Vedanta Economics Book 10 Final (2077)

4UNIT MONEY, BANKING AND NON-BANKING
FINANCIAL INSTITUTIONS

Learning Objectives Weight:22 Lecture Hours

On Completion of this unit the student will be
able to:
• Explain the difficulties of barter system

• Define and explain the functions of money

• Define bank and explain the types of banks

• Explain the functions of central bank Before you begin

• Understand and explain the functions of Money makes the world go around. Econo-
mies rely on the exchange of money for
commercial bank
products and services. Money has changed
• Understand credit and credit instruments substantially since the days of shells and

• Explain the importance of credit instruments skins, but its main function hasn’t changed
at all. Regardless of what form it takes,

money offers us a medium of exchange

for goods and services and allows the

economy to grow as transactions can be

completed at greater speeds.

Very Short Type Short Type Long Answer Type Total Marks
1 1 1 16

51 Vedanta High School Economics - 10

4.0 MEANING OF BARTER SYSTEM

Barter is the direct exchange of goods for goods. It involves the system of trading or
exchange where goods and services are exchanged with other goods and services. This
system was prevalent before the invention of money.
Barter system of trading originated when man required such things which he couldn’t

produce himself. He started producing such goods and services which he is able to produce
and the surplus goods were exchanged for deficit goods. Thus in a barter, one person sells
goods to other in exchange of other goods. In a barter system a particular want is satisfied
in a single transaction.
In the initial period of human civilization, the wants of the people were limited. They
used to fulfill their wants within the household or by exchanging surplus goods with
deficit goods. With the development of human civilization, wants increase in number and
variety. As a result, it becomes increasingly difficult to transact under barter system. This
led to the origin of money.

DIFFICULTIES OF BARTER SYSTEM

In barter system most difficulties were faced because there are no alternative except to
exchange goods for goods. The following are the major difficulties of barter system.

1. Lack of Double Coincidence of Wants: Barter exchange needs double coincidence wants.
It is the act in which one has to find a person who needs the goods he has and has the
goods he needs. In reality it is very difficult to get such a coincidence. There cannot be
exchange in the absence of double coincidence of wants. Barter system lacks this double
coincidence of wants.

2. Lack of Common Measure of Value: One of the serious difficulties of barter system
is lack of standard measure of value acceptable to all. Barter system lacks units of
standard measurement. For example, Ram needs goats and Shyam needs cow. Here the
problem arises as to how many goats can be exchanged for a cow? There is no common
measure of value in exchange of goats and cow.

3. Difficult to Exchange Indivisible Goods: The commodity of higher worth has to be
divided into small pieces to make exchange for the commodity of lower worth. But all
commodities cannot be divided into small pieces. Some commodities lose their utility
and become worthless if they are sub divided. For example a person has a horse and he
wants to exchange his horse with some rice, soap, sugar, clothes etc. In this situation
he cannot divide his horse into many pieces for those goods.

4. Lack of Deferred Payment: In barter system it is difficult to exchange goods in credit.

Goods must be exchanged with goods. There is no provision to get goods in credit and

there is difficulty for deferred payment. For example, Deffered payment in-

Shyam taken a cow from Ram and has to pay back KEY volves paying for a good or
IDEA
after a year. In this case complexity arises as to what a service at a future point in
and how much to pay after one year to Ram. time.

5. Limits the Scope of Market: Barter system limits the scope of market. Due to the
difficulty of transport and communication, it is difficult to exchange goods in distant
places. At times, the transportation cost may far exceed the value of goods transacted if
the trading parties are far off.

6. Limits Specialization: Barter exchange is done on a small scale. Large scale production

Vedanta High School Economics - 10 52

is not possible. Its trade and market is limited. Hence, it is difficult to achieve high
level of specialization.

7. Difficult to Store Value: Some goods are perishable in nature. Some commodities, such
as milk, fish, vegetable, wheat, and cotton lose value with the passage of time. Such
commodities could not store for a long period.

8. Lack of Transfer of Value: Under barter system there is difficulty of transfer of wealth
from one place to another place. Immovable property cannot be transferred to another
place. The transfer of movable property is very difficult and costly.As for example, it is
difficult to transfer land, buildings.

4.1 MONEY

Money is one of the fundamental inventions of mankind. It has become so important
that the modern economy is described as the money economy. Even in the early
stages of economic development, the need for exchange arose. Exchange took place
first in the form of barter. The inconveniencies of barter system led to think about the
commodity that could be the medium of exchange. This led to the invention of money.
There is a controversy among economists as to the place and nature of the origin of
money, but money was in existence from ancient time. Different things were used as
money in different times in the history.

In primitive agricultural society cattle were used as money. In the process of
development animal skins, precious stones, rice etc were also used as money. With
the growth of society metallic money like iron, copper, gold also acted as money. As
business activities expanded,metallic money was also found as inconvenient and paper
money was introduced. In the modern society people feel difficulties in large payment
through paper notes so cheques, drafts, bill of exchange are used as money.

The first known paper currency appeared in China. In all, China experienced over 500
years of early paper money, from the 9th through the 15th century. Over this period,
paper notes grew in production and their value rapidly depreciated and inflation
soared. Then beginning in 1455, the use of paper money in China disappeared for
several hundred years. This was still many years before paper currency would reappear
in Europe, and three centuries before it was considered common.

MEANING AND DEFINITION OF MONEY

Money is a concept which we all understand but which is difficult to define in exact
terms. Money is any marketable good or token used by The increasing difficul-

a society as a store of value, a medium of exchange, or ties of barter system led to

a unit of account. Since different things are used as KEY the invention of money
money the definition of money is not unanimous and IDEA

different economists defined money differently.

Crowther:“Anything that is generally acceptable as a means of exchange and at the same
time, acts as a measure and as a store of value.”

Seligman: “Money is one thing that possesses general acceptability”.
Kent: “Anything which is commonly used and generally acceptable as a medium of exchange
or as a standard of value.”
Robertson: “Money is anything which is widely accepted in payment for goods or in
discharge of other kinds of business obligations.”

53 Vedanta High School Economics - 10

The definition of money given by Crowther may be considered a comprehensive
definition as it focused on the general acceptability, medium of exchange, measuring
value and store value of money. Money is generally accepted because the monetary
authority promised for its value.

Thus money is a legal tender which has general acceptability as a medium of exchange,

measure and store of value and is used in the settlement of debts.

Glossary Legal tender: That which is sanctioned by the law
Perishable: Likely to decay or go bad quickly
Controversy: Disagreement
Specialization: The process of becoming an expert in a particular area

FORMS OF MONEY - Stages in the Evolution of Money

Money has evolved through various stages over the years. The various stages in the
evolution of money may also be taken as the types of money:

1. Animal Money: The first stage in the evolution of money was animal money. In the
ancient Indian and Roman civilization, animals like cow and ram were used as money.
The use of cows as money (Go- dhan) can be traced to Vedic age.

2. Commodity Money: The commodities used as money is called commodity money.
People had used different types of commodities like animal leather, bones during
hunting age and grains during agricultural age as money. These commodities lacked
the basic features of good money and were discarded as money.

3. Metallic Money: The money made of metal is called metallicIn case of standard
money. It refers to the coins made up of with metal like silver,money, the face value is
copper, nickel etc. Metallic money was used from the end of theequal to metallic value.

19th century. It is an unlimited legal

The metallic money is of the following two types: tender

a. Standard or Full-bodied Money: The gold and silver coins with definite weight and
purity are called standard or full-bodied money. The face value of such money is
equal to the intrinsic value. Its value does not fall even by melting. This money is
unlimited legal tender. People are bound by law to accept any quantity of it.

b. Token or Subsidiary Money: The money made of inferior metals is called token or
subsidiary money. The coins made of aluminum, copper are token money. The face
value of token money is higher than the intrinsic value. Since this money is limited
legal tender, nobody can be made to accept more than a particular quantity.

4. Paper Money: Paper money came to be used after the Great Depression of 1930. This

money is made of paper. It consists of currency notes issued by the government or
Key Terms
central bank of the country. In Nepal paper notes are

issued by Nepal Rastra Bank. Paper money is issued Intrinsic: Inward; internal
against the reserve of precious metals like gold, silver in Bullion: Gold or silver in bulk
before coining, or valued by
the central bank.
weight
The paper money can be divided into four types:

a. Representative Money: The paper money which is fully backed by gold and silver

reserve is called representative paper money. Since they can be converted into

gold in case of need, they are also called convertible paper money. They are fully

convertible into gold, coins or bullion.
Vedanta High School Economics - 10
54

b. Convertible Paper Money: The paper money which is convertible into standard
coins is called convertible paper money. It is backed by metallic reserves and
eligible securities. The circulation and supply of this kind of paper money is more
flexible as compared to representative paper money.

c. Inconvertible Paper Money: The paper money which is not convertible into

standard coins and bullion is called inconvertible paper money. No metallic reserve

is maintained by the monetary authorities for such money. Notes issued by central

banks of all countries represent inconvertible paper money. They are also known as

fiduciary money. Fiat money is issued dur-

d. Fiat Money: It is a form of inconvertible paper KEY ing emergency or crisis and
money. Paper money which circulates on the IDEA is an incovertible paper
authority of the government is fiat money. It is money

issued during emergency or crisis. It is also called emergency currency. Since, it

is issued by the state, it is unlimited legal tender. But there is no legal provision to

convert it into gold or silver.

5. Bank Money or Credit Money: With the expansion of banking practices, people feel
paper money as inconvenient for large payment. So credit instrument were introduced
to act as money. Such money is not legal tender money and is called near money. For
example, cheque, bills of exchange, bonds, equity shares etc. are credit money.

• In case of Token money face value is greater than its metallic valueKeynote

• Token money is a limited legal tender
• Bank money is not actual money and is considered near money
• Fiat money is issued during emergency or crisis

A FUNCTIONS OF MONEY

There are many functions of money. Broadly the functions are divided into the following
three categories.

A. PRIMARY FUNCTIONS:
The primary functions of money are the main functions of money. They are:

1 Medium of Exchange: The most important function of money is that it acts as a medium
of exchange. Money is accepted freely in exchange for all other goods. The buying and
selling of goods is done through the medium of money. Money makes easy to exchange
goods because it is generally accepted against goods.

2. Measure of Value: Money acts as a common measure of value. It is a unit of account
and a standard of measurement. Money is the standard thing which measures the value
of all the good and services produced in the economy. The value of goods and services
is reduced to a single unit of account. As it measures the value of all economic goods
and services, it is helpful in accounting these values.

B. SECONDARY FUNCTIONS:
The secondary functions of money are the subsidiary functions of money. They are:

1. Store of Value: Money also serves as a store of value. Wealth can be sold for money and
can be stored in the form of money. Money can be easily stored for future use. It is the
most convenient and economical means of storing earnings and wealth. It has the merit
of general acceptability and its value remains stable as compared to other goods.

55 Vedanta High School Economics - 10

2. Transfer of Value: Money has transfer value because if money is transferred from on
hand to another, value is transferred. In the same way fixed assets like land and house
can be transferred through money. People transfer value by selling commodities or
property to others and by buying commodities and property with others.

3. Standard of Deferred Payment: Standard of deferred payment refers to the future

payment of the debt taken. It means payment can be Key Terms

spread over a period of time. Due to general acceptability Deferred: postponed or at
of money, future payments are expressed in terms of some point of time in future-
money. So, as a standard of deferred payment money Asset: wealth
facilitates borrowing and lending activities.

C. CONTINGENT FUNCTIONS:
Prof. Kinley has mentioned four contingent functions of money. These functions are as

follows:

1. Distribution of National Income: The total output of the economy is produced by the
joint effort of the land, labour, capital and entrepreneur. The rewards for these factors
of production are rent, wage, interest and profit respectively. Money makes easy to pay
these factors in common unit.

2. Maximum satisfaction: People derive maximum satisfaction with the help of money. A
person derives maximum satisfaction when he equates marginal utility of a commodity
to its price expressed in monetary terms. Likewise, the producers also spend money in
different factors so as to make marginal productivity of all factors equal to their prices.
This helps to maximize benefits.

3. Basis of credit system: Credit plays an important role in business. Banks provide credit
to its loanees as money. Thus money is the base of credit. The payments of cheque, pay
orders, treasury bills are also in terms of money.

4. Liquidity to wealth: In economics, money is taken as perfect liquid asset. This means
money can be converted into goods and services easily. Personal wealth can be kept in
the form of money. Money in liquid form helps its possessor to spend it as and when
needed. Thus money acts as the most liquid asset in the economy.

CHECKPOINT 1. Define barter system. What are the inconveinences of barter system?

2. Define money. What are its types?

3. What are the main functions of money?
4. Explain how money helps to overcome the difficulties of barter system?

4.3 BANK

ORIGIN OF BANKING

The term “Bank” comes from the Italian word ‘banco’ or a German word ‘banc’. The Greek word
‘banque’ means a bench where financial transactions used to be made. A ‘banco’ was a table covered
in green cloth where the Jewish money lenders perform their transactions in the marketplace.

The roots of banking can be traced to the earliest civilizations. Some sort of banking was prevalent in the
ancient civilizations of Romans, Egyptians, Babylonians and Indians. The Egyptians and early societies
of the Middle East developed the prototype upon which modern banking is based. The practice of safe-
keeping and savings flourished in the temple of Babylon as early as 18th century B.C. There are records of
loans from the 18th century B.C in Babylon that were made by temple priests to merchants. Chanakya in
his Arthashastra written in about 300 B.C. mentioned about the existence of powerful guilds of merchant

Vedanta High School Economics - 10 56

bankers who received deposits, and advanced loans and issued hundis (letters of transfer). In ancient

Nepal Shankadhar Shakya role in emancipation of the debt ridden people may be considered to that of

a banker. Pause for Thought

History apart, it was the ‘merchant banker’ who first evolved the How does banking system
system of banking by trading in commodities than money. Their help in the economic devel-
trading activities required the remittances of money from one place
to another. For this, they issued ‘hundis’ ( letter of transfer) to remit opment of a country?

funds.

