Economics

In figure 4.6, quantity supplied is shown shifts to the right of the original supply
on the X axis and price on the Y axis. Quantity curve. It is shown in figure 4.8
supplied rises from OQ to OQ1, with a rise in
price from OP to OP1, resulting in an upward Increase in supply
movement from M to N along the same supply
curve SS. It is known as Expansion of supply. Y SS = Original supply curve

S1S1 = Shift in supply curve

2) Contraction of supply : Contraction of S
supply refers to a fall in the quantity supplied, S
due to fall in the price of a commodity,
Price P M N1
Price
other factors remaining constant. In case of S

contraction of supply, there is a downward S Q QX
movement on the same supply curve. It is 1 1
shown in figure 4.7
0

Contraction of supply Quantity Supplied

Y SS = Supply Curve Fig. 4.8
In figure 4.8, quantity supplied is shown on
NM = Contraction of Supply the X axis and price on the Y axis. Supply rises

S from OQ to OQ1 at the same price OP, resulting
PN in an outward shift of the original supply curve to
the right from SS to S1S1. It is known as Increase
P M in supply.
2
S 2) Decrease in supply : Decrease in supply
refers to a fall in the supply of a given
0 Q QX commodity due to unfavourable changes in
2 other factors such as increase in the prices
of inputs, increase in tax rate, outdated
Quantity Supplied
Fig. 4.7

In figure 4.7, quantity supplied is shown technology, strikes by worker, while price
on the X axis and price on the Y axis. Quantity remains constant. The supply curve shifts
supplied falls from OQ to OQ2 with a fall in to the left of the original supply curve. It is
price from OP to OP2, resulting in a downward shown in figure 4.9
movement from N to M on the same supply curve
SS. It is known as Contraction of supply. Decrease in supply
SS = Original supply curve
Changes in Supply :
Y S2S2 = Shift in supply curve
When other factors change and price remains S
constant, it is known as changes in supply. There
2

P N MS
Price
are two types of changes in supply : S
1) Increase in supply : Increase in supply refers 2

to rise in the supply of a given commodity S
due to favourable changes in other factors

such as fall in the price of inputs, fall in tax 0 Q QX
rates, technological upgradation etc., while 2
price remains constant. The supply curve
Quantity Supplied
Fig. 4.9

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In figure 4.9, quantity supplied is shown on machinery etc.
the X axis and price on the Y axis. Supply falls
from OQ to OQ2 at the same price OP, resulting Total Variable Cost (TVC) : Total variable
in an inward shift of the original supply curve to costs are those expenses of production
the left from SS to S2S2. It is known as Decrease which are incurred on variable factors such
in supply. as labour, raw material, power, fuel etc.

You should know : 2) Average Cost (AC) : Average cost refers to

1) Supply : Supply is a micro-economic cost of production per unit. It is calculated
concept. Supply refers to quantity of a
commodity that a seller is willing and able by dividing total cost by total quantity of
to offer for sale at a particular price, during
a certain period of time. production.
TC
2) Aggregate supply : It is a macro-economic AC = TQ
concept. It refers to the minimum amount of
sales proceeds which entrepreneurs expect AC = Average cost
to receive from the sale of output at a given
level of employment. TC = Total cost

Concepts of Cost and Revenue : TQ = Total quantity

A) Cost Concepts : For example, If the total cost of production
When an entrepreneur undertakes an act
of production, he has to use various inputs like of 40 units of commodity is ` 800 then the
raw material, labour, capital etc. He has to
make payments for such inputs. The expenditure average cost is :
incurred on these inputs is known as the cost of TC
production. Cost of production increases with an AC = TQ
increase in need of output. There are three types
of costs which are as follows :    = 800
40
1) Total Cost (TC) : Total cost is the total
expenditure incurred by a firm on the factors    = ` 20 per unit
of production required for the production of
goods and services. Total cost is the sum 3) Marginal cost (MC) : Marginal cost is the
of total fixed cost and total variable cost at net addition made to total cost by producing
various levels of output. one more unit of output.

TC = TFC + TVC MCn = TCn – TCn-1
  n = Number of units produced
TC = Total cost
MCn = Marginal cost of the nth unit
TFC = Total Fixed Cost TCn = Total cost of nth unit
TCn-1 = Total cost of previous units
TVC = Total Variable Cost
If previous total cost of producing 4 units
Total Fixed Cost (TFC) : Total fixed costs is ` 200 and total cost of producing 5 units
are those expenses of production which is ` 250, then :
are incurred on fixed factors such as land,
MCn = TCn – TCn-1
  = ` 250 – ` 200

  = ` 50

Find out :

If a firm produces 600 units of a
commodity in a day and incurs a total cost
of ` 30,000. Calculate the Average Cost.

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B) Revenue Concepts : For example, if the total revenue of 15 units,

The term ‘revenue’ refers to the receipts is ` 3000, then average revenue is calculated as :
obtained by a firm from the sale of certain
quantities of a commodity at given price in the AR = TR
market. The concept of revenue relates to total TQ
revenue, average revenue and marginal revenue.
  = 3000
15

1) Total Revenue (TR) : Total revenue is the   = ` 200
total sales proceeds of a firm by selling a
commodity at a given price. It is the total 3) Marginal Revenue : Marginal revenue is
income of a firm. Total revenue is calculated the net addition made to total revenue by
as follows : selling an extra unit of the commodity.

Total revenue = Price × Quantity MRn = TRn – TRn-1
MRn = Marginal revenue of nth unit
For example, if a firm sells 15 units of a TRn = Total revenue of nth unit
commodity at ` 200 per unit TR is calculated TRn-1 = Total Revenue of previous units
as : n = Number of units sold

TR = P × Q For example, if the previous total revenue
from the sale of 20 tables is ` 4000 and
= ` 200 × 15 that from the sale of 21 tables is ` 4200,
marginal revenue is calculated as :
= ` 3000
MRn = TRn – TRn-1
2) Average Revenue (AR) : Average revenue   = 4200 – 4000
is the revenue per unit of output sold. It is
obtained by dividing the total revenue by   = ` 200 per table
the number of units sold.

AR = TR
TQ
Find out :
AR = Average Revenue
TR= Total Revenue If a firm sells 400 units of a commodity
TQ =Total Quantity at ` 10 unit. Calculate the TR and AR.

EXERCISE

Q. 1. Complete the following statements : b) decrease in supply
c) expansion of supply
1) When supply curve is upward sloping, it’s slope d) increase in supply
is ..............
3) A rightward shift in supply curve shows
a) positive   ................
b) negative
c) first positive then negative  a) contraction of supply
d) zero b) decrease in supply
c) expansion of supply
2) An upward movement along the same supply d) increase in supply
curve shows ................
4) Other factors remaining constant, when less
a) contraction of supply

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quantity is supplied only due to a fall in price, it Q. 5. Observe the following table and answer the
shows ................ questions :
a) contraction of supply A) Supply schedule of chocolates
b) decrease in supply
c) expansion of supply Price in ` Quantity supplied in units
d) increase in supply 10 200
15
5) Net addition made to the total revenue by selling 20 300
an extra unit of a commodity is .................. 25 350
30
a) total Revenue 35
b) marginal Revenue 40
c) average Revenue
d) marginal Cost 1) Complete the above supply schedule.

Q. 2. Complete the Correlation : 2) Draw a diagram for the above supply schedule.

1) Expansion of supply : Price rises :: Contraction 3) State the relationship between price and
of supply : quantity supplied.

2) Total revenue : :: Average revenue : B) Observe the market supply schedule of potatoes
TR/TQ and answer the following questions.

3) Total cost : TFC + TVC :: Average cost : Price Firms Market
supply
in ` “A” “B” “C”
(kg)
4) Demand curve : :: Supply curve : 1 20 45 100
Upward
2 37 30 45 155
154
5) : Change in supply :: Other factors 3 40 55
constant : Variation of supply
4 44 50

Q. 3. Give economic terms : 1) Complete the quantity of potato supplied by the
1) Cost incurred on fixed factor. firms to the market in the above table.
2) Cost incurred per unit of output.
3) Net addition made to total cost of production. 2) Draw the market supply curve from the schedule
4) Revenue per unit of output sold. and explain it.

Q. 4. Distinguish between : Q. 6. Answer the following questions :
1) Stock and Supply. 1) Explain the concept of total cost and total
2) Expansion of Supply and Increase in Supply.
3) Contraction of Supply and Decrease in Supply. revenue.
4) Average Revenue and Average Cost. 2) Explain determinants of supply.

Q. 7. Answer in detail :
1) State and explain law of supply with exceptions.



45

5 Forms of Market

Introduction : various criteria. This is shown in following
fig. 5.1.
Market is generally understood as a
particular place or locality where goods are sold I) On the basis of place :
and purchased. But, in economics, market refers 1) Local market : Local market is a market
to an arrangement through which buyers and
sellers come in contact with each other directly in which sellers sell and customers buy a
or indirectly and exchange of goods and services product in the region or area in which it is
takes place among them. produced.

Definition of Market : 2) National market : National market is
a domestic market in a given country.
According to Augustin Cournot, Each national market is governed by the
“Economists understand the term market, not regulation of its own country.
any particular market place in which things are
bought and sold, but the whole of any region 3) International market : International
in which buyers and sellers are in such a close market is a worldwide market in which
contact with one another that the prices of the buyers and sellers trade in goods and
same goods tend to equality easily and quickly.” services across the national borders.
Thus, market is a network of dealings
between potential buyers and potential sellers. At II) On the basis of time :
any point of time, a market will exist if there are : 1) Very short period : Very short period is a
1) Buyers and sellers
2) A product or service to be bought and sold period in which supply is fixed and price is
3) Price of the product determined by the demand. The time period
4) Close contact between buyers and sellers is for a few days or weeks in which the
5) Knowledge about market supply of commodity cannot be increased.

Classification of Market : 2) Short period : Short period is a period of
Market can be classified on the basis of less than one year. In this period, firms can
only make adjustments in inputs like labour
to increase the supply of goods and services.

3) Long period : Long run is a period of time
in which all factors of production and costs

Classification of Market on the basis of

I) Place II) Time III) Competition
A) Local A) Very short period
B) National B) Short period A) Perfect
C) International C) Long period competition

B) Imperfect
competition

D) Very long period

i) Monopoly ii) Oligopoly iii) Monopolistic competition
Fig. 5.1

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are variable. In the long run, firms are able none of them is in a position to influence
to adjust all costs. It is for a few years, the price in the market.
generally up to five years.
2) Homogeneous product : An important
4) Very long period : Very long period is feature of a perfectly competitive market
a production time that is so long that all is that the product sold is homogeneous or
inputs are variable. It is of more than five identical in respect of size, design, colour,
years. taste etc. All the products are perfect
substitutes to each other.
III) On the basis of Competition :
Competition among the sellers and buyers is 3) Free entry and exit : There are no barriers
the most important criteria for classification of to the entry and exit of firms. Any firm can
markets in economics. Let us study the various enter or quit the industry at its own will. If
types of markets on the basis of competition there is hope of profit, the firm will enter the
among the sellers : market and if there is possibility of loss the
firm will leave the market.
A) Perfect Competition :
Meaning and Definition : Perfect 4) Single price : A single uniform price
competition is an ideal and imaginary prevails under perfect competition which
concept of market rather than an actual is determined by the interaction of demand
market. According to Mrs. Joan Robinson, and supply.
“Perfect competition prevails when the
demand for the output of each producer is 5) Perfect knowledge of market : The buyers
perfectly elastic.” and sellers possess a perfect knowledge
about the market conditions. Every seller
 A perfectly competitive market is and buyer has the knowledge about price,
one in which the number of buyers and quality, source of supply of products etc.
sellers is very large. All the buyers and
sellers are engaged in buying and selling 6) Perfect mobility of factors of production :
a homogeneous product without any There is perfect mobility of factors of
restrictions. Moreover both buyers and production under perfect competition.
sellers possess perfect knowledge of market Labour and capital are mobile not only
conditions. geographically but also occupationally.

 Following are the features of Perfect 7) Absence of transport cost : In perfect
Competition : competition, price is uniform because we
assume that transport cost does not exist.
1) Large number of sellers and buyers : This assumption will lead to uniformity in
Under perfect competitions, there are large price.
number of sellers and buyers. As mentioned
earlier, each seller forms a negligible part 8) No government intervention : Laissez-
in the total market. Hence, none of them faire policy is an important feature of
is in a position to influence the price and perfect competition. It means there is
supply in the market. Thus, sellers are price absence of Government intervention in
takers under perfect competition. economic activities.

  The number of buyers is also large. The Price determination under Perfect Competition:
share of each buyer is so negligible that The interaction of demand and supply

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determine price of the commodity in perfect diagram, X axis represents quantity demanded and
competition. This is known as ‘equilibrium quantity supplied, whereas Y axis represents the
price.’ Marshall has compared the process of price. DD is the downward sloping demand curve
price determination to the cutting of cloth with which shows inverse relationship between price
a pair of scissors. Just as both the blades of and quantity demanded. SS is the upward sloping
scissors are required to cut the cloth, both the supply curve which shows direct relationship
forces of demand and supply are essential to between price and quantity supplied. E is the
determine the equilibrium price in the market. equilibrium point where DD and SS curve intersect
This is explained with the help of the following each other. Accordingly ` 300 is the equilibrium
schedule and diagram. price and 3000 kgs. is the equilibrium quantity
demanded and supplied. This equilibrium price is
Table no 5.1 Demand and Supply Schedule determined by market demand and market supply.

