Module 5

Syllabus
⚫ Fiscal and Monetary Policies
⚫ Fiscal policy – features, roles; features and role of budget; types of deficit -
budget, fiscal, revenue and primary deficits; sources of revenue for Union
and State governments; GST. Monetary policy – meaning and roles;
instruments of monetary policy: Bank rate policy; repo rates; open market
operations; cash reserve ratio; SLR; selective credit controls. An overview
of Keynesian theory of employment
 Fiscal policy
⚫ Fiscal policy is defined as the conscious attempt of the government to
achieve certain macro economic goals of policy by altering the volume and
pattern of its revenue and expenditures and the balance between them. The
major economic goals of fiscal policy are to maintain a high average level
of employment and business activity, to minimize fluctuations in
employment activity, prevent inflation and to produce and promote
economic growth
⚫ The fiscal policy is used to control inflation through making deliberate changes
in government revenue and expenditure to influence the level of output and
prices. It is a budgetary policy. Fiscal policy is the use of government taxes and
spending to alter macro economic outcomes of the country.
⚫ The use of government spending and taxes to adjust aggregate demand is the
essence of fiscal policy. The simplest solution to the demand shortfall would be
to increase government spending. The government increases it’s spending
through construction of tanks, schools, highways. This increased spending is a
fiscal stimulus. Economic stability is a macro goal of the fiscal policy of a
country whether developed or developing. By economic stabilization it means;
controlling recession or depression and price stability.
Objectives Of Fiscal Policy:
⚫ 1. To maintain economic stability in the country
⚫ 2. To bring Price stability
⚫ 3. To achieve full employment
⚫ 4. To provide social justice
⚫ 5. To promote export and introduce import substitution
⚫ 6. To mobilize more public revenue
⚫ 7. To reallocate available resources
⚫ 8. To achieve balanced regional growth.
Instruments of fiscal policy
⚫ public expenditure
⚫ Increase in taxes/ public revenue
⚫ Pubic debt
⚫ Deficit financing
⚫ Public expenditures include normal government expenditures, capital
expenditures on public works, relief expenditures, subsidies of various
types, transfer payments and social security benefits. The increased public
spending have a multiple effect upon income, output and employment
exactly in the same way as increased investment has its effect on them.
Similarly a reduction in public spending can reduce the level of economic
activity through the reverse operation of the government expenditure
⚫ Public revenue - in order to meet public expenditure, a state need
funds. Such funds are called public revenue are raised from various
sources. The common sources of public revenue are taxes, borrowing
from public, profits of public sector undertaking, deficit financing and
foreign aid.
⚫ Public debt- when the state finds it difficult to match its inflows and
outflows , it resorts to public debt. Public debt may be internal or
external , when the government borrows from its own people in the
country, it is called internal debt on the other hand, when the
government borrows from outside sources, the debt is called external
debt. Public loans may be in the form of market loans and small
savings. public debt is a sound fiscal weapon to fight against inflation
and deflation. It brings about economic stability and full employment
in an economy
⚫ Deficit financing-when the government expenditure exceeds the
government revenue from taxes, profits of public undertakings,
borrowings from the public etc it resorts to deficit fi[Link]ficit
financing involves either drawing down of balances of the government
held in the central bank or by borrowing from the central bank.
⚫ Deficit financing is the budgetary situation where expenditure is higher than the
revenue. It is a practice adopted for financing the excess expenditure with
outside resources. The expenditure revenue gap is financed by either printing of
currency or through borrowing.
⚫ Nowadays most governments both in the developed and developing world are
having deficit budgets and these deficits are often financed through borrowing.
Hence the fiscal deficit is the ideal indicator of deficit financing.
⚫ In India, the size of fiscal deficit is the leading deficit indicator in the budget. It
is estimated to be 3.9 % of the GDP (2015-16 budget estimates). Deficit financing
is very useful in developing countries like India because of revenue scarcity and
development expenditure needs.
⚫ Various indicators of deficit in the budget are:
⚫ Budget deficit = total expenditure – total receipts
⚫ Revenue deficit = revenue expenditure – revenue receipts
⚫ Fiscal Deficit = total expenditure – total receipts except borrowings
