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PUBLIC SECTOR ECONOMICS

Public sector economics is an area of study that is directly relevant to our everyday
lives. It affects the taxes we pay, the buses and trains on which we travel, the
workers who empty our bins, the gas and electricity delivered to our homes, and
even the water coming out of our taps!

Public sector economics is concerned with justifying the existence of governments

and explaining how they can affect economic activity. It explains how the invisible
hand of the market is tempered by the visible hand of government in the mixed
economy of both private and public sectors adopted by the vast majority of nations.

Traditionally, public-sector economics has been concerned with the study of how
governments can deal with the failure of markets to achieve efficient outcomes.
Possible remedies which are considered include using public expenditure and
taxation, taking some firms into state ownership and introducing regulation. These
are all areas of microeconomic theory, policy and practice.

Roles Played by Public Sector in Indian Economy

Article

Here we detail about the following nine important roles played by public sector in
Indian economy, i.e., (1) Generation of Income, (2) Capital Formation, (3)
Employment, (4) Infrastructure, (5) Strong Industrial Base, (6) Export Promotion
and Import Substitution, (7) Contribution to Central Exchequer, (8) Checking
Concentration of Income and Wealth, and (9) Removal of Regional Disparities.

1. Generation of Income:

Public sector in India has been playing a definite positive role in generating income
in the economy. The share of public sector in net domestic product (NDP) at current
prices has increased from 7.5 per cent in 1950-51 to 21.7 per cent in 2003-04.
Again the share of public sector enterprises only (excluding public administration
and defence) in NDP was also increased from 3.5 per cent in 1950-51 to 11.12 per
cent in 2005-06.

2. Capital Formation:

Public sector has been playing an important role in the gross domestic capital
formation of the country. The share of public sector in gross domestic capital

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formation has increased from 3.5 per cent during the First Plan to 9.2 per cent
during the Eighth Plan. The comparative shares of public sector in the gross capital
formation of the country also recorded a change from 33.67 per cent during the
First Plan to 50 per cent during the, Sixth Plan and then declined to 21.9 per cent in
2005-06.

But the Public sector is not playing a significant role in respect of mobilization of
savings. The share of public sector in gross domestic savings increased from 1.7
per cent of GNP during 1951-56 to only 3.6 per cent during 1980-85. During 1980s,
the share of public sector in gross domestic savings declined from 16.2 per cent in
1980-81 to 7.7 per cent in 1988-89.

In this connection Narottam Shah observed, The failure of the public sector
contributes only 21 per cent of the nations savings; that also in part, through
heavy taxation and semi-fictitious profits of the Reserve Bank. The remaining 79
per cent of the nations savings came from the private sector. Again the share of
public sector in gross domestic savings increased from 4.78 per cent in 1990-91 to
6.61 per cent in 2005-06.

3. Employment:

Public sector is playing an important role in generating employment in the country.

Public sector employments are of two categories, i.e:

(a) Public sector employment in government administration, defence and other

government services and

(b) Employment in public sector economic enterprises of both Centre, State and
Local bodies. In 1971, the public sector offered employment opportunities to about
11 million persons but in 2003 their number rose to 18.6 million showing about 69
per cent increase during this period.

Again in 2003, the public sector offered employment opportunities to 18.6 million
persons which was 69 per cent of the total employment generated in the country as
compared to 71 per cent employment generated in 1991. However, there is
considerable decline in the annual growth rate of employment in the public sector
from 1.53 per cent during 1983-1994 to 0.80 per cent during 1994- 2004.

Moreover, about 69.0 per cent of the total employments are generated in the public
sector. Moreover, at the end of March 2004, about 51.7 per cent of the total
employment (i.e. about 96 lakh) generated in public sector is from Government

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administration, community, social and personal services and the remaining 48.3 per
cent (i.e., nearly 89.7 lakh) of the employment in public sector is generated by
economic enterprises run by the Centre, State and Local Governments.

The maximum number of employment is derived from transport, storage and

communications (28.1 lakh). The public sector manufacturing is the next industry
which generated employment to the extent of 11.1 lakh persons.

4. Infrastructure:

Without the development of infrastructural facilities, economic development is

impossible. Public sector investment on infrastructure sector like power,
transportation, communication, basic and heavy industries, irrigation, education
and technical training etc. has paved the way for agricultural and industrial
development of the country leading to the overall development of the economy as a
whole. Private sector investments are also depending on these infrastructural
facilities developed by the public sector of the country.

5. Strong Industrial base:

Another important role of the public sector is that it has successfully build the
strong industrial base in the country. The industrial base of the economy is now
considerably strengthened with the development of public sector industries in
various fields likeiron and steel, coal, heavy engineering, heavy electrical
machinery, petroleum and natural gas, fertilizers, chemicals, drugs etc.

The development of private sector industries is also solely depending on these

industries. Thus by developing a strong industrial base, the public sector has
developed a suitable base for rapid industrialization in the country. Moreover, public
sector has also been dominating in critical areas such as petroleum products, coal,
copper, lead, hydro and steam turbines etc.

6. Export Promotion and Import Substitution:

Public sector enterprises have been contributing a lot for the promotion of Indias
exports. The foreign exchange earning of the public enterprises rose from Rs. 35
crore in 1965-66 to Rs. 5,831 crore in 1984-85 and then to Rs. 34,893 crore in
2003- 04. Thus, the export performance of the public sector enterprises in India is
quite satisfactory.

The public sector enterprises which played an important role in this regard include
Hindustan Steel Limited, Hindustan Machine Tools (HMT) Limited, Bharat Electronics
Ltd., State Trading Corporation (STC) and Metals and Minerals Trading Corporation.

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Some public sector enterprises have shown creditable records in achieving import
substitution and thereby saved precious foreign exchange of the country. In this
regard mention may be made of Bharat Heavy Electricals Limited (BHEL), Bharat
Electronics Ltd., Indian Oil Corporations, Oil and Natural Gas Commission (ONGC).
Hindustan Antibiotics Ltd. (HAL) etc. which have paved a successful way tor import
substitution in the country.

7. Contribution to Central Exchequer:

The public sector enterprises are contributing a good amount of resources to the
central exchequer regularly in the form of dividend, excise duty, custom duty,
corporate taxes etc. During the Sixth Plan, the contribution of public enterprises to
the central exchequer was to the tune of Rs. 27,570 crore.