Price per Quantity Quantity Relationship Y Excess Supply
Kg. of demanded supplied between DD
(in Kg.) Price (in `) per kg 500 D SS > DD S
Apples (in `) (in Kg.) and SS
1000 400
100 5000 DD > SS E
2000
200 4000 DD > SS 300 DD = SS
3000
300 3000 DD = SS

400 2000 4000 DD < SS

500 1000 5000 DD < SS

From the table no 5.1, following conclusions 200
can be drawn :
100 S DD > SS
1) When price rises from ` 100 to ` 200 D
quantity demanded falls from 5000 kgs. to
4000 kgs. whereas supply increases from Excess Demand
1000 kgs. to 2000 kgs. This is because
demand falls with rise in price and supply 0 1000 2000 3000 4000 5000 X
rises with a rise in price. This is the stage
where demand is greater than supply (DD > Quantity Demanded and Quantity Supplied (in kgs.)
SS). Fig. 5.2

2) When price rises to ` 300, quantity B) Imperfect Competition :
demanded and quantity supplied become Imperfect competition is a type of market
equal that is 3000 kg. This is the stage of showing some but not all the features of a
equilibrium where demand and supply competitive market. Following are some of the
become equal (DD = SS). Hence, ` 300 types of imperfect market.
becomes the equilibrium price.
I) Monopoly :
3) When price further rises from ` 400 to `
500, demand falls from 2000 kgs. to 1000 Meaning and Definition : The term monopoly
kgs. and supply rises from 4000 kgs. to 5000 is derived from the Greek word ‘Mono’ which
kgs. Thus, supply is greater than demand. means single and ‘poly’ which means seller.
(SS > DD). Monopoly is a market in which there is only one
seller who controls the entire market supply for
The process of price determination is a product which has no close substitute.
explained in the following figure 5.2. In this
According to E. H. Chamberlin, “Monopoly
refers to a single firm which has control over
the supply of a product which has no close
substitute.”

48

Following are the main features of 2) Public monopoly : When the production
monopoly market : is solely owned, controlled and operated
by the Government, it is known as public
1) Single seller : In monopoly, there is no monopoly. It is usually welfare oriented.
competition as there is only one single For example, Indian Railways.
producer or seller of the product. But, the
number of buyers is large. 3) Legal monopoly : This monopoly emerges
on account of legal provisions like patents,
2) No close substitute : There are no close trade mark, copyrights etc. The law forbids
substitutes for the product of the monopolist. the potential competitors to imitate the
Therefore, the buyers have no choice. design or form of the product registered
They have to either buy the product from under given branded names. For example,
the monopolist or go without it. The cross Amul products.
elasticity of demand for his product is either
zero or negative. 4) Natural monopoly : The monopoly created
on the basis of natural conditions like
3) Barriers to entry : Entry of the rivals is climate, rainfall, specific location etc. is
restricted due to legal, natural, technological known as natural monopoly. For example,
barriers which do not allow the competitors wheat from Punjab.
to enter the market.
5) Simple monopoly : In simple monopoly,
4) Complete control over the market supply: seller or a firm charges a uniform price for
The monopolist has complete hold over the its product to all the buyers.
market. He is the sole producer or seller of
the product. 6) Discriminating monopoly : In
discriminating monopoly, firm charges
5) Price maker : A monopolist can fix the price different prices to different buyers for the
of his own product as he controls the whole same product. For example, doctor charges
market supply. Monopolist is a price maker. different fees to different patients.

6) Price discrimination : Monopolist being a 7) Voluntary monopoly : To avoid cut
price maker, he can charge different prices throat competition, some monopolists
to different consumers for the same product, voluntarily come together and form a
on the basis of time, place etc. Thus, price group of monopolists. This facilitates
discrimination is an important feature of them to maximise the profit. For example,
monopoly market. For example, students Organisation of Petroleum Exporting
and senior citizens are provided railway Countries (OPEC).
tickets at concessional rates.
You should know :
7) No distinction between firm and industry: Price descrimination under monopoly
A monopolist is the sole seller and producer
of the product. A monopoly firm itself is an
industry.

Types of monopoly : Personal Place wise Time wise Use
Following are some of the types of
monopoly : Doctors Differences ST bus fare Electricity
1) Private monopoly : When an individual or
charge in house differs for charges are
private body controls a monopoly firm it is
known as private monopoly. For example, different rent in rural over night different for
Tata Group.
fees to and urban and day domestic and
d ifferent areas time travels commercial

patients uses

49

Find out : 4) Entry barriers : The firm can easily
Types of monopoly for the following exit from the industry whenever it wants.
products/services : But has to face certain entry barriers
1) Tea in Assam such as Government licence, patents etc.
2) Atomic energy
3) Logo of a commercial bank 5) Lack of uniformity : There is a lack of
uniformity among the firms in terms of their
Do you know? size. Some firms may be small while others
Monopsony is the converse of monopoly. may be of bigger size.
It exists when there are many sellers but
only one buyer. Buyer’s monopoly is rarely 6) Uncertainty : There is a considerable
found. A monopsonist can exploit the sellers element of uncertainty in this type of market
just as a monopolist may exploit the buyers. due to different behaviour patterns. Rivals
In the labour market, a particular kind of may join hands and co-operate or may try
labour is used by one employer only. to fight each other.

III) Monopolistic competition :
Different brands of liquid cleaners :

II) Oligopoly : Fig. 5.3
The term oligopoly is derived from the
Greek words ‘Oligo’ which means few and Meaning and Definition : Monopolistic
‘poly’ which means sellers. It is that market competition is very realistic in nature. In this
where there are a few firms (sellers) in the market there are some features of perfect
market producing either a homogeneous product competition and some features of monopoly
or a differentiated product. For example, mobile acting together. Prof. E. H. Chamberlin coined
service providers, cement companies etc. this concept in his book “Theory of Monopolistic
Features of oligopoly : Competition” which was published in 1933.
According to Chamberlin, “Monopolistic
1) Few firms or sellers : Under oligopoly competition refers to competition among a large
market, there are few firms or sellers. These number of sellers producing close but not perfect
few firms dominate the market and enjoy substitutes.”
a considerable control over the price of a Following are the main features of
product. monopolistic competition :

2) Interdependence : The seller has to be 1) Fairly large number of sellers : In
cautious with respect to any action taken monopolistic competition, the number of
by the competing firms. Since there are sellers is large but comparatively it is less
few sellers in the market, if any firm makes than that of perfect competition. Due to this
the change in the price, all other firms in reason sellers’ behaviour is like monopoly.
the industry also try to follow the same to
remain in the competition.

3) Advertising : Advertising is a powerful
instrument in the hands of oligopolist. A
firm under oligopoly can start an aggressive
and attractive advertising campaign with
the intention of capturing a large part of
market.

50

2) Fairly large number of buyers : In this demand for its product and thus increase
market there are fairly large number of the volume of sales. It includes expenditure
buyers. Consequently, no single buyer on advertisements, readio and television
can influence the price of the product by broadcasts, hoardings, exhibitions, window
changing his individual demand. display, free gifts, free samples etc.

3) Product differentiation : Product 6) Close substitutes : In monopolistic
differentiation is the main feature of competition, goods have close substitutes to
monopolistic competition. In this market, each other. For example, different brands of
there are many firms producing a particular soaps, toothpastes etc.
product, but the product of each firm is in
some way differentiated from the product 7) Concept of group : Under monopolistic
of every other firm in the market. This is competition, Chamberlin introduced the
known as product differentiation. Product concept of ‘Group’ in place of industry.
differentiation may take the form of brand Industry means the number of firms
names, trade marks, peculiarity of package producing identical products. A ‘Group’
or container, shape, quality, cover, design, means a number of firms producing
colour etc. This means that the product of differentiated products which are closely
a firm may find close substitutes and its related. For example, group of firms
cross elasticity of demand is very high. For producing medicines, automobiles etc.
example, mobile handsets, cold drinks etc.
Find out :
4) Free entry and exit : Under monopolistic Close substitutes for the following
competition there is freedom of entry and products.
exit, that is new firms are free to enter the
market if there is profit. Similarly, they can Products Substitutes
leave the market, if they find it difficult to 1) Gemini Oil
survive. 2) Colgate Toothpaste
3) Red Label Tea
5) Selling Cost : Selling cost are peculiar to 4) Bru Caffee
monopolistic competition only. It refers to 5) Activa Two-wheeler
the cost incurred by the firm to create more

EXERCISE

Q. 1. A) Choose the correct option : Options :1) a and b 2) b and c

1) In economic sense, market includes following 3) a, b and c 4) only d

activities 2) Classification of markets on the basis of place

a) The place where goods are sold and a) Local market, National market, International

purchased. market

b) An arrangement through which buyers and b) Very short period market, Local market,
sellers come in close contact with each other National market.
directly or indirectly.
c) Short period market, National market,
c) A shop where goods are sold. International market.
d) All of the above.
d) Local market, National market, Short period
market.

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Options :1) a, b and c 2) b, c and d Q. 4. Find the odd word out :
3) only a 4) a and d 1) Selling cost : Free gifts, Advertisement

3) Homogeneous product is a feature of this hoardings, Window displas, Patents.
market.
2) Market sructure on the basis of competition
a) Monopoly     : Monopoly, Oligopoly, Very Short Period
b) Monopolistic competition market, Perfect competition.
c) Perfect competition
d) Oligopoly 3) Features of monopoly : Price maker, Entry
barriers, Many sellers, Lack of substitutes.
Options :1) c and d 2) a, b and c
3) a, c and d 4) only c 4) Legal monopoly : Patent, OPEC, Copyright,
Trade mark.

4) Under Perfect competition, sellers are Q. 5. Answer the following :
1) Explain the features of Oligopoly.
a) Price makers b) Price takers
2) Explain the types of Monopoly.
c) Price discriminators d) None of these

Options :1) a, b and c 2) only b Q. 6. Observe the table and answer the questions :
3) only c 4) a and c
Price of Demand (in Supply Relation
Q. 2. Give economic terms : banana dozen) (in between DD
1) The market where there are few sellers.
2) The point where demand and supply curve (per dozen) and SS
dozon) in ` 100
intersect. DD > SS
3) The cost incurred by the firm to promote sales. 10 500 300 DD > SS
4) Number of firms producing identical product. 20 400 DD = SS
5) Charging different prices to different consumers 500 DD < SS
30 DD < SS
for the same product or services.
40 200

50

Q. 3. Complete the Correlation : 1) Fill in the blanks in the above schedule.

1) Perfect competition : Free entry and exit :: 2) Derive the equilibrium price from the above
: Barriers to entry. schedule with the help of a sutiable diagram.

2) Price taker : :: Price maker :: Monopoly. Q. 7. Answer in detail : Monopolistic
1) Explain the meaning of

competition with its features.

3) Single price : Perfect competition :: 2) Explain the meaning of Perfect competition
Discriminated prices : with its features.



52

6 Index Numbers

Introduction : reference to time, geographical location
Index numbers are one of the most used and other characteristics such as income,
statistical tools in economics. An index number profession etc.”
is a device to measure changes in an economic 2) Croxton and Cowden : “Index Numbers
variable (or group of variables) over a period of are devices for measuring differences in the
time. Index numbers were originally developed to magnitude of a group of related variables.”
measure changes in the price level. In the present
context, it is also used to measure trends in a Features of Index Numbers :
wide variety of areas that includes stock market 1) Index numbers are statistical devices.
prices, cost of living, industrial and agricultural 2) Index numbers are specialized averages
production, changes in exports and imports etc.
Index numbers are not directly measurable, but which are capable of being expressed in
represent relative changes. percentages.
3) Index numbers measure the net change in
Do you know? one or more related variables over a period
Origin of Index Numbers : During the 17th of time or between two different time
century, Rice Vaughan, an Englishman and periods or two different localities.
eminent writer was concerned with the rise in 4) Index number which is computed from a
prices which had occurred in his native land single variable is called a ‘univariate index’,
over the preceding century. The first study whereas an index which is constructed from
using Index Numbers was done in the early a group of variables is called a ‘composite
18th century. In 1707, William Fleetwood index’.
made a comparison of the prices of certain 5) The year for which the index number is
commodities such as wheat, oats, beans, prepared is the current year.
cloth, meat etc. for the periods 1440-1460 6) The year with which the changes are
and 1686-1706. The results of this study are measured is called the base year.
presented in his work, ‘Chronicon Preciosum’ 7) The base year’s index is assumed as 100
(1707). In 1738, Charles de Ferrare Dutot and accordingly the value of the current
of France constructed a simple aggregative year is calculated.
index for two periods 1508 and 1735 and 8) Index numbers are also referred to as
compared the costs for an identical list of ‘barometers of economic activity’, since it
commodities. However, the first recorded is used to measure the trends and changes
index number appeared in the work of G.R. in the economy.
Carli, an Italian who used a modified form of
the simple average of price relatives in 1764. You should know :
Terminologies used in index numbers -
Definitions of Index Numbers : Base Year : The year with respect to which
1) Spiegel : “An index number is a statistical comparisons are made is the base year. It is
denoted by the suffix ‘o’.
measure designed to show changes in a
variable or a group of related variables with Current Year : The year for which
comparisons are required to be made is the

53

current period. It is denoted by the suffix ‘1’. • Consumer Price Index
• Wholesale Price Index
Notations • Index of Agricultural Production
p0 = Price of the commodity in the base year • Index of Industrial Production
p1 = Price of the commodity in the current • Index of Service Production
year • Index of Export/Import
q0 = Quantity of the commodity consumed • Human Development Index
or purchased in the base year
q1 = Quantity of the commodity consumed Significance of Index Numbers in Economics :
or purchased in the current year Index numbers are indispensable tools of
economic analysis. Following points explain the
Types of Index numbers : significance of index numbers :
1) Framing suitable policies : Index numbers
PRICE INDEX NUMBER
provide guidelines to policy makers in
INDEX QUANTITY INDEX NUMBER framing suitable economic policies such
NUMBERS VALUE INDEX NUMBER as agricultural policy, industrial policy,
fixation of wages and dearness allowances
SPECIAL PURPOSE INDEX NUMBER in accordance with the cost of living etc.