⚫ Primary Deficit = Fiscal deficit- interest payments
⚫ Effective revenue Deficit-= Revenue Deficit – grants for the creation of capital assets
⚫ Monetized Fiscal Deficit = that part of the fiscal deficit covered by borrowing from the RBI.
⚫ Simply budget deficit is printing money to finance a part of the budget. In India, there is no
budget deficit at present. Hence one there is no budget deficit entry in Government’s budget.
Another absent deficit identity is monetized fiscal deficit. This is borrowing by the government
from RBI to finance the budget. Such a borrowing practice is not adopted in India from 1997
onwards. Hence the monetized fiscal deficit is also not there.
⚫ The leading deficit indicator and also the best one to measure the health of the budget
in the Indian context is fiscal deficit. The fiscal deficit represents borrowing by the
government. This borrowing is made by the government mostly from the domestic
financial market by issuing bonds or treasury bills.
⚫ The root factor that cause deficit in the budget is the revenue deficit. Revenue deficit is
the difference between revenue receipts and revenue expenditure in an accounting
sense.
⚫ In recent years, government is following another deficit term called effective revenue
deficit. Actually, revenue expenditure indicates expenditure to finance day to day
functions of the government. They are not productive. But according to the
government some revenue expenditure creates assets and hence is productive. This
revenue expenditure which creates assets is deducted to get Effective Revenue Deficit.
⚫ The last type of deficit is Primary Deficit that shows the difference between fiscal
deficit and interest payments.
Monetary policy
⚫ Monetary policy is the action taken by the monetary authorities generally
the central bank to control and regulate the demand and supply of money
with the public and flow of credit with a view to achieve predetermined
economic goals. The objectives of monetary policy are same as that of the
fiscal policy.
Instruments of monetary policy
⚫ The instruments of monetary policy refers to the monetary variables that
the central bank can change as its discretion with a view to controlling and
regulating the money supply and the availability of credit
⚫ RBI control credit through
⚫ Quantitative methods/ general
⚫ Qualitative methods/selective methods
Quantitative measures.
⚫ These aims at controlling the cost and quantity of credit by adopting;
⚫ Bank rate policy
⚫ Open market operations
⚫ cash reserve ratio
Bank rate policy
⚫ The rate of interest of every central bank is known as bank rate. It is also
known as discount rate. At this rate, the central bank rediscounts bills of
exchange and government securities held by the commercial banks. When
the cash reserves of the commercial banks tend to fall below the legal
minimum, the bank may obtain additional cash from the central bank
either by rediscounting bills with the central bank or by borrowing from it
against eligible securities.
⚫ The bank charges interest for this service. It controls credit by making
variations in the bank rate. A rise in the bank rate makes borrowing from
the central bank costly. So the commercial banks borrow less and they in
turn raise their lending rates to customers. This discourages business
activity, thereby there is decrease in demand for goods and services, and
ultimately fall in the price level. The bank rate is therefore raised to
control inflation. In the opposite case, lowering the bank rate offsets the
deflationary tendencies
Open market operations
⚫ Direct buying and selling of securities, bills and bonds of government and
private financial institutions by the central bank on its own initiative is
called open market operations. In periods of inflation, the central bank
sells in the money market first class bills. Buyers of this bill, say
commercial banks, make payments to the central bank. It reduces the size
of the cash reserves held by the commercial bank with the central bank.
Some banks are forced to decrease lending. Thus, business activities based
on bank loans and which are responsible for boom conditions are
curtailed
⚫ In times of depression, the central bank buys bills and securities from the
commercial banks paying cash to them for such purchases. It increases
the cash reserves of the central banks. Thereby the banks expand their
loans resulting in the expansion of investment, employment, production
and prices. Thus, the central bank, through its open market operations,
influences business activity and economic conditions of the country.
The cash reserve ratio (CRR)
⚫ The CRR us the percentage of total deposits which commercial banks are
required to maintain with the central bank. The objective of CRR is to
prevent the shortage of cash in meeting the demand for cash by the