Again this contribution has increased from Rs. 7,610 crore in 1980-81 to Rs. 18,264
crore in 1989-90 and then to Rs. 85,445 crore in 2003-04. Out of this total
contribution, the amount of dividend contributed only 2 to 3 per cent of it.

8. Checking Concentration of Income and Wealth:

Expansion of public sector enterprises in India has been successfully checking the
concentration of economic power into the hands of a few and thus are redressing
the problem of inequalities of income and-wealth of the economy. Thus, the public
sector can reduce this problem of inequalities through diversion of profits for the
welfare of the poor people, undertaking measures for labour welfare and also by
producing commodities for mass consumption.

9. Removal of Regional Disparities:

From the very beginning industrial development in India was very much skewed
towards certain big port cities like Mumbai, Kolkata and Chennai. In order to
remove regional disparities, the public sector tried to disperse various units towards
the backward states like Bihar, Orissa, and Madhya Pradesh. Thus, considering all
these foregoing aspects it can be observed that in-spite of showing poor
performance, the public sector is playing dominant role in all-round development of
the economy of the country.

What is 'Welfare Economics'

Welfare economics focuses on the optimal allocation of resources and goods and how the
allocation of these resources affects social welfare. This relates directly to the study of income
distribution and how it affects the common good. Welfare economics is a subjective study that
may assign units of welfare or utility to create models that measure the improvements to
individuals based on their personal scales.

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BREAKING DOWN 'Welfare Economics'

Welfare economics looks at the distribution of resources and how it affects an economy's overall
sense of well-being. With different optimal states existing in an economy in terms of the
allocation of resources, welfare economics seeks the state that will create the highest overall
level of social satisfaction among its members.
Welfare economics uses the perspective and techniques of microeconomics, but they can be
aggregated to make macroeconomic conclusions. Some economists suggest that greater states
of overall social good might be achieved by redistributing incomes in the economy. This models
the theories behind economic, or allocative, efficiency, suggesting that there exists a point
where the social well-being experienced from the allocated resources can hit a maximum, a
point considered to be the most efficient. If that point is reached, the economy is functioning in a
way that any subsequent changes to raise the feelings of well-being in one area would require
the lowering of well-being in another.

Welfare Economics and Public Policy

Issues regarding welfare economics may serve as guides during the creation of public policy.
Welfare economics includes efforts to establish a minimum quality of living expectation within an
area including access to commonly required services and the availability of living-wage jobs or
affordable housing.

Welfare economics works in contrast to capitalist ideals. Government intervention regarding

economic matters is fully rejected in pure capitalism. Focus is instead put in individual choice,
accomplishment and development, as well as the pursuit of personal wealth. The theory behind
capitalism supports that the society will experience an associated benefit through the pursuit of
personal wealth.

Welfare Economics and Utility

"Utility" refers to the perceived value associated with a particular good or service. The perceived
value is intrinsic and relates to whether a buyer feels the amount of value received for a certain
good or service is at least equal to or greater than the amount of funds required to purchase it.
Additionally, it suggests that a certain unit of currency, such as a dollar, has the same perceived
value to an individual as it does to a corporation, regardless of how the income amounts of each
entity differ.

What is an 'Externality'

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An externality is a consequence of an economic activity experienced by unrelated third parties;

it can be either positive or negative. Pollution emitted by a factory that spoils the surrounding
environment and affects the health of nearby residents is an example of a negative externality.
The effect of a well-educated labor force on the productivity of a company is an example of a
positive externality.

BREAKING DOWN 'Externality'

Externalities occur in an economy when the production or consumption of a specific good
impacts a third party that is not directly related to the production or consumption. Externalities,
such as pollution, are one of the main reasons why governments step in with increased
regulations.

Almost all externalities are considered to be technical externalities. These types of externalities
have an impact on the consumption and production opportunities of unrelated third parties, but
the price of consumption does not include the externalities. This makes it so there is a
difference between the gain or loss of private individuals and the aggregate gain or loss of the
society as a whole. Oftentimes the action of an individual or organization results in positive
private gains but detracts from the overall economy. Many economists consider technical
externalities to be market deficiencies. This is why people advocate for government intervention
to curb negative externalities through taxation and regulation.

Positive and Negative Externalities

Most externalities are negative. Pollution, for example, is a well-known negative externality. A
corporation may decide to cut costs and increase profits by implementing new operations that
are more harmful for the environment. The corporation realizes costs in the form of expanding
its operations but also generate returns that are higher than the costs. However, the externality
also increases the aggregate cost to the economy and society, making it a negative externality.
Externalities are negative when the social costs outweigh the private costs.

Some externalities are positive. Positive externalities occur when there is a positive gain on both
the private level and social level. Research and development (R&D) conducted by a company
can be a positive externality. R&D increases the private profits of a company but also has the
added benefit of increasing the general level of knowledge within a society. So, while a
company such as Google profits off of its Maps application, society as a whole greatly benefits

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in the form of a useful GPS tool. Positive externalities have public, or social, returns that are
higher than the private returns.

Labour market
India has emerged as the fastest growing major economy in the world as per the Central
Statistics Organisation (CSO) and International Monetary Fund (IMF). According to the
Economic Survey 2015-16, the Indian economy will continue to grow more than 7 per cent in
2016-17.
The improvement in Indias economic fundamentals has accelerated in the year 2015 with the
combined impact of strong government reforms, RBI's inflation focus supported by benign
global commodity prices.

The economy of India is the seventh-largest economy in the world measured bynominal
GDP and the third-largest by purchasing power parity (PPP).[32] The country is classified as
a newly industrialised country, one of the G-20 major economies, a member of BRICS and
a developing economy with an average growth rate of approximately 7% over the last two
decades.

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Monetary and financial system

What is the difference between a "financial system" and a "monetary system"?

The monetary system is the system that manages and facilitates the provision/printing, flow and
circulation of money and credit. Monetary institutions are therefore the central bank (which
facilitates money provision and manages circulation) and banks (which facilitate the provision
of credit). Monetary variables are the interest rate, deposit rate, inflation rate, etc.