1) Price Index Number : It measures the 2) Studies trends and tendencies : Index
general changes in the prices of goods. It numbers are widely used to measure changes
compares the level of prices between two in economic variables such as production,
different time periods. prices, exports, imports etc. over a period of
time. For example, by examining the index
2) Quantity Index Number : It is also called of industrial production for the last five
volume index number. It measures changes years, we can draw important conclusions
in the level of output or physical volume of about the trend of industrial production
production in the economy. For example, whether it shows an upward tendency or a
changes in agricultural production, industrial downward tendency.
production etc. over a period of time.
3) Forecasting about future economic
3) Value Index Number : The value of a activity : Index numbers are useful for
commodity is the product of its price and making predictions for the future based on
quantity (p × q). Value index number the analysis of the past and present trends
measures the changes in the value of a in the economic activities. For example,
variable in terms of rupee. It is a more based on the available data pertaining to
informative index as it combines both, imports and exports, future predictions can
changes in the price as well as quantity. be made. Thus, forecasting guides in proper
decision making.
4) Special Purpose Index Number : They
are constructed with some specific purpose. 4) Measurement of inflation : Index numbers
For example, import-export index numbers, are also used to measure changes in the
labour productivity index numbers, share price level from time to time. It enables
price index numbers etc. the government to undertake appropriate
anti-inflationary measures. There is a
Do you know? legal provision to pay the D.A. (dearness
Some of the widely used index numbers
by the Government of India :

54

allowance) to the employees in organised number. For example, in the construction
sector on the basis of changes in Dearness of price index numbers it is impossible to
Index. include each and every commodity. The
commodities to be selected should represent
5) Useful to present financial data in the tastes, habits and customs of the people.
real terms : Deflating means to make Besides this, only standardized or graded
adjustments in the original data. Index items should be included to give better
numbers are used to adjust price changes, results.
wage changes etc. Thus, deflating helps
to present financial data in real terms (at 4) Selection of price quotations : Prices of
constant prices). the selected commodities may vary from
place to place and shop to shop in the same
Construction of Index Numbers : market. Therefore, it is desirable that price
Following steps are involved in the quotations should be obtained from an
construction of index numbers : unbiased price reporting agency. To achieve
1) Purpose of index number : The purpose accuracy, proper selection of representative
places and persons is required.
for constructing the index number, its scope
as well as which variable is intended to 5) Choice of a suitable average : Construction
be measured should be clearly decided to of index numbers requires choice of a
achieve fruitful results. suitable average. Generally, Arithmetic
mean is used in the construction of index
2) Selection of the base year : Base year is numbers because it is simple to compute
also called the reference year. It is the year compared to other averages.
against which comparisons are made. The
base year should be normal i.e. it should be 6) Assigning proper weights : Weight
free from natural calamities. It should not refers to the relative importance of the
be too distant in the past. different items in the construction of an
index number. Weights are of two types
Do you know? i.e. quantity weights (q) and value weights
In 2015, the Central Statistical (p x q). Since all items are not of equal
Organisation (CSO) under the Ministry of importance, by assigning specific weights,
Statistics changed the base year for tabulating better results can be achieved.
Gross Domestic Product from 2004-05 to
2011-12. Periodic rebasing of GDP series 7) Selection of an appropriate formula :
every seven to ten years is carried out to Various formulae are devised for the
account for the changing economic structure construction of index numbers. Choice of a
and relative prices. Besides this, the base suitable formula depends upon the purpose
year of Index of Industrial Production (IIP) of index number and availability of data.
and the base year of Wholesale Price Index
(WPI) has also been changed from 2004-05 Methods of Constructing Index Numbers :
to 2011-12. At present, the process of further There are two methods of constructing
rebasing the base year is underway. index numbers:

3) Selection of items : It is necessary to select a a) Simple Index Number 
sample of the number of items to be included
in the construction of a particular index b) Weighted Index Number

The following chart explains the methods
of constructing index numbers :

55

CONSTRUCTION OF SIMPLE INDEX where, Σq1 = sum total of the quantities of the
INDEX NUMBERS NUMBER current year

WEIGHTED Σq0 = sum total of the quantities of the base year
INDEX NUMBER
Ex 2 : Construct a Quantity index number using

A) Simple Index Number : In this method, the simple method from the given data :
every commodity is given equal importance.
It is the easiest method of constructing index Steps : 1) Add the quantities of the different
numbers. This method can be applied to commodities of the base year to derive Σq0
determine 2) Add the quantities of the different commodities
of the current year to derive Σq1
1) Price Index Number

2) Quantity Index Number 3) Apply the formula : Σq1
3) Value Index Number Σq0
Quantity Index Number Q01 = × 100

Some Solved Examples : Commodities Qty. in 2000 Qty. in 2001

1) Price index number : It is measured as: (Base year) q0 (Current year) q1

Price Index Number P01 = Σp1 × 100 A 30 45
Σp0
B 55 70
where, Σp1 = sum total of the prices of the current year
C 90 105
Σp0 = sum total of the prices of the base year
D 35 60
Ex 1 : Construct a Price index number using the

simple method from the given data : Total Σq0 = 210 Σq1 = 280

Steps : 1) Add the prices of the different Quantity Index Number Q01 = Σq1 × 100
Σq0
commodities of the base year to derive Σp0 280
2) Add the prices of the different commodities of Q01 = 210 × 100 = 133.33

the current year to derive Σp1 Q01 =133.33

3) Apply the formula : Σp1
Σp0
Price Index Number P01 = × 100 3) Value Index Number : It is measured as :

Commodities Prices in 2010 Prices in 2015 Value Index Number V01 = Σp1q1 × 100
(in `) Base (in `) (Current Σp0q0

year) p0 year) p1 where, Σp1q1 = sum total of the product of the
prices and quantities of the current year.
A 20 30

B 60 80 Σp0q0 = sum total of the product of the prices and
quantities of the base year.
C 100 130

D 40 60 Ex 3 : Construct a Value index number using the
Total Σp0 = 220 Σp1 = 300 simple method from the given data :

Price Index Number P01 = Σp1 × 100 Steps : 1) Find the product of prices and their
300 Σp0
respective quantities of the different commodities
P01 = 220 × 100 = 136.36
for the base year to derive p0q0. Take the sum
P01 =136.36 total of the products to derive Σp0q0.

2) Quantity index number : It is measured as : 2) Find the product of prices and their respective

Quantity Index Number Q01 = Σq1 × 100 quantities of the different commodities for the
Σq0

56

current year to derive p1q1. Take sum total of the Ex. 1 : Construct Laaspeyre’s Index for the given
products to derive Σp1q1. data :

3) Apply the formula : Commodities Base year Current year
A
Value Index Number V01 = Σp1q1 × 100 p0 q0 p1 q1
Σp0q0 20 4 30 6

Commodities Base year Current year B 10 5 20 8
P p0 q0 p0q0 p1 q1 p1q1 C 40 8 60 5
5 4 20 20 10 200
D 30 4 40 4

Q 10 3 30 30 8 240 Solution : Base Current
Commodities year year
R 15 2 30 40 6 240

S 20 1 20 50 4 200 A p0 q0 p1 q1 p1 q0 p0 q0
B 20 4 30 6 120 80
Total Σp0q0 = 100 Σp1q1 = 880 C 10 5 20 8 100 50
D 40 8 60 5 480 320
Value Index Number V01 = Σp1q1 × 100 Total 30 4 40 4 160 120
Σp0q0
880 860 570
V01 = 100 × 100 = 880

V01 = 880 Steps : 1) Find out the product p1q0 of the
different commodities.

B) Weighted Index Number : In this method, 2) Find out the product p0q0 of the different
suitable weights are assigned to various commodities.

commodities. It gives relative importance 3) Add all the products p1q0 obtained to derive
to the commodity in the group. In most of Σp1q0.
the cases ‘quantities’ are used as weights.
There are various methods of constructing 4) Add all the products p0q0 obtained to derive
weighted index number such as Laaspeyre’s Σp0q0.
Price Index, Paasche’s Price Index etc.
5) Apply the given formula :

Some Solved Examples : P01 = Σp1q0 × 100
Étienne Laspeyres : German Σp0q0
economist Étienne Laspeyres
(1834–1913) formulated an P01 = 860 × 100 = 150.87
index for measuring current 570
prices or quantities in relation to
those of a selected base period. Thus, Laaspeyre’s index P01 = 150.87

The distinctive feature of the Laspeyres index Do you know?
is that it uses a group of commodities purchased Sensex and Nifty are stock market indices
in the base period as the basis for comparison. which represent Bombay Stock Exchange
(BSE) and National Stock Exchange (NSE)
1) Laaspeyre’s Price Index Number : In respectively.
Sensex, also called BSE 30, is the market
this technique, ‘base year’ quantities are index consisting of 30 well-established
and financially sound companies listed on
considered as weights. Laaspeyre’s price Bombay Stock Exchange (BSE). The base
year of Sensex is 1978-79.
index is calculated as : Nifty, also called NIFTY 50, is the market

P01 = Σp1q0 × 100
Σp0q0

57

index consisting of 50 well-established 5) Apply the given formula :
and financially sound companies listed on
National Stock Exchange of India (NSE). P01 = Σp1q1 × 100
The base year of Nifty is taken as 1995. Σp0q1

P01 = 134 × 100 = 212.69
63

Hermann Paasche : German economist Hermann Thus, Paasche’s index P01 = 212.69

Paasche (1851-1925) developed Find out :
an index for measuring current
price or quantity levels relative   • List of crops included in the Index of
to those of a selected base period. Agricultural Production in India.

Paasche’s index uses current-   • List of products included in the Index of

period weighting. Industrial Production in India.

2) Paasche’s Price Index Number : In this Limitations of index numbers :
Index numbers are useful in practice.
technique, quantities of the ‘current year’ However they suffer from certain limitations.
Therefore, they are not completely reliable.
are considered as weights. Paasche’s Price
1) Based on samples : Index numbers are
Index is calculated as : generally based on samples. We cannot
include all the items in the construction of
P01 = Σp1q1 × 100 the index numbers. Hence they are not free
Σp0q1 from sampling errors.

Ex. 2 : Construct Paasche’s Index for the given 2) Bias in the data : Index numbers are
constructed on the basis of various types of
data : data which may be incomplete. There may
be bias in the data collected. This is bound
Commodities Base year Current year to affect the results of the index numbers.

M p0 q0 p1 q1 3) Misuse of Index Numbers : Index numbers
N 2 10 58 can be misused. They compare a situation in
O 45 83 the current year with a situation in the base
P 17 2 10 year. Hence a person may choose a base
58 10 5 year which will be suitable for his purpose.
For example, a businessman may choose a
Solution : year in which his profit is high as the base
year and show that his profit is falling in the
Commodities Base Current p1 q1 p0 q1 current years.
year year 40 16
M p0 q0 24 12
N 2 10 p1 q1 20 10
O 58 50 25
P 45 134 63
Total 83
17
2 10
58
10 5

Steps : 1) Find out the product p1q1 of the
different commodities.

2) Find out the product p0q1 of the different 4) Defects in formulae : There is no perfect
commodities.
formula for the construction of an index

3) Add all the products p1q1 obtained to derive number. It is only an average and so it has
Σp1q1. all the limitations of an average.

4) Add all the products p0q1 obtained to derive 5) Changes in the economy : The habits,
Σp0q1. tastes and expectations of the people in

58

a country are always changing and all 8) Limited scope : An index number has
these changes cannot be included in the limited scope because if it is constructed for
estimation of index numbers. one purpose then it cannot be used for any
other purpose.
6) Qualitative changes : The price or quantity
index numbers may ignore the changes Find out :
in qualities of the products. At any given Newspaper headlines related to the
time, a better quality commodity will have following types of index numbers :
a higher production cost and a higher price • Price Index
than an ordinary commodity which is a • Agricultural Productivity Index
substitute for the better product. • Index of Industrial Production
• Equity Share Price Index
7) Arbitrary weights : The weights assigned
to different commodities may be arbitrary.

EXERCISE

Q. 1. Choose the correct option : c) In most of the cases, quantities are used as
weights.
1) Statements that are incorrect in relation to index
numbers. d) Laaspeyre's and Paasche's method is used in
the calculation of weighted index numbers.
a) Index number is a geographical tool.
b) Index numbers measure changes in the air Options :1) b, c and d 2) a, c and d
3) a, b and d 4) a, b, c and d
pressure.
c) Index numbers measure relative changes in 4) Statements related to limitations of index
numbers.
an economic variable.
d) Index numbers are specialized averages. a) Index numbers are not completely reliable.
b) There may be a bias in the data collected.
Options :1) c and d 2) a and b c) Every formula has some kind of defect.
3) b and c 4) a and d d) Index numbers ignore changes in the

2) Statements that highlight the significance of qualities of products.
index numbers. Options :1) a, c and d 2) a, b, c and d
3) a, b and d 4) b, c and d
a) Index numbers are useful for making future
predictions. 5) Choose the correct pair :

b) Index numbers help in the measurement of Group A Group B
inflation.
1) Price Index   a)  Σp1q1 × 100
c) Index numbers help to frame suitable Σp0q0
policies.
2) Value Index   b)  Σq1 × 100
d) Index numbers can be misused. Σq0
Options :1) b, c and d 2) a, c and d
3) a, b and d 4) a, b and c 3) Quantity Index   c)  Σp1q1 × 100
Σp0q1
3) Statements that apply to weighted index
numbers. 4) Paasche's Index   d)  Σp1 × 100
Σp0
a) Every commodity is given equal importance.
b) It assigns suitable 'weights' to various Options :1) 1-d, 2-c, 3-a, 4-b 2) 1-d, 2-a, 3-b, 4-c

commodities. 3) 1-b, 2-c, 3-d, 4-a 4) 1-c, 2-d, 3-a, 4-b

59

Q. 2. Complete the Correlation : 4) Calculate Laaspeyre's and Paasche's index from
the given data :
1) Price Index : Inflation :: : Agricultural

production Base Year Current Year

2) : Base year prices :: p1 : Current year Commodity Price Quantity Price Quantity
prices
X 8 30 12 25
3) Laaspeyre's index : :: Paasche's index
Y 10 42 20 16
: Current year quantities

4) : Single variable :: Composite index : Q. 4. Distinguish between :
1) Simple Index Numbers and Weighted Index
Group of variables
Numbers.
Q. 3. Solve the following : 2) Price Index and Quantity Index.
3) Laaspeyre's Index and Paasche's Index.
1) Calculate Price Index number from the given
data : Q. 5. State with resons whether you agree or
disagree with the following statements :
Commodity ABCD 1) Index numbers measure changes in the price

Price in 2005 (`) 6 16 24 4 level only.
2) Index numbers are free from limitations.
Price in 2010 (`) 8 18 28 6 3) Index numbers can be constructed without the

2) Calculate Quantity Index number from the given base year.

data : Q. 6. Answer the following :
1) Explain the features of index numbers.
Commodity PQRS T 2) Explain the significance of index numbers in

Base year quantities 170 150 100 195 205 economics

Current year quantities 90 70 75 150 95 Q. 7. Answer in detail :
1) Explain the steps involved in the construction of
3) Calculate Value Index number from the given
index numbers.
data :

Commodity Base Year Current Year
Price Quantity Price Quantity

A 40 15 70 20

B 10 12 60 22

C 50 10 90 18

D 20 14 100 16

E 30 13 40 15

60

7 National Income

Definitions of National Income :
Following are some of the important
definitions of national income :

1) National Income Committee (NIC) : The
National Income Commitee was appointed
by the Government of India in August 1949
with Prof. P. C. Mahalanobis as Chairman
and Prof. D. R. Gadgil and Dr. V. K. R. V.
Rao as the members.

