-cyclical fiscal policy to minimize these short run
costs.
Keynes was among the first to advocate that federal
budget deficits are appropriate in the short run when the
economy is operating below full employment.

Objectives of Fiscal Policy

Professor Lind Holm in his book Introduction to Fiscal
Policy, laid down the following four main objectives of
fiscal policy
(i)
desirable prices,

The achievement of

(ii)
The achievement of
desirable consumption level,
(iii)
The achievement of
desirable employment level, and

(iv)
The achievement of
desirable income distribution.
The objectives of fiscal policy differ in different
countries according to their economic conditions and
needs. That is why, the fiscal policy is known as the
process of shaping taxation and public spending with a
view to achieve certain specific objectives. In advanced
countries, the objectives of fiscal policy is to increase
aggregate demand by stimulating consumption
function, whereas in underdeveloped countries, the
consumption of luxurious items has to be discouraged
in order to encourage saving for increasing the rate of
economic development. In economically advanced
countries, the goal of fiscal policy may be to reduce the
inequality of income in order to check under
consumption; whereas in a backward economy, unequal
distribution of wealth may be allowed rather encouraged
for promoting capital formation. Though the objectives
are controversial but they are grouped into three:
1. To achieve full employment without much
inflation,
2. To dampen the swings of business cycle
and promote moderate price stability in the
economy,
3. To increase the potential rate of growth
with consistency if possible without interfering
with attainment of other objectives of society.
1. Full-Employment: An economy can attain the
potential rate of growth when the full-employment rate
of capital formation, rate of technological change, the
improvement in levels of skill and education, and
increased availability of other factor units are
achieved. Total spending (C + I + G) must at all times
keep pace with rising national income (Y), or otherwise
the unemployment will develop.
2. Price Level Stability: The maintenance of a reasonably
stable general price level is also regarded as a major
objective of fiscal policy. A decline in the general price
level is incompatible with the maintenance of full
employment and would generate bitter labour strife, as
well as injuring debtors. Inflation a rising price level
does offer the limited advantage of aiding
investment. However, a continued inflation of any
magnitude produces is undesirable.
Stability in the price level does not require stability of
prices of all individual commodities. Commodities
experiencing more than average increases in
productivity will decline in price; and those with little
change in productivity will rise as money wages rise to
reflect the higher productivity in the other fields. If
money wages keep pace with productivity in
manufacturing, the general price level will rise slowly.

23 | P a g e
As full employment is approached unions may tend to
push money wages up faster than productivity and
prices will rise. Some trade off between the two
objectives may be necessary, that is, society may have
to accept some unemployment in order to avoid
inflation. One study concludes that 4% unemployment
is necessary if the increase in the general price level is
to be held to 1 percent; with 3 percent unemployment
the price level increase will be 2 percent or more.
3. Sustained Economic Growth: The third goal of fiscal
policy is to increase the potential rate of economic
growth. A higher rate of economic growth requires a
higher rate of capital formation and a higher S/Y ratio at
full employment. But additional saving requires
reduction in consumption. It is a choice between
present and future consumption.

Tools of Fiscal Policy / Types

of Fiscal Policy
The government uses various fiscal weapons in order to
achieve a growing high employment economy free from
excessive inflation or deflation. They are as follows:
1. Built-in Stabilisers / Automatic Fiscal Policy: The
automatic or built-in stabilisers are as follows:
(a) Taxes: Our present tax system automatically
operates to eliminate the cyclical fluctuation in the
economy. When a wave of optimistic sentiments prevails
in the business circles and there is a rise in prices, rise
in profits and the need is to contract the inflationary
pressure, the progressive tax system comes to rescue
and contracts the surplus purchasing power from the
economy. When a country is faced with falling income
and expenditure, the burden of tax automatically
lessens. The state has not to make any conscious effort
to counteract deflationary potential. As the graduated
rates apply on income, the burden of the tax is
reduced. The consumers are thus left with more
purchasing power to spend on consumption as well as
on producer goods. We, thus, conclude that the
progressive tax system contains automatic stabilising
properties.
(b) Unemployment Compensation: In advanced
countries of the world, people receive unemployment
compensation and other welfare payments when they
are out of job. As soon as they get employment, these
payments are stopped. When national income is
increasing, the unemployment fund grows due to two
main reasons:
(i) Government receives greater amount of
payroll taxes from the employees, and
(ii) The unemployment compensation decreases.

Thus, during boom period, the unemployment

compensation reserve funds help in moderating the
inflationary pressure by curtailing income and
consumption. When the economy is contracting,
unemployment compensation and other welfare
payments augment the income stream and they prove a
powerful factor increasing income, output and
employment in the country.
(c) Farm Aid Programme: Farm aid programmes also
stabilise against the wave like cyclical
fluctuation. When the prices of the agricultural products
are falling and the economy is threatened with
depression, government purchases the surplus
products of the farmers. The income and total spending
of the agriculturists thus remain stabilised and the
contraction phase is warded off to some extent.
When the economy is expanding, the government sells
these stocks and absorbs the surplus purchasing
power. It thus reduces inflationary potential by
increasing the supply of goods and contracting the
pressure of too great spending.
(d) Corporate Savings and Family Savings: The credit
of having automatic or built-in stabiliser does not go to
the state alone. The corporations and companies and
wise family members too play an important part to
contract cyclical fluctuations. For instance, the
corporations pay a fixed amount every year to the
shareholders and withhold part of the dividends of the
boom years to pay in the depression years. Thus
holding back some earnings of good years contracts the
purchasing power and releasing of money in poorer
years, expands the purchasing power of the
people. Similarly, wise persons also try to save
something during the prosperous days in order to
spend the savings in the rainy days.
2. Discretionary Fiscal Policy: By discretionary fiscal
policy is meant the deliberate changing of taxes and
government spending by the control authority for the
purpose of offsetting cyclical fluctuations in output and
employment. The discretionary fiscal policy has shortrun as well as long-run objectives:
(a) Short-Run Counter-Cyclical Fiscal Policy: The
main weapons or stabilisers of short-run discretionary
fiscal policy are:
(i) Persuasion,
(ii) Changes in tax rates,
(iii) Varying public works expenditure,
(iv) Credit aids, and
(v) Transfer payments.

24 | P a g e
(i) Persuasion: In a capitalistic society, the
entrepreneurs are not aware of each others investment
plans. They, therefore, in competition with one another
over-invest capital in a particular industry or industries
and thus cause overproduction and unemployment in
the economy. Similarly, in depression period, there is
no agency to guide them. If government publishes the
total investment plans and marginal efficiency of capital
in various industries, much of the investment can
proceed at a moderate speed and there can be stability
to some extent in income, output and employment.

(ii) Stabilisation of price level

(iii) Reduction in inequality of income
Phases of Long-Run or Full Fiscal Policy: The long-run
fiscal policy has two phases:
(i) Secular Exhilaration, and
(ii) Secular Stagnation

(ii) Changes in tax rates: It is an important weapon of

fiscal policy for eliminating the swings of the business
cycle. When the government finds that planned
investment is exceeding planned savings and the
economy is likely to be threatened with inflationary
gap. It increases the rates of taxes. The higher taxes,
other things remaining the same, reduce the disposable
income of the people who then are forced to cut down
their expenditure. The economy is thus, saved from
inflationary situation.
If, on the other hand, planned saving is in excess of
planned investment and the economy is likely to be
faced with deflationary gap, the taxes are lowered
considerably so that people are left with more
disposable income. When purchasing power of the
people increases, the rate of spending on consumption
and investment increases. The economy is thus saved
from deflationary situation.
(iii) Varying public works expenditure: Another
important factor, which influences economic activity, is
public expenditure. In times of depression, the
government can contribute direct to the income stream
by initiating public works programmes and in boom
period it can withdraw funds from the income stream by
curtailing them.
(iv) Credit aids: The government can also avert
depression by offering long-term credit aids to the
needy industrialists of starting or expanding the
business. It can also give financial help to insurance
companies and bankers to prevent their failures.
(v) Transfer Payments: Variation in transfer expenditure
programmes can also help in moderating the business
cycle. When the business is brisk, the government can
refrain from giving bonuses to the workers and thus can
lessen the pressure of too great spending to some
extent. When the economy is in recession, these
payments can be released and more bonuses can be
given to stimulate aggregate effective demand.
(b) Long-Run Fiscal Policy: The objectives of long-run
fiscal policy / full fiscal policy are as below:
(i) High level of employment

In the above diagram, the cyclical fluctuation around the

income level (along Y axis) on line 1, can be eliminated
by an effective short-run fiscal policy.
At trend line 2, the economy is in a state of secular
exhilaration, i.e., it is having a perpetual inflationary
gap. It is obvious that the condition of chronic inflation
is not desirable and so is to be remedied. The built-in
stabilisers and discretionary stabilisers can only offset
the cyclical fluctuations but cannot bring down the level
of income to full employment level. So we have to adopt
long-term fiscal measures. The economists recommend
that government should (i) create surplus financing, and
(ii) public debt over a long period of years.
The trend line 3 indicates a state of chronic depression
which Professor Hansen calls secular stagnation. When
the economy is having a deflationary gap over decades,
the anti-cyclical fiscal measures alone cannot lift the
economy from secular stagnation. The following longterm fiscal measures are recommended to overcome the
situation:
1.

Secular increase in public debt utilised for

productive purposes,

2.

A greater equality in income brought about by

progressive taxation, abolition of monopolies,

25 | P a g e
provision of better facilities to the low paid
workers, etc., and
3.

Compensatory spending is another long-run

method for lifting economy out of the morass
of severe depression. Government should
increase its investment spending by raising
funds on taxing hoards and borrowing at low
rate of interest from the commercial
banks. The compensatory spending by the
government fills up the gap between actual
spending and the full employment spending.

Role of Fiscal Policy

(Demand Side Effects)

(iii)
should always be
accompanied by an equal increase in
taxes, so that the budget remains in
balance, i.e., balanced budget
multiplier.
(iv)
is an effective
policy tool when the economy is in
Stagflation.
(v)
is impossible if the
budget is already in deficit and the
economy is in Depression.

Governments can use fiscal policy as a counter-cyclical

tool, because changes in government outlays and taxes
affect aggregate demand and aggregate supply. Using
fiscal policy as a counter-cyclical tool to promote full
employment and price stability with little or no regard
for its effect on the national debt is known as functional
finance. According to Keynes, market economies had a
proclivity to fall into depression when consumer and
business spending declined. Instead of waiting for selfcorrecting market mechanisms to work, Keynes
advocated deliberate deficit spending by the
government to stimulate aggregate demand. This would
immediately create jobs and incomes for otherwise
unemployed workers.
The role of fiscal policy is to remove the inflationary or
deflationary gap from the economy. The government
can apply three main fiscal tools, i.e., tax, government
spending, and transfer payments:
1. Expansionary Fiscal Policy / During Deflation: During
deflation the government has three choices:
(a) Increase government spending,
i.e., government purchases multiplier
(b) Decrease taxes, i.e., tax multiplier
(c)

Increase transfer payments

(a) Increase government spending: An increase in

government spending for public goods and services:
(i)
initiates a multiplier
effect which results in a cumulative
increase in total spending that is
greater than the initial change in
government spending
(ii)
is always
undertaken when the public wants
more government services.

In the above diagram, the economy is operating at

equilibrium point E1, which is less than the full
employment level of E2, or in other words, the economy
is facing deflationary gap. At point E1, the aggregate
demand curve AD1intersects the aggregate supply curve
AS. When government spending is increased, the
aggregate demand increases from AD 1 to AD2. Now the
new aggregate demand curve AD 2 intersects the
aggregate supply curve AS at a new point of equilibrium,
i.e., E2. At this new equilibrium point E2, the national
output is higher than before and the economy is
operating under full employment level.
(b) Decrease taxes: Generally speaking, the tax
multiplier for a decrease in taxes is weaker than the
government spending multiplier, because:
(i)
voluntary.

paying taxes is

(ii)
the underground
economy avoids paying taxes through tax
loopholes.

26 | P a g e
(iii)
income taxes can be
passed on to somebody else.
(iv)

part of a tax cut will be

saved.
(v)
politically, it's not as
easy to cut taxes as it is to cut
government spending.

2. Contractionary Fiscal Policy / During Inflation: During

inflation the government has three choices:
(a) Decrease government spending,
i.e., government purchasing multiplier
(b) Increase taxes, i.e., tax multiplier
(c) Decrease transfer payments
(a) Decrease government spending: During inflation, a
decrease in government spending:
(i)
will cause a decrease in aggregate
demand more than the change in
government spending through multiplier
effect
(ii) is always undertaken when there
is a severe inflationary gap in the
economy
(iii) is an effective fiscal measure
when the economy is in hyper inflation

In the above diagram, the economy is operating at

equilibrium point E1, which is less than the full
employment level of E2, or in other words, the economy
is facing deflationary gap. At point E1, the aggregate
demand curve AD1intersects the aggregate supply curve
AS. When government decreases taxes to give a boost
in consumption and investment expenditure, the
aggregate demand increases from AD 1 to AD2. Now the
new aggregate demand curve AD 2 intersects the
aggregate supply curve AS at a new point of equilibrium,
i.e., E2. At this new equilibrium point E2, the national
output is higher than before and the economy is
operating under full employment level.

(iv) a decrease in government

spending should always be followed by an
decrease in taxes, so that the budget
remains in balance, i.e., balanced budget
multiplier

(c) Increase transfer payments: During deflation,

when transfer payments (pensions, unemployment
compensation, allowances, etc.) are increased, the
multiplier effect is of minor magnitude. However, it can
help in:
(i)
removing deflationary gap
from the economy,
(ii)
increasing purchasing power
of the people, and
(iii)
bringing full employment level
in the economy (to some extent)

In the above diagram, the economy is operating at the

equilibrium point E1, which is higher than the fullemployment level of EO, or in other words, the economy
is facing an inflationary gap. At point E1, the aggregate
demand curve AD1 intersects the aggregate supply
curve AS. When the government reduces its spending,
the aggregate demand curve shifts from AD 1 to

27 | P a g e
ADO. Now the new aggregate demand curve
ADO intersects the aggregate supply curve AS at a new
point of equilibrium, i.e., EO. At this new equilibrium
point EO, the national output is less than before and the
economy is operating under full employment level.
(b) Increase taxes: If the economy is operating at a
level above full employment level, the government can
remove this inflationary gap through excessive
taxation. The removal of inflationary gap will depend on
the multiplier effect of increase in tax or tax
multiplier. These fiscal measures will bring the
following changes in the economy:
(i)

decrease in aggregate demand

(ii) decrease in consumption and

investment expenditures, and
(iii) finally a decrease in national
output cutting the extra inflationary
pressure in the economy

and socially apathetic. However, a decrease in transfer

payments can remove the inflationary gap from the
economy.

Fiscal Policy with Reference

to Under-Developed
Countries
The role of fiscal policy in less-developed countries
differs from that in developed countries. In developed
countries, the role of fiscal policy is to promote full
employment without inflation through its spending and
taxing powers. Whereas the position of developing
nations is entirely different. The LDCs or economically
backward countries are caught up in vicious circle of
poverty. The vicious circle of low income, low
consumption, low savings, low rate of capital formation
and low income has to be broken by suitable fiscal
measures. Fiscal policy in developing countries is thus
used to achieve which are different from advanced
countries. The principle objectives of fiscal policy in a
developing economy are as under:
1.

To mobilise resources for financing

development

2.

To promote economic growth in the private

sector

3.

To control inflationary pressure in the

economy

4.

To promote economic stability with

employment opportunities

5.

To ensure equitable distribution of income and

wealth

1. Resource mobilisation: Resource mobilisation for

financing the development programmes in the public
sector can be attained through:

In the above diagram, the economy is operating at the

equilibrium point E1, which is higher than the fullemployment level of EO, or in other words, the economy
is facing an inflationary gap. At point E1, the aggregate
demand curve AD1 intersects the aggregate supply
curve AS. When the government increases taxes, the
aggregate demand curve shifts from AD 1 to ADO. Now
the new aggregate demand curve ADO intersects the
aggregate supply curve AS at a new point of equilibrium,
i.e., EO. At this new equilibrium point EO, the national
output is less than before and the economy is operating
under full employment level.
(c) Decrease transfer payments: Decrease in transfer
payments can improve the inflationary situation in the
economy, but decreases in pensions, unemployment
compensations, allowances, can be very controversial

(a) Taxation: Taxation is an important instrument for

fiscal policy. It is widely used to mobilise the available
resources for capital formation in the economy. The
moping up of surplus resources through taxation is an
effective mean of raising resources for capital
formation. There are two types of taxes which are levied
to transfer funds from private to public use:
(i) Direct taxes: are levied on the income, profits
and wealth of the people who have potential economic
surplus.
(ii) Indirect taxes: are the taxes such as excise duty,
sales tax, etc, imposed mostly on good which have
higher income elasticity of demand.

28 | P a g e
(b) Tax on farm income: Agriculture sector is another
important source of revenue which can be tapped for
capital formation. Agriculture is the largest sector of
under-developed countries and should be subject to
progressive taxation. The government can raise a
substantial amount of tax revenue from agriculture
sector.

government can take direct investment on economic

and social overheads.

2. Promoting development in the private sector: In a

mixed economy, private sector constitutes an important
part of the economy. While framing fiscal policy, the
interests of the private sector should also be
prioritised. The private sector of any economy makes
significant contribution to the development of the
economy. The fiscal methods for stimulating private
investment in developing countries are:

Possible Offsets / Limitations

/ Critical Evaluation of Fiscal
Policy

(a) Income from government saving schemes

be exempted from taxation, in order to boost
up private saving,
(b) Rates of return on voluntary contribution
to provident fund, insurance premium, etc., be
raised for incentive to save,
(c) Retained profits of the public companies
should be taxed at preferential rates or
exempted from taxation, in order to boost
private investment, and
(d) Rebates and liberal depreciation
allowances can also be granted to encourage
investment in the private sector.
3. Restraining inflationary pressure: One of the
important objectives of fiscal policy is to use taxation as
an instrument for dealing with inflationary or
deflationary pressure. In developing countries, there is
a tendency of the general prices to go up due to
expenditure on development projects, pressure of
wages on prices, long gestation period between
investment expenditure and production, etc. Fiscal
measures are used to counter act the inflationary
pressure. Tax structure is devised in such a manner
that it mops up a major proportion of the rise in
income. Government also tries to reduce its own
spending and achieve budgetary surplus. It helps
reducing inflationary pressure in the economy.
4. Securing equitable distribution of income and
wealth: A wider measure of equality in income and
wealth is an integral part of economic development and
social advance. The fiscal operations, if carefully
worked out can bring about a redistribution of income in
favour of the poorer sections of the society. The
government can reduce the high bracket incomes by
imposing progressive direct taxes. For raising the
income of the poor above the poverty line and
narrowing the gap between rich and poor, the

5. Promoting economic stability: The ultimate objective

of fiscal measures is to promote economic stability with
increased employment opportunities and higher living
standards.

1. Crowding-out effect: mostly emphasized by

monetarists stating that when expansionary fiscal policy
is adopted, the government has to borrow. Thus
government, for purpose will compete to private sector
as a result rate of interest will go up because of increase
in money demand. The increase in rate of interest will
result in reduction in the volume of private investment
and a fall in national income. Such decrease in national
income will offset that effect of increase in national
income which became possible due to adoption of
expansionary fiscal policy. There are two types of
crowding out effects:
(a) Indirect crowding out: is the tendency of
expansionary fiscal policy through deficit spending
increases interest rate which in turn reduces investment
and consumption. The interest rate declines because
government finances budget deficit by government
borrowing and this will compete with the private sector
in terms of borrowing money. Because of this, aggregate
demand increases by less than the amount of the
increase in government spending.
(b) Direct Crowding out: refers to the situation when
expenditure offsets directly. Actions taken by the private
sector will offset government spending actions. That is
the way private sector will spend their money cancel out
government actions.
2. Open economy effect: When interest rate increases as
a result of government deficit spending through
borrowing, then foreigners will demand more rupees. As
a result rupee appreciates which means that the value of
rupee will increase relative to other currencies.
Therefore, exports will decrease and imports will
increase and aggregate demand will decrease by the
amount of export decrease.
3. Time lags:
(a) Recognition time lag: the time lag required to get
information about the economy (recession or inflation)
(b) Administrative time lag or action time lag: the time
required between recognizing the economic problem

29 | P a g e
and applying fiscal policy into effective. It is too short
for both monetary and fiscal policy.
(c) Operational lag or effect time lag: the time that
elapses between the onset of the policy and the results
of that policy.
4. Supply side economics: Both traditional fiscal policy
and Supply Side economists suggest tax cuts to
stimulate GDP. Fiscal policy emphasizes the short run
effects of tax cuts on aggregate demand. Supply side
economics emphasizes the long run effects of tax cuts
on economic capacity. In the supply side model,
economic capacity is largely determined by the quantity
of available resources. Reducing marginal tax rates can
increase the supply of resources and expand productive
capacity (e.g., by reducing taxes on personal income,
corporate profits, capital gains, savings and capital
investment).
This introduces an apparent contradiction: the same
policies are recommended to support two different
goals. In actuality, both viewpoints may be
correct. Fiscal policy focuses on fiscal policy's short
run effects. In the short run, lower taxes can increase
household consumption and business investment. This
increases GDP. Supply side economics doesn't address
short run economic fluctuations. It takes time to
translate changes in marginal tax rates into increases in
productive capacity. Supply side economics focuses on
the long run impacts of tax rate changes.

Fiscal Policy vs. Monetary

Policy
Keynes and the early Keynesian economists believed
that counter-cyclical fiscal policy was more effective
than monetary policy for stabilizing the economy. This
belief considers the mechanisms through which
monetary policy affects macroeconomics performance
and experience during the Great
Depression. Specifically, an increase in the money
supply stimulates the economy both directly and
indirectly. (See Monetary Policy.) As the money supply
increases, and supply exceeds demand, individuals will
reduce their money holdings by increasing both
consumption and savings. Increases in consumption
increase aggregate demand. Increases in savings
reduce interest rates. As interest rates fall, investment
demand increases and consumption demand increases
further (as savings rates fall). Thus, expansionary
monetary policy stimulates GDP in the short run through
a direct increase in consumption demand and indirectly
through a decrease in interest rates. As with
expansionary fiscal policy, expansionary monetary
policy is inflationary in the long run, after prices adjust
to restore full employment.
Keynesians felt that pessimistic expectations during a
recession would negate the short run effects of

expansionary monetary policy. In particular, as the

money supply increases, pessimistic individuals won't
use the excess money supply to increase
consumption. Thus, there is no direct effect on
GDP. Furthermore, investment and consumption
demand will not increase as interest rates
fall. Pessimistic individuals won't increase
consumption as interest rates fall and pessimistic firms
will not invest. Thus, there is no indirect effect on
GDP. Pessimism renders monetary policy ineffective in
the Keynesian model. Keynes referred to this situation
as a "liquidity trap." Therefore, early Keynesians relied
on counter-cyclical fiscal policy to stabilize GDP.
Most modern Keynesian economists recognize that
monetary policy has a short run impact on GDP
(Keynes liquidity trap is no longer
relevant). Furthermore, the policy implementation lags
are significantly shorter for monetary policy than they
are for discretionary fiscal policy. Discretionary fiscal
policy requires parliamentary approval; monetary policy
can be implemented autonomously by the central
bank. Thus, Keynesians increasingly support automatic
fiscal stabilizers and monetary policy; discretionary
fiscal policy plays a smaller role.

Monetary Policy
Monetary policy changes the nation's money supply to
influence macroeconomics performance, including
unemployment, inflation and economic
growth. Monetary policy is conducted by the nation's
central bank, the Federal Reserve System in the United
States. Changes in the money supply relative to its
demand affect financial markets, including interest and
exchange rates. These changes alter investment,
consumption and net exports, which in turn influence
macroeconomics performance.
Increasing the money supply relative to its demand
creates an excess supply of money. Individuals will
spend some of this money on consumption goods and
save the rest in either savings accounts or by investing
in stocks, bonds and other interest bearing assets. An
increase in savings reduces interest rates. Capital
market competition and arbitrage spreads the lower
interest rates across all short run financial markets. As
interest rates fall, investment demand and consumer
durable purchases increase. Finally, lower interest rates
affect exchange rates. As domestic interest rates fall
relative to international interest rates, domestic
investment shifts to foreign markets; foreign investment
in domestic capital markets also decreases. This
increases the supply of rupees relative to demand in the
international currency markets, lowering the price of a
rupee. Lower exchange rates stimulate exports and
reduce imports. Thus, increasing the money supply
increases aggregate demand for consumption,
investment and net exports.

30 | P a g e
Monetary policy, like fiscal policy, is a demand side
macroeconomics policy. In particular, monetary policy
indirectly affects aggregate demand and
macroeconomics performance through the financial
markets. Fiscal policy, which involves changes in
government expenditures and taxes, directly affects
aggregate demand. Government expenditures influence
government demand; tax policy influences both
consumption and investment demand.
Demand side macroeconomics policies are often used
to offset business cycles and stabilize economic
performance, particularly prices and unemployment. If
the economy is operating below full employment,
monetary and fiscal policies can be used to increase
aggregate demand. Presumably, businesses will
increase output to satisfy the increase in aggregate
demand. If there are unemployed resources, including
human, capital and natural resources, output can
increase without significantly increasing prices. As the
economy approaches full employment, and there are
few slack resources, increases in aggregate demand
primarily affect wages and prices. Businesses must
compete against one another for the limited supply of
resources; product prices increase with wages and
input prices. Given these responses, expansionary
monetary and fiscal policy can stimulate employment
during an economic downturn; contractionary monetary
and fiscal policy can alleviate inflationary pressures
when the economy is over heated.

country. Fiscal policy through variations in government

expenditure and taxation profoundly affects national
income, employment, output and prices.

Contents

1. Meaning of Fiscal policy

2. Objectives of Fiscal Policy

3. Fiscal Policy for Economic Growth

4. Budgetary PolicyContra-cyclical Fiscal Policy

1. Meaning of Fiscal policy

Fiscal policy means the use of taxation and public

Macroeconomic stabilization is generally considered a
short run policy. In the long run, market prices for
capital, labour and other inputs adjust to full
employment. The economy automatically converges to
full employment in the long run. In contrast, supply side
economics addresses long run economic
performance. Supply side economics emphasizes
aggregate supply. Supply side economics hypothesizes
that long run economic growth requires expanding
productive capacity. In the supply side model, reducing
marginal tax rates increases productive capacity by
increasing the labour supply and capital
investment. Increasing economic capacity enables the
economy to accommodate growth while reducing
inflationary pressures.

expenditure by the government for stabilisation or

growth. According to Culbarston, By fiscal policy we
refer to government actions affecting its receipts and
expenditures which we ordinarily taken as measured by
the governments receipts, its surplus or deficit. The
government may offset undesirable variations in private
consumption and investment by compensatory
variations of public expenditures and taxes.

Fiscal Policy: Meaning,

Objectives and Other
Information

Arthur Smithies defines fiscal policy as a policy under

which the government uses its expenditure and revenue
programmes to produce desirable effects and avoid
undesirable effects on the national income, production

The role of fiscal policy for economic growth relates to

and employment. Though the ultimate aim of fiscal

the stabilization of the rate of growth of an advanced

policy in the long-run stabilisation of the economy, yet it

31 | P a g e
can be achieved by moderating short-run economic

disposable income thereby increasing consumption and

fluctuations. In this context, Otto Eckstein defines fiscal

investment expenditure of the people.

policy as changes in taxes and expenditures which aim

at short-run goals of full employment and price-level
stability.

On the other hand, a reduction of public expenditure

during inflation reduces aggregate demand, national
income, employment, output and prices; while an

2. Objectives of Fiscal Policy

increase in taxes tends to reduce disposable income

and thereby reduces consumption and investment

The following are the objectives of fiscal policy:

expenditures. Thus the government can control

deflationary and inflationary pressures in the economy

1. To maintain and achieve full employment.

by a judicious combination of expenditure and taxation

programmes. For this, the government follows

2. To stabilise the price level.

compensatory fiscal policy.
3. To stabilise the growth rate of the economy.

4. To maintain equilibrium in the balance of payments.

5. To promote the economic development of

underdeveloped countries.

Compensatory Fiscal Policy:

The compensatory fiscal policy aims at continuously

compensating the economy against chronic tendencies
towards inflation and deflation by manipulating public
expenditures and taxes. It, therefore, necessitates the

3. Fiscal Policy for Economic Growth

adoption of fiscal measures over the long-run rather

than once-for-all measures it a point of time.

The role of fiscal policy for economic growth relates to

the stabilisation of the rate of growth of an advanced
country. Fiscal policy through variations in government
expenditure and taxation profoundly affects national
income, employment, output and prices. An increase in
public expenditure during depression adds to the

When there are deflationary tendencies in the economy,

the government should increase its expenditures
through deficit budgeting and reduction in taxes. This is
essential to compensate for the lack in private
investment and to raise effective demand, employment,
output and income within the economy.

aggregate demand for goods and services and leads to

a large increase in income via the multiplier process;

On the other hand, when there are inflationary

while a reduction in taxes has the effect of raising

tendencies, the government should reduce its

32 | P a g e
expenditures by having a surplus budget and raising

In the downward phase of the business cycle when

taxes in order to stabilise the economy at the full

national income is declining, taxes which are based on a

employment level.

percentage of national income automatically decline,

The compensatory fiscal

policy has two approaches:

thereby reducing the tax yield. At the same time,

government expenditures on unemployment relief and
social security benefits automatically increase. Thus

(1) Built-in stabilisers; and

there would be an automatic budget deficit which would

counteract deflationary tendencies.

(2) Discretionary fiscal policy.

(1) Built-in Stabilisers:

On the other hand, in the upward phase of the business

cycle when national income is rising rapidly, the tax

The technique of built-in flexibility or stabilisers

yield would automatically increase with the rise in tax

involves the automatic adjustment of the expenditures

rates. Simultaneously, government expenditures on

and taxes in relation to cyclical upswings and

unemployment relief and social security benefits

downswings within the economy without deliberate

automatically decline. These two forces would

action on the part of the government. Under this system,

automatically create a budget surplus and thus

changes in the budget are automatic and hence this

inflationary tendencies would be controlled

technique is also known as one of automatic

automatically.

stabilisation.
Its Merits:
The various automatic stabilisers are corporate profits
tax, income tax, excise taxes, old age, survivors and
unemployment insurance and unemployment relief
payments. As instruments of automatic stabilisation,
taxes and expenditures are related to national income.
Given an unchanged structure of tax rates, tax yields

Built-in stabilisers have certain advantages as a fiscal

device:

1. The built-in stabilisers serve as a cushion for private

purchasing power when it falls and lessen the hardships
on the people during deflationary period.

vary directly with movements in national income, while

government expenditures vary inversely with variations

2. They prevent national income and consumption

in national income.

spending from falling at a low level.

33 | P a g e
3. There are automatic budgetary changes in this device

4. This device keeps silent about the stabilising

and the delay in taking administrative decisions is

influence of local bodies, state governments and of the

avoided.

private sector economy.

4. Automatic stabilisers minimise the errors of wrong

5. They cannot eliminate the business cycles. At the

forecasting and timing of fiscal measures.

most, they can reduce its severity.

5. They integrate short-run and long-run fiscal policies.

6. Their effects during recovery from recession are

unfavourable. Economists, therefore, suggest that built-

Its Limitations:

It has the following limitations:

in stabilisers should be supplemented by discretionary

fiscal policy.

(2) Discretionary Fiscal Policy:

1. The effectiveness of built-in stabilisers as an
automatic compensatory device depends on the

Discretionary fiscal policy requires deliberate change in

elasticity of tax receipt, the level of taxes and flexibility

the budget by such actions as changing tax rates or

of public expenditures. The greater the elasticity of tax

government expenditures or both.

receipts, the greater will be the effectiveness of

automatic stabilisers in controlling inflationary and

It may generally take three forms:

deflationary tendencies. But the elasticity of tax receipts

(i) Changing taxes with government expenditure
is not so high as to act as an automatic stabiliser even
constant,
in advanced countries like America.
(ii) changing government expenditure with taxes
2. With low level of taxes even a high elasticity of tax
constant, and
receipts would not be very significant as an automatic
stabiliser doing a downswing.

(iii) variations in both expenditures and tax

simultaneously.

3. The built-in stabilisers do not consider the secondary

effects of stabilisers on after-tax business incomes and

(i) When taxes are reduced, while keeping government

of consumption spending on business expectations.

expenditure unchanged, they increase the disposable

income of households and businesses. This increase
private spending. But the amount of increase will

34 | P a g e
depend on whom the taxes are cut, to what extent, and

The discretionary fiscal policy depends upon proper

on whether the taxpayers regard the cut temporary or

timing and accurate forecasting:

permanent.
1. Accurate forecasting is essential to judge the stage of
If the beneficiaries of tax cut are in the higher middle

cycle through which the economy is passing. It is only

income group, the aggregate demand will increase

then that appropriate fiscal action can be taken. Wrong

much. If they are businessmen with little incentive to

forecasting may accentuate rather than moderate the

invest, tax reductions are temporary. This policy will

cyclical swings. Economics is not an exact science in

again be less effective. So this is more effective in

correct forecasting. As a result, fiscal action always

controlling inflation by raising taxes because high rates

follows after the turning points in the business cycles.

of taxation will reduce disposable income of individuals

and businesses thereby curtailing aggregate demand.