The financial system consists of institutions which partake in the transaction of money for
investment and speculative reasons. Money provided by the monetary system is used in the
financial system to buy and sell financial securities in the capital market (e.g. stocks,
government and corporate bonds) and the money market (e.g. certificates of deposit and
treasury bills), and alternative investment securities (e.g. Mutual funds and real estate).
Institutions that operate within the financial system are insurance companies, stockbrokers,
pension funds, mutual funds, hedge funds, etc. Financial variables are bond yields, stock prices,
futures prices, etc.

The performance and trend of the financial system is tracked by observing financial variables
such as those enumerated above. While the performance and trend of the monetary system is
tracked by observing monetary variables.

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This century, the monetary system and the financial system have merged to move together very
closely. The monetary system provides funds in the form of credit for participants in the
financial system to invest and speculate with. Thus, a badly performing monetary system reflects
as a badly performing financial system. A badly performing financial system prompts the
participants of the monetary system to take action to lift up the financial system. This is because
the financial system is a very large component of the entire economy, and what happens in the
financial system affects the real economy.

What is a 'Financial System'

A financial system is the system that covers financial transactions and the exchange of money
between investors, lender and borrowers. A financial system can be defined at the global,
regional or firm specific level. Financial systems are made of intricate and complex models that
portray financial services, institutions and markets that link depositors with investors.

BREAKING DOWN 'Financial System'

The firm's financial system is the set of implemented procedures that track the financial activities
of the company. On a regional scale, the financial system is the system that enables lenders
and borrowers to exchange funds. The global financial system is basically a broader regional
system that encompasses all financial institutions, borrowers and lenders within the global
economy.
There are multiple components making up the financial system of different levels: Within a firm,
the financial system encompasses all aspects of finances. For example, it would include
accounting measures, revenue and expense schedules, wages and balance sheet verification.
Regional financial systems would include banks and other financial institutions, financial
markets, financial services In a global view, financial systems would include the International
Monetary Fund, central banks, World Bank and major banks that practice overseas lending.

Financial Market Components

Financial systems are strictly regulated because they directly influence financial markets. The
stability of the financial markets plays a crucial role in the monetary protection of consumers.
These financial systems are mostly handled by financial institutions which include commercial
banks, central banks, public banks and cooperative banks. Cooperative banks and development
banks managed by states are also listed under financial institutions that have heavily regulated
financial systems.

Financial systems are not only evident in bank financial institutions. Some institutions have
market brokering, investment and risk pooling services. However, these institutions are non-

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bank financial institutions that are not regulated by a bank regulation firm or agency. Examples
of non-bank financial institutions are companies that offer mutual funds, insurance, and financial
loans. Companies with commodity traders are also considered to be non-bank financial
institutions that have financial systems.

Another component of financial systems are financial markets that trade commodities, securities
and other items that are traded according to general supply and demand. Financial markets
include the primary markets and secondary markets. Primary markets provide avenues for
buyers and sellers to buy and sell stocks and bonds. Secondary markets provide a venue for
investors and traders to purchase instruments that have been previously bought.

Aside from financial institutions and markets, financial systems are also evident in financial
instruments. These financial instruments include cash instruments and derivative instruments.
Cash instruments include loans, deposits and securities. Derivative instruments are financial
instruments that are dependent on an underlying asset's performance.

CENTRAL BANK

What is a 'Central Bank'

A central bank, or monetary authority, is a monopolized and often nationalized institution given
privileged control over the production and distribution of money and credit. In modern
economies, the central bank is responsible for the formulation of monetary policy and the
regulation of member banks.

The central bank of the United States is the Federal Reserve System, or the Fed, which
Congress established with the 1913 Federal Reserve Act.

BREAKING DOWN 'Central Bank'

Central banks are inherently non-market-based or even anticompetitive institutions. Many
central banks, 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 established and
protected by law.

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The critical feature of a central bank distinguishing it from other banks is legal monopoly
privilege for the issuance of bank notes and cash; privately owned 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
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, reserve requirements and
deposit guarantees, among other tools.

The first prototypes for modern central banking were the Bank of England and the Swedish
Riksbank in the 17th century. The Bank of England was the first to acknowledge the role
of lender of last resort. Other early central banks, notably Napoleons Bank of France and
Germany's Reichsbank, were established to finance expensive government military operations.

Central Bank: 7 Most Important Functions of the Central Bank of India

A central bank has been defined in terms of its functions. According to Vera Smith, The primary
definition of central banking is a banking system in which a single bank has either complete
control or a residuary monopoly of note issue. W.A. Shaw defines a central bank as a bank
which control credit.

1. Regulator of Currency:

The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it

circulate as legal tender money. It has its issue department which issues notes and coins to

commercial banks. Coins are manufactured in the government mint but they are put into

circulation through the central bank.

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

Central banks everywhere act as bankers, fiscal agents and advisers to their respective

governments. As banker to the government, the central bank keeps the deposits of the central

and state governments and makes payments on behalf of governments. But it does not pay

interest on governments deposits. It buys and sells foreign currencies on behalf of the

government.

It keeps the stock of gold of the government. Thus it is the custodian of government money and

wealth. As a fiscal agent, the central bank makes short-term loans to the government for a

period not exceeding 90 days. It floats loans, pays interest on them, and finally repays them on

behalf of the government. Thus it manages the entire public debt.

3. Custodian of Cash Reserves of Commercial Banks:

Commercial banks are required by law to keep reserves equal to a certain percentage of both

time and demand deposits liabilities with the central banks. It is on the basis of these reserves

that the central bank transfers funds from one bank to another to facilitate the clearing of

cheques.

Thus the central bank acts as the custodian of the cash reserves of commercial banks and

helps in facilitating their transactions.

4. Custody and Management of Foreign Exchange Reserves:

The central bank keeps and manages the foreign exchange reserves of the country. It is an

official reservoir of gold and foreign currencies. It sells gold at fixed prices to the monetary

authorities of other countries. It also buys and sells foreign currencies at international prices.

Further, it fixes the exchange rates of the domestic currency in terms of foreign currencies.

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5. Lender of the Last Resort:

By granting accommodation in the form of re-discounts and collateral advances to commercial

banks, bill brokers and dealers, or other financial institutions, the central bank acts as the lender

of the last resort.