depositors. The central bank enjoys the legal powers to change the CRR of
the banks at its own discretion.
Qualitative or selective credit control
⚫ Qualitative methods of credit control means the regulation and control of
the supply of credit among its possible users. Their aim is to channelize
the flow of bank credit from speculative and other undesirable purposes
to socially desirable and economically useful schemes. The selective credit
controls are the following;
⚫ Margin requirements---These aim to prevent excessive use of credit to
purchase securities by speculators. The central bank fixes minimum
margin requirements on loans for purchasing securities.
⚫ Regulation of consumer credit--- under this instrument, the central bank
regulates the bank credit by consumers in order to buy durable consumer
goods in instalments. To achieve this, it adopts two devices, minimum
down payment, and maximum period of repayment.
⚫ Rationing of credit--- it is employed to control and regulate the purpose
for which credit is granted by the commercial banks.
⚫ Direct action- it refers to the directives of the central bank to enforce the
commercial banks to follow a particular policy. The central bank gives
such directions in respect of; lending policies, the purpose for which
advances may be made, and the margins to be maintained in respect of
secured loans etc.
⚫ Publicity- the central bank publishes weekly, monthly or quarterly statements of
the assets and liabilities of the commercial banks for the information of the
public. It also publishes statistical data relating to money supply, prices,
production, employment and of capital and money market etc.
 main sources of government revenue in
India.
⚫ A. Tax Revenue:
⚫ Union Excise Duties:
⚫ They are, presently, by far the leading source of revenue for the Central
Government and are levied on commodities produced within the country,
but excluding those commodities on which State excise is levied (viz.,
liquors and narcotic drugs).
⚫ The most important commodities from the revenue point of view are
sugar, cotton, mill cloth, tobacco, motor spirit, matches and cement
⚫ Customs:
⚫ Customs duties include both import and export duties. These are the
second-most important source of revenue for the Central Government.
⚫ Income Tax:
⚫ Income tax is at present another important source of revenue for the
Central Government. It is levied on the incomes of individuals, Hindu
undivided families and unregistered firms.
⚫ Corporation Tax:
⚫ The income-tax on the net profits of joint stock companies is called corporation tax.
⚫ Wealth Tax:
⚫ It is an annual tax on the net wealth of individuals and Hindu undivided families. It is a
progressive tax.
⚫ Gift Tax:
⚫ It is a tax on gifts of property by an individual in his lifetime to future successors.
⚫ Capital Gains Tax:
⚫ It is applicable to capital gains resulting from the sale, exchange or transfer of capital assets.
⚫ Hotel Expenditure Tax:
⚫ Recently, a new tax has been levied on those who patronise high class hotels.
⚫ ax on Foreign Travel:
⚫ Another new tax levied on foreign travel for conserving foreign exchange as well as to
raise revenue.
⚫ B. Non-Tax Revenue:
⚫ Interest Receipts:
⚫ This largest non-tax source of Central Government’s revenue receipts is the interest it
earns mainly on the loans it has advanced to State Governments, to financial and
industrial enterprises in the public sector.
⚫ Surplus Profits of the Reserve Bank of India (RBI):
⚫ The surplus profits of the RBI is also a part of the revenues of the Central Government.
In recent years, these have been quite substantial because of the large borrowing by the
Government from the RBI against Treasury Bills for financing the Five-Year Plans.
⚫ Currency, Coinage and Mint:
⚫ The Government also derives income from running the Currency Note
Printing Presses. Moreover, profits are made from the circulation of coins
— this profit being the difference between the face value of the coins and
their manufacturing cost.
⚫ Railways:
⚫ The railways in India are owned and run by the Government of India.
Accordingly, they pay a fixed dividend to general revenues, i.e., to the
Central Government, on the capital invested in the railways. Besides, a
part of the net profits made by the railways is also payable to the Central
Government.
⚫ Profits of Public Enterprises:
⚫ Public enterprises owned by the Central Government, e.g., the Steel
Authority of India (SAIL), Hindustan Machine Tools (HMT), Bharat
Heavy Electricals Ltd. (BHEL), State Trading Corporation (STC). The
profits of such Public Sector Units (PSUs) are another source of revenue
for the Government of India.
⚫ Other Non-Tax Sources of Revenue:
⚫ The main source among them is the Departmental Receipts of the various
ministries of the Central Government by way of fees, penalties, etc.
The Sources of State and Local
Tax Revenues