The next stage in the growth of banking was the goldsmith. In England, goldsmiths were responsible
not only for storing gold and issuing receipts. The merchants in the neighbourhood started leaving
their bullion, money and ornaments in his care. As this practice spread, the goldsmith started charging
something for taking care of the money and bullion. As evidence for receiving valuables, he used to issue
a receipt. Since gold and silver coins had no marks of the owner, the goldsmith started lending them. As
the goldsmith was prepared to give the holder of the receipt equal amount of money on demand, the
goldsmith receipt serves like cheques as a medium of exchange and a means of payment.

The next stage in the growth of banking was the moneylender. The goldsmith found that on an average
the withdrawals of coins were much less than the deposits with him. So he started advancing the coins on
loan by charging interest. As a safeguard, he kept some money in the reserve. Thus the goldsmith-money
lender became a banker who started performing the two functions of modern banking that of accepting
deposits and advancing loans.

The Bank of Venice established in 1157 AD was the first public bank in the world. It was followed by other

banks in the course of origin of modern banking. Bank of Barcelona established in 1401 (still functioning)

and Bank of Genoa established in 1406 were the second and the third banks established as a public

enterprise. Sveriges Riksbank, (Riksbanken), the central Bank of Sweden established in 1668 A.D. is the

world’s oldest central bank and still in operation. Bank of England established in 1694 was the second

central bank in the world and is also called ‘Mother of Modern Banks’. Most of the earlier banks were
A bank is an institution that
established in Europe as Europe was the trading hub at that time.
dealts in money and credit

MEANING AND DEFINITION OF BANK

A bank is a financial institution which deals with deposits and advances and other
related services. It receives money from those who want to save in the form of deposits
and it lends money to those who need it.

Though the modern banks perform variety of functions it is difficult to give the precise
definition of bank. It can be defined as an institution which deals with money and
credit. It accepts deposits from public, makes the fund available to those who need
them. It also helps in the remittance of money.

Crowther: “A bank- collects money from those who have it to spare or who are saving it
out of their incomes, and it lends this money to those who require it”.

Walter Lifley: “ A bank is an institution of individual who is always ready to receive
money on deposits to be returned against the cheque of their depositors”.

In modern time, a bank performs several other activities besides deposit collection and
lending. Banks have been growing with respect to not only their functions, but also in
terms of their types, dealing with different facets of money and credit. Modern banks
accept deposit from the public, make funds available to those who need them, and help
in remittance of money from one place to another.

57 Vedanta High School Economics - 10

4.4 TYPES OF BANK

Banks are divided into different kinds on the basis of functions, specialization and
nature. The type of bank differs from country to country. Generally the following are
the types of banks on the basis of the functional scope.

1. Commercial Bank: The commercial bank is the oldest type of bank. In general, the term
bank is used to mean a commercial bank. It performs all kinds of banking business and
generally finances trade and commerce. The main objective of this bank is to, earn profit.
This type of bank was initially established to provide short-term loans to the traders.
Hence, this bank is called commercial bank. Commercial bank collects deposits in
current, saving and fixed account from the general public and institutions. It provides
loans to individuals and institutions from the deposits. The modern commercial banks
provide loans not only to traders but also to agriculture, industry and services.

Nepal Bank Limited established in November 15, 1927 (Kartik 30, 1994 B.S.) is Nepal’s
first commercial bank. It was formed under the principle of Joint venture (between
government and general public).

2. Central Bank: Central Bank is the apex monetary institution which controls, monitors
and supervises the banking structure of the country. It makes monetary management
of the country and implements the monetary policy of the government. A central bank
is established in every country. This bank is established under complete government
ownership. Its objective is not profit earning. The main function of it is monetary
management and to contribute to economic development. Sveriges Riksbank, or simply
Riksbanken, established in 1668 A.D. is the central Bank of Sweden. It is the world’s
oldest central bank and still in operation. The Bank of England established in 1694 is
the second central bank of the world.

Nepal Rastra Bank which was established in 2013 BS, under the NRB act 2012 B.S (1955
A.D) is the central bank of Nepal. Nepal Rastra Bank was established to discharge the
central banking responsibilities including guiding the development of the embryonic
domestic financial sector.

3. Industrial Bank: The bank established for the development of industries is known as
industrial bank. This bank provides long term loans and industrial consultancy for
the establishment, development and modernization of industries. It also purchases,
sells and underwrites the shares and debentures of industries. It also makes direct
investments in industries in case of need. It encourages industrial investments by
providing information’s on industrial feasibility and by helping to raise loans from the
market. Since this bank deals in shares and debentures and underwrites and invests in
industries, this bank is also referred to as ‘investment bank‘.

Nepal Industrial Development Corporation (NIDC) established in 1959 (2016 B.S.) is an
example of Nepal’s industrial bank.

4. Agricultural Bank: The bank established for the development and modernization of
agriculture sector is called agricultural bank. It provides short-term loans for buying
manure, seed and small implements, and for payment of wages. It also provides long-
term loans to purchase land, machinery and expensive equipments. There are some
other types of agriculture bank like land mortgage bank and co-operative bank. The
land mortgage bank provides loans to the farmers against the security of their lands. It

Vedanta High School Economics - 10 58

provides long-term credit to buy agricultural machinery, equipments and making large
improvements in land.

Agricultural Development Bank, established in 1968 A.D under the ADBN Act 1967
is the Agricultural Bank of Nepal. The bank was established with the main objective
of providing institutional credit for enhancing the production and productivity of the
agricultural sector in the country.

5. Development Bank: Development banks are specialized financial institutions which
are established to finance the development of specific sectors like agriculture, industry
and rural areas in the country. Development banks generally provide medium-term and
long- term loans. But they also provide short-term loans for agriculture. Beside making
available loans they also make available managerial and technical services. The rural
development banks and development banks involved in micro finance are established
to provide banking services to the rural poor. The rural poor deposit their saving both
individually and collectively. They receive collective loan without collateral and
personal loan on the basis of personal collateral.

6. Rural Bank: The concept of Rural Bank was developed in Bangladesh in 1976 A.D as
Grameen Bank by Prof. Muhammad Yunus. It won him Nobel Peace Prize in 2006 A.D.
Rural Bank is a financial institution which is established to provide banking services
to the rural people. It provides micro finance facilities to the rural people. Generally,
it is based on the concept of banking to the rural poor. The rural poor can obtain loans
from rural banks on easy term and on group guarantee basis without security. One of
the main objectives of rural bank is to alleviate rural poverty.

Grameen Bikas Bank, Nirdhan Utthan Bank, etc. Prof. Muhammad Younis is
are the rural banks operating in Nepal. Such Micro a Bangladeshi economist
finance (Micro Credit Development Bank) could who developed the concept
help poor people who do not have any collateral, of Grameen Bank. It won
but a willingness to work and a desire to do some him Nobel Prize in 2006
business activities from which he/She will acquire A.D
employment as well as income.

7. Saving Bank: The saving bank is established to collect the scattered savings of low-
income people. On the one hand, it increases capital formation by mobilizing small
savings. On the other hand, it encourages savings among low-income people. In reality,
it is not a bank at all. The man, who deposit’s money in this bank, can withdraw only
a definite amount each week.

8. Exchange Bank: The bank established to deal in foreign currency is called exchange
bank. Its objective is to help in international trade. This bank provides loans to
importers by discounting their bills and remits the money of importers to their parties.
This task is undertaken either through its own branch in foreign countries or through
correspondent banks. There is no separate exchange bank in Nepal. The foreign
exchange is controlled by Nepal Rastra Bank.

Glossary Fiscal policy: Income and expenditure policy of the government
Collateral: Something pledged as security for repayment of a loan
Vault: Safe or box for keeping valuables
f Remit: Transfer money
Apex: Topmost

59 Vedanta High School Economics - 10

4.5 FUNCTIONS OF CENTRAL BANK

Central bank is the apex monetary and banking authority of the country. A central bank
is an institution charged with the responsibility of regulating the supply, availability,
and cost of money in the interests of the general public. It performs different activities
to establish the sound banking system and maintain the credibility of banking system
in the economy. The functions of central bank are explained below:

A. TRADITIONAL FUNCTIONS

De Kock has provided the following traditional functions of central bank:

.1. Bank of Note Issue: Central bank has the monopoly of note issue. The currency notes
issued by central bank are declared unlimited legal tender throughout the country.
Central bank has to keep gold, silver, other precious metal or strong foreign currencies
reserves against the note issued. Since central bank issues notes, it controls the supply
of money in the country.Nepal Rastra Bank had started to issue notes since 2016 Phalgun.

2. Banker, Agent and Adviser to the Government: The central bank works as the banker,
agent and advisor of the government. As a banker to the government, the central bank
provides banking services to the government as the services provided by commercial banks
to the people. As an agent of the government, it raises public debt by issuing treasury bills
and bonds. The management of public debt is done by the central bank. The central bank
also acts as the financial adviser to the government. It advises to the government on all
financial and monetary matters and helps in formulating various economic policies.

3. Bankers bank: The central bank helps the commercial banks in the way the commercial
banks help the people. As a bankers’ bank, the central bank performs several functions.
It acts as custodian of cash reserves of commercial and other banks. It also maintains
deposits of cash reserves as required by the commercial banks. It also discounts bills of
commercial banks. It provides guidance to all banks and regulates their activities.

4. Lender of the Last Resort: The central bank also provides financial support to the banks
in the time of crisis. When the commercial banks face financial crisis, they approach
the central bank for assistance. The central bank provides financial assistance to banks
by discounting approved securities and collateral loans and advances. So that it is
called the lender of the last resort.

5. Custodian of Foreign Reserves: The central bank is the custodian of foreign exchange
reserves of a country. All the foreign exchange transactions of a country are done through
the central bank. It controls both the receipts and payments of foreign exchange. It helps
in maintaining stability of the exchange rate by buying and selling foreign currencies in
the market. The NRB formulates and implements foreign exchange rate policy, manages
foreign exchange reserves, and makes transactions in foreign exchange.

6. Clearing House Function: The central bank acts as a clearing house for transfer and
settlement of mutual claims of the commercial banks. Since commercial banks keep their
cash reserves with the central bank, it is easier and convenient to clear and settle claims
and counter claims between them by making transfer entries in their accounts maintained
with the central bank.

7. Controller of Credit: The central bank is the controller of credit. It has the power to

influence the volume of credit created by banks. To control the credit central bank may

use different instruments like bank rate, liquidity ratio, open market operation, cash

reserve ratio etc.

Vedanta High School Economics - 10 60

GlossaryB. DEVELOPMENTAL FUNCTIONS

The Central bank also performs a variety of developmental and promotional functions.
The central bank is called the catalyst of economic development. Promotional functions
change with the development of banking system. They are:

1. Development of Banks: The central bank helps in the development of bank and non-
banking financial institutions. It encourages banks to open branches in remote areas by
providing compensation and interest free loan.

2. Development of Financial Institution: The financial institutions like NIDC, ADB,
Nepal Stock Exchange, Credit Guarantee Corporation have been established with the
initiative and financial assistance of NRB.

3. Special Programs: In developing countries, the central bank performs certain special
programs for the upliftment of targeted groups. Programs like priority sector credit
program, cottage and small industries project, micro-credit for women have been
launched with the initiative of NRB.

4. Economic Study and Research: Various statistical data are necessary for formulation of
budget, economic planning and policies. The central bank also conducts research and
studies in the field of family budget survey, agricultural credit survey, industrial survey
etc.

5. Publicity: The central bank regularly publishes reports, journals and bulletins so as to
inform the researchers, policy-maker, foreign institutions and the general public about
the existing monetary, exchange, economic situation of the country. The Economic
Review, Economic Report, Macro Economic Indicators, Quarterly Economic Bulletin,
are some of the publications of Nepal Rastra Bank.

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4.6 FUNCTIONS OF COMMERCIAL BANK

Commercial bank is regarded as the oldest financial institution in the history of bank. The
main objective of this bank is to earn profit. It performs all kinds of banking business and
generally finances trade and commerce. Some of the important functions of commercial
banks are discussed below.
No interest is provided

A. PRIMARY FUNCTIONS KEY on current account. Such
IDEA account is suitable for trad-
Acceptance of deposits and granting of loans are the ers and businessmen
primary or the main functions of commercial banks.

1. Acceptance of Deposits: Acceptance of deposits from individuals. organization, firms,
companies, industries is the main function of commercial banks. The commercial
banks accept deposits in different accounts. The main forms of deposit accepted by
banks are as follows:

a. Current or Demand Deposit: Current account is maintained to facilitate traders
and businessmen who have to make a number of withdrawals in a day. In current
account there is no interest and no restriction in withdrawals. The amount deposited
in this account can be withdrawn by drawing cheque without prior information.

61 Vedanta High School Economics - 10

b. Saving Deposit: The low income people and those not needing to draw money
frequently deposit their money in the saving account. Interest is provided on the
deposit.

c. Fixed or Time Deposit: The amount deposited for a fixed period is called fixed
or time deposit. Amount deposited in fixed account can be withdrawn after some
fixed period as mentioned at the time of deposit. Generally the rate of interest is
high in fixed deposits compared to deposits in saving account.

2. Provides Loans: Commercial bank provides different types of loans. The bank earns
profit by giving the amounts deposited with it in the form of loans. Since the bank
creates credit, with its deposits, it is called manufacturer of credit. The main forms of
loan provided by the bank are as follows:

a. Loans and Advances: The loans and advances are provided by the bank to
individuals and institutions for various purposes. The bank provides loans only
against securities like gold, silver, government and non-government securities
which are easily marketable, stable in value and liquid.

b. Overdraft: It is similar to cash credit arrangement. It is a facility in which the
bank allows the current account holders to overdraw their current accounts by a
specified limit. The clients generally avail the bank overdraft facility to meet urgent
and emergency requirements. Interest is charged on daily balances, on the amount
actually withdrawn, subject to some minimum charges.

c. Cash Credit: The cash credit is not based on personal security. It is provided against
the collateral of shares, debentures etc. The borrower needs to pay interest only on
the actual amount taken as in overdraft.

d. Discounting of Bills: The bank provides loans by discounting bills such as the bill
of exchange. The bank discounts the rate of interest from the face value of the bill
and allows drawing the remaining amount by cheque. This is called discounting of
bills. After the maturity of the bills, the bank receives full payment of the bill

e. Call Money: It is a very short period loan made by a Key Term
bank to other banks or financial institutions. Such
loans can be called back at a short notice of one day to Bill of exchange: a binding
fourteen days. agreement by one party to pay
a fixed amount of cash to an-
Beside these, there are different types of loans like other party as of a predeter-
housing loan, hire purchase loan, personal loan, mined date or on demand
educational loan etc. provided to loanee against

collateral.