The central bank lends to such institutions in order to help them in times of stress so as to save

the financial structure of the country from collapse. It acts as lender of the last resort through

discount house on the basis of treasury bills, government securities and bonds at the front

door.

6. Clearing House for Transfer and Settlement:

As bankers bank, the central bank acts as a clearing house for transfer and settlement of

mutual claims of commercial banks. Since the central bank holds reserves of commercial banks,

it transfers funds from one bank to other banks to facilitate clearing of cheques.

7. Controller of Credit:

The most important function of the central bank is to control the credit creation power of

commercial bank in order to control inflationary and deflationary pressures within this economy.

For this purpose, it adopts quantitative methods and qualitative methods. Quantitative methods

aim at controlling the cost and quantity of credit by adopting bank rate policy, open market

operations, and by variations in reserve ratios of commercial banks.

What are 'Monetary Aggregates'

Money aggregates are broad categories that measure the money supply in an economy. In the
United States, the standardized monetary aggregates are labeled M0 (physical paper and coin),
M1 (all of M0plus travelers checks and demand deposits), M2 (all of M1, money market shares
and savings deposits); an aggregate known as M3 (which includes time deposits over $100,000
and institutional funds) has not been tracked by the Federal Reserve since 2006 but is still
calculated broadly by analysts.

BREAKING DOWN 'Monetary Aggregates'

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One additional aggregate is the monetary base (MB), which differs from money supply. The MB
aggregate is not widely observed. It includes not only the total supply of money in circulation but
specifically includes the portion of commercial banks' reserves that are stored within the central
bank.
The Federal Reserve uses money aggregates as a metric for how open-market operations like
trading in Treasury securities or changing the discount rate affect the economy. Investors
and economistsobserve the aggregates closely because they offer a more accurate depiction of
the actual size of a countrys working money supply. Because M1 and M2 data is reported on a
weekly basis, investors are able to measure the money aggregates' rate of change and
monetary velocity overall.

Impact
Studying monetary aggregates can generate a lot of information about the financial stability and
overall health of a country. For example, monetary aggregates that grow at a pace that is too
rapid may cause fear of overinflation if there is a greater amount of money in circulation to be
used on the same amount of goods and services, prices are likely to rise in response which is
a common example of the law of supply and demand. If this occurs, central banking groups are
likely to be forced to raise interest rates or stop the money supply growth in some way.

For decades, monetary aggregates were essential for understanding a nation's economy and
were key in establishing central banking policies in general. The past few decades have
revealed that there is a lower connection between fluctuations in the money supply and
significant metrics like inflation, as well as gross domestic product (GDP) and unemployment.
As of 2016, the central bank's monetary policy is better understood by looking at the amount of
the money the Federal Reserve is releasing into the economy. M2 is still considered to be useful
as an indicator of potential inflation when it is compared to GDP growth.

What is a 'Commercial Bank'

A commercial bank is a financial institution that provides various financial service, such as
accepting deposits and issuing loans. Commercial bank customers can take advantage of a
range of investment products that commercial banks offer like savings accounts and certificates
of deposit. The loans a commercial bank issues can vary from business loans and auto loans to
mortgages.

BREAKING DOWN 'Commercial Bank'

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Commercial banks offer their customers investment products such as savings accounts,
checking accounts and certificates of deposit. Bank customers like such products because in
the United States, they are secured by a government agency, the Federal Deposit Insurance
Corporation (FDIC). In exchange for their money, commercial banks offer their customers
interest on their deposits. The way commercial banks make money is by using their customers'
deposits for loans with interest rates above the rates they pay to depositors. The spread
between what the banks pays out in interest and what it takes in in interest is the bank's net
interest income.
The types of loan a commercial bank can issue vary and a commercial bank may specialize in
just one or a few types of loans. Commercial banks can offer mortgages, which help borrowers
buy homes with the homes as the collateral backing the loans. They can also issue car loans
with automobiles as collateral. Commercial banks also can engage in issuing personal loans,
lines of credit or credit cards. In addition to the interest it earns on its loan book, a commercial
bank can generate revenue by charging its customers fees for mortgages and other banking
services.

Evolution of Commercial Banks

The traditional commercial bank is a brick and mortar institution with tellers, safe deposit boxes,
vaults and ATMs. However, today some commercial banks do not have any physical branches
and require consumers to complete all transactions by phone or Internet. In exchange, such
commercial banks generally pay higher interest rates on investments, deposits and charge
lower fees as they do not have to maintain physical locations and all the ancillary charges that
come along with them such as rent, property taxes and utilities.

Differences with Investment Banks

Commercial banking activities are different than those of investment banking, which include
underwriting, acting as an intermediary between an issuer of securities and the investing public,
facilitating mergers and other corporate reorganizations, and also acting as a broker for
institutional clients. Some commercial banks, such as Citibank and JPMorgan Chase, also
have investment banking divisions, while others, such as Ally, operate strictly on the commercial
side of the business.

Commercial Banks: Primary and Secondary Functions of Commercial Banks!

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(1) Primary Function:

1. Accepting Deposits:

It is the most important function of commercial banks. They accept deposits in several forms

according to requirements of different sections of the society.

The main kinds of deposits are:

(i) Current Account Deposits or Demand Deposits:

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

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

transactions with such deposits.

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

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

running these accounts.

(ii) Fixed Deposits or Time Deposits:

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

period of time.

(iii) Saving Deposits:

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

1. The depositors are given cheque facility to withdraw money from their account. But, some

restrictions are imposed on number and amount of withdrawals, in order to discourage frequent

use of saving deposits.

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2.They carry a rate of interest which is less than interest rate on fixed deposits. It must be noted

that Current Account deposits and saving deposits are chequable deposits, whereas, fixed

deposit is a non-chequable deposit.

2. Advancing of Loans:

The deposits received by banks are not allowed to remain idle. So, after keeping certain cash

reserves, the balance is given to needy borrowers and interest is charged from them, which is

the main source of income for these banks.

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

(i) Cash Credit:

Cash credit refers to a loan given to the borrower against his current assets like shares, stocks,

bonds, etc. A credit limit is sanctioned and the amount is credited in his account. The borrower

may withdraw any amount within his credit limit and interest is charged on the amount actually

withdrawn.

