CHAPTER ONE Both inflow and expenditure are integral parts

of any functional economy. They tend to come

CIRCULAR FLOW OF INCOME in handy for analysing the performance of an
economy and further help to formulate
effective strategies for different economic
The circular flow of income is about how sectors. It must also be noted that the circular
money gets paid around in the economy. There flow of money creates a link between
are two main types of actors in this flow. There consumers and producers and helps create
are businesses, which produce goods and functional market networks.
services, employ people to work for them, pay On that note, let’s find out more about the
wages on their behalf and charge customers for circular flow of income in an economy from
the things they sell. There are the households, below.
which consume goods and services, employ
people to work for them, provide wages to What is Circular Flow of
those people from their incomes and who have
Income?
money left over from their budgets after they
have bought what they need. We will be The circular flow of income can be explained
looking at how these flows go around in a as a functional economic model which
simple circular flow diagram later on in this represents how money flows through the
article. different sectors in an economy. It depicts how
produced goods and services, income and
Identifiable Expenditure expenditure tend to flow in an economy. One
Approach can explain the circular flow of income and
expenditure with three types of economy,
This first step considers how households spend namely – two-sector economy, three-sector
their money. A large part of household economy and four-sector economy.
spending is on things that are made by Typically, there are 3 phases of the circular
businesses, for example, houses, cars and flow of income in a simple economy or closed
furniture. These are the 'identifiable economy –
expenditure items'. Some of these goods are
called 'final' because they are finished products 1. Production Phase: It is primarily
that aren't used again to make anything else. concerned with income generation.
For example, when you buy a car, it is finished 2. Income Phase: It includes movement of
and can't be used to produce any other goods. factor income like rent, wage, interest
Another household spending is on things that and profits from production firms to
are called 'intermediate' because they are used households.
to produce other things. For example, when 3. Expenditure Phase: In this phase, the
you buy coal, it is an intermediate good income generated through factors of
because it is used to produce electricity. The production is spent mostly on goods and
calculation of national income takes into services which are produced by firms.
account only final goods. It does this by
looking at how much money is spent on each Notably, there are several factors of production
type of good. and consumption like labour, capital,
enterprise, rent, wage, interest and profit, services that generate income by supplying the
which tend to affect the circular flow of same to households within the economy.
money. Also, there are different types of the
circular flow of economic activity one should In simple words, the circular flow of income in
become aware of. a two-sector economy can be defined as the
flow of money and receipt of goods, services
and factor services between business firms and
Types of Circular Flow of households.
Income
Generally, they are of 4 types –
1. Real Flow: It indicates the movement of
factor services from households in an
economy to its business units. It also
shows the movement of goods and
services from business units to households
of an economy.
2. Money Flow: It indicates the movement
of money from different economic sectors
in terms of factor payments for availing
factor services. Take a look at this diagram above to
3. Injections: In practice, money is understand the functioning circular flow of
introduced into an economy for firms and income in a two-sector economy effectively.
households borrowing from financial Here, the outer flow indicates the monetary
institutions. flow, while the inner flow indicates the real
4. Leakages: Typically, indicates the flow of income. In turn, it indicates that the
withdrawal of money from the flow. expenses incurred by the household sector
emerge as an income source for the business
On that note, let’s take a close look at how firms and vice versa. Hence, it can be said that-
money flows in a two-sector economy.
Money received by producers = Household
earnings = Households’ expenses on
consumptions.
Circular Flow of Income: In a
Two-Sector Economy
However, such a model is based on some
Notably, it is a hypothetical concept, where the assumptions to make it more practical. Such
economy comprises only two sectors, namely, assumptions which as follow –
households and business firms. In such a setup,
the households serve as a source of factors, and 1. There are 2 sectors in the economy, i.e.
they generate income by providing factor business firms and households.
services to business firms. On the other hand, 2. The economic activities are free from
business firms serve as a provider of goods and government intervention.
 3. It is a closed economy, where business Expenditure method of national income
firms do not participate in import and formula = C + G + I + NX
export.
3. Value Added Method
Test Your Knowledge: Can you name all the
sectors in the circular flow of income in a four In this method, the main emphasis is laid upon
sector economy? value-added to any given product at each
production stage. One needs to factor in the
value of all goods and services produced by all
firms in every industry in the economy.
What are the Methods of
Calculating National Income? Value-added method formula = (NDPFC) +
Net factor income from abroad
There are 3 methods to compute national
income – It must be noted that here, NDPFC is the net
domestic income of an economy.
1. Income Method
Models (Forms) of Circular Flow of
In the case of the income method of calculating
national income, the primary emphasis is on National Income and its Significance
production factors such as land, labour, capital
and enterprise. It also factors in income Four models (Forms) of circular flow of national
income and its significance are:
through rent, salaries, interest, wages and
profits. Notably, it excludes transfer payment, (a) Circular Flow of Income in a Two Sector
lottery, profit tax and sale of second-hand Economy (b) Introduction of Capital Market
goods. (Financial system) (c) Introduction of Government
Sector (Circular Flow of income in a three sector
Formula of income method of national income economy) (d) Introduction of External Sector
= Rent + Wages + Interest + Profit + Mixed (Circular flow of income in a four sector
Income. economy).

The structure of macro economy is given by the

2. Expenditure Method circular flows of income and output. National
income accounting has its foundation in the model
In this expenditure method of calculating of circular flow.
national income, the main focus is on the
expenses of residents, business firms or the Circular flow of income can be depicted in two
government. It is inclusive of the following – sectors (Households and Firm), three sectors
(Households, Firm and Government) and four
1. Goods and services purchased by sectors (Households, Firm, Government and Rest
households (C) of the World) models. Let us first start with two
2. Expenses of business firms (I) sector model.
3. Government expenses (G)
4. Net exports (NX)
(a) Circular Flow of Income in a Two
Sector Economy:

Let us start with a simplified model involving two

sectors, namely, household sector and firm sector,
assuming that there is no government. We further
assume that the economy is a closed one having no
exports or Imports. Similarly, there is no saving by
the households, who spend all what they earn; and
no investment by the firms.

Such an economy has two types of markets—

Product Market and Factor Market. Under these
presumptions, the firm sector hires factor services
from households who are owners of factors of (b) Introduction of Capital Market
production (land, labour, capital and enterprise) for (Financial system):
producing goods and services and pays them
remuneration (or compensation) in the form of We now drop the above- mentioned assumptions
money for rendering the productive services. one by one and move a step further by bringing in
the role of capital market consisting of financial
For the factors of production, these are factor institutions. Financial institutions are primary
incomes known as rent, wages, interest and profit intermediaries between savers and investors (or
which have been generated in the production lenders and borrowers). All lendings and
process. Thus, money income flows from firm borrowings are channeled through capital market.
sector to the households. With this money, the In practical life, whatever is earned by the
households purchase from the firms, manufactured households is not spent on consumption goods.
goods and services to satisfy their wants with the
result that the same money flows back from A part of earning is saved and deposited in the
households to the firm sector. capital market leading to money flow from
households to the capital market. Similarly, firm
Thus, the entire income of the economy comes also saves with the aim of meeting cost of
back to firms in the form of sale revenue. The depreciation and expanding its production
counter flow of money from households to the capacity. Firms also borrow to finance their
firms leading to the circular flow of money investment in plant and equipment. Thus, savings
between the two sectors is represented in the of the firms going to the capital market and
following diagram. borrowing by the former from the latter also create
money flows as shown in the following diagram.
Leakage and Injections: (c) Introduction of Government Sector
(Circular Flow of income in a three
A leakage is the amount of money which is sector economy):
withdrawn from the now of income whereas
injections are the amount of money that is added to We move further by introducing Government
the flow of income in the economy Thus, (i) Sector which purchases goods from firms and
savings, (ii) taxes by households and firms and (iii) labour services from households. Between
import spending constitute a leakage from the households and the government, money flows from
circular flow of income (money). government to the households when the
government makes transfer payments (like old-age
On the other hand, (i) investment spending, (ii) pension, scholarships, etc.) and factor payments
government spending and (iii) export earnings (for hiring services of factors of production) to the
become injection into the circular flow of income households. Money flows back to the government
(money). For equilibrium at macro level leakage when it collects direct taxes (income tax, wealth
must be equal to Injections as equilibrium tax) from the households.
condition C + S = C + I Indicates S = I or Leakage
= Injections For instance. In a two sector economy Similarly, there are flows of money between the
when a part of income earned by households from government sector and the firm sector when
firms is held back (i.e., saved), unsold stocks of government realises corporate taxes from the
output will accumulate leading to depression. firms, grants them subsidies (like land and
Therefore, pluming of leakage is must if electricity at cheap rates) and makes payment for
production is to be sustained. the goods purchased by it. These flows have been
shown in the Fig. below
Remember, from macroeconomic point of view, Conclusion
there are four sectors, namely,
In a nutshell, the circular flow of income
(i) Households, diagram represents the flow of money and
receipt of goods, services and factor services
(ii) Firms between business firms and households sectors
in a two-sector economy. Notably, the
(iii) Government and
economic activities are free from government
intervention and it is a closed economy model
(iv) External sector.