B. AGENCY FUNCTIONS

Commercial banks perform agency function on behalf of their clients. The following
are some of the agency functions done by the commercial bank.

1. Acts as a Representative: Commercial banks also perform various functions as a
representative of their clients. They collect cheques, commercial bills, and promissory
notes for their clients. They also buy and sell bonds and securities, collect dividends,
interest etc for their clients.

2. Transfer Funds: People need to transfer their money from one place to another, which is
also known as remittance function. Commercial banks can charge some fee to transfer
the funds with their clients.

Vedanta High School Economics - 10 62

3. Execution of Standing Order: Commercial banks execute the standing order of their
clients. They make payments of electricity and water supply bills, insurance premium,
telephone bills as directed upon.

4. Works as Referee: The bank also works as the referee of the customers. The information

on economic condition of other persons or institutions may be taken from the bank.

But due to the need of maintaining secrecy, such information is supplied only on the
Key Term
consent of the concerned party.
Will: A legal document that
5. Income tax Consultancy: Commercial banks provide sets forth a person’s wishes re-
income tax consultancy to their clients in regard to garding the distribution of his
preparation of tax returns. property after his death

6. Trustee and Executor of Will: Commercial banks keep safe

the wills of their customers and execute the same after the fulfilment of the conditions

mentioned therein.

C. GENERAL UTILITY FUNCTIONS

Commercial banks provide various general utility services to the people. Some of the
utility functions provided by the commercial banks are presented below:

1. Traveller’s Cheque: Commercial banks issue traveller’s cheque to help the traveller’s
to travel without carrying cash money. Traveller’s cheque is a safe means of carrying
money. Travellers can use traveller’s cheque for easy and safe transaction purpose.

2. Locker Facility: Commercial banks provide locker facility Key Takeaways
to their clients. The customers can keep their valuable
documents in locker. The safety of the goods and documents • Overdraft facility is pro-
kept in locker is guaranteed by the commercial banks. Banks vided only to trusted cli-
charge a minimum of an annual fee for this service. ents

• Bill of exchange is used in
3. Letter of Credit: Commercial banks issue letter of credit in international trade
favour of their clients. This helps their clients to perform • Travellers cheques are
foreign trade. given top priority at the

4. Economic Information and Statistics: A separate department counter
of research and statistics can be found in every bank. It • Letter of credit is a bank
publishes monthly and annual bulletins giving information guarrantee to its possessor

about the situation of trade, industry, rate of interest etc.

5. Underwriting of Securities: Commercial bank underwrites securities floated by
businesses and industries. This helps to instill public confidence in securities.

6. Issue of gift cheques: Commercial banks also issue gift cheques of various denominations
to be used in auspicious occasions.

7. Other functions: They also perform other functions such as bank guarantee, investement,
collect external and interal bills, handle government transaction etc. as instructed by
central bank.

CHECKPOINT 1. Define bank.. What are the different types of bank?

2. Briefly explain the origin of banking.

3. What are the functions of central bank?

4. What are the functions of commercial bank?

63 Vedanta High School Economics - 10

4.2 CREDIT

The word Credit is derived from the Latin word ‘Credo’. The meaning of Credo in Latin
is “I believe”. Credit signifies the creditor believes that the debtor will pay back the
loan. It is a contractual agreement in which a borrower receives something of value now
and agrees to repay the lender at some date in the future, generally with interest. 

Samuelson and Nordhaus defined credit as “ In monetary theory, the use of some
else’s funds in exchange for a promise to pay (usually with interest) at a later date.”

Similarly, Penguin Dictionary of Economics defines credit as “Granting the use or
possession of goods and services without immediate payment.”

Credit is the act of granting possession of something to a person without immediate
payment. It is the act of giving money, property or other material goods to another party
in exchange for future repayment of the principal amount along with interest or other
financial charges.

TYPES OF CREDIT

a. Consumer Credit: Consumer credit is basically the amount of credit used by consumers
to purchase goods or services that are consumed and whose value depreciates quickly.
Consumer credit can be defined as ‘money, goods or services provided to an individual in
lieu of payment.’ 

b. Trade Credit: Credit advanced by a bank to an individual firm, or organization in the form
of cash loans is called bank credit.

c. Bank Credit: Credit consisting of loans and overdrafts to a bank’s customers is the bank
credit.

FACTORS DETERMINING THE CREDITWORTHINESS OF A DEBTOR

Lenders, especially bankers, use a formula known as the six C’s of credit when evaluating

the creditworthiness of a debtor.

a. Character: This is essentially a summary of the individual. Creditors look for people
who appear to be trustworthy and reliable, and who are willing and able to meet their
financial obligations.

b. Capacity: This is the individual’s ability to repay the loan; it is based on present and
anticipated earnings balanced against existing debts.

c. Collateral: The item pledged by the borrower as security for the loan, which may be real
estate, stocks, savings, a mortgage, etc.

d. Conditions: Both regulatory and economic conditions are considered. Regulatory
conditions apply to the lenders individual circumstances; for example, when banks are
not lending in specific areas. Economic conditions determine the lender’s general policy
towards loan.

e. Credit History: It refers to the individual’s credit history. An individual history of
authenticity and financial prudence determines creditworthiness of a person.

f. Capital: It is the net worth on an individual as indicated by a personal financial statement.

Vedanta High School Economics - 10 64

INSTRUMENTS OF CREDIT

Credit is embodied in various documents called the instruments of credit. The most
important instruments are discussed below,

1. Cheque: A cheque is an unconditional order, drawn on a specified banker and is payable
on demand. It is a written order on a printed form by a depositor (drawer) to his bank to
pay a sum of money to himself ot to somebody else. It is a common instrument of credit.
People pay their dues in cheque. However cheque is not money. The creditor accepts
cheque believing that the cheque can be converted into cash from the bank.

a. Bearer Cheque : When the words “or bearer” appearing on the face of the cheque are not
cancelled, the cheque is called a bearer cheque. It is payable to any person who presents it
for payment at bank counter. The bearer cheque is payable to the person specified therein
or to any other else who presents it to the bank for payment and requires no endorsement.
The drawer runs the risk of losing his money if there is loss of cheque.
Point to Note

No identification is needed
when a bearer cheque is
presented for encashment.
However, in normal banking
practice, where the amount
of the cheque is substantial,

b. Order Cheque: An order cheque is one which is payable to a particular person. In such a
cheque the word ‘bearer’ may be cut out or cancelled and the word ‘order’ may be written.
It is the safer form of payment because the bank is responsible for paying the money
to the right person. The person who presents the cheque to the bank has to prove
his identity to get cash against the cheque. The payee can transfer an order cheque to
someone else by signing his or her name on the back of it.

c. Crossed Cheque: This is the safest form of payment as it cannot be cashed in the bank
counter. The person can tranfer this amount to his own or to somebody else’s account.
The cheque is crossed by drawing two parallel lines across it face or in a corner and
written as “& co” or “Account Payee”. A crossed cheque may be of the following types:

i. General Crossed Cheque: In a general crossed cheque, two parallel transverse lines,
with or without the words ‘not negotiable’ in between, may be drawn. Such a cheque
is crossed generally. The effect of general crossing is that the payment of the cheque
will not be made at the counter, it can be collected only through a banker.

Point to Note
A crossed cheque can be made

bearer cheque by cancelling
the crossing and writing that

the crossing is cancelled and

affixing the full signature of

drawer.the identity of the en-

casher is insisted on.

ii. Special Crossed Cheque: In special crossing, the cheque bears across its face an
addition of the banker’s name, with or without the words ‘Not negotiable’ or ‘A/c.

65 Vedanta High School Economics - 10

Payee only’. The payment of such cheque is not made unless the bank named in

crossing is presenting the cheque. The effect of special crossing is that the bank

makes payment only to the banker whose name is written in the crossing. Specially

crossed cheques are more safe than a generally crossed cheques.
Point to Note
No identification is needed

when a bearer cheque is

presented for encashment.
However, in normal banking

practice, where the amount

of the cheque is substantial,

2. Promissory Note: A promissory note is a contract where one party (the maker or issuer)

makes an unconditional promise in writing to pay a sum of money to the other (the
payee), either at a fixed or determinable future time or on demand of the payee, under

specific terms. This document can be used for personal or commercial transactions. It

is obligated to repay the amount declared in the promissory note. PAoinprtotmo iNssootery note
Promissory Note is a written, dated
promise to pay a
Rs.1000000 March 22, 2020

Two months after date, I promise to pay M/s Vedanta Publication specific amount of-
Pvt. Ltd. or order, the sum of Ten Lakhs Rupees only for value money to a particu-
recieved with interest at the rate of 8% per annum. lar person. Promis-
sory notes usually

refer to the borrower

Stam p MM/s rA.pSeaxyTornadKinagrkIni c. as the maker of the
note and the lender
as the payee.

3. Bill of Exchange: It is an order by a seller to a buyer or creditor to a debtor to pay a

certain amount of money to himself or to bearer or to another person named therein.

The seller or the creditor who draws the bill is called the “drawer” and the debtor

whom the bill is drawn is called the “drawee”. The seller may order the payment to be

made to a third person called “payee”. Bill of exchange is used in internal as well as

foreign trade. PAoibnitlltooNf oetxechange
is a binding agree-
R s.1000000 Inlan d Bill of Exc hangeKathmandu ment by one party to
March 22, 2020 pay a fixed amount

Thirty days after date pay M/s Vedanta Publication Pvt. Ltd. or of cash to another
bearer, the sum of Ten Lakhs Rupees only for value recieved. party as of a prede-
termined date or on

demand. Bills of ex-

M/s United Books For M/s Vedanta Publication Pvt. change are primar-
Birtamode Mr. Jeewan Shrestha ily used in interna-

tional trade

4. Bank drafts: A bank draft is a cheque drawn by a bank on its own branch or on another

bank requiring the latter to pay a specified amount to the person named in it or to the

order thereof. One of the cheapest methods of sending money through is a bank draft.

Bank draft can be converted into cash only after some period of time

Vedanta High School Economics - 10 66

ViewpointIMPORTANCE OF CREDIT AND CREDIT INSTRUMENTS

In this modern era, credit instruments play a vital role in the expansion of business
activities. The following are the major importances of credit instruments.

1. Economizes the Use of Money: Credit instruments replace the metallic and paper
money to some extent because in large scale transaction it is easier to pay in the form
of credit instrument. This also reduces the risk of huge transaction of money. The less
circulation of paper and metallic money increases the durability of money.

2. Increase in BusinessVoluume: There is large amount of transaction in modern business.
The traders are financed mostly by credit. In absence of credit, trade would be on very
restricted scale. The credit instruments have much more importance in such expansion
of business activities in this modern world.

3. Mobilization of Saving: Credit instruments facilitate the mobilization of saving through
capital formation. This means that credit instruments encourages savings and mobilize
saving. The accumulation and mobilization of saving is capital formation.

4. Increases the Consumption Habit of People: Using the credit instruments people also
get credit facilities. This facility encourages the individuals to purchase the good in
credit. Thus, the consumption level of the people rises.

5. Support to International Trade: In foreign trade sometimes the currencies are not
acceptable. For example, Nepalese currency is not acceptable in foreign market to
purchase goods. In this case credit instruments can be used as money. The credit
instruments are very supportive in international trade.

6. Solves Liquidity Problem: Credit instruments functions as money and are used as means
of payments. In the absence of credit instruments, people would have to use liquid
money which would not be sufficient to meet the volume of business transactions and
can create liquidity problem. So, the use of credit instruments help to solve liquidity
problem.

7. Large Scale Production: The developing countries like Nepal faces capital shortage
problem. Our production sources are limited. So credit instruments have provided
necessary capital to industrialists. This facilitates large scale production and reduces
cost per unit.

8. Shifting of Capital To Productive Purposes: There are people who have surplus money
but are not capable to do any business. So they lend it to the financial institutions.
Credit makes possible the shifting of money to those people who can use it productively.

9. Safe Payment: Metallic money is bulky and paper currency is unsafe to carry as well. The
use of credit instruments in payments ensures safety in payment.

10. Provision of Working Capital: Sometimes an industrialist faces finance problem to
purchase raw material or for payment of wages. In such a situation he avails credit facility.

• Credit Instruments may be an order for payment of money to a spec-
ified person or it may be a promise to pay the loan.

.... What are the various credit instruments in operations at present?
• Credit Instruments play a vital role in the expansion of business

activities.
..... Explain the role of credit instruments in expansion of business

67 Vedanta High School Economics - 10

4.7 CONCEPT OF MONEY MARKET AND CAPITAL MARKET
The financial system is an important element of an economy. The financial resources
are exchanged through the financial system. The financial market is the heart of the
financial system. The financial market refers to a place or mechanism through which
financial instruments are traded.

According to Cooper and others “Financial markets are the markets in which financial
instruments are traded“.

The two important types of financial market are the money market and capital market.
Concepts of these two types of financial market have been presented below.

CONCEPT OF MONEY MARKET

The money market refers to the whole area where money is bought and sold. To be more
precise, money market is simply a process of buying and selling of money. Unlike a stock
exchange, the money market is not a particular place but is a system. The transactions
may take place between different persons by telephone, fax without personal meeting.

The short-term funds are transacted in the money market. In general the term of the loan
is less than one year.The main function of the money market is to make available working
capital to the business and loan to the government. It also makes available loans for the
speculation of goods and securities.

According to Dudley G. Luckett :‘The money market is a market for short term (less than
one year) loans. It’s very name suggests that it is money that is being bought and sold“.

In brief, the money market is a means of exchange of short term credit. It is quite different
from the capital market which deals in long term credit.