2. There are delays in proper timing of public spending.

In fact, discretionary fiscal policy is subject to three time

(ii) The second method is more useful in controlling

lags.

deflationary tendencies. When the government

increases its expenditure on goods and services,
keeping taxes constant, aggregate demand goes up by
the full amount of the increase in government spending.
On the hand, reducing government expenditure during
inflation is not so effective because of high business
expectations in the economy which are not likely to
reduce aggregate demand.

(iii) The third method is more effective and superior to

the other two methods in controlling inflationary and
deflationary tendencies. To control inflation, taxes may
be increased and government expenditure be raised to

(i) There is the decision lag, the time required in

studying the problem and taking the decision. The lag
involved in this process may be too long.

(ii) Once the decision is taken, is an execution lag. It

involves expenditure which is to be allocated for the
execution of the programme. In a country like the USA it
may take two years and less than a year in the U.K.

(iii) Certain public work projects are so cumbersome

that it is not possible to accelerate or slow them down
for the purpose of raising or reducing spending on
them.

fight depression.
Conclusion:
Its Limitations:

35 | P a g e
Despite the higher multiplier effect of government

Thus the budget deficit has an expansionary effect on

spending as against changes in tax rates, the latter can

aggregate demand whether the fiscal process leaves

be operated more promptly than the former. Emphasis

marginal propensities unchanged or whether a

has thus shifted to taxation as the best fiscal device for

redistribution of disposable receipts occurs. The E

controlling cyclical fluctuations. Thus when the turning

expansionary effect of a budget deficit is shown

point of a business cycle is already underway,

diagrammatically in Figure 1. C is the consumption

discretionary fiscal action tends to strengthen the built-

function. C + I+G represent consumption, investment

in stabilisers, as has been the experience of developed

and government expenditure (the total spending

countries like the USA.

function) before the budget is introduced. Suppose

Budgetary PolicyContracyclical Fiscal Policy

4.

government expenditure of G is injected into the

economy.

The budget is the principal instrument of fiscal policy.

Budgetary policy exercises control over size and
relationship of government receipts and expenditures.
We discuss below the common budgetary policies that
can be adopted for stabilising the economy.

(1) Budget DeficitFiscal Policy during Depression:

Deficit budgeting is an important method of overcoming

depression. When government expenditures exceed
receipts, larger amounts are put into the stream of
national income than they are withdrawn. The deficit
represents the net expenditure of the government which
increases national income by the multiplier times the
increase in net expenditure. If the MPC is 2/3, the
multiplier will be 3; and if the net increase in
government expenditure is Rs.-100 crores it will
increase national income to Rs. 300 crores (= 100 x 3).

As a result, the total spending function shifts upward to

C +1 + G1. Income increases OY from OF to OF, when the
equilibrium position moves Income from E1 to E1 .The
increase in income YY1 (= EA = MiE1A) is greater than the
increase in government expenditure E1B (=G). BA (E1A
E1B) represents increase in consumption. Thus the
budget deficit is always expansionary, the rise in
national income being (YY1) greater than the actual

36 | P a g e
amount of government spending (G = E1B). In this

case we also assume that some consumption and

method of budget deficit, taxes are kept intact.

investment expenditures increase due to tax relief.

Budget deficit may also be secured by reduction in

(2) Surplus BudgetFiscal Policy during Boom:

taxes and without government spending. Reduction in

Surplus in the budget occurs when the government
taxes tends to leave larger disposable income in the
revenues exceed expenditures. The policy of surplus
hands of the people and thus stimulates increase in
budget is followed to control inflationary pressures
consumption expenditure. This, in turn, would lead to
within the economy. It may be through increase in
increase in aggregate demand output, income and
taxation or reduction in government expenditure or
employment. This is illustrated in Figure 2, where is
both. This will tend to reduce income and aggregate
the original consumption function. Suppose tax is
demand by the multiplier times the reduction in
reduced by ET, it will shift the consumption function
government or/and private consumption expenditure (as
upward to C1.Income will increase from OY to OY1.
a result of increased taxes).

This is explained with the aid of Figure 1, where the

economy is at the initial equilibrium position E1.
Suppose the government expenditure is reduced by G
so that the total spending function + I + G shifts
downward to + I + G. Now E is the new equilibrium
position which shows that the income has declined to
OY from OY1 as a result of reduction in government
However, reduction in taxes is not so expansionary via

expenditure by E1B. The fall in income Y1 Y 1(= AE) > E1 B

increased consumption expenditure because the tax

the reduction in expenditure because consumption has

relief may be saved and not spent on consumption.

also been reduced by BA.

Businessmen may not also invest more if the business

There may be budget surplus without government
expectations are low. Therefore, to safeguard against
spending when taxes are raised. Enhanced taxes reduce
such eventualities the government should follow the
the disposable income with the people and encourage
policy of reduction in taxes with increased government
reduction in consumption expenditure. The result is fall
spending and its multiplier effect will be much higher in
in aggregate demand, output income and employment.

37 | P a g e
This is illustrated in Figure 3. is the consumption

expenditure rises more than the fall in consumption

function before the imposition of the tax. Suppose a tax

expenditure due to the tax and there is net increase in

equal to ET is introduced. The consumption function

national income.

shifts downward to C1. The new equilibrium position is

E1. As a result, income falls from OY to OY1.

The balanced budget theorem is based on the combined

operation of the tax multiplier and the governmentexpenditure multiplier. In this, the tax multiplier is
smaller than the government-expenditure multiplier. The
government-expenditure multiplier is

Or Y = 1/1-c G

Y/G = 1/1-c

Which indicates that the change in income (Y) will

(3) Balanced Budget:
equal the multiplier (1/1- c) times the change in
Another expansionist fiscal policy is the balanced

autonomous government expenditure?

budget. In this policy the increase in taxes (T) and in

The tax multiplier is
government expenditure (G) are of an equal amount.
This has the impact of increasing net national income.

Y = CT/1-c

This is because the reduction in consumption resulting

from the tax is not equal to the government expenditure.

The basis for the expansionary effect of this kind of

balanced budget is that a tax merely tends to reduce the
level of disposable income. Therefore, when only a
portion of an economys disposable income is used for
consumption purposes, the economys consumption
expenditure will not fall by the full amount of the tax. On

Y/T = -c/1-c

Which shows that the change in income (Y) will equal

multiplier (1/1- c) times the product of the marginal
propensity to consume (c) and the change in taxes (T).

A simultaneous change in public expenditure and taxes

may be expressed as a combination of equations (1) and
(2). Thus the balanced budget multiplier

the other hand, government expenditure increases by

the full amount of the tax. Thus the government

kb = Y/G + Y/T = 1/1-c + -c/1-c = 1-c/1-c = 1or kb =1

38 | P a g e
Since G = T, income will change by an amount equal

with income at OY0 level. Tax of AG amount is imposed.

to the change in government expenditure and taxes.

As a result, the consumption function shifts downward

to C1.Now g government expenditure of GE amount is

To understand it, it is explained numerically. Suppose

the value of 2/3 and the increase in government

injected into the economy which is equal to the tax

yield AG.

expenditure G = Rs 10 crores. Since G = T, therefore

the increase in taxes (lumpsum) T = Rs. 10 crores.

The new government expenditure line is C1+ G which

determines OY income at point E. The increase in

We first calculate the government-expenditure multiplier,

kg = Y/G =1/1-c =1/1-2/3 =3

income Y0Y equals the tax yield A G and the increase in

government expenditure GE. This proves that income
has risen by 1 (one) times the amount of increase in

The tax multiplier is kT = Y/T =-c/1-c = -2/3/1-2/3 = 2

government expenditure which is a balanced budget

expansion.

To arrive at the increase in income as a result of the

combined operation of the government expenditure
multiplier and the tax multiplier, we write the balanced
budget multiplier equation as

kb = Y = 1/1-c G + c/1-c T

and fit in the above values of c, G and T so that

kb = Y = 3G 2 T

Fiscal Policy

= 310 2 10 = Rs. 10 crores

Thus the increase in income (Y) exactly equals the

Fiscal Policy refers to the use of the spending levels and

increase in government expenditure (G) and the

tax rates to influence the economy. It is the sister

lumpsum tax (T) i.e., Rs. 10 crores. Hence kb= 1.

strategy to monetary policy which deals with the central

banks influence over a nations money supply. The

This balanced budget multiplier or unit multiplier is

governing bodies use combinations of both these

explained with the help of Figure 4. is the

policies to achieve the desired economic goals. Thus,

consumption function before the imposition of the tax

39 | P a g e
the essential tools of fiscal policy are taxing and

power, mostly, lying in the hands of the prime minister

spending. [1]

or the finance minister and the parliament with the

degree of power of either bodies changing through time.

As the American economy slid into recession in 1929,

economists relied on the Classical Theory of

Discretionary Fiscal Policy and

economics, which promised that the economy would

Automatic Stabilizers

self-correct if government did not interfere. But as the

recession deepened into the Great Depression and no
correction occurred, economists realized that a revision
in theory would be necessary. John Maynard Keynes
developed Keynesian Theory, which called for
government intervention to correct economic instability.
Keynes recommended that, during periods of recession,
the government should increase spending in order to
prime the pump of the economy. At the same time, he
recommended, it should decrease taxes in order to give
households more disposable income with which they
can buy more products. Through both methods of fiscal
policy, the increase in aggregate demand stimulates
firms to increase production, hire workers, and increase
household incomes to enable them to buy more. Keynes
advocated the opposite positions during times of rapid
inflation. Keynes presented his ideas in a book
called The General Theory of Employment, Interest and

The government exercises fiscal policy to prevent

economic fluctuations from taking place. When actions
are undertaken to minimize economic fluctuations, it is
known as discretionary fiscal policy. Discretionary fiscal
policy is employed when an increase in unemployment
and inflation is observed. [3]

Another element that can come into play during

economic fluctuations is Automatic Stabilizers. They are
taxes and transfers that automatically change with
changes in economic conditions in a way that dampens
economic cycles. For example, at times of economic
downturns, the amount of money spent on food stamps
automatically rises as more people apply for it or the
rules are eased. The additional spending generated by
the food stamps helps to soften the downturn for the
individuals receiving the help, and also benefits the
businesses and employees where the money is spent. [4]

Money, published in 1936. [2]

The fiscal policy is controlled by those people in the

government who have control over the tax rates and

Types of Fiscal Policies

government spending. It varies from country to country.

The individuals who have control over the budget are
referred to as the fiscal authority. In the United States, it
is held by the executive and legislative branches;
whereas in Europe, there are varied models with the

There are two types of fiscal policy: expansionary and

contractionary. The objective of expansionary fiscal
policy is to reduce unemployment. Thus, an increase in
government spending and/or decrease in taxes are

40 | P a g e
implemented that results in better GDP and reduced

The macroeconomic effects of fiscal policy have to be

unemployment. However, it can also cause some

studied under two circumstances: one with reduced

inflation. On the other hand, the objective of

expenditure (less spending) and the other with reduced

contractionary fiscal policy is to reduce inflation.

revenue (less taxes). The results of lessened

Therefore, a decrease in government spending and/or

expenditure have, in general, a small effect on GDP; and

an increase in taxes are implemented that leads to

they dont impact private consumption significantly.

decreasing inflation. However, it can also trigger some

Although they do have a negative effect on private

unemployment. [5] In other words, fiscal policy that

investment, a varied effect on housing prices, lead to a

increases aggregate demand directly through an

quick fall in stock prices and depreciation of the real

increase in government spending is typically called

effective exchange rate.

expansionary or loose. By contrast, fiscal policy is often

considered contractionary or tight if it reduces demand
via lower spending.

Reduced taxes have the inverse outcomes as they have

positive (although lagged) effects on GDP and private
investment; have a positive effect on both housing and
stock prices; and lead to appreciation of the real

Effects of Fiscal Policy

effective exchange rate. [7]

The objectives of fiscal policy vary with duration and

economy of application. In the short term, governments

Limits of Fiscal Policy

may focus on macroeconomic stabilization with aims of

stimulating an ailing economy, combating rising
inflation, or helping reduce external vulnerabilities. In
the longer term, the aim may be to foster sustainable
growth or reduce poverty with actions on the supply
side to improve infrastructure or education. Although
these objectives are common among countries, their
relative importance differs depending on the country
circumstances. In the short term, priorities may reflect
the business cycle or response to a natural disaster
while in the longer term; the catalysts can be
development levels, demographics, or resource
endowments. [6]

Fiscal policy is a powerful tool that can maintain the

economy in perfect balance. However, putting them into
practice is quite a difficult task because of various
reasons.

Government spending levels cant be altered with that

easily. A major chunk of government funds is devoted to
health care, social service, and veterans benefits and
such. Thus, changes in expenditure generally must
come from the small part of the budget that includes
discretionary spending. This gives the government less
leeway for increasing or lowering spending.

41 | P a g e
Another inhibiting factor is working with estimations.
When lawmakers put fiscal policies in place, they base

Impact of Expenditure on
Economic Growth in Pakistan

their decisions partly on the past behaviors of

Introduction

individuals. It is risky to assume that people will, for

Theoretically the two opposite views about

relationship between economic growth and
national income are Keynesian and Wagners
view. According to Wagner (1890) public
expenditure rises as a results of rise in real per
capita income known as Wagners Law. In
short the rise in government expenditure is the
outcome of economic growth and causality
should run from national income to Gov.
Expenditure. While Keynesian consider
economic growth as an independent variable
and economic growth is due to public
expenditure. Keynes support rising
government expenditure for enhancing
economic growth (short term & long term
growth). In Keynesian view casualty should
goes from government expenditure to national
income. Several empirical studies have been
conducted in countries around the world for
investigation of existence of Keynesian and
Wagners Hypothesis. The empirical research
of Srinivasan (2013) International Journal of
Academic Research in Business and Social
Sciences February 2015, Vol. 5, No. 2 ISSN:
2222-6990 232 www.hrmars.com and Ebaidalla
(2013 supports Wagners Law. However
empirical research of Musgrave (1969) & Mann
(1980) did not support both the views. There
are six various version of Wagner hypothesis.
First model which is given by
PeacockWiseman (1961), second model is
presented by Gupta (1967), third model by
Goffman (1968), fourth model by Pryor (1969),
fifth by Musgrave (1969) & sixth model is given
by Mann (1980) are given below. Model 01: ln
(Gex) = + ln (Gdp) + u Model 02: ln (Gex/
Pop) = + ln (Gdp /Pop) + u Model 03: ln
(Gex) = + ln (Gdp/ Pop) + u Model 04: ln
(Gce) = + ln (Gdp) + u Model 05: ln (Gex/
Gdp) = + ln (Gdp/ Pop) + u Model 06: ln (Gex
/Gdp) = +ln (Gdp) + u Where ln =natural log,
Gexp = Government Expenditure, Gce =
Government Consumption expenditure, Pop=
population This study aimed to test the two
hypotheses about expenditure and economic
growth for Pakistan. LITERATURE REVIEW
Nkiru and Daniel (2013) examined the
relationship among economic and government
expenditure by using ECM for Nigeria. The
authors used annual data from 1977 to 2012.
Expenditure on education was taken as
government expenditure for Nigeria in the
study. The authors found significant and
positive effect of expenditure on growth.
However, Sevietenyi (2012) also conducted
study for Nigeria and found that Wagner Law
does not exist in Nigeria but the results are
supporting Keynesian hypothesis. Author used
Toda-Yamamoto Granger Causality test and
Cointegration test in the given study. Abbas
and Afzal (2010) tested the validity of Wagner
hypothesis for Pakistan. They have used time
series data of Pakistan from (1960-2007) and

example, respond the same way to a tax cut in the future

as they have in the past.

Although changes in fiscal policy affect the economy,

changes take time. By the time the policy takes effect,
the economy might be moving in the opposite direction.
In these cases, fiscal policy would only add to the new
trend, instead of correcting the original problem.

The pressure that people in authority experience of

pleasing the citizens hinders fiscal policy as well.
Expansionary fiscal policy (reduced taxes) is a popular
choice, but it cant be applied in every situation, and
thus, puts the authorities in a predicament when
contractionary policy has to be applied, and instills fear
a backlash from the voters. Furthermore, execution of
fiscal policy isnt a simple task. It requires a coordinated
effort from multiple pockets of the government which is
very difficult to make happen. In addition, a problem
prevalent in one part of the country may not be as
troublesome in another or possibly the opposite of that.
In addition, in order to be effective, the fiscal policy has
to be in coordination with the monetary policies of the
central bank as well. [2]

42 | P a g e
used Cointegration and Granger Causality test.
Authors have examined the Wagner Law for
four periods in Pakistan. The four periods are
1960-1972, 1981-1991, 1981-2007, and 19912007. According to results Wagner Hypothesis
doesnt hold for the period 1981-1991. The
results of causality shows that among fiscal
deficit and public spending there is
unidirectional causality. Similarly, income and
fiscal deficits also have unidirectional
causality. However, causality does not exist
between income and public spending. Shams
and Murad (2009) test the Wagner Law in
Bangladesh by using Granger Causality test
and Cointegration test. The study period was
1972-73 to 2007-08.The authors have test all
the five versions of Wagner Law for
Bangladesh. According to authors findings
absence of Wagner Law in Bangladesh. Moosa
(2013) results show existence of Wagners
hypothesis in Saudi Arab. For empirical
analysis the author used six different version
of Wagners Law by using Error Correction
Mechanism (ECM) and Cointegration for GDP
(real) and GDP (non-oil). The data for this
research was annual data from 1970-2012.The
studies of Mahjoub (2013) found existence of
International Journal of Academic Research in
Business and Social Sciences February 2015,
Vol. 5, No. 2 ISSN: 2222-6990 233
www.hrmars.com Wagner Hypothesis in
Sudan. Similarly, Sriviasan (2013) results
shows existence of Wagner hypothesis in India
from 1973-2012. Ju Huang (2013) tests the
Wagner Law for Taiwan China. He used Toda
and Yamamoto causality test and Bound test.
For empirical analysis annual data from 1979
to 2012 has been used. The results of both
tests indicates absence of causality among
variables (national income and government
expenditure) for both countries along with in
long run there is no relationship among
national income and government expenditure
in China and Taiwan. Methodology For
empirical investigation of long run relationship
among Expenditure (LnEXP) and economic
growth (lnGDP) I have used Johansen
Cointegration and Causality Test. The reason
for choosing these tests is to find out the
causal relationship between variables and to
know the long run relation. The period of study
is 1972-2013. For this study the variables are
Gross national expenditure and Gross
domestic product of Pakistan. Johansen test
has been used for knowing the long run
relationship while granger causality test is
used to check the causal relation among
variables of the study. The data sources are
World Development indicators and Pakistan
Bureau of Statistics. Augmented Dicky Fuller
Test is used to check the stationary and non
stationary in the data. Granger Causality Test
Following model is proposed for Granger
Causality test LNGDPt = o + 1 n i
1LNGDPt-1 + 1 n j 2 LNEXPt-1 +t
LNEXPt = o + 1 n j 1LNGDPt-1 + 1 n j
2 LNEXPt-1 +vt Where LNEXPt = Natural
logarithm of Expenditure LNGDPt = Natural
logarithm of Gross Domestic Product t & vt =
Error Term DATA ANALYSIS AND RESULTS:

Acquired secondary data was processed and

analyzed using E-Views-7 software. Table-1
and Table-2 shows the results of Augmented
Dicky Fuller (ADF) for variable expenditure
(EXP) & Gross domestic product. Both
variables are transformed into natural
logarithm form represented as LN. The
variables lnEXP & lnGDP at level are nonstationary. They became stationary after first
difference. Insert Table 01 From results of trace
statistics (Table 3) trace statistics < critical
value, therefore we cannot reject null
hypothesis and hence we conclude that
variables are not integrated. Similarly Max
International Journal of Academic Research in
Business and Social Sciences February 2015,
Vol. 5, No. 2 ISSN: 2222-6990 234
www.hrmars.com Eigen Statistics (Table 4), we
cannot reject null hypothesis because max.
Eigen stats < critical value which means
variables have not long run relationship
among each other. Insert Table 02 & 03
Pairwise Granger Causality test result shows
no causality between lnGDP and LnEXP in
Pakistan for study period .The results
indicates non-existence of Wagners Law and
Keynesian Law in Pakistan. The study results
are supporting the views of Musgrave (1969),
Mann and empirical studies conducted by
(1980) Shams and Murad (2009) for
Bangladesh, Ju Huang (2013) for Taiwan China.
Insert Table 04 Conclusion The research aims
at analyzing impact of expenditure on
economic growth in Pakistan. Variables of the
study are initially non-stationary (at level) they
are converted in to stationary by taking first
difference. Results of cointegration show that
there is no any relationship in long run among
growth and expenditure. Similarly, pairwise
causality test also indicates no causal
relations among variables. The results are
supporting the views of Musgrave (1969) &
Mann (1980) according to them expenditure
and growth have not causal relation. However,
this empirical research doesnt support
Keynesian and Wagner hypothesis in Pakistan
for study period. The implication from this
study.

What is the Significance of

Money in Modern Economic
Life?
Money occupies a central position in our modern
economy. Money is everywhere and for everything in the
modern economic life. Money has become the religion
of the day in the ordinary business of life.
As Marshall rightly put: "Money is the pivot around
which economic science clusters." And, "the major part
of the subject matter of economics is concerned with
the functioning and malfunctioning of money."

43 | P a g e
Indeed, the benefits conferred by the use of money,
credit structure and the changes in the value of money,
all have profound influence on the economic behaviour
of mankind today.
Every branch of economic activity in a money economy
is basically different from what it would have been in a
barter economy.
As Robertson states, "The existence of a monetary
economy helps society to discover what people want
and how much they want it and so to decide what shall
be produced and in what quantities, and to make the
best use of its limited productive power.
And it helps each member of society to ensure that the
means of enjoyment to which he has access yield him
the greatest amount of actual enjoyment which is within
his reach."
Money has created a far reaching effect on all facets of
economic activities: consumption, production,
exchange and distribution, as also on public finance and
economic welfare.
Money and Consumption:
Money enables a consumer to generalise his purchasing
power. It gives him command over a wide variety of
goods. It enables him to canalise his purchasing power
and get what he wants. In fact, it is money through its
immense purchasing power that makes a consumer
sovereign in a capitalist economy.
The consumer's sovereignty can be expressed through
money spending. Money provides freedom of choice of
consumption. Money and the price mechanism help a
consumer to allocate his income over goods in such a
way so that he derives maximum satisfaction from their
consumption.
Money and Production:
"In the modern world, industry is closely enfolded in the
garment of money," says Pigou. The institution of
money has made present-day mass production
possible. Without money, production on a large scale
would be impossible. For:
(i) Money has made extreme division of labour possible.
Intensive specialisation is necessary for large scale
production.
(ii) Money is the sine qua non for modern enterprise.
Entrepreneurs are concerned, while planning their
production activities, with the cost of production and
selling prices together with the resulting profit, all
calculated in terms of money.
(iii) The use of money enables a producer to concentrate
on the organisation of the production process. Money
provides a basis for supporting more complex methods
of organising production.
(iv) Money has facilitated borrowing and lending and
these are essential in present day production. Credit is
the main pillar of modern business.

(v) Money is the most liquid and general form of capital

which is highly mobile between different regions and
industries.
(vi) Money helps the producer to discover through the
price mechanism what buyers want and how much they
want, so that he can produce and supply accordingly. In
fact, money has changed the basic characteristics of
production.
Money and Exchange:
Money overcomes the difficulties of a barter system of
exchange. In a money economy, it is a simple matter to
ascertain the market price in terms of monetary units.
Money facilitates trade by serving as a medium of
exchange. Thus, rapid exchange in a modern economic
system is possible because of money. Money is the
basis of the pricing mechanism through which
economic activities are adjusted.
Money and Distribution:
Money eases the process of distribution of factors'
rewards like wages, interests and profits which are all
measured and disbursed in terms of money. It is with the
help of money that the shares of different factors of
production are properly adjusted.
Accounting, receiving and storing of its share of income
by any factor-unit in kind is most inconvenient. Here
money comes to the rescue.
Money and Public Finance:
In a modern economy, government plays a very
important role. Government receives income in the form
of taxes, fees, prices of public utility services, etc. and
uses this income for administrative and developmental
purposes.
But the great magnitude of public revenues and public
expenditure in a modern state would become impossible
without money. Further, fiscal devices like public
borrowing and deficit financing for economic
development can be adopted only in a monetary
economy.
In recent times, the fiscal policy of a government has
acquired very great importance in economic life, since
economic activities can be regulated through budgetary
operations that are facilitated by the institution of
money.
Money, thus, plays an important role in the shaping of
the economic life of a country. The growth of money
economy has made the growth of economic liberalism
and, hence, of the present day free enterprise or
capitalist system possible.
In fact, the pattern of economic life has changed in
accordance with the changes in the economic progress.
For better performance of an economy, a country's
monetary system should be operated in such a manner
as to maintain high levels of employment and avoidance
of business fluctuations. The economic history of the

44 | P a g e
Great Depression in the thirties reminds us of its
importance.
Money occupies a strategic position in the culture of a
modern society. The smooth functioning of the money
economy enables society to raise its standard of living
by increasing production and equitable distribution
through the medium of exchange.
Thus, money helps in widening the materialistic base of
culture and civilisation. Marshall, therefore, maintained
that the history of money is synonymous with the
history of civilisation.
To quote Horace: "All things human and divine,
renowned Honour and worth, at money's shrine go
down."
Above all, money is the measuring rod of economic
welfare. Macro-economic goals of a welfare state are
expressed and their realisation is tested in terms of
money.
Money serves as an index of economic growth. National
income and per capita income are measured in terms of
money. Again, physical planning for economic
development has its counterpart of financial planning
expressed in terms of money.
Money also influences international economy.
International economic relations and foreign trade
transactions are carried out through internationally
accepted money key currency.
In the final analysis, we cannot think of a well- organised
social, economic and political life in the present day
without money.

MONEY

Quantity theory of money

Keynes, Chicago and Friedman

I. The Controversy and its Possible Resolution Was

there a Chicago Quantity-Theory oral tradition, or not;
and if so, what was it?
Robert Leeson, of Murdoch University, has collected
some fifty contributions to a narrow but intriguing topic
in the history of the Chicago School and monetary
economics: whether or not, prior to Milton Friedmans
publication in 1956 of his restatement of the quantity
theory, there had been (as he claimed) an oral tradition
at the University of Chicago of the quantity theory; and,
if there was, of what did it consist? Friedman attributed
to that oral tradition a model in which the quantity
theory was in the first instance (vol. 1, p. 1, Leeson

quoting Friedman) a theory of the demand for money;

indeed, a stable demand for money. Friedman claimed
that the tradition was spawned by Henry Simons and
Lloyd Mints directly and by Frank Knight and Jacob
Viner at one remove. Thirteen years later, Don Patinkin
questioned the validity of Friedmans interpretation of
the quantity theory and his Chicago version (vol. 1, p.
87). Patinkin identified The Other Chicago version
thusly: The quantity theory is, first and foremost, not a
theory of the demand for money, but a theory which
relates the quantity of money (M) to the aggregate
demand for goods and services (MV), and thence to the
price level (P) and/or level of output (T); all this in
accordance with Fishers MV=PT (vol. 1, pp. 89, 91).
After a further twenty-two years Patinkin held that the
disagreement was not about whether or not there was
such an oral tradition, but what the nature of that
tradition was (vol. 1, p. 381). Friedman also has
modified his position.
Leeson has gathered the important material pertinent to
the questions about the Chicago oral tradition. He has
mastered both that material and the intellectual
environment in which the controversy took place, an
environment dominated by Keyness General Theory. Of
the two volumes total of 915 pages, some 180-plus
pages contain Leesons essays on the contents of his
four parts: The Initial Controversy, The Debate Widens,
How Unique was the Chicago Tradition?, and Towards a
Resolution of the Dispute. What does Leeson conclude?
Leeson places a great deal of interpretive weight on
Friedman having taken Mintss graduate course in
money and banking (Economics 330) during his first
year as a graduate student at Chicago in 1932-33.
Leeson has been fortunate in having been given access
by Friedman to his notes from Mintss Economics 330.
Leeson notes that Friedmans lecture notes are
currently in his possession and have not been
processed into his archives at the Hoover Institution
(vol. 2, p.515n.1). The next important round may well
center on the notes. The course was organized around
Keyness Treatise, one feature of which was an
increased emphasis on money demand in a revised
quantity theory framework (vol. 2, p. 486).
Additional interpretive weight is placed by Leeson on a
private seminar held by graduate students; quite a
group, for they included Friedman, Albert G. Hart,
George Stigler, Allen Wallis, Kenneth Boulding, and
others, as well as a stream of visiting economists.
Leeson concludes:It therefore seems likely that
Friedman took the ideas he was exposed to in
Economics 330 and used them as an organising
framework with which to understand the
macroeconomic dislocation of the 1930s. If intense
student discussion is admissible as an oral tradition
then Friedmans assertion has some validity. A version
of the quantity theory which was in the first instance a
theory of the demand for money was apparently a
central and vigorous part of the oral tradition at
Chicago at least among graduate students in 1932-3
(and possibly until the General Theory made Keynes a
suspect figure). (Vol. 2, p. 488)
One difficulty with Friedmans initial position has to do
with the concept of an oral tradition. Friedman was
part of the 1932-33 (and beyond) discussion; the oral
part of the concept is unobjectionable. But the
tradition part is highly suspect, on which more below.

45 | P a g e
A second difficulty is that many different readings were
given the Treatise (not unlike the later General Theory),
each reading stressing different combinations of
variations within a general quantity theory framework.
This meant, on the one hand, that a variety of oral
traditions likely co-existed throughout the discipline
and, on the other hand, that some or many of them
included significant attention to the demand for money.
Leeson stresses the latter: Friedmans initial assertion
about Chicago uniqueness in this context must now
appear unreliable. It is therefore improbable that
the Treatise with its emphasis on money demand
informed macroeconomic discussions in Chicago only.
Indeed, Friedman in the preface to these volumes has
retreated from his initial assertion about Chicago
uniqueness (vol. 2, pp. 488, 489). In his preface,
Friedman begins his defense saying that he early was
baffled at what all the fuss was about. very little
was at stake. He then takes, correctly but irrelevantly,
the position that if he has been confused about the
origin of the ideas it would not affect by an iota the
validity or usefulness of those ideas. He concludes that
he remains persuaded that I was the beneficiary of a
Chicago oral tradition, but this evidence convinces me
that I gave Chicago more credit for uniqueness than was
justified. The issue, he repeats, is entirely about the
origin of ideas, not about the validity of content (vol. 1,
p. x). Friedman seems to have taken too much for
granted; Chicago was no more homogeneous than was
the discipline as a whole on the quantity theory.
Leeson is claiming, therefore, only that Friedmans
assertion had some validity in the sense that much
macroeconomic discussion at Chicago and elsewhere
in the early 1930s resembled his 1956 restatement, that
tradition is too strong, and the uniqueness claim is
wrong and must be dropped.
II. Historiographical Considerations
The collection bears on several historiographical
considerations.
1. The historical record is uneven. Political history
leaves many documents. Social and economic history,
until relatively recently, left few lasting markers, but
often sufficient indirect evidence to enable imaginative
scholars to intuit larger patterns. With only sparse
materials bearing on an interpretive problem, historians
of thought and others may well find it easy to leap to
conclusions. But where one has a vast body of
evidence, such leaps seem presumptuous. With
sparseness, the world may seem simpler than it actually
was; with plentitude, the big, bloomin confusion is
amply evident. So it is with the problem of the Chicago
oral tradition.
The existence and content of an oral tradition plus our
ability to discern them are highly problematical. Until
very recently, as historical time goes, the technology to
record oral communication did not exist. Even now,
absent mechanical recording, the oral, once uttered, no
longer endures (vide Adam Smith on unproductive
labor). One result is false and/or biased memory.
Clarence E. Ayres, a long-time friend of Frank Knight,
was like Knight an imposing and convincing lecturer. It
turns out that institutionalists trained by Ayres had
different views of institutionalist doctrine (such as the
so-called Veblen-Ayres dichotomy) depending on when
they sat in Ayress classes. There was an oral tradition
at Texas centering on Ayres, but for that reason it

registered important variations over time. I would expect

the same at Chicago, the notable difference being that
Friedman, Stigler et alia were more successful.
2. Schools of thought, one surmises, once were loosely
and partly non-deliberately and partly deliberately
formed. As schools became obvious vehicles for
promoting ideas and reputations, they became more
highly, if still loosely, organized. Friedman and Stigler,
as part of their professional activity, engaged in the role
of cheerleader for Chicago. Friedmans claim may well
have been an example of the Chicago propensity to
promote itself by self-publicizing its beliefs. Stigler was
the premier practitioner but rare is the public
presentation e.g., papers given at professional
meetings by a Chicagoan that does not make some
claim for the unique brilliance of the Chicago point of
view. Leeson aptly quotes Stigler that it was both true,
and necessary to their survival that learned bodies are
each run by a self-perpetuating inner clique' (Leeson,
vol. 1, p. 296). The twin objectives were the promotion of
ideas, a certain definition of reality with which to
influence policy; and the quest for power in both the
economics profession and the larger world. Such
constitutes the deliberate invention of tradition, and the
members of the Chicago School have much company, in
the world of academic public relations, in constructing
suitable advertisements for themselves and their ideas.
With the Chicago School on the cutting edge of
theoretical development, such promotion is to be
expected.
When it comes, therefore, to Friedmans motives I
would prefer style Leeson opines that If his
Restatement [of the quantity theory] exaggerated the
degree of continuity with respect to earlier Chicago
versions of the quantity theory this may have been a
rhetorical flourish designed to provide an additional
motivational stimulus to his students (vol. 2, p. 490).
True enough, as far as it goes; Leeson has gone further
(Leeson 2000a and 2003, both dealing with Friedmans
and Stiglers struggle for influence). The StiglerFriedman strategy was directed not only to motivate
students but to influence the discipline of economics
and its world of policy. That Keynes and others also
practiced this strategy (vol. 2, p. 491), enables us to
identify and put it into perspective.
Moreover, Friedmans methodological position served
the purpose of erecting his economic theory, here his
monetary theory, as the maintained hypothesis under
the guise of predictive power.
In any event, the quantity theory in any form is no
substitute for a comprehensive macroeconomics. There
is more to history of the quantity theory than the price
level as a function of either the supply of money or the
demand for money. There also are several different
monetary theories of production. There is less to the
quantity theory than its devotees often would have us
believe. The quantity theory is not alone in deriving its
attractiveness from its utility for mobilizing political
psychology.
3. Significant differences existed over what is absolute
truth in monetary economics, whether such existed,
and if it did, what it was; over the relative weight to be
given to inflation and unemployment as policy goals;
over what is sound or proper monetary policy; and
the evaluation of current policies and current events.