Fig. 7.1

Introduction :

National Income is one of the important P.C.Mahalanobis V. K. R. V. Rao D. R. Gadgil
subject matter of macroeconomics. The national
economy comprises of all the firms and factories, According to NIC “A national estimate
shops and markets, banks and financial measures the volume of commodities and
institutions, various departments and their offices services turned out during a given period
etc. National income is a composite measure counted without duplication.”
of all economic activities such as production,
distribution, exchange and consumption, but is 2) Prof. A.C. Pigou : “National dividend is
also an objective indicator of economic welfare that part of objective income
of the people in a country. of the community including of
course income derived from
In India, establishment of the National abroad which can be measured
Income Committee (NIC) in 1949 marked the in money.”
beginning of Government efforts for regular
compilation of National Income estimates. At 5) Prof. Irving Fisher : “National dividend
present, Central Statistical Organisation (CSO) or income consists solely of
compiles and publishes data on national income services as received by ultimate
and allied aggregates every year. consumers, whether from their
material or from their human
Meaning : environments.”

Modern economy is a money economy. Features of National Income :
Hence, national income of a country is expressed 1) Macro Economic concept : National
in terms of money.
The total income of the nation is called income represents income of the economy
national income. as a whole rather than that of an individual.
In real terms, national income is the flow Hence it is a macro economic concept.
of goods and services produced in an economy
during a year. 2) Value of only final goods and services : In
order to avoid double counting in national
income, the value of only final goods and

61

services produced in the economy are Firms, Government and Foreign sector)
considered. The value of intermediate goods Y = C + I + G + (X-M)
or raw materials is not considered. For The circular flow of goods and money in a
example, while estimating the production two sector model is explained below :
of shirts, there is no need to take the value
of cotton, as it is already included in the Two sector model of Circular flow of National
price of the shirts. Income :
There are two sectors, households and
3) Net aggregate value : National income firms. It divides the diagram into two parts. The
includes net value of goods and services upper half represents the factor market and the
produced and does not include depreciation lower half represents the commodity market.
cost. (i.e. wear and tear of capital assets) Fig. no. 7.2 explaines circular flow of
income and expenditure in a two sector model.
4) Net income from abroad : National
income includes net income from abroad i.e. Land, Labour, Capital and Enterprise
difference between export value and import
value (X-M) and net difference between Consumption Expenditure on
receipts from abroad and payments made Goods and Services
abroad (R-P).
Households Firms
5) Financial year : National income is always
expressed with reference to a time period. Factor Income, Rent,
In India, it is from 1st April to 31st March. Wages, Interest, Profit

6) Flow concept : National income is a flow Flow of Goods and Services
concept as it shows flow of goods and
services produced in the economy during a Fig. 7.2
year. In the above figure 7.2, the factors of
production flow from the households to the
7) Money value : National income is always firms. The firms use these factors to produce
expressed in monetary terms. It represents goods and services required by the households.
only those goods and services which are Thus, goods flow from the households to the
exchanged for money. firms and from the firms back to the households.
It is called product flows.
Circular Flow of National Income : In the same way, money flows from the
Circular flow of income is the basic concept firms to the households in the form of factor
in macro economics. The circular flow of income payments such as rent, wages, interest and
refers to the process whereby an economy's profit. Households use this income to purchase
money receipts and payments flow in a circular goods and services. Thus, money flows from the
manner continuously through time. firms to the households and from the households
back to the firms. It is called money flows.
Circular flow of income can be determined In the circular flow of income, production
for the following : generates factor income, which is converted
into expenditure. This flow of income continues
1) Two sector Economy (Households and as production is a continuous activity due to
Business Firms.)  Y = C + I never ending human wants. It makes the flow of
income circular
2) Three sector Economy (Households,
Business Firms and Government sector)
Y=C+I+G

3) FourSectorEconomy(Households,Business

62

Do you know? 4) Net National Product (NNP) : Net National
Product is the net market value of all final
I) Three Sector Model of Circular Flow goods and services produced by the residents
of National Income : Under a three sector of a country, during a period of one year.
model, the government sector is added to
the existing two sectors i.e. households and ∴ NNP = GNP – Depreciation.
business firms.
Find out :
II) Four Sector Model of Circular Income : India’s GDP data.
In an four sector model, foreign sector
is added to the existing three sectors You should know :
i.e. households, business firms and Concept of Green GNP :
government sector. It is defined as, “Green GNP is an
indicator of sustainable use of natural
Different Concepts of National Income : environment and equitable distribution of
Following are some of the important benefits of development.”
concepts related to national income. Gross National product does not take
1) Gross Domestic Product (GDP) : Gross into consideration the cost in terms of (i)
Environmental pollution, (ii) Depletion of
Domestic Product is the gross market value natural resources caused by production of
of all final goods and services produced output. Mere increase in GNP will not reflect
within the domestic territory of a country, improvement in quality of life, when it
during a period of one year. increases environmental pollution or reduce
∴ GDP = C + I + G + (X-M) , available resources for future generations.
So Green GNP has been introduced while
Where C = Private consumption expenditure measuring economic welfare.
I = Domestic Private Investment Following are the characteristics of Green
G = Government's consumption and Investment GNP :
1) Sustainable economic development, i.e.
Expenditures
X - M = Net export value (Value of Exports - development which should not cause
environmental degradation (pollution)
Value of imports and depletion of natural resources.
2) Equitable distribution of benefits of its
2) Net Domestic Product (NDP) : Net development.
Domestic Product is the net market value 3) Promotes economic welfare for a long
of all final goods and services produced, period of time.
within the territorial boundaries of a Measurement :
country, during a period of one year. Green GNP = GNP - (Net fall in stock of
natural capital + pollution load.)
∴ NDP = GDP – Depreciation.

3) Gross National Product (GNP) : Gross
National Product means the gross value of
final goods and services produced annually
in a country, which is estimated according
to the price prevailing in the market.

∴ GNP = C + I + G + (X-M) + (R-P).
(R = receipts from abroad and P = payments
made abroad)

63

Find out : consumers. Hence, the value of final output
Names of five countries making use of includes the value of intermediate products.
the concept of Green GNP.   For example, the price of bread includes,
the cost of wheat, making of flour, etc.,
Methods of Measurment of National Income : wheat and flour are both intermediate goods.
There are three methods of measuring Their values are paid up during the process
national income. of production. In the final product i.e. bread,
1) Output Method/Product Method the values of intermediate goods are already
2) Income Method included.
3) Expenditure Method  Thus, a separate accounting of the
values of intermediate goods, along with
Output Method the accounting of the value of final product,
would mean double counting. To avoid this,
Methods of Measurement Income Method the value of only the final product or goods
of National Income Expenditure Method must be computed.

1) Output Method : ii) Value Added Approach / The Value
Added Method : In order to avoid double
This method of measuring national income counting value added approach is used.
According to this approach, the value added
is also known as product method or inventory at each stage of the production process is
included. The difference between the value
method. of final outputs and inputs, at each stage of
production is called the value added. Thus,
This method approaches national income GNP is obtained as the sum total of the
values added by all the different, stages of
from the output side. According to this method, the production process, till the final output is
reached in the hands of consumers, to meet
the economy is divided into different sectors, the final demand. This can be illustrated
with the help of the following table.
such as agriculture, mining, manufacturing,

small enterprises, commerce, transport,

communication and other services. The output or

product method is followed either by valuing all

the final goods and services, produced during a

year, at their market price or by adding up all the

values at each higher stage of production, until

these products are turned into final products. Table No. 7.1 - Value Added Method

While using this method utmost care must Production stage Value of Value of Value
output ` input ` added `
be taken to avoid multiple or double counting.

To avoid double counting this method suggests Cotton 150 0 150

two alternative approaches for the measurement Yarn 250 150 100

of GNP. Cloth 400 250 150

i) Final Goods Approach / The Final Product Shirt (final goods) 500 400 100
Approach : Final goods are those goods
which are ready for final consumption. Total value 500
According to this approach, value of all final
goods and services produced in primary, Value added at each stage is calculated by
secondary and tertiary sector are included deducting the value of inputs from the value of
and the value of all intermediate transactions output produced. The sum total added at different
are ignored. Intermediate goods are involved stages make GNP. In the above table the value of
in the process of producing final goods, that final good (Shirt) is ` 500. The sum total of value
is, the final flow of output purchased by added at each stage of production is also ` 500.
Thus the total value added is equal to the value of
final goods. (150 + 100 + 150 + 100 = 500)

64

Precautions : all added together, but income received in the
While estimating national income by output form of transfer payments are ignored. The data
method, following precautions should be taken: pertaining to income are obtained from different
sources, for instance, from income tax returns,
1) To avoid double counting, only the value of reports, books of accounts, as well as estimates
final goods and services must be taken into for small income.
account. GNP can be treated as the sum of factor
incomes, earned as a result of undertaking
2) Goods used for self consumption by economic activity, on the part of resource
farmers should be estimated by a guess owners and reflected in the production of the
work. Imputed value of goods produced total output of goods and services during any
for self consumption is included in national given time period.
income. Thus, GNP, according to income method, is
calculated as follows:
3) Indirect taxes included in the market prices NI = Rent + Wages + Interest + Profit +
are to be deducted and subsidies given by Mixed Income + Net income from abroad.
the government to certain products should NI = R + W + I + P + MI + (X–M)
be added for accurate estimation of national
income. Precautions :
While estimating national income by
4) While evaluating output, changes in the income method, the following precautions
price level between different years must be should be taken.
taken into account.
1) Transfer incomes or transfer payments like
5) Value of exports should be added and value scholarships, gifts, donations, charity, old
of imports should be deducted. age pensions, unemployment allowance
etc., should be ignored.
6) Depreciation of capital assets should be
deducted. 2) All unpaid services like services of a
housewife, teacher teaching her/his child,
7) Sale and purchase of second hand goods should be ignored.
should be ignored as it is not a part of
current production. 3) Any income from sale of second hand goods
like car, house etc., should be ignored.
 Output method is widely used in the
underdeveloped countries. However, it 4) Income from sale of shares and bonds
is less reliable because of the margin of should be ignored, as they do not add
error. In India, this method is applied to anything to the real national income.
agriculture, mining and manufacturers,
including handicrafts. But it is not applied 5) Revenue received by the government
for transport, commerce and communication through direct taxes, should be ignored, as
sectors in India. it is only a transfer of income.

2) Income Method : 6) Undistributed profits of companies, income
This method of measuring national income from government property and profits from
is also known as factor cost method. This public enterprise, such as water supply,
method estimates national income from the should be included.
distribution side.
According to this method, the income 7) Imputed value of production kept for self-
payments received by all citizens of a country, consumption and imputed rent of owner
in a particular year, are added up, that is, occupied houses should be included.
incomes that accrue to all factors of production
by way of rents, wages, interest and profits are In India, the National Income Committee

65

of the Central Statistical Organization, uses business sector for production of goods and
the income method for adding up the income services in any economy (G).
arising from trade, transport, professional
and liberal arts, public administration and 4) Net Foreign Investment/Net Exports : It
domestic services. refers to the difference between exports and
imports of a country during a period of one
3) Expenditure Method : year.
This method of measuring national income
is also known as Outlay Method. 5) Net Receipts (R-P) : The difference
According to this method, the total between expenditure incurred by foreigners
expenditure incurred by the society, in a on domestic goods and services (R) and
particular year, is added together. Income can expenditure incurred abroad by residents
be spent either on consumer goods or on capital on foreign goods and services (P).
goods. Thus, we can get national income by
summing up all consumption expenditure and Precautions:
investment expenditure made by all individuals, While estimating national income by
firms as well as the government of a country Expenditure Method, the following precautions
during a year. should be taken.
Thus, gross national product is found by adding
up     NI = C + I + G + (X–M) + (R–P) 1) Expenditure on all intermediate goods and
services should be ignored, in order to avoid
1) Private Final Consumption Expenditure double counting.
(C) : Private Final Consumption Expenditure
(C) by households on non-durable goods, 2) Expenditure on the repurchase of second
such as food, which are used immediately; hand goods, should be ignored, as it is not
expenditure on durable goods such as car, incurred on currently produced goods.
computer, television set, washing machine
etc., which are generally used for a longer 3) Expenditure on transfer payments
period of time; and expenditure on services like scholarships, old age pensions,
like transport services, medical services, etc. unemployment allowance etc., should be
ignored.
2) Gross Domestic Private Investment
Expenditure (I) : It refers to expenditure 4) Expenditure on repurchase of financial
made by private businesses on replacement, assets such as shares, bonds, debentures etc.,
renewals and new investment (I). should not be included, as such transactions
do not add to the flow of goods and services.
3) Government Final Consumption and
Investment Expenditure (G) : 5) Indirect taxes should be deducted.

i) Government's final consumption 6) Expenditure on final goods and services
expenditure refers to the expenditure should be included.
incurred by government on various
administrative services like, law and order, 7) Subsidies should be included.
defence, education, health etc.   Out of these methods, the Output Method

ii) Government's investment expenditure refers and Income Method are extensively used.
to the expenditure incurred by government, In advanced countries like U.S.A. and U.K.
on creating infrastructural facilities like the Income Method is popular. Expenditure
construction of roads, railways, bridges, Method is rarely used by any country
dams, canals, which are used by the because of practical difficulties. In India,
the Central Statistical Organization (CSO)
adopts a combination of both output method
and income method to estimate national
income of India.