(d) Introduction of External Sector The calculation of national income is a

(Circular flow of income in a four measure of the total amount of economic
sector economy): activity in a country over some time. It takes
into account all the money that has been earned
Our model will remain incomplete without by selling things and all the money that has
converting the closed economy into an open been paid out for wages, rent, interest and so
economy where imports and exports are made. One on. It can be used to see how well the economy
country’s exports are another country’s imports. is performing and how it is changing. The
With the increase of a country’s imports, money calculation of national income is usually
flows to the rest of world (ROW) whereas in the broken down into three steps. These are the so-
case of exports, money flows in from ROW. called 'identifiable expenditure approach'
which looks at how households use their
There is a Trade Surplus for an economy when its
exports exceed imports but the economy suffers money, the 'expenditure method' which
Trade Deficit when imports exceed exports. Mind, considers how businesses use their incomes
imports are leakages and exports are injections into and finally there is the 'income method'. We
the circular flow of income in the economy. will look at each of these in turn.

Significance of circular flow in income:

(i) It reflects structure of an economy.

(ii) It shows interdependence among different

sectors.

(iii) It gives information about injections and

leakages from flow of money.

(iv) It helps in estimation of national income and

related aggregates.

CHAPTER TWO
 NATIONAL INCOME ACCOUNTING firms factors of production comprising households
are paid income, these income receipts are spent by
the house hold sector on consumption and their
National Income savings are mobilized by the producers for
investment spending.
National income is the flow of with in goods and
services produced in an economy in a particular
period-a year National Income is denned as money Gross Domestic Product (GDP)
measures of the net aggregates of all commodities
and services accruing to the inhabitants of a Gross domestic product is the money value of all
community during a specific period. The concept final goods and services produced in the domestic
of National income has been interpreted in three territory of a country during an accounting year.
ways.

(a) National product  GDP is the total value of output produced by

the factors of production located within the
(b) National Dividend country's boundary in a year. The factor of
production may be owned by any one citizen or
(c) National expenditure foreigner.

(a) National product: It consists of all the goods GDP = GNP - Net income earned from abroad.
and services produced by the community and
exchanged for money during a year. It does not GDP -C+I+G+(X-M)
include goods and service which are not paid for
such as hobbies, housewives services, charitable Where C = consumption goods,
work etc.
I = Gross investment
(b) National Dividend: It consists of all the
incomes in cash and kind, accruing to the factors of G = Government services
production in the course of generating the national
product. It represents the total of income flow This is measured at market prices
which will exactly equal the value of the nation
product turned out by the community during the GDP at factor cost = GDP at market price +(S-T)
year.
S = Government subsidies
(c) National Expenditure: This represents the
total spending or outlay of the community on the T = indirect taxes
goods and services produced during a given year.

 Since income is the source of expenditure, Gross National Product (GNP)

national expenditure constitutes the disposal of
national income which is evidently equal to it in
value.  GDP can be denned as whatever is produced
 Modern economists consider national income within the domestic territory of a country in a year
as a flow in three forms income, output and is its gross domestic product. It includes the
expenditure. When goods are produced by the
contribution made by nonresident’s producers by GNP at market price = C + I + G + (X - M) + (R -
way of wages, rent, interest etc. P) At market price

X = export, R = Income receipts from abroad

Hence Gross National product is denned as the M = import, P = Income paid abroad
sum of the gross domestic product and net factor
incomes from abroad.
Net National Product (NNP)
GNP = GDP + (X - M)
 Net National product is obtained by subtracting
Where, X == Export, M = import depreciation value from GNP

When X -
NNP = GNP − Depreciation M=0

Then GNP = GDP

 Net national product is the value of total
consumption plus the value of net investment of
community.
1. In an open economy GNP may be obtained by
adding up:

(i) The value of all consumption goods which are Personal Income: Personal income is the total
currently produced. money income received by individuals in the
community personal income is the aggregate
(ii) The value of government services which are earned and unearned income. Undistributed profits
measured in terms of governmental expenditure on of the corporations reduce the personal income of
various goods and services for rendering certain individuals to that extent.
services to the benefit of the entire community
PI = NI - undistributed profit
(iii) The value of net product i.e. the difference
between total exports and total imports of the PI = NNP + transfer payment (R)
nation. This value may be positive or negative. ∴ PI=¿+ R−U

(iv) The value of all capital goods produced which Disposable personal income: Disposable
is denned as gross investment. personal income is the sum of the consumption and
saving of individuals.
(v) The net amount earned abroad. This represents
the difference between the incomes received by the DI = C + S
nationals abroad on their foreign investment,
minus the income paid by them abroad on the  Disposable personal income: (DPI) rather than
foreigner's investment. National income is the determinant of consumption
because the consumption of a person depends on
his take home pay.
Personal savings: Personal savings refer to the (a) At market price of goods and services
difference between disposable personal income
and personal consumption expenditure. (b) At factor cost

When NNP is obtained at factor cost it is called

National Income
GNP at market pri Depreciatio NNP
ce n at market
price
GNP at market pric Net Income GDP at market  NNP at factor cost is the volume of
e from abroad price commodities and services turned out during an
GNP at market pric Net indirect GNP accounting year, counted without duplication.
e taxes at factor cost
NNP at market pric Net indirect NNP at NNP at factor cost = National Income
e taxes factor cost
GDP at market pric Net indirect GDP NNP at factor cost = NNP at market price -
e taxes at factor cost Indirect Tax + Subsidy
GDP at factor cost Depreciatio NNP
n at factor cost Notes:
GDP at factor cost Depreciatio NDP
n at factor cost

National income Account:

 National Income accounts are the systematic Methods of Measuring National Income
records and presentation of national income
statistics. Thus, national income accounting also There are three methods of calculating National
known as "economic accounting" or social Income:
accounting transcends the mere compilation and
publication of statistical information. (i) Product or Output Method
 Its purpose is to present data in such a form that (ii) Income Method
interrelations among items are most easily
discerned from the structure of statements. (iii) Expenditure Method

Per Capita Income: Per capita income is an

indicator to show the living standards of people in
a country. If real PCI increases, it is considered to (i) Product or Output Method: in the product
be an improvement in the overall living standard of method, the measures of GDP are calculated by
people. adding the total value of the output (of goods and
services) produced by all activities during any time
period, such as a year. The major challenges of this
GDP = per capita Income total number of people method is the problem of double
counting.
National, Income:
(ii) Income Method: In the income method, the
NNP can be calculated in two ways measures of GDP are calculated which are engaged
in the production of output. The various incomes
included to compute the gross national income are

 Wages and salaries

 Interest and surplus of government enterprise

 Rents

 Net flow of income from abroad

 Income of self employed

 Profit and dividends of business operation

The sum of all these factor incomes provide

us the measure of national income.

(iii) Expenditure Method: in the expenditure

method, the measures of GDP are calculated by
adding all the expenditure made in the economy.
These Components are?

C = Consumption expenditure
CHAPTER FOUR
I = Domestic investment
MONEY AND BANKING
G = Government expenditures Money:
In ordinary usage, what we use to pay for things is
X = Exports of goods and services referred to as money. But the definition of money is
still an unresolved fescue of monetary economics.
M = Imports of goods and services Though money is a concept which still lacks
absolute clarity in scientific terms.
NR = Net income receipts from assets abroad
Define Money.
Ans: Money is something which is generally
acceptable as a medium of exchange and can be
The sum of all these aggregate expenditure converted into other assets without loosing its time
provides us the measure of national income. and value.
GDP = E = C+I+G+(X−M)
There are two Approaches to defining money
Where, E = Aggregate expenditure (a) Traditional approach (b) Empiricists approach.
In traditional approach, money is regarded as any
object which is generally acceptable as a 1. Time deposits and saving deposits with
means of payment in transacting an exchange commerce banks another banks:
of goods or services. Traditional approach is 2. Bill of exchange
based on two criteria one is its general 3. Banker's acceptances
acceptability and its functional aspects. 4. Gilt-edged securities and all other redeemable
In empiricists approach. Money is a complex and marketable government securities
phenomenon. It does not define itself to 5. Cash-surrender values of life insurance policies
currencies and demand deposits of banks, but 6. Negotiable credit instruments
also includes a host of financial asset such as 7. Shares of joint stock companies
bonds, government securities, time deposit 8. Shares of investment trusts
with banks and equity shares, which serve as 9. Savings in units of unit trust
a store of value. 10. Postal saving deposits
11. Traveler cheese
Static functions of Money: 12. Deposits of building societies
13. Purchasable shares in saving and loan
1. As a medium of exchange associations
2. As a measure of value of unit of account 14. Savings bonds and certificates
3. As a standard of deferred payment
4. As a store of value

Dynamic role of Money:

1. It plays a very active and high important part in

the economic system by influencing the general
level of process. Its volume and function of money
whether the motivation comes from the state itself
or from the general public, can lead to a rise or fall
in the general price level.
Financial Market:
2. Money directs idle resources into productive
channels, and there-by affect output, income, Financial markets refer to the institutional
employment, consumption and consequently the arrangements for dealings in financial assets and
economic welfare of the community at large. credit instruments of different types such as
currency, cheese, bank deposits, bill, bonds etc.
3. Money makes it possible to have financial
economic planning as workable proposition of The main functions of the financial markets are
physical planning at the micro-level and macro 1. To facilitate creation and allocation of credit and
level. liquidity
2. To serve as intermediaries in the process
Near Money: A modern community holds various mobilization of savings in the economy
kinds of financial asset to store value. Money 3. To provide financial convenience to the people.
however is the most liquid of all assets. They are 4. To assist the process of economic development
referred to as quasi-money instruments or near- through a more balanced regional and sectorial
money. The following items are generally distribution of investible funds.
considered as near money.
 3. Collateral loan market: When loans are
offered against collateral securities like stocks and
bonds, they are called "collateral loans" and the
Money Market: market is known as the collateral loan market. This
market is geographically most diversified.
The term "money market" refers to the institutional 4. Acceptance Market: It refers to the market
arrangements facilitating borrowing and lending of for banker's acceptances involved in trade
short term funds. In a money market, funds may be transactions. A banker's acceptance is a draft drawn
borrowed for periods varying from a day, a week, 3 to by an individual or firm upon a bank ordering it to
6 months and against different types of instruments pay to the order of a designated party or to bearer a
such as bills of exchange, short-term securities, certain sum of money at a particular future date and
banker's acceptances etc. called near money". this draft is accepted by the bank. Banker's
· Money market is a short-term credit market. An acceptances can be easily sold or discounted in the
essential feature of the money market is the money market called the acceptance market.
dealings in assets of relative liquidity such as
treasury bills, bills of exchange, short-term 5. Bill Market: It is a market in which short-
government securities etc. term papers or bills are bought and sold. The most
important types of short term papers are the bills of
exchange and the treasury bills.
Constituents of the money markets:
· The bill of exchange is a written
Important components of the money market are as unconditional order signed by the drawer requiring
follows: the party to whom it is addressed (the drawee) to pay
on demand or at a fixed or determinable future time
1. Call Money Market: the market for a definite sum of money to the order of a specified
extremely short-period loans is referred to as the person (the payee) or to the bearer
"call money markets". Bill brokers and dealers in
stock exchange usually borrow money at call loans
from the commercial banks. What is the basic characteristic of money?
Ans: Durability and weight.
2. Call money market: It is a market where
short term surplus funds of Commercial banks and Characteristics or features of money
other financial institutions are traded. The issuers of
call money or the borrowers are Commercial banks. 1. Durability: Money must be durable and
Co-operative banks, financial institutions and not likely to deteriorate rapidly with
Discount and Finance House of India. These frequent handling. Currency notes and
participants usually borrow and lend call/notice coins are being used repeatedly and shall
money for one day for period upto 14 days. If money continue to do so for many years.
is lent for a day it is called call money or overnight 2. Medium of exchange: Money is the thing
money on the other hand, if it is for a period more that acts as a medium of exchange for the
than one day and less than 14 days, it is called notice sale and purchase of goods and services.
money. Scheduled Commercial banks are the large 3. Weight: Money must be light in weight.
scaled borrower and lenders in the call money Paper money is better than metal coins
market. because it is light in weight.
4. Measure of value: It not only serves as
medium of exchange but also acts as a
 measure of value. The value of all the 4. Money works as a common denominator
goods and services is expressed in terms of into which the values of all goods and
money. services are expressed.
5. When we express the values of a
What are the main functions of money? commodity in terms of money, it is called
Ans: price and by knowing prices of the various
commodities, it is easy to calculate
“Money is a matter of the following four exchange ratios between them.
functions: A medium, a measure, a standard, a
store”.

Explain the ‘medium of exchange’ function of Define Barter system.

money. Barter system of exchange is a system in which
goods are exchanged for goods.
Ans:
What are its drawbacks?
1. Money when used as a medium of
exchange helps to eliminate the basic It’s Drawbacks are:
limitation of barter trade, that is, the lack of
double coincidence of wants. 1. Lack of double coincidence of wants.
2. Individuals can exchange their goods and 2. Lack of divisibility.
services for money and then can use this 3. Difficulty in storing wealth.
money to buy other goods and services 4. Absence of common measure of value.
according to their needs and convenience. 5. Lack of standard of deferred payment.
3. Thus, the process of exchange shall have
two parts: a sale and a purchase. How does money overcome the shortcoming
4. The ease at which money is converted into of a barter system?
other goods and services is called “liquidity
of money”.
Money has overcome the shortcoming of a barter
2. Explain the ‘ Unit of account’ function of system in the following manner:
money. (a) Medium of exchange
Ans: • Under barter system, there is lack of double
coincidence of wants.
1. Another important function of money is • With money as a medium exchange individuals
that it serves as a common measure of can exchange their goods and services for money
value or a unit of account. and then use this money to buy other goods and
2. Under barter economy there was no
services according to their needs and
common measure of value in which the
values of different goods could be conveniences.
measured and compared with each other. • A buyer can buy goods through money and a
Money has also solved this difficulty. seller can sell goods for money.
3. As Geoffrey Crowther puts it, “Money acts (b) Measure of value
as a standard measure of value to which all • Under barter system, there was no common
other things can be compared.” Money measure of value. Money has also solved this
measures the value of economic goods. difficulty.
• As Geoffrey Crowther puts it, “Money acts as a 1. Under barter system, there is lack of
standard measure of value to which all other things double coincidence of wants.
can be compared.” Money measures the value of 2. With money as a medium exchange
economic goods. individuals can exchange their goods and
• Money works as a common denominator into services for money and then use this money
which the values of all goods and services are to buy other goods and services according
to their needs and conveniences.
expressed.
3. A buyer can buy goods through money and
• When we express the values of a commodity in
a seller can sell goods for money.
terms of money, it is called price and by knowing
prices of the various commodities, it is easy to
calculate exchange ratios between them.
(c) Store of value Explain Standard of deferred payments
• Under barter system it is very difficult to store function of money.
wealth for future use.
• Most of the goods are perishable and their storage Ans:
requires huge space and transportation cost.
• Wealth can be conveniently stored in the form of 1. Credit has become the life and blood of a
money. modem capitalist economy.
• Money can be stored without loss in value. 2. In millions of transactions, instant
payments are not made.
• Money can easily be stored for future use.
3. The debtors make a promise that they will
(d) Standard of deferred payments
make payments on some future date. In
• Under barter system, transactions on deferred those situations money acts as a standard of
payments are not possible. deferred payments.
• With money, the debtors make a promise that 4. It has become possible because money has
they will make payments on some future dates. In general acceptability, its value is stable, it
those situations money acts as a standard of is durable and homogeneous.
deferred payments.
• It has become possible because money has 4. Explain Store of value function of money.
general acceptability, its value is stable, it is
durable and homogeneous. Ans:

1. Wealth can be conveniently stored in the

form of money. Money can be stored
What is meant by double coincidence of wants? without loss in value.
Ans: Double coincidence of wants means that 2. Savings are secured and can be used
goods in possession of two different persons must whenever there is a need.
be useful and needed by each other. 3. In this way, money acts as a bridge
between the present and the future.
4. Money means goods and services. Thus,
Explain the problem of double coincidence of money serves as a store of value.
wants faced under barter system. How has 5. It is also known as asset function of money.
money solved it? [CBSE 2013 (Set-I)]
Ans:
 time for which deposits are made. Fixed deposit is
an example of time deposit.

State the components of supply of money.

What is the legal definition of money? Ans:
Ans: Legally, money is anything proclaimed by
law as a medium of exchange. Paper notes and 1. Coins and currency notes with public.
coins (together called currency) is money as a 2. Demand deposits with banks.
matter of law.

6. Define money supply

What is transaction demand for money? How is
Ans: The stock of money held by the public at a it related to the value of transactions over
point of time, in an economy, specified period of time?
is referred to as the money supply. Money supply Ans: Deleted from syllabus.
is a stock concept.
5. Money as a Legal Tender Money.
7. What items are included in the M3 measure of Currency (coins and notes) is a legal tender
money supply? money which cannot be refused in payment
Ans: for transactions- Everybody is bound to
accept it in exchange for goods and
1. M3(currency notes and coins with public + services and in discharge of debts. None
demand deposits of commercial and co- can refuse to accept it because non-
operative banks + other deposits with RBI), acceptance is an offence. It is issued by the
2. Time deposits of all commercial and co- government or duly authorised Central
operative banks. Bank.