46 | P a g e
Some authors treated the quantity theory as a matter of
causal relation and explanation, often differing as to the
content and direction of explanation, whereas others
saw it as a truism, identity or tautology.
The epistemological nature of much discussion of the
quantity theory was mixed. Some of it was theory as
hypothesis. Some was comprised of declarative
statements without supporting evidence or with
carefully constructed evidence. Who is to say which
version of the quantity theory is correct? Is there one
correct version? What are the criteria of correctness
and the meta-criteria by which to chose from among the
criteria, et seq.?
These questions are difficult to answer, for two reasons.
First, consider W. H. Hutts distinctions between
rational-thought, custom-thought, and powerthought. Rational-thought is disinterested objective
inquiry leading to the accumulation of undisputed
social-science knowledge (once class-driven ideology
has been removed). Custom-thought is modes of
thinking infused with implicit premises derived from
tradition and customary ways of doing and looking at
things. Power-thought is modes of thought and
expression that are constructed to influence power,
politics, and policy, through their service in psychopolitical mobilization (Hutt 1990, p. 3 and passim). All
three types of thought, especially the latter two, are
found in the literature collected by Leeson. Second,
inasmuch as no theory, or no version of a theory, can
cover all pertinent variables and answer all our
questions, correctness by any definition is elusive
especially when various versions of the quantity theory
have been adopted to weaken if not destroy the targeted
opponent, Keynesian economics. Here, power and
persuasion rank well above scientificity (amply
developed in Leeson 2000a and 2003).
Economic arguments are used to manipulate political
psychology and political psychology is used to
manipulate economic policy. Ideology and wishful
thinking have relatively easy entry, especially for
economists and politicians who favor creation of a
certain felicitous picture in the publics mind as part of
the process of creating/manipulating public opinion.
Monetary theory and policy (like many other fields in
economics) were characterized by overintellectualization and economic politics, treated as if
conducted cognitively and in sterile environments,
whereas they existed in a real world of power play,
selective perception, psychology, uncertainty, the quest
for wealth and prestige, and efforts to influence the
economic role of government. Monetary policy is a
function of power, ideology, tradeoffs, power play over
the distributions of opportunity, income and wealth.
Each model of monetary theory was more or less
attractive to particular ideologies and invoked as a
weapon in support of policies based on ideology,
practical politics, etc.
III. How Different Versions of the Quantity Theory Could
Exist
The question of the existence of a Chicago oral tradition
and its possible content must confront the variety of
forms given the quantity theory. Many individual
quantity theorists had their own positions to advance;
they had different perspectives, and monetary theory
comprised many different considerations on which their
different, and changing, perspectives could be brought

to bear. Quantity-theory formulations could vary among

theorists and each was nested in a larger and variegated
model of the money economy. It is impossible to cover
all this in a short review but at least the following can be
said in abbreviated form.
Sophisticated versions of the quantity theory were
possible but because of the vast number of possible
complications, advocates were often interested in
simple versions easily discussed and taught. The quest
for singular explanations of macroeconomic phenomena
real balance effects, sticky or inflexible prices, etc.
was also relevant. Notice the phrases in the first
instance (Friedman) and first and foremost (Patinkin).
What, if anything, comes afterward? The problem is, in
part, that economists tend to adopt the simplest and
most highly stylized versions of their theories, often
caricatures of the sophisticated versions held by at least
some leading theorists. Advocates were either unaware
of the magnitude of possible complications or had their
perception thereof narrowed and/or finessed by
ideologically driven a priori beliefs, and so on.
The quantity theory exhibited highly variegated content.
The quantity theory was ubiquitous. One formulation or
another constituted the core of what most individual
economists seem to have understood as monetary
theory. While the quantity theory was its most
conspicuous component, monetary theory included
more than the quantity theory. Disagreements centered
in part on different versions of the quantity theory using
different elements of monetary theory. Ralph Hawtreys
pure monetary theory of the business cycle had
widespread impact for many years. Dennis Robertson,
Irving Fisher, John H. Williams, Alfred Marshall, and preGeneral Theory John Maynard Keynes, among others,
were more conspicuous than any Chicagoan with the
exception of James Laurence Laughlin, who opposed
the quantity theory.
It took centuries for the Fisherian and Cambridge
versions of the quantity theory to become increasingly
the analytical norm. Neither version emerged fully
grown. When velocity of circulation (V) is used, attention
is drawn to such technical matters as the facility with
which the banking system transfers balances between
accounts. When 1/K is substituted for V in Fishers
version, it both resulted from and reinforced attention to
the reasons for holding money. What looked to some to
involve only a mathematical change, for others now
meant that attention was directed to the reasons why
people might want to hold money. What we now call real
balances (or real balance effect) or liquidity preference
was long appreciated and treated as hoarding.
The money economy could be examined in pure
abstract terms, independent of monetary, banking and
other financial institutions, or with an emphasis on the
institutions that helped form and operated through the
money economy. Significant disagreements existed as
to the nature and substance of fundamental monetary
and other macroeconomic processes, the nature and
origin of actual monetary and macroeconomic
problems, and the solutions to those problems.
Considerable confusion results from some economists
claims that their agenda for government
monetary/macroeconomic policy constitutes noninterventionism whereas all other agendas are
interventionist.
Major controversies were waged over what is money, the
monetary standard, the role of reserves, what

47 | P a g e
commercial banks do, the nature and role of a central
bank; fractional reserves and the money multiplier; the
Cambridge cash-balance approach, Wicksells monetary
theory, and so on.
Some work postulated the economy to be fundamentally
stable (e.g., through great weight given to Says Law);
others postulated particular combinations of quantitytheory and business-cycle models. Changes in M could
be deemed to affect only changes in P and nominal Y
(i.e., T). Changes in Y (or T) could be seen as leading to
changes in M and thence in P; or changes in Y (or T)
could be seen as leading to changes in P and thence in
M. Different supplementary assumptions might lead to
changes in the direction of flows of causation or
influence. Especially critical was whether an increase in
Y (or T) was possible: whereas an increase in M and
thence P could lead to an increase in Y (or T) at less
than full employment, at full employment an engineered
increase in M could not lead to an increase in real Y (or
real T).
Much work seemed directly or indirectly influenced by
monetary and banking arrangements existing within
some form of gold standard. A monetary system
predicated upon gold meant that changes in either gold
or money meant a change in the other and in the price
level. Currency and credit could be treated differently
(as was done by Fisher, for example), influenced by
differences in view of specie, paper and bank balances.
The relation of reserves to M could vary, as could the
money multiplier, reasons for holding money or
spending on consumer and/or capital goods, the
respective roles of commercial banks and central banks
(including targets), the relation of interest rates to the
quantity theory variables, neutral versus non-neutral
money, and so on.
Friedmanian monetarism to the extent it can be
meaningfully generalized proposed that the private
sector is stable, or would be stable in the absence of
monetary and fiscal policy; that changes in the supply
of money, vis-a-vis a stable demand for money
(expectable in a stable economy) lead to changes in the
interest rate and, especially, the price level; that
changes in the supply of money generate changes in
spending; that prices are generally flexible; and that visa-vis all other factors only money matters or money
matters most (hard versus soft monetarism). The
Keynesian fiscalist alternative to the extent it too can
be meaningfully generalized proposes that the private
sector is unstable, and that government can reinforce
this instability, introduce its own instability, or counter
instability; that changes in spending are governed by
more than changes in the supply of money; that
changes in the supply of money are the consequence,
not the cause, of changes in spending in part, the
supply of money is a function of the demand for money;
prices are generally inflexible; inflation is largely or
typically a function of aggregate demand increasing
beyond the full employment level; that increases in the
supply of money can generate inflation but changes in
the supply of money are not the critical factor governing
changes in spending; that price-level instability is not
the only monetary/macroeconomic problem, because
full employment is not guaranteed and the supply of
money is key to neither the price level nor the level of
real income.
In addition, the two schools monetarism and
fiscalism identify different transmission processes

applicable to changes in the supply of money leading to

increased spending. The fiscalist argues that increases
in the supply of money are endogenous, resulting from
increases in the demand for money by borrowers in
order to spend more, and that the increases in the
supply of money limit increases in interest rates
(generated by the increased demand for money) and
thereby increases investment and income. The
monetarist argues that increases in the supply of money
are exogenous (generated by the central bank), leading
to excess money balances which leads to greater
spending, to return monetary balances to desired levels.
The differences turn on whether the increases in the
supply of money are endogenous or exogenous,
whether the increased supply of money is felt through
the lowering of the interest rate or the creation of excess
balances, and whether a stable economy and a stable
demand for money is a suitable or a utopian premise.
Furthermore, modeling the demand for money is no
simple matter. Even putting aside (and there is no
conclusive reason to do so) the fiscalist-Keynesian
model of transaction, speculative and precautionary
motives, the monetarist demand for money has been
modeled differently by different people and even by
Friedman himself. The demand for money most
generally is said to be a function of permanent income,
wealth, price level, expected rate of inflation, and
liquidity preference; more narrowing, it is a function of
permanent income, wealth, and price level, all felt by
Friedman to be relatively stable in the short run (i.e., if
the economy is left to run well on its own), plus the
interest rate.
Anyone not permanently wedded to either monetarism
or fiscalism likely might consider a much more complex
interplay of monetary and spending variables and
relationships, including structural and expectational
factors. Keynesian fiscalism is likely more capable of
encompassing a wider range of variables than is the
quantity theory. A major point, however, is that there are
a multitude of possible complex interplays of all such
variables, relationships and factors. An even more
important general point is that all of the foregoing
constitutes the social construction of economic theory.
The argument over the content of the Chicago oral
tradition is part of that process. Only in part is the
argument a controversy about the actual economy. It is
primarily, albeit not solely, a quest for a theory with
which to successfully challenge Keynes and fiscalist
economics and its policies. In very large part, the
argument is about the control of government policy. It is
the quest to define and then to enlist a Huttian customthought in the service of a Huttian power-thought. The
quest for power and control over policy thus drives
economic theory (a quest that pervades Friedmans
work; see Samuels 2000; Leeson 2000a and 2003).
The question thus arises as to whether the quantity
theory in whatever form is itself (1) a definition of
economic reality, (2) a tool of analysis with which to
investigate economic reality or (3) an instrument of
rhetoric with which to mobilize and manipulate political
psychology. For example, Leeson says that James W.
Angell (who taught Friedman monetary theory at
Columbia) used the quantity theory to advance the
proposition that the principal cause of unemployment
was excessive variations in the volume of bank credit.
Angell also prefaced his analysis with a statement about
his preference for planned economies ' (vol. 1, p.
290). Economists of my generation will recall how
Samuelson and Friedman, in their televised debates in

48 | P a g e
the 1960s, each invoked aggregate demand and the
supply of money; but Samuelson had changes in
aggregate spending drive changes in the supply of
money, whereas Friedman had changes in the supply of
money drive changes in aggregate spending. More is at
stake than a conflict about direction of causal flow, just
as when advocates of both under-consumption and
over-investment theories of the business cycle pointed
to the same data to prove their case: unsold goods.

considerable support. Moreover, whether monetarism

and the modified quantity theory represents a theory of
money at all, or a monetary theory of trade and the
business cycle, is an open question, one that in part
depends on ones macroeconomic perspective, of which
they are certainly a number in fashion (idem, p. 525).
The Chicago tradition, oral or otherwise, is not alone in
its attitude of pushing its perspective.
This book must be read, therefore, with cognizance of
its elusive background. If a reader is tempted to agree
with some statement made by an author included in
Leesons collection, that reader must ask, on what
narrowing premise(s) does this statement rest? The
hermeneutic circle is involved between orienting
perspective and conclusionary position. However, I am
also convinced that my stricture about the hermeneutic
circle is and must be self-referential.

Perusal of several standard reference works confirms

the foregoing argument that the quantity theory is not
something given but a matter of social construction, a
work in progress, and thus characterized by multiple
specifications and interpretations. The entry in the Elgar
Companion to Classical Economics indeed opens with
the caution One of the conclusions drawn by Hugo
Hegeland from his thoroughgoing study of the
historical development and interpretation of the quantity
theory of money was that the interpretation of the
quantity theory shows almost as many variations as the
number of its interpreters. This assertion is hardly an
exaggeration and even after half a century of further
intensive research in this field it is probably as valid
now as then. the theory is like a chameleon. From the
outset writers on the subject have understood [the]
quantity theory of money to mean sometimes very
different things (Rieter 1998, p. 230)

IV. A Contribution to the Resolution of the Dispute

Mints was not the only instructor in Economics 330. In
volume 23-C (2005) of Research in the History of
Economic Thought and Methodology, I am publishing F.
Taylor Ostranders notes from Charles O. Hardys
course in Economics 330 given in 1933-34, the next
academic year following Friedmans enrollment in
Mintss course. The notes indicate that Hardy discussed
the work of Hawtrey, Frederic Benham, Fisher, Keynes
and Laughlin and suggest that the demand for money
was part of the course but by no means as central as the
notion of an oral tradition centering on the demand for
money would have it be.

Why should the Chicago tradition, oral or otherwise, be

different?
The opening of the entry in the Penguin Dictionary of
Economics asserts that the theory states the
relationship between the quantity of money and the
price level. The entry goes on to mark the importance of
what is or is not assumed, and says of Friedman that the
theories of the demand for money, based on a quantity
theory of money approach, do not differ a great deal
from the theories based on the Keynesian framework
(Bannock, Baxter and Rees 1972, p. 339). Is the Chicago
tradition, a la Friedman, different (from Keynesian
treatments)?
The Routledge Dictionary of Economics has Friedman
reviving interest in the [quantity] theory by expounding
it as a theory of demand for real balances (Rutherford
1995, p. 379). The MIT Dictionary of Modern
Economics has the theory be one of the demand for
money, saying that it formed the most important
component of macroeconomic analysis before
Keynes General Theory (Pearce 1992, p. 356).
A careful reading of all the cited reference works will
reveal different positions on whether full employment is
an assumption or a conclusion, what else has to be
assumed, and so on.
At least one reference work indicates how far the
rationality assumption has come in monetary theory:
The underlying premise of the basic quantity theory is
that no rational person holds money idle, for it produces
nothing and yields no satisfaction, adding some pages
later, that is, people demand money only for
transaction purposes (Johnson, Ley and Cate 1997, pp.
518, 525). These authors also write that In the area of
policy it would be easy to exaggerate the differences
between the Keynesian and monetarist positions.
However, in general, the notion of policy ineffectiveness
as elaborated and expanded over the past 30 years by
Friedman and others may represent the monetarists
greatest challenge to the Keynesian heritage. For good
or ill, it is an opinion which has come to enjoy

At the time Hardy taught the course taken by Ostrander

during 1933-34, Friedman was a fellow student, and
monetary economics was represented by Melchior Palyi
and Lloyd Mints as well as Simon, Viner and Knight, in
addition to Hardy. Hardy was clearly a leading student of
monetary policy. Though apparently not regarded as a
leading monetary theorist, he evidently knew his theory,
as he easily grounded policy in theory and was
respected for his contributions to policy analysis.[1]
Each of the Chicago economists specializing, at least in
part, in monetary economics went his own way,
concentrating on some combination of what interested
them and what they considered important. Peering over
all their shoulders was the well-known anti-quantity
theory orientation of the long-time chair of the
Department of Economics, Laughlin.
Among Ostranders notes are the following statements:

The quantity theory is a truism

For Fisher V was fixed, any change in M
forces a corresponding change in P.
T being unchanged the habits of the people
with respect to the money they will hold being
unchanged the Keynes formula is convertible into the
Fisher formula.
Hardy has a preference for a commodity
standard, but can not find a suitable commodity. Even
such a commodity theory would not invalidate the
Quantity Theory. Laughlins doctrine is essentially that
of the 19th century English Banking School; the
Quantity Theory is that of the Currency School.
The following are Ostranders notes bearing on the
demand for money:

49 | P a g e

Problem of the Value of

Money

Money defined by means of its functions

Classical theory emphasized medium of exchange
brings upturnover. But if exchange were always
instantaneous, there would not be much need for money
it is not instantaneous. * Thus the function of money
as a store of value. Suspended purchasing power.
Where the real demand for money comes from. * The
classical approach does not allow of any good
connection betweenvalue theory and monetary theory.
Distinction between this use of money and hoarding is
only one of degree. [In margin: ?]

Big changes in prices over short periods are never the

result of changes in the supply of money or the supply
of goods but of changes in the demand for money (or
goods).
The prospect of a decline in value of money does not of
itself overcome the desirability of money as
a liquidfactor in unsettled conditions. * Liquidity
attained by holding goods expecting price rise
attained by holding money expecting price fall. Why
is it that people are still speculating on a price fall? The
issue is whether the strongest government in the world
is strong enough to devaluate its own currency. *
Governments can raise prices by issuing greenbacks or
by issuing bonds. [Greenbacks] may be held as an
investment hoarded no change in prices. Bonds
may be held as investment-no change in prices. I.e.,
both bonds or money may be spent, and may be held as
investment only difference between gold and bonds
is one of degree.

- Keynes assumes hoards to be unchanged if

the demand schedule for hoarding remains unchanged.
(Hardy, Hayek, Robertson had assumed the quantity of
hoards to be unchanged.) Thus there is a change in
velocity.

This is Wicksells theory. Keynes enlarges it, saying it

would be true only in a barter economy. In a monetary
economy, there are 3 variables. The willingness to save,
the willingness to borrow to produce new capital, the
relative attractiveness, as a store of value, of monetary
funds and of other investments. * Savings made by
purchase of new securities, or hoarding. * Investment
made by borrowing from investors, or drawing on
investors hoards. Equilibrium requires I = S, also
demand for cash balances to be in equilibrium to [sic:
with] demand for securities.
Economics 330 was not the only monetary course given
at Chicago. Taylor Ostrander also took Economics 332,
Monetary Theory, from Melchior Palyi during his year in
residence at Chicago. His notes from the class are
published in Archival Supplement 23-B (2005). Among
conclusions stated in my introductory comments are
these: One facet of the lectures is Palyis general
attitude toward the quantity theory, indeed substantially
all monetary theory, as a theory of control. The aspect of
quantity theory discussion that loomed so large, namely,
automaticity, especially after World War Two, when the
quantity theory (properly applied) was lauded as the

non-interventionist alternative to Keynesian fiscal and

monetary policy, is subdued, but not altogether absent.
Another is the evident variety of ways in which the
quantity theory was operationalized, i.e., how M, V, and T
were conceptualized and handled. This also contrasts
somewhat with post-War usage, when the policy
choices, hence exercise of control, latent in the different
versions would have been conspicuous though
eclipsed by the lauded automaticity, even though
conservatives like Frank Knight pointed out the
inevitable non-automatic, non-rule, elements of
administering the quantity theory.
Among other things we read that the quantity theory
was * A form of approach to supply such as set forth by
Bodin and Davenant. * Value of money not a function of
demand, but of factors such as velocity, interest rate, or,
if ruled by demand, then demand is ruled by something
else.
More recently came * Marshall, Fisher [indecipherable
words] Renewed the old control approach, and united
it with the Neo-Nominalist approach. Then came in
Keynes, Robertson, Pigou, Fisher. * Velocity stressed
(lenfant terrible of previous monetary theory) becomes
center of interest. Reformulation of quantity theory in
light of Velocity. Dozens of reformulations due to differ
concepts of velocity. Changes in it, measurement,
causes. * Does velocity have a life of its own or is it a
function of other things, or a constant. * Most difficult to
approach from statistical, descriptive or theoretical
points of view.
Earlier * The old quantity theory approach looked to
money and goods (asked or assumed which is variable
which is independent). * The new quantity theory looks
to the ratio of savings and investment. First appeared
in a paper of Jevons, in [18]70s.
Generally, Two types of Quantity Theory: (1) Mere
functional relationship; algebraic * A formal expression
for the demand for money (Pigou). * On one side is
money, on the other side is the physical aspect no
causal explanation. [Single vertical line alongside in
margin from (1) to here] Banking School there can
not be an excess or deficiency of money. Price level is
influenced by physical side only. (2) An explanation of
the cause of exchange.
On the demand for money, we find the following:
The demand for money. * The Banking School of
Thought but underlies the Currency School too
the difference between them is on another line. *
The velocity of circulation is a passive factor, or a nonchanging factor. * Cost of production theory of value of
metals, and of money generally. * In case of paper
money, it substitutes some psychological factor for
quantity or considers quantitative changes a result of
psychology. * Policy of this approach is sound banking
based on commercial paper automatic control.
This approach is more developed by businessmen than
by scientists. * Men of not-systematic methods, bankers.
Tooke descriptive, not abstract. Adolph
Wagner (Germany) Laughlin (U.S.) never tried to be
systematic. [! to left of name]
This approach became that of the 19th century up to the
War. * In spite of Marshall and others. * Bankers and
Central Bankers wouldnt listen to any others. * Keynes
(Indian Monetary Policy 1912) * Robertson (Industrial
Fluctuation, 1915) [Bracket connects the two lines,

50 | P a g e
Keynes and Robertson, with arrow pointing to next line.]
Both, at this early date, had tendencies more to the
anti-quantitative than to quantitative approach. Mill
could approach the transfer problem from an entirely
different point of view from his approach to bank credit
foolish.
Writing about the Banking School, * Money a matter of
quantity which can be regulated by control of its
quantity by issue. By affecting demand for money by:
Discount rate Open market operations Public
works (governments).

The quantity theory of money states that the quantity of

money is the main determinant of the price level or the
value of money. Any change in the quantity of money
produces an exactly proportionate change in the price
level

As for Adam Smith, * Implies (by not discussing it) a

constant elasticity of demand for money.
We also read * In the single country, value of money is
based on interaction of supply of and demand for
money.
There is more but altogether what is shown (1) indicates
more or less conventional attention to the quantity
theory as the core of monetary theory and (2) does not
indicate a distinctive Chicago approach centering on the
demand for money, a claim no one now seems to be
making. The earlier negative position of Laughlin has
fallen prey to the selective memory of any oral tradition
(Friedman wrote the entry on Laughlin for The New
Palgrave). Laughlin, who opposed the quantity theory,
was chair of the Department of Economics for many
years and was a conspicuous person in the profession.
Any complete rendition of Chicago tradition
presumably would have to include his anti-quantity
theory position. Perhaps he was an embarrassment
treated largely in silence. Mints may or may not deal
with his view; Palyi seems to deal with it only in
passing. And Friedman seems not to, as well. He is too
busy inventing what he wants that tradition to be.
In partial summary, therefore, Leeson is correct that no
oral tradition existed at Chicago by 1932-33 with the
substance initially identified by Friedman. If one clearly
existed (and it is not certain that one did), it likely was
different from and more complex, and likely more
ambiguous, than what Friedman proposed. And surely
the conversation of one years graduate students, by
itself, is no oral tradition. As Leeson shows, they most
certainly did not all agree on issues, though this was the
framework that they, and Mints, apparently employed to
inform their arguments. Graduate students discussed
macroeconomic issues using a framework that was in
some ways similar to Friedmans 1956 restatement.
Friedmans assertion only has some validity if
intense student discussion is admissible as an oral
tradition Friedmans assertion has more validity than
Patinkin gave it credit for, but calling it a tradition
vastly overstates the case (see Leeson 2000b). Both
Friedman and Patinkin exaggerated their case. Friedman
was a polemicist who sought influence; Patinkin was an
historian whose framework was losing influence. There
was an element of justification for Friedmans assertion
he had not invented it in the 1950s, as some
detractors suggested. Traditions are potent rhetorical
devices, and Friedman sought to make the most of this
rhetorical device to serve his counter-revolution.

The Fishers Quantity Theory

of Money (Assumptions and Criticisms)

In the words of Irving Fisher, Other things remaining

unchanged, as the quantity of money in circulation
increases, the price level also increases in direct
proportion and the value of money decreases and vice
versa. If the quantity of money is doubled, the price
level will also double and the value of money will be one
half. On the other hand, if the quantity of money is
reduced by one half, the price level will also be reduced
by one half and the value of money will be twice.

Fisher has explained his theory in terms of his equation

of exchange:

PT=MV+ M V

Where P = price level, or 1 IP = the value of money;

M = the total quantity of legal tender money;

V = the velocity of circulation of M;

M the total quantity of credit money;

V = the velocity of circulation of M;

T = the total amount of goods and services exchanged

for money or transactions performed by money.

51 | P a g e
This equation equates the demand for money (PT) to

the price level. To begin with, when the quantity of

supply of money (MV=MV). The total volume of

money is M, the price level is P.

transactions multiplied by the price level (PT) represents

the demand for money.

According to Fisher, PT is SPQ. In other words, price

level (P) multiplied by quantity bought (Q) by the
community (S) gives the total demand for money. This
equals the total supply of money in the community
consisting of the quantity of actual money M and its
velocity of circulation V plus the total quantity of credit
money M and its velocity of circulation V. Thus the total
value of purchases (PT) in a year is measured by
MV+MV. Thus the equation of exchange is
PT=MV+MV. In order to find out the effect of the
quantity of money on the price level or the value of
money, we write the equation as
When the quantity of money is doubled to M2, the price
P= MV+MV
level is also doubled to P2. Further, when the quantity of
T

money is increased four-fold to M4, the price level also

increases by four times to P4. This relationship is

Fisher points out the price level (P) (M+M) provided the

expressed by the curve P = f (M) from the origin at 45.

volume of tra remain unchanged. The truth of this

proposition is evident from the fact that if M and M are

In panel of the figure, the inverse relation between the

doubled, while V, V and T remain constant, P is also

quantity of money and the value of money is depicted

doubled, but the value of money (1/P) is reduced to half.

where the value of money is taken on the vertical axis.

When the quantity of money is M1 the value of money is

Fishers quantity theory of money is explained with the

help of Figure 65.1. (A) and (B). Panel A of the figure
shows the effect of changes in the quantity of money on

HP. But with the doubling of the quantity of money to M2,

the value of money becomes one-half of what it was
before, 1/P2. And with the quantity of money increasing

52 | P a g e
by four-fold to M4, the value of money is reduced by 1/P4.

Criticisms of the Theory:

This inverse relationship between the quantity of money

The Fisherian quantity theory has been subjected to
and the value of money is shown by downward sloping
severe criticisms by economists.
curve 1/P = f (M).
1. Truism:
Assumptions of the Theory:
According to Keynes, The quantity theory of money is
Fishers theory is based on the following assumptions:
a truism. Fishers equation of exchange is a simple
1. P is passive factor in the equation of exchange which

truism because it states that the total quantity of money

is affected by the other factors.

(MV+MV) paid for goods and services must equal their

value (PT). But it cannot be accepted today that a certain

2. The proportion of M to M remains constant.

percentage change in the quantity of money leads to the

same percentage change in the price level.

3. V and V are assumed to be constant and are

independent of changes in M and M.

2. Other things not equal:

4. T also remains constant and is independent of other

The direct and proportionate relation between quantity

factors such as M, M, V and V.

of money and price level in Fishers equation is based

on the assumption that other things remain

5. It is assumed that the demand for money is

proportional to the value of transactions.

6. The supply of money is assumed as an exogenously

determined constant.

unchanged. But in real life, V, V and T are not constant.

Moreover, they are not independent of M, M and P.
Rather, all elements in Fishers equation are interrelated
and interdependent. For instance, a change in M may
cause a change in V.

7. The theory is applicable in the long run.

Consequently, the price level may change more in
8. It is based on the assumption of the existence of full

proportion to a change in the quantity of money.

employment in the economy.

Similarly, a change in P may cause a change in M. Rise

in the price level may necessitate the issue of more
money. Moreover, the volume of transactions T is also
affected by changes in P. When prices rise or fall, the

53 | P a g e
volume of business transactions also rises or falls.

in prices were the most critical and important

Further, the assumptions that the proportion M to M is

phenomenon of the economic system. Third, it places a

constant, has not been borne out by facts. Not only this,

misleading emphasis on the quantity of money as the

M and M are not independent of T. An increase in the

principal cause of changes in the price level during the

volume of business transactions requires an increase in

trade cycle.

the supply of money (M and M).

Prices may not rise despite increase in the quantity of
3. Constants Relate to Different Time:

money during depression; and they may not decline

with reduction in the quantity of money during boom.

Prof. Halm criticises Fisher for multiplying M and V

Further, low prices during depression are not caused by
because M relates to a point of time and V to a period of
shortage of quantity of money, and high prices during
time. The former is a static concept and the latter a
prosperity are not caused by abundance of quantity of
dynamic. It is therefore, technically inconsistent to
money. Thus, the quantity theory is at best an imperfect
multiply two non-comparable factors.
guide to the causes of the trade cycle in the short
4. Fails to Measure Value of Money:

period according to Crowther.

Fishers equation does not measure the purchasing

6. Neglects Interest Rate:

power of money but only cash transactions, that is, the

One of the main weaknesses of Fishers quantity theory
volume of business transactions of all kinds or what
of money is that it neglects the role of the rate of
Fisher calls the volume of trade in the community during
interest as one of the causative factors between money
a year. But the purchasing power of money (or value of
and prices. Fishers equation of exchange is related to
money) relates to transactions for the purchase of
an equilibrium situation in which rate of interest is
goods and services for consumption. Thus the quantity
independent of the quantity of money.
theory fails to measure the value of money.
7. Unrealistic Assumptions:
5. Weak Theory:
Keynes in his General Theory severely criticised the
According to Crowther, the quantity theory is weak in
Fisherian quantity theory of money for its unrealistic
many respects. First, it cannot explain why there are
assumptions. First, the quantity theory of money for its
fluctuations in the price level in the short run. Second, it
unrealistic assumptions. First, the quantity theory of
gives undue importance to the price level as if changes
money is unrealistic because it analyses the relation

54 | P a g e
between M and P in the long run. Thus it neglects the

9. Neglects Store of Value Function:

short run factors which influence this relationship.

Another weakness of the quantity theory of money is
Second, Fishers equation holds good under the
that it concentrates on the supply of money and
assumption of full employment. But Keynes regards full
assumes the demand for money to be constant. In order
employment as a special situation. The general situation
words, it neglects the store-of-value function of money
is one of the under-employment equilibrium. Third,
and considers only the medium-of-exchange function of
Keynes does not believe that the relationship between
money. Thus the theory is one-sided.
the quantity of money and the price level is direct and
proportional.

10. Neglects Real Balance Effect:

Rather, it is an indirect one via the rate of interest and

Don Patinkin has critcised Fisher for failure to make use

the level of output. According to Keynes, So long as

of the real balance effect, that is, the real value of cash

there is unemployment, output and employment will

balances. A fall in the price level raises the real value of

change in the same proportion as the quantity of money,

cash balances which leads to increased spending and

and when there is full employment, prices will change in

hence to rise in income, output and employment in the

the same proportion as the quantity of money. Thus

economy. According to Patinkin, Fisher gives undue

Keynes integrated the theory of output with value theory

importance to the quantity of money and neglects the

and monetary theory and criticised Fisher for dividing

role of real money balances.

economics into two compartments with no doors and

11. Static:
windows between the theory of value and theory of
money and prices.

Fishers theory is static in nature because of its such

unrealistic assumptions as long run, full employment,

8. V not Constant:
etc. It is, therefore, not applicable to a modern dynamic
Further, Keynes pointed out that when there is

economy.

underemployment equilibrium, the velocity of circulation

of money V is highly unstable and would change with

Loans Create Deposits

changes in the stock of money or money income. Thus

introduction

it was unrealistic for Fisher to assume V to be constant

Loans create deposits. Weve heard it many times now.

and independent of M.