(ii) Demand Loans:

Demand loans refer to those loans which can be recalled on demand by the bank at any time.

The entire sum of demand loan is credited to the account and interest is payable on the entire

sum.

(iii) Short-term Loans:

They are given as personal loans against some collateral security. The money is credited to the

account of borrower and the borrower can withdraw money from his account and interest is

payable on the entire sum of loan granted.

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(2) Secondary Functions:

1. Overdraft Facility:

It refers to a facility in which a customer is allowed to overdraw his current account upto an

agreed limit. This facility is generally given to respectable and reliable customers for a short

period. Customers have to pay interest to the bank on the amount overdrawn by them.

2. Discounting Bills of Exchange:

It refers to a facility in which holder of a bill of exchange can get the bill discounted with bank

before the maturity. After deducting the commission, bank pays the balance to the holder. On

maturity, bank gets its payment from the party which had accepted the bill.

3. Agency Functions:

Commercial banks also perform certain agency functions for their customers. For these

services, banks charge some commission from their clients.

Some of the agency functions are:

(i) Transfer of Funds:

Banks provide the facility of economical and easy remittance of funds from place-to-place with

the help of instruments like demand drafts, mail transfers, etc.

(ii) Collection and Payment of Various Items:

Commercial banks collect cheques, bills, interest, dividends, subscriptions, rents and other

periodical receipts on behalf of their customers and also make payments of taxes, insurance

premium, etc. on standing instructions of their clients.

(iii) Purchase and Sale of Foreign Exchange:

Some commercial banks are authorized by the central bank to deal in foreign exchange. They

buy and sell foreign exchange on behalf of their customers and help in promoting international

trade.

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(iv) Purchase and Sale of Securities:

Commercial banks buy and sell stocks and shares of private companies as well as government

securities on behalf of their customers.

(v) Income Tax Consultancy:

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

their income tax returns.

(vi) Trustee and Executor:

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

death as executors.

(vii) Letters of Reference:

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

similar information about other traders to their customers.

4. General Utility Functions:

Commercial banks render some general utility services like:

(i) Locker Facility:

Commercial banks provide facility of safety vaults or lockers to keep valuable articles of

customers in safe custody.

(ii) Travellers Cheques:

Commercial banks issue travelers cheques to their customers to avoid risk of taking cash

during their journey.

(iii) Letter of Credit:

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

(iv) Underwriting Securities:

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Commercial banks also undertake the task of underwriting securities. As public has full faith in

the creditworthiness of banks, public do not hesitate in buying the securities underwritten by

banks.

(v) Collection of Statistics:

Banks collect and publish statistics relating to trade, commerce and industry. Hence, they

advice customers on financial matters. Commercial banks receive deposits from the public and

use these deposits to give loans. However, loans offered are many times more than the

deposits received by banks. This function of banks is known as Money Creation.

CAPITAL AND DEBT MARKET

DEBT MARKET IS ALSO KNOWS AS DEBT OR CREDIT MARKET

What are 'Capital Markets'

Capital markets are markets for buying and selling equityand debt instruments. Capital markets
channel savings and investment between suppliers of capital such as retail
investors and institutional investors, and users of capital like businesses, government and
individuals. Capital markets are vital to the functioning of an economy, since capital is a critical
component for generating economic output. Capital markets include primary markets, where
new stock and bond issues are sold to investors, andsecondary markets, which trade
existing securities.

BREAKING DOWN 'Capital Markets'

Capital markets are a broad category of markets facilitating the buying and selling of financial
instruments. In particular, there are two categories of financial instruments that capital in which
markets are involved. These are equity securities, which are often known as stocks, and debt
securities, which are often known as bonds. Capital markets involve the issuing of stocks and
bonds for medium-term andlong-term durations, generally terms of one year or more.

Capital markets are overseen by the Securities and Exchange Commission in the United States
or other financial regulators elsewhere. Though capital markets are generally concentrated in

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financial centers around the world, most of the trades occurring within capital markets take
place through computerized electronic trading systems. Some of these are accessible by the
public and others are more tightly regulated.

Other than the distinction between equity and debt, capital markets are also generally divided
into two categories of markets, the first of which being primary markets. In primary markets,
stocks and bonds are issued directly from companies to investors, businesses and other
institutions, often through underwriting. Primary markets allow companies to raise capital
without or before holding aninitial public offering so as to make as much direct profit as
possible. After this point in a companys development, it may choose to hold an initial public
offering so as to generate more liquid capital. In such an event, the company will generally sell
its shares to a few investment banks or other firms.

At this point the shares move into the secondary market, which is where investment banks,
other firms, private investors and a variety of other parties resell their equity and debt securities
to investors. This takes place on the stock market or the bond market, which take place
on exchangesaround the world, like the New York Stock Exchange or NASDAQ; though it is
often done through computerized trading systems as well. When securities are resold on the
secondary market, the original sellers do not make money from the sale. Yet, these original
sellers will likely continue to hold some amount of stake in the company, often in the form of
equity, so the companys performance on the secondary market will continue to be important to
them.

Capital markets have numerous participants including individual investors, institutional investors
such as pension funds and mutual funds, municipalities and governments, companies and
organizations, banks and financial institutions. While many different kinds of groups, including
governments, may issue debt through bonds (these are called government bonds), governments
may not issue equity through stocks. Suppliers of capital generally want the maximum
possible return at the lowest possible risk, while users of capital want to raise capital at the
lowest possible cost.

The size of a nations capital markets is directly proportional to the size of its economy. The
United States, the worlds largest economy, has the largest and deepest capital markets.
Because capital markets move money from people who have it to organizations who need it in

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order to be productive, they are critical to a smoothly functioning modern economy. They are
also particularly important in that equity and debt securities are often seen as representative of
the relative health of markets around the world.

On the other hand, because capital markets are increasingly interconnected in

a globalized economy, ripples in one corner of the world can cause major waves elsewhere.
The drawback of this interconnection is best illustrated by the global credit crisis of 2007-09,
which was triggered by the collapse in U.S. mortgage-backed securities. The effects of this
meltdown were globally transmitted by capital markets since banks and institutions in Europe
and Asia held trillions of dollars of these securities.