66

You should know : 6) Valuation of Government Services :
Mixed income refers to the incomes of Government provides a number of public
self employed persons who use their own services such as law and order, defence,
land, labour, capital and entrepreneurship public administration, education, health
to produce various goods and services. services etc. The calculation of these
services at market price is difficult, as the
Difficulties in the Measurement of National real value of these services is not known.
Income : Therefore, it is difficult to calculate national
There are various difficulties in the Income.
measurement of national income.
7) Changing price level : Difficulties in
A) Theoretical Difficulties or Conceptual calculating national income also arise due
Difficulties : to changes in price levels. For example,
1) Transfer payments : Individuals get when the price level rises, the national
income may show an increase even though
pension, unemployment allowance etc. but the production may have decreased. Also,
whether these transfer payments should when the price level falls, the national
be included in national income or not, is a income may show a decrease even though
major problem. On one hand they are a part there may be an increase in production.
of individual income and on the other hand,
they are part of Government expenditure. B) Practical Difficulties or Statistical
Hence, these transfer payments are not Difficulties :
included in national income.
In practice, a number of difficulties arise
2) Illegal income : Illegal incomes like income in the collection of statistical data required for
from gambling, black marketing, theft, estimation of national income. Some of the
smuggling etc. are not included in national practical difficulties are as follows :
income.
1) Problem of double counting : The greatest
3) Unpaid services : For the purpose of difficulty in calculating national income is
calculating national income, only paid of double counting. It arises from the failure
goods and services are considered. However, to distinguish properly, between a final and
there are a number of unpaid services which an intermediate product. For example, flour
are not accounted for in the calculation of used by a bakery is an intermediate product
national income. For example, services of and that by a household is final product.
housewives and the services provided out
of love, affection, mercy, sympathy, charity 2) Existence of non-monetized sector : In
etc. are not included in national income. India, especially in rural areas, there exists
the non-monetized sector. Agriculture, still
4) Production for self consumption : The being in the nature of subsistence farming, a
products kept for self consumption by the major part of production is partly exchanged
farmers and other allied producers do not for other goods and services. It is excluded
enter the market. Hence, it is not accounted while counting national income.
for in the national Income.
3) Inadequate and unreliable data : Adequate
5) Income of foreign firms : According to and correct data on production and cost
IMF, income of a foreign firm, should data relating to crops, fisheries, animal
be included in the national income of the husbandry, forestry, construction workers,
country, where the firm actually undertakes small enterprises etc., are not available in
the production work.

67

a developing country. Besides this, data 1) For the Economy : National income data

on unearned incomes, consumption and are important for the economy of a country.

investment expenditure of rural and urban In present times, the national income data are

population are also not available. This does regarded as accounts of the economy, which

not reveal the actual size of national income. are known as ‘Social Accounts’. It tells us

4) Depreciation : Depreciation refers to wear how the aggregates of a nation's income,
and tear of capital assets, due to their use output and product result from the income of
in the process of production. There are no different individuals, products of industries
uniform, common or accepted standard and transactions of international trade.

rates of depreciation applicable to the 2) National policies : National income data

various capital assets. Thus, it is difficult to forms the basis of national policies such

make correct deductions for depreciation. as employment policy, industrial policy,

5) Capital gains or losses : Capital gains agricultural policy etc. These figures
or capital losses, which accrue to the enable us to know the direction in which
property owners by increase or decrease in the industrial output, investment and saving
the market value of their capital assets or etc., change. National Income also helps
changes in demand, are not included in the to generate economic models like growth
national income because these changes do model, investment models etc. Thus, proper
not result from current economic activities. measures can be adopted to bring the
economy to the right path.
6) Illiteracy and ignorance : Due to ignorance
and illiteracy, small producers do not keep 3) Economic planning : For economic
an account of their production. So they planning, data pertaining to national
cannot give information about the quantity income is very essential. This includes data
or value of their output. related to a country's gross income, output,
savings, investment and consumption which
7) Difficulties in the classification of can be obtained from different sources.
working population : In India, working
population is not clearly defined. For 4) Economic Research : National income
instance, farmers in India are not engaged data are also used by the research
in agriculture round the year. Obviously, in scholars of economics. They make use of
the off season, they engage themselves in various data of the country's input, output,
alternative occupations. In such a case, it is income, savings, consumption, investment
very difficult to identify their incomes from employment etc., which are obtained from
a particular occupation. social accounts.

8) Valuation of inventories : Raw materials, 5) Comparison of Standard of Living :
intermediate goods, semi-finished and National income data helps us to compare
finished products in the stock of the the standards of living of people in different
producers are known as inventories. Any countries and of people living in the same
mistake in measuring the value of inventory, country at different times.

will distort the value of the final production 6) Distribution of Income : National income

of the producer. Therefore, valuation of statistics enables us to know about the

inventories requires careful assessment. distribution of income in the country from

Importance of National Income : the data related to wages, rent, interest and
The following points explain the importance profits. We understand the disparities in the
of the National Income : incomes of different sections of the society.

68

EXERCISE

Q. 1. Complete the following statements : d) Expenditure method – National Income = Rent
1) While estimating national income, we include        + Wages + Interest + Profit

only value of final goods and services in order Options : 1) a   2) b   3) c   4) d
to .........
a) make computation easier Q. 4. Identify and Explain the following concepts :
b) avoid double counting 1) Vrinda receives monthly pension of Rs.5,000/-
c) maximize national welfare of the people
d) evaluate the total economic performance of a from the State Government.
nation 2) Viru kept aside 100 kgs. out of 500 kgs. of

2) NDP is obtained by ......... wheat produced in his farm for his family.
a) deducting depreciation from GNP 3) Sheetal purchased wheat flour for her bakery
b) deducting depreciation from GDP
c) including depreciation in GDP from the flour mill.
d) including depreciation in GNP 4) Shobha collected data regarding the money

3) In India, national income is estimated using value of all final goods and services produced
......... in the country for the financial year 2018-2019.
5) Rajendra has a total stock of 500 gel pens in his
a) output method shop which includes the 200 gel pens produced
b) income method in the previous financial year.
c) expenditure method
d) combination of output and income method Q. 5. Answer the following :
1) Explain the two sector model of circular flow of
Q. 2. Complete the Correlation :
national income.
1) : C + I + G + (X-M) :: GNP : C + I + G 2) Explain the importance of national income.
+ (X-M) + (R-P). 3) Explain the features of national income.
4) Explain the concept of Green GNP.
2) Output method : :: Income method :
Factor cost method Q. 6. State with reasons, whether you agree or
disagree with the following statements :
3) Theoretical difficulty : Transfer payments :: 1) There are many theoretical difficulties in the
: Valuation of Inventories
measurement of national income.
Q. 3. Choose the correct option : 2) Under output method, value added approach is
1) Wrongly matched pair :
used to avoid double counting.
a) National Income Committee – 1949
Q. 7. Answer in detail :
b) Financial year – 1st April to 31st March 1) Explain the practical difficulties involved in the

c) Income method – National Income = Rent measurement of national income.
+Wages+Interest+ Profit 2) Explain the income method and expenditure
+ Mixed income + Net
Income from abroad method of measuring national income.



69

8 Public Finance in India

Find out :
More examples of obligatory and
optional functions of the government.

Meaning and Nature of Public Finance :

Fig. 8.1 To perform the above mentioned functions,
adequately and efficiently, any government
Introduction : needs funds which can be received from various
Public finance is one of the old branches of sources. The concept of public finance is a
economics which highlights the role and functions combination of two words ‘public’ and ‘finance,
of the government in an economy. Government ‘Public’ is a collective for the individuals living
is a formal or informal institution created by the within an administrative territory. In economics,
people in a specific region to perform various it is used to signify the government which
functions such as protection from external represents the public. ‘Finance’ simply means
attacks, protection of private property of the income and expenditure. Thus, ‘public finance’
people, generation of employment, maintaining is nothing but a study of the principles of income
internal law and order, provision of social needs and expenditure of the government at central,
like education, health, etc. state and local levels. This study is done under
the public finance branch in economics.
These functions of the government can be
classified as : Definitions of Public Finance :

1) Obligatory functions : Protection from Different economists have defined public
external attacks, maintaining internal law finance in their own ways. Let us study some of
and order etc. are obligatory functions of these definitions :
the government.
1) According to Hugh Dalton : “Public
2) Optional functions : Provision of education finance is one of those subjects which are
and health services, provision of social on the borderline between economics and
security like pensions and other welfare politics. It is concerned with the income and
measures etc. are optional functions of the expenditure of public authorities and with
government. the adjustment of one with the other.” Since
we study the activities of the governments
in political science too, public finance also
constitutes a part of the study of political
science.

2) According to Prof. Findlay Shirras :
“Public finance is the study of the principles
underlying the spending and raising of
funds by public authorities.”

70

Differences Between Public Finance and Private Finance :

Points of difference Public finance Private finance
1) Objectives
To offer maximum social To fulfil private interests
2) Determination of advantage to the society
expenditure
Government first determines the An individual considers his income
3) Credit status
volume and different ways of its and then determines the volume of
4) Right to print
currency expenditure expenditure
5) Elasticity of finance
High degree of credit in the Credit of a private individual is
6) Effect on economy market limited

The Government can print notes Private individual does not enjoy
through Reserve Bank of India such right

Public finance is more elastic There is not much scope for
changes in private finance

Tremendous impact on the Marginal effect on the national
economy of country economy

Structure of Public Finance :
The components or scope of public finance can be shown as below :

Structure of Public Finance at a Glance

I) Public II) Public III) Public IV) Fiscal V) Financial
Expenditure Revenue Debt Policy Administration

A) Tax B) Non-Tax Internal External

Direct Indirect (Revenue expenditure
and debit policy for
  1) Proportionate Goods and
  2) Progressive Services Tax overall growth)
  3) Regressive
(GST)   1) Fees   1) Public expenditure
  2) Public revenue
  2) Prices of public good and service   3) Public debt

  3) Special Assessment

  A) Revenue expenditure   4) Fines and penalties

  B) Capital expenditure   5) Gifts, grants and donations

  C) Developmental expenditure   6) Special levy

  D) Non- Developmental expenditure   7) Borrowings

Fig. 8.2
On the basis of figure 8.2, the explanation is as follows :

71

I) Public Expenditure : in generation of employment, increase in
Public expenditure is that expenditure which production, price stability etc. is known as
is incurred by the public authority [Central, developmental expenditure. For example,
State and Local Bodies] for protection of their expenditure on health, education, industrial
citizens, for satisfying their collective needs and development, social welfare, Research and
for promoting their economic and social welfare. Development (R & D) etc.

Till 20th century, the majority of the D) Non-Developmental Expenditure : On the
governments had adopted a policy of laissez other hand, that government expenditure
faire. Under this policy, the functions of which does not yield any direct productive
government were restricted to the obligatory impact on the country is called non-
functions. But, the modern governments not developmental expenditure. For example,
only perform the obligatory functions such administration costs, war expenditure etc.
as defence and civil administration, but also These are unproductive in nature.
perform optional functions for promoting social
and economic development of their countries. Do you know?
Therefore, study of public expenditure is an
important part of study of public finance. Trends in Public Expenditure in India

since Independence

Classification of Public Expenditure : Sr. No. Year Total Expenditure (` Cr.)
Different economists have classified public
expenditure on different bases. We shall now 1 1991-92 72,317
study some of the important classification of
public expenditure. 2 2001-02 3,62,450

3 2005-06 5,06,123

4 2009-10 10,24,487

A) Revenue Expenditure : Revenue 5 2015-16 11,95,025
expenditure of the government is for
incurred carrying out day-to-day functions 6 2016-17 13,74,203
of the government departments and
various services. It is incurred regularly. 7 2017-18 14,35,233
For example, administration costs of the
government, salaries, allowances and 8 2018-19 17,29,682
pensions of government employees, medical
and public health services etc. Source - Economic Survey, Government of India- 2018-19

Given table shows trends in public

expenditure in India since 1991-92 for

select years. It can be clearly observed

that there is tremendous growth in the total

B) Capital Expenditure : Capital expenditure public expenditure of the country over the
of the government is expenditure for
progress and development of the country. period.
For example, huge investments in different
development projects, loans granted to Reasons for Growth in Public Expenditure :
the state governments and government It is observed that there is a continous
companies, repayment of government growth in public expenditure in a developing
loans etc. country like India.