But how well is it understood? The phrase is typically

invoked accurately, in conjunction with a rejection of the

55 | P a g e
money multiplier fable found in economic textbooks.

fact that there was gold serving as a fixed value

From an operational perspective, banks do not lend

backstop for certain monetary assets shouldnt obscure

reserves to their non-bank customers. Loans create

the fact that a monetary system is a fiat construction at

deposits is an operation in endogenous money. And

its foundation. Gold at one time was a hard constraint

where central banks impose a level of required reserves

on the behavior of the monetary authorities. But the

based on deposits, the timing of the demand for and

authorities will inevitably create paradigms of

supply of reserves in respect of such a requirement

operational constraint and guidelines in any monetary

follows the creation of the deposit it does not precede

system. These restrictions include central bank balance

it. The money multiplier story is bunk. And loans create

sheet constraints (e.g. gold backing; Treasury overdraft

deposits is correct as an observation.

constraints; supply and pricing of bank reserves that

are consistent with the monetary policy interest rate

Nevertheless, there is a larger context for deposits,

target) and other guidelines (such as the reaction

which includes their fate after they have been created.

function of the policy rate to various measures of

Deposits are used to repay loans, resulting in the death

inflation, output, or employment). The full category of

of both loan and deposit. But there is more. As part of

potential constraints is broad and varied. But none of

the birth/death analogy, there is the lifetime of loans and

this alters the fact that a monetary system is basically a

deposits to consider. This sequence of birth, life, and

bookkeeping device for the intermediation of real

death in total may be helpful in putting loans create

economic activity. It is a construct that enables moving

deposits into a broader context. There is potential for

beyond a barter economic system that can only be

confusion if loans create deposits is embraced too

imagined as a counterfactual.

enthusiastically as the defining characteristic, without

considering the full life cycle of loans and deposits.

The Choice for Banking

Indeed, we shall see further below that deposits fund

Starting from this monetary bookkeeping foundation, a

loans is as true as loans create deposits and that there

fundamental choice exists. Will the system include a

is no contradiction between these two things.

competitive banking sector? More broadly, will financial

capitalism exist in substance and form? Will there be

Monetary Systems

competition? Within this landscape, will there be more

The monetary system and the financial system are

than one bank? While a banking singularity (a single,

constructions of double entry accounting. It has been

concentrated, nationalized institution) is usually

this way for a long time. This did not start in 1971. The

considered to be non-pragmatic, it serves as a useful

56 | P a g e
theoretical reference point for understanding how banks

temporary duplication of balance sheet growth across

actually work. The competitive framework that is often

two different banks is captured within the accounting

taken for granted is in fact a choice for banking system

classification of bank float. The duplication gets

design including the presence of a reserve system that

resolved and eliminated when the deposit issuing bank

enables active management of individual bank balance

clears the cheque back to the lending bank and receives

sheets.

a reserve balance credit in exchange, at which point the

lending bank sheds both reserve balances and its

Loans Create Deposits

payment liability. The end result is that the system

When we say loans create deposits, we mean at least

balance sheet has grown by the amount of the original

that the marginal impact of new lending will be to create

loan and deposit. The loan has created the deposit,

a new asset and a new liability for the banking system

although loan and deposit are domiciled in different

typically for the originating lending bank at first. A bank

banks. The system has expanded in size. The growth is

makes a loan to a borrowing customer. That is a debit

now reflected in the size of the deposit issuing banks

under bank assets. Simultaneous, it credits the deposit

balance sheet, with an increase in deposits and reserve

account of the same customer. That is a new bank

balances. The lending banks balance sheet size is

liability. Both of those accounting entries represent

unchanged from the start (at least temporarily), with

increases in their respective categories. This is

loan growth offset by a reserve balance decline.

operationally separate from any notion of reserves that

may be required in association with the creation of bank

Money Markets

deposits.

In this latter example, it is possible and even likely, other

things equal, that the lending bank additionally will seek

In another version of the same lending transaction, the

to borrow new funding from wholesale money markets

lending bank presents the borrower with a cheque or

and that the deposit issuing bank will lend funds into

bank draft. The lending bank debits the borrowers loan

this market. This is a natural response to the respective

account and credits a payment liability account. The

change in reserve distribution that has been created

banks balance sheet has grown. The borrower may then

momentarily for the two banks. Without further action,

deposit that cheque with a second bank. At that

the lending bank has lost reserves and the deposit bank

moment, the balance sheet of the second bank the

has gained reserves. They may both seek to normalize

deposit issuing bank grows by the same amount, with

these respective reserve positions, other things equal.

a payment due asset and a deposit liability. This

Adjusting positions through money market operations is

57 | P a g e
a basic function of commercial bank reserve

control over bank expansion, based on a reserve supply

management. Thus, this example features the core role

function which is a fiction. The facts of endogenous

of bank reserves in clearing a payment from one bank to

money creation have been demonstrated by empirical

another. The final resolution of positions in this case is

studies going back decades. Moreover, the facts are

that the balance sheets of both banks will have

obvious to anybody who has actually been involved with

expanded, indirectly connected through money market

or closely studied the actual reserve management

transactions that follow on from the initial loans create

operations of either a commercial bank or a central

deposits transaction. However, this too may be a

bank. In truth, no empirical study is required the

temporary situation, as the original transaction

banking world operates this way on a daily basis and it

involving two different banks will inevitably be followed

is absurd that so many economics textbooks make up

up by further transactions that shift bank reserves

stories to the contrary. The truth of the loans creates

between various bank counterparties and in various

deposits meme is pretty well understood now at least

directions across the system.

by those who take the time to learn the facts about it.

The Money Multiplier Fable

Central Bank Reserve Injections

The money multiplier story a fable really claims that

A central bank that imposes a reserve requirement will

banks expand loans and deposits on the basis of a

follow up new deposit creation with a system reserve

central bank function that gradually feeds reserves to

injection sufficient to accommodate the requirement of

banks, allowing them to expand their balance sheets

the individual bank that has issued the deposit. The new

with new loans and reservable deposits according to

requirement becomes a targeted asset for the bank. It

reserve ratios that bind the pace of that expansion

will fund this asset in the normal course of its asset-

according to the reserves supplied. This is entirely

liability management process, just as it would any other

wrong, of course. In fact, bank balance sheet expansion

asset. At the margin, the bank actually has to compete

occurs largely through the endogenous process

for funding that will draw new reserve balances into its

whereby loans create deposits. And central banks that

position with the central bank. This action of course is

impose reserve requirements provide the required

commingled with numerous other such transactions

reserve levels as a matter of automatic operational

that occur in the normal course of reserve management.

response after the loan and deposit expansion that

The sequence includes a time lag between the creation

generates the requirement has occurred. The multiplier

of the deposit and the activation of the corresponding

fable describes a central bank with direct exogenous

reserve requirement against that deposit. Thus, there is

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a lag between two system growth impulses loans

The loans create deposits meme is best understood as

create deposits as the endogenous feature and a

a balance sheet growth dynamic, distinct from any

subsequent central bank reserve injection as an

reserve effect that might occur as part of an associated

exogenous follow up. The required reserve injection is

interbank clearing transaction at the time (e.g. the

typically small by comparison, according to the reserve

second example above) or as part of a deposit ratio

ratio. The central bank can provide the reserves in

requirement that might be activated at a later date. The

different ways, such as by purchasing bonds or by

banking system can be visualized in continuous time,

conducting system repurchase operations with

punctuated by discrete banking transactions that are

investment dealers. In the case of either bond

reflected as accounting entries. If one divides time into

purchases or system repurchase agreements, additional

very small time intervals, individual banking

system deposits might be created when the end seller

transactions can be isolated as the only transactions

(or lender) of the bonds is a non-bank. And that second

that occur during a given interval of time. Thus, the

order creation of deposits may be reservable as well.

growth dynamic of loans create deposits can be

But what might appear to be a potentially infinite series

conceived of as an instantaneous balance sheet

of reserve injections is in fact highly controlled in the

expansion at the point of corresponding accounting

real world because the reserve ratio is relatively small.

entries. As noted in the examples above, this expansion

Some countries such as Canada have no such required

may then migrate across individual banks when the

reserve ratio. Indeed, the case of zero required reserves

lending and deposit issuing bank are different.

nicely emphasizes the nature of the money multiplier as

an annoying analytical error and distraction from

Deposits Fund Loans

accurate comprehension of how banks actually work.

Some interpretations of the loans create deposits

But as a separate point, central bank injections of

meme overreach in their desired meaning. The

required reserves illustrate how not all deposits are

contention arises occasionally that loans create

necessarily created by commercial bank loans. Loans

deposits means banks dont need deposits to fund

create deposits is true, but not exclusive. This aspect is

loans. This is entirely false. This is the point that

made clear also by the example of central bank

requires emphasis in this essay.

quantitative easing, noted further below.

There is no inconsistency between the idea that loans
The Growth Dynamic

create deposits and the idea that banks need deposits

to fund loans. Bank balance sheet management must

59 | P a g e
respond to both growth dynamics and steady state

We note again that loans are not the sole source of

conditions in the dimension of nominal balance sheet

deposit creation. A commercial banks purchase of

size. A bank in theory can temporarily be at rest in terms

securities from a non-bank will typically result in new

of balance sheet growth, and still be experiencing

deposit creation somewhere in the system. There are

continuous shifting in the mix of asset and liability types

cases where deposit creation results from other liability

including shifting of deposits. Part of this deposit

or equity conversion commercial bank debt

shifting is inherent in a private sector banking system

redemption and stock buybacks are examples of this.

that fosters competition for deposit funding. The birth of

Existing fixed term deposits can convert to demand

a demand deposit in particular is separate from

deposits and vice versa. And central bank quantitative

retaining it through competition. Moreover, the fork in

easing most often results in new deposit creation

the road that was taken in order to construct a private

because the bonds that the central bank purchases are

sector banking system implies that the central bank is

typically sourced from non-bank portfolios, and

not a mere slush fund that provides unlimited funding to

exchanged for deposits. Nevertheless, loans creates

the banking system. In fact, active liability management

deposits is a reasonable reference point and standard

is important in private sector banking in the system we

for the process of deposit creation.

actually have. Other systems have been proposed, in

which central banks intervene in some way to adjust the

Bank Asset-Liability Management

landscape of competitive liability management (e.g. the

The loans create deposits dynamic comprises the

Chicago Plan; full reserves) or to subsume this

production of much of the money that serves as a basic

competition more comprehensively (e.g. the MMT

source of liquidity in a monetary economy. The

Mosler plan). These are ideas for significant change that

originating accounting entries are simple a loan asset

should not be confused with the characteristic of

and a deposit liability. But this is only the start of the

competitive banking as it now exists. Some analysts

story. Commercial bank asset-liability management

tend toward language that conflates factual and

functions oversee the comprehensive flow of funds in

counterfactual cases in this regard. To repeat bank

and out of individual banks. They control exposure to

liability management is very competitive in the system

the basic banking risks of liquidity and interest rate

we have, by design. The loans create deposits meme,

sensitivity. Somewhat separately, but still connected

while true, only touches on this competitive dynamic.

within an overarching risk management framework,

banks manage credit risk by linking line lending
functions directly to the process of internal risk

60 | P a g e
assessment and capital allocation. Banks require capital

deposits, as banks seek a supply of longer duration

especially equity capital to take risk and to take

funding for asset-liability matching purposes. And they

credit risk in particular.

can convert to new debt or equity securities issued by a

particular bank, as buyers of these instruments draw

Interest rate risk and interest margin management are

down their deposits to pay for them. All of these

critical aspects of bank asset-liability management. The

changes happen across different banks, which can lead

ALM function provides pricing guidance for deposit

to temporary imbalances in the nominal matching of

products and related funding costs for lending

assets and liabilities, which in turn requires active

operations. This function helps coordinate the

management of the reserve account level, with

operations of the left and the right hand sides of the

appropriate liquidity management responses through

balance sheet. For example, a central bank interest rate

money market operations in the short term, or longer

change becomes a cost of funds signal that transmits to

term strategic adjustment in approaches to loan and

commercial bank balance sheets as a marginal pricing

deposit market share. The key idea here is that banks

influence. The asset-liability management function is the

compete for deposits that currently exist in the system,

commercial bank coordination function for this

including deposits that can be withdrawn on demand, or

transmission process, as the pricing signal ripples out

at maturity in the case of term deposits. And this

to various balance sheet categories. Loan and deposit

competition extends more comprehensively to other

pricing is directly affected because the cost of funds

liability forms such as debt, as well as to the asset side

that anchors all pricing in finance (e.g. the fed funds

of the balance sheet through market share strategies for

rate) has been changed. In other cases, a change in the

various lending categories. All of this balance sheet flux

term structure of market interest rates requires similar

occurs across different banks, and requires that

coordination of commercial bank pricing implications.

individual banks actively manage their balance sheets to

And this reset in pricing has implications for

ensure that assets are appropriately and efficiently

commercial bank approaches to strategies and targets

funded with liabilities and equity.

for the compositional mix of assets and liabilities.

In examining all of these effects, it is helpful to consider
The life of deposits is more dynamic than their birth or

the position of the banking system in its totality, in

death. Deposits move around the banking system as

conjunction with the position of individual banks that

banks compete to retain or attract them. Deposits also

constitute the whole. For example, the US commercial

change form. Demand deposits can convert to term

banking system is composed of thousands of individual

61 | P a g e
banks. Between discrete loans create deposits events,

financially effective. And even if loan books remain

the banking system is in continuous balance sheet

temporarily unchanged, all manner of other banking

churn. Specifically, deposits are moving back and forth

system assets and liabilities may be in motion. This

between individual banks, as a matter of normal

includes securities portfolios, deposits, debt liabilities,

payment system operations. They are also moving and

and the status of the common equity and retained

inter-converting in the form of term deposits at both the

earnings account. And of course, loan books dont

retail and wholesale level. This overall liquidity churn

remain unchanged for very long, in which case the

feeds economic activity of all sorts, where households,

loan/deposit growth dynamic comes directly into play

businesses, and governments are making payments to

on a recurring basis.

each other for various goods and services and other

types of transactions, and are making choices about the

Conclusion

portfolio structure of their liquid assets. This is the core

In summary, the original connection by which deposits

liquidity provided by the banks to their customers. And

are created by loans typically disappears at some point

this is the stuff that involves a good deal of transferring

following deposit creation at the micro bank level

of reserves back and forth between banks, in order to

and/or the macro system level. The original demand

affect accounting completion of balance sheets that are

deposits associated with specific loan creation become

in continuous flux in size and composition.

commingled as they move back and forth between

different banks. And they not only move between banks,

Bank Reserve Management

but they can change in form within any bank. They can

The ultimate purpose of reserve management is not

be converted into term deposits or other funding forms

reserve positioning per se. The end goal is balance

such as bank debt or common and preferred stock. The

sheets that are in balance, institution by institution

task of dealing with this compositional flux falls under

and where deposits fund loans, alongside various other

the joint coordination of bank asset-liability

asset-liability matching configurations. The reserve

management and reserve management. The overarching

system records the effect of this balance sheet activity.

point of observation is that both system growth and

The reserve account is the inverse exogenous money

system competition for existing balance sheet

image of the nominal configuration of the rest of the

composition are in constant operation. Loans create

balance sheet. The balance sheet requires asset liability

deposits only describes the marginal growth dynamic at

management coordination in order to match up assets

the inception of deposit creation. Deposits fund loans

and liabilities both in nominal terms and in a way that is

is the more apt description that applies to a good

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portion of what constitutes ongoing balance sheet
management in competitive banking.

What is a 'Central Bank'

financing flexibility the central government by providing

a politically attractive alternative to taxation.

Central banks conduct standard monetary policy by

manipulating the money supply and interest rates. They
regulate member banks through capital requirements,

A central bank, or monetary authority, is a monopolized

and often nationalized institution given privileged

reserve requirements and deposit guarantees, among

other tools.

control over the production and distribution of money

and credit. In modern economies, the central bank is

The first prototypes for modern central banking were the

responsible for the formulation of monetary policy and

Bank of England and the Swedish Riksbank in the 17th

the regulation of member banks.

century. The Bank of England was the first to

acknowledge the role of lender of last resort. Other early

BREAKING DOWN 'Central Bank'

Central banks are inherently non-market-based or even
anticompetitive institutions. Many central banks,

central banks, notably Napoleons Bank of France and

Germany's Reichsbank, were established to finance
expensive government military operations.

including the Fed, are often touted as independent or

even private. However, even if a central bank is not
legally owned by the government, its privileges are

Methods of Credit Control used by Central Bank

established and protected by law.

Article Shared by Saqib Shaikh
The critical feature of a central bank distinguishing it
from other banks is legal monopoly privilege for the

The following points highlight the two categories of

issuance of bank notes and cash; privately owned

methods of credit control by central bank.

commercial banks are only permitted to issue demand

liabilities, such as checking deposits.

Functions of Central Banks

The normative justification for central banking rests on
three critical factors. First, the central bank manages the
growth of national monetary aggregates in an attempt to
guide economic policy, often with the aim of full
employment. The bank also acts as an emergency
lender to distressed commercial banks and other
institutions. Finally, a central bank offers much greater

The two categories are: I. Quantitative or General

Methods II. Qualitative or Selective Methods.

63 | P a g e
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 sensethe Central Bank starts the purchase

and sale of Government securities in the money market.
But in the Broad Sensethe Central Bank purchases
and sale not only Government securities but also of
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.

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

As the Central Bank is only the lender of the last resort

Bank is able to exercise a check on the expansion of

the bank rate is normally higher than the market rate.

credit.

For example:

Further, if there is deflationary situation and the

Commercial Banks are not creating as much credit as is

If the Central Bank wants to control credit, it will raise

desirable in the interest of the economy. Then in such

the bank rate. As a result, the market rate and other

situation the Central Bank will start purchasing

lending rates in the money-market will go up. Borrowing

securities in the open market from Commercial Banks

will be discouraged. The raising of bank rate will lead to

and private individuals.

contraction of credit.
With this activity the cash will now move from the
Similarly, a fall in bank rate mil lowers the lending rates

Central Bank to the Commercial Banks. With this

in the money market which in turn will stimulate

increased cash reserves the Commercial Banks will be

commercial and industrial activity, for which more credit

in a position to create more credit with the result that

will be required from the banks. Thus, there will be

the volume of bank credit will expand in the economy.

expansion of the volume of bank Credit.

64 | P a g e
3. Variable Cash Reserve Ratio:

cash reserve ratio method is superior to open market

operations on the following grounds:

Under this system the Central Bank controls credit by

changing the Cash Reserves Ratio. For exampleIf the

(1) Open market operations is time consuming

Commercial Banks have excessive cash reserves on the

procedure while cash reserves ratio produces

basis of which they are creating too much of credit

immediate effect in the economy.

which is harmful for the larger interest of the economy.

So it will raise the cash reserve ratio which the

(2) Open market operations can work successfully only

Commercial Banks are required to maintain with the

where securities market in a country are well organised

Central Bank.

and well developed.

This activity of the Central Bank will force the

While Cash Reserve Ratio does not require such type of

Commercial Banks to curtail the creation of credit in the

securities market for the successful implementation.

economy. In this way by raising the cash reserve ratio of

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

(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.

Reserve ratio with a view to expand the cash reserves of

the Commercial Banks.

Category # II. Qualitative or Selective Method of

Credit Control:

With this, the Commercial Banks will now be in a

position to create more credit than what they were doing

The qualitative or the selective methods are directed

before. Thus, by varying the cash reserve ratio, the

towards the diversion of credit into particular uses or

Central Bank can influence the creation of credit.

channels in the economy. Their objective is mainly to

control and regulate the flow of credit into particular

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

industries or businesses.

The following are the important methods of credit

control under selective method:

1. Rationing of Credit.

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2. Direct Action.

maintenance of sound credit conditions. Even then the

Commercial Banks do not fall in line, the Central Bank

3. Moral Persuasion.

has the constitutional power to order for their closure.

4. Method of Publicity.

This method can be successful only when the Central

Bank is powerful enough and has cordial relations with

5. Regulation of Consumers Credit.

6. Regulating the Marginal Requirements on Security

Loans.

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.

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.

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.

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.

2. Direct Action:
4. Method of Publicity:
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

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 seminars present a correct picture of the economic
conditions of the country before the public and give a
prospective economic policies. In developed countries
Commercial Banks automatically change their credit
creation policy. But in developing countries Commercial

66 | P a g e
Banks being lured by regional gains. Even the Reserve

money in circulation. (Related reading What Are Central

Bank of India follows this policy.

Banks?)

5. Regulation of Consumers Credit:

The methods central banks use to control the quantity

of money vary depending upon the economic situation

Under this method consumers are given credit in a little

and power of the central bank. In the United States, the

quantity and this period is fixed for 18 months;

central bank is the Federal Reserve, often called the

consequently credit creation expanded within the limit.

Fed. Other prominent central banks include

This method was originally adopted by the U.S.A. as a

theEuropean Central Bank, Swiss National Bank, Bank

protective and defensive measure, there after it has

of England, Peoples Bank of China, and Bank of Japan.

been used and adopted by various other countries.

(Related reading Get To Know The Major Central Banks)

6. Changes in the Marginal Requirements on Security

Why the Quantity of Money Matters

Loans:
The quantity of money circulating in an economy affects
This system is mostly followed in U.S.A. Under this

both micro and macroeconomic trends. At the micro

system, the Board of Governors of the Federal Reserve

level, a large supply of free and easy money means

System has been given the power to prescribe margin

more personal spending. Individuals also have an easier

requirements for the purpose of preventing an

time getting loans such as personal loans, car loans,

excessive use of credit for stock exchange speculation.

orhome mortgages.

This system is specially intended to help the Central

At the macroeconomic level, the amount of money

Bank in controlling the volume of credit used for

circulating in an economy affects things like gross

speculation in securities under the Securities Exchange

domestic product, overall growth, interest rates,

Act, 1934.

and unemployment rates. The central banks tend to

control the quantity of money in circulation to achieve

How Central Banks Control

The Supply Of Money

economic objectives and effect the monetary policy.

Through this article, we take a look at some of the
common ways that central banks control the quantity of
money in circulation.

If a nations economy were a human body, then its heart

would be the central bank. And just as the heart works

1. Print More Money

to pump life-giving blood throughout the body, the

central bank pumps money into the economy to keep it

As no economy is pegged to a gold standard, central

healthy and growing. Sometimes economies need less

banks can increase the amount of money in circulation

money and sometimes they need more. In this article,

by simply printing it. They can print as much money as

well discuss how central banks control the quantity of

they want, though there are consequences for doing so.

67 | P a g e
Merely printing more money doesnt affect the output or

3. Influence Interest Rates

production levels, so the money itself becomes less

valuable. Since this can cause inflation, simply printing

In most cases, a central bank cannot directly set interest

more money isn't the first choice of central banks.

rates for loans such as mortgages, auto loans, or

personal loans. However, the central bank does have

2. Set the Reserve Requirement

certain tools to push interest rates towards desired

levels. For example, the central bank holds the key to

One of the basic methods used by all central banks to

the policy ratethis is the rate at which commercial

control the quantity of money in an economy is

banks get to borrow from the central bank (in the United

the reserve requirement. As a rule, central banks

States, this is called the federal discount rate). When

mandate depository institutions to keep a certain

banks get to borrow from the central bank at a lower

amount of funds in reserve against the amount of net

rate, they pass these savings on by reducing the cost of

transaction accounts. Thus a certain amount is kept in

loans to its customers. Lower interest rates tend to

reserve and this does not enter circulation. Say the

increase borrowing and this means the quantity of

central bank has set the reserve requirement at 9

money in circulation increases.

percent. If a commercial bank has total deposits of $100

million, it must then set aside $9 million to satisfy the

4. Engage in Open Market Operations

reserve requirement. It can put the remaining $91 million

into circulation.

Central banks affect the quantity of money in circulation

by buying or selling government securities through the

When the central bank wants more money circulating

process known as open market operations (OMO). When

into the economy, it can reduce the reserve requirement.

a central bank is looking to increase the quantity of

This means the bank can lend out more money. If it

money in circulation, it purchases government

wants to reduce the amount of money in the economy, it

securities from commercial banks and institutions. This

can increase the reserve requirement. This means that

frees up bank assetsthey now have more cash to loan.

banks have less money to lend out and will thus be

This is a part of an expansionary or easing monetary

pickier about issuing loans.

policy which brings down the interest rate in the

economy. The opposite is done in case where money

In the United States (effective January 22, 2015), smaller

needs to taken out from the system. In the United

depository institutions with net transaction accounts up

States, the Federal Reserve uses open market

to $14.5 million are exempt from maintaining a reserve.

operations to reach a targeted federal funds rate.

Mid-sized institutions with accounts ranging between

The federal funds rate is the interest rate at which banks

$14.4 million and $103.5 million must set aside 3 percent

and institutions lend money to each other overnight.

of the liabilities as reserve. Depository institutions

Each lending-borrowing pair negotiate their own rate

bigger than $103.6 million have a 10 percent reserve

and the average of these is the federal funds rate. The

requirement.

federal funds rate, in turn, affects every other interest

rate. Open market operations are a widely used

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instrument as they are flexible, easy to use, and
effective.

Public Debt: Meaning,

Objectives and Problems
Meaning:

5. Introduce a Quantitative Easing Program

In India, public debt refers to a part of the total
In dire economic times, central banks can take open

borrowings by the Union Government which includes

market operations a step further and institute a program

such items as market loans, special bearer bonds,

of quantitative easing. Under quantitative easing, central

treasury bills and special loans and securities issued by

banks create money and use it to buy up assets and

the Reserve Bank. It also includes the outstanding

securities such as government bonds. This money

external debt.

enters into the banking system as it is received as

payment for the assets purchased by the central bank.

However, it does not include the following items of

The bank reserves swell up by that amount, which

borrowings:

encourages banks to give out more loans, it further

helps to lower long-term interest rates and encourage
investment. After the financial crisis of 2007-2008, the

(i) small savings,

(ii) provident funds,

Bank of England and the Federal Reserve launched

quantitative easing programs. More recently, the

(iii) other accounts, reserve funds and deposits.

European Central Bank and the Bank of Japan have also

announced plans for quantitative easing.

The aggregate borrowings by the Union Government

comprising the public debt and these other borrowings

The Bottom Line

are generally known as net liabilities of the

Government.

Central banks work hard to ensure that a nation's

economy remains healthy. One way central banks do

Objectives:

this is by controlling the amount of money circulating in

the economy. They can do this by influencing interest

In India, most government debt is held in long-term

rates, setting reserve requirements, and employing open

interest bearing securities such as national savings

market operation tactics, among other approaches.

certificates, rural development bonds, capital

Having the right quantity of money in circulation is

development bonds, etc. In industrially advanced

crucial to ensuring a healthy and sustainable economy.

countries like the U.S.A., the term government or public

debt refers to the accumulated amount of what
government has borrowed to finance past deficits.

In such countries the government debt has a very

simple relationship to the government deficit the
increase in debt over a period (say one year) is equal to

69 | P a g e
its current budgetary deficit. But, in India, the term is

development work under the Five Year Plans and other

used in a different sense.

projects. As a result the volume of public debt is

increasing day by day.

The State generally borrows from the people to meet

three kinds of expenditure:

The Burden of Public Debt:

(a) to meet budget deficit,

When a country borrows money from other countries (or

foreigners) an external debt is created. It owes its all to

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

others. When a country borrows money from others it

situations and

has to pay interest on such debt along with the

principal. This payment is to be made in foreign

(c) to finance development activity.

(a) Public Debt to Meet Budget Deficit:

exchange (or in gold). If the debtor nation does not have

sufficient stock of foreign exchange (accumulated in the
past) it will be forced to export its goods to the creditor

It is not always proper to effect a change in the tax

nation. To be able to export goods a debtor nation has to

system whenever the public expenditure exceeds the

generate sufficient exportable surplus by curtailing its

public revenue. It is to be seen whether the transaction

domestic consumption.

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.

Thus an external debt reduces societys consumption

possibilities since it involves a net subtraction from the
resources available to people in the debtor nation to
meet their current consumption needs. In the 1990s,
many developing countries such as Poland, Brazil, and

(b) Public Debt to Meet Emergencies like War:

Mexico faced severe economic hardships after incurring

large external debt. They were forced to curtail domestic

In many countries, the existing public debt is, to a great

consumption to be able to generate export surplus (i.e.,

extent, on account of war expenses. Especially after

export more than they imported) in order to service their

World War II, this type of public debt had considerably

external debts, i.e., to pay the interest and principal on

increased. A large portion of public debt in India has

their past borrowings.

been incurred to defray the expenses of the last war.

The burden of external debt is measured by the debt(c) Public Debt for Development Purposes:

service ratio which returns to a countrys repayment

obligations of principal and interest for a particular year

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

on its external debt as a percentage of its exports of

goods and services (i.e., its current receipt) in that year.
In India it was 24% in 1999. An external debt imposes a
burden on society because it represents a reduction in

70 | P a g e
the consumption possibilities of a nation. It causes an

reckoned a distortion from efficiency and well-being.

inward shift of the societys production possibilities

Moreover, if most bondholders are rich people and most

curve.

tax-payers are people of modest means repaying the

debt money redistributes income (welfare) from the poor

Three Problems:

to the rich.

When we shift attention from external to internal debt we

2. Capital Displacement (Crowding-Out) Effect:

observe that the story is different.

Secondly, if the government borrows money from the
It creates three problems:

people by selling bonds, there is diversion of societys

limited capital from the productive private to

(1) Distorting effects on incentives due to extra tax

burden,

(2) Diversion of societys limited capital from the

productive private sector to unproductive capital sector,
and

(3) Showing the rate of growth of the economy.

unproductive public sector. The shortage of capital in

the private sector will push up the rate of interest.

In fact, while selling bonds, the government competes

for borrowed funds in financial markets, driving up
interest rates for all borrowers. With the large deficits of
recent years, many economists have been concerned in
the competition for funds; also higher interest rates

These three problems may now be briefly discussed:

have discouraged borrowing for private investment, an

effect known as crowding out.

1. Efficiency and Welfare Losses from Taxation:

This, in its turn, will lead to fall in the rate of growth of
When the government borrows money from its own

the economy. So, decline in living standards is

citizens, it has to pay interest on such debt. Interest is

inevitable. This seems to be the most serious

paid by imposing tax on people. If people are required to

consequence of a large public debt. As Paul Samuelson

pay more taxes simply because the government has to

has put it: Perhaps the most serious consequence of a

pay interest on debt, there is likely to be adverse effects

large public debt is that it displaces capital from the

on incentives to work and to save. It may be a happy

nations Stock of wealth. As a result, the pace of

coincidence if the same individual were tax-payer and a

economic growth slows and future living standards will

bond-holder at the same time.

decline.

But even in this case one cannot avoid the distorting

3. Public Debt and Growth:

effects on incentives that are inescapably present in the

case of any taxes. If the government imposes additional

By diverting societys limited capital from productive

tax on Mr. X to pay him interest, he might work less and

private to unproductive public sector public debt acts as

save less. Either of the outcome or both must be

71 | P a g e
a growth-retarding factor. Thus an economy grows

grow more slowly than in the absence of large

much faster without public debt than with debt.

government debt and deficit as is shown by comparing

the top lines in Fig. 22.3.

When we consider all the effects of government debt on

the economy, we observe that a large public debt can be

This seems to be the most important point about the

detrimental to long-run economic growth. Fig. 22.3

long-run impact of huge amount of public debt on

shows the relation between growth and debt. Let us

economic growth. To conclude with Paul Samuelson and

suppose an economy were to operate over time with no

W. D. Nordhaus: A large government debt tends to

debt, in which case the capital stock and potential

reduce a nations growth in potential output because it

output would follow the hypothetical path indicated by

displaces private capital, increases the inefficiency from

the solid lines in the diagram.

taxation, and forces a nation to service the external

portion of the debt.

Conclusion:

There is no doubt a feeling among some people that

interest payment on the national debt repayment is a
drain on the nations limited economic resources. It is
pure waste of our resources to use them to pay interest
on the debt.

This argument is wrong because interest payment on

the debt if domestically held do not prevent a use
of economic resources at all. It is, of course, true that if
our debt is held by foreigners, we will suffer a loss of
Now suppose the government increase a huge deficit

resources.

and debt; with the accumulation of debt over time, more

and more capital is displaced, as shown by the dashed
capital line in the bottom of Fig. 22.3. As the government
imposes additional taxes on people to pay interest on
debt, there are greater inefficiencies and distortions
which reduce output further.