⚫ SGST.
⚫ Entry Tax.
⚫ Stamp Duty.
⚫ Property Tax.
⚫ Water Tax.
⚫ Electricity Tax.
⚫ Other local charges and duties.
⚫ State Governments also get their share of Income Tax and Excise duty from
Central Government as per the recommendations of Finance Commissions
constituted by Central Government.
GST
⚫ GST is an Indirect Tax which has replaced many Indirect Taxes in India.
The Goods and Service Tax Act was passed in the Parliament on 29th
March 2017. The Act came into effect on 1st July 2017; Goods & Services
Tax Law in India is a comprehensive, multi-stage, destination-based
tax that is levied on every value addition.
⚫
⚫ In simple words, Goods and Service Tax (GST) is an indirect tax levied on
the supply of goods and services. This law has replaced many indirect tax
laws that previously existed in India.
⚫ GST is one indirect tax for the entire country.

⚫ So, before Goods and Service Tax, the pattern of tax levy was as follows
⚫ Under the GST regime, the tax will be levied at every point of sale. In case
of intra-state sales, Central GST and State GST will be charged. Inter-state
sales will be chargeable to Integrated GST.
⚫ Now let us try to understand the definition of Goods and Service Tax –
“GST is a comprehensive, multi-stage, destination-based tax that will
be levied on every value addition.”
Multi-stage

⚫ There are multiple change-of-hands an item goes through along its supply
chain: from manufacture to final sale to the consumer.
⚫ Let us consider the following case:
⚫ Purchase of raw materials
⚫ Production or manufacture
⚫ Warehousing of finished goods
⚫ Sale to wholesaler
⚫ Sale of the product to the retailer
⚫ Sale to the end consumer
Goods and
Services Tax will
be levied on
each of these
stages which
makes it a
multi-stage tax.
Value Addition

GST will be levied on these

value additions i.e. the
monetary worth added at
each stage to achieve the
final sale to the end
customer.
Destination-Based

⚫ Consider goods manufactured in Maharashtra and are sold to the final

consumer in Karnataka. Since Goods & Service Tax is levied at the point of
consumption, in this case, Karnataka, the entire tax revenue will go to
Karnataka and not Maharashtra.
Advantages Of GST

⚫ GST will mainly remove the Cascading effect on the sale of goods and
services. Removal of cascading effect will directly impact the cost of
goods. Since tax on tax is eliminated in this regime, the cost of goods
decreases.
⚫ GST is also mainly technologically driven. All activities like registration,
return filing, application for refund and response to notice needs to be
done online on the GST Portal. This will speed up the processes.
⚫ What are the components of GST?
⚫ There are 3 taxes applicable under this system: CGST, SGST & IGST.
⚫ CGST: Collected by the Central Government on an intra-state sale (Eg:
transaction happening within Maharashtra)
⚫ SGST: Collected by the State Government on an intra-state sale (Eg:
transaction happening within Maharashtra)
⚫ IGST: Collected by the Central Government for inter-state sale (Eg:
Maharashtra to Tamil Nadu)
Transaction New Regime Old Regime
Sale within the State CGST + SGST VAT + Central Revenue will be
Excise/Service shared equally
tax between the
Centre and the
State

Sale to another State IGST Central Sales There will only

Tax + be one type of
Excise/Service tax (central) in
Tax case of
inter-state sales.
The Center will
then share the
IGST revenue
based on the
destination of
goods.
⚫ Illustration:
⚫ Let us assume that a dealer in Gujarat had sold the goods to a dealer in Punjab
worth Rs. 50,000. The tax rate is 18% comprising of only IGST.
⚫ In such case, the dealer has to charge Rs. 9,000 as IGST. This revenue will go to
the Central Government.
⚫ The same dealer sells goods to a consumer in Gujarat worth Rs. 50,000. The GST
rate on the good is 12%. This rate comprises of CGST at 6% and SGST at 6%.
⚫ The dealer has to collect Rs. 6,000 as Goods and Service Tax. Rs. 3,000 will go to
the Central Government and Rs. 3,000 will go to the Gujarat government as the
sale is within the state.
⚫ In the pre-GST regime, every purchaser including the final consumer paid
tax on tax. This tax on tax is called Cascading Effect of Taxes.
⚫ GST avoids this cascading effect as the tax is calculated only on the
value-add at each stage of transfer of ownership.
Tax calculations in earlier regime:
Action Cost 10% Tax Total
Manufacturer 1,000 100 1,100
Warehouse adds label 1,400 140 1,540
and repacks @ 300
Retailer advertises @ 2,040 204 2,244
500
Total 1,800 444 2,244
Tax calculations in current regime:
Action Cost 10% Tax Actual Liability Total