Differentiation From 'Money Markets'

People often confuse or conflate capital markets with money markets, though the two are
distinct and differ in a few important respects. Capital markets are distinct from money markets
in that they are exclusively used for medium-term and long-term investments of a year or more.
Money markets, on the other hand, are limited to the trade of
financial instruments with maturities not exceeding one year. Money markets also use different
financial instruments than capital markets do. Whereas capital markets use equity and debt
securities, money markets use deposits, collateral loans, acceptances and bills of exchange.

Because of the significant differences between these two kinds of markets, they are often used
in different ways. Due to the longer durations of their investments, capital markets are often
used to buy assets that the buying firm or investor hopes will appreciate in value over time so as
to generate capital gains, and are used to sell those assets once the firm or investor thinks the
time is right. Firms will often use them in order to raise long-term capital.

Money markets, on the other hand, are often used to general smaller amounts of capital or are
simply used by firms as a temporary repository for funds. Through regularly engaging with
money markets, companies and governments are able to maintain their desired level of liquidity
on a regular basis. Moreover, because of their short-term nature, money markets are often
considered to be safer investments than those made on the equities market. Due to the fact that
longer terms are generally associated with investing in capital markets, there is more time
during which the security in question may see improved or worsened performance. As such,

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equity and debt securities are generally considered to be riskier investments than those made
on the money market.

What is the 'Bond Market'

The bond market also called the debt market or credit market is a financial market in which
the participants are provided with the issuance and trading of debt securities. The bond market
primarily includes government-issued securities and corporate debt securities, facilitating the
transfer of capital from savers to the issuers or organizations requiring capital for government
projects, business expansions and ongoing operations.

BREAKING DOWN 'Bond Market'

In the bond market, participants can issue new debt in the market called the primary market or
trade debt securities in the market called the secondary market. These products are typically in
the form of bonds, but they may also come in the form of bills and notes. The goal of the bond
market is to provide long-term financial aid and funding for public and private projects and
expenditures.

Participants
The participants of the bond market are nearly the same as the participants in other financial
markets. In bond markets, the participants are either buyers of funds (that is, debt issuers) or
sellers of funds (institutions). Participants include institutional investors, traders, governments
and individuals who purchase products provided by large institutions. These projects may be in
the form of pension funds, mutual funds and life insurance, among many other product types.

Types of Bond Markets

The general bond market can be classified into corporate bonds, government and agency
bonds, municipal bonds, mortgage-backed bonds, asset-backed bonds, and collateralized debt
obligations.

Corporate Bond
Corporations provide corporate bonds to raise money for different reasons, such as financing
ongoing operations or expanding businesses. The term "corporate bond" is usually used for
longer-term debt instruments that provide a maturity of at least one year.

Government Bonds

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National governments issue government bonds and entice buyers by providing the face
value on the agreed maturity date with periodic interest payments. This characteristic makes
government bonds attractive for conservative investors.

Municipal Bonds
Local governments and their agencies, states, cities, special-purpose districts, public utility
districts, school districts, publicly owned airports and seaports, and other government-owned
entities issue municipal bonds to fund their projects.

Mortgage Bonds
Pooled mortgages on real estate properties provide mortgage bonds. Mortgage bonds are
locked in by the pledge of particular assets. They pay monthly, quarterly or semi-annual interest.

Bond Indices
Just like the S&P 500 Index or Russell Indexes for equities, bond indices manage and measure
bondportfolio performance. Big names include Barclays Capital Aggregate Bond Index, the
Merrill Lynch Domestic Master and the Citigroup U.S. Broad Investment-Grade Bond Index.
Many bond indices are members of broader indices that may be used to provide and measure
the performances of global bond portfolios.

What is 'Monetary Policy'

Monetary policy consists of the actions of a central bank, currency board or other regulatory
committee that determine the size and rate of growth of the money supply, which in turn affects
interest rates. Monetary policy is maintained through actions such as modifying the interest rate,
buying or selling government bonds, and changing the amount of money banks are required to
keep in the vault (bank reserves).

The Federal Reserve is in charge of the United States' monetary policy.

BREAKING DOWN 'Monetary Policy'

Broadly, there are two types of monetary policy, expansionary and contractionary. Expansionary
monetary policy increases the money supply in order to lower unemployment, boost private-
sector borrowing and consumer spending, and stimulate economic growth. Often referred to as
"easy monetary policy," this description applies to many central banks since the 2008 financial
crisis, as interest rates have been low and in many cases near zero.

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Contractionary monetary policy slows the rate of growth in the money supply or outright
decreases the money supply in order to control inflation; while sometimes necessary,
contractionary monetary policy can slow economic growth, increase unemployment and depress
borrowing and spending by consumers and businesses. An example would be the Federal
Reserve's intervention in the early 1980s: in order to curb inflation of nearly 15%, the Fed raised
its benchmark interest rate to 20%. This hike resulted in a recession, but did keep spiraling
inflation in check.

Central banks use a number of tools to shape monetary policy. Open market operations directly
affect the money supply through buying short-term government bonds (to expand money
supply) or selling them (to contract it). Benchmark interest rates, such as the LIBOR and
the Fed funds rate, affect the demand for money by raising or lowering the cost to borrowin
essence, money's price. When borrowing is cheap, firms will take on more debt to invest in
hiring and expansion; consumers will make larger, long-term purchases with cheap credit; and
savers will have more incentive to invest their money in stocks or other assets, rather than earn
very littleand perhaps lose money in real termsthrough savings accounts. Policy makers
also manage risk in the banking system by mandating the reserves that banks must keep on
hand. Higher reserve requirements put a damper on lending and rein in inflation.

In recent years, unconventional monetary policy has become more common. This category
includesquantitative easing, the purchase of varying financial assets from commercial banks. In
the US, the Fed loaded its balance sheet with trillions of dollars in Treasury
notes and mortgage-backed securitiesbetween 2008 and 2013. The Bank of England,
the European Central Bank and the Bank of Japan have pursued similar policies. The effect of
quantitative easing is to raise the price of securities, therefore lowering their yields, as well as to
increase total money supply. Credit easing is a related unconventional monetary policy tool,
involving the purchase of private-sector assets to boostliquidity. Finally, signaling is the use of
public communication to ease markets' worries about policy changes: for example, a promise
not to raise interest rates for a given number of quarters.