In the case of domestically held (internal) debt, internal

payment on the debt involves a transfer of income from
Indian taxpayers to Indian bondholders of the same
generation. Since, in most cases, taxpayers and bondholders are different entities, a large national debt
inevitably involves income redistribution effects. But

What is more serious is that an increase in external debt

lowers national income and raises the proportion of
GNP that has to be set aside every year for servicing the
external debt. If we now consider all the effects of public
debt together, we see that output and consumption will

internal debt does not involve any using up of the

nations real economic resources.

72 | P a g e
Limit to Public Debt:

Should we pay off the debt? First of all, it would be a

huge, probably impossible, burden, even over several

Though there is no clear end limit to internal debt there

years, to raise, through taxes and other revenues, the

should be a definite limit to external debt. Moreover the

amount needed to pay off the debt. Second, with

upper limit to internal debt should be set by the annual

repayment of the debt, a significant income

rate of growth of per capita GNP.

redistribution would occur as the average taxpayer

became poorer due to the increased tax burden and the
holders of government securities became richer with
their newly redeemed funds.

Also, some portion of the debt is external, or foreignowned. While, under normal conditions, this is not a
serious concern, in a period of accelerated repayment it
would mean a sizable outflow of rupees from the India.
Finally, in order to pay off the public debt, a series of
surplus budgets would be needed.

However, as Keynes pointed out, a surplus budget has a

Assessing the Debt (Optional):

contractionary impact on the economy. While the debt

was being paid off, economic activity would decline. In

What kind of burden does the national debt impose on

short, the opportunity cost of lowering the national debt

taxpayers and on future generations?

would be a slowing down of the economic activities.

One of the most obvious and significant burdens of the

national debt is the interest that must be paid to borrow
and maintain a debt of this magnitude. The interest

Public and Private Debt

burden of the national debt cumulates as additional debt

Public debt refers to borrowing by a Government from

is incurred each year. Because the debt is not being

within the country or from abroad, from private

retired, interest must be paid year after year.

individuals or association of individuals or from banking

and non-banking financial institutions.

The rising burden of the debt service or interest cost

of maintaining the debt will be passed on to future

Classification of Public Debt:

generations who will have to pay the interest on the

current debt. At the same time, however, many of those
to whom interest will be paid will be Indian citizens who
own government securities.

Internal and External debt: Internal debt is raised

from within the country and external debt is owed
to

foreigners

institutions.

or

foreign

governments

or

73 | P a g e
No.

Productive and Unproductive debt: The productive

debt is expected to create assets which will yield

Particulars
Burden of debt

Burden of public debt

is not imposed
directly on
Government.
Government collects
it from the public of
the country

Burden of
individual debt
directly impose
individual

Borrow money

Government can
borrow from the
citizens forcefully

Individual can
borrow if the len
wishes to lend
him/her

Benefit

Public will get benefit

if they lend money to
Government

Lender will not

any benefit from
borrower if he/s
lends money to
individual

Issue of note

If necessary,
Government can
issue notes to pay
debt

There is no sco
to issue note in
case of individu

Payment of debt

Generally.
Government imposes
tax on public to pay
debt

Individual has to
pay debt from
his/her income

Types of debt

Government can
borrow from both
internal and external
sources

Individual can o
borrow from
external source

Irredeemable debt

Government can
borrow money on
irredeemable basis

Individual has to
borrow money o
redeemable bas

Interest rate on debt

Interest rate on debt

is less in case of
public debt

Interest rate on
debt is more in
case of individu
debt

on the loan. In other words, they are expected to

pay their way; they are self-liquidating. On the other

natural disaster do not create any asset; they are

dead weight and are regarded as unproductive.
Short-term and Long-term debt: Short-term loans are
repayable after short interval of time, e.g. treasury
bills payable after three months, ways and means
advances from the central bank. They are intended
to bridge the gap temporarily between current
revenue and current expenditure. It is also called
unfunded debt Long-term loans are payable after a
long time covering several years. They are also
called funded debt.
Redeemable and Irredeemable debt: If government
takes loan to pay at the specified time, it is called
redeemable debt. On the other hand, if government
takes loan to pay the specified interest for a long
time but does not promise to pay the principal at
specified time, it is called irredeemable debt.
Compulsory and Voluntary debt: If government takes
loan

from the

public

forcefully, it

is

called

compulsory debt. Government mainly takes this

type of loan at the time of war and natural disaster.
If public gives loan to the government voluntarily. It
is called voluntary loan. For example, buying prize
bond,

national

defense

certificate,

certificate etc.

Differences between Public and Private Debts:

savings

Private Deb

income sufficient to pay the principle and interest

hand, loans raise for war or protection against

Public Debt

Public Revenue
The public revenue can be broadly classified into two:
(a) Tax Revenue: It is the most important and major
source of public revenue. Government may require the
members of the community to contribute to the support
of governmental functions through the payment of
taxes. An individual has no right to directly demand
social services in return to his payment of tax nor has
he any other choice except to pay the tax when it is
levied on him.

74 | P a g e
Taxes, in general, serve both functions of a revenue
system:
(i)
(ii)
investment.

convenient, but not so if it is to be paid personally to the

taxing authority. In the latter case there will be a lot of
inconvenience and harassment.

they provide funds, and

they reduce private consumption and

(b) Non-Tax Revenue: Non-tax revenue is derived from

public undertakings called Prices and other
miscellaneous receipts. It also raises loans, short-term
and long-term, to augment its revenues. Other minor
revenue sources are fees, special assessment, fines,
forfeitures and escheats, tributes and indemnities, gifts
and grants.

Adam Smiths Canon of

Taxation
Adam Smiths contribution to this part of economic
theory is still regarded as classic. His presented theory
on taxation is still considered as the foundation of all
discussions on the principles of taxation. There are four
essentials of his theory of taxation, i.e., equality,
certainty, convenience and economy. The first canon is
ethical and other three are administrative in character:
1. Canon of Equality: means the principle of justice, i.e.,
in accordance to ability to pay. This is the most
important canon of taxation. It lays the moral
foundation of the tax system. The cannon of equality
does not mean that every taxpayer should pay at the
same sum. That would be manifestly unjust. Nor does
it means that they should pay at the same rate, which
means proportional taxation, for a proportional tax is
also not a very just tax. What this canon really means is
the equality of sacrifice. The amount of the tax paid is
to be in proportion to the respective abilities of the
taxpayers. This clearly points to progressive taxation,
i.e., taxing higher incomes at higher rates.
2. Canon of Certainty: means the tax which each
individual is bound to pay ought to be certain, and not
arbitrary. The time of payment, the manner of payment,
the quantity to be paid, ought to be clear and simple to
the taxpayer. According to Adam Smith, uncertainty in
taxation encourages insolence or corruption.
3. Canon of Convenience: Every tax, according to Adam
Smith, ought to be levied at the time or in the manner in
which it is most convenient for the taxpayers to pay
their dues. The canon of certainty says that the time
and the manner of payment should be certain. But the
canon of convenience states that the time of payment
and the manner of payment should be convenient. For
example, if a tax on land or house is collected at a time
when rent is expected to be received, it satisfies the
canon of convenience. If the tax can be paid through
cheque, or credit card, or internet, the manner is

4. Canon of Economy: The tax will be economical if the

cost of collection is very small. If, on the other hand,
the salaries of the officers engaged in collecting the tax
eat up a big portion of the tax revenue, the tax is
certainly uneconomical. Similarly, such other huge and
unnecessary administrative costs will make the tax
collection an extravagant task. If there is corruption or
oppression involved in the frequent visits to the income
tax office and the odious examination by the taxing
officer the canon of economy is not satisfied.
In broader sense, the canon of economy means a tax
must not obstruct in any manner the ultimate prosperity
of the country. It would infringe the canon of economy if
it retards the development of trade and industry in any
manner. If incomes are subjected to a very heavy tax,
saving may be discouraged, capital will not accumulate
and the productive capacity of the community will be
seriously impaired.
Other Canons of Taxation
1. Fiscal Adequacy or Productivity: The State should be
able to function with the revenue raised from the people
by means of taxes. The government should be free from
financial embarrassments. It will be necessary,
therefore, that the tax proceeds should adequately cover
the government expenditure and the government does
not run into a deficit. But at the same time, the
government should also not err on the side of
excess. In their zeal to raise more revenue, they should
not cripple, in any manner, the productive capacity of
the community.
2. Canon of Elasticity: The canon of elasticity is closely
connected with that of fiscal adequacy. As the needs
of the State increase, the revenue should also increase
otherwise they will cease to be adequate. To meet an
emergency or a period of stress and strain, the
government should be in a position to augment its
financial resources. Income tax is considered to be an
elastic tax, as it can be considerably increased when
needed.
3. Canon of Flexibility: There is a difference between
flexibility and elasticity. Flexibility means that there
should be no rigidity in the tax system so that it can be
quickly adjusted to new conditions; and elasticity
means that the revenues can be increased. The
presence of flexibility is a condition of elasticity. A tax
system cannot be altered without bringing about a
revolution or without much flexibility in the tax system.
4. Canon of Simplicity: According to Armitage Smith, a
system of taxation should be simple, plain and

75 | P a g e
intelligible to the common understanding. This canon is
essential if corruption or oppression is to be avoided.
5. Canon of Diversity: Another important principle of
taxation diversity. A single tax or only a few taxes will
not do. There should be a variety of taxes so that all the
citizens, who can afford to contribute to the State
revenue, should be made to do so. They should be
approached in a variety of ways. There should be a wise
admixture of direct and indirect taxes. But too great
multiplicity will be bad and uneconomical.
6. Social and Economic Objectives: In modern times,
economists emphasised that the tax system should be
based on the principle that the effects of taxation should
be compatible with the economic and social objectives
and preferences of the community. The social and
economic objectives of a standard tax system are:
(i)
Reduction of inequalities in the
distribution of income and wealth: For this purpose,
progressive taxes must be levied instead of proportional
taxes.
(ii)
Accelerating economic growth: For this
purpose, the tax system must be so designed as to raise
the rates of saving and investment. This is a very
important objective for less developed countries (LDCs),
where there is a deficiency of savings and investments.
(iii)
Price stability: to ensure stable
economic growth. When LDCs launch economic
development programme they have to face inflation or
soaring prices. An integrated tax policy would solve
this problem.

Objectives of Taxation in
Developing Economies
(a) Ability to contribute to economic
development: Each person should be made to
contribute to economic development, according to his
ability to do so. All his unused capacity must be
utilised, through appropriate tax measures, for purposes
of economic development. Suppose a person is making
a large saving but he lets it lie idle. Such saving must
be mobilised and channelised into investment.
(b) Mobilisation of economic surplus: In all
backward countries, a significant portion of national
output goes to the big landlords and other idle rich
people. A large portion of their income is spent on
conspicuous consumption, e.g., building of palaces,
etc. This is unproductive expenditure and a waste from
the point of national development. Economic growth
can be accelerated if an appreciable portion of this
surplus income is mobilised and made available for
productive investment.

(c) Increasing the incremental saving ratio: As

economic development proceeds apace, incomes
rise. But there is a danger that propensity to consume
may also increase so that extra incomes generated in
the economy are utilised in consumption rather then
invested in production. This has to be prevented. In
other words, the consumption is not allowed to increase
in proportion to increase in income. For this purpose
commodity taxes are quite effective.
(d) Income elasticity of taxation: In backward
economies, the share of taxation out of the national
income is less than 10%. This share must be
progressively raised as national income increases as a
result of economic development. This needs built-in
flexibility in the tax system. Progressive taxation of
income provides this flexibility. Taxation of goods
having a high income-elasticity of demand also imparts
to the tax system much needed flexibility.
(e) Equity: The canon of equity demands that the
burden of economic development must be distributed
among the different sections of the community
equitably. That is why the richer classes are prevented
from increasing their consumption in proportion to the
rise in their incomes. This is how they make a sacrifice
for the economic development of their country. The
poor people also make a sacrifice because rising prices
curtail their consumption. In this manner, sacrifices in
consumption are shared by all sections of the
society. Thus, the burden of economic development is
equitably distributed among all. This is also known
ashorizontal equity.

Characteristics of A Good Tax

System
(a) Simple, financially adequate and elastic: The
tax system should be simple, financially adequate and
elastic. In other words, the system should be easily
intelligible; it should be sufficiently productive of
revenue; and the tax structure should be adaptable to
meet the changing requirements of the economy.
(b) Broad based: The tax system should be as
much broad-based as possible. It should be multiple tax
system. There should be diversity in the system. But
too great multiplicity in tax system should be avoided.
(c) Administratively efficient: The tax system
should be efficient from the administrative point of
view. It should be simple to administer. There should
be little scope for evasion or accumulation of arrears. It
should be foolproof and knave-proof. Chances of
corruption should be minimised.
(d) Balanced and harmonious: Another important
characteristic of a good tax system is that it should be a
harmonious whole. It should have a balanced
structure. It should be truly a system and not a mere

76 | P a g e
collection of isolated taxes. Every tax should fit in
properly in the system as a whole so that it is a part of a
connected system. Each tax should occupy a definite
and due place in the financial structure.
(e) Ensuring the reduction of economic
inequalities: A good tax is that it should be an
instrument for the reduction of economic
inequalities. The purpose of public finance is not
merely to raise revenues for the State but to raise the
revenue in such a manner as to reduce the economic
inequalities. In this manner, the State may also be able
to divert idle resources in bank balances or lockers to
more productive areas.
(f) Ensuring economic stability: From the point of
view of ensuring economic stability, it is necessary that
the tax system must be progressive in relation to
changes in the national income. This means that when
national income rises, an increasing part of rise in
income should automatically accrue to the tax
authorities and when national income falls, as in a
depression, the tax revenue should fall faster than the
fall in national income.
(g) Ensuring that national income is
increasing: The tax system should ensure that the
national income is increasing during boom
periods. Similarly, in depression, tax revenues should
fall faster than income so that the purchasing power of
people does not fall as fast as their pre-tax
income. Thus, an overall progressive tax system is an
important factor in ensuring stability.
(h) An instrument of economic growth: For
developing economies, the tax system has to serve as
an instrument of economic growth. Economic
development rather than economic stability is the
objective of under-developed countries. Their tax
system must be so shaped as to accelerate economic
development. For this purpose, it must mobilise the
required resources and channelise them into
investment. It must, in short step up savings and
investment and raise the level of income and
employment in the economy.
(i) Socially advantageous: The tax system should
be socially advantageous and promote general
economic welfare. From this point of view, taxes on
goods of mass consumption should be avoided. The
burden of tax on basic items should not be excessive.
(j) Optimum allocation of resources: The tax
system should be so framed as to ensure that the
productive resources of the economy are optimally
allocated and utilised. For this purpose, it is essential
that the tax system should be economically neutral. In
other words, it should interfere as little as possible with
the consumers choices for consumption goods and the
producers choices regarding the use of factors.

Classification of Tax
Some classifications of taxes are as follows:
1. Proportional & Progressive Tax: A proportional tax is
one in which, whatever the size of income, same rate or
percentage is charged.
On the contrary, progressive tax refers to the tax system
in which the rate of tax increases with the increase in
table income. It is based on the principle higher the
income, higher the tax.
2. Regressive & Digressive Tax: A tax is said to be
regressive when its burden falls more heavily on lowincome earners / poor than the high-income earners /
rich. It is opposite of progressive tax.
A tax is called digressive when the higher income does
not make a due sacrifice, or when the burden imposed
on them is relatively less. This tax may be progressive
up to a certain limit beyond which a uniform rate is
charged.
3. Specific & Advolarem Tax: A specific tax is according
to the weight of the commodity. An advolarem tax is
according to the value of a commodity.
4. Direct & Indirect Tax: Direct tax is one which is paid
by the person on which it is charged. The examples of
direct taxes are income tax, wealth tax, etc.
On the contrary, the indirect taxs is paid by one person
and its burden is fall on other, generally the
consumer. The examples of indirect taxes are sales tax,
central excise duty, custom duty, recreational tax, etc.

Sources of Tax Revenue /

Major Types of Tax
1. Income Tax: It is a form of direct tax which is levied on
individuals total earnings. It is the most effective tax
vehicle for attaining equity, particularly if it is
progressive tax. Following are the requirements for an
optimal income tax system:
(a) All incomes should be treated uniformly and all
rupees of income should be accorded equal tax
treatment regardless of the source.
(b) Just as equals should be treated equally,
unequals should be treated unequally.
(c) The tax structure should be sensitive to changes
in economic activity in order to dampen the changes

77 | P a g e
(d) The tax structure should be designed in such a
fashion as to facilitate compliance and in enforcement,
consistent with the attainment of the other objectives.

As industrial and commercial development continues

the increased use of custom duties lessens the revenue
potential.

2. Corporate Tax: The following are the primary tax

consequences of the existence of the corporation:

7. State Duties: There are several other duties imposed

by the government broadly classified as state
duty. These include the tax on the earnings of
commercial deposits and on sales and purchase of
properties. These are some what different types of tax
as:

(a) The corporations earnings are accumulated as

reserves giving rise to capital gains.
(b) The division between initial earning of the income
and subsequent payment of dividends encourages
government to tax both the corporation and the dividend
earners.
(c) The division between ownership and top
management in a large corporation may cause the
reactions to the tax to be different from the personal
income tax.
Under perfectly competitive markets the corporate tax
shifted to reduce the real income of stockholders. Under
imperfectly competitive markets the firms use mark-up
price for shifting the tax burden on consumers.
3. Wealth Tax: A wealth tax is a levy upon individuals not
corporations, on the basis of their net wealth. Corporate
property is reached via securities outstanding in the
hands of the owners and creditors. The wealth tax can
take form of either progressive or proportional
tax. Wealth tax is not a major source of revenue and in
most countries they form 1 to 2% of the total tax
revenue.
4. Sales Tax: Sales tax is applied to all or a wide range of
commodities and services. It is collected from vendors
rather than individual consumers. The sales tax is
finally borne by consumers. The sales tax is often refer
to regressive tax relative to income.
5. Excise Duty: It is actually imposed on the
manufacturers but the consumers have to pay it. It is a
form of indirect tax imposed on widely used
commodities often regarded as non-essential such as
cigarettes, liquor, tobacco, etc.
6. Custom Duty: Custom duties are of two types:
(i)

specific, and

(ii)

advolarem.

Specific custom duty is fixed per physical units of

goods, e.g., television, CD players, computers, etc. The
advolarem custom duty is according to the value of a
good and charged at a certain rate.

(a) the taxes imposed by the federal

government and used by itself,
(b) the taxes imposed by the federal
government and distributed among provinces,
and
(c) the taxes imposed by the provincial
governments and used by themselves.
8. Other Sources:
(i) Fee: It is also a compulsory payment but made only
by those who obtain a definite service in return from the
government. The fee covers the part of the cost of
service provided to the consumer / client. The licence
fee, however, is much more than the cost of service and
there is not much of a positive service in return.
(ii) Price: A price is the payment of a service of
business character, for example, charges for travelling
on railway. The price is different from fee. The fee is for
public interest. You can escape a price by not
purchasing the said service / commodity.
(iii) Special Assessment: According to Professor
Seligman, special assessment is a compulsory
contribution, levied in proportion to the special benefit
derived, to defray the cost of a specific improvement to
property undertaken in the public interest. Suppose the
government build a road or bridge or provide mass
transport system or makes suitable sewerage and water
supply arrangements, all the property will appreciate in
value. The State has the right to levy a special tax on the
owners of land or property known as special
assessment.
(iv) Rates: Rates are levied by the local bodies,
municipalities and district boards for local
purposes. They are generally levied on immovable
property of the residents, but not necessarily for any
special improvements effected or special benefits
conferred.

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Sources from Non-Tax

Revenues

Direct Tax and Indirect Tax:

In Pakistan, following are the sources of non-tax

revenue available for Federal Government:
1. Income from Property & Enterprise: The
Government receives income from the owned lands,
forests, mines, canal water and various public
enterprises.

There are two main types of taxes (1) direct tax and
(2) indirect tax.

2. Profit from Post Office and TNT: The Government

also receives income from its Post and Telegraph
departments

Definition and Explanation of Direct Tax:

3. Trading Profits: The Government of Pakistan earns

trading profits from exports of rice, cotton and edible oil
4. Interest Receipts: It is the most important head in
the NTR source. The interest and the return from
investment received from various autonomous bodies,
and central bank and state-owned banks come under
this head
5. Surcharges: The difference between the sales price
and the production cost / import price of petroleum
products, gas and fertilisers represents the surplus
profit or the surcharge, which is used to iron out the
fluctuations in the prices of these essential
commodities.

A tax is said to be direct tax when impact and Incidence

of a tax are on one and same person, i.e., when a person
on whom tax is levied is the same who finally bears the!
burden of tax.

For Instance, income tax is a direct tax because impact

and incidence falls on the same person.

If impact of tax falls on one persons and incidence on

the another, the tax is called indirect.

6. Other Sources of Non-Tax Revenue: The other

minor heads of non-tax revenue are:
(i)

Dividends and returns

For example, tax on saleable articles is usually an

indirect tax because it can be shifted on to the
consumers.

(ii)
Receipts from civil
administration and other functions

Merits of Direct Tax:

(iii)
Miscellaneous sources,
which includes passport, CNIC
(Computerised National Identity
Card), copyright fees and other
receipts.

(i) Direct taxes afford a greater degree of progression.

They are, therefore, more equitable.

(ii) They entail less expenses on collection and as such

are economical.

(iii) They satisfy canons of certainty, elasticity,

productivity and simplicity.

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(iv) Another advantage of direct taxes is that they create

civic consciousness in people. When a person has to
bear burden of tax, he takes active interest in affairs of
state.

Demerits of Direct Tax:

(i) It is easy to evade a direct tax than an indirect tax.

Taxpayer is seldom happy when he pays tax. It pinches
him that his hard-earned money is being taken by
government. So he often submits false statements of his
income and thus tries to evade tax. Direct tax is in fact a
tax of honesty.

(ii) Direct tax is very inconvenience because taxpayer

has to prepare lengthy statements of his income and
expenditure. He has to keep a record of his income upto-date throughout the year. It is very laborious for
taxpayer to prepare and keep these records.

(iii) Direct tax is to be paid in lump some every year

while income which a person earns is received in small
amounts. It often becomes difficult by taxpayers to pay
large amounts in one installment.

Indirect Taxes:

Indirect taxes are those taxes which are paid in the first
instance by one person and then are shifted on to some
other persons. The impact is one person but the
incidence is on the other.

Merits of Indirect Tax:

(i) It is not possible to evade indirect tax. The only way

to avoid this tax is not to buy taxed commodities.

(ii) They are more convenient because they are wrapped

in prices. Consumer often does not know that he is
paying tax.

(iii) Another advantage of tax is that every member of

society contributes something towards revenue of state.

(iv) Indirect tax is also elastic to a certain extent. State

can increase its revenue within limits by increasing
rates of taxes.

(v) If state wishes to discourage consumption of

intoxicants and harmful drugs, it can raise their prices
by taxing them. This is a great social advantage which a
community can achieve from tax.

Demerits of Indirect Tax:

(i) A very serious objection leveled against indirect

taxation is that it is regressive in character. It is
inequitable. Burden of tax falls more on poor people
than on rich.

(ii) Indirect tax is also uneconomical. State has to spend

large amounts of money on collection of taxes.

(iii) Revenue from indirect tax is uncertain. State cannot

correctly estimate as to how much money will it receive
from this tax.

(iv) As lax is wrapped up in prices; therefore, it does not

create civic consciousness.

(v) If goods produced by manufacturers are taxed at

higher rates, it hampers trade and industry and causes

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widespread unemployment in the country.

After discussing merits and demerits of two types of

taxes, we come to conclusion that for reducing
inequality of income and raising sufficient funds for
state, both these taxes are essential, A country should
not place exclusive reliance on any one type, but should
employ both these forms of taxation.

expense incurred in conferring a common benefit upon

the residents of the state".

If we analyze this definition, we will come to the

following conclusions: First, a tax is a compulsory
payment to the public authority. Secondly, a tax is to be
paid by a person on whom it is levied whether he
derives any benefit from it or not. Thirdly, a person who
pays taxes to the state cannot claim that because he
pays taxes, therefore, a specific service in return should
be provided to him.

We agree here with Galdston when he says:

"Direct and Indirect taxes are like two equally fair sisters
to whom as Chancellor of Exchequer, he had to pay
equal addresses".

In recent times, however, there has been a slight change

in utilization of both these types of taxes. Every state, in
order to reduce inequality of income, is trying to raise
major portion of its income from direct taxes.

Types of Taxes:

For instance, he cannot demand that a constable should

be posted at his residence to protect his property at
night. The government spends money which it derives
from taxes in maintaining law and order in the country
and like other individuals he gets benefit from it. There
is no direct quid pro quo (direct return) in the case of a
tax.

In the words of Thomas:

"A tax is a compulsory contribution made to government

under stated conditions and not a return for a specific
service rendered".

There are following types of taxes:

(2) Fee:

(1) Tax:
Definition and Explanation of Fee:

Definition and Explanation of Tax:

A tax is a compulsory contribution to the public

authority to cover the cost of services rendered by state
for the general benefit of its people. In the words
of Plehn:

"Taxes are generally compulsory contributions of wealth

levied upon persons, natural or corporate to defray the

A fee is a payment made by the citizens of a country to

state for obtaining a definite service in return. Fee. like
tax, is not compulsory contribution. It is only paid by
those persons who enjoy the special benefit of the
services rendered by the state. The amount of the fee is
generally less than the cost of rendering the service.

For instance, student's fee is not equal to the cost of

service rendered to .him. Some part of the total cost is
covered by fees and some by taxes. Plehn has defined
fee in the following word:

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"A fee may be defined as a compulsory contribution of

wealth made by a person, natural or corporate, under
the authority of public power to defray a part or all the
expenses involved in some action of the government,
which while creating a common benefit also confirms a
special benefit or one that is arbitrarily so regarded".

(3) Price:

Definition and Explanation of Price:

Price, like fee, is also a payment made by a person for

obtaining a definite service in return. The difference
between a fee and price is that public purpose is more
prominent in fee than it is in price. Price is a voluntary
payment with a quid pro quo. When a government runs a
business, it receives revenue.

We can say in other words that special assessment is a

compulsory payment for improvement.

For instance, a corporation provides water, electricity,

drainage, paves streets, lays out parks, etc., etc., in a
particular locality of the city. The value of all the
property situated in that locality will go up. The
corporation has every right to share a part of this
unearned increment by taxing the owners of the
property who have, benefited from the improvement.
This tax which is levied in respect of improvement made
to the property by the public authority is called "special
assessment". Special assessment is more or less in
proportion to the benefits enjoyed by the owners of
immovable properties.

Stages of Evolution of Money

by Smriti Chand

Some of the major stages through which money has

For instance, government sells timber from, its forest,
iron, coal, copper salt, etc., from its mines it also
charges fare on state buses or from railways. The total
revenue which the government receives from such
services of business character is called price in
Economics.

evolved are as follows: (i) Commodity Money (ii) Metallic

Money (iii) Paper Money (iv) Credit Money (v) Plastic
Money.

Money has evolved through different stages according

(4) Special Assessment:

to the time, place and circumstances.

(i) Commodity Money:

Definition and Explanation of Special Assessment:
In the earliest period of human civilization, any
commodity that was generally demanded and chosen by
Special assessment is a compulsory contribution made
by the owner of a property for some benefit conferred to
his property by the public authority. In the words
of Seligman:

common consent was used as money.

Goods like furs, skins, salt, rice, wheat, utensils,

weapons etc. were commonly used as money. Such
"Special assessment is a compulsory contribution
levied in proportion to the special benefits derived to
defray the cost of a specific Improvement to property
undertaken in the public, interest".

exchange of goods for goods was known as Barter

Exchange.

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(ii) Metallic Money:

(v) Plastic Money:

With progress of human civilization, commodity money

The latest type of money is plastic money in the form of

changed into metallic money. Metals like gold, silver,

Credit cards and Debit cards. They aim at removing the

copper, etc. were used as they could be easily handled

need for carrying cash to make transactions.

and their quantity can be easily ascertained. It was the

Types of money

main form of money throughout the major portion of

There are three types of money in the economy, but as

members of the public, we will have only ever used two
of them cash, and the numbers in your bank account.

recorded history.

1. Cash:
(iii) Paper Money:
Physical money, or cash, is created under the authority
It was found inconvenient as well as dangerous to carry

of the Bank of England, with coins manufactured by the

Royal mint, and notes printed by specialist printer De La

gold and silver coins from place to place. So, invention

Rue. The profits from the creation of cash (known as

of paper money marked a very important stage in the

seigniorage) go directly to the government. Of course, it

is inconvenient and risky to use cash for larger

development of money. Paper money is regulated and

controlled by Central bank of the country (RBI in India).
At present, a very large part of money consists mainly of
currency notes or paper money issued by the central

transactions. This is one of the reasons why today cash

makes up less than 3% of the total money supply.
Nowadays people use credit and debit cards, which
allow money to be transferred electronically between
bank accounts (see point 3).

bank.

(iv) Credit Money:

2. Central bank reserves

Emergence of credit money took place almost side by

Central bank reserves are a type of electronic money,

created by the central bank and used by banks to make

side with that of paper money. People keep a part of

their cash as deposits with banks, which they can
withdraw at their convenience through cheques. The
cheque (known as credit money or bank money), itself,
is not money, but it performs the same functions as

payments between themselves. In some respects they

are like an electronic version of cash. However,
members of the public and normal businesses cannot
access central bank reserves, as they are only available
to those organisations who have accounts at the Bank
of England, i.e. banks. Central bank reserves are not
counted as part of the money supply for the economy,

money.

due to the fact that they are only used by banks to make
payments between themselves.

83 | P a g e
Electronic Money includes some decentralized systems.
3. Commercial bank money

The third type of money accounts for approximately 97%

of the money in circulation. However, unlike central

They are:
Bitcoin, and

Ripple Monetary System.

i) Bitcoin:

bank reserves and cash, it is not created by the central

bank or any other part of government. Instead,

Bitcoin is a Peer to Peer Electronic Money system with

commercial bank money is created by private, high-

maximized inflation limit.

street or commercial banks, usually in the process of

ii) Ripple Monetary System:

making loans (as described below). While this money is

Ripple Monetary system is a system that is developed to

electronic in form, it need not be before computers,

distribute electronic money system independent to local

banks could still create money by simply adding

currency.

deposits to their balance sheets.

Offline Anonymous System:
Commercial bank money is referred to by various

Offline Anonymous System can be done offline. In this

names, including: bank deposits, sight deposits,

electronic money system, the merchants do not need to

demand deposits, time deposits, term deposits, bank

have interaction with banks before receiving currency

liabilities and bank credit.

from the users. Instead of that, the merchants can

collect spent money by users and deposits the money

What is Electronic Money

later to the bank. The merchant can deliver his storage

media in bank for exchanging the electronic money to

Scrip or money that is exchanged only through

cash.

electronically is referred to as electronic money.

Electronic Money is also referred as e money,

Types of electronic currencies:

Electronic Cash, Digital Money, Electronic Currency,

Digital Currency, e currency, Digital Cash, and Cyber

There are two types of electronic currencies namely:

Currency. Electronic Money uses Internet, Digital Stored

Hard Electronic Currency and Soft Electronic Currency.

Value systems, and Computer Networks.

Hard Electronic Currency does not allow

Some of the examples of electronic money are Direct

reversing charges i.e. it supports only Non

Deposit, EFT (Electronic Funds Transfer), Virtual

Reversible transaction. The advantage of this type is

Currency, and Digital Gold Currency.

that it reduces the operating cost of e currency

Different Systems of Electronic Money:

Electronic Money includes three different systems
namely:

system.
Soft Electronic Currency allows payment
reversals. The payment is reversed only in case of
dispute or fraud. The payment reversible time will be
72 hrs or even more. Some examples of this type

Centralized Systems,

Decentralized Systems, and

Offline Anonymous Systems.

Centralized Systems:

are Credit Card and Pay Pal.

Electronic Money systems are developing day by day.
Some of the developments are: it can be used with
Secured Credit Cards for wide range facilities and the
bank accounts that are linked can be used with an

There are many centralized systems that directly sell

internet to exchange currency with Secure

their e currency to end users is WebMoney, Pay Pal,

Micropayment system like Pay Pal.

Hub Culture Ven, and CashU but Liberty Reserve sells

Definition of Barter System:

only via 3rd party digital currency exchangers.

Decentralized Systems:

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The economic system which functions without the use
of money is given the name of barter system. In other
words the economy which lacks any monetary media
and the goods are exchanged with goods directly is a
representative of barter system. Accordingly, we find
that barter system is furnished with the followings:

In 1995 IRTA commissioned the top ten international

accounting and advisory firm, Horwath & Horwath (now
Crowe Horwath International), to examine whether the
creation of exchange deficits represented a sound
financial practice and whether the IRTA recommended

(i) There is a direct exchange of goods and money is not

employed for transaction of goods and services.

guidelines restricting exchange deficits was reasonable

and prudent. The 1995 Horwath report titled Deficit
Spending Limits of Reciprocal Trade Exchanges
concluded that reasonable deficit spending, within

(ii) All the activities pertaining to consumption,

distribution and allocation are performed on the basis of
values of goods, not on the basis of money.