C) Developmental Expenditure : Let us study some of the important reasuns :

Developmental expenditure is productive 1) Increase in the Activities of the
Government : As mentioned earlier,
in nature. The expenditure which results the modern government performs many
functions for the social and economic

72

development of the country. These functions production, employment and overall growth
include spread of education, public health, in the economy. Hence, the government
public works, public recreation, social makes huge efforts for implementing
welfare schemes etc. It is observed that various schemes and programmes for
new functions are continuously being industrial development. This results in
undertaken and old functions are being increase in government expenditure.
performed more efficiently on a large scale
by the government. This leads to increase in 8) Disaster Management : Many natural and
public expenditure. man-made calamities like earthquakes,
floods, cyclones, social unrest etc. are
2) Rapid Increase in Population : Population occurring more frequently. The government
of developing countries like India is has to spend a huge amount for the
increasing fast. In 2011 Census, it was disaster management which increases total
121.02 crores. As a result, the government expenditure.
has to incur greater expenditure to fulfil the
needs of the increasing population.  Modern governments are working for
‘welfare state’. Hence, there is a continuous
3) Growing Urbanization : Spread of increase in the public expenditure.
urbanization is a global phenomenon
of the day. This leads to increase in the Find out :
government expenditure on water supply, Reasons for growth in public expenditure
roads, energy, schools and colleges, public other than given above.
transport, sanitation etc.
Find out :
4) Increasing Defence Expenditure : In Important social welfare schemes by the
modern times, defence expenditure of Govt.
the government is increasing even in the
peace time due to unstable and hostile II) Public Revenue :
international relationships. Public revenue means the aggregate
collection of income with the government
5) Spread of Democracy : Majority of the through various sources. Public revenue holds
countries in the world are democratic in the permanent position in the study of public
nature. A democratic form of government is finance which is part of study of economics.
expensive due to regular elections and other Thus, the necessity of public revenue arises due
such activities. This results in the increase to public expenditure.
in total expenditure of the government. The main sources of public revenue are as
follows.
6) Inflation : Just like a private individual, the
government has to buy goods and services Sources of Public Revenue :
from the market for the spread of economic A) Taxes B) Non-tax Revenue :
and social development. Normally, prices
show a rising trend. Due to this, the A) Taxes :
government has to incur increasing costs. 1) According to Prof. Taussig : “The essence

7) Industrial Development : Industrial of a tax as distinguished from other charges
development leads to an increase in by government is the absence of a direct

73

quid pro quo between the tax payer and the this canon, every tax should be levied in
public authority.” such a manner and at such a time that it
2) According to Prof. Seligman, “A tax is a becomes convenient to the tax payer.
compulsory contribution from the person to
the government without reference to special 4) Canon of Economy : According to this
benefits conferred.” canon, the cost of tax collection should
 A tax possesses following essential be the minimum. If a major portion
characteristics : of the tax proceeds is spent on the tax
  1) It is a compulsory contribution to the collection itself, then such a tax cannot
government and every citizen of the country be considered as a good tax.
is legally bound to pay the tax imposed upon
him. It is a major source of revenue to the Types of Taxes :
government. If any person does not pay a
tax, he can be punished by the government.    There are two main types of taxes. They are :
  2) Tax is paid by a taxpayer to enable
government to incur expenses in the 1) Direct Tax and 2) Indirect Tax.
common interests of the society.
  3) The payment of a tax by a person does Let us study in details :
not entitle him to receive any direct and
proportionate benefits or services from the 1) Direct Tax : It is paid by the taxpayer on
government in return for the tax. his income and property. The burden of tax
  4) Tax is imposed on income, property or is borne by the person on whom it is levied.
commodities and services. As he cannot transfer the burden of the tax
to others, impact and incidence of direct
You should know : tax falls on the same person. For example-
personal income tax, wealth tax etc.
Canons (Principles) of Taxation :
Adam Smith, the founder of Modern 2) Indirect Tax : It is levied on goods or
economics propounded the following four services. It is paid at the time of production
canons of taxation : or sale and purchase of a commodity or a
1) Canon of Equity or Equality : Smith service. The burden of an indirect tax can
be shifted by the taxpayer (producers) to
suggested that every person will pay the other person/s. Hence, impact and incidence
taxes to the government in proportion to of tax are on different heads. For example,
his ‘ability to pay’. It means rich people newly implemented Goods and Services
should pay more tax compared to the poor. Tax [GST] in India has replaced almost all
2) Canon of Certainty : According to indirect taxes, custom duty.
Smith, the taxpayer should know in
advance how much tax he has to pay, Do you know?
at what time he has to pay the tax and Direct taxes are further classified into
in what form the tax is to be paid to the three categories depending upon the rate of
government. tax. These are :
3) Canon of Convenience : According to 1) Proportionate tax : When a tax is levied

at the same and constant rate on all
incomes, it is called proportional tax.

2) Progressive tax : A tax, the rate of which
increases with every increase in income

74

is called progressive tax. In India we violating traffic rules. However, the income
have progressive tax rate system. from this source is small.

3) Regressive tax : In regressive taxation, 5) Gifts, Grants and Donations : The
the larger the income of a tax-payer, the government may also earn some income
smaller is the proportion of the tax levied in the form of gifts by the citizens and
on him. others. The government may also receive
grants from the foreign governments and
B) Non-Tax Revenue Sources : institutions for general and specific purposes.
Foreign aid has become an important source
Public revenue received by the government of development finance for a developing
administration, public enterprises, gifts and country like India. However, this source of
grants etc. are called as non-tax revenue. These revenue is uncertain in nature.
sources are different than the taxes. A brief
information about these sources are as follows : 6) Special levies : This is levied on those
commodities, the consumption of which
1) Fees : A tax is paid compulsorily without is harmful to the health and well-being
any return service whereas, fee is paid in of the citizens. Like fines and penalties,
return for certain specific services rendered the objective is not to earn income, but to
by the government. For example- education discourage the consumption of harmful
fee, registration fee, etc. commodities by the citizens. For example-
duties levied on wine, opium and other
2) Prices of public goods and services : intoxicants.
Modern governments sell various types of
commodities and services to the citizens. A 7) Borrowings : The government can borrow
price is a payment made by the citizens to from the people in the form of deposits,
the government for the goods and services bonds etc. It also gets loans from foreign
sold to them. For example- railway fares, governments and organizations such as
postal charges etc. IMF, World Bank etc. Loans are becoming
more and more popular source of revenue
3) Special Assessment : The payment made for the governments in the modern times.
by the citizens of a particular locality
in exchange for certain special facilities Do you know?
given to them by the authorities is known Goods and Services Tax [GST]
as ‘special assessment.’ For example- The Goods and Services Tax [GST]
local bodies can levy a special tax on the came into effect in India on July 1, 2017. It
residents of a particular area where extra/ was proposed by the Kelkar Task Force on
special facilities of roads, energy, water Implementation of the Fiscal Responsibility
supply etc. are provided. and Budget Management [FRBM] Act
in July, 2004. The 101st Amendment in
4) Fines and Penalties : The government the Constitution Act, 2016 provided for
imposes fines and penalties on those who the constitution of the Goods and Services
violate the laws of the country. The objective Tax Council[GSTC] comprising the
of the imposition of fines and penalties is Union Finance Minister, the Minister of
not to earn income, but to discourage the State[Revenue] and the Finance Ministers
citizens from violating the laws framed by of each state, empowering the Council to
the Government. For example, fines for

75

make recommendations on the GST rates,   • Reducing final price of goods.
exemptions, thresholds of the tax etc.   • Boost to the industrial sector.
  • Poverty Eradication by generating
GST is different from an excise or sales
tax imposed as a single-stage levy on the more employment and more financial
manufacture or sale of a product. It is a resources.
comprehensive tax base with nationwide
coverage of goods and service. GST would Sample showing GST voucher
replace the following taxes levied and
collected by the Centre and States such as III) Public Debt :
Central Excise Duty, Service tax, Additional Like a private individual, the government
Duties of Customs, State Value Added Tax, also needs to raise loans. In fact, raising debt is
Entry Tax, Entertainment Tax etc. the most common activity of any government,
because government expenditure generally
Central Goods and Services Tax [CGST] exceeds government revenue. Public debt policy
- It is a tax levied on interstate supplies of the government plays an important role in
of both goods and services by the central public finance.
government which will be governed by the There are mainly two types of public debt.
CGST Act. They are :
State Goods and Services Tax [SGST]- 1) Internal Debt and 2) External Debt
This tax is received by the state in which 1) Internal Debt : When a government
the goods or services are consumed and
not by the state in which these goods are borrows from its citizens, banks, central
manufactured. bank, financial institutions, business houses
Integrated Goods and Services Tax etc. within the country, it is known as
[IGST]- It is a tax levied on all interstate internal debt.
supplies of goods and services which will 2) External Debt : When a government
be governed by the IGST Act. borrows from foreign governments,
Compensation Part - It is for the loss of foreign banks or institutions, international
expected income on the part of the State organizations like International Monetary
Governments. Fund, World Bank etc., it is known as
external debt.
Expected Benefits of GST :

  • Creation of a unified common national
market for India.

  • Boost to foreign investments and ‘Make
in India’, campaign.

  • Harmonization of laws, procedures and
rates of tax.

  • Boost export and manufacturing activity.

  • Improvement in the overall investment
climate in the country.

  • Simplifying the tax system in the country.

76

Table no. 8.1 shows the difference between Government Budget :
Internal debt and External debt. Budgetisanimportantinstrumentoffinancial
administration through which all the financial
Table 8.1 affairs of the state are regulated. Budget is a
financial statement showing the expected receipts
Differences between Internal and External Debt and proposed expenditures of the government in
the coming financial year. In India, a financial
Sr. No. Internal Debt External Debt year is from 1st April to 31st March. Article 112
of the Constitution of India has a provision for
1 Raised within the Raised outside annual financial statement. In every budget, a set
economy the economy of seven budget documents describe the details of
Government finance in India.
2 Voluntary or Voluntary in The word ‘Budget’ is derived from the
compulsory in nature nature French word ‘Bougette’,which means a bag
or a wallet containing the financial proposals.
3 Use of domestic Use of foreign These financial proposals are in the form of the
currency currency Government expenditure and revenue.

4 Less complex for More Do you know?
management complex for
management The term ‘Budget’ is not used in the
Constitution of India. It refers to the ‘Annual
Try this : Financial Statement’ of the Government.
Classify the following activities into
Internal and External Debt : Revenue and Capital Budgets :

1) Government selling bonds to its citizens. Central Budget provisions are divided into-
1) Revenue Budget and
2) Government of India borrowing funds
from the World Bank for provision of 2) Capital Budget.
water supply.
1) Revenue Budget : It consists of revenue
3) Government of India takes loans from receipts and revenue expenditure of the
Nationalized Banks for developing government. Revenue receipts are divided
infrastructure facilities in the country. into tax and non-tax revenue. Revenue
expenditure comprises of interest paid on
4) Government of India takes loans from Government borrowings, subsidies and
World Bank for Mumbai Metro Train. grants given to the state governments.

IV) Fiscal Policy : 2) Capital Budget : The capital budget
Fiscal policy is the means by which a consists of capital receipts and capital
government adjusts its spending levels and payments. Capital receipts are Government
tax rates to monitor and influence a nation's loans raised from the public and the Reserve
economy. It deals with the public expenditure, Bank of India, divestment of equity holding
public revenue and public debt. In short, it in the public sector enterprises, loans
is the financial policy implemented by the received from the foreign Governments and
Government. other foreign bodies, State deposit funds,
special deposits etc.
V) Financial Administration :
A smooth and efficient implementation
of revenue, expenditure and debt policy of
the Government, is referred to as financial
administration. This includes preparation and
implementation of the Government budgets
along with overall growth of the country.

77

Capital payments refer to the capital of inflation, there is a tendency for prices
expenditures on various development to rise rapidly. This needs to be checked,
projects, investments by the Government, particularly in the interest of those who
loans given to the state Governments, have more or less a fixed income. The rise in
and Government companies, corporations prices can be checked by lowering the level
and other parties. Besides, it includes of effective demand in the economy. This
expenditure on social and community can be done by increasing taxes which would
development, defence and general services. increase the revenue of the government and
reduce the purchasing power of the people.
Types of Budget : As a result, the aggregate demand will fall
leading to downward movement in the price
The budgetary provisions of public level. Thus, inflationary pressures can be
expenditure and revenue need to be at different controlled.
levels as per the changing needs of the economy.   However, a surplus budget should not be
Accordingly, Government budget is of three used in the situations other than inflation
types : as it may lead to unemployment and low
1) Balanced Budget levels of output in an economy.

2) Surplus Budget 3) Deficit Budget : Government budget
is said to be deficit, when anticipated
3) Deficit Budget Government receipts are less than the
estimated Government expenditure. That
1) Balanced Budget : Government budget is anticipated Government Receipts <
is said to be balanced, when estimated estimated Government expenditure.
revenue and expenditure of the government
are equal. That is, Government Receipts =   A deficit budget may prove useful during
Government Expenditure. the period of depression. In the period of
depression, all economic activities are at
 The concept of a balanced budget was low level which results in unemployment.
advocated by the classical economists like This can be checked by increasing
Adam Smith. It was considered as neutral Government expenditure, by borrowing
in its effect on the working of the economy money and through deficit financing. This
and hence, they regarded it as the best. will increase employment and aggregate
effective demand for goods and services
 However, modern economists believe which would encourage further investment.
that the policy of balanced budget may In modern times, deficit budget is the most
not always be suitable for the economy. commonly implemented policy of any
The modern Governments are welfare Government.
entities and hence, they cannot keep their
expenditure at the level of their receipts.  Developing countries like India have
consistently resorted to deficit budget
2) Surplus Budget : Government budget technique for economic development.
is said to be surplus, when estimated
Government receipts are more than the Importance of Budget :
estimated Government expenditure. Union Budget is important because it
i.e. anticipated Government Receipts > affects people and economy in general in a
estimated Government Expenditure.

 A surplus budget may prove useful
during the period of inflation. In the period

78

number of ways. Taxes are the most interesting because Governments use it as a medium for
part of any budget. Taxes determine the fate implementing economic policies in the country.
of businesses and individuals. The level of Budgetary actions of the Government affect
disposable income of the taxpayers depends on production, size and distribution of income and
the tax rates presented in the budget. Government utilization of human and material resources of
expenditure on various heads such as defence, the country.
administration, infrastructure, education and Thus, the scope and importance of public
health care etc. affects the lives of the citizens finance in a modern economy has undergone an
and overall economy. Also, budget is important immense change since last 100 years.

EXERCISE

Q. 1. A) Choose the correct option : c) Fees
d) Special Levy
1) Optional functions of Government : Options : 1) b and c
3) a, b, c and d
a) Protection from external attack 2) a and c
4) c and d
b) Provision of education and health services

c) Provision of social security measures 5) Trends shown by Public expenditure of any

d) Collection of tax Government shows following trend.