State two components of money supply. Or 6. Demand Deposits. Deposits in a bank

State the components of money supply. Or which are payable on demand are called
What is included in money supply? demand deposits. It also provides the
facility of medium of exchange which is a
function of money, when payments are
Ans: Currency notes and coins with public + made by cheques.
demand deposits with the banks.
7. Cheque. It is a paper instructing the bank
Define demand deposits. to pay a specific amount from the person's
Ans: Demand deposits are those deposit which can account to the person in whose name the
be withdrawn by the depositor at any time by cheque has been made.
means of cheque. No interest is paid on such
deposits. 8. Loan Activities of Banks. Basically banks
borrow money to lend. Banks pay interest
(suppose x %) from whom it borrows. After
keeping a portion of deposits as reserves,
What are time deposits in banks? banks lend to people who demand money
Ans: Time deposits are the deposits which can not as loan and bank charges interest (suppose
be withdrawn before the expiry of the stipulated y %} from them. The difference between
 what is charged from borrowers y %) and Rich urban households depend largely on
what is paid to depositors is their main formal sources of credit. Lower rate of
sources of income. After meeting all interest on loans is charged as compared to
expenses of banks out of this income, the informal sources of credit.
resultant is profit/loss for the bank.
13. Informal Sector Credit in India. It
includes traders, employers, moneylenders,
relatives, friends, etc. No organisation is
there to supervise its lending activities,
Higher interest on loans is charged as
compared to formal sources of credit. Poor
households largely depend on informal
sources of credit.

14. Self Help Groups (SHG) for the Poor. It

helps in pooling the savings of the
members, who are poor women. Members
can get timely loans for a variety of
purposes and at a reasonable rate of
interest. It helps borrowers to overcome the
9. Credit (loan).it plays a vital and positive problem of lack of collateral. It also
role in economic life. Money/finance is provides a platform to discuss variety of
very important for a firm or organisation social issues of their concern.
just like air in the balloon. Credit (loan)
refers to an agreement in which the lender 15. Chit Fund. Chit means a transaction under
supplies the borrower with money, goods which a person enters into an agreement
or services in return for the promise of with a specified number of persons that
future payment. Main demand for credit is every one of them shall subscribe a certain
for crop production in case of rural areas. amount of money by way of periodic
instalments over a definite period.
10. Debt-trap. Suppose a person takes a loan Reasonable rate of interest is charged
and due to unavoidable circumstances he is against the loan taken by subscriber
not able to repay his loan. Now he faces a members.
difficult situation and has to take a tough
decision, either he has to borrow a fresh
loan or sell some part of his property to
repay the earlier loan.

11. Terms of Credit. It includes details

regarding interest rate, collateral and
documentation requirement, and the mode
of payment.

12. Formal Sector Credit in India. It includes

loans from banks and cooperatives. RBI
supervises their functions of giving loans.
 CHAPTER FIVE 2. Inflation is a process of persistently rising price
level.
INFLATION AND UNEMPLOYMENT 3. Inflationary price rise is persistent and is
irreversible within a short time.
4. A cyclical movement is not inflation. Inflation is
Inflation: rising trend in the price level.
5. Inflation is endogenous to the economic system.
· According to crofter a state in 6. Inflation is a post full employment phenomenon
which the value of money is falling i.e. and Monetary phenomenon.
prices are rising. The common feature
of inflation is a price rise the degree of
which may be measured by price Reflection: It is a situation of rising prices,
indices. deliberately undertaken to relieve a depression with
· Rowan suggests the following rising prices, employment, output and income also
formula to measure the percentage rate increase till the economy reaches the fall
of inflation: employment ceiling.

P(t )=( p ( t )− p(t−1)× 100) · In above diagram, the FF line represent the
Where P (t)-P (t-1). full employment ceiling and represents the normal
P = Price level path. In the beginning when the economy is at a
t = time point of below full employment equilibrium an
t -1 period of observation time increase in money supply leads the economy to
move on the path of AB.
· However, till the economy reaches the point
B, price rise is accompanied by the expansion of
employment and output. This situation is called
"Semi inflation" or "reflation".
Disinflation: When prices are falling due to anti-
inflationary measures adopted by the authorities
with no corresponding decline in the existing
level of employment, output and income the result
is disinflation.
· When acute inflation afflicts the community,
disinflation is adopted as a cure. Disinflation is
said to take place when deliberate attempts are
made to curtail expenditure of all sorts to lower
Fig: Model of a Trade cycle price and money incomes for the benefit of the
community.
· Inflation occurs when prices rise after the Deflation: It is a condition of falling prices
stage of full employment is reached in the economy, accompanied by a decreasing level of employment,
with no corresponding rise in employment and output and income.
output. · Deflation is just the opposite of inflation.
The following are the main characteristic of inflation Deflation occurs when the total expenditure of the
1. Inflation is a long-term operating dynamic community is not equal to the existing prices. The
process. value of money goes up and prices fall.
· However Each and every fall in price (vi) Providing of economic subsidy by the
cannot be called deflation. The process of reversing Government to the industrial sector of the
inflation without either creating unemployment or economy.
reducing output is called disinflation and not
deflation.
Types of Inflation:

The state of deflation may appear in the economy

due to following reasons-

(i) When the Government withdraws money

from circulation.
(ii) When Government imposes heavy direct
taxes or fakes heavy loans from the public
(voluntary or compulsory or both).
(iii) When the Central Bank sells the securities
in open market (which reduces the quantity
of money in circulation).
Hyperinflation:
(iv) When Central Bank controls the credit Hyperinflation is inflation that is "out of control"
money and adopts various measures such as a condition in which price increases rapidly as a
increase in CRR, credit rationing and direct currency loses its value. The main cause of
action. hyperinflation is a massive and rapid increase in
(v) When the Central Bank increases the Bank the amount of money, which is not supported by
rate (which curtails the quantity of credit in growth in the output of goods and services.
The main features of hyperinflation are:
the economy).
1. During hyperinflation, the price rise severe.
(vi) When state of over-production (excess The rice index moves up by leaps and bounds.
supply over demand) takes place in the 2. It represents the most pathetic deterioration in
economy. people's purchasing power.
3. It is apparently generated by a massive fiscal
Measures of Checking Deflation dislocation.
4. It is amplified by wage price spiral.
(i) Increasing money supply. 5. Hyperinflation is a monetary disease.
6. The velocity of circulation of money increases
very fast.
(ii) Promote credit creation by the banks.
7. The structure of the relative prices of goods
(iii) Curtailment in taxes so as to increase the become highly unstable.
purchasing power of the people. 8. Overall economic distortions take place.
(iv) Increasing the public expenditure and the 9. Inequalities increase.
employment opportunities in the economy. 10. The real wages tend to decline fast
(v) Increasing the money supply in circulation
by repayment of old public debts.
 1. Increase in public expenditure Increase
in
2. Investment Increase
3. Increase in marginal propensity to
4. Consume. Increasing exports and
surplus balance of payments.
5. Diversification of goods.

(b) Cost push inflation:

· In this inflation, a sustained rise in

general price level resulting from an
autonomous rise in cost. In other words,
cost push inflation is another type of
inflation in which price rise is due to
increased input costs.
Demand pull Inflation:

· According to the demand pull

theory, prices rise in response to an
Causes of Inflation
excess of aggregate demand over
existing supply of goods and services.
In this theory when quantity of money The inflation occurs due to two main factors:
increases, the rate of interest will fall
and consequently investment will (a) Increase in demand for goods and services.
increase. This increased investment
expenditure will soon increase the (b) Decrease in the supply of goods &
income of the various factors of services.
production. (a) Factors causing an Increase in demand for
As a result, aggregate consumption goods & services:
expenditure will increase leading to an
effective increase in the effective
demand. (i) Increase in public expenditure
· Demand pull inflation is a situation
where the total monetary demand (ii) Increase in private expenditure
persistently exceeds total supply of
goods and services at current prices, so (iii) Increase in exports
that prices are pulled upward by the
continuous upward shift of the (iv) Reduction in taxation
aggregate demand function.
· Demand pull theory implies the (v) Rapid growth of population
following sequences. Increasing
demand, increasing prices, increasing (vi) Black money
costs?increase in income? increasing
demand?increasing prices ? and so on
(vii) Deficit financing
Causes of demand pull inflation
 (viii) Cheap money policy the volume of cash reserves of Bank can regulate the
supply of money and credit in the economy there by
(ix) Increase in consumer spending influencing the structure of interest rates and the
availability of credit.
(x) Department of Tax internal debts.
Both these factors affect the components of
(b) Factors causing Decrease in supply of
aggregate demand (Consumption + investment) and
goods and services: the flow of expenditure in the economy.
· Central bank uses three quantitative
(i) Shortage of supplies of factors weapons for monetary management.
These are as follows:
(ii) Industrial disputes (a) Bank rate policy
(b) Open market operations
(iii) Natural calamities (c) Variable reserve ratio to control the volume of
credit in an economy.
(iv) Loop-sided Production
2. Fiscal policy: Fiscal policy is a budgetary
policy in relation to taxation, public borrowing and
(v) Hoarding by consumers
public expenditure changes in the total expenditure
can be effected by fiscal measures to combat
(vi) Hoarding by traders inflation, and fiscal measures would involve increase
in taxation and decrease in government spending.
(vii) Operation of Law of Diminishing Returns. · During inflation the government is
supposed to counteract an increase in private
Non-monetary factors that affects inflation spending obviously During a period of full
(a) A high population growth employment inflation, the aggregate demand in
(b) Natural calamities and Bad weather conditions relation to the limited supply of goods and services
(c) Speculation and Hoarding is reduced to the extent that government
(d) High prices of imports expenditures is curtailed.
(e) Monopolies
(f) Underutilization of resources Control or 3 Direct control: Direct control refer to the
inflation regulatory measures undertaken to convert an open
inflation into a repressed one. Such regulatory
Control of inflation: in modern economy following measures involve the use of direct control on prices
are the broad categories of instruments commonly and rationing of scarce goods.
used in control inflation. Monetary policy: · The function of price control is a fix a legal
ceiling beyond which prices of particular
1. Monetary policy: Monetary policy used goods may not increase.
to control inflation is based on the assumption that a · Direct control have the following
rise prices (inflation) is due to excess of monetary advantages:
demand for goods and services by the people 1. They can be introduced or changed quickly and
because easy bank credit is available to them. easily, hence the effects of these change can be
rapid.
· Monetary management is aimed at the 2. Direct controls can be more discriminatory than
commercial banking system and through this action monetary and fiscal controls.
its effects are primarily felt in the economy as a
whole monetary management by directly affecting
3. There can be variation in the intensity of the essential commodities leads to higher burden on
operation of controls, from time to time, in different poor.
sectors.
RBI assists in controlling inflation through
monetary measures such as quantitative and
Impact of Inflation
selective credit controls and by manipulating the
Cash Reserve Ratio (CRR) and the Statutory
1. Inflation is the most regressive form of
Liquidity Ratio (SLR). These are the monetary
situation as it affects the poor and vulnerable
policies adopted by government.
sections of the society the most. Such a situation
leads to increasing income disparities.
On the supply side, the mechanism of Public
Distribution
2. Inflation dampens exports by making our
products expensive and, conversely, makes imports
System (PDS) ensures availability of essential
attractive.
commodities for the vulnerable sections of society.
This helps maintain price levels. Fixation of
Such a situation may warrant formal or informal
maximum prices helps to eliminate the incentive
devaluation of the currency in order to make our
for hoarding and speculative activity in food-
exports competitive.
grains. Control over private trade in food-grains
3. Inflation leads to recession, as people with and adoption of Open General Licence (OGL) to
fixed incomes set apart an increasing share of their ease the imports of sugar, pulses, etc., in case of
income to meet the growing costs of essential shortages are also some of the common measures
commodities, leaving very little for expenditure on undertaken. Coupled with this is the open market
non-essential items. The production of such items sale of rice and wheat resorted to by FCI from its
has to be reduced, leading to shutdowns and buffer stock in times of price rise.
recession.

Policy Measure to Control Inflation

Inflation and Price Control in the Post-reform
The issue of inflation is addressed from both Period
demand and supply sides. Demand management
One of the major achievements of economic
implies putting a check on the demand of the
reforms of 1991 was the removal of restrictions on
public for goods and services. Demand
production and prices. The direction was to move
management is achieved by measures such as
from a regulated to a market-related environment.
postponing public expenditure, reducing excess
Contrary to expectations, the removal of
liquidity either through taxes or saving schemes
restrictions did not lead to a spurt in prices.
and restrictions on ad hoc treasury bills. While
However, inflationary pressure remained
such measures help contain the money supply,
moderately high caused, paradoxically, by the very
there is a danger that these will contract the
success of the reform process, which brought in
economy and lead to an increase in unemployment.
large foreign investment leading an increase in
Rationalisation of excise and import duties of
 money supply. Foreign inflows need to be These services are available to all and the
sterillised by the RBI by withdrawing from enjoyment by one is not at the expense of
circulation an equivalent amount of rupee either another. No price can be put on these services.
through open market operation or through (ii) Merit goods: It includes primary
regulating bank credit. At the same time, it was education, immunisation, public health
important to maintain the correct exchange rate for programmer, etc. Not only individual beneficiary
the rupee so that its appreciation does not make our but society at large benefits by making these
exports uncompetitive. Following are some of the goods available.
fiscal policies adopted by government:
Providing subsidy for these goods is essential.
 Release of buffer stock of food grains to (iii) Non-merit goods: In non-merit goods
maintain the price level. the benefit goes directly to the individual while
the costs are borne by the society. Pollution
 Import of some essential commodities like caused by automobile emission is an example of
edible oils. non-merit goods

 Strict fiscal and monetary discipline:

 Compensating farmers for the loss on Unemployment

account of withdrawal of fertilizer subsidy,
through upward revision of procurement prices. Unemployment refers to a situation when a labour
does not obtain employment opportunity despite
 To maintain price stability, the Central his willingness to work on existing wage rate.
Issue Price for rice and wheat has not been revised India is a developing economy where the nature of
since july 2002. There has been a continuous unemployment is entirely different from that of
reduction in the import duty on edible oils. developed nations. In India, the unemployment rate
measures the number of people actively looking
for a job as a percentage of the Labour force. As
per the Ministry of Labour and Employment,
Public Goods, Merit Goods and Subsidies the unemployment rate for the year 2020 is
9.01%.
Subsidies are a major burden on the national
budget. There are inevitable leakages in subsidies
and much of it does not reach the intended Different types of Unemployment in Nigeria
beneficiaries. In many cases, the benefits are taken (1) Structural Unemployment
by the undeserving. Most of our agricultural and
food subsidies suffer from this drawback. In order In this type of unemployment demand for labour
to assist proper targeting of subsidies, goods are falls short to the supply of labour due to rapidly
classified into three categories: growing population and their immobility.
(i) Public goods: It includes national (2) Disguised Unemployment
defence, police, general administration, etc.
It refers to a state of unemployment in which more common type of unemployment in the developed
people are engaged in work than are really needed. capitalist economies.
In the late 1950 s, about one-third of workers in
India were disguisedly unemployed.
Magnitude of Unemployment
(3) Seasonal Unemployment There is great diversity in the forms of
unemployment. It has been found that no single
It refers to an unemployment that occurs at certain measure can adequately capture the magnitude of
seasons of the years. The period of such unemployment in India. In addition to the decadal
unemployment varies from state to state, census figures, the National Sample Survey
depending upon the methods of farming, the Organisation (NSSO) conducts more detailed
condition of soil, the type and numbers of crops sample surveys every five years on employment
grown, etc. and unemployment. It uses three different tests for
(4) Open Unemployment measuring:

It refers to that economic phenomenon in which · The Usual Status (US) concept
persons are able and willing to work at the which has a reference period of one year and
prevailing wage rate, but fail to get work. It is classifies a person as unemployed if she was not
called open unemployment because such working but was available for work for most or all
unemployment can be seen and corrected in terms of the period of one year.
of the number of unemployed people.
· The Current Weekly Status (CWS)
(5) Industrial Unemployment includes a person if she has not worked even for
one hour during the week, though available for
It refers to the unemployment among the illiterates, work.
who wish to work in industrial establishments. The
slow pace of industralisation is unable to generate · The Current Daily Status (CDS)
sufficient employment opportunities. As a result, measures the employment status during the seven
there is a huge industrial unemployment in the days preceding the survey and adds up all the
country. hours of work undertaken during this reference
period to decide the un/underemployment status of
(6) Frictional Unemployment the person.
Chronic unemployment can be measured by the
It refers to temporary unemployment which exists
US and CWS data. However, the policy
during the period, wherein workers leave one job
formulation regarding supplementary employment
and join some other.
all the three sets of data are used in conjunction.
The Planning Commission and NSSO have been
(7) Cyclical Unemployment
using the CDS data recently as this gives a more
It is associated with the down-swing and realistic estimate.
depression phases of business cycle. It is the most
 CHAPTER SIX
PUBLIC FINANCE

Public finance is the study of the role of the

government in the economy. It is the branch of
economics which assesses the government revenue
and government expenditure of the public authorities
and the adjustment of one or the other to achieve
desirable effects and avoid undesirable ones.
 Taxes examples of indirect taxes. The difference
between the two is that in the case of direct taxes
Taxes are the main source of government the burden or incidence has to be borne by the
revenues. The primary purpose of taxation is the taxpayers themselves whereas in the case of an
mobilisation of resources and channelising the indirect tax, the burden can be shifted to another
same for productive investment. Taxation can also person. For example, a trader who is the assessee
be used as a measure to promote equity and in the case of sales tax shifts the burden on to the
reduce disparities or to encourage or discourage purchasers by recovering the sales tax from them.
consumption of particular items. Taxation is in the Another difference between indirect and direct
nature of a compulsory levy and there is no quid taxes is that the rich and the poor will have to pay
pro quo between the amount paid and the services the same rate of indirect tax while a direct tax can
provided by the government. be made progressive by prescribing different rates
Taxes are broadly divided into two - direct and of tax for different income levels.
indirect.
Taxes like income tax and property tax are direct
taxes, while excise duty and sales tax are