IRTAs pre-determined guidelines, represented sound

commercial practice and is desirable because of
the benefits to trade exchange members.

Barter system remained in operation for a long time. As

long as world's population was limited, the desires were
not diversified, and the goods were produced on small
scale the economic activities were carried under barter
system . But with the passage of time the world's
population expanded, the narrower and self sufficient
life of villages broke; education spread; the era of
invention and innovations started; and above all people
experienced diversification in their desires. In such
phenomenon Barter system failed to respond efficiently,
and it had to be abandoned.

Guidelines and
Recommendations for Barter
Exchange Deficits

The purpose of this memo is to define the parameters of

reasonable deficit spending so as to provide a clear
standard for trade exchange owners to follow.
II. Monetary Management Responsibilities of a Trade Exchange

The barter exchange must have the authority to assure

adequate liquidity exists in the barter system by
regulating the supply of trade dollars (money supply)
needed to finance the smooth turnover of products and
services being offered in the exchange. Simply put,
there needs to be enough trade dollars in the system for
members to be able to buy goods and services they

I. Preamble

wish to purchase. To perform this function, the barter

exchange issues credit lines to credit worthy members
which represents the main source of the money supply
when the credits are spent in to the trade
exchange. Exchanges will typically reserve the right to
borrow trade dollars from the exchange via a
permission clause in their membership agreement.
When a barter exchange borrows trade dollars from
the exchange and spends those trade dollars within the
system it also increases the supply of trade dollars in
circulation.

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The key question is; What is the proper and prudent

IMPORTANT TAX NOTE: In the US, based on the

amount of an exchange deficit so as to provide an

accounting doctrine of constructive receipt, an

appropriate level of money supply elasticity and how is

exchange deficit is viewed as taxable revenue by the

such a parameter defined? With too little money supply

IRS for the fiscal year it was incurred. The exchanges

members are unable to buy, and with too much money

deficit created each fiscal year must be reported on the

supply members will not sell and the system will freeze-

exchanges tax return as revenue for the year it

up. A properly managed deficit will provide the optimum

was realized. If your company has an exchange deficit

level of liquidity in the system so as to maximize

for the prior fiscal year, your company will owe the

exchange member trading.

IRS taxes on deficit amount at a tax rate of 34 percent.

Two Types of Deficits

IMPORTANT CAUTION: Exchange owners who fail to

declare trade income to appropriate internal

There are two types of deficits in a barter exchange

and/or external regulating authorities from personal or

system, exchange deficits and system deficits.

family trade accounts controlled by the exchange

The combined total of both types of deficits equals the

owners, or any other trade accounts that exist whereby

total deficit of the system.

the exchange owners receive a direct or indirect

benefit, may be subject to criminal charges based on

1) Exchange Deficits

Barter exchanges have a fundamental fiduciary duty to

the legal doctrine of larceny by conversion.

2) System Deficits

the members of their exchange to manage the exchange

in a prudent manner. In addition to the trade exchanges

Exchange system deficits result from write-offs for bad

role as the financial exchange manager for the system,

debt, insolvency or bankruptcy of exchange member

the exchange also acts a member of the exchange itself

accounts and result in more positive balances (liability

by buying and selling within the exchange. When an

to members of the exchange) than negative-balances

exchange manager purchases more goods and services

(goods and services owed to the exchange which

from the exchange then trade dollars that it earns, the

represent an asset to the exchange).

corresponding negative trade balance is known as an

exchange deficit. In such case, the barter exchange is

IRTA recommends that all exchanges create a member

actually borrowing from the membership of the

loan fund, (aka as a bad debt reserve account), to

exchange collectively, and the barter exchange becomes

effectively save earned trade dollars to zero-out a

the debtor while the exchange members are collectively

members negative balance account if such account is

the creditor. Owners personal accounts, employee trade

uncollectible or insolvent. By maintaining a proper

accounts and/or inventory accounts in a negative

member loan fund barter exchanges are able to

position are included as part of the total exchange

minimize system deficits because uncollectible negative

deficit.

trade balance accounts are off set by a corresponding

entry from the member loan fund.

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A portion of trade dollars earned by an exchange from

2) Create new avenues to earn trade dollars such as

new member sign-ups, monthly fees, advertising or

selling advertising in your newsletter or

renewals can be deposited monthly in the member loan

website, purchasing inventory at a discount and re-

fund. The percentage of an exchanges monthly earned

selling it at market value or charging a fee on

trade dollars that should be deposited into the member

your members negative trade balances.

loan fund varies based on the exchanges overall deficit.

A higher deficit requires a larger percentage of the

3) Maintain a healthy member loan fund to off-set the

exchanges earned trade dollars to be deposited into the

deficits created by members account defaults.

member loan, while a smaller deficit would require

V. Conclusion

less earned trade dollars be deposited.

Excessive deficit spending by a barter exchange will
IMPORTANT TAX NOTE: There are two types of deficits;
system and exchange deficits, system deficits pose the
lesser risk purely from a tax liability standpoint.
III. IRTA Recommended Parameters for Exchange and System
Deficits

cause serious liquidity problems in an exchange

that threaten the financial stability of the entire
exchange. However, properly managed exchange
deficits that fall within the recommended IRTA guideline
of 2.5 to 3.0 times the annualized average monthly
trade volume (calculated only on one side) can increase

IRTA studied numerous deficit control models used by

leading reputable barter exchanges and obtained the
opinions of the top accountants in the barter industry to
arrive at the recommendations contained herein.

IRTA Deficit Standard:

trade volume and revenue by providing the right level

of money supply sufficient to allow members to buy and
sell freely within the system. Exchanges that do not
meet the IRTA recommended deficit guideline need to
immediately implement the recommended deficit
reduction methods contained herein to lower their

2.5 to 3.0 times monthly annualized averaged trade

exchange deficit to the IRTA recommended standard of

volume, (calculated on one side only, either buy or

2.5 to 3.0 times their average monthly trade volume.

sell) Example: XYZ Exchanges monthly annualized

Functions of Money

trade volume is 400,000 a month. IRTA maximum

Money is often defined in terms of the

three functions or servicesthat it provides. Money
serves as a medium of exchange, as a store of value,
and as a unit of account.

recommended exchange deficit: 1.2 million

IV. Recommended Methods to Reduce an Exchange Deficit

Exchanges that exceed the recommended maximum

deficit threshold of 2.5 to 3.0 times their average
monthly trade volume should reduce their deficit by
implementing the following actions:

1) Spend less trade dollars as an exchange.

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. The difficulty with
a barter system is that in order to obtain a particular
good or service from a supplier, one has to possess a
good or service of equal value, which the supplier also
desires. In other words, in a barter system, exchange
can take place only if there is a double coincidence of
wants between two transacting parties. The likelihood of
a double coincidence of wants, however, is small and
makes the exchange of goods and services rather

87 | P a g e
difficult. Money effectively eliminates the double
coincidence of wants problem by serving as a medium
of exchange that is accepted in all transactions, by all
parties, regardless of whether they desire each others'
goods and services.

traditionally used to try to combat unemployment in

a recession by lowering interest rates in the hope that
easy credit will entice businesses into expanding.
Contractionary policy is intended to slow inflation in

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.

Monetary policy

order to avoid the resulting distortions and deterioration

of asset values.

Monetary policy differs from fiscal policy, which refers

to taxation, government spending, and associated
borrowing.[4]

Monetary Policy: Meaning,

Objectives and Instruments
of Monetary Policy
Meaning of Monetary Policy:

Monetary policy refers to the credit control measures

adopted by the central bank of a country.

Johnson defines monetary policy as policy employing

central banks control of the supply of money as an
instrument for achieving the objectives of general

Monetary policy is the process by which the monetary

authority of a country controls the supply of money,
often targeting aninflation rate or interest rate to ensure
price stability and general trust in the currency.[1][2][3]

Further goals of a monetary policy are usually to

economic policy. G.K. Shaw defines it as any

conscious action undertaken by the monetary
authorities to change the quantity, availability or cost of
money.

contribute to economic growth and stability, to

lower unemployment, and to maintain

Objectives or Goals of Monetary Policy:

predictable exchange rates with other currencies.

Monetary economics provides insight into how to craft

The following are the principal objectives of monetary

optimal monetary policy.

policy:

Monetary policy is referred to as either being

1. Full Employment:

expansionary or contractionary, where an expansionary

policy increases the total supply of money in the
economy more rapidly than usual, and contractionary
policy expands the money supply more slowly than
usual or even shrinks it. Expansionary policy is

Full employment has been ranked among the foremost

objectives of monetary policy. It is an important goal not

88 | P a g e
only because unemployment leads to wastage of

variations, open market operations and changing

potential output, but also because of the loss of social

reserve requirements. They are meant to regulate the

standing and self-respect.

overall level of credit in the economy through

commercial banks. The selective credit controls aim at

2. Price Stability:
controlling specific types of credit. They include
One of the policy objectives of monetary policy is to

changing margin requirements and regulation of

stabilise the price level. Both economists and laymen

consumer credit. We discuss them as under:

favour this policy because fluctuations in prices bring

Bank Rate Policy:

uncertainty and instability to the economy.

The bank rate is the minimum lending rate of the central
3. Economic Growth:
bank at which it rediscounts first class bills of exchange
One of the most important objectives of monetary policy

and government securities held by the commercial

in recent years has been the rapid economic growth of

banks. When the central bank finds that inflationary

an economy. Economic growth is defined as the

pressures have started emerging within the economy, it

process whereby the real per capita income of a country

raises the bank rate. Borrowing from the central bank

increases over a long period of time.

becomes costly and commercial banks borrow less from

it.

4. Balance of Payments:
The commercial banks, in turn, raise their lending rates
Another objective of monetary policy since the 1950s
to the business community and borrowers borrow less
has been to maintain equilibrium in the balance of
from the commercial banks. There is contraction of
payments.
credit and prices are checked from rising further. On the
Instruments of Monetary Policy:

contrary, when prices are depressed, the central bank

lowers the bank rate.

The instruments of monetary policy are of two types:

first, quantitative, general or indirect; and second,

It is cheap to borrow from the central bank on the part of

qualitative, selective or direct. They affect the level of

commercial banks. The latter also lower their lending

aggregate demand through the supply of money, cost of

rates. Businessmen are encouraged to borrow more.

money and availability of credit. Of the two types of

Investment is encouraged. Output, employment, income

instruments, the first category includes bank rate

89 | P a g e
and demand start rising and the downward movement of

are adversely affected. In the opposite case, when the

prices is checked.

reserve ratio is lowered, the reserves of commercial

banks are raised. They lend more and the economic

Open Market Operations:

activity is favourably affected.
Open market operations refer to sale and purchase of

Selective Credit Controls:

securities in the money market by the central bank.

When prices are rising and there is need to control

Selective credit controls are used to influence specific

them, the central bank sells securities. The reserves of

types of credit for particular purposes. They usually take

commercial banks are reduced and they are not in a

the form of changing margin requirements to control

position to lend more to the business community.

speculative activities within the economy. When there is

brisk speculative activity in the economy or in particular

Further investment is discouraged and the rise in prices

is checked. Contrariwise, when recessionary forces

sectors in certain commodities and prices start rising,

the central bank raises the margin requirement on them.

start in the economy, the central bank buys securities.

The reserves of commercial banks are raised. They lend

The result is that the borrowers are given less money in

more. Investment, output, employment, income and

loans against specified securities. For instance, raising

demand rise and fall in price is checked.

the margin requirement to 60% means that the pledger

of securities of the value of Rs 10,000 will be given 40%

Changes in Reserve Ratios:

of their value, i.e. Rs 4,000 as loan. In case of recession
This weapon was suggested by Keynes in his Treatise

in a particular sector, the central bank encourages

on Money and the USA was the first to adopt it as a

borrowing by lowering margin requirements.

monetary device. Every bank is required by law to keep

Conclusion:

a certain percentage of its total deposits in the form of a

reserve fund in its vaults and also a certain percentage

For an effective anti-cyclical monetary policy, bank rate,

with the central bank.

open market operations, reserve ratio and selective

control measures are required to be adopted

When prices are rising, the central bank raises the

reserve ratio. Banks are required to keep more with the
central bank. Their reserves are reduced and they lend
less. The volume of investment, output and employment

simultaneously. But it has been accepted by all

monetary theorists that (i) the success of monetary
policy is nil in a depression when business confidence
is at its lowest ebb; and (ii) it is successful against

90 | P a g e
inflation. The monetarists contend that as against fiscal
policy, monetary policy possesses greater flexibility and

controlling the nation's entire money supply

the Government's banker and the bankers'

bank ("lender of last resort")

it can be implemented rapidly.

Central bank

managing the country's foreign

exchange and gold reserves and the Government's
stock register

A central bank, reserve bank, or monetary authority is

an institution that manages a state's currency, money
supply, and interest rates. Central banks also usually
oversee the commercial banking system of their
respective countries. In contrast to a commercial bank,

regulating and supervising the banking

industry

Monetary policy[edit]

a central bank possesses a monopoly on increasing

the monetary base in the state, and usually also prints
[1]

the national currency, which usually serves as the

state's legal tender.

The primary function of a central bank is to control the

nation's money supply (monetary policy), through active
duties such as managing interest rates, setting
the reserve requirement, and acting as a lender of last
resort to the banking sector during times of bank
insolvency or financial crisis. Central banks usually also
have supervisory powers, intended to prevent bank
runs and to reduce the risk that commercial banks and
other financial institutions engage in reckless or
fraudulent behavior. Central banks in most developed
nations are institutionally designed to be independent
from political interference.[2][3] Still, limited control by the
executive and legislative bodies usually exists.[4][5]

Central banks implement a country's chosen monetary

policy.
Currency issuance[edit]

At the most basic level, monetary policy involves

establishing what form of currency the country may
have, whether a fiat currency, gold-backed
currency (disallowed for countries in the International
Monetary Fund), currency board or a currency union.
When a country has its own national currency, this
involves the issue of some form of standardized
currency, which is essentially a form of promissory
note: a promise to exchange the note for "money" under
certain circumstances. Historically, this was often a
promise to exchange the money for precious metals in
some fixed amount. Now, when many currencies are fiat
money, the "promise to pay" consists of the promise to

Activities and responsibilities

accept that currency to pay for taxes.

Functions of a central bank

A central bank may use another country's currency

may include:

either directly in a currency union, or indirectly on a

currency board. In the latter case, exemplified by

implementing monetary policies.

setting the official interest rate used to

the Bulgarian National Bank, Hong Kong and Latvia, the

local currency is backed at a fixed rate by the central
bank's holdings of a foreign currency. Similar to

manage both inflation and the country's exchange

commercial banks, central banks hold assets

rate and ensuring that this rate takes effect via a

(government bonds, foreign exchange, gold, and other

variety of policy mechanisms

financial assets) and incur liabilities (currency

outstanding). Central banks create money by issuing

91 | P a g e
interest-free currency notes and selling them to the

Men are involuntarily unemployed if, in the

public (government) in exchange for interest-bearing

event of a small rise in the price of wage-

assets such as government bonds. When a central bank

goods relatively to the money-wage, both the

wishes to purchase more bonds than their respective

aggregate supply of labour willing to work for

national governments make available, they may

the current money-wage and the aggregate

purchase private bonds or assets denominated in

demand for it at that wage would be greater

foreign currencies.

than the existing volume of employment.

John Maynard Keynes, The General Theory

The European Central Bank remits its interest income to

the central banks of the member countries of the

of Employment, Interest and Money p11

Price stability[edit]

European Union. The US Federal Reserve remits all its

profits to the U.S. Treasury. This income, derived from
the power to issue currency, is referred to
as seigniorage, and usually belongs to the national

Inflation is defined either as the devaluation of

a currency or equivalently the rise of prices
relative to a currency.

government. The state-sanctioned power to create

currency is called the Right of Issuance. Throughout

Since inflation lowers real

history there have been disagreements over this power,

wages, Keynesians view inflation as the

since whoever controls the creation of currency

solution to involuntary unemployment.

controls the seigniorage income. The expression

However, "unanticipated" inflation leads to

"monetary policy" may also refer more narrowly to the

lender losses as the real interest rate will be

interest-rate targets and other active measures

lower than expected. Thus, Keynesian

undertaken by the monetary authority.

monetary policy aims for a steady rate of

Goals[edit]

inflation. A publication from the Austrian

School, The Case Against the Fed, argues that

High employment[edit]

Frictional unemployment is the time period between

jobs when a worker is searching for, or transitioning

the efforts of the central banks to control

inflation have been counterproductive.

Economic growth[edit]

from one job to another. Unemployment beyond

frictional unemployment is classified as unintended
unemployment.

Economic growth can be enhanced by

investment in capital, such as more or better
machinery. A low interest rate implies that

For example, structural unemployment is a form of

unemployment resulting from a mismatch between
demand in the labour market and the skills and
locations of the workers seeking employment.
Macroeconomic policy generally aims to reduce
unintended unemployment.

Keynes labeled any jobs that would be created by a rise

in wage-goods (i.e., a decrease in real-wages)
as involuntary unemployment:

firms can loan money to invest in their capital

stock and pay less interest for it. Lowering the
interest is therefore considered to encourage
economic growth and is often used to
alleviate times of low economic growth. On
the other hand, raising the interest rate is
often used in times of high economic growth
as a contra-cyclical device to keep the
economy from overheating and avoid market
bubbles.

92 | P a g e
Further goals of monetary policy are stability

Interest rates[edit]

of interest rates, of the financial market, and

of the foreign exchange market. Goals
frequently cannot be separated from each
other and often conflict. Costs must therefore
be carefully weighed before policy
implementation.

By far the most visible and obvious power of

many modern central banks is to influence
market interest rates; contrary to popular
belief, they rarely "set" rates to a fixed
number. Although the mechanism differs from
country to country, most use a similar

Policy instruments[edit]

mechanism based on a central bank's ability

to create as much fiat money as required.

The Central Bank of Brazil inBraslia.

The mechanism to move the market towards a

'target rate' (whichever specific rate is used) is

The main monetary policy

generally to lend money or borrow money in

instruments available to central banks

theoretically unlimited quantities, until the

are open market operation, bank reserve

targeted market rate is sufficiently close to the

requirement, interest rate policy, re-lending

target. Central banks may do so by lending

and re-discount (including using the term

money to and borrowing money from (taking

repurchase market), and credit policy (often

deposits from) a limited number of qualified

coordinated with trade policy). While capital

banks, or by purchasing and selling bonds. As

adequacy is important, it is defined and

an example of how this functions, the Bank of

regulated by the Bank for International

Canada sets a target overnight rate, and a

Settlements, and central banks in practice

band of plus or minus 0.25%. Qualified banks

generally do not apply stricter rules.

borrow from each other within this band, but

never above or below, because the central

To enable open market operations, a central

bank will always lend to them at the top of the

bank must hold foreign exchange

band, and take deposits at the bottom of the

reserves (usually in the form of government

band; in principle, the capacity to borrow and

bonds) andofficial gold reserves. It will often

lend at the extremes of the band are unlimited.

have some influence over any official or

[18]

mandated exchange rates: Some exchange

mechanisms.

Other central banks use similar

rates are managed, some are market based

(free float) and many are somewhere in

The target rates are generally short-term rates.

between ("managed float" or "dirty float").

The actual rate that borrowers and lenders

receive on the market will depend on
(perceived) credit risk, maturity and other
factors. For example, a central bank might set
a target rate for overnight lending of 4.5%, but
rates for (equivalent risk) five-year bonds
might be 5%, 4.75%, or, in cases of inverted
yield curves, even below the short-term rate.
Many central banks have one primary
"headline" rate that is quoted as the "central

93 | P a g e
bank rate". In practice, they will have other

A typical central bank has several interest

tools and rates that are used, but only one

rates or monetary policy tools it can set to

that is rigorously targeted and enforced.

influence markets.

"The rate at which the central bank lends

Marginal lending rate (currently 0.30% in

money can indeed be chosen at will by the

the Eurozone[20]) a fixed rate for

central bank; this is the rate that makes the

institutions to borrow money from the

financial headlines." Henry C.K. Liu.

[19]

Liu

central bank. (In the USA this is called

explains further that "the U.S. central-bank

the discount rate).

lending rate is known as the Fed funds rate.

The Fed sets a target for the Fed funds rate,

Main refinancing rate (0.05% in the

which its Open Market Committee tries to

Eurozone[20]) the publicly visible

match by lending or borrowing in the money

interest rate the central bank announces.

market ... a fiat money system set by

It is also known asminimum bid rate and

command of the central bank. The Fed is the

serves as a bidding floor for refinancing

head of the central-bank because the U.S.

loans. (In the USA this is called

dollar is the key reserve currency for

the federal funds rate).

international trade. The global money market

is a USA dollar market. All other currencies

Deposit rate, generally consisting

markets revolve around the U.S. dollar

of interest on reserves and sometimes

market." Accordingly, the U.S. situation is not

also interest on excess reserves (-0.20%

typical of central banks in general.

in the Eurozone[20]) the rates parties

receive for deposits at the central bank.

Typically a central bank controls certain types

of short-term interest rates. These influence

These rates directly affect the rates in the

the stock- and bond markets as well

money market, the market for short term

asmortgage and other interest rates. The

loans.

European Central Bank for example

Open market operations[edit]

announces its interest rate at the meeting of

its Governing Council; in the case of the U.S.
Federal Reserve, the Federal Reserve Board of
Governors. Both the Federal Reserve and the
ECB are composed of one or more central
bodies that are responsible for the main
decisions about interest rates and the size
and type of open market operations, and
several branches to execute its policies. In the
case of the Federal Reserve, they are the local
Federal Reserve Banks; for the ECB they are

Through open market operations, a central

bank influences the money supply in an
economy. Each time it buys securities (such
as agovernment bond or treasury bill), it in
effect creates money. The central bank
exchanges money for the security, increasing
the money supply while lowering the supply of
the specific security. Conversely, selling of
securities by the central bank reduces the
money supply.

the national central banks.

Open market operations usually take the form
of:

94 | P a g e

Buying or selling securities ("direct

preventing indefinite lending: when at the

operations") to achieve an interest rate

threshold, a bank cannot extend another loan

target in the interbank market .

without acquiring further capital on its

balance sheet.

Temporary lending of money

for collateral securities ("Reverse

Reserve requirements[edit]

Operations" or "repurchase operations",

otherwise known as the "repo" market).
These operations are carried out on a
regular basis, where fixed maturity loans
(of one week and one month for the ECB)
are auctioned off.

Historically, bank reserves have formed only a

small fraction of deposits, a system
called fractional reserve banking. Banks
would hold only a small percentage of their
assets in the form of cash reserves as
insurance against bank runs. Over time this

Foreign exchange operations such

as foreign exchange swaps.

process has been regulated and insured by

central banks. Such legal reserve
requirements were introduced in the 19th

All of these interventions can also influence

century as an attempt to reduce the risk of

the foreign exchange market and thus the

banks overextending themselves and

exchange rate. For example, the People's

suffering from bank runs, as this could lead to

Bank of China and the Bank of Japan have on

knock-on effects on other overextended

occasion bought several hundred billions

banks. See also money multiplier.

of U.S. Treasuries, presumably in order to

stop the decline of the U.S. dollar versus
the renminbi and the yen.

As the early 20th century gold standard was

undermined by inflation and the late 20th
century fiat dollar hegemony evolved, and as

Capital requirements[edit]

banks proliferated and engaged in more

complex transactions and were able to profit

All banks are required to hold a certain

from dealings globally on a moment's notice,

percentage of their assets as capital, a rate

these practices became mandatory, if only to

which may be established by the central bank

ensure that there was some limit on the

or the banking supervisor. For international

ballooning of money supply. Such limits have

banks, including the 55 member central banks

become harder to enforce. The People's Bank

of the Bank for International Settlements, the

of China retains (and uses) more powers over

threshold is 8% (see the Basel Capital

reserves because the yuan that it manages is

Accords) of risk-adjusted assets, whereby

a non-convertible currency.

certain assets (such as government bonds)

are considered to have lower risk and are

Loan activity by banks plays a fundamental

either partially or fully excluded from total

role in determining the money supply. The

assets for the purposes of calculating capital

central-bank money after aggregate

adequacy. Partly due to concerns about asset

settlement "final money" can take only one

inflation and repurchase agreements, capital

of two forms:

requirements may be considered more

effective than reserve requirements in

95 | P a g e

physical cash, which is rarely used in

wholesale financial markets,

Public Expenditure: Meaning,

Importance, Classification
and Other Details

central-bank money which is rarely used

by the people

The currency component of the money supply

is far smaller than the deposit component.
Currency, bank reserves and institutional loan
agreements together make up the monetary
base, called M1, M2 and M3. The Federal
Reserve Bank stopped publishing M3 and
counting it as part of the money supply in
2006.[21]
Exchange requirements[edit]

To influence the money supply, some central

banks may require that some or all foreign
exchange receipts (generally from exports) be
exchanged for the local currency. The rate that

Meaning:

Of the two main branches of public finance, namely,

public revenue and public expenditure, we shall first
study the public expenditure. The classical economists
did not analyse in depth the effects of public
expenditure, for public expenditure throughout the
nineteenth century was very small owing to the very
restricted Government activities.

The Governments followed laissez faire economic

policies and their functions were only confined to
defend the country from foreign aggression and to

is used to purchase local currency may be

market-based or arbitrarily set by the bank.

maintain law and order within their territories. But now,

This tool is generally used in countries with

the expenditure of Government all the world over has

non-convertible currencies or partially

convertible currencies. The recipient of the
local currency may be allowed to freely
dispose of the funds, required to hold the
funds with the central bank for some period of
time, or allowed to use the funds subject to

greatly increased. Therefore, the modern economists

have started analysing the effects of public expenditure
on production, distribution and the levels of income and
employment in the economy.

certain restrictions. In other cases, the ability

to hold or use the foreign exchange may be

Importance of Public Expenditure:

otherwise limited.

In this method, money supply is increased by

the central bank when it purchases the foreign
currency by issuing (selling) the local

Thanks to the macroeconomic theory advanced by J.M.

Keynes, the role of public expenditure in the
determination of level of income and its distribution is

currency. The central bank may subsequently

reduce the money supply by various means,

now well recognised. Keynesian macroeconomics

including selling bonds or foreign exchange

provides a theoretical basis for recent developments in

interventions.
public expenditure programmes in the developed
countries.

96 | P a g e
The public expenditure can be used as a lever to raise

classified into revenue expenditure and capital

aggregate demand and thereby to get the economy out

expenditure. Revenue expenditure is a current or

of recession. On the other hand, through variation in

consumption expenditure incurred on civil

public expenditure, aggregate demand can be managed

administration (i.e., police, jails and judiciary), defence

to check inflation in the economy.

forces, public health and education.

Public expenditure can also be used to improve income

This revenue expenditure is of recurrent type which is

distribution, to direct the allocation of resources in the

incurred year after year. On the other hand, capital

desired lines and to influence the composition of

expenditure is incurred on building durable assets. It is

national product. In the developing countries also, the

a non-recurring type of expenditure. Expenditure

role of public expenditure is highly significant.

incurred on building multipurpose river projects,

highways, steel plants etc., and buying machinery and

In the developing countries, the variation in public

equipment is regarded as capital expenditure.

expenditure is not only to ensure economic stability but

also to generate and accelerate economic growth and to

Transfer Payments and Expenditure on Goods and

promote employment opportunities. The public

Services. Another useful classification of public

expenditure policy in developing countries also plays a

expenditure divides it into transfer payments and non-

useful role in alleviating mass poverty existing in them

transfer payments. Transfer payments refer to those

and to reduce inequalities in income distribution. In

kinds of expenditure against which there is no

what follows, we shall study the types of public

corresponding transfer of real resources (i.e., goods and

expenditure, the causes of growth of public expenditure

services) to the Government.

and its effects on production, distribution and economic

growth in both the developed and the developing
countries.

Expenditure incurred on old-age pensions,

unemployment allowance, sickness benefits, interest on
public debt during a year etc., are examples of transfer

Classification of Public
Expenditure:

payments because the Government does not get any

service or goods against them in the particular year.

Revenue Expenditure and Capital Expenditure:

Public expenditure has been classified into various

categories. Firstly, Government expenditure has been

On the other hand, expenditure incurred on buying or

using goods and services is a non-transfer payment as
against such an expenditure, the Government receives

97 | P a g e
goods or services. It is therefore called expenditure on

jails and judiciary), interest on public debt etc., are put

goods and services. It may be noted that expenditure on

into the category of non-development expenditure.

defence, education, health etc., are non-transfer

expenditure as in return for these, Government obtains
the services of army personnel, teachers, doctors etc.,
as well as some goods or equipments used in these
activities.

It may be noted that, till recently, expenditure on

education and health were regarded as nondevelopmental type. It has now been realised that the
expenditure on education and public health promotes
the growth of what is called human capital which

Investments expenditure is undoubtedly non-transfer

promotes economic growth as much as physical capital,

expenditure as through it Government obtains capital

if not more. Therefore, these days, expenditure on

goods. It is worthwhile to mention that whereas in case

education, research and health are generally regarded

of transfer payments, it is the beneficiaries that decides

as developmental expenditure.

about the use of resources, in the case of nontransferable type of expenditure, the Government itself
decides about the use of real resources, especially
whether they are to be used for consumption or
investment purposes.

It is worth noting that division of Government

expenditure into developmental or non-developmental is
the modern counterpart of the distinction drawn by
classical economists between productive and
unproductive public expenditure, which has been a

Developmental and Non-Development Expenditure:

subject of great controversy.

Another useful classification of public expenditure rests

For instance, it has been pointed out that even

on whether a particular expenditure by the Government

Government expenditure on defence and civil

promotes development. All those expenditures of

administration helps to maintain conditions in which

Government which promote economic growth are called

productive activity can be carried out. It is, therefore,

developmental expenditure.

claimed by some that indirectly, expenditure on defence

and civil administration is also productive.

Expenditure on irrigation projects, flood control

measures, transport and communication, capital

Thus, we see that what Government expenditure is

formation in agricultural and industrial sectors are de-

developmental or productive and what non-

scribed as developmental. On the other hand,

developmental or unproductive is not based on any

expenditure on defence, civil administration (i.e., police,

98 | P a g e
objective or fool-proof criteria and is therefore

from economic growth of Germany, this applies equally

somewhat arbitrary.

to other countries, both developed and developing ones.

Growth of Public Expenditure:

Wiseman-Peacock Hypothesis:

Public expenditure has phenomenally increased all the

The second hypothesis about the growth of public

world over. A pertinent question is what the causes of

expenditure has been put forward by Wiseman and

this phenomenal growth are in public expenditure. It will

Peacock in their study of public expenditure of U.K.

be useful to discuss this with reference to India. This is

According to this Wiseman-Peacock hypothesis,

because the factors responsible for a large increase in

Government expenditure does not increase at a steady

public expenditure over time in India are generally

rate continuously but in jerks and step-like manner.

applicable to other countries too. It will be interesting to

mention here two laws about the growth of public

However, in the view of the present author, both these

expenditure.

factors, one making for a continuous increase in

Government activity and consequently public

Wagners Law of Increasing State Activity:

expenditure as emphasised by Wagner and others like

war and depression causing the public expenditure to

First, there is Wagners Law of Increasing State Activity.

rise by jerks as emphasised by Wiseman and Peacock
According to Wagner, a German economist, there are
have been responsible for the enormous increase in
inherent tendencies for the activities of the Government
public expenditure. In what follows, we shall explain the
to increase both extensively and intensively. In other
factors responsible for growth in public expenditure
words, according to this law as an economy develops
with special reference to the Indian economy.
over time, the activities or functions of the Government
increase.

1. Defence:

With the development of the economy, new functions

An important factor responsible for public expenditure

and activities are undertaken by the Government and

is the mounting defence expenditure incurred by

old functions are performed more thoroughly. The

countries all the world over. It is not only during actual

expansion in the Government functions and activities

wars that defence expenditure has been rising but even

leads to the increase in public expenditure. Though

during peace time, the countries have to remain in the

Wanger based his law on the historical evidence drawn

99 | P a g e
state of military preparedness demanding large defence

with the growth of population. Further, when population

expenditure.

increases, more has to be spent on administrative

services (police, jails, judiciary etc.) to maintain law and

There is arms race going on between countries. A poor

order in the country.

country like India has to safeguard its hard earned

freedom and this involves a lot of expenditure on

With the progress of the economy and the growth of

building up efficient and adequate armed forces. India is

population, the extent of urbanisation increases. In

wedged in between two enemies, namely, expansionist

India, the proportion of urban population to the total

China and aggressive Pakistan, which have been

population has raised from 11.3 per cent in 1921 to 25.5

strengthening their armed forces.

per cent in 1991 and to 27.8 per cent in 2001.