CONCEPT OF CAPITAL MARKET

The market dealing in long term finance is known as capital market. This market makes
available funds for long-term investment. Hence, capital market is a market for long term
credit. The meaning of capital market becomes clear from the following definitions:-

According to Dudley G. Luckett: “A capital market is just what the name implies: a market
for capital funds. Strictly speaking, the capital market encompasses any transactions
involving long-term debt or equity obligations“.

DIFFERENCE BETWEEN MONEY MARKET AND CAPITAL MARKET

The money market and the capital market are interrelated. The main points of difference
between these two are as follows:-

1. Definition: Money market is a component of the financial markets where short-term
borrowing takes place. Capital market is a component of financial markets where long-
term borrowing takes place.

2. Maturity: In general, these two markets are separated on the basis of the maturity of the
credit instruments related to these markets. The maturity of the instruments of money
market is one year or less than one year. On the other hand, the maturity of the instruments
of capital market is more than one year.

3. Risks: The risks are less in money market. There is less possibility of default of the credit
of less than one year maturity. Likewise, the risk of interest rate is also low in the money
market. On the other hand, the credit of the capital market is of long term nature. Due to

Vedanta High School Economics - 10 68

this risks are more and are of varied nature in capital market.

4. Instruments: The main instruments of money market are -treasury bills, commercial
papers, certificate of deposit which are of short-term nature. On the other hand, the main
instruments of the capital market are -debentures, equities or shares and government
securities which are of long-term nature.

5. Institutions: The different financial institutions related to short-term credit participate
in the money market. But there is predominance of commercial banks. In fact, the
commercial bank is an institution related to the money market. On the other hand,
different kinds of financial intermediaries participate in the capital market. The
main participants of the capital market are - development bank, finance company,
provident fund, insurance company, Investment Company and so on.

6. Finance: The money market deals in only short-term funds. It receives short term deposits
and also provides the short-term credit. On the other hand, the capital market receives
long-term deposits and also grants long term loan and equity capital to the business and
the government.

7. Basic Role: The basic role of money market is liquidity adjustment. While the basic role
of capital market is to put capital to work.

8. Relation with the Central Bank: The money market has close and direct relationship
with the central bank. The central bank implements its monetary policy through this
market. The central bank directly regulates the commercial banks in the money market.
On the other hand, the central bank has influence over the capital market only indirectly
through money market. Similarly, the institutions of the capital market are less regulated
by the central bank.

4.8 NON BANKING FINANCIAL INSTITUTIONS

Non Banking Financial Institutions are the institutions that provide banking services
without meeting the legal definition of a bank such as holding a banking license.
There are a number of non-banking financial institutions, which include investment
banks, leasing companies, insurance companies, investment funds, finance firms, etc. A
non-banking financial institution offers a range of financial services. Investment banks
offer services to corporations which include underwriting of debt and share issues,
securities trading, investment, corporate advisory services, derivate transactions,

Financial institutions such as insurance companies offer protection against specific
losses for which an insurance premium is paid. Mutual funds act as savings institutions
in which investors are able to invest their funds in collective investment and receive

interest income in return. Financial institutions act as brokers or dealers and facilitate
the transactions in financial assets. Likewise, leasing companies facilitate the purchase
of equipment, real estate financing companies make capital available for real estate.

Following are the business in which NBFCs are engaged: Point to Note

1. Loans and advances Underwriting is one of the
most important functions in
2. Acquisition of shares/stocks/bonds/debentures/securities. the financial world wherein

3. Leasing an individual or an insti-

4. Hire-purchase tution undertakes the risk
5. Insurance business associated with a venture,
an investment, or a loan in

lieu of a premium.

69 Vedanta High School Economics - 10

IMPORTANCE OF NON BANKING FINANCIAL INSTITUTIONS

NBFIs provide liquidity and safety to financial assets and help in transferring funds from
ultimate lenders to ultimate borrowers for productive purposes. The importance of NBFIs
can be explained under the following points:

1. Reduce Hoarding: NBFIs help to reduce hoardings. By bringing the ultimate lenders (or
savers) and ultimate borrowers together, NBFIs reduce hoarding of cash by the people.

2. Help the Household Sector: The household sector relies on NBFIs for making profitable
use of its surplus funds and also to provide consumer credit loans, mortgage loans, etc.
Thus they promote saving and investment habits among the ordinary people.

3. Help the Business Sector: NBFIs also help the non-financial business sector by financing
it through loans, mortgages, purchase of bonds, shares, etc. Thus they facilitate investment
in plant, equipment and inventories.

4. Provide Liquidity: NBFIs provide liquidity when they convert an asset into cash easily
and quickly without loss of value in terms of money. When NBFIs issue claims against
themselves and supply funds they always try to maintain their liquidity.

5. 10. Brokers of Loanable Funds: NBFIs play an important role as brokers of loanable funds.
They act as intermediaries between the ultimate saver and the ultimate investor. They
sell indirect securities to savers and purchase primary securities from investors. Indirect
securities are the short-term liabilities of financial intermediaries.

6. Reduce Risks: When the non-bank financial intermediaries convert debt into credit, they
reduce the risk to the ultimate lender. First, they create liabilities on themselves by selling
indirect securities to the lenders. Then they buy primary securities from borrowers of
funds.So by acting as intermediaries between the lenders and borrowers of funds, NBFIs
take the risk on themselves and reduce it on the ultimate lenders.

7. Investment of Funds: NBFIs exist because they want to earn profit by investing the
mobilised savings. Different financial intermediaries follow different investment policies.
For instance, mutual savings banks invest in mortgages, and insurance companies invest
in bonds and securities. Thus intermediaries mobilise public savings, invest them and
thereby help in capital formation and economic growth.

8. Economies of Scale: NBFIs specialise in trading large financial assets and thus have lower
costs in buying and selling securities. They employ expert Staff and efficient machinery
and equipment, thereby increasing productivity in the transfer of funds.

9. Bring Stability in the Capital Market: NBFIs deal in a variety of assets and liabilities.
If there were no NBFIs, there would be frequent changes in the demand and supply of
financial assets and their relative yields, thereby bringing instability in the capital market.
As NBFIs function within a legal framework and set rules, they provide stability to the
capital market and benefit savers and firms through diversified financial services.

10. Help in the Growth Process of Economy: NBFIs help in the growth process of the economy.
They intermediate between ultimate lenders who are savers and ultimate borrowers
who are investors. By performing this function, they discourage hoarding by the people,
mobilise their savings and lend them to investors.

Vedanta High School Economics - 10 70

DISTINCTION BETWEEN BANKS AND NON BANKING FINANCIAL INSTITUTIONS

1. Financial institutions can be divided into two types: banking financial institutions and
non-banking financial institutions. A bank is known as financial intermediaries that act
as middlemen between depositors or suppliers of funds and lenders who are the users of
funds.

2. The main tasks of a banking financial institution are to accept deposits and then to use
those funds to offer loans to its customers. . A non-banking financial institution offers a
range of financial services.

3. The main difference between the two types of financial institutions is that banking financial
institutions can accept deposit into various savings and demand deposit accounts, which
cannot be done by a non-banking financial institution.

4. The primary purposes in depositing funds in banks are convenience, interest income,
and safety. Whereas the primary purpose in investing funds in non-banking financial
institutions is to gain additional income.

5. While banks take part in the country’s payment mechanism, non-banking financial
companies are not involved in such transactions.

A INSURANCE COMPANY

Insurance is a means of protection from financial loss. It is defined as the equitable
transfer of the risk of a loss, from one entity to another, in exchange for payment. An
insurer is a company selling the insurance; an insured or policyholder is the person or
entity buying the insurance policy. An institution which provides insurance cover to the
insured is an insurance company. It is a financial institution that provides coverage, in
the form of compensation resulting from loss, damages, injury, treatment or hardship in
exchange for premium payments.

An insurance company is usually comprised of multiple insurance agents. An insurance
company can specialize in one type of insurance, such as life insurance, health insurance,
or auto insurance, or offer multiple types of insurance.

CHARACTERISTICS OF AN INSURANCE COMPANY

The insurance company has the following characteristics which are, generally, observed
in case of life, marine, fire and general insurances.

1. Sharing of Risk: Insurance is a device to share the financial losses which might befall on
an individual or his family on the happening of a specified event. The loss arising from
these events if insured are shared by all the insured in the form of premium.

2. Co-operative Device: The insurance company brings a group of persons together
voluntarily or through publicity or through solicitation of the agents.

3. Value of Risk: The risk is evaluated before insuring to charge the amount of share of an
insured, herein called, consideration or premium.

4. Payment at Contingency:The payment is made at a certain contingency insured. If the
contingency occurs, payment is made., otherwise no amount is given to the policy-holder.

5. Large Number of Insured Persons: To spread the loss immediately, smoothly and cheaply,
large number of persons should be insured. An insuance company does it to spread risks.

71 Vedanta High School Economics - 10

TYPES OF INSURANCE COMPANIES

There are two main types of The very first insurance company was
insurance companies. They are: founded as Nepal Mal Chalani Tatha Bee-
ma Company Ltd. in 2004 B.S in Nepal.
1. Life Insurance Company during 2016 BS the company was renamed
2. Non Life Insurance Company as Nepal Insurance and Transport Compa-
ny Pvt. Ltd. while In the recent days the firm
LIFE INSURANCE is known as Nepal Insurance Company Ltd.

Life insurance is a contract between the insured person and the company that is providing
the insurance. It is a protection against the loss of income that would result if the insured
passed away. There are various benefits that can be realized through the life insurance.
Some of them are: Mortgage Protection, protection against disabilities, children’s education,
tax relief, marriage expenditure etc.

Life insurance is again categorized into different types.

a. Term Life Insurance: Term life insurance stays in effect for a specified period or until a
certain age of the insured.

b. Whole Life Insurance: Whole life insurance normally covers an individual until his or her
death, unless it lapses due to non-payment of premium or is cancelled.

NON LIFE INSURANCE

It is also known as General Insurance. Insurance mainly concerned with protecting the
policy holder from losses or damaged caused by specific risk.It is basically an insurance
policy to protect an individual against losses and damages other than those covered by
Life insurance.

The categorization of non life insurance is dependent upon the need level such as:

a Property/casualty Insurance
b Health and Disability Insurance
c Business and Commercial Insurance

Various types of non life insurance are commercial, marine, aviation, agriculture, health,
financial, engineering insurance, travel insurance, home insurance etc.

IMPORTANCE OF INSURANCE COMPANIES

Insurance companies play an important role in economic development of country.The
importance of insuraance companies may be pointed out as:

1. Provide Safety and Security:Insurance provide financial support and reduce
uncertainties in business and human life. It provides safety and security against
particular event. There is always a fear of sudden loss. Insurance provides a cover
against any sudden loss. For example, in case of life insurance financial assistance is
provided to the family of the insured on his death.

2. Saving and Insurance: Insurance companies lead to economic development by
mobilizing savings and investing them into productive activities. Insurance companies
are able to mobilize long-term savings to support economic growth and also facilitate
economic development by providing insurance cover to a large segment of our people
as well as to business enterprise.

Vedanta High School Economics - 10 72

3. Capital Formation and Insurance: Capital formation may be defined as increase in
capital stock of the country consisting of plant, equipment, machinery, tools, building,
means of transport, communication, etc.

4. Increased Employment: Insurance companies also help to create employment
opportunities. Liberalization and the opening up of sector to private players has now
created a vast opportunity for employment.

5. Insurance as Financial Intermediary: Financial intermediaries perform the function
of channelizing saving into domestic investment. They facilitate efficient allocation of
capital resources, which in turn improve productivity and economic efficiency which
result in reduced capital output ratio. The insurance companies perform extremely
useful function in economy as financial intermediaries.

6. Promotes Trade and Commerce: The increase in GDP is positively correlated to growth
of trade and commerce in economy. Even banks demand insurance cover of assets while
granting loans for purchase of assets. Thus insurance covers, promotes specialization
and flexibility in the economic system that play contributory role in healthy and smooth
growth of trade and commerce.

7 Facilitates Efficient Capital Allocation: Insurance provides cover to large number of
firms, enterprises and businesses and also deploy their funds in number of investment
projects. The vast pool of knowledge and expertise so gained enable them to distinguish
between productive and high return projects. Therefore, they promote efficient and
productive allocation of capital resources, which in turn lead to increased productivity
and efficiency in the system.

8. Encouraging Financial Stability: Insurer promotes financial stability in economy
by insuring the risks and losses of individuals, firm and organizations. Because
of uninsured large losses, firm may not be able to compensate for it leading to its
insolvency. Moreover, it relieves the tensions and anxiety of individuals by securing
the loss of their lives and assets.

9. Reducing Burden on Government Exchequer: Insurance companies, particularly life
insurers provide a variety of insurance products covering needs of children, women
and aged etc under social security network and thereby reduce the burden on Govt.
exchequer in providing these services.

10. Spreading of Risk: Insurance facilitates spreading of risk from the insured to the insurer.
The basic principle of insurance is to spread risk among a large number of people. A large
number of persons get insurance policies and pay premium to the insurer. Whenever a

ECONOMISTS PROFILE Muhammad Yunus 1940–Present
Muhammad Yunus has done much for the economies of the
world’s poorer areas. Early in his career, Yunus discovered
that very small loans had a disproportionately positive impact
on a poor person. Loaning to poor people was a practice banks
were reluctant to subscribe to before Yunus’ work. The micro-
credit was born, now widely used in developing countries and
with the potential to alleviate poverty. Critics of micro credit
argue that the practice leaves the world’s poor in a debt trap.