Progressive tax means rates of tax

increase for increasing values or volumes
on which the tax is levied.
Taxes can also be categorized as
progressive, regressive and proportional
taxes. Income tax is a progressive tax as it has
(1) Progressive Tax exemptions for very small incomes, low
rates for the first slab of taxable income,
and higher rates for the largest incomes.
Indirect taxes can be progressive if there
are exemptions or low tax rates for goods
heavily consumed by me poor, and higher otherwise there will be no limit to increase
rates on luxury items, mostly consumed by or decrease as the case may be.
the rich.
India has adopted this system for income
tax. This is pro-poor way of taxation and is Nigerian Tax Structure
popular in the whole world.
Nigeria operates a decentralized tax system where
each level of government is independently
(2) Regressive tax responsible for the administration of taxes within its
jurisdiction. Nigeria generate revenue to fund
government expenditure through a pool of taxes from
each tier of government.
Regressive tax is one where the proportion
of tax paid falls as income rises.
 Direct taxes are those which are imposed
The most regressive tax is a poll tax, levied on a person either on his income or wealth
at a fixed rate per person regardless of and the tax liability cannot be escaped. It is
income. A tax system can be made governed by Central Board of Direct Taxes
regressive by having indirect taxes levied at (CBDT).
relatively high rates on goods heavily  Indirect tax is collected by middle men in
consumed by the poor. the channels of distribution of goods. It is
governed by Central Board of Excise and
Customs (CBEC).
(3) Proportional Tax

Proportional tax is one by which the

revenue collected rises proportionally with
income. A tax system could be made
approximately proportional by having a
uniform rate of income tax with very few
exemptions, and indirect taxes levied at
similar rates on as many goods and services
as possible.
At some level, progressive and regressive
taxes have to be made proportional,

(A)
Direct taxes Custom duty had been the largest revenue
Income Tax generator since independence. But in recent years
It is the tax levied directly on the income of the the corporate tax has overtaken the custom duty
people by the Central Government. as the largest revenue earner.

Corporation tax Service tax

It is the tax on income (profit) of the companies. It is a tax imposed on the person, who avails
In 1996, government introduced Minimum any specified service. It was introduced in 1994-
Alternate Tax (MAT) on companies which 95 to address the asymmetric and distortionary
escaped the corporation tax net by using the treatment of goods and services in tax framework
provisions of exemptions, deductions, incentives, and to widen the tax net. The number of services
depreciation and so on. liable for taxation was raised from 3 in 1994-95
to 119 in 2011-12. However, this concept of a list
of services liable for taxation was changed by the
(B) Indirect Taxes Budget 2012. In this budget, the government
Central excise duty revamped the taxation provisions for services by
The commodities which are produced within introducing a new system of taxation of services
the country levied by central excise duty. in India. In the new system all services, except
However, commodities on which state those specified in the negative list, are subject to
governments impose excise dunes (e.g. liquor, taxation. In budget 2016, government has
drugs) are exempted from the central excise duty. imposed acess called Krishi Kalyan cess @ 0.5%
In recent years large number of goods have come on all taxable services, making effective service
under excise duty. Moreover, the rates of these tax rate as 15%.
duties have also been increasing.
Value Added Tax (VAT)
It was first introduced in France in
Customs duty 1950s to overcome the cascading effect
It is the tax imposed on commodities imported of several taxes-from raw material to
into India (import duty) or those exported the final product in the process of
from India (export duty). production. In VAT, the tax on all inputs
Since imposing duties on exports reduced the can be deducted from the tax paid on the
competitive position of the country, the output, so that taxes are levied only on the
government withdrew export duties. In recent value added to each stage in the
times, there has been considerable increase in production process. VAT system of
revenue from import duties because of heavy taxation has been adopted in more than
imports of iron and steel, petroleum products, 150 countries including Australia and
chemicals, etc. In the new requirements under Canada. The main advantage of VAT over
WTO, import duty will be the only means to curb any other form of indirect tax is that it
inputs. shifts the tax base towards the point of
final consumption from the first point of
 sale. It thus ensures the ?tax neutrality? of 1. Non-oil exports.
the production decisions. VAT was 2. Goods and services purchased by
introduced in India in 2005. The basic diplomats.
3. Goods purchased for use in humanitarian
features of the tax include 2 rates of 4%
donor funded projects. Humanitarian
for common consumption commodities donor funded project includes projects
and inputs and 12.5% for the others. Some undertaken by Non-Governmental
essential items are exempted and precious Organizations and Religious and Social
metals are taxed at 1 %. Clubs or Societies recognized by law
whose activity is not for profit and in the
public interest.

Goods & Service Tax (GST) & value added services VAT exempt items include services by
(VAT) 2020 microfinance banks, services by Peoples Bank
VAT rate is 7.5% of the value of the goods or and Mortgage Institutions, locally manufactured
services and payable on supply of all goods and sanitary towels, pads, tampons and basic food
services except those exempted from VAT under items. The basic food items are: additives, bread,
the VAT Act. 1 February 2020 as the effective cereal, cooking oils, culinary herbs, fish, flour &
date for the 7.5% VAT has been statutorily starch, fruits, live or raw meat & poultry, milk,
authorised in the Finance Act recently enacted on nuts, pulses, roots, salt (excluding industrial salt),
31 December 2020 (“the 2020 Act”). VAT vegetables and water. The Minister recently
applies on the supply of intangibles (excluding issued the Value Added Tax (Modification Order)
interest in land, building, money or securities). 2020 to clarify the scope of the VAT exempt
The tax authority clarified in the Circular that this items. For example, the scope of medical services
would include rights in goods or property (e.g. which are VAT exempt excludes cosmetology,
rights in mineral resources, copyrights, spa, gymnasium and similar services. The 2020
trademarks). All supplies of taxable goods and Act further adds the following to the list of VAT
services to a person in Nigeria, whether or not the exempt items: commercial aircrafts, commercial
supplies were made from within or outside aircraft engines and spare parts, airline
Nigeria will be subject to VAT. The 2020 Act transportation tickets issued by commercial
provides that a non-resident who makes taxable airlines in Nigeria, and the hire, rental or lease of
supplies to Nigeria is required to register with the tractors, ploughs and other equipment for
agricultural purposed from VAT. It bears
tax authority obtain a Tax Identification mentioning that Rivers State (a State in Nigeria)
Number and may also appoint a representative for recently challenged the power of the Federal
the purpose of its tax obligations. The VAT is, Government to administer and collect VAT
however, to be withheld and remitted to the tax within its State on constitutional grounds. The
authority by the recipient of the goods or services resulting judgment of the Court upheld the
from the non-resident person, or such other position of Rivers State and in consequence, the
person appointed by the tax authority. A Rivers State Government has enacted its VAT
threshold of NGN 25,000,000 (approximately Law. However, the decision of the Court is
USD 70,000) turnover triggers VAT registration currently being appealed.
obligation. Under the subsisting VAT Act, there
are zero rated goods and services which attract
VAT at 0% and they are as follows:
Different heads of income under tax structure
in Nigeria;

 Personal income
 House property
 Profit in business or profession
 Capital gains by sale of immovable assets
 Other sources

Personal income tax rates

The table below shows a summary of the taxable
income tax bands and applicable rates of tax on
an annual basis.
Annual income (NGN) Personal income tax (PIT) rate (%)
First 300,000 7
Next 300,000 11
Next 500,000 15
Next 500,000 19
Next 1,600,000 21
Above 3,200,000 24
Inclusive Development