Central banks are often, at least in theory, independent from other policy makers. This is the
case with the Federal Reserve and Congress, reflecting the separation of monetary policy
from fiscal policy. The latter refers to taxes and government borrowing and spending.

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The Federal Reserve has what is commonly referred to as a "dual mandate": to achieve
maximum employment (in practice, around 5% unemployment) and stable prices (2-3%
inflation). In addition, it aims to keep long-term interest rates relatively low, and since 2009 has
served as a bank regulator. Its core role is to be the lender of last resort, providing banks with
liquidity in order to prevent the bank failures and panics that plagued the US economy prior to
the Fed's establishment in 1913. In this role, it lends to eligible banks at the so-called discount
rate, which in turn influences the Federal funds rate (the rate at which banks lend to each other)
and interest rates on everything from savings accounts to student loans, mortgages and
corporate bonds.

Fiscal Policy

Fiscal Policy is the means by which a government adjusts its spending levels and tax rates to
monitor and influence a nation's economy. It is the sister strategy to monetary policy through
which a central bank influences a nation's money supply. These two policies are used in various
combinations to direct a country's economic goals. Here we look at how fiscal policy works, how
it must be monitored and how its implementation may affect different people in an economy.

Before the Great Depression, which lasted from Sept. 4, 1929 to the late 1930s or early 1940s,
the government's approach to the economy was laissez-faire. Following World War II, it was
determined that the government had to take a proactive role in the economy to regulate
unemployment, business cycles, inflation and the cost of money. By using a mix of monetary
and fiscal policies (depending on the political orientations and the philosophies of those in
power at a particular time, one policy may dominate over another), governments are able to
control economic phenomena.

How Fiscal Policy Works

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known
as Keynesian economics, this theory basically states that governments can influence
macroeconomic productivity levels by increasing or decreasing tax levels and public spending.
This influence, in turn, curbs inflation (generally considered to be healthy when between 2-3%),
increases employment and maintains a healthy value of money. Fiscal policy is very important
to the economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous increase
in tax rates and cuts in government spending set to occur in January 2013, would send the U.S.

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economy back to recession. The U.S. Congress avoided this problem by passing the American
Taxpayer Relief Act of 2012 on Jan. 1, 2013.Quantitative Easing is also a type of fiscal policy,
implemented in Europe in several iterations in response to the eurozone debt crisis.

Balancing Act
The idea, however, is to find a balance between changing tax rates and public spending. For
example, stimulating a stagnant economy by increasing spending or lowering taxes runs the risk
of causing inflation to rise. This is because an increase in the amount of money in the economy,
followed by an increase in consumer demand, can result in a decrease in the value of money -
meaning that it would take more money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are up, consumer
spending is down and businesses are not making substantial profits. A government thus
decides to fuel the economy's engine by decreasing taxation, which gives consumers more
spending money, while increasing government spending in the form of buying services from the
market (such as building roads or schools). By paying for such services, the government
creates jobs and wages that are in turn pumped into the economy. Pumping money into the
economy by decreasing taxation and increasing government spending is also known as "pump
priming." In the meantime, overall unemployment levels will fall.

With more money in the economy and fewer taxes to pay, consumer demand for goods and
services increases. This, in turn, rekindles businesses and turns the cycle around from stagnant
to active.

If, however, there are no reins on this process, the increase in economic productivity can cross
over a very fine line and lead to too much money in the market. This excess in supply
decreases the value of money while pushing up prices (because of the increase in demand for
consumer products). Hence, inflation exceeds the reasonable level.

For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not
improbable, means to reach economic goals. If not closely monitored, the line between a
productive economy and one that is infected by inflation can be easily blurred.

And When the Economy Needs to Be Curbed

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When inflation is too strong, the economy may need a slowdown. In such a situation, a
governmentcan use fiscal policy to increase taxes to suck money out of the economy. Fiscal
policy could also dictate a decrease in government spending and thereby decrease the money
in circulation. Of course, the possible negative effects of such a policy in the long run could be
a sluggish economy and high unemployment levels. Nonetheless, the process continues as the
government uses its fiscal policy to fine-tune spending and taxation levels, with the goal of
evening out the business cycles.

Who Does Fiscal Policy Affect?

Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending on the
political orientations and goals of the policymakers, a tax cut could affect only the middle class,
which is typically the largest economic group. In times of economic decline and rising taxation, it
is this same group that may have to pay more taxes than the wealthier upper class.

Similarly, when a government decides to adjust its spending, its policy may affect only a specific
group of people. A decision to build a new bridge, for example, will give work and more income
to hundreds of construction workers. A decision to spend money on building a new space
shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do
much to increase aggregate employment levels.

The Bottom Line

One of the biggest obstacles facing policymakers is deciding how much involvement the
government should have in the economy. Indeed, there have been various degrees of
interference by the government over the years. But for the most part, it is accepted that a
degree of government involvement is necessary to sustain a vibrant economy, on which the
economic well-being of the population depends.

INFLATION

What is 'Inflation'
Inflation is the rate at which the general level of prices for goods and services is rising and,
consequently, thepurchasing power of currency is falling. Central banksattempt to limit inflation,
and avoid deflation, in order to keep the economy running smoothly.

BREAKING DOWN 'Inflation'

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As a result of inflation, the purchasing power of a unit of currency falls. For example, if the
inflation rate is 2%, then a pack of gum that costs $1 in a given year will cost $1.02 the next
year. As goods and services require more money to purchase, the implicit value of that money
falls.

The Federal Reserve uses core inflation data, which excludes volatile industries such as food
and energy prices. External factors can influence prices on these types of goods, which does
not necessarily reflect the overall rate of inflation. Removing these industries from inflation data
paints a much more accurate picture of the state of inflation.

The Fed's monetary policy goals include moderate long-term interest rates, price stability and
maximum employment, and each of these goals is intended to promote a stable financial
environment. The Federal Reserve clearly communicates long-term inflation goals in order to
keep a steady long-term rate of inflation, which in turn maintains price stability. Price stability, or
a relatively constant level of inflation, allows businesses to plan for the future, since they know
what to expect. It also allows the Fed to promote maximum employment, which is determined by
nonmonetary factors that fluctuate over time and are therefore subject to change. For this
reason, the Fed doesn't set a specific goal for maximum employment, and it is largely
determined by members' assessments. Maximum employment does not mean zero
unemployment, as at any given time people there is a certain level of volatility as people vacate
and start new jobs.