73 Vedanta High School Economics - 10

CONCEPTS FOR REVIEW

Barter Legal tender Representative money

Token money Fiat money Credit money

Capital formation Deferred payment Shares

Debentures Time deposits Call money

Overdraft Collateral Bill of exchange

UNIT OVERVIEW

Barter: It is the direct exchange of goods for Credit: Credit is the act of granting possession
goods. of something to a person without immediate
Difficulties of barter system payment. There are three main types of credit:
1. Lack of Double Coincidence of Wants 1. Consumer credit
2. Lack of Common Measure of Value 2. Trade credit
3. Lack of Divisibility 3. Bank credit
4. Lack of Store of Value
5. Lack of deferred payment Factors determining the creditwothiness
6. Lack of Transfer of Value
7. Limits the Scope of Market Lenders, especially bankers, use a formula
8. Limits Specialization known as the six C’s of credit when evaluating
the creditworthiness of a debtor. They are:
Money: Anything which has general 1. Character
acceptability as a medium of exchange, 2. Capacity
measure and store of value and is used in the 3. Collateral
settlement of economic obligations is called 4. Condition
money. 5. Credit history
6. Capital
Forms of money Instruments of Credit:
1. Animal money 1. Promissory note
2. Commodity money 2. Bill of exchange
3. Metallic money 3. Cheque
4. Paper money 4. Draft
5. Bank money Importance of credit instruments
1. Large Scale Production
Functions of money 2. Shifting of Capital To Productive Purposes
3. Economy in the Use of Metal
A. Primary Functions: 4. Provision of Working Capital
a. Medium of exchange 5. Safe Payment
b. Measure of value 6. Transfer of capital
B. Secondary Functions: 7. Emergence of New Businessman
a. Store of value 8. Increase in business volume
b. Transfer of value 9. International Payments
c. Standard of deferred payment 10. Solves liquidity problem
C. Contingent Functions:
a. Basis of credit Bank: A bank is an institution that deals in
b. Distribution of national income money and credit.
c. Liquidity to wealth
d. Maximization of satisfaction

Vedanta High School Economics - 10 74

Types of Banks different types of loans. The bank earns profit
1. Central bank by giving the amounts dep
2. Commercial bank a. Loans and Advances
3. Agricultural bank b. Overdraft
4. Industrial bank c. Cash Credit
5. Development bank d. Discounting of Bills
6. Rural bank e. Call Money
7. Saving bank
8. Exchange bank B. Agency Functions: Commercial banks
perform agency function on behalf of their
Central Bank: Central Bank is the apex clients. They are:
monetary institution which controls, monitors 1. Acts as a representative
and supervises the banking structure of the 2. Transfer funds
country. 3. Execution of standing order
Functions of central bank 4. Works as referee
A. Traditional Functions 5. Income tax consultancy
1. Monopoly of Note Issue 6. Trustee and executor of will

2. Banker, agent and advisor to the C. General utility functions: Some of the
government utility functions provided by the commercial
3. Bankers’ Bank banks are presented below:
4. Lender of the Last Resort 1. Traveller’s cheque
5. Clearing House Function 2. Locker facility
6. Custodian of Metallic Reserve 3. Letter of credit
7. Controller of Credit 4. Economic Information and Statistics
B. Development Functions: 5. Underwriting of securities
1. Development of Banks 6. Issue of gift cheques
2. Development of Financial Institution
3. Special Programs Money Market: The money market is a means of
4. Economic Study and Research exchange of short term credit
5. Publicity
6. Relationship with International Agencies Capital Market: Capital market is a market for long
term credit.
Commercial Bank: In general, the term bank is
used to mean a commercial bank. It performs Non-Banking Financial Institutions: Non Banking
all kinds of banking business and generally Financial Institutions are the institutions that
finances trade and commerce. provide banking services without meeting the
Functions of Commercial Bank legal definition of a bank such as holding a banking
A. Primary Functions: Acceptance of deposits license.
and granting of loans are the primary or main
functions of commercial banks. Insurance Company: It is a financial institution that
provides coverage, in the form of compensation
1. Accepting Deposits: The commercial banks resulting from loss, damages, injury, treatment or
accept deposits in different accounts hardship in exchange for premium payments.
a. Current or Demand Deposit
b. Saving Deposit
c. Fixed or Time Deposit

2. Providing Loans: Commercial bank provides

75 Vedanta High School Economics - 10

QUESTIONS FOR REVIEW

Very Short Answer Type Questions
1. Write the types of exchange.
2. Define Money.
3. What are the kinds of money?
4. Point out the primary functions of money.
5. What is a credit instrument?
6. Mention any two types of credit instruments.
7. Define a Cheque.
8. What is the difference between full bodied’ coin and token money?
9. What are the kinds of paper money?
10. Define barter exchange.
11. Define Bank.
12. When was the Nepal Rastra Bank established?
13. Which is the first central bank in the world?
14. What do you understand by Locker Facility?
15. What is call money?
16. What is Traveler’s Cheque?
17. What do you mean by overdraft?
18. What is a credit instrument?
19. Define Cheque.
20. Write the types of exchange
21. Define money market.
22. Define capital market.
23. What do you mean by non-banking financial institutions?

Short Answer Type Questions

1. What are the difficulties of barter system.
2. Explain the role of money in a modern economy.
3. Explain the importance of credit instruments
4. Explain the role of banking system in economic development of a country.
5. What are the types of banks? Explain.
6. Explain the agencial functions of commercial bank.

7. Distinguish between money market and capital market

8. Distinguish between Banks and Non Banking Financial Institutions.

Long Answer Type Questions
1. Define money. What are the functions of money?
2. Define commercial banks. Also describe its functions.
3. What is central bank? Explain the functions of central bank.

Vedanta High School Economics - 10 76

5UNIT PUBLIC FINANCE

Learning Objectives Weight:18 Lecture Hours

On Completion of this unit the student will be

able to:

• Define public finance and explain its

importance

• Show the classification of public expenditure

• in Nepal you begin

BeforeExplain the sources of government revenue
• Define tax and point out the difference Public finance is the study of the role of
the government in the economy. It is the
• between direct tax and indirect tax tax branch of economics which assesses the
Explain the characteristics of a good government revenue and government ex-

system penditure of the public authorities and the

• Define budget and explain its types adjustment of one or the other to achieve

• Explain the importance of buget desirable effects and avoid undesirable
ones.
• Explain the process of budget formulation

process in Nepal

Very Short Type Short Type Long Answer Type Total Marks
1 2 0 11

77 Vedanta High School Economics - 10

5.0 MEANING OF PUBLIC FINANCE

The term ‘Public Finance’ is made up of two words. The general meaning of public
is a group of people and the word finance connotes the science of managing money
and credit. Hence, Public finance means the science of managing money and credit of
public authorities or the government.

In simple layman terms, public finance is the study of finance related to government
entities. It revolves around the role of government income and expenditure in the
economy. However in the modern day context, public finance has a wider scope –
it studies the impact of government policies on the economy. Public Finance deals
with the financial activities of government concerning revenue, expenditure and debt
operations and their effects on the economy. It tries to analyse the impacts of these
financial activities of government on individuals and corporate bodies. Different
economists have defined public finance in different ways:

Harold Groves: “Public finance is that science which deals with government revenue
and expenditure”
Bastable: “Public finance deals with income and expenditure of public authorities of the

state and their mutual relations as also with financial administration and control”

H. Dalton; ”Public finance is concerned with income and expenditure of public authorities

and with the adjustment of the one to the other”

Findley Shirras: “Public finance is that science, which deals with the methods to collect

revenue and make expenditure by government authority”

The various definitions given by different economists point out the following aspects
of public finance:

a. Public Revenue: This includes methods of raising public revenue and theories of
taxation.

b. Public Expenditure: This includes the principles and effects of public expenditure.

c. Public Debt: This includes methods of raising public KEY Auditing refers to the ex-
debt and the management of public debt. budget IDEA amination of the records
and reports of an enterprise
d. Financial Administration: This includes by specialists

formulation, budget approval and auditing.

IMPORTANCE OF PUBLIC FINANCE

The importance of public finance in developing countries like Nepal are as follows:

1. Allocation of Resources: The government can make efficient allocation of resources by
fiscal means. The pattern of production can be changed by the efficient allocation of
resources. The government can divert the resources from unproductive to productive
sectors with the help of different taxes and appropriate expenditure policy.

2. Macro-economic Stabilization: The public revenue and expenditure are the important
tools of stabilization. These help to determine the level of rate of inflation, current
account deficit, increase of national debt and economic activities. Public finance helps
to control both inflation and deflation.

3. Provision of Social Goods and Infrastructure: The government makes available the

public goods directly. The public enterprises are established to supply such public

goods like electricity, drinking water, transport. These increase general economic
Vedanta High School Economics - 10
78

welfare. The government also involves itself in building social infrastructures like

health and education facilities. It also uses public expenditure on physical and human

capital formation. Key Term and
gov-
4. Democratic Planning: Public finance is of special Fiscal policy: income
significance in democratic countries. The government expenditure policy of the
directs the economy towards particular direction ernment
indirectly through public finance. Democracy can also be

strengthened by the effective use of fiscal policy.

5. Capital Formation: The low capital accumulation is a main problem of developing
countries. The rate of economic growth can be increased by capital accumulation. The
ratio of saving to national income should be increased for capital accumulation. For
this, the government should increase public saving. An important method to increase
public saving is taxation.

6. Redistribution of Income and Wealth: Public finance helps to redistribute income and
wealth. It helps in alleviation of poverty. The government takes away the income and
wealth concentrated on the rich by imposing progressive taxes. The funds so collected
are spent on the welfare of the poor. Hence, public finance helps to reduce inequality
of income and wealth.

7. Mobilization of Resources: The available resources in the country can be effectively
mobilized towards the productive sectors with the help of public finance. Public
expenditure and tax are the best means of resource mobilization. Tax encourages people
to reduce consumption and increase savings. This saving is available for investment.
The resources mobilized through taxes are diverted to productive sectors by the
government.

8. Promotion of Economic Development: Public finance helps the government to promote
economic development. The means of public finance like tax, public borrowing, public
expenditure helps to transform the backward economy into a modern one. It helps the
government to make best use of resources. Likewise, the taxes discouraging productive
investments should be removed.

9. Technology, Enterprise and Efficiency: One of the important factors of economic

development is improved technology. The imposition of taxes on production increases

cost of production. Hence, taxes imposed encourage the use of improved technology in

order to reduce the cost of production. Likewise, the private Key Takeaways
enterprises should be encouraged through tax incentive and • Public Finance includes
subsidy. public revenue, public

10. Correct Balance of Payment: The development process expenditure, public debt
creates difficulty in balance of payment. This situation and financial adminis-
occurs when the economy is unable to earn foreign exchange tration.
• The two main aspects of
through exports. Hence, taxes should be designed so as to public finance are public
encourage inflow of foreign capital and influence the level of expenditure and public
export and reduce import. Generally, high tax rate is levied revenue
on imports and low tax rate on exports.

Glossary Inflation: Apersistent rise in the general price level

Deflation: A persistent decrease in the price level

Subsidy: Financial incentive or support provided by the government

Progressive tax: Tax rate that increases with the increase in income level

79 Vedanta High School Economics - 10

5.1 GOVERNMENT EXPENDITURE

Government Expenditure deals with the principles and problems relating to the
allocation of public spendings. Here we study the fundamental principles governing
the flow of public funds into different channels; classification and justification of
public expenditure; expenditure policies of the government and the measures adopted
for general welfare.

Government expenditure is also known as public expenditure. Revenue collected by
the government has to be spent for administrative and development purposes of the
country. It plays an important role in economic development of a country.

Causes of Increase in Government Expenditure in Modern Times

1. Rapid Growth of Population: The growth in population requires massive investment in
health and education, law and social order, etc. A young population requires increasing
expenditure on education and youth services, while the ageing population requires
transfer payments like old age pension, social security & health facilities.

2. Defence Expenditure: There has been enormous increase in defence expenditure
in modern times. The defence expenditure has increased tremendously due to
modernization of defence equipment used by army, air force etc.

3. Increase in National Income: The increase in national income also resulted in more
income to the government by way of tax revenue and other income. As a result, the
government expenditure also increases. The government is not only expected to expand
its traditional activities but also has to undertake new activities.

4. Government Subsidies: The government has been providing subsidies on a number of
items such as food, fertilizers, exports, education, etc. Because of the massive amounts
of subsidies, public expenditure has increased.

5. Debt Servicing: The internal debt as well as external debt is on the increase. The
government in developing countries borrows heavily both from the domestic market
and from foreign sources, to meet its expenditure. As a result of which, the government
has to make huge amounts of money towards interest payments.

6. Expansion of Administrative Machinery: There has been an increase in the
administrative machinery in the country overtime. Heavy expenditure is to be incurred
on police, tax administration, administration of public enterprises, etc.

7. Development Projects: The government in developing countries has to undertake
various development projects such as irrigation, iron and steel, heavy machinery,
power, telecommunications, etc. The development projects require lot of capital and
revenue expenditure.

8. Industrialization: Setting up key and basic industries requires huge capital and profit
may arise only in the long run. It is the government which starts such industries in a
planned economy. The public sector has to create a strong infrastructure as a support
base for the industrial sector by investing huge capital.

9. Economic Incentives: Economic incentives such as subsidies, cheap credit, tax
concession, cheap electricity, etc. given by the government to the agriculturists and
industrialists have caused monetary burden on the government. While, recoveries in

Vedanta High School Economics - 10 80

Glossary respect of both economic and social services have been insignificant.

10. Welfare State Ideology and Wagner’s Law: The modern State is a welfare state. It aims
at promoting the economic, political, and social well-being of its citizens. It makes
every effort to improve the living standard of the common people. For this purpose, it
has to undertake many functions and services never visualized before.

ROLE OF PUBLIC EXPENDITURE IN A DEVELOPING ECONOMY

1. Social and Economic Overheads: Economic development is handicapped in developing
countries due to deficiency of capital and infrastructure. Economic overheads like roads
and railways, irrigation and power projects and social overheads like hospitals, schools,
and colleges and technical institutions are essential. Capital for such overheads cannot
sufficiently come out of private sources. Public expenditure is necessary to build up
the economic and social overheads.

2. Balanced Regional Growth: It is considered desirable to bring about a balanced regional
growth. Special attention has to be paid for the development of backward areas and
under-developed regions. This requires huge amounts for which reliance has to be
placed on public expenditure.

3. Development of Agriculture and Industry: Agricultural development provides the base
for industrial development and has to be given top priority. The government also has
to incur heavy expenditure in the agricultural sector on irrigation, power, seed farms,
fertilizers, warehouses, etc., and in the industrial sector by setting up public enterprises
like steel plants, heavy electricals, heavy engineering, machine-making factories, etc.