 Inclusive growth refers to both the pace and

pattern of the economic growth of a country.
 It focuses on economic growth which is a 2. In under-developed countries, deficit-financing
necessary and crucial condition for poverty has been considered essential for financing the plans of
reduction. economic development.
 It adopts a long term perspective and is
3. It is used for the mobilisation of surplus, non-
concerned with sustainable growth.
 Inter-related elements of inclusive growth are:
utilised and idle resources in the economy.
4. It is used as an instrument of economic policy for
1. Poverty reduction and increase in quantity removing the conditions of depression and to raise the
and quality of employment level of output and employment.
2. Agricultural development
3. Social sector development Public debt
4. Reduction in regional disparities
Budgetary deficits must be financed by either
5. Protecting the environment
taxation, borrowing or printing currency notes.
Governments have mostly relied on borrowing,
giving rise to what is called government debt. Public
debt has three components:
(i) Internal debt; It includes market loans
from banks and financial institutions, short-term
borrowings on treasury bills and other bonds and
certificates issued by the government.
(ii) Other internal liabilities: It includes small
saving schemes, provident fund, reserve fund of the
railways, post and telegraph on which the Central
Government has to pay interest.
Deficit Financing
(iii) External debt: It includes loan from
foreign countries and international
The process of bridging the gap between the
financial institutions like the World Bank,
revenue and expenditure is called deficit
IMF, ADB, etc.
financing. In other words, Deficit financing refers
to the ways in which the budgetary gap is
financed.
Deficit financing was first done in the USA in
1930s as a tool to get out of the effects of the
Great Depression. India tried this in 1969 and it
gradually became a routine phenomenon in Indian
fiscal management.
External aid and borrowings
Objectives of Deficit financing A developing country often resorts to foreign aid
1. It is used as a tool for meeting financial needs if it finds that domestic sources are not large
of government, especially in times of war. enough. But a country going for foreign aid has
to take two precautions:
 (i) Keeping the borrowing level low so Components of the Government Budget
that country does Not fall in a debt trap, and
(ii) Keeping foreign aid strings-free.  There is a constitutional requirement in
External grants and borrowings are different India (Article 112) to present before the
Parliament a statement of estimated
things. External aids and grants may come free receipts and expenditures of the
or with very low or even zero interest rates. government in respect of every financial
However, these may come with many terms and year which runs from 1 April to 31
conditions attached which are usually not good March.
for a country’s economy and autonomy. External  This 'Annual Financial Statement'
borrowings mean taking loans from other constitutes the main budget document.
Further, the budget must distinguish
countries. External borrowing is often preferred
expenditure on the revenue account from
as it brings foreign currency which may help the other expenditures.
government in various ways. It is also preferred
over internal borrowings because if the Therefore, the budget comprises of the
government itself starts borrowing from the Revenue Budget and the Capital Budget.
banks of the country, there might not be enough
left for other borrowers.  The revenue account
 The Revenue Budget shows the current
receipts of the government and the
Internal Borrowings expenditure that can be met from these
These are not usually preferred because they might receipts.
hamper the investment scenario of the public and  Revenue receipts
corporate sector of India, but, it may be resorted to as  Revenue receipts are receipts of the
and when required. government which are non-redeemable,
that is, they cannot be reclaimed from the
government. They are divided into tax and
Printing currency
non-tax revenues.
It is usually the last resort for '[lie government in  Tax revenues
managing its deficit. It might help the government in  Tax revenues consist of the proceeds of
times of need hut it should be undertaken only in case taxes and other duties levied by the
of extreme necessity as it lies many damaging effects central government. Tax revenues, an
on the economy. It increases inflation proportionally. important component of revenue receipts,
It may also lead to a pressure on the government for comprise of direct taxes - which fall
directly on individuals (personal income
an upward revision in salaries of government
tax) and firms (corporation tax), and
employees, which in turn will lead to an increase of indirect taxes like excise taxes (duties
government's expenditure, further necessitating levied on goods produced within the
printing of currency and more inflation. Thus- it may country), customs duties (taxes imposed
begin a vicious cycle. Moreover, it also has the on goods imported into and exported out
obvious drawback in me tact that it cannot help in of India) and service tax.
 Other direct taxes like wealth tax, gift tax
case of expenditures that are or be done in foreign
and estate duty (now abolished) have
currency. never been of much significance in terms
 of revenue yield and have thus been and other receipts for services rendered by
referred to as 'paper taxes'. the government.
 Corporation tax contributed the largest  Cash grants-in-aid from foreign countries
share in revenues in 2012-13 (34.4 per and international organisations are also
cent) while personal income tax included.
contributed the second largest (190 per  The estimates of revenue receipts take
cent). into account the effects of tax proposals
 The share of direct taxes in gross tax made in the Finance Bill.
revenue has increased from 19.1 per cent
in 1990-91 to 53.4 per cent in 2012-13.
 The redistribution objective is sought to
be achieved through progressive income Revenue expenditure
taxation, in which higher the income,
higher is the tax rate.  Revenue expenditure is expenditure
 Firms are taxed on a proportional basis, incurred for purposes other than the
where the tax rate is a particular creation of physical or financial assets of
proportion of profits. the central government.
 With respect to excise taxes, necessities of  It relates to those expenses incurred for
life are exempted or taxed at low rates, the normal functioning of the government
comforts and semi-luxuries are departments and various services, interest
moderately taxed, and luxuries, tobacco payments on debt incurred by the
and petroleum products are taxed heavily. government, and grants given to state
governments and other parties (even
though some of the grants may be meant
for creation of assets).
Chart: The Components of the Government  Budget documents classify total
expenditure into plan and non-plan
Budget
expenditure.
 This is shown in item 6 on Table within
revenue expenditure, a distinction is made
between plan and non-plan.
 According to this classification, plan
revenue expenditure relates to central
Plans (the Five-Year Plans) and central
assistance for State and Union Territory
plans.
 Non-plan expenditure, the more important
component of revenue expenditure, covers
Non-tax revenue a vast range of general, economic and
social services of the government.
 Non-tax revenue of the central  The main items of non-plan expenditure
government mainly consists of interest are interest payments, defence services,
receipts on account of loans by the central subsidies, salaries and pensions.
government, dividends and profits on  Interest payments on market loans,
investments made by the government, fees external loans and from various reserve
funds constitute the single largest
 component of non-plan revenue government and the pattern of their
expenditure. financing.
 Defence expenditure, is committed
expenditure in the sense that given the
national security concerns, there exists
little scope for drastic reduction. Capital receipts
 Subsidies are an important policy
instrument which aim at increasing  All those receipts of the government
welfare. Apart from providing implicit which create liability or reduce financial
subsidies through under-pricing of public assets are termed as capital receipts.
goods and services like education and  The main items of capital receipts are
health, the government also extends loans raised by the government from the
subsidies explicitly on items such as public which are called market
exports, interest on loans, food and borrowings, borrowing by the government
fertilisers. from the Reserve Bank and commercial
 The amount of subsidies as a per cent of banks and other financial institutions
GDP 1.7 per cent in 1990-91 and 2.56 per through the sale of treasury bills, loans
cent in 2012-13. received from foreign governments and
 Service Tax, a tax on services like international organisations, and recoveries
telephone services, stock brokers, health of loans granted by the central
clubs, beauty parlours, dry cleaning government.
services etc. introduced in 1994-95 to  Other items include small savings (Post-
correct the disparity in taxation between Office Savings Accounts, National
goods and services, has become a buoyant Savings Certificates, etc.), provident
source of revenue in recent years. funds and net receipts obtained from the
 The number of services subject to taxation sale of shares in Public Sector
has increased from 3 in 1994-95 to 100 in Undertakings (PSUs) (This is referred to
2007-08. as PSU disinvestment).
 A Finance Bill, presented along with the
Annual Financial Statement, provides
details of the imposition, abolition,
remission, alteration or regulation of taxes Table: 
proposed in the Budget. (As