Options : 1) b and c 2) a, b and c a) Constant b) Increasing

3) b, c and d 4) All of the above c) Decreasing d) Fluctuating

2) Obligatory functions of the Government : Options : 1) only a 2) only b

a) Provision of employment 3) only c 4) only d

b) Maintaining internal law and order 6) Identify the right group of pairs from the given
options.
c) Welfare measures

d) Exporting goods and services i) Direct tax a) Non-tax revenue

Options : 1) c and d 2) a and b ii) Indirect tax b) Inflation

3) only b 4) a, c and d iii) Fees and Fines c) GST

3) "Definition - Public finance is one of those iv) Surplus budget d) Personal income tax
subjects which are on the borderline between
economics and politics." ......... given by Options : a) i-d ii-c iii-b iv-a

a) Adam Smith   b) i-c ii-d iii-a iv-b

b) Alfred Marshall   c) i-d ii-c iii-a iv-b

c) Prof. Hugh Dalton   d) i-a ii-b iii-c iv-d

d) Prof. Findlay Shirras Q. 2. Distingwish between following concepts :
1) Public finance and Private finance.
Options : 1) only a 2) only b 2) Internal debt and External debt.
3) Developmental expenditure and Non-
3) only c 4) only d
developmental expenditure.
4) Non-tax sources of revenue : 4) Special assessment and Special levy.
a) Direct and Indirect Tax 5) Direct Tax and Indirect tax.
b) Direct Tax and Fees

79

Q. 3. State with reasons whether you agree or population was numerals enough and earning enough
disagree with the following statement : to generate the taxes to pay for the care of those
not working. This model is ill-suited for less, well-
1) Obligatory function is the only function of the off India with growing life expectancy, increasing
Govenment. urbanization and resultant migration. Social security
under urbanization will be different from social
2) Fines and penalties are a major source of security in a static society.
revenue for the Government.
1) State the conventional notion of social security.
3) The goods and services tax (GST) has replaced
almost all indirect taxes in India. 2) What kind of conceptual change is suggested in
the given paragraph.
4) Democratic Governments do not lead to
increase in public expenditure. 3) What is a legacy of social security from the rich
world?
5) Public finance is more elastic than private
finance. 4) Which features of India make the traditional
model of social security ill-suited for the
Q. 4. Read the given passage and answer the economy?
questions :
“The conventional notion of social security is Q. 5. Answer the following :
that the government would make periodic payments
to look after people in their old age, ill-health, 1) State the types and importance of Government
disability and poverty. This idea should itself budget.
change from writing a cheque for the beneficiary to
institutional arrangements to care for beneficiaries, 2) Explain the principles of taxation.
including by enabling them to look after themselves,
to a large extent. 3) Explain non-tax sources of revenue of the
The write-a-cheque model of social security is Government.
a legacy from the rich world at the optimal phase
of its demographic transition, when the working Q. 6. Answer in detail :

1) Explain various reasons for the growth of public
expenditure.



80

9 Money Market and Capital Market in India

Introduction : Try this :
Finance is the backbone of an economy. From the given examples, identify the
Finance, basically refers to the management of type of finance involved (Personal finance/
money. It includes funds needed by individuals, Corporate finance /Public finance) :
business houses and the Government for various • Building a retirement corpus
purposes. Thus, finance is categorized as • Raising share capital through sale of
personal finance, corporate finance and public equity shares
finance. The financial system of the country is • Collection of tax revenue
responsible for the mobilization and allocation • Clearing home loan through EMI
of funds. It helps in creation of wealth which (Equated Monthly Instalment)
is vital for the economic development of the • Expenditure on social infrastructure such
country. The financial system in India comprises as health and education
of financial institutions, financial markets, • Managing working capital needs
financial instruments and financial services.

FINANCIAL INSTITUTIONS A) Money Market in India :
Meaning :
INDIAN FINANCIAL MARKETS Money market is a market for lending and
FINANCIAL FINANCIAL INSTRUMENTS borrowing of short term funds. It is a market for
“near money” i.e. short term instruments such
SYSTEM as trade bills, government securities, promissory
notes etc. Such instruments are highly liquid,
FINANCIAL SERVICES less risky and easily marketable with a maturity
period of one year or less than one year.
This chapter deals exclusively with
financial markets in India. Financial markets Do you know?
are an important component of the financial Some Financial Instruments :
system. •  Bonds refer to debt instruments issued by
companies or the government as a means of
Meaning of Financial Market : borrowing long term funds.
Financial market refers to a market where •  Equity shares refer to shares of a
sale and purchase of financial assets such company held by an individual or a group.
as bonds, stocks, derivatives, government •  Derivatives refer to a financial security
securities, foreign currency etc. is undertaken. which derives its value/price from the
Financial markets operate through banks, non- underlying assets such as bonds, stocks,
banking financial institutions, brokers, mutual currency, interest rates, commodities etc.
funds, discount houses etc. Financial markets •  Government securities refer to debt
include two distinct markets i.e. the Money instruments issued by a government with a
market and Capital market. promise of repayment at maturity.

FINANCIAL MARKETS

MONEY MARKET CAPITAL MARKET

81

•  Trade bills refer to bills of exchange 1) Organized Sector : The organised sector
drawn on and accepted by a trader (trade of the money market consists of the
acceptance) in payment of goods. Reserve Bank of India, commercial banks,
co-operative banks, regulated financial
•  Promissory note is a financial instrument intermediaries etc. Let us now discuss the
that contains a written promise by one organized sector of the money market in
party to pay another party a definite sum of India.
money, either on demand or at a specified
future date. a) Reserve Bank of India (RBI): Every
country in the world has a Central Bank
Structure of Money Market in India : which is at the apex of the banking system.
The money market in India is dichotomous It is entrusted with the responsibility of
by nature. It comprises of both, the organized regulating the money market in the country.
sector as well as the unorganized sector. The Reserve Bank of India is the central bank of
organized sector includes the Reserve Bank of our country. RBI was set up on the basis of
India (RBI), commercial banks, co-operative the recommendations of the Hilton Young
banks, development financial institutions, Commission. The RBI Act of 1934 provides
investment institutions and the Discount and the statutory basis of the functions of the
Finance House of India (DFHI). The unorganized bank. RBI commenced its operations on 1st
sector on the other hand, comprises of indigenous April, 1935 as a private shareholders’ bank.
bankers, money lenders and unregulated non- RBI was nationalized on 1st January, 1949.
bank financial intermediaries. It is the most important constituent of the
Money market centres in India are located money market.
at Mumbai, Delhi and Kolkata. However,
Mumbai is the only active money market centre Popular Definitions of Central Bank :
in India with money flowing in from all parts of
the country. Dr. M. H. de Kock : “Central bank is one which
The following chart explains the structure constitutes the apex of the monetary and banking
of money market in India : structure of the country.”

Prof. W. A. Shaw : “Central bank is a bank
which controls credit.”

RBI

COMMERCIAL BANKS

ORGANIZED CO-OPERATIVE BANKS
SECTOR
DEVELOPMENT FINANCIAL Functions of Reserve Bank of India
UNORGANIZED INSTITUTIONS
SECTOR 1) Issue of Currency Notes : RBI has the
DISCOUNT AND FINANCE sole right to issue currency notes of all
HOUSE OF INDIA denominations, except one rupee note
and coins. As per the ‘Minimum Reserve
INDIGENOUS BANKERS System’ of 1957, RBI is required to maintain
minimum gold and foreign exchange
MONEY LENDERS reserves of Rs 200 crores, out of which at

UNREGULATED NON-BANK
FINANCIAL INTERMEDIARIES

Fig. 9.1

82

least ` 115 crores should be in gold and the 6) Collection and Publication of Data : RBI
remaining ` 85 crores should be in terms of collects and compiles statistical information
foreign currency and government securities. related to banking and other financial
sectors of the economy.
2) Banker to the Government : RBI acts
as a banker, agent and advisor to the 7) Promotional and Developmental
Government. It transacts the business of Functions : RBI also performs certain
both, the Central and State Governments. It promotional and developmental functions
accepts money as well as makes payments such as extending banking services to semi-
on behalf these Governments. It also urban and rural areas, providing security
undertakes the management of public debt. to depositors, development of specialized
It advises the Government on a wide range institutions for agricultural credit, industrial
of economic issues. finance etc.

3) Banker’s Bank : RBI exercises statutory 8) Other Functions : RBI acts as a clearing
control over the commercial banks. All house for settling the accounts between
scheduled banks are compulsorily required its member banks. As a lender of last
to maintain a certain minimum of cash resort, it also provides liquidity to banks
reserves with the RBI against their demand experiencing financial difficulty.

and time liabilities. RBI provides financial Find out :
assistance to banks in the form of discounting
of eligible bills. Loans and advances are Names of the Central Banks of the
also provided against approved securities.
following countries :
4) Custodian of Foreign Exchange
Reserves : RBI acts as a custodian of the • USA • UK (United Kingdom)
country’s foreign exchange reserves. It has
to maintain the official rate of exchange of • CANADA • SWEDEN
rupee as well as ensure its stability. RBI also
• RUSSIA • FRANCE

• GERMANY • JAPAN

• CHINA • AUSTRALIA

undertakes to buy and sell the currencies b) Commercial banks : Commercial banks act
of all the members of the International as intermediaries in the country’s financial
Monetary Fund (IMF). system to bring the savers and investors
together. They are profit seeking financial
5) Controller of Credit : As a supreme banking institutions. Acceptance of deposits and
authority of the country, RBI has the power granting loans and advances are the
to influence the volume of credit created primary functions of commercial banks.
by commercial banks. It also monitors Commercial banks play an important role in
the purpose or use of credit. Quantitative mobilizing savings and allocating them to
methods such as bank rate, open market various sectors of the economy. It includes
operations, variable reserve ratios such both scheduled commercial banks and non-
as Cash Reserve Ratio (CRR), Statutory scheduled commercial banks. Scheduled
Liquid Ratio (SLR) etc. control the volume commercial banks are those included in
of credit created. Qualitative methods the second schedule of the Reserve Bank of
such as fixing margin requirements, credit India Act, 1934. In terms of ownership and
rationing, moral suasion etc. regulate the function, commercial banks in India can be
purpose or use of credit.

83

classified into four categories: at regular intervals for a specified period of
• Public sector banks time.

• Private sector banks • Fixed deposits refer to a lumpsum amount
deposited by a customer for a specified
• Regional rural banks period of time. Compared to all other
deposits, fixed deposits carry a high rate of
• Foreign banks interest.

Popular Definitions of Commercial Bank : 2) Providing loans and advances :
Commercial banks mobilize savings
Banking Regulation Act of 1949 : “Banking and lend these funds to institutions and
means the accepting, for the purpose of lending individuals for various purposes. Based on
or investment, of deposits of money from the the tenure, loans include call loans, short
public, repayable on demand or otherwise, and term, medium term and long term loans.
withdrawable by cheque, demand draft, order or Longer the duration of the loans, greater will
otherwise.” be the rate of interest. Besides this, banks
also provide cash credit, overdraft facility
Prof. Cairncross : “A bank is a financial as well as discount bills of exchange.
intermediary, a dealer in loans and debts.”
3) Ancillary functions : Commercial banks
Functions of Commercial Banks : also provide a range of ancillary services
such as transfer of funds, collection of
1) Acceptance of deposits : Deposits constitute money, making periodical payments on
the main source of funds for commercial behalf of the customer, merchant banking,
banks. Savings lead to the creation of foreign exchange, safe deposit lockers,
deposits. Deposits are categorized as (i) D-mat facility, internet banking, mobile
Demand deposits and (ii) Time deposits. banking etc.

i) Demand Deposits : Deposits that are 4) Credit Creation : Credit creation is an
withdrawable on demand are known as important function of commercial banks.
demand deposits. They are in the form Commercial banks are creators of credit.
of Current account and Savings account Demand and time deposits constitute the
deposits. primary deposits of banks. After meeting the
reserve requirements out of the net demand
• Current account is usually opened by and time liabilities, the balance amount
businessmen, corporations, industrial is used for giving loans. Thus, secondary
houses, trusts etc. They are provided deposits or ‘derivative deposits’ are
with overdraft facility. Overdraft means created out of the loans given by the banks.
withdrawal in excess of the balance in the    For instance, when the bank provides loan
account. to its customer, the loan amount is credited
into the bank account of the customer. The
• Savings account are operated by a large bank that receives the loan amount as a
number of people, particularly the salaried deposit, keeps aside a certain portion in the
class, small traders etc. who wish to save a form of reserves. After meeting the reserve
part of their income with the bank. requirements, the bank lends the remaining
amount. This procedure is followed by the
ii) Time deposits : Deposits that are repayable
after a certain period of time are known
as time deposits. They are in the form of
recurring deposits and time deposits

• Recurring deposit refers to a deposit
wherein a customer deposits a fixed amount

84

entire banking system in the country, leading co-operative banks and state co-operative
to creation of credit. In short, commercial banks.
banks create deposits out of the loans given Fig. 9.3 explains the structure of co-
thereby leading to crediton. operative banks in India :

Three Tier Co-operative Credit Structure

State Co-operative Bank
State (Apex Bank)
Level

District District Central
Level Co-operative Bank

Primary Primary Co-operative
Level credit Societie

Fig. 9.3

Try this :
Collect information of Co-operative
banks operating in your region at different
levels.

Fig. 9.2 d) Development Financial Institutions
(DFIs) : Development financial institutions
Try this : are agencies that provide medium and
Pair the logos given with their respective long-term financial assistance. They help
banks as given in the bracket below: in the development of industry, agriculture
(State Bank of India, HSBC Bank, Union and other key sectors. Industrial Finance
Bank of India, Axis Bank, Standard Corporation of India (IFCI) was the first
Chartered Bank, HDFC Bank) development financial institution to be
established in 1948.