4. Exploitation and Development of Mineral Resources: Minerals provide a base for further
economic development. The government has to undertake schemes of exploration and
development of essential minerals, e.g., gas, petroleum, coal, etc. Public expenditure
has to play its pivotal role in the exploration and development of mineral resources.

5. Education: Education not only contributes to mental development of man but also
raises productivity. Moreover mass education is a necessary condition for the success
of democracy. The state has made attempts to create various types of educational
facilities. The government has also set up specialized institutes for medical & technical
education which involves heavy expenditure.

6. Defence Expenditure: Defence is the main factor which has increased public expenditure
in modern times. Now armament race among the nations is increasing day by day. This
expenditure has contributed to the increase in expenditure.

7. Control of Inflation: With the rising prices, the government has to keep on increasing
public expenditure to carry out its functions and maintain the supply of public goods
intact. During inflation, the government has to pay additional dearness allowance to its
employees which obviously call for an extra burden on public expenditure.

8. Subsidies and Grants: The Central Government gives grants to State governments
and the State governments to local authorities to induce them to incur some desirable
expenditure. Subsidies have also to be given to encourage the production of certain
goods especially for export to earn much-needed foreign exchange.

Planned economy: An economy where development planning is done by the government
Economic overheads: Roads, power transmission systems, telecommunications, etc
Pivotal: Of crucial importance
Warehouse: Storage

81 Vedanta High School Economics - 10

SECTORS OF GOVERNMENT EXPENDITURE – Scope of public expenditure

In the past, the functions of the government were few and limited only to protection of
the country and maintenance of law and order in the country. However, modern states
are welfare states and they work to promote public welfare. The sectors of government
expenditure are as follows:

1. Defence and Security: Protection of the country from external aggression and
maintenance of law and order in the country is the primary function of the government.
The government has to spend on armament, security forces and other departments of
defence.

2. Administration: The government has to incur regular expenditure on administrative
units. It has to make payments of salaries and allowance to elected representatives and
employees employed in various government ministries and departments.

3. Economic Sector: The government incurs developmental expenditure on economic
sectors like agriculture, industry, trade, tourism, irrigation, hydropower, transport and
communication etc. to increase the rate of economic growth.

4. Social Services: The government has to provide social services and facilities to the
people. It has to allocate its expenditure on education, drinking water, health services,
electricity and so on.

5. Basic Infrastructures: Infrastructural development is the basis of economic development.
The government has to construct and develop roads, bridges, hydropower projects etc.
to increase capital formation and develop the economy.

6. Social Security: The government has to provide old age pension, unemployment
allowance, pension and gratuity to retired employees etc.

7. Debt Management: Developing countries have to run internal and external debt to
finance developmental projects. As a result, the government has to make huge amounts
of money towards interest payments.

5.2 CLASSIFICATION OF GOVERNMENT EXPENDITURE IN NEPAL

Government Expenditure in Nepal is classified into recurrent expenditure and capital
expenditure.

A. RECURRENT EXPENDITURE

Recurrent expenditure is also known as regular expenditure or administrative
expenditure. It is incurred to run the administrative function of government throughout
one fiscal year. It constitutes the expenditure on following headings.

1. Constitutional Organs: Expenditure of the government on parliament, Secretariat,
Supreme Court, CIAA, Auditor General Office, Election Commission, Civil Service
commission, Judicial Council and Attorney General office are included under this.

2. Regular Administration: Expenditures of the government on the council of ministries,
government secretariat, various departments, district administration, police and jail
are included.

3. Revenue Administration: Expenditure of the government for the revenue such as land
revenue, custom duty, and excise duty are included under this.

4. Economic Administration and Planning: Expenditure related to economic plan
formulation and collection of statistical data is included.

Vedanta High School Economics - 10 82

Viewpoint5. Judicial Administration: All expenditures related to the judicial administration are
included.

6. Foreign Services: Expenditures related to embassies and diplomatic consultancies are
included.

7. Defence: Expenditure made on defence through National Security Council (NSC) is
included under this.

8. Social Services: Expenditures made on education, health, drinking water, local
development, population and environment and sports and culture and social welfare
are included.

9. Economic Services: Expenditures made on economic development such as agriculture.
irrigation, land reform, forest, industry, mining, transportation, communication,
electrity, etc are included under this.

10. Loan and Investment: Expenditure made on private loans and investment in productive
sector is included under this heading.

11. Payment of Loan and Interest: Expenditure made for paying the principal and interest
of internal and external loans are included.

12. Miscellaneous Expenditure: Expenditure made on grants and gratitudes, travelling,
donation, pension, allowance, emergency help, etc are included under this.

B. CAPITAL EXPENDITURE

Expenditure of government in various development works in the country is known as
capital expenditure. It constitutes the expenditures made on following headings:

1. Administrative Improvement: This includes expenditure of the government for
successful execution of various development projects.

2. Economic Administrative Planning: This includes expenditure of the government for
the formulation of the development planning and research work.

3. Social Services: The expenditure made on the development work for education, health,
drinking water, population and environment, local development, etc are kept under
social services.

4. Economic Services: Under economic services, the expenditures made for infrastructure
development in agriculture, irrigation, land reform, forest, industry, mining are
included.

5. Communication: The expenditure of the government for the development of the postal
service and telecommunication are included under this.

6. Transportation: Expenditure for the development of transportation comes under this
expenditure. This includes expenditures for the construction of roads and bridges,
development and expansion of air service and other transportation sectors.

7. Development of Electricity: Under this expenditure, expenditures for the development
of electricity in the country.

8. Miscellaneous: This includes the expenditure made on various leadings which are not
predetermined. For example, donation, travel expenses, awards, etc.

• Public Expenditure is vital for economic development of a country.
...... How is public expenditure classified in Nepal?
..... How can public expenditure help in economic development of a country?



83 Vedanta High School Economics - 10

Distinction between Recurrent Expenditure and Capital Expenditure

Recurrent Expenditure Capital Expenditure Points to Note
It is recurring in nature • Recurrent expendi-
Its utility doesn’t last long It is non recurring ture are the regular
It doesn’t generate future return
It is considered unproductive Its utility lasts long expenditure of the
An efficient government minimizes It generates future return government
It is the consumption expenditure It is considered productive • Capital expenditure
are the developmen-

It pays to maximize such expenditure tal expenditure of the
government
It is the investment expenditure

5.3 GOVERNMENT REVENUE

The income of the government through sources like taxes, borrowings, fees and
donations etc, is called government revenue. However, Prof. Dalton has defined the
term in two senses- broad and narrow senses.
In its wider sense it includes all the incomes or receipts which a public authority may
secure during any period of time. It includes receipts from public borrowings and sale
of public assets.

In its narrow sense, however, it includes only those sources of income of the public
authority which are ordinarily known as “revenue resources.” It includes tax revenue,
interest receipts, dividends and profits of government enterprises, fees, fines, gifts and
grants.

To avoid ambiguity, thus, the former is termed “public receipts” and the later “public
revenue.”

SOURCES OF GOVERNMENT REVENUE

The government has to perform various socio-economic activities to achieve economic
stability, high economic growth, economic development and law and order in the
country. In order to carry out these functions the government has to collect large amount
of revenue from various sources. The sources of government revenue are classified into
tax revenue and non-tax revenue.

A. Tax Revenue: Taxes are the first and foremost sources of public revenue. Taxes are
compulsory payments to the government without expecting direct benefit or return by
the taxpayer. Taxes collected by Government are used to provide common benefits to
all mostly in the form of public welfare services. The following sources are included
under tax revenue.

1. Custom Duty: Customs Duty is a tariff or tax imposed on goods when transported
across international borders. This includes import and export taxes imposed by
the government in foreign trade. This is a very important source of government
revenue.

2. Internal Goods and Services Tax: Under this, taxes like excise duty, sales tax, value
added tax, entertainment tax, vehicle tax, toll tax, etc are included.

3. Land and Property Tax: This includes land tax, land registration fee, house tax, etc.
Government collects a large sum of money through land and property taxes.

4. Income Tax: An income tax is a tax that governments impose on income generated

Vedanta High School Economics - 10 84

by businesses and individuals within their jurisdiction. Under income tax, income
earned by citizens and business firms of the country.

B. Non Tax Revenue: The revenue obtained by the government from sources other than
the tax is called Non-Tax Revenue. Public income received through the administration,
commercial enterprises, gifts, and grants is the source of Pause for Thought
non-tax revenues of the government. Non-tax revenue Is it desirable to have in-
includes the following sources of government revenue. creased revenue by way of
1 Commercial Revenue: Income earned from the fines and penalties? Why?
business form established and run by the government
comes under commercial revenue. Income earned from Janakpur Cigarette Factory
Nepal Airlines Corporation, Nepal Electricity Authority, Nepal Telecom, etc are
included under this.

2. Fees, License and Permits: Fees means the revenue collected by the government
from the services provided by it in the field of education, training and registration.
Government also collects revenue from the distribution of licenses. Government
also collects revenue by giving permission for mountaineering expedition, national
parks visits and historical and religious places visits.

3. Fines and Penalties: Fine is a monetary punishment imposed for the violation of
law and order. Amount to be paid for the violation of bail and bond is penalty. these
are undesirable sources of government revenue.

4. Escheat: The claim of government on the property on the death of a person who
does not have legal inheritance is called escheats. Likewise, the bank deposit not
claimed by anybody or the property of dissolved organizations also goes to the
government. Similarly, the property confiscated by the government also falls under
escheat.

5. Special Assessment or Betterment Levy: Some public improvements such as the
construction of road or sewerage, bridge etc. benefit the residents of that area.
The charge levied on the property or residents benefitted from such improvement
is called special assessment or betterment levy. Special assessment is partially
compulsory and partially voluntary. Since it is compulsory, it is like tax. But since
it is imposed for the special benefit received, it is different from tax.

6. Public Borrowings: Loan taken by the government from different sectors is known
as public borrowing. Internal loan is taken from the citizens, firms and businessmen
of the country.

The above mentioned sources of public revenue arise from the internal sources. There
are external sources of government revenue too that falls under public receipts.They
are given below:

a. External loan: External loan is such type of loan which can be taken from the
international institution and government of other countries. It must be paid back
after some time with interest.

b. Gifts and Grants: The money received by a government from other governments
without any obligation is known as grants. Developing countries receive grants
from developed countries. Money, got from the grant need not be paid back. So, for
developing countries, it is considered as an important source.

85 Vedanta High School Economics - 10

5.4 CONCEPT OF TAX

Tax is a compulsory charge imposed by the government to the people and institutions.
The people do not receive direct benefit for tax payment. The tax is compulsory in
the sense that nobody can reject to pay tax. It is the main source of government revenue.

According to Taylor: “Taxes are compulsory payment to government without expectation of
direct benefit in return to the tax payer”.

A tax is quid-pro quo and has the following features: Tax is a compulsory

• Tax is a compulsory payment. charge imposed by the gov-
• People do not receive direct benefit from tax. KEY ernment which has to be
IDEA paid without any expecta-
• The fund raised from tax is spent on public welfare.
tion of direct benefit

5.5 PRINCIPLES OR CHARACTERISTICS OF A GOOD TAX SYSTEM

Taxation principles are the guidelines that a governing entity should use when devising a
system of taxation. A good tax system should possess the following characteristics:

1. Canon of Ability or Equality: A good tax system should possess the quality of equality.
All citizens should borne government expenditure according to their ability. This does
not mean that the rich and poor alike should pay tax equally or at the same rate. It simply
means equality of sacrifice.

2. Canon of Certainty: The tax which an individual has to pay should be certain and not
arbitrary. According to Adam Smith, the time of payment, the manner of payment, the
quantity to be paid, i.e., tax liability, ought all to be clear and plain to the contributor and
to everyone.

3. Canon of Convenience: According to Adam Smith while imposing tax, the time and
method of tax payment should be convenient to the tax payers. A convenient tax system
encourages tax payers to pay tax in time. An inconvenient tax is unpopular.

4. Canon of Economy: According to Adam Smith a good tax should possess canon of economy.
This means that the amount of tax should be minimum and its cost of collection should be
lower than the revenue raised from it. It also implies that the tax should not have adverse
effect on production.

5. Canon of Productivity: The canon of productivity was formulated by Bastable. According
to this canon, the government should raise revenue sufficient enough to meet its
expenditures. For this only one tax yielding more revenue should be imposed instead of
imposing many taxes yielding low income.

6. Canon of Elasticity: The tax system should be elastic. The government expenditure
increases every year. Hence, tax should be easier to increase revenue in case of need.
An income tax is a good example of elastic tax. The government can increase revenue by
increasing the limit of income tax.

7. Canon of Flexibility: Flexibility denotes that there should be no rigidity in the tax system.
Flexibility is needed for elasticity. In brief, the tax system of a country should be liable to
change promptly in case of need.

8. Canon of Simplicity: The tax system should be easier to comprehend even by the common
people. The people do not hesitate to pay tax only when they can easily understand the
objective, method of payment, time of payment, and effect of tax.

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9. Canon of Diversity: The government should raise revenue from people of all classes for
public welfare by imposing variety of taxes. But since diversity increases the cost of tax,
caution must be taken on it.

10. Canon of Uniformity: There should be uniformity in tax system. The method of imposing
all taxes should be same. Likewise, there should be uniformity in tax rates.

Glossary Toll tax: A road tax imposed on vehicles

Bail: a temporary release of an accused on monetary guarrantee

Excise Duty: A tax imposed on liquor

Canon: Principles

5.6 TYPES OF TAXES

Taxes are broadly classified into two types on the basis of impact and incidence They are:
Direct taxes are those which
a. Direct Tax cannot be shifted and has to be
b. Indirect Tax paid by the person himself on

A. DIRECT TAX whom it is imposed

The tax which cannot be shifted to other is called direct tax. Direct taxes are the taxes on
property, profit and income. The impact (initial burden) and incidence (final burden) of
this tax fall on the same person. For example, income and property taxes are the direct
taxes which should be paid by the person on whom it is imposed and cannot be shifted.

MERITS OF DIRECT TAXES

1. Equality: The canon of equality states that the taxes should be implied on the basis of
equality This tax is based on the ability to pay principle. Hence, this has a feature of
equity. Since the rate of tax increases with increase in income, more burdens falls on the
rich.