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per

τηε
cent of
GDP)
1. Revenue Receipts (a+b) 8.7
The capital account
a. Tax revenue (net of state's 7.3
 The Capital Budget is an account of the share)
assets as well as liabilities of the central b. Non-tax revenue 1.4
government, which takes into 2. Revenue Expenditure of which 12.3
consideration changes in capital.
a. Interest payments 3.1
 It consists of capital receipts and capital
expenditure of the government. This [Link] subsidies 2.4
shows the capital requirements of the c. Defence expenditure 1.1
3. Revenue Deficit (2-1) 3.6 Five-Year Plans, it has also become a
4. Capital Receipts (a+b+c) of 5.3 significant national policy statement.
which  The budget, it has been argued, reflects
and shapes, and is, in turn, shaped by the
a. Recovery of loans 0.2 country's economic life.
b. Other receipts (mainly PSU 0.3  Along with the budget, three policy
disinvestment) statements are mandated by the Fiscal
c. Borrowings and other 4.9 Responsibility and Budget Management
liabilities Act, 2003 (FRBMA).
 The Medium-term Fiscal Policy Statement
5. Capital Expenditure 1.6
sets a three-year rolling target for specific
[Link] Expenditure [2+5=6(a)+6(b)] 13.9 fiscal indicators and examines whether
a. Plan expenditure 4.1 revenue expenditure can be financed
b. Non-plan expenditure 9.9 through revenue receipts on a sustainable
basis and how productively capital
7. Fiscal deficit 4.9
receipts including market borrowings are
8. Primary Deficit [7-2(a)] 1.8 being utilised.
Source: Economic Survey, 2013-14  The Fiscal Policy Strategy Statement sets
the priorities of the government in the
fiscal area, examining current policies and
justifying any deviation in important
Capital expenditure fiscal measures.
 The Macroeconomic Framework
 There are expenditures of the government Statement assesses the prospects of the
which result in creation of physical or economy with respect to the GDP growth
financial assets or reduction in financial rate, fiscal balance of the central
liabilities. government and external balance.
 This includes expenditure on the
acquisition of land, building, machinery, Measures of Government Deficit
equipment, investment in shares, and
loans and advances by the central  When a government spends more than it
government to state and union territory collects by way of revenue, it incurs a
governments, PSUs and other parties. budget deficit. There are various measures
 Capital expenditure is also categorised as that capture government deficit and they
plan and non-plan in the budget have their own implications for the
documents. economy.
 Plan capital expenditure, like its revenue  Revenue deficit
counterpart, relates to central plan and  The revenue deficit refers to the excess of
central assistance for state and union government's revenue expenditure over
territory plans. revenue receipts
 Non-plan capital expenditure covers o Revenue deficit = Revenue
various general, social and economic expenditure - Revenue receipts
services provided by the government.  The revenue deficit includes only such
 The budget is not merely a statement of transactions that affect the current income
receipts and expenditures. Since and expenditure of the government.
Independence, with the launching of the
 When the government incurs a revenue  (Fiscal Deficit = Revenue Deficit +
deficit, it implies that the government is Capital Expenditure - Non-debt creating
dissaving and is using up the savings of capital receipts).
the other sectors of the economy to  A large share of revenue deficit in fiscal
finance a part of its consumption deficit indicated that a large part of
expenditure, borrowing is being used to meet its
 This situation means that the government consumption expenditure needs rather
will have to borrow not only to finance its than investment.
investment but also its consumption  Primary deficit
requirements.  The borrowing requirement of the
 This will lead to a buildup of stock of debt government includes interest obligations
and interest liabilities and force the on accumulated debt. The goal of
government, eventually, to cut measuring primary deficit is to focus on
expenditure. present fiscal imbalances.
 Since a major part of revenue expenditure  To obtain an estimate of borrowing on
is committed expenditure, it cannot be account of current expenditures exceeding
reduced. revenues, we need to calculate what has
 Often the government reduces productive been called the primary deficit.
capital expenditure or welfare  It is simply the fiscal deficit minus the
expenditure. interest payments:
 This would mean lower growth and o Gross primary deficit = Gross
adverse welfare implications. fiscal deficit - Net interest
 Fiscal deficit liabilities
 Fiscal deficit is the difference between the  Net interest liabilities consist of interest
government's total expenditure and its payments minus interest receipts by the
total receipts excluding borrowing. government on net domestic lending.
 Non-debt creating capital receipts are
those receipts which are not borrowings
and, therefore, do not give rise to debt.
Examples are recovery of loans and the
Fiscal Policy
proceeds from the sale of PSUs. The fiscal
deficit will have to be financed through
borrowing.
 Net borrowing at home includes that
directly borrowed from the public through  One of Keynes's main ideas in The
debt instruments (for example, the various General Theory of Employment, Interest
small savings schemes) and indirectly and Money was that government fiscal
from commercial banks through Statutory policy should be used to stabilise the level
Liquidity Ratio (SLR). of output and employment.
 The gross fiscal deficit is a key variable in  Through changes in its expenditure and
judging the financial health of the public taxes, the government attempts to increase
sector and the stability of the economy. output and income and seeks to stabilise
 From the way gross fiscal deficit is the ups and downs in the economy.
measured as given above, it can be seen  In the process, fiscal policy creates a
that revenue deficit is a part of fiscal surplus (when total receipts exceed
deficit: expenditure) or a deficit budget (when
total expenditure exceed receipts) rather
 than a balanced budget (when expenditure  The burden of debt must be discussed
equals receipts). keeping in mind that what is true of one
 In what follows, we study the effects of small trader's debt may not be true for the
introducing the government sector in our government's debt, and one must deal
earlier analysis of the determination of with the 'whole' differently from the 'part'.
income.  Unlike any one trader, the government
 The government directly affects the level can raise resources through taxation and
of equilibrium income in two specific printing money.
ways - government purchases of goods  By borrowing, the government transfers
and services (G) increase aggregate the burden of reduced consumption on
demand and taxes, and transfers affect the future generations. This is because it
relation between income (Y) and borrows by issuing bonds to the people
disposable income (YD) - the income living at present but may decide to pay off
available for consumption and saving with the bonds some twenty years later by
the households. raising taxes.
 These may be levied on the young
population that have just entered the work
force, whose disposable income will go
Debt down and hence consumption. Thus,
national savings, it was argued, would
 Budgetary deficits must be financed by fall.
either taxation, ben-owing or printing  Also, government borrowing from the
money. people reduces the savings available to the
 Governments have mostly relied on private sector. To the extent that this
borrowing, giving rise to what is called reduces capital formation and growth,
government debt. debt acts as a 'burden' on future
 The concepts of deficits and debt are generations.
closely related. Deficits can be thought of  Traditionally, it has been argued that
as a flow which add to the stock of debt. when a government cuts taxes and runs a
 If the government continues to borrow budget deficit, consumers respond to their
year after year, it leads to the after-tax income by spending more.
accumulation of debt and the government  It is possible that these people are short-
has to pay more and more by way of sighted and do not understand the
interest. These interest payments implications of budget deficits.
themselves contribute to the debt.  They may not realise that at some point in
the future, the government will have to
raise taxes to pay off the debt and
accumulated interest. Even if they
Perspectives on the appropriate amount of comprehend this, they may expect the
government debt future taxes to fall not on them but on
future generations.
 There are two interlinked aspects of the  A counter argument is that consumers are
issue. One is whether government debt is forward-looking and will base their
a burden and two, the issue of financing spending not only on their current income
the debt. but also on their expected future income.
 They will understand that borrowing  Firms may not be able to produce higher
today means higher taxes in the future. quantities that are being demanded at the
 Further, the consumer will be concerned ongoing prices. Prices will, therefore,
about future generations because they are have to rise.
the children and grandchildren of the  However, if there are unutilised resources,
present generation and the family which is output is held back by lack of demand. A
the relevant decision making unit, high fiscal deficit is accompanied by
continues living. higher demand and greater output and,
 They would increase savings now, which therefore, need not be inflationary.
will fully offset the increased government  It has been argued that there is a decrease
dissaving so that national savings do not in investment due to a reduction in the
change. amount of savings available to the private
 This view is called Ricardian equivalence sector.
after one of the greatest nineteenth  This is because if the government decides
century economists, David Ricardo, who to borrow from private citizens by issuing
first argued that in the face of high bonds to finance its deficits, these bonds
deficits, people save more. will compete with corporate bonds and
 It is called 'equivalence' because it argues other financial instruments for the
that taxation and borrowing are equivalent available supply of funds.
means of financing expenditure.  If some private savers decide to buy
 When the government increases spending bonds, the funds remaining to be invested
by borrowing today, which will be repaid in private hands will be smaller. Thus,
by taxes in the future, it will have the some private borrowers will get 'crowded
same impact on the economy as an out' of the financial markets as the
increase in government expenditure that is government claims an increasing share of
financed by a tax increase today. the economy's total savings.
 It has often been argued that 'debt does  However, one must note that the
not matter because we owe it to economy's flow of savings is not really
ourselves'. This is because although there fixed unless we assume that income
is a transfer of resources between cannot be augmented.
generations, purchasing power remains  If government deficits succeed in their
within the nation. goal of raising production, there will be
 However, any debt that is owed to more income and, therefore, more saving.
foreigners involves a burden since we In this case, both government and industry
have to send goods abroad corresponding can borrow more.
to the interest payments.  Also, if the government invests in
infrastructure, future generations may be
better off, provided the return on such
investments is greater than the rate of
Other perspectives on deficits and debt interest.
 The actual debt could be paid off by the
 One of the main criticisms of deficits is growth in output. The debt should not
that they are inflationary. This is because then be considered burdensome. The
when government increases spending or growth in debt will have to be judged by
cuts taxes, aggregate demand increases. the growth of the economy as a whole.
  For example, if an economy experiences a
recession and GDP falls, tax revenues fall
Deficit reduction because firms and households pay lower
taxes when they earn less.
 Government deficit can be reduced by an  This means that the deficit increases in a
increase in taxes or reduction in recession and falls in a boom, even with
expenditure. In India, the government has no change in fiscal policy.
been trying to increase tax revenue with
greater reliance on direct taxes (indirect
taxes are regressive in nature - they
impact all income groups equally).
Fiscal Responsibility and Budget Management
 There has also been an attempt to raise
Act, 2003 (FRBMA)
receipts through the sale of shares in
PSUs. However, the major thrust has been
towards reduction in government
expenditure.
 In a multi-party parliamentary system,
 This could be achieved through making
electoral concerns play an important role
government activities more efficient
in determining expenditure policies. A
through better planning of programmes
legislative provision, it is argued, that is
and better administration.
applicable to all governments - present
 A recent study by the Planning
and future - is likely to be effective in
Commission has estimated that to transfer
keeping deficits under control.
Re 1 to the poor, government spends Rs.
 The enactment of the FRBMA, in August,
3.65 in the form of food subsidy, showing
2003, marked a turning point in fiscal
that cash transfers would lead to increase
reforms, binding the government through
in welfare.
an institutional framework to pursue a
 The other way is to change the scope of
prudent fiscal policy.
the government by withdrawing from
 The central government must ensure inter-
some of the areas where it operated
generational equity, long-term macro-
before. Cutting back government
economic stability by achieving sufficient
programmes in vital areas like agriculture,
revenue surplus, removing fiscal obstacles
education, health, poverty alleviation, etc.
to monetary policy and effective debt
would adversely affect the economy.
management by limiting deficits and
 Governments in many countries run huge
borrowing. The rules under the Act were
deficits forcing them to eventually put in
notified with effect from July, 2004.
place self-imposed constraints of not
increasing expenditure over pre-
determined levels.
 These will have to be examined keeping
in view the above factors. We must note
that larger deficits do not always signify a
more expansionary fiscal policy.
 The same fiscal measures can give rise to
a large or small deficit, depending on the
state of the economy.