Manufacturer 1,000 100 100 1,100

Warehouse adds 1,300 130 30 1,430

label and repacks
@ 300

Retailer 1,800 180 50 1,980

advertises @ 500

Total 1,800 180 1,980

An outline of Keynesian Theory of
Employment
J. M. Keynes
▪ John Maynard Keynes was the greatest and the most eminent
economist of the mid-twentieth century.
▪ During the period 1929-33 - Great Depression in the capitalist
countries which caused huge unemployment, low income and
low production.
▪ His famous book “General Theory of employment, interest
and money” published in 1936” challenged the validity of the
classical theory of employment.
▪ He is not only criticized the classical theory of income and
wealth but also - propounded new theory of employment and
output Keynesian Revolution
▪ This book gives a systematic treatment to the theory of
employment, explaining the real causes of unemployment.
▪ He tries to provide that under employment equilibrium is the
normal features of capitalist economy.
 Keynesian theory of income and employment
⚫ Keynesian theory of income and employment is a - short
period – where the stock of capital techniques of production,
efficiency of labour, size of population have been assumed to
remain constant.
⚫ In this theory, the amount of employment depends upon the
level of national income and output.
⚫ This is because, given the amount of capital, technology and
labour efficiency increase in income and output can be
obtained by employment of more labour.
⚫ Unemployment causes due to lack of effective
demand/deficiency of outlay on consumption and investment
function.
⚫ The level of income and employment in an economy at any
given time depends upon the effective aggregate demand.
▪ The Keynesian theory of employment touches all aspects
of the economy as a whole and hence his theory can be
called macro economics.
▪ According to him, national income determined the level of
employment – greater the national income, higher will be
the level of employment and lower the level of national
income, the lower the amount of employment.
▪ He strongly argues that Government intervention must be
required at time of depression – where level of income,
employment and output at the lower level – lack of
aggregate demand.
 Level of Employment and
Income

Level of Effective
Demand

Government
Consumption Investment Expenditure

Size MEC
of Propensity Rate of
Inco to Interest
Expectatio
me Consume Replacement
n of
cost
Liquidity Supply of Profit
Preference Money

Transacti Speculativ
on Precautionary
e
Motives Motives
Motives
 Fundamental Equation
▪ The fundamental equation of Keynes is
Y=C+I
Y = National Income
C = Consumption
I = Investment
▪ According to Keynes, the level of national income
determines the level of employment.
▪ If NI increases the level of employment could also be
increased.
▪ So that, increasing the level of NI employment also
increases and thereby the economy should be move
from the under-employment to full employment
condition.
▪ According to Keynes the three constituents of national income
are – consumption, investment and expenditure
▪ Government expenditure plays a dominant role and according
to Keynes formula
Y=C+I+G
Y = National Income
C = Consumption
I = Investment
G = Government Expenditure.
▪ Keynes total income depends on total employment – this
depends on effective demand in the economy.
▪ Effective demand depends on consumption expenditure and
investment expenditure.
▪ Consumption depends on income and propensity to consume –
Investment depends on Marginal Efficiency of Capital (MEC)
and rate of interest.
 2. Principle of Effective Demand
▪ The level of income and employment in a country at any
given time depends on effective demand.
▪ An increase in effective demand will lead to an increase in
production and income and it leads to increases in
employment.
▪ A decrease in effective demand will result in contraction
of production and income and in the level of employment.
▪ Effective demand is the point at which aggregate demand
will be equal to aggregate supply.
▪ It is the equilibrium point determined by the equality of
aggregate demand function and aggregate supply function.
▪ According to Keynes, effective demand is equal to the
total volume of output available in the economy
⚫ The aggregate demand function includes consumer and
capital goods.
⚫ Keynesian theory of employment related to short period –
where technique of production as unchanged.
⚫ Therefore, an increase in the output of the economy is
possible only if there is an increase in employment.
⚫ Thus according to Keynes – effective demand = total
output = employment = total income = consumption
expenditure + investment expenditure.
⚫ Consumption expenditure is determined by two factors –
level of income and the propensity to consume.
⚫ Investment expenditure depends upon the marginal
efficiency of capital (MEC) and rate of interest.
⚫ Deficiency of effective demand means – when increases in the
national income, consumption is not increasing
proportionately, thereby creating gap between income and
consumption (MPC < 1).
⚫ This gap should be covered by an increase in investment.
⚫ Therefore Y = C + S
Y=C+S
S=I
⚫ Therefore, level of employment in the economy at any time
depends on the volume of effective demand.
⚫ These effective demand determined by aggregate demand
function (ADF) and aggregate supply function (ASF) – where
both ADF & ASF intersect each other that point is called as
equilibrium.
⚫ This equilibrium point is known as fully employment
equilibrium
 3. The Propensity to Consume
▪ Consumption function or propensity to consume forms a
vital part of Keynesian analysis.
▪ As we studied that effective demand depends on
consumption and investment in the economy.
▪ Consumption is one of the important determinants of level
of employment.
▪ According to Keynes, consumption depends on two
factors size of income and propensity to consume.
▪ The amount of income which is spent on consumption out
of a given total income is known as propensity to
consume.
▪ Propensity to consume expresses a relationship between
income and consumption.
▪ When income increases, consumption are also increases
not as much of income increases – a part of income is
likely to be saved. So consumption will be less than
income.
▪ An individual/family/community will spend a part of the
income on consumption – it may be 70% - 80% of the
income and the rest may be saved.
▪ The propensity to consume depends on various factors
such as price level, interest rate, stock of wealth and
several subjective factors remains constant (short period).
▪ Thus Keynesian consumption function depends on level of
income.
C = a + bY
ab = constant
C = consumption represents MPC
Y = level of income