2. Certainty: The taxpayer knows the amount to be paid, time of payment and method of
payment of tax. Similarly, the government knows the revenue to be earned from this tax.
Hence, this tax has the feature of certainty.

3. Elastic: The direct tax is elastic. The revenue from direct taxes rises with increase in
income or property and decrease with decrease in income and property. Similarly, the
government can raise the rate of taxes to increase revenue.

4. Economical: The direct tax is deducted from the source. It has to be paid the person
himself on whom it is imposed. The government does not need to spend on the collection
of taxes because they are already taken right at the source of the income. Hence, the cost
of collection is less and economical.

5. Productive: The direct tax is productive. The revenue from this tax increases with increase
in national income. As a community grows in numbers and prosperity, the return from
direct taxes expands automatically.

6. Progressive: The direct tax can be made progressive. This means that higher rates can
be fixed to those having more income and property. This helps to reduce inequality of
income and property.

7. Educative: The direct tax creates people’s awareness. It makes the tax payers aware of their
obligation. Similarly, they become aware as to how and where the government spends the
money raised from them.

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Keynote8. Anti-inflationary: The direct tax is an important weapon to reduce inflation. The
purchasing power of men can be reduced by raising the tax rate. This helps to reduce
inflation.

DEMERITS OF DIRECT TAXES

1. Inconvenient: The tax payers should keep records or accounts for the evaluation of direct
tax. It is inconvenient to keep account and to visit tax frequently. It is inconvenient also
for the reason that this tax should be paid in lump sum amount.

2. Evasion: The tax payers may submit the wrong records in the tax office and conceal actual
income for tax evasion. Hence, there is a tendency for evasion in direct tax. This creates
economic ills like black marketing, corruption and concealment of black money. In fact,
the direct tax is levied on honests and the dishonests are free of tax.

3. Arbitrary: The direct tax is not based on any scientific formula. The Ministry of Finance
fixes it in arbitrary manner. It may have serious effects on the people. In reality, there is no
objective criterion of ability to pay tax.

4. Narrow-based: The base of this tax is narrow. Since, this tax is imposed on the rich; it
does not cover all classes of people. Hence, the revenue from it is very low in the country
like Nepal where the majority of the people are poor.

5. Lack of Inspiration: The direct tax kills the spirit of people to work more, earn more, save
and invest more. As a tax payer, you know that the harder you work and generate more
income, the more you will have to pay in direct taxes. Therefore, it dramatically affects
ability to work and motivation to excel

6. Affects Capital Formation: The direct taxes can affect savings and investment. Due to
taxes, the net income of the people gets reduced. This in turn reduces savings. Reduction
in savings results in low investment. The low investment affects capital formation in the
country.

7. Limited Scope: Poor people are exempted from payment of direct taxes. In countries like
India where masses are poor, direct taxes can reach only a few rich people. So collection of
revenue through direct taxes becomes marginal and therefore, collection of revenue from
direct taxes is not adequate for mobilisation of resources.

8. Unpopular: Direct taxes impose a money burden on the tax payer and the tax payer cannot
shift this money burden to someone else. The tax payer becomes sensitive and the tax
payer also resists. When tax rates are revised upward or some new taxes are introduced,
the tax payers become violent.

• Grants have no economic obligation to pay back
• Special assesment is like tax but only on residents that are specially

benefitted by certain projects
• A direct tax is imposed on property, profits and income

B. INDIRECT TAX

The tax which can be shifted to other is called indirect tax. Indirect taxes are the taxes on
consumption and production. The impact (initial burden) and incidence (final burden) of
this tax fall on the different person. In the case of indirect tax, the burden of tax can be
shifted by the taxpayer to someone else. Indirect tax has the effect to raising the price of
the products on which they are imposed. Sales tax, VAT, Excise duty, Custom duty etc. are
examples of indirect taxes.

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MERITS OF INDIRECT TAXES

1. Convenient: As the tax is paid by the consumers while purchasing goods and services, it
is convenient to make payment. The tax is concealed in the price and the burden of tax is
not felt. This tax can be collected by the government from producers or importers. So it is
convenient to the government too.

2. Difficulty of Evasion: It is difficult to evade the indirect tax. Since the tax is included in
the price, the purchaser of goods should pay the tax compulsorily.

3. Broad-based: The commodities are consumed by both the rich and poor people. Hence,
all those who consume the commodity, pay it. It is an important device to bring majority
of people within the tax net.

4. Social Value: The indirect tax has social value as well. The imposition of high taxes
on harmful commodities like cigarette, alchohol discourages their consumption.

5. Progressive: The indirect tax can also be made progressive to some extent. It is done by
imposing low tax on the goods of mass consumption and high tax on luxurious goods.
Consequently, the burden of tax falls more on the rich and less on the poor.

6. Elastic: The indirect tax may be as elastic as indirect tax. For this, taxes are imposed on
goods having inelastic demand. This helps to increase revenue by increasing tax rate
according to need. But this is against the principle of equity.

DEMERITS OF DIRECT TAXES

1. Inequality: The indirect tax is not equitable. The rich find poor should pay tax in the
same rate. The burden falls comparatively more on the poor. In this sense, indirect tax is
regressive. It increases inequality of income.

2. Uneconomical: Many staff should be recruited to collect this tax. Hence, the cost of
collection of tax may be higher than tax revenue.

3. Uncertainty: When the tax rate is increased, the price of the commodities, also increase.
Therefore, the people reduce the consumption of those commodities. They also use
substitute goods if available. Hence, there is no certainty of revenue from this source.

4. Uneducative: The indirect tax is invisible. There is no direct relationship between the tax
payers and the government. The people do not directly feel the burden of tax. Hence, it
does not create people’s awareness.

5. Inflationary Effect: Since the indirect tax is included in the price of the commodity, it
increases price level. It thus may adversely affect the lives of common people.

6. Unproductive: The indirect tax increases the price of the goods and reduces savings. This
directly affects capital formation and obstructs the industry and commerce.

7. Smuggling and Corruption: The indirect tax like custom encourages smuggling and
corruption. The traders smuggle the goods to evade custom. Likewise, the tax officers help
the traders to escape tax by undervaluation of goods. Hence, corruption is encouraged by
indirect tax.

CHECKPOINT 1. What are the various sectors of public expenditure?

2. How is public expenditure classified in Nepal?

3. What are the characteristics of a good tax system?

4. What are the merits and demerits of direct taxes?

5. What are the merits and demerits of indirect taxes?

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5.7 BUDGET

The word budget is derived from the French word “bougette” which means a small
leather bag. As such, the Finance minister of a country carries a bag containing
abstracts of budget papers while presenting the budget in the Parliament. A budget is
the estimation of probable income and expenditure of the government, the financial
policies, taxation measures, utilization of resources, mobilization of capital etc. The
meaning of budget is different in the views of different economist.

PE Taylor: “The budget is the master financial plan of the government. It brings together
estimates of anticipated revenue and proposed expenditure for the budget period and
from these estimates the activities to be understood and means of their financing can be
inferred.”

Prof. Bastable:, “The budget has come to mean the financial arrangements of a given
period, with the usual implication that has been submitted to the legislature for approval.”

In conclusion, budget is the estimation of government revenue and government
expenditure for the coming fiscal year. It may thus be defined as a financial master
plan of the government which contains anticipated income and proposed expenditure
for the coming year. It is a powerful means to run various economic activities.

OBJECTIVES OF BUDGET

The objectives of a budget can be explained as below:

1. To make definite planning with regard to the estimated revenue and proposed
expenditures under various heads.

2. To take decisions regarding taxation, borrowings, expenditures and other fiscal measures
systematically.

3. To identify various operations of the government and to judge the performance in regard
to economic development.

4. To make an instrument of achieving various objectives of economic policy.

5. To act as an index of government functioning. The revenue and expend-
6. To manage public enterprises effectively. iture in a budget are only
KEY estimates and not the real-
TYPES OF BUDGET IDEA ised figures

On the basis of differential gap between revenue and expenditure budget can be classified
into three categories:

1. Balanced Budget: If the anticipated revenue is equal to planned expenditure in a budget
it is called balanced budget.

2. Surplus Budget: If the anticipated revenue is greater than the planned expenditure
in a budget it is called surplus budget. Such a budget may be prepared by developed
countries.

3. Deficit Budget: If the anticipated revenue is less than planned expenditure in a budget
it is called deficit budget. To fill up the deficit in a budget, the government may resort to
deficit financing. Developing countries generally prepare deficit budget.

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COMPONENTS OF BUDGET

The following are the major components of budget.

1. Summary of Economic Progress: This includes the various economic activities
performed in the current fiscal year. Collection of revenue, amount of expenditure,
inflation, situation of foreign trade, economic growth etc. are taken under consideration.

2. Objective: Various objectives such as collection of more revenue, control of government
expenditure, proper allocation of resources or other objectives of budget guided by the
current plan are included.

3. Estimaton of Expenditure: Expenditures are divided in two parts: recurrent expenditure
and capital expenditure. So estimations of expenditure in various sectors are included.

4. Revenue Proposals: Revenue is most important factor to fulfill the estimated
expenditure. So it includes collection of revenue from tax source, non-tax source and
other sources.

5. Sources of Deficit Financing: Deficit in the budget has to be filled up through borrowings
or issuing new currency. The internal sources and external sources of deficit financing
has to be mentioned.

PROCESS OF BUDGET FORMULATION IN NEPAL

The process of budget formulation begins nearly about six months before the new fiscal
year. The budget formulation process takes many steps as explained below:

1. Circulars: In the first stage, the budget division of Finance Ministry prepares the
guidelines of budget in consistent with economic planning and fiscal policy. It sends
circulars to the government ministries and departments to send the estimate of revenue
and expenditure on the basis of the guidelines.

2. Estimate of Overall Expenditure: In the second stage, the level of government expenditure
for the next budget period is determined. The level of government expenditure should be
enough, to achieve development objectives and economic stability. The final decision on
the budget limit is done by the national council having representatives of all governmental
agencies.

3. Establishment of Priorities: In the third stage, the planning authority fixes priority on
main sectors of government activity. After determining the amount of expenditure for the
coming year, the expenditure is allocated according to different sectors or regions. The
projects should be prepared within the limit fixed for the concerned sectors.

4. Project Preparation and Selection: In the fourth stage, the operating department formulates
the proposed projects and submits to the planning authority. The planning authority, after
making review of the projects, selects the projects to include in the coming budget. After
the selection of the projects, the planning authority informs and sends a list of approved
projects to the concerned departments.

5. Submission of Financial Estimates: In the fifth stage, the list of the selected projects and
financial estimates are submitted to the budget by planning authority. This is the stage of
budget preparation. The budget office reviews the projects in the presence of departmental
representatives and reconciles any difference in opinion.

6. Presentation and Approval of Budget: The estimated budget for the coming fiscal year
is presented by the Finance Ministry. The parliament discusses over the draft budget
for several days. The proposed budget with necessary adjustment is then approved
by the parliament simple majority voting. The budget approved by the parliament is

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finally attested by the president. Once the president attest the budget, it takes the formViewpoint
of the fiscal law for the year.

7. Implementation of Budget: The budget is implemented by the government. The
government has the sole authority to implement budget and it allows other authorities
to implement the budget.

8. Auditing: Auditing is the last stage of budget formulation. The auditing of the budget
is made in order to judge whether the funds are spent properly or not according to the
rules and the regulation. The auditor prepares final report and submit it to the head of
the state.

• A budget is a financial masterplan of the government. It reflects the plan
and policies of the government

… What are the different types of budget?
.... What type of budget will be suitable for a developing country like Nepal?



IMPORTANCE OF BUDGET

Budget is an important tool for policy makers, executive body of the government,
business company and the general people as well. The importance of budget can be
explained as:

1. Important to the Policy Makers: Budget is important for the policy makers. Policy
makers can design income, expenditure and debt policy to enhance economic growth
of a country. Policy makers can set national priorities according to the budget situation
through tax policy, expenditure policy and some other policies as well.

2. Importance to the Executive Body of the Government: The budget prepared by
the executive body has to be approved by the legislative body to implement it. The
executive body is responsible to implement budget. Budget functions as a guide to
various departmental heads for what they have to do during the fiscal year. It is a
guideline to the executive body of the government.

3. Importance to the Business Community: Business community is profit oriented. Tax
and expenditure policy of the budget are the main determining factors of profit. Thus,
budget helps them to determine their activities. They can invest in those sectors where
they can enjoy subsidies, tax holidays and do not have to pay tax or have to pay only
minimum tax.

4. Importance to the People: People can get much information from the budget. They can
know the plan, programme, and policies of the government which can help them to
adjust their financial programme according to the budget. So, budget is important to
the people.

5. Economic Growth: Budget helps to promote rapid and balanced economic growth so as
to improve living standard of the people. Economic growth implies a sustained increase
in real GDP of the economy, i.e., a sustained increase in volume of goods and services.
Public welfare is the main guide.

6. Reduction of Poverty and Unemployment: Budget helps to eradicate mass poverty and
unemployment by creating employment opportunities and providing maximum social
benefits to the poor. In fact, social welfare is the single most important objective of a
welfare state.

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7. Redistribution of Income: Equalities in income distribution mean allocating the
income distribution in such a way that reduces income inequalities and there is no
concentration of income among the few rich. It primarily requires that the rate of
increase in real income of poor sections of society should be faster than that of the rich
sections of society. Fiscal instruments like taxation, subsidies and public expenditure
can be made use of to achieve the object.

8. Economic Stability: Government can bring economic stability through taxes, subsidies
and expenditure. For instance, when there is inflation, the government can reduce its
expenditure. When there is depression, the government can reduce taxes and grant
subsidies to encourage spending by the people.

9. Reallocation of Resources: Budget can be used as an instrument to reallocate resources
so as to achieve social and economic objectives. Again, the government provides more
resources into socially productive sectors like public sanitation, rural electrification,
education, health, etc. where private sector initiative is not forthcoming. Moreover the
government allocates more funds to production of socially useful goods and diverts
resources from some other areas to promote balanced economic growth.