Monetarism theorizes that inflation is related to the money supply of an economy. For example,
following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and
especially silver flowed into the Spanish and other European economies. Since the money
supply had rapidly increased, prices spiked and the value of money fell, contributing to
economic collapse.

Historical Examples of Inflation and Hyperinflation

Today, few currencies are fully backed by gold or silver. Since most world currencies are fiat
money, the money supply could increase rapidly for political reasons, resulting in inflation. The
most famous example is the hyperinflation that struck the German Weimar Republic in the early
1920s. The nations that had been victorious in World War I demanded reparations from
Germany, which could not be paid in German paper currency, as this was of suspect value due

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to government borrowing. Germany attempted to print paper notes, buy foreign currency with
them, and use that to pay their debts.

This policy led to the rapid devaluation of the German mark, and with it, hyperinflation. German
consumers exacerbated the cycle by trying to spend their money as fast as possible, expecting
that it would be worth less and less the longer they waited. More and more money flooded the
economy, and its value plummeted to the point where people would paper their walls with the
practically worthless bills. Similar situations have occurred in Peru in 1990 and Zimbabwe in
2007-2008.

Inflation and the 2008 Global Recession

Central banks have tried to learn from such episodes, using monetary policy tools to keep
inflation in check. Since the 2008 financial crisis, the U.S. Federal Reserve has kept interest
rates near zero and pursued a bond-buying program now discontinued known
as quantitative easing. Some critics of the program alleged it would cause a spike in inflation in
the U.S. dollar, but inflation peaked in 2007 and declined steadily over the next eight
years. There are many, complex reasons why QE didn't lead to inflation or hyperinflation,
though the simplest explanation is that the recession was a strong deflationary environment,
and quantitative easing ameliorated its effects.

Inflation in Moderation: Harms and Benefits

While excessive inflation and hyperinflation have negative economic consequences, deflation's
negative consequences for the economy can be just as bad or worse. Consequently, policy
makers since the end of the 20th century have attempted to keep inflation steady at 2% per
year. The European Central Bank has also pursued aggressive quantitative easing to counter
deflation in the Eurozone, and some places have experienced negative interest rates, due to
fears that deflation could take hold in the eurozone and lead to economic stagnation. Moreover,
countries that are experiencing higher rates of growth can absorb higher rates of
inflation. India's target is around 4%,Brazil's 4.5%.

Real World Example of Inflation

Inflation is generally measured in terms of a consumer price index (CPI), which tracks the prices
of a basket of core goods and services over time. Viewed another way, this tool measures the
"real"that is, adjusted for inflationvalue of earnings over time. It is important to note that the

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components of the CPI do not change in price at the same rates or even necessarily move the
same direction. For example, the prices of secondary education and housing have been
increasing much more rapidly than the prices of other goods and services; meanwhile fuel
prices have risen, fallen, risen again and fallen againeach time very sharplyin the past ten
years.

Inflation is one of the primary reasons that people invest in the first place. Just as the pack of
gum that costs a dollar will cost $1.02 in a year, assuming 2% inflation, a savings account that
was worth $1,000 would be worth $903.92 after 5 years, and $817.07 after 10 years, assuming
that you earn no interest on the deposit. Stuffing cash into a mattress, or buying a tangible asset
like gold, may make sense to people who live in unstable economies or who lack legal recourse.
However, for those who can trust that their money will be reasonably safe if they make
prudent equity or bond investments, this is arguably the way to go.

There is still risk, of course: bond issuers can default, and companies that issue stock can go
under. For this reason it's important to do solid research and create a diverse portfolio. But in
order to keep inflation from steadily gnawing away at your money, it's important to invest it in
assets that can be reasonably be expected to yield at a greater rate than inflation.

PHILIPS CURVE

What is the 'Phillips Curve'

The Phillips curve is an economic concept developed by A. W. Phillips showing
that inflation andunemployment have a stable and inverse relationship. The theory states that
with economic growthcomes inflation, which in turn should lead to more jobs and less
unemployment. However, the original concept has been somewhat disproven empirically due to
the occurrence of stagflation in the 1970s, when there were high levels of both inflation and
unemployment.

BREAKING DOWN 'Phillips Curve'

The concept behind the Phillips curve states the change in unemployment within an economy
has a predictable effect on price inflation. The inverse relationship between unemployment and
inflation is depicted as a downward sloping, concave curve, with inflation on the Y-axis and

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unemployment on the X-axis. Increasing inflation decreases unemployment, and vice versa.
Alternatively, a focus on decreasing unemployment also increases inflation, and vice versa.

The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and
initiate the following effects. Labor demand increases, the pool of unemployed workers
subsequently decreases and companies increase wages to compete and attract a smaller talent
pool. The corporate cost of wages increases and companies pass along those costs to
consumers in the form of price increases.

This belief system caused many governments to adopt a "stop-go" strategy where a target
rate of inflation was established, and fiscal and monetary policies were used to expand or
contract the economy to achieve the target rate. However, the stable trade-off between inflation
and unemployment took a turn in the 1970s with the rise of stagflation, calling into question the
validity of the Philips curve.

The Phillips curve shows the inverse relationship between inflation and unemployment: as
unemployment decreases, inflation increases.

KeyPoint

The relationship between inflation rates and unemployment rates is inverse. Graphically, this means
the short-run Phillips curve is L-shaped.

A.W. Phillips published his observations about the inverse correlation between wage changes and
unemployment in Great Britain in 1958. This relationship was found to hold true for other industrial
countries, as well.

From 1861 until the late 1960's, the Phillips curve predicted rates of inflation and rates of

unemployment. However, from the 1970's and 1980's onward, rates of inflation and unemployment

differed from the Phillips curve's prediction. The relationship between the two variables became unstable.

TERMS

stagflation
Inflation accompanied by stagnant growth, unemployment, or recession.
Phillips curve
A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in
an economy.

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The Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve

argues that unemployment and inflation are inversely related: as levels of unemployment

decrease, inflation increases. The relationship, however, is not linear. Graphically, the short-run

Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation

rate is on the y-axis .

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