C+
Y
C R
2
P
C1
Consumpti
on

Y1 Y2
Incom
e
⚫ The propensity to consume higher in the lower income level
and lower in high income level (poor and rich)
⚫ Propensity to consume is fairly stable during short period as the
consumption habits of the community will not change.
⚫ Propensity to consume – two types
⚫ Average propensity to consume (APC) – refers to the total
amount of consumption expenditure divided by a given total
income at a particular period.
APC = Total Consumption
Total Income

⚫ Marginal propensity to consume (MPC) –refers to the additional changes in

consumption as result of changes in income
MPC = ΔC
ΔY
 4. Marginal Efficiency of Capital (MEC)
▪ Keynesian effective demand consists of two major components –
consumption and investment.
▪ Consumption function – more or less stable in the short period.
Therefore investment function has the vital role in determination of
effective demand.
▪ The level of investment depends upon two important factors –
marginal efficiency of capital and rate of interest.
▪ MEC refers to the expected profitability of an additional capital asset.
▪ It may be defined as the highest rate of return over cost expected from
the marginal or additional unit of capital asset.
▪ For example, suppose a plant costs Rs. 10.000 to an entrepreneur and
the expected yield from the plant is Rs. 500 per annum.
▪ Then the marginal efficiency of the plant would be 500 X 100 = 5%
10.000
 5. Rate of Interest
▪ The rate of interest is determined on the liquidity
preference of the people.
▪ Liquidity preference is governed by transaction motive,
precautionary motives and speculative motives.
▪ The supply of money and the liquidity preference together
determine the rate of interest.
 Investment function
▪ Investment function is the crucial factor in the
determination of effective demand.
▪ Investment demand depends upon two factors MEC and
rate of interest.
▪ Rate of interest is comparatively stable and does not
frequently change in the short run. Therefore, the
fluctuations in the level of investment depends on MEC.
▪ Higher the MEC higher will be the level of investment and
vice-versa.
▪ During the period of depression the prospects of profit will
become little and they may not be increased by the
economy.
▪ Investment has two types
1. Induced investment and
2. Autonomous investment.
▪ Autonomous investment is an investment which does not
change with the changes in the income level – independent of
income.
▪ Keynes thought that the level of investment depends upon
MEC and rate of interest – therefore, changes in income level
will not affect investment.
▪ Autonomous investment generally takes place in houses, roads,
public undertakings and in other types of economic
infrastructure such as power, transport and communication.
▪ This autonomous investment depends more on population
growth and technical progress than on the level of income.
▪ Most of the autonomous investment undertaken by government
– at time of depression enhancing aggregate demand.