10. Management of Public Enterprises: Private monopolies in key sectors are detrimental to
social welfare. To curb monopolies in heavy, basic and key sectors owned and managed
by private enterprises, government establishes and operates such units in the public
sector. This is necessary to avoid distortion of priorities of the government and society.
Budget serves as an effective tool in this regard.

.

ORIGIN OF BUDGET IN NEPAL
After the overthrow of the Rana rule in February 1951 that among the many changes that have taken place,

the presentation of an annual budget has found a place. Tradition of presenting annual budget in Nepal dates

back to the 1950s. One of the new changes brought about immediately after the overthrow of Rana regime

in February, 1951 was the beginning of presenting annual budget of the country.

The first annual budget was presented in 1951. The budget covered the period March 1951-February 1952.
Since there was no legislature due to the fact that Nepal’s political history was going through the beginning
of transitional phase, the first budget (1951-52) was presented at the end of the year BS 2007 through Radio
Nepal.

The budget amount was Rs. 5,25,29,000. It had set a goal of collecting taxes amounting to Rs. 3,06, 19,000.
The then finance minister Subarna Shamsher who was one of the members of the council of ministers led by
the then Prime Minister Matrika Prasad Koirala.

CONCEPTS FOR REVIEW
Public finance Public revenue Public expenditure

Tax revenue Non tax revenue Budget

Recurrent expenditure Capital expenditure Surplus budget

Deficit budget Debt servicing Subsidies

Auditing Budget in brief Authorization

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UNIT OVERVIEW

Public Finance: Public finance is a special 4. Exploitation of mineral resources

branch of economics which deals with the 5. Education
principles, problems, policies and processes of 6. Increase in administrative machinery
the government. 7. Spread of urbanization

Importance of Public Finance 8. Increase in defence expenditure

1. Allocation of resources 9. Development of government projects

2. Macro-economic stabilization 10. Debt servicing

3. Provision of social goods

4. Democratic planning Sectors of Government Expenditure
5. Capital formation 1. Defence and security:

6. Redistribution of income and wealth 2. Administration

7. Mobilization of resources 3. Economic sector
8. Promotion of economic development 4. Social services
9. Technology, enterprise and efficiency 5. Basic infrastructures
10. Correct balance of payments 6. Social security
7. Debt management

Causes of increase in government expenditure Sources of government revenue
a. Rapid growth of population 1. Tax revenue
b. Defence expenditure a. Custom Duty
c. Increase in national income b. Tax on consumption and production
d. Government subsidy c. Land revenue and registration
e. Debt servicing d. Tax on property, profit and income
f. Expansion of administrative machinery 2. Non tax revenue
g. Development projects a. Gifts and donations
h. Urbanization b. Fees, licenses and permits
i. Industrialization c. Fines and penalties
j. Economic incentives d. Escheat
e. Betterment levy
Classification of public expenditure in Nepal f. Income from public enterprises
In Nepal public expenditure is classified as:

a. Recurrent expenditure: Recurrent g. Gifts and grants
expenditure is also known as regular h. Foreign aid
expenditure or administrative expenditure. It

is incurred to run the administrative function Government Budget: A budget is a financial
of government throughout one fiscal year. master plan of the government about

b. Capital expenditure: Capital anticipated income and proposed expenditure
for the coming year.
expenditure is also known as development

expenditure. Expenditure of government in Objectives of budget
various development works in the country is
known as capital expenditure. 1. To make definite planning with regard
to the estimated revenue and proposed
Importance of public expenditure expenditures under various heads.

1. Economic and social overheads 2. To take decisions regarding taxation,
2. Secure balance regional growth borrowings, expenditures and other fiscal
3. Agriculture and industrial development measures systematically.

3. To identify various operations of the

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UNIT OVERVIEW

government and to judge the performance Components of Budget
in regard to economic development. 1. Summary of economic progress
2. Objective
4. To make an instrument of achieving 3. Estimaton of expenditure
various objectives of economic policy. 4. Revenue proposals
5. Sources of deficit financing
5. To act as an index of government
functioning. Process of budget formulation

6. To manage public enterprises effectively.

Importance of budget The budget formulation begins few months
a. Important to the policy makers before the start of the coming fiscal year. In
b. Importance to the executive body Nepal, the fiscal year begins from 1st Shrawan
c. Importance to the business community and ends in last of Ashad. The steps of budget
d. Importance to the people formulation are:
e. Economic growth
f. Reduction of poverty and employment 1. Circulars by budget division of the finance
g. Income redistribution ministry
h. Economic stability
i. Reallocation of resources 2. Estimation of overall expenditure to be done
as per the budget limit
Types of budget
1. Balanced budget (Income= Expenditure) 3. Establishment of priorities
2. Surplus budget (Income > Expenditure)
3. Deficit budget (Income < Expenditure) 4. Submission of final estimates

5.The completion of final budget by the budget
office

6. Authorization and execution

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QUESTIONS FOR REVIEW

Very Short Answer Type Questions

1. What is public finance?
2. What is meant by government budget?
3. Mention two internal sources of government revenue.
4. Mention two non tax revenue of the government?
5. What is meant by betterment levy?
6. What is meant by escheat?
7. Why are fines and penalties undesirable source of government revenue?
8. What is meant by deficit budget?
9. Write any two solutions to solve the deficit budget.
10. State the external sources of government revenue.
11. What is meant by tax?
12. Under which category of taxes does Income tax and Property Tax lie?
13. What source of revenue do taxes fall?
14.. What will be the government expenditure policy during depression?
15. What sort of expenditure falls under recurrent expenditure?
16. What sort of expenditure falls under capital expenditure?
17. What kind of budget is prepared by developing countries?

Short Answer Type Questions
1. What are the sources of public finance?
2. Explain the differences between public finance and private finance.
3. Explain the importance of public expenditure.
4. Explain in brief the sectors of government expenditure.
5. What are the reasons for increase in public expenditure in modern times?
6. Explain the different sources of Government revenue.
7. What are the components of budget? Explain.
8. Explain the importance of budget in the context of Nepal.
9. Mention the objectives of a government budget.

10. How is public expenditure classified in Nepal? Explain.

Long Answer Type Questions

1. What are the characteristics of a good tax system? Explain
2. Explain the merits and demerits of direct tax
3. Explain the merits and demerits of indirect tax
4. Define budget. Explain the process of budget formulation in Nepal.

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6UNIT DEVELOPMENT ECONOMICS

Learning Objectives Weight:18 Lecture Hours

On Completion of this unit the student will be

able to:
• Understand the concept of economic

development

• Explain the traditional and modern views of

• development you begin

BeforeDistinguish between economic growth and
Economic development usually refers to
economic development
the adoption of new technologies, transi-
• Explain the various indicators of economic tion from agriculture-based to industry-
development based economy, and general improvement

• Explain the characteristics of developing in living standards.Various theories of
countries
development have been developed over the

• Understand and explain the various theories years by economists to help solve basic
issues concerning economic development
of economic development
and economic growth.

Very Short Type Short Type Long Answer Type Total Marks
2 2 0 12

97 Vedanta High School Economics - 10

6.1 MEANING OF ECONOMIC GROWTH

In simplest terms, economic growth refers to an increase in aggregate production in
an economy. It is an increase in the capacity of an economy to produce goods and
services, compared from one period of time to another. So, the word growth refers to
the prosperity of the nation. In economics, economic growth refers to rising of income,
production, consumption levels etc.

As per Paul Romer economic growth occurs whenever people take resources and
rearrange them in ways that are more valuable.

Friedman defined growth as an expansion of the system in one or more dimension
without a change in its structure.

According to Simon Kuznets, “A country’s economic growth may be defined as a long-
term rise in capacity to supply increasingly diverse economic goods to its population, this
growing capacity based on advancing technology and the institutional and ideological
adjustments that it demands”.

Economic Growth is the positive change in the real output of the country in a particular
span of time. It is commonly measured in terms of the increase in aggregated market
value of additional goods and services produced, using estimates such as GDP. Economic
growth means more output, while economic development implies both more output
and changes in the technical and institutional arrangement by which it is produced and
distributed. So, it is said that economic growth is essential for economic development
but not the sufficient condition.

6.2 MEANING OF ECONOMIC DEVELOPMENT

The literal meaning of development is a passage from a lower to higher stage. It is the
quantitative as well as qualitative improvement in economic variables. Quantitative
improvement in economic variables refers to economic growth. As such, economic
development implies growth plus change.

Economic development is a dynamic concept. The economic prosperity of any country
may be defined as economic development. In general. economic development is
taken to be the development and expansion of material capital. But in modern time,
development of social and human capital is also covered by economic development.
Economic development is only a part of overall development. However, it includes
every sector in one way or the other. Economic development affects social, political,
technical, religious and cultural development.

According to Prof.Meier, “Economic development is the process whereby the real per
capita income of a country increases over a long period of time subject to stipulation that
the number of people below and absolute poverty lines does not increase, and that the
distribution of income does not become more unequal.”

Michael P Todaro gave a comprehensive definition of economic development.
According to him, “Development must therefore be conceived of as a multidimensional
process involving major changes in social structures, popular attitudes, and national
institutions, as well as the acceleration of economic growth, the reduction of inequality,
and the eradication of poverty.”

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Amartya Sen the 1998 Nobel laureate in economics writes of “development as
freedom.” As Sen put it, “Economic growth cannot be sensibly treated as an end in
itself. Development has to be more concerned with enhancing the lives we lead and the
freedoms we enjoy.”

At least three basic components or core values serve as a conceptual basis and practical
guideline for understanding the inner meaning of development. These core values are
- sustenance, self-esteem, and freedom from servitude. They relate to fundamental
human needs that find their expression in almost all societies and cultures at all times.

So, economic development means the process of changing living style to modern
ways of living. Economic development refers not only to economic growth but also to
be economic change in social and cultural sectors. We may conclude that economic
development is a multi dimensional process whereby the entire socio-economic,
political, legal, institutional and technological framework of the economy move in the
positive direction.

DISTINCTION BETWEEN ECONOMIC GROWTH AND ECONOMIC DEVELOPMENT

Normally growth and development are used synonymously. However, in particular, the
two terms have been distinguished by different economists as follows:

1. Economic growth refers to the process of expansion of backward economies, while
economic growth relates to that of advanced economies.

2. Economic growth is a narrow concept. While economic development is a broad concept.

3. Economic growth signifies the progress of an economy under the stimulus of certain
favourable circumstances. Economic development is the outcome of conscious and
deliberate efforts involved in planning.

4. The raising of income levels is generally called economic growth in rich countries and
in poor ones it is called economic development.

5. Growth strictly means an increase in real income, gross and per capita. On the other
hand, development is a process of expansion, fulfilling the desire to have an increase

in national income.

Keynote • Economic growth is an increase in the production of goods and ser-
vices in an economy.

• Increases in capital goods, labor force, technology, and human capital

can all contribute to economic growth.

6.3 INDICATORS OF ECONOMIC DEVELOPMENT

Many indicators are used to measure economic development in developing countries.
Some of the major indicators of economic development are as follows.

1. Per Capita Income Criterion: The most commonly used indicator of economic
development is per capita income. Economists like Meier, Paul Baran, Buchanan and
Elis have accepted the increase in PCI as an indicator of economic development. A
sustained increase in per capita income for a long period of the time indicates the
economic development of the country. Prior to the 1970’s development was assessed on
the basis of per capita income. Development strategies have therefore focused on rapid
industrialization at the cost of agriculture and rural development. It also ignores social
indicators and hence is not considered a satisfactory measure of development.

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2. Gross National Product (GNP) Criterion: Simon Kuznets, Meade, Meier and Baldwin
have used Real GNP as an index of economic development. Real GNP refers to the
country’s total output of final goods and services in real terms rather than in monetary
terms. According to this method the state of continuous increase in real GNP can be
taken as the indicator of economic development. This is especially applicable for the
poor and middle class countries. But the short run increase in GNP due to rise in price
cannot be taken as economic indicator for the country.

3. Basic Human Needs: This criterion was developed by World Bank. The approach is
associated with Holis Chenery. According to this criteria, the development is evaluated
on the basis of the fulfillment of the basic needs of the people in terms of health,
education, water, food, clothing, shelter, work etc. The fulfillment of these basic needs
on a satisfactory note implies a satisfactory level of economic development and vice
versa. The approach can serve well if used as a complement to income indicator of
development such as per capita income.

4. Physical Quality of Life Index (PQLI): This criterion was developed by Morris David
Morris. The PQLI summarizes infant mortality, life expectancy at age one and basic
literacy. The three indices - infant mortality, life expectancy at age one and literacy rate
are measured on a scale of 0 to 100. The three indices are Pause for Thought
averaged to derive the composite index PQLI. The index Is it desirable to have in-
enables researchers to rank countries, not by incomes creased revenue by way of
but by changes in real life chances. Higher PQLI index fines and penalties? Why?
implies higher level of development.

5. Human Development Index: The HDI was created by an Indian economist Amartya

Sen and a Pakistani economist Mahbub ul Haq in 1990. United Nations Development

Programme put forward Human Development Index in its annual Human Development

Report 1990. It is the most widely used indicator of development. The HDI is based

on three aspects of human development. They are income for a decent living life

expectancy at birth and education index which is the average of years of schooling for

adults aged 25 years and expected years of schooling for children of school entering
PAominatrttyoaNoSteen and
age. HDI ranks each country on a scale of 0 to 1.

The HDI classifies the countries into three groups by using threeMahbub-ul Haq
criteria of development-
jointly developed

a. Low human development from 0.0 to 0.50. the Human Devel-
b. Medium human development from 0.51 to 0.79. opment Index and it
c. High human development from 0.80 to 1.0. was adopted by the
UNDP in 1990

With HDI value of 0.574, Nepal rank 148 out of 188 countries as per the HDI report
2018. The HDI does not reflect on inequalities, poverty, human security, empowerment,
etc. So, new measures like Human Poverty Index (HPI) and Multidimensional Poverty
Index (MPI) were introduced recently by UNDP to supplement HDI.

Glossary Sustenance: Survival
Self esteem: Self respect
Servitude: slavery or bondage of any kind
Death
Mortality:

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