India had to fight three wars since independence. India

As a result of the increasing urbanisation, the existing

has thus to remain in a state of military preparedness.

towns expand and the new ones come up. Urbanisation

Internally also in view of clash of linguistic, territorial

calls for greater per capita expenditure on social and

and political interests, lot of expenditure has to be

administrative services. Therefore, the increase in

incurred on maintaining internal security.

urbanisation in India has tended to increase the

government expenditure.

2. Population Growth and Urbanisation:

3. Activities of a Welfare State:
Another factor responsible for the increase in public
expenditure is the growth in population and

The Government activities and functions have been in-

urbanisation of the economies. Population has been

creasing due to the change in the nature of State. The

increasing in almost all countries of the world, though at

modern States are no longer Police States concerned

varying rates.

mainly with the maintenance of law and order. They

have now become Welfare States.

In India the population has been increasing at an

alarming rate since independence. The population of

A Welfare State is one which provides for social

India which was 36 crores in 1951 has now gone upto

insurance of its citizens against old age, sickness,

about 100 crores in 2001. The scale of government

unemployment etc. The modern Governments have

activities such as providing education, public health,

therefore to incur a lot of expenditure on social security

roads and transport facilities has to increase in harmony

100 | P a g e
measures such as old age pensions, unemployment

maintenance of economic stability has become an

allowances, sickness benefits.

important objective of the Government.

4. Maintaining Economic Stability:

It is in line with the objective of employment that in

India, the Government has taken over several private

As pointed out by Wagner, state functions increase with

the advancement and progress of the economy. In the
nineteenth and early twentieth century, the Government

sick mills and incurs a lot of expenditure on them so

that workers employed in them are not rendered
unemployed.

followed laissez-fair policy. Now, need for active

intervention of the Government has been increasingly

Further, the Indian Government, both Central and States,

felt.

incur a lot of expenditure on relief public works in rural

areas when drought and other natural calamities occurs.

Thanks to J.M. Keynes whose macroeconomic theory

clearly brought out that the working of free-market
mechanism does not ensure economic stability at full

Besides, a lot of public expenditure is being incurred on

special employment schemes to promote employment in
the economy.

employment level. According to his theory, lapses from

full employment or depressions are caused by

5. Economic Growth and Development:

deficiency of aggregate demand due to the slackened

private investment activity.

The most important factor in developing countries such

as ours that has led to a phenomenal increase in public

In order to compensate for this shortfall in private

expenditure is the expansion in developmental activities

investment, the Government has to step up its

of the Government. In countries like India which have

expenditure on public works. The increase in

socialistic tendencies the public sector plays an

Government expenditure raises aggregate demand

important role in promoting economic growth and

manifold through the working of what Keynes has called

development.

income multiplier.
Not only public utility services such as water supply,
This helps to push the economy out of depression and

electricity, post and petroleum and transport services

to raise levels of income and employment. Now, this

have been undertaken by the public sector, but also the

compensatory fiscal policy is being followed by all the

Government has invested a huge sum of resources in

world over, since achievement of full employment and

industrial and agricultural development of the economy.

101 | P a g e
Several steel plants, multipurpose irrigation projects,

crores were spent on the interest payments which went

fertilizer factories, coal mining, exploration and

up to Rs. 125.9 crores in 2004-05 by the Central

production of oil and petroleum, different kinds of

Government.

machine-making industries and chemical plants have

been started and are being operated in the public sector.

On these a huge amount of expenditure is being

incurred by the Government in India. Owing to these
developmental activities of the Government in India, the
proportion of developmental expenditure to the total
Government expenditure has greatly increased. In 200304, Central Governments plan expenditure, which is
mainly developmental expenditure, was 122.3 thousand
crores which rose to 137.4 thousand crores in 2004-05.

6. Mounting Debt Service Charges:

7. Mounting Expenditure on Subsidies:

Governments, both in the developed and developing

countries, incur a lot of expenditure on subsidies to the
various sections of population. In India, the Government
has been providing subsidies on food, fertilizers,
exports and education, and expenditure on them has
been increasing at a rapid rate which is the main cause
of large fiscal deficit in India.

For example while in 2002-2003, the Central,

Government expenditure on subsidies was of the order
of Rs. 44.6 thousand crores and for the year 2004-2005 it

The Governments in all developing countries (including

was estimated to go up to Rs. 46.5 thousand crores.

India) has been borrowing heavily in recent years to

finance their increasing activities. Not only the debt
money has to be paid back when it matures, interest
payments have also to be made annually to the
creditors.

The expenditure of Central Governments expenditure

on subsidies on food, fertilizers, exports now account
for about 7 per cent of budget expenditure. While the
aim of giving food subsidy is to help the people below
the poverty line, the aim of fertilizer subsidy is to

These debt service charges have resulted in enormous

promote the growth of agriculture and help small

increase in public expenditure. It should be noted that

farmers.

the Government in India has not only been borrowing

from within the country but also from abroad through
foreign aid or commercial loans from private capital
markets to finance her development plans. It has been
estimated that for the year 1998-99, Rs. 75 thousand

8. Anti-Poverty Schemes:

Another important cause of increasing public

expenditure in India is huge expenditure which he
Government is incurring on employment generating

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anti- poverty schemes. It has now been realised that

and efficiently used, can have a wholesome effect on the

economic growth alone will not eradicate poverty, at

economy.

least in the short run. Therefore, various employment

schemes have been started by the Government for the
people living below the poverty line.

Public expenditure can augment productive capacity of

the economy and improve productivity of its working
class. It can also reduce inequalities in income

Prominent among these anti-poverty schemes in India

distribution, if properly designed. In the following we

are Jawahar Rozgar Yojna, Prime Ministers Employment

shall spell out in detail the impact of public expenditure

Scheme and Integrated Rural Development Scheme

on production and income distribution in the economy.

(IRDP). Expenditure on these schemes has greatly risen

Effect of Public Expenditure

on Production:

in recent years.

Conclusion:

We have seen above that, several factors have been

working to cause increase in public expenditure in all
the economies of the world. Though most of the factors
are common operating all the world over, there are some
additional factors in developing countries like India
which have adopted socialist path to economic
development wherein public sector plays a dominant
role in the process of socio-economic development.
This calls for more rapid growth of public expenditure.

Effects of Public Expenditure on Production and

Distribution:

Having studied the causes of large increase in public

expenditure, it will be useful to explain the effects of
public expenditure on the production and distribution in
the economy. Public expenditure, if properly allocated

It is generally pointed out that all kinds of expenditure

by Government are not productive. For instance,
Government expenditure on defence and civil
administration (police, jail and judiciary) is said to be
unproductive for it does not apparently add to the
volume of production of the economy.

It is true that public expenditure on defence and civil

administration are unproductive directly, but even they
can under certain circumstances in an indirect way
promote production and employment. This will be made
clear a bit later.

Further, the effects of public expenditure on production

may be different in the case of a developed economy
from that of a developing economy, for the
circumstances in them differ a good deal. Let us first
take the case of a developed economy.

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Effect of Public Expenditure

on National Output at Times
of Depression:
Developed economies often find themselves in the grip
of a depression or recession caused by lack of
aggregate effective demand. At certain times in the
developed countries effective demand falls due to the
decline in private investment.

At times of depression in an industrialised developed

economy, there is idle productive capacity on the one
hand and unemployed manpower on the other. Under
these circumstances, the increase in Government
expenditure on public works or any other type of
investment or even expenditure on defence and civil
administration will lead to the manifold increase in
income and employment through the process of
multiplier, as has been explained by J.M. Keynes.

The increase in aggregate demand will cause fuller

utilization of the existing productive capacity and
unemployed manpower resulting in expansion in
volume of production, employment and national income.
This will become clear from Fig. 30.1 where along the Xaxis we measure national product or income and on the
Y-axis aggregate demand which comprises
consumption demand (C) and investment demand (I). It
will be seen from Fig. 30.1 that prior to the Government
expenditure the aggregate demand curve cuts the 45
line representing aggregate supply curve at point E.

Thus OY1 is the equilibrium level of national product or

income determined by aggregate demand and supply.

This equilibrium level may not be established at fullemployment level. Suppose full employment of labour
and other resources corresponds to OY2 level of
national product.

This implies that in equilibrium at OY1, level of income

aggregate demand is not sufficient to ensure full
employment. If under these circumstances the
Government undertakes extra expenditure, say equal to
EH or G. then the aggregate demand curve will shift
upward to C + I + G position (dotted).

As will be seen from the figure the increase in

Government expenditure will cause the equilibrium level
to shift to OY2 level of national product resulting in
higher level of employment. It will be further noticed that
the increase in national output (i.e., income) equal to
Y1Y2 (i.e., AY) will be greater than the Government
expenditure (G) depending upon the magnitude of
multiplier. It may be noted that the magnitude of
multiplier depends upon the marginal propensity to
consume of the people.

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expenditure is directed to scientific research and
development (R & D), it will ensure progress in
technology and raise productivity or power to produce
of workers.

Thirdly, it has now been found that Government

expenditure on education and public health helps in
building human capital which also greatly enhances
productivity or power to produce of the people. Against
these, it may be pointed out that certain types of
Government expenditure may adversely affect
production.
From the foregoing analysis we conclude that the
increase in Government expenditure preferably financed

Government expenditure on social insurance like health

by borrowings from the banks or printing new notes at

insurance, unemployment insurance, and old age

times of depression will raise aggregate demand and

pensions is said to be of such a type. By insuring

thereby lead to the multiple increases in national output

against their future and uncertain contingencies like

and employment. But once the level of full employment

sickness, unemployment and old age, they blunt the

is attained the increase in Government expenditure

edge of the desire to work and save more.

cannot raise production through raising aggregate

The social security expenditure by the Government
demand. Instead, prices will rise.
makes the people indifferent towards the future and
However, even in the developing countries such as India

makes them neglect savings. This is bound to affect

are ways in which government expenditure, if

adversely productive efforts in the present. Because of

judiciously planned, can promote production.

the future security, people will work less and save less.

First, if the Government expenditure is incurred on

However, in our view, if such social security expenditure

investment projects for capital formation, for instance

is kept within proper limits and if it is used to help the

on building of canals, railways, and other infrastructural

really needy and helpless, the adverse effects of social

facilities, it will expand productive capacity and

security expenditure on productive efforts and savings

generate long-term economic growth. Secondly, if public

may be negligible. Further, Government expenditure on

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social security makes the working people contented and

distribution not only through devising proper tax

create healthy social environment and industrial peace

structure but also through various forms of public

which is conducive to production.

expenditure.

Apart from augmenting total production, the

Through public expenditure the Government

Government expenditure also affect allocation of

redistributes income in favour of the poor. Too large

resources as between different industries and can divert

inequalities in income distribution as produced by the

resources to socially desirable channels. Through

free working of market system are not only socially

subsidies and grants and also through its purchase

unjust, but also not conducive to the maximisation of

policy, the Government may succeed in diverting

social output. Not all types of public expenditure reduce

resources to hitherto neglected industries.

inequalities in income distribution. The following forms

of public expenditure redistribute income in favour of

Thus, besides raising the level of production, the

the poor and thus reduce inequalities.

Government expenditure can influence the pattern of

production or composition of output. Likewise, by

1. Social Security Measures:

diverting resources through subsidies and bounties to

the backward regions it can promote growth of output in
backward regions.

Expenditure on unemployment insurance, sickness

benefits, old age pensions is some of the social security
measures which help the people at times of

We thus see that public expenditure, if wisely

contingencies. In India only in recent years some State

conducted, can promote production by raising the levels

Governments such as those of Haryana, Punjab, Delhi

of productivity or powers to produce and save. It can

have introduced old age pension scheme. In capitalist

also cause reallocation of resources between industries

countries such as U.S.A., Great Britain the social

and regions and exert wholesome influence on the

security system to help the people emerged with the

pattern of production work by the Government

idea of a Welfare State and in these countries

undertaken through public enterprises.

Governments spend a large sum of money on the social

Effects of Public Expenditure

on Distribution:

security system.

2. Expenditure on Subsidies:
In the modern times the Government modifies the free
working of market mechanism in respect of income

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Expenditure on various types of subsidies has also a

Similarly, the Governments spend a lot on public

redistributive effect. In India subsidies on food-grain,

hospitals and dispensaries to provide health care to the

sugar, kerosene oil, handloom cloth, fertilizers are

poor people. Likewise, in many countries poor people

provided to the people and Government spend a good

are given financial aid by the Government to build

part of its budget on these subsidies.

houses: In India under Indra Awas Yojna, poor people

are being given aid to build their low cost houses.

Food-grain, sugar, kerosene oil are sold through ration

shops (i.e., public distribution system) at prices below

Expenditure on Anti-Poverty Programmes:

the market prices and the difference is borne by the

Government as a subsidy. It may be noted that at
present benefits of these subsidies are enjoyed not only
by the poor but all those who are relatively well off. If the
public expenditure on subsidies is to have a real
redistributive effect, these subsidies should be targeted
to the poor.

3. Expenditure on Social Infrastructure:

An important step for increasing incomes of the poor

people is starting of several employment generating
anti-poverty schemes. Prominent among these antipoverty schemes in India are Jawahar Rozgar Yojna,
Employment Assistance Scheme (EAS), Integrated Rural
Development Programme (IRDP).

Recently in India, employment guarantee scheme under

National Rural Employment Guarantee Act (NREGA) has

Public expenditure by the Government on social

been started which greatly help the rural poor. By

infrastructure such as education, health care of the

generating employment these schemes raise incomes of

people, housing for the poor also tend to reduce income

the poor.

inequalities. With free or subsidised education, free or

highly subsidised health care facilities the poor peoples
real income go up.

The modern government spends a lot of money on

schools, colleges, etc., to promote education. In most
states in India education upto the middle class is free
and for higher levels wards of the poor people are either
given free education or charged only low fees.

Encouragement to Labour-intensive Industries:

The Indian Government gives various types of subsidies

to the cottage and small-scale Industries which adopt
labour-intensive technique. Being labour-intensive, the
growth of these industries generates a large number of
employment opportunities which improve income
distribution.

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Negative Income Tax to Achieve More Equal Distribution

come and there will be filled by the Government.

of Income:

Likewise, many people save to live comfortably in old

age, in periods of sickness. But when all these difficult

Last but not the least, to achieve more equal distribution

of income and make a big dent into the poverty problem,
a proposal which has been recently put forward by
some economists in the USA and Great Britain is
introduction of negative Income Tax.

Though the name shows it is a tax, but in fact it is a form

of expenditure, called transfer expenditure. In this
negative income tax scheme, payments are made by the
Government to the poor to raise their incomes.

Under this system, the Government has first to define

poverty income standard for families of different sizes.
Then it makes payment in the form of direct money
transfer to bring the incomes of all families upto that
standard or at least to close a large part of the gap
between their income and poverty income standard.

But the use of public expenditure to reduce inequalities

in income distribution has certain bad effects also. The
first and foremost evil effect is that it adversely affects
incentives to work and save of the people. Thus, when
people know that in times of difficulties such as
unemployment, old age, sickness, the Government will
come to their help they will be less willing to work hard.

The poor would not work more when they know

whatever their income, the gap between the minimum in-

periods are taken care of by the Government their

willingness to work more and save more will be badly
hurt. Thus, expenditure to reduce income inequalities
will tend to affect adversely incentives to work, save and
invest more. All these discourage production and
growth.

It is important to note that redistributive effects of public

expenditure must be considered in the light of how it is
financed. For example, if redistributive public
expenditure is financed through taxation and if the tax
system of the country is regressive, it will work against
the desirable distributive effects of public expenditure.

For example, if public expenditure is financed through

deficit financing, as has been the case in India for
several years, it causes inflation in the economy. This
inflation hurts the poor most and will therefore cancel
out the desired distributive effects of public
expenditure. Thus, if reduction in income inequalities
has to be achieved not only the pattern of public
expenditure, but also method of financing it and the
system of taxation has to be suitably designed and
adjusted.

INCIDENCE OF GENERAL
SALES TAX IN PAKISTAN:
I. Introduction

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The tax system of Pakistan can be analyzed from
different perspectives and in various dimensions. It may
be evaluated in terms of economic or administrative
efficiency or with respect to quest for revenue to finance
government expenditures. Nonetheless, equity
implication and redistribution aspect of a tax system
remains an important and integral part for designing tax
policies, especially, in countries where a high
percentage of population lives below the poverty line.
Therefore, the study of tax incidence and the resulting
distribution of tax burden is an important policy issue in
Pakistan. General Sales Tax (GST) dominates the tax
structure1 of Pakistan with a 40 per cent share in the
total tax collected by the Federal Board of Revenue. The
revenue collected from GST is roughly 4 per cent of the
Pakistans GDP and is imposed2 on goods sold
(imported or manufactured) in Pakistan. During the last
decade two studies have been conducted to assess GST
incidence in Pakistan. These studies used the detail
Household Income and Expenditure Survey (HIES) data
for the years 2000-01 and 2004-05 and analyzed the
trends in distribution of GST burden across the tiers of
income distribution. In the methodological perspective,
results of these studies (in terms of tax progressivity)
are based on an average rate of progression by
comparing effective tax rate (ETR) for each income
group. Recently, the Pakistan Bureau of Statistics has
released HIES data for the year 2010-11. Thus, the main
purpose of this research is to update GST incidence by
applying the latest household consumption data.3 The
study also furnishes additional information by
disaggregating results for regions, provinces and
commodity groups. Besides providing graphical
presentation of tax incidence through ETR, Kakwani
Summary Indices are also estimated to observe the
intensity of GST progressivity. Moreover, a sensitivity
analysis is also attempted to observe the impact of
diverse GST rate for expenditure groups on tax burden
or distribution of the tax incidence. The paper is
organized as follows. Data and methodological issues
are briefly discussed in Section II, while relevant
evidence from the earlier studies is provided in Section
III. Next, Section IV furnishes the empirical findings in
terms of overall incidence, distributional impact, intertemporal comparison and Kakwani Summary Indices.
Findings from the simulation exercise are also
discussed in this section. Finally, Section V provides
some concluding remarks. II. Data and Methodology The
tax incident analyses are concerned with the share of
tax paid by different economic groups of the society.
Therefore, the only data necessary is a variable which
defines the economic groups and an estimate of tax
paid on different commodities by each group. The most
common source of data is a nationally representative
household income and the expenditure survey. 74
PAKISTAN JOURNAL OF APPLIED ECONOMICS 2 GST
in its present form was introduced in Pakistan at the
standard rate of 12.5 per cent in 1992. However, for
reducing budget deficit, the rate of GST was raised to 18
per cent in 1995 with a reduced rate of 2 per cent,
introduced to bring small businessmen into the tax net.
The said rate was, however, subsequently reduced to 15

per cent, due to the pressure of the taxpayers. In 1999,

further tax of 3 per cent was introduced on supplies
made by registered persons to unregistered persons. By
2004, GST was administered at the five different rates
i.e., 2 per cent, 15 per cent, 18 per cent, 20 per cent and
23 per cent. Finally, the anomaly of different rates was
removed by introducing a uniform rate of 15 per cent
with effect from July 2004. The said rate was
subsequently increased to 16 per cent in 2007 and 17
per cent in 2009. With effect from July 1, 2011, the rate of
GST was again reduced to 16 per cent. However, in the
Finance Bill 2013-14, an increase of one per cent in GST
was approved by the National assembly. Thus, the GST
rate of 17 per cent is presently applicable on the value of
goods imported into Pakistan and taxable supplies. This
rate is used in computing tax burden in this study. 3 It is
worth to note that the year 2010-11 is characterized with
very low GDP growth rate, high inflation and worst
macroeconomic indicators as compared to the year
2004-05. However, the trends in growth and
macroeconomic indicators are fairly similar to the year
2000-01. The latest available Household Integrated
Economic Survey (HIES) conducted during the year
2010-11 by the Pakistan Bureau of Statistics, was used
in the study. It covers 16,341 households across the four
provinces of Pakistan. HIES is the only national
representative survey which contains detail data on
household consumption and income together with the
data on socio-economic and demographic variables.
HIES data is employed in almost all empirical work on
incidence of consumption tax in Pakistan. Despite the
criticism by Kemal (2003), Gazdar (2000) and Zaidi (1992)
stating that HIES understates the income accrued to the
highest income group and also that poorest households
are inadequately represented or systematically
excluded, particularly those which are homeless. HIES
data is used intensively by academia, development
partners, foreign scholars, and the government, to
determine the welfare status of households, especially
in terms of monetary and multidimensional poverty.
Nonetheless, this issue does not just pertain to HIES but
it is a common observation about large surveys in
general [Refaqat (2008)]. It is also argued that the issue
of understatement or underreporting at both tails is
perhaps not so serious in the context of tax incidence
study as against the studies on poverty and inequality.
Household welfare may be represented by the current
income or expenditure, while the groups are defined by
welfare levels (poor v/s. non-poor, quintiles or deciles of
the welfare distribution, etc). Traditionally, current
income per household or per capita is used in the
majority of tax incidence studies as a welfare indicator.
However, there are concerns for the use of income as a
welfare indicator. Cubero and Hollar (2010) summarized
the problems with income as: 1. It is volatile and subject
to temporary shocks. A survey conducted over a
particular period ignores position of the household
relative to its life cycle. Ideally, the capacity to pay
should be measured relative to permanent or lifetime
income. 2. Certain type of income tends to be underrepresented in surveys, particularly, income from
agriculture, self-employment, professional services, and

109 | P a g e
capital (interest, dividends). 3. Inheritances, transfers,
and family remittances are often poorly captured in
survey-based measures of household income. More
importantly, in an economy where most of the
economically active population is not in a salaried
remuneration class but is either self-employed or work
in farms or other family business; the assessment of
income in a single survey visit to household, like HIES is
not appropriate. Further, in countries where the rate of
tax evasion is very high, people in general have
tendency to understate their income in fear of tax
authorities.4 JAMAL AND JAVED, INCIDENCE OF
GENERAL SALES TAX IN PAKISTAN 75 4 Authors are
grateful to the anonymous referee for pointing out this
reasoning against the use of income as a proxy of
household welfare. Due to these constraints, in using
income as a proxy of household welfare, consumption is
used by number of studies on tax incidence analysis.
Consumption is less volatile than the current income
and might be taken as a reasonable proxy for permanent
income.5 It is also less likely to be under-reported then
income.6 Thus, per capita household expenditure is
preferred in this research as an indicator of the
household welfare. Economic incidence model of tax
studies analyzes the distributional effect of tax system
to evaluate who ultimately bears the burden of tax.
Various measures are suggested in the theoretical and
empirical literature to evaluate distributional impact of
tax. Most of these measures are derived from the social
welfare functions and assumptions about the societys
preference for income equity.7 This paper, however,
focus on the following two widely used measures. One
basic measure of economic incidence of tax is to
evaluate average rate of progression (ARP) which is the
most common measure used to determine tax
progressivity. ARP compares effective tax rate (ETR)
across deciles or quintiles of welfare indicators. A tax
structure is said to be progressive when effective tax
rises and moves up to the scale of welfare. It is
regressive when effective tax falls against rise in the
scale of welfare indicators; and it is proportional when
effective tax rate remain constant across the welfare
levels. The effective tax rate for this study is the GST
paid by a particular decile as a percentage of its total
household expenditure. According to the ability-to-pay
principle, a taxation scheme or tax structure is equitable
if taxpayers are charged according to their ability to pay.
Therefore, based on the principle of ability-to-pay, a
progressive tax would be regarded as being equitable
because those with a greater ability to pay would pay a
higher proportion of their income in the form of
taxation.8 A proportional tax may be regarded as
equitable to the extent that all taxpayers would pay the
same proportion of their income as tax. Thus, higher
income taxpayers would be paying a higher absolute
amount of tax than the lower income taxpayers. 76
PAKISTAN JOURNAL OF APPLIED ECONOMICS 5
Cubero and Hollar (2010) also noted that because
consumption tends to be more evenly distributed than
income in most countries, studies that use consumption
as a welfare measure tend to find that overall taxation,
and consumption-based taxes in particular, are more

progressive than studies that use current income. 6

Ercelan (1991) however argued that similar
understatements in expenditure are also possible and
subsistence expenditure may well involve quasipermanent indebtedness. 7 Most common measures are
tax progressivity, Lorenz and Concentration curves,
Quasi-Gini Coefficient, Kakwani Index, Suits index,
Reynolds-Smolensky (RS) index etc. There are also
other measures of progression. For a description and
mathematical expression of these measures, see
Gemmell and Morrissey (2002). For a comprehensive
discussion regarding numerous structural and
distributional measures of progressivity, see Kiefer
(1984). 8 Alternatively, according to the benefit principle,
a taxation scheme is fair if taxpayers are charged
according to the benefit they receive from the
government services. Even a regressive tax may be
regarded as being fair to the extent that the distribution
of benefit of government services may accrue more to
the lower income taxpayers than to the higher income
taxpayers. Tax progressivity through distribution of ETR
is generally presented graphically to depict the
departures from proportionality. Although, it provides
useful information but it cannot quantify the amount of
redistribution which takes place through a tax system.
Moreover, magnitudes associated with deciles or visual
inspection of progressivity or regressivity (across
regions, territories or type of expenditures) becomes
difficult when there are a number of comparisons to be
made. In such cases, summary indices of progressivity
are useful. Of these, the most widely used is the
Kakwani Index, which is directly related to the graphical
method. The Kakwani Index (K) is defined as twice the
area between a tax concentration curve (quasiGini
coefficient)9 and the Lorenz curve and is calculated as K
= C G, where C is the tax payments concentration
index and G is the Gini coefficient for pre-tax income.
The value of K ranges from 2 to +2; the closer it is to
those extremes, the more regressive or progressive a
tax would be. A tax is progressive if the tax
concentration curve lies below the income curve, in
which case K would be positive. A negative value for K
occurs when the tax curve lies above the pre-tax income
concentration curve and reflects a regressive tax. If the
tax and income curves coincide, K will be zero and
reflects a proportional tax. III. Review of the Pakistans
Empiric A number of studies have been conducted in
Pakistan within the framework of either the progressivity
of tax incidence or the impact of government
expenditure across the income groups. This section
briefly presents the empirical evidences described in the
selected studies. To measure social incidence of indirect
taxes in Pakistan, a comprehensive study was carried
out by Refaqat (2008)10 for the years 1990-91 and 200001. According to the author, the intention of the study
was to analyze, as to how the indirect tax reforms reflect
the policy objectives particularly in the light of equity
and distributional consideration envisaged in the tax
reforms strategy. Results at the national level for (199091) indicate clear progressivity of GST incidence with
small (1.08 to 1.52 per cent) magnitudes of incidence.
However, the study reports that despite exemption of

110 | P a g e
basic food items, GST incidence for 2000- 01 appears to
be at best proportional over majority of the population.
Moreover, magnitudes of GST incidence differed at large
as compared to the year 1990-91 which was mainly due
to the limited scope of GST in this year, and also due to
the pattern of exemptions that clearly favored the poor.
JAMAL AND JAVED, INCIDENCE OF GENERAL SALES
TAX IN PAKISTAN 77 9 The Gini coefficient for a tax
concentration curve is called quasi-Gini coefficient.
Conceptually, a concentration curve and a Lorenz curve
differ in a way that the former plots cumulative shares of
X (e.g., tax payments) with respect to the
deciles/quintiles distribution of Y (e.g., pre-tax
income/expenditure), whereas, the latter represents the
cumulative share of Y with respect to the deciles or
quintiles distribution of Y. 10 Refaqat submitted this as a
thesis for the degree of Doctor of Philosophy, University
of Bath. The study inferred that the rural and urban GST
incidence trend lie very close to each other. The regional
incidence for the year 2000-01 averaged around 4.62 per
cent for the rural areas when compared with 4.80 per
cent for the urban areas. Thus, it appears that the tax
burden or the level of average GST incidence faced in
both regions was quite similar. On an average,
approximately 5 per cent of the households total
expenditure was paid as GST, whereas, in rural areas
only one per cent (4.62/4.8) less than their urban
counterparts was paid. In addition, it was also found
that an overall incidence trend for regional population
appeared to be progressive, i.e., effective tax rose with
level of welfare for both the urban (at least over the
bottom six deciles) and the rural areas. Regarding
disaggregated incidence at commodity level for the year
2000-01, it was concluded that GST on food items,
clothes, fuel and utilities appeared to be regressive. The
author argues that this should not be a surprise; given
their underlying expenditure patterns which show these
to be necessities. On the other hand, GST incidence for
durable items, and POL products, appeared to be
progressive (as these are luxuries). Furthermore, the
incidence trend for tobacco and personal care items
appeared to be proportional for a large segment of
population. From the detailed disaggregated analysis at
commodity and regional levels, the author suggested
that separate analysis provides a very good opportunity
to the policymakers to fine-tune GST exemptions to
safeguard the poor without too much cost to the
exchequer. Based on this work on social incidence of
indirect taxation in Pakistan, Refaqat (2003) used data
from the HIES and derived two IMF working papers and
provided a comprehensive incidence and distributional
analysis of GST in Pakistan. The author imputed
effective tax rates for a detailed list of consumption
items by expenditure deciles and deduced that GST is
somewhat progressive with average effective rate
around 3.49 to 4.19 per cent. Detail categories of
consumption goods were analyzed and it was found that
tax burden on some specific items including cigarettes,
cooking oil, gas, kerosene and electricity is regressive.
Similarly, Refaqat (2005) assessed the welfare impact of
GST reforms on Pakistani households using the two
HIES data sets of 1991 and 2001. The author stated

even though we did not find the GST incidence to be

clearly regressive but our result show these reforms to
be slightly welfare reducing, during the period 19902001. Using the distributional characteristics approach it
also show that taxation of items, such as, vegetable
ghee, sugar and basic fuels, deprived poor people and
their households face similar level of GST tax incidence
as compared to the rich households, despite clear
difference in consumption. It is worth to reproduce the
crux of Refaqats work [(2003), (2005) and (2008)] on
social incidence in Pakistan, wherein it is concluded
that a move from dependence on trade tax revenue to
GST/VAT revenue has made the overall indirect tax
system of Pakistan, a little more progressive. Regarding
GST incidence specifically, it was 78 PAKISTAN
JOURNAL OF APPLIED ECONOMICS asserted: results
have revealed that progressivity of GST pre-reform
(1990-91) incidence was mainly due to the limited scope
of GST/VAT at that time; due to patterns of exemptions
which clearly favored the poor. However, the postreform (2000-01) GST/VAT incidence, despite, focused
on equity and distributional consideration in the
reforms agenda, and it appeared at best to be
proportional. A high level of disaggregation of
incidence to reveal its sensitivity to key commodities
was also carried out. The work indicates: it appears
that post-reforms (2000-01) indirect tax incidences were
sensitive to taxation of key commodities and include
sugar, edible oils, and basic fuel/utilities. Incidentally,
taxation of these commodities also appeared to have a
strong distributional effect on the poor. The results
show that indirect tax system can be made strongly
progressive by exempting these commodities". Wahid
and Wallace (2008) updated the incidence analysis using
HIES data for the year 2004-05. Their work however was
broad-based and estimated incidence distribution of all
major taxes (direct and indirect) in Pakistan. With
respect to GST incidence they deduced that the effective
tax rate was proportional - slightly progressive, and
interestingly, it was found that the distribution of overall
tax burden was progressive. However, this progressivity,
according to the study, was almost exclusive because of
burden of the income tax falling on the top income
group; otherwise, in most households, both direct and
indirect taxes were nearly proportional. The Social
Policy and Develoment Centre (2004) analyzed the
federal taxation in Pakistan and found that all
components of indirect tax system along with the
overall tax system was clearly regressive. Moreover, the
study inferred that if fertilizers and pesticides are
exempted from the GST net, it will make the GST
incidence slightly progressive. However, contrary to the
studies cited above, effective taxation was estimated by
using 1989-90 input-output tables for Pakistan, after
calibrating for the year 2001-02. Shirazi et al. (2001) is
perhaps the only study which was attempted to analyze
redistribution effects of the government taxes as well as
the expenditure across the income groups. They
concluded that in absolute terms, the fiscal system
redistributes small amount to the poor class, as
compared to the rich class. In contrast, lower income
groups received more benefits as compared to their

111 | P a g e
contribution to the national income. The expenditure
and tax burden however was distributed across the
population in an arbitrary way. Thus, the findings were
dubious, especially for the poorest income group. Malik
and Saqib (1989) used the input-output table of 1975-76
and the Household Income and Expenditure Survey
1979 to estimate the tax burden across income groups.
For summarizing the nature of redistribution of income
due to tax, they developed Suite Index which is similar
to the Gini Index of income inequality. They concluded
that over all, the tax system turns out to be slightly
progressive for the country. However, for rural areas, the
system is slightly regressive. Moreover, they concluded
that indirect tax which is a major source of Government
revenue is generally, slightly regressive. JAMAL AND
JAVED, INCIDENCE OF GENERAL SALES TAX IN
PAKISTAN 79 Kazi `(1984) analyzed the inter-sectoral tax
burden for Pakistan. On the basis of sectoral
expenditure and sectoral population, tax burden and tax
allocation were estimated. The results showed the overtaxation of agriculture when compared to the relative
capacity of taxation in each sector. It was also found
that in agriculture sector rich farmers were under-taxed.
One of the study on tax incidence for Pakistan was
conducted byJeetun (1978), wherein the total tax
incidence and total indirect tax burden exhibited either
the slight progressivity or a U-curve pattern (i.e.,
implying redistribution by taking place from the very
poor and the rich towards the middle income class). He
also found that the urban class was burdened with
higher proportion of tax incidence than the rural class.
The study provides detailed disaggregated results
based on incidence of components of the tax system. To
conclude, most studies cited above indicate that
irrespective of the methodology, tax structure and
governance, consumption tax in Pakistan was not
regressive, i.e., effective tax rate did not fall against the
rise in income. The tax rate remained more or less
proportional, that is, constant across the welfare level.
Some progressivity in the tax burden, however, is
reported, especially in the disaggregated analysis in
terms of regions or commodity. Another important
observation highlighted by Refaqat (2008) and Wahid
and Wallace (2008) is that most of the research in
Pakistan remained preoccupied with the tax progression
issues. As a result, issues such as tax evasion,
distributional role of tax exemption of specific
commodity, uniform versus non-uniform GST rate, etc.,
are not addressed at large in the context of Pakistan.