Let's recall :

c) Co-operative Banks : Co-operative banks You have already studied in class
came into existence with the enactment of XI about NABARD which is the apex
the Co-operative Credit Societies Act of institution in the rural credit structure. It
1904. Co-operative banks supplement the provides credit for promotion of agriculture,
efforts of commercial banks by meeting small-scale industries, cottage and village
the credit needs of the local population. industries, handicrafts etc.
It fulfills the banking needs of small and
medium income groups. The co-operative Development financial institutions
credit sector comprises of co-operative have diversified their operations with the
credit institutions such as primary co- advent of liberalization and globalization.
operative credit societies, district central They have set up subsidiaries to offer a
wide range of new products and services

85

such as commercial banking, consumer labourers, small and marginal farmers,
finance, broking, venture capital finance, artisans, small traders etc. usually borrow
infrastructural financing, e-commerce etc. money from the money lenders. At present,
Thus, development financial institutions are the activities of the money lenders have been
in the process of converting themselves into restricted by RBI due to their exploitative
universal banks. RBI has issued guidelines tendencies.
for development financial institutions
to become commercial banks. For e.g. iii) Unregulated Non-Bank Financial
ICICI (Industrial Credit and Investment Intermediaries : They include Chit funds,
Corporation of India) has become a Nidhi, loan companies etc. Under Chit
universal bank by a reverse merger with its funds, members make regular contribution
subsidiary ICICI Bank. to the fund. Bids or draws are made on the
basis of a criteria mutually agreed upon by
e) Discount and Finance House of India the members. Accordingly, the collected
(DFHI) : The Discount and Finance House fund is given to the chosen member. Chit
of India (DFHI) was set up in 1988 as a funds mostly operate in Kerala and Tamil
money market institution based on the Nadu. Nidhi is also a type of mutual
recommendations of the Vaghul Committee. benefit fund thriving on the contribution
It is jointly owned by the RBI, public sector of its members. Loans are provided to
banks and financial institutions to impart members at reasonable rates of interest.
liquidity to the money market instruments. Loan companies are finance companies.
They provide loans to traders, small-scale
2) Unorganized Sector : The unorganized industries and self-employed persons.
money market in India comprises of Being unregulated, they charge a high rate
indigenous bankers, money lenders of interest on loans.
and unregulated non-bank financial
intermediaries. The activities of the UNREGULATED NIDHI
unorganized money market are largely NON-BANK CHIT FUNDS
confined to the rural areas. FINANCIAL LOAN COMPANIES

i) Indigenous bankers : They are financial INTERMEDIARIES
intermediaries that function similar to
banks. They mostly deal in indigenous Do you know?
short-term credit instruments such as
hundi. The rate of interest differs from one Money market instruments :
market to another. Indigenous bankers are
mostly confined to certain social strata. The following instruments are traded in
They are an important source of funds in the money market :
unbanked areas and provide loans directly
to agriculture, trade and industry. • Call / Notice Money Market : When
money is borrowed or lent for a day, it is
ii) Money lenders : They mostly operate in known as call (overnight) money. When
the villages. Money lenders usually charge money is borrowed or lent for more than
a high rate of interest. The loans provided a day up to 14 days, it is known as notice
by money lenders are for both productive money.
and unproductive purpose. Agricultural
• Treasury Bills (TBs) : They are short
term instruments issued by the RBI on

86

behalf of the government to meet temporary Government to fulfil its short term financial
liquidity shortfalls. requirements on the basis of Treasury Bills.

• Commercial Papers (CPs) : It is an 6) Implementation of Monetary policy :
unsecured promissory note, negotiable and Monetary policy is implemented by the
transferable by endorsement and delivery central bank. It aims at managing the
with a fixed maturity period. quantity of money in order to meet the
requirements of different sectors of the
• Certificate of Deposits (CDs) : They are economy and to increase the pace of
unsecured, negotiable instruments in bearer economic growth. A well-developed money
form issued by commercial banks and market ensures successful implementation
development finance institutions. of the monetary policy. It guides the central
bank in developing an appropriate interest
• Commercial Bills (CBs) : They are policy.
short term, negotiable and self-liquidating
instruments with low risk. 7) Economizes the use of cash : Money market
deals with various financial instruments
Role of Money Market in India : that are close substitutes of money and not
The following points outline the role of the actual money. Thus, it economizes the use
money market in India : of cash.

1) Short-term requirements of borrowers : 8) Growth of Commerce, Industry and Trade:
Money market provides reasonable access Money market facilitates discounting bills of
for meeting the short-term financial needs exchange to local and international traders
of the borrowers at realistic prices. who are in urgent need of short-term funds. It
also provides working capital for agriculture
2) Liquidity Management : Money market and small scale industries.
is a dynamic market. It facilitates better
management of liquidity and money in the Problems of the Indian Money Market :
economy by the monetary authorities. This, Compared to advanced countries, the Indian
in turn, leads to economic stability and money market is less developed in terms of
development of the country. volume and liquidity. Following points explain
the problems of the Indian Money Market :
3) Portfolio Management : Money market
deals with different types of financial 1) Dual Structure of the Money Market :
instruments that are designed to suit the risk Presence of both, the organized and
and return preferences of the investors. This unorganized sector in the money market
enables the investors to hold a portfolio of leads to disintegration, lack of transparency
different financial assets which in turn, helps and increased volatility. The unorganized
in minimizing risk and maximizing returns. markets lack co-ordination and do not come
under the direct control and supervision of
4) Equilibrating mechanism : Through the RBI.
rational allocation of resources and
mobilization of savings into investment 2) Lack of uniformity in the rates of
channels, money market helps to establish interest : The money market comprises
equilibrium between the demand for and of various entities such as commercial
supply of short-term funds. banks, co-operative banks, non-bank
finance companies, development finance
5) Financial requirements of the
Government : Money market helps the

87

institutions, investment companies etc. The 4) National Electronic Fund Transfer (NEFT)

category of borrowers is also different. and Real Time Gross Settlement (RTGS)

3) Shortage of funds : Money market faces were introduced as an improved payment
shortage of funds due to inadequate savings. infrastructure.

Low per capita income, poor banking 5) Electronic dealing system was introduced

habits among the people, indulgence in to bring about technological upgradation.
wasteful consumption, inadequate banking
facilities in the rural areas etc. have also Do you know?
been responsible for the paucity of funds in Recent developments in banking sector :

the money market. • Small Finance Banks : Small finance
banks aim to promote financial inclusion
4) Seasonal fluctuations : Demand for funds through supply of credit to small business
varies as per the seasons. During the peak units, small and marginal farmers, micro
season, from October to June, finance and small industries and other unorganized
is required on a large scale for various sector entities through high technology but
purposes such as trading in agricultural low cost operations.
produce, investment in business activities

etc. This results in wide fluctuations in the • Payments Banks : Apayments bank is like
money market. any other bank, but operating on a smaller
scale without involving any credit risk. In
5) Lack of financial inclusion : Banking simple words, it can carry out most banking
facilities in the country are still inadequate operations but can’t advance loans or issue
and inaccessible to the vulnerable groups credit cards. It can accept demand deposits
such as the weaker sections and the low (up to ` 1 lakh), offer remittance services,
income groups. This shows lack of financial mobile payments / transfers / purchases and
inclusion. other banking services like ATM/debit cards,
net banking and third party fund transfers.
6) Delays in technological upgradation :
Use of advanced technology is a pre- • Universal Banks : Universal banks refer
requisite for the development and smooth to those banks that offer a wide range of
functioning of financial markets. Delays financial services, such as, commercial
in upgradation of technology hampers the banking and investment banking and other
working of the money market. activities especially insurance. It is a multi-
purpose and multi-functional financial
Reforms introduced in the Money Market : supermarket providing both banking and
Following are some of the important financial services through a single window.
reforms introduced in the money market :
1) Introduction of new instruments such as • Local Area Banks : Local area bank
scheme was introduced in August, 1996 to
Treasury bills of varying maturity periods, enable mobilization of rural savings by local
Commercial Papers (CPs), Certificate of institutions especially private local banks
Deposits (CDs) and Money Market Mutual and make them available for investments
Mutual Funds (MMMFs). in the local areas. This helps to bridge the
gap in credit availability and strengthen the
2) RBI Repos and Reverse Repos were institutional credit from work in the rural
introduced under the Liquidity Adjustment and semi-urban areas.
Facility (LAF).

3) Interest rates to be largely determined by
market forces.

88

B) Capital Market in India : 1) Government Securities Market : It is
Meaning : also known as the gilt-edged market. It
Capital market is a market for long term funds deals in government and semi-government
both equity and debt raised within and outside the securities. Such securities carry a fixed rate
country. It is also an important constituent of the of interest.
financial system. Development of an effective
capital market is necessary for promoting more 2) Industrial Securities Market : It deals
investments as well as achieving economic with the shares and debentures issued by
growth. The demand for long term funds comes old and new companies. It is further divided
from agriculture, trade and industry. Individual into Primary Market (New Issues) and
savers, corporate savings, banks, insurance Secondary Market (Old Issues). Primary
companies, specialized financial institutions are market helps to raise fresh capital through
the suppliers of long term funds. sale of shares and debentures. Secondary
market deals with securities already issued
by companies. Secondary markets function
through stock exchanges.

 Stock exchange is an important
constituent of the capital market. It is an
association or organization in which stocks,
bonds, commodities etc are traded. Bombay
Stock Exchange (BSE) and National Stock
Exchange (NSE) are the premier stock
exchanges in the country.

Fig. 9.4 3) Development Financial Institutions
(DFIs) : They provide medium term and
Structure of Capital Market in India : long term financial assistance to the private
The capital market in India comprises of sector. They include Industrial Finance
the Gilt-Edged or the Government Securities Corporation of India (IFCI), Industrial
Market, Industrial Securities Market, Investment Bank of India (IIBI), EXIM
Development Financial Institutions and Bank etc.
Financial Intermediaries.
Fig. 9.5, explains the structure of India’s 4) Financial Intermediaries : Financial
Capital Market. intermediary is an organization which
acts as a link between the investor and the

Indian Capital Market

Government Securities Industrial Securities Market Development Financial Institutions Financial Intermediaries
New Issues Market Old Issues Market

IFCI ICICI SFCs IDBI IIBI UTI

Merchant Banks Mutual Funds Leasing Companies Venture Capital Companies Others

Fig. 9.5
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borrower to meet the financial objectives of 2) Insider trading and price manipulation :
both the parties. They consist of merchant Insider trading means buying or selling of
banks, mutual funds, leasing companies, a security by someone who has access to
venture capital companies etc. non-public information or ‘unpublished
information’ for personal benefit. Price
Role of Capital Market in India : manipulation or price rigging on the other
hand means to simply raise the prices of
1) Mobilizes long term savings : There shares through buying and selling of shares
is an increasing demand for investment within certain individuals themselves for
funds by industrial organizations and personal gains. Such illegal practices have
the government. But the availability of also affected the smooth functioning of
financial resources is insufficient to meet capital market.
this growing demand. Capital market helps
to mobilize long term savings from various 3) Inadequate debt instruments : Debt
section of the population through the sale of instruments include bonds, debentures
securities. etc. There is not much trading in the debt
securities due to narrow investor base, high
2) Provides equity capital : Capital market cost of issuance, lack of accessibility to
provides equity capital or share capital small and medium enterprises.
to entrepreneurs which could be used to
purchase assets as well as fund business 4) Decline in the volume of trade : Regional
operations. stock exchanges have witnessed a sharp
decline in the volume of trade because
3) Operational efficiency : Capital market investors prefer to trade in securities listed
helps to achieve operational efficiency by in premier stock exchanges like BSE,
lowering the transaction costs, simplifying NSE etc.
transaction procedures, lowering settlement
timings in purchase and sale of stocks. 5) Lack of informational efficiency : A
market is said to be informationally efficient
4) Quick valuation : Capital market helps to if a company’s stock prices incorporate all
determine a fair and quick value of both the available information into the current
equity (shares) and debt (bonds, debentures) prices. However, the stock market in India
instruments. lacks informational efficiency compared to
advanced countries.
5) Integration : Capital market leads to
integration among real and financial Find out :
sectors, equity and debt instruments, List of regional stock exchanges in India.
government and private sector, domestic
and external funds etc.

Problems of the Capital Market : Reforms introduced in the Capital Market :
Following points explain the problems
faced by the Indian Capital Market : Following are some of the important
reforms introduced in the capital market :
1) Financial Scams : Increasing number of
financial frauds have resulted in irreparable 1) Securities and Exchange Board of India
loss for the capital market. Besides this, it (SEBI) was established in 1988 but given
has also lead to public distrust and loss of statutory powers in 1992 to protect the
confidence among the individual investors. interest of the investors and promote the
development of the securities market.

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2) National Stock Exchange (NSE), the leading 6) Investor Education and Protection Fund
stock exchange in India was established (IEPF) was established in 2001 to promote
in 1992. investors’ awareness and protecting the
interest of the investors.
3) Computerized Screen Based Trading
System (SBTS) was introduced as a part of Do you know?
modernization. Economic Policy in an Economy

4) Demat account has been introduced since Monetary Policy Fiscal Policy
1996 to facilitate easy purchase and sale
of shares by the investors through the Implemented by Implemented by
electronic method. Central Bank Central government

5) Increased access to global funds by Deals with Money Deals with taxes,
Indian companies was permitted through Supply expenditure etc.
American Depository Receipts (ADRs) and
Global Depository Receipts (GDRs). Aims at financial Aims at economic and

stability social development

Quantitative in nature Qualitative in nature

EXERCISE

Q. 1. Complete the following statements : were b) accelerate the country's economic growth.
1) Development financial institutions c) mobilise the savings and allocating them to
established to .............
various sectors of the economy.
a) provide short term funds. d) control the credit.

b) develop industry, agriculture and other key Q. 2. Complete the correlation :

sectors. 1) Money market : Short term funds :: :
Long term funds
c) regulate the money market.

d) regulate the capital market. 2) : Central Bank :: SBI : Commercial
Bank
2) Money market faces shortage of funds due to
........... 3) Co-operative banks : Organized sector ::
Indigenous bankers :
a) inadequate savings. 
b) growing demand for cash. 4) Primary market : :: Secondary market
c) presence of unorganized sector.   : Old issues
d) financial mismanagement.
Q. 3. Find the odd word :
3) Individual investors have lost confidence in the
capital market due to ........... 1) Types of Bank Accounts : Saving a/c, D-mat
a/c, Recurring a/c, Current a/c
a) lack of financial instruments.  
b) high transaction costs. 2) Unregulated Financial intermediates : Mutual
c) low returns. fund, Nidhi, Chit fund, Loan Companies
d) financial scams.
3) Financial Assets : Bonds, Land, Govt.
4) Commercial banks act as intermediaries in the Securities, Derivatives
financial system to ...........
4) Quantitative Tools : Bank rate, Open market
a) make profits operations, Foreign Exchange rate, Variable
reserve ratios

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