A commercial bank is a profit-based financial institution

that grants loans, accepts deposits, and offers other
financial services, such as overdraft facilities and
electronic transfer of funds.

According to Culbertson,

Commercial Banks are the institutions that make short

make short term bans to business and in the process
create money.

In other words, commercial banks are financial

institutions that accept demand deposits from the
general public, transfer funds from the bank to another,
and earn profit.

Commercial banks play a significant role in fulfilling the

short-term and medium- term financial requirements of
industries. They do not provide, long-term credit, so that
liquidity of assets should be maintained. The funds of
commercial banks belong to the general public and are
withdrawn at a short notice; therefore, commercial
banks prefers to provide credit for a short period of time
backed by tangible and easily marketable securities.
Commercial banks, while providing loans to businesses,
consider various factors, such as nature and size of
business, financial status and profitability of the
business, and its ability to repay loans.

Commercial banks are of three types, which are as

follows:

Commercial Banks: Its

Functions and Types
Commercial banks are the most important components
of the whole banking system.

(a) Public Sector Banks:

Refer to a type of commercial banks that are
nationalized by the government of a country. In public
sector banks, the major stake is held by the
government. In India, public sector banks operate under
the guidelines of Reserve Bank of India (RBI), which is

112 | P a g e
the central bank. Some of the Indian public sector banks
are State Bank of India (SBI), Corporation Bank, Bank of
Baroda, Dena Bank, and Punjab National Bank.

(b) Private Sector Banks:

Refer to a kind of commercial banks in which major part
of share capital is held by private businesses and
individuals. These banks are registered as companies

The functions of commercial banks (as shown in Figure-

with limited liability. Some of the Indian private sector

1) are discussed as follows:

banks are Vysya Bank, Industrial Credit and Investment

(a) Primary Functions:

Corporation of India (ICICI) Bank, and Housing

Refer to the basic functions of commercial banks that

Development Finance Corporation (HDFC) Bank.

include the following:

(i) Accepting Deposits:

(c) Foreign Banks:

Implies that commercial banks are mainly dependent on

Refer to commercial banks that are headquartered in a

public deposits.

foreign country, but operate branches in different

countries. Some of the foreign banks operating in India

There are two types of deposits, which are discussed as

are Hong Kong and Shanghai Banking Corporation

follows:

(HSBC), Citibank, American Express Bank, Standard &

(1) Demand Deposits:

Chartered Bank, and Grindlays Bank. In India, since

Refer to kind of deposits that can be easily withdrawn

financial reforms of 1991, there is a rapid increase in the

by individuals without any prior notice to the bank. In

number of foreign banks. Commercial banks mark

other words, the owners of these deposits are allowed

significant importance in the economic development of

to withdraw money anytime by simply writing a check.

a country as well as serving the financial requirements

These deposits are the part of money supply as they are

of the general public.

used as a means for the payment of goods and services

as well as debts. Receiving these deposits is the main

Functions of Commercial Banks:

function of commercial banks.

Commercial banks are institutions that conduct

business for profit motive by accepting public deposits

(2) Time Deposits:

for various investment purposes.

Refer to deposits that are for certain period of time.

Banks pay higher interest on rime deposits. These

The functions of commercial banks are broadly

deposits can be withdrawn only after a specific time

classified into primary functions and secondary

period is completed by providing a written notice to the

functions, which are shown in Figure-1:

bank.

(3) Advancing Loans:

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Refers to one of the important functions of commercial

(2) General Utility Functions:

banks. The public deposits are used by commercial

Include the following functions:

banks for the purpose of granting loans to individuals

(i) Providing Locker Facilities:

and businesses. Commercial banks grant loans in the

Implies that commercial banks provide locker facilities

form of overdraft, cash credit, and discounting bills of

to its customers for safe keeping of jewellery, shares,

exchange.

debentures, and other valuable items. This minimizes

the risk of loss due to theft at homes.

(b) Secondary Functions:

Refer to crucial functions of commercial banks. The

(ii) Issuing Travelers Checks:

secondary functions can be classified under three

Implies that banks issue travelers checks to individuals

heads, namely, agency functions, general utility

for traveling outside the country. Travelers checks are

functions, and other functions.

the safe and easy way to protect money while traveling.

These functions are explained as follows:

(iii) Dealing in Foreign Exchange:

(1) Agency Functions:

Implies that commercial banks help in providing foreign

Implies that commercial banks act as agents of

exchange to businessmen dealing in exports and

customers by performing various functions, which are

imports. However, commercial banks need to take the

as follows:

permission of the central bank for dealing in foreign

(i) Collecting Checks:

exchange.

Refer to one of the important functions of commercial

banks. The banks collect checks and bills of exchange

(iv) Transferring Funds:

on the behalf of their customers through clearing house

Refers to transferring of funds from one bank to

facilities provided by the central bank.

another. Funds are transferred by means of draft,

telephonic transfer, and electronic transfer.

(ii) Collecting Income:

Constitute another major function of commercial banks.

(3) Other Functions:

Commercial banks collect dividends, pension, salaries,

Include the following:

rents, and interests on investments on behalf of their

(i) Creating Money:

customers. A credit voucher is sent to customers for

Refers to one of the important functions of commercial

information when any income is collected by the bank.

banks that help in increasing money supply. For

instance, a bank lends Rs. 5 lakh to an individual and

(iii) Paying Expenses:

opens a demand deposit in the name of that individual.

Implies that commercial banks make the payments of

various obligations of customers, such as telephone

Bank makes a credit entry of Rs. 5 lakh in that account.

bills, insurance premium, school fees, and rents. Similar

This leads to creation of demand deposits in that

to credit voucher, a debit voucher is sent to customers

account. The point to be noted here is that there is no

for information when expenses are paid by the bank.

114 | P a g e
payment in cash. Thus, without printing additional

b. Involves very simple process of loan granting

money, the supply of money is increased.

c. Requires minimum document and legal formalities to
(ii) Electronic Banking:

pass the loan

Include services, such as debit cards, credit cards, and

Internet banking.

Types of Credit Offered by Commercial Banks:

A commercial bank offers short-term loans to
individuals and organizations in the form of bank credit,

d. Involves good customer relationship management

e. Consumes less time because of modern techniques

and computerization

f. Provides door-to-door facilities

which is a secured loan carrying a certain rate of

interest.

In addition to advantages, the bank loan suffers from

various imitations, which are as follows:

There are various types of bank credit provided by a

commercial bank, as shown in Figure-2:

a. Imposes heavy penalty and legal action in case of

default of loan

b. Charges high rate of interest, if the party fails to pay

the loan amount in the allotted time

c. Adds extra burden on the borrower, who needs to

Bank Loan:

incur cost in preparing legal documents for procuring

Bank loan may be defined as the amount of money

loans

granted by the bank at a specified rate of interest for a

fixed period of time. The commercial bank needs to

d. Affects the goodwill of the organization, in case of

follow certain guidelines to extend bank loans to a

delay in payment

client. For example the bank requires the copy of

Cash Credit:

identity and income proofs of the client and a guarantor

to sanction bank loan. The banks grant loan to clients
against the security of assets so that, in case of default,
they can recover the loan amount. The securities used
against the bank loan may be tangible or intangible,
such as goodwill, assets, inventory, and documents of
title of goods.

Cash credit can be defined as an arrangement made by

the bank for the clients to withdraw cash exceeding their
account limit. The cash credit facility is generally
sanctioned for one year but it may extend up to three
years in some cases. In case of special request by the
client, the time limit can be further extended by the
bank.

The advantages of the bank loan are as follows:

a. Grants loan at low rate of interest

The extension of the allotted time depends on the

consent of the bank and past performance of the client.

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The rate of interest charged by the bank on cash credit

written formalities. The bank charges very low rate of

depends on the time duration for which the cash has

interest on bank overdraft up to a certain time.

been withdrawn and the amount of cash.

The advantages of the bank overdraft are as follows:
The advantages of the cash credit are as follows:

a. Involves no documentation for the extension of

a. Involves very less time in the approval of credit

overdraft amount

b. Involves flexibility as the cash credit can be extended

b. Imposes nominal interest on the overdraft amount

for more time to fulfill the need of the customers.

c. Charges fee only on the amount exceeding the
c. Helps in fulfilling the current liabilities of the

account limit

organization
The disadvantages of the bank overdraft are as follows:
d. Charges interest only on the amount withdrawn by

a. Incurs high cost for the clients, if they fail to pay the

the customer. The interest on cash credit is charged

amount of overdraft for a longer period of time

only on the amount of cash withdrawn from the bank,

not on the total amount of credit sanctioned.

b. Hampers the reputation of the organization, if it fails

to pay the amount of overdraft on time

The cash credit is one of the most important

instruments of short-term financing but it has some

c. Allows the bank to deduct overdraft amount from the

limitations.

customers accounts without their permission

These limitations are mentioned in the following points:

Discounting of Bill:

a. Requires more security for the approval of cash

Discounting of bill is a process of settling the bill of

exchange by the bank at a value less than the face value

b. Imposes very high rate of interest

before maturity date. According to Sec. 126 of

Negotiable Instruments, a bill of exchange is an

c. Depends on the consent of the bank to extend the

unconditional order in writing addressed by one person

credit amount and the time limit

to another, signed by the person giving it, requiring the

person to whom it is addressed to pay on demand or at

Bank Overdraft:
Bank overdraft is the quickest means of the short-term

fixed or determinable future time a sum certain in money

to order or to bearer.

financing provided by the bank. It is a facility in which

the bank allows the current account holders to overdraw

The facility of discounting of bill is used by the

their current accounts by a specified limit. The clients

organizations to meet their immediate need of cash for

generally avail the bank overdraft facility to meet urgent

settling down current liabilities.

and emergency requirements. Bank overdraft is the

most popular form of borrowing and do not require any

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Conditions laid down by the bank for discounting of bill
are as follows:
a. Must be intended to specific purpose

WHY IT MATTERS:
Clearinghouses, acting as middlemen between buyers
and sellers, provide both efficiency and stability to
the financial markets they serve. However, they take on
a high amount of risk because they act as both buyer

b. Must be enclosed with the signature of the two

persons (company, bank or reputed person)

and seller for a brief moment in almost every

transaction. If a buyer fails to pay for the securities he
has purchased, the clearinghouse must seek recovery

c. Must be less than the face value

of the funds or wait for them to become available.

Because the clearinghouse is on the hook if either

d. Must be produced before the maturity period.

Clearinghouse

party defaults on their agreement, they generallywill not

process transactions for traders who take on too much
risk. To mitigate risk, clearinghouses also often require

traders to deposit additional funds into their brokerage

A clearinghouse is an intermediary between buyers and

accounts in order to maintain minimum

sellers of financial instruments.

"margin requirements." These funds ensure that the

HOW IT WORKS (EXAMPLE):

Clearinghouses take the opposite position of each side
of a trade. When two parties agree on theterms of a

clearinghouse will have access to enough funds

to offset losses incurred by traders to get in over their
heads and fail to meet their financial obligations.

transaction, a clearinghouse sits in the middle, acting as

both the buyer and the seller. Clearinghouses exist to
ensure the smooth functioning of financial markets.
Fewer transactions would take place if sellers were

Methods of Credit Control

used by Central Bank

worried that buyers would refuse to pay them, and vice

versa. A clearinghouse ensures that transactions
happen as planned.

The following points highlight the two categories of

methods of credit control by central bank.

For example, if you agree to sell your 100 shares of

Company XYZ to John for $10,000, the clearinghouse
ensures that John is delivered the 100 shares and you
are delivered $10,000. It also records and reports the
transaction to everyone involved. Either way, the
clearinghouse is responsible for ensuring that the
transaction happens in an accurate and timely manner.
Clearinghouses operate in most areas of the business
world. For example, in the futures markets,
clearinghouses ensure that the buyers and sellers fulfill
their obligations related to the futures contract being
traded and oversee the proper delivery of the underlying
instrument. A country'scentral bank (e.g. the Federal
Reserve in the U.S.) acts as a clearinghouse for checks,
interbank payments, foreign exchange transactions, and
other fund transfers in the banking system.

The two categories are: I. Quantitative or General

Methods II. Qualitative or Selective Methods.

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Category # I. Quantitative or General Methods:

and sale not only Government securities but also of

1. Bank Rate Policy:

other proper and eligible securities like bills and

securities of private concerns. When the banks and the

The bank rate is the rate at which the Central Bank of a

private individuals purchase these securities they have

country is prepared to re-discount the first class

to make payments for these securities to the Central

securities.

Bank.

It means the bank is prepared to advance loans on

This gives result in the fall in the cash reserves of the

approved securities to its member banks.

Commercial Banks, which in turn reduces the ability of

create credit. Through this way of working the Central

As the Central Bank is only the lender of the last resort

the bank rate is normally higher than the market rate.

For example:

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:

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 exampleIf the

(i) In the narrow sense, and

Commercial Banks have excessive cash reserves on the

basis of which they are creating too much of credit

(ii) In broad sense.

which is harmful for the larger interest of the economy.

So it will raise the cash reserve ratio which the

In narrow sensethe Central Bank starts the purchase

and sale of Government securities in the money market.
But in the Broad Sensethe Central Bank purchases

Commercial Banks are required to maintain with the

Central Bank.

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This activity of the Central Bank will force the

While Cash Reserve Ratio does not require such type of

Commercial Banks to curtail the creation of credit in the

securities market for the successful implementation.

economy. In this way by raising the cash reserve ratio of

the Commercial Banks the Central Bank will be able to

(3) Open market operations will be successful where

put an effective check on the inflationary expansion of

marginal adjustments in cash reserve are required.

credit in the economy.

But the variable cash reserve ratio method is more
Similarly, when the Central Bank desires that the

effective when the commercial banks happen to have

Commercial Banks should increase the volume of credit

excessive cash reserves with them.

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?

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.

Either variable cash reserve ratio or open market

operations:

The following are the important methods of credit

control under selective method:

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

1. Rationing of Credit.

2. Direct Action.

operations on the following grounds:

3. Moral Persuasion.
(1) Open market operations is time consuming
procedure while cash reserves ratio produces

4. Method of Publicity.

immediate effect in the economy.

5. Regulation of Consumers Credit.
(2) Open market operations can work successfully only
where securities market in a country are well organised

6. Regulating the Marginal Requirements on Security

and well developed.

Loans.

119 | P a g e
1. Rationing of Credit:

3. Moral Persuasion:

Under this method the credit is rationed by limiting the

This method is frequently adopted by the Central Bank

amount available to each applicant. The Central Bank

to exercise control over the Commercial Banks. Under

puts restrictions on demands for accommodations

this method Central Bank gives advice, then request and

made upon it during times of monetary stringency.

persuasion to the Commercial Banks to co-operate with

the Central Bank is implementing its credit policies.

In this the Central Bank discourages the granting of

loans to stock exchanges by refusing to re-discount the

If the Commercial Banks do not follow or do not abide

papers of the bank which have extended liberal loans to

by the advice or request of the Central Bank no gross

the speculators. This is an important method of credit

action is taken against them. The Central Bank merely

control and this policy has been adopted by a number of

was its moral influence and pressure with the

countries like Russia and Germany.

Commercial Banks to prevail upon them to accept and

follow the policies.

2. Direct Action:
4. Method of Publicity:
Under this method if the Commercial Banks do not
follow the policy of the Central Bank, then the Central

In modern times, Central Bank in order to make their

Bank has the only recourse to direct action. This

policies successful, take the course of the medium of

method can be used to enforce both quantitatively and

publicity. A policy can be effectively successful only

qualitatively credit controls by the Central Banks. This

when an effective public opinion is created in its favour.

method is not used in isolation; it is used as a

supplement to other methods of credit control.

Its officials through news-papers, journals, conferences

and seminars present a correct picture of the economic

Direct action may take the form either of a refusal on the

conditions of the country before the public and give a

part of the Central Bank to re-discount for banks whose

prospective economic policies. In developed countries

credit policy is regarded as being inconsistent with the

Commercial Banks automatically change their credit

maintenance of sound credit conditions. Even then the

creation policy. But in developing countries Commercial

Commercial Banks do not fall in line, the Central Bank

Banks being lured by regional gains. Even the Reserve

has the constitutional power to order for their closure.

Bank of India follows this policy.

This method can be successful only when the Central

5. Regulation of Consumers Credit:

Bank is powerful enough and has cordial relations with

the Commercial Banks. Mostly such circumstances are

Under this method consumers are given credit in a little

rare when the Central Bank is forced to resist to such

quantity and this period is fixed for 18 months;

measures.

consequently credit creation expanded within the limit.

This method was originally adopted by the U.S.A. as a

120 | P a g e
protective and defensive measure, there after it has

by members as methods for borrowing and giving in the

been used and adopted by various other countries.

short term, from a few days to simply under a year.

Money

Difference between Capital Market and Money Market

market

comprise

of

negotiable

certificates of deposit (CDs), commercial paper, Bankers

acceptances,

A financial market is a place that unites purchasers and

securities

federal

funds,

U.S.

Treasury

bills,

municipal notes and repurchase agreements (repos).

dealers to exchange monetary resources, for example,

stocks,

securities,

commodities,

currencies

and

Capital Market VS Money Market

derivatives. The motivation behind a financial market is

to set costs for worldwide exchange, raise capital and

Capital Market is recognized from money market on the

exchange liquidity and degree of risk. In spite of the fact

premise of the maturity period, credit instruments and

that there are numerous segments to a financial market,

the foundations:

two of the most generally utilized are capital markets

and money markets.

In this article we will found out about these two

segments of financial market and the differences
between them.

Capital Market

Credit Instruments:

The primary instruments utilized as a part of the capital

market are stocks, debentures, shares, bonds and
securities of the legislature.

The primary credit instruments of the money market are

bills of exchange, call money, insurance advances and

Capital market is for selling and buying of debt and

acceptances.

equity instruments. Capital markets direct investments

and savings between suppliers of capital, for example,

Time period:

retail financial specialists and institutional speculators,

and clients of capital like organizations, government and
people. Capital markets are crucial to the working of an
economy, since capital is a discriminating segment for
creating economy output. Capital markets incorporate
primary markets, where new stock and security issues
and sold to investors, and secondary markets, which

The capital market compact in borrowing and lending of

long term funding which means the time period is more
than one year.

The money market make an agreement for borrowing

and lending of short term funds which shows time
period is one year or less than one year.

exchange existing securities.

Money Market

A section of the money related business in which

budgetary instruments with high liquidity and short
maturities are exchanged. The money market is utilized

Form of credit instruments:

The credit instruments managed for in the capital

market are a larger number of heterogeneous than those
in money market.

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In

money

market

credit

instruments

are

less

heterogeneous and homogeneity exists here.

The fundamental part of capital market is that of giving

capital something to do, ideally to long term, prolific and
secure employment.

Institutions:
The essential part of money market is that of making

The fundamental institutions of the capital market are

adjustment of liquidity.

commercial banks, stock exchanges and nonbank

foundations, for example, mortgage banks, insurance

Connection with Central Bank:

agencies, building social orders, and so forth.

The capital market only undergo with central banks
The central institutions working in the money market

authority, however, indirect connection exists and works

are

with the help of money market.

commercial

banks,

central

banks

acceptance

houses, bill brokers, nonbank budgetary organizations

The money market is intimately and directly connected

and so forth.

with central bank of the nation.

Reason of loan:

Market Regulation:

The capital market accommodates the long term fund

needed by the industrialists and supply fixed capital to

The institutions are not firmly regulated under capital

purchase land, apparatus, and so on.

market.

The money market meets the short term funding needed

Commercial banks are firmly controlled in money

in

market.

business;

it

gives

working

cash-flow

to

the

industrialists.
Conclusion

Risk:
From the above article we come to know that the

In capital market, the risk is more as compare to in

instruments in capital market are stocks, debentures,

money market. The reason behind this is the time

shares, bonds and securities while in money market

period. The maturity of more than one year provides

there are bills of exchange, call money, insurance

more time for default. But, in capital market risk differs

advances and acceptances. In capital market borrowing

both in nature and degree.

and lending is there for long term but it is for short term
in money market. The institutions of the capital market

In money market, risk factor is very small because time

are commercial banks, stock exchanges and nonbank

period is less than one year is given so defaulter have

foundations whereas commercial banks, central banks

less time to default thats way the risk is minimized.

acceptance houses, bill brokers etc are institutions in

money market. The main part of capital market is that of

Essential role:

giving capital something to do and secure employment

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while the part of money market is that of making

A financial adviser doesnt directly lend or borrow for

adjustment of liquidity.

you. They can offer specialist advice on your behalf. It

saves you understanding all the intricacies of the
financial markets and spending time looking for best

Functions and Examples of

Financial Intermediaries

investment.

3. Credit Union.
Definition of financial intermediaries

Credit unions are informal types of banks which provide

facilities for lending and depositing within a particular

A financial intermediary is a financial institution such as

community.

bank, building society, insurance company, investment

bank or pension fund.

4. Mutual funds/ Investment trusts

A financial intermediary offers a service to help an

individual/ firm to save or borrow money. A financial

These are mutual investment schemes. These pool the

intermediary helps to facilitate the different needs of

small savings of individual investors and enable a

lenders and borrowers.

bigger investment fund. Therefore, small investors can

benefit from being part of a larger investment trust. This

For example, if you need to borrow 1,000 you could

enables small investors to benefit from smaller

try to find an individual who wants to lend 1,000. But,

commission rates available to big purchases.

this would be very time consuming and you would find it

Benefits of Financial Intermediaries

difficult to know how reliable the lender was.

Therefore, rather than look for individuals to borrow a

1.

Lower search costs. You dont have to find the

right lenders, you leave that to a specialist.

sum, it is more efficient to go to a bank (a financial

intermediary) to borrow money. The bank raises funds
from people looking to deposit money, and so can afford

2.

Spreading risk. Rather than lending to just one

individual, you can deposit money with a financial

to lend out to those individuals who need it.

intermediary who lends to a variety of borrowers if one

Examples of Financial Intermediaries

1. Insurance Companies

fails, you wont lose all your funds.

3.

Economies of scale. A bank can become

efficient in collecting deposits, and lending. This

If you have a risky investment. You might wish to insure,

enables economies of scale lower average costs. If

against the risk of default. Rather than trying to find a

you had to sought out your own saving, you might have

particular individual to insure you, it is easier to go to an

to spend a lot of time and effort to investigate best ways

insurance company who can offer insurance and help

to save and borrow.

spread the risk of default.

4.
2. Financial Advisers

Convenience of Amounts. If you want to

borrow 10,000 it would be difficult to find someone
who wanted to lend exactly 10,000. But, a bank may

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have 1,000 people depositing 10 each. Therefore, the

Government prepares the budget for fulfilling certain

bank can lend you the aggregate deposits from the bank
and save you finding someone with the exact right sum.
Potential Problems of Financial Intermediaries

There is no guarantee they will spread the risk.

objectives. These objectives are the direct outcome of

governments economic, social and political policies.

The various objectives of government budget are:

Due to poor management, they may risk depositors

money on ill-judged investment schemes.

Poor information. A financial intermediary may

become complacent about spreading the risk and invest
in schemes which lose their depositors money (for

Through the budgetary policy, Government aims to

reallocate resources in accordance with the economic

example, banks buying US mortgage debt bundles,

(profit maximisation) and social (public welfare)

which proved to be nearly worthless precipitating the

priorities of the country. Government can influence

global credit crunch.)

1. Reallocation of Resources:

allocation of resources through:

They rely on liquidity and confidence. To be

profitable, they may only keep reserves of 1% of their

(i) Tax concessions or subsidies:

total deposits. If people lose confidence in the banking

system, there may be a run on the bank as depositors
ask for their money bank. But the bank wont have

To encourage investment, government can give tax

concession, subsidies etc. to the producers. For

sufficient liquidity because they cant recall all their

long-term loans. (This can be overcome to some extent
by a lender of last resort, such as the Central Bank and /
or government)

example, Government discourages the production of

harmful consumption goods (like liquor, cigarettes etc.)
through heavy taxes and encourages the use of Khaki
products by providing subsidies.

Important Objectives of
Government Budget
Some of the important objectives of government budget
are as follows: 1. Reallocation of Resources 2. Reducing
inequalities in income and wealth 3. Economic Stability

(ii) Directly producing goods and services:

If private sector does not take interest, government can

directly undertake the production.

2. Reducing inequalities in income and wealth:

4. Management of Public Enterprises 5. Economic

Growth and 6. Reducing regional disparities.

Economic inequality is an inherent part of every

economic system. Government aims to reduce such
inequalities of income and wealth, through its budgetary

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policy. Government aims to influence distribution of

5. Economic Growth:

income by imposing taxes on the rich and spending

The growth rate of a country depends on rate of saving
more on the welfare of the poor. It will reduce income of
and investment. For this purpose, budgetary policy aims
the rich and raise standard of living of the poor, thus
to mobilise sufficient resources for investment in the
reducing inequalities in the distribution of income.
public sector. Therefore, the government makes various
3. Economic Stability:

provisions in the budget to raise overall rate of savings

and investments in the economy.

Government budget is used to prevent business

fluctuations of inflation or deflation to achieve the
objective of economic stability. The government aims to
control the different phases of business fluctuations
through its budgetary policy. Policies of surplus budget

6. Reducing regional disparities:

during inflation and deficit budget during deflation helps

to maintain stability of prices in the economy.

The government budget aims to reduce regional

disparities through its taxation and expenditure policy

4. Management of Public Enterprises:

There are large numbers of public sector industries

(especially natural monopolies), which are established
and managed for social welfare of the public. Budget is
prepared with the objective of making various
provisions for managing such enterprises and providing
those financial help.

for encouraging setting up of production units in

economically backward regions.

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Table of Contents
Public Finance: Meaning and Concept of Public Finance

Meaning:.............................................1
Historical background.........................1
The Concept of Functional Finance:....4
Vicious Circle of Poverty.....................6
Differences between Public and Private Finance

Importance of Public Finance............10

Mixed Economic System'..................11
Main Principles of Public Expenditure and implications.
Main Causes of Growth of Public Expenditures

11

12

Effects of Public Expenditure in an Economy 15

Introduction.........................................15
5 Canons of Public Expenditure | Principles of Public Expenditure 17
(1) Canons of Maximum Social Benefit:17
(2) Canons of Economy:....................17
(3) Canons of Sanction:.....................17
(4) Canons of Surplus or Balanced Budget:

17

(5) Canons of Flexibility or Elasticity:. . .18

Public Debt.......................................18
Classification of Public Debt..........18
Causes of Increase in Public Debt..19
Purposes of Public Debt....................19
Methods of Debt Redemption.............19
Burden of Public Debt.......................19
Role of Public Borrowing in a Developing Economy
Difficulties of Public Borrowings in UDCs20

20

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Hicks Classification of Public Debts....20
Hansons Classification of Public Debt. 20
Fiscal Policy...................................21
Objectives of Fiscal Policy..............21
Tools of Fiscal Policy / Types of Fiscal Policy 22
Role of Fiscal Policy (Demand Side Effects) 24
Fiscal Policy with Reference to Under-Developed Countries

26

Possible Offsets / Limitations / Critical Evaluation of Fiscal Policy

Fiscal Policy vs. Monetary Policy....28
Monetary Policy.............................28
Fiscal Policy: Meaning, Objectives and Other Information 29
1. Meaning of Fiscal policy..............29
2. Objectives of Fiscal Policy...........30
3. Fiscal Policy for Economic Growth30
The compensatory fiscal policy has two approaches:

31

4. Budgetary PolicyContra-cyclical Fiscal Policy

33

Fiscal Policy........................................37
Types of Fiscal Policies...................38
Effects of Fiscal Policy....................38
Limits of Fiscal Policy.....................39
Impact of Expenditure on Economic Growth in Pakistan 40
What is the Significance of Money in Modern Economic Life?

41

MONEY..............................................42
Quantity theory of money.............42
Keynes, Chicago and Friedman..........42
Problem of the Value of Money......47
The Fishers Quantity Theory of Money (Assumptions and Criticisms) 49
Assumptions of the Theory:.............50
Criticisms of the Theory:.................51
Loans Create Deposits.............53
Monetary Systems.........................53
What is a 'Central Bank'................60
BREAKING DOWN 'Central Bank'.......60

27

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Functions of Central Banks............60
Methods of Credit Control used by Central Bank

61

Category # I. Quantitative or General Methods: 61

Category # II. Qualitative or Selective Method of Credit Control:
How Central Banks Control The Supply Of Money 64
Public Debt: Meaning, Objectives and Problems

66

Meaning:......................................66
Objectives:...................................66
The Burden of Public Debt:.............67
Three Problems:............................67
Limit to Public Debt:.......................69
Assessing the Debt (Optional):........70
Public and Private Debt.................70
Public Revenue...................................71
Adam Smiths Canon of Taxation...72
Other Canons of Taxation..................72
Objectives of Taxation in Developing Economies
Characteristics of A Good Tax System

73

73

Classification of Tax.......................74
Sources of Tax Revenue / Major Types of Tax
Sources from Non-Tax Revenues....75
Direct Tax and Indirect Tax:..............76
Definition and Explanation of Direct Tax:76
Merits of Direct Tax:.......................76
Demerits of Direct Tax:...................76
Indirect Taxes:..................................76
Merits of Indirect Tax:.....................76
Demerits of Indirect Tax:.................76
Types of Taxes:..............................76
(1) Tax:............................................76
Definition and Explanation of Tax:....76
(2) Fee:...........................................77
Definition and Explanation of Fee:....77

74

62

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(3) Price:.........................................77
Definition and Explanation of Price:. .77
(4) Special Assessment:....................77
Definition and Explanation of Special Assessment:

77

Stages of Evolution of Money................77

Types of money.............................78
2. Central bank reserves.................78
3. Commercial bank money.............79
What is Electronic Money..............79
Definition of Barter System:..........79
Guidelines and Recommendations for Barter Exchange Deficits 80
II. Monetary Management Responsibilities of a Trade Exchange

80

Two Types of Deficits.....................80

III. IRTA Recommended Parameters for Exchange and System Deficits
IV. Recommended Methods to Reduce an Exchange Deficit

81

82

V. Conclusion.................................82
Functions of Money.......................82
Monetary policy.............................82
Monetary Policy: Meaning, Objectives and Instruments of Monetary Policy
Meaning of Monetary Policy:...........83
Objectives or Goals of Monetary Policy:83
Instruments of Monetary Policy:.......83
Central bank..................................85
Activities and responsibilities..............85
Functions of a central bank...........85
Monetary policy[edit].........................85
Currency issuance[edit]..................85
Goals[edit]....................................86
Policy instruments[edit]......................87
Interest rates[edit]..........................87
Open market operations[edit]..........88
Capital requirements[edit]...............89
Reserve requirements[edit].............89

83

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Exchange requirements[edit]...........90
Public Expenditure: Meaning, Importance, Classification and Other Details

90

Classification of Public Expenditure:91

Effect of Public Expenditure on Production: 97
Effect of Public Expenditure on National Output at Times of Depression:
Effects of Public Expenditure on Distribution:

97

99

INCIDENCE OF GENERAL SALES TAX IN PAKISTAN: 102

Commercial Banks: Its Functions and Types

105

Cash Credit:.................................109
Clearinghouse.............................110
A clearinghouse is an intermediary between buyers and sellers of financial instruments.
....................................................110
HOW IT WORKS (EXAMPLE):.........110
WHY IT MATTERS:.........................110
Methods of Credit Control used by Central Bank

111

Category # I. Quantitative or General Methods: 111

Category # II. Qualitative or Selective Method of Credit Control:
Difference between Capital Market and Money Market 114
Money Market................................114
Capital Market VS Money Market...114
Functions and Examples of Financial Intermediaries
Examples of Financial Intermediaries116
Benefits of Financial Intermediaries116
Potential Problems of Financial Intermediaries 117
Important Objectives of Government Budget

117

116

112