MONEY, BANKING,INTERNATIONAL TRADE

ANDPUBLIC FINANCE

MONEY, BANKING,INTERNATIONAL TRADE

ANDPUBLIC FINANCE

ISO 9001:2015 CERTIFIED

D.M. MITHANIM.A., Ph.D.,

Professor Emeritus,L.J. Institute of Business Management (MBA),

Ahmedabad, India.

Adjunct Professor,Oriental Institute of Management,

Vashi, Navi Mumbai.

Former Professor, OYA Graduate School of Business,Universiti Utara Malaysia (UUM), Malaysia.

Former Reader,Department of Commerce, University of Mumbai,

Mumbai, India.

Former Head of Economics Department,Maharashtra College of Arts, Science and Commerce,

Mumbai.

© D.M. MITHANI, 2018No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical,photocopying, recording and/or otherwise without the prior written permission of the author and the publisher.

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PREFACE TO THE TWENTIETH REVISED EDITION: 2018-19

Dealing with money, banking, international trade and public finance in one book all at the same time ismore exciting and challenging to the writer as well as to the reader, as it provides a new dimension to one’sunderstanding of the macroeconomic world.

There is no dearth of books and literature on these fascinating subjects, yet most of them do not adequatelymeet the specific requirements of the student community at large. Too often, students are required to consult alarge number of books and journals to obtain the information they seek. The few good books available havebecome out of date as the syllabii in the various universities and modes of analysis have changed considerablyin recent years. Besides, economics of money, banking, trade and finance has undergone a dynamic evolution.New ideas and new institutions have emerged with far-reaching effects on the relevant issues and problems andtheir solution.

In such a situation, a study cannot become complete and illuminating unless the students are kept abreastof the prevalent trends. Most of the books available are, however, inadequate in this respect, to greater or lesserdegree. I have purposely designed this book so as to meet the felt need. Distinct features of the present book:

1. It is comprehensive.

2. It has an integrated approach with an Indian perspective.

3. It lucidly discusses the subject matter in a style that draws the student into the depth of the study,facilitating sound knowledge, understanding and appreciation of the subject.

4. It reviews the essential core topics of each field of money, banking, international trade and finance in aclear, precise and sequentially integrated manner so that the student can acquire an understanding ofthe subject.

5. It synthesises the materials scattered in numerous foreign authors’ books and journals. The subject matterhas been presented in a logical order, in a lucid and narrative style, using numerous illustrations, chartsand diagrams. It also gives a simple formulist presentation wherever needed.

6. It aims at giving a thorough grounding on the subject.

7. It contains discussions on the subject matter developed right from an introductory to an advanced level,suitably arranged section-wise so that the students can pick up the sections of his requirements, omittingthe rest.

8. Most of the chapters in the book are written in a fairly self-contained manner. As such, the student canread the text in the order which suits best his interest and the requirements of his own syllabus orpreference.

9. It incorporates numerous questions at the end of each chapter. These have been designed: (a) to test thestudent’s understanding of the subject matter discussed in the text; (b) to encourage the student himselfto absorb the ideas expounded; and (c) to enable him to review definitions and important conceptsduring the course of his study. In the objective test section, multiple choice questions are set to providepractice in answering this form of questions, usually set in many professional examinations such as I.A.S.,I.E.S., etc.

10. The book is designed to meet the varying needs of the graduate and postgraduate students and othersinterested in economics.

As a whole, this bookshould be of value to at least three categories of students:

(i) undergraduates in economics and commerce reading for B.A. and B.Com. degree at the variousIndian Universities; (ii) post-graduate students at M.A. and M.Com. levels; and ( iii) those preparing forprofessional examinations such as I.E.S., I.A.S., C.A., M.B.A., C.A.I.I.B., C.W.A., etc.

Finger Points to Exam Preparation: Never ever be nervous. Read, Read, Read and be prepared. Have focus of your reading on core topic of the subject/syllabus. While writing your answers, rely on your memory of what you have read. Choose the answer, the questions first which you feel you can give best answers. Give answers to all the questions with your rational choice in priority. Your first answer would be the best as examiners usually start reading the beginning with more attention

in forming an opinion. Remember: First Impression is the Best Impression. Whenever possible, try to quote two relevant popular personalities' golden view or sentence in your answer

by underlining. Underline important/key sentence in your answer. Always begin a new answer to a new question on a new page at the top. Underline the number of the question, then Answer to Q. 4 Answer to Q. 6

Whenever supplementary answer book is added to the main answer book, at the end on the page, give anindication, such as Sir Please see to Answer to Question further continued on next supplement tied.

Relax once exam paper is handed over to the Supervisor. Do not worry about the result for the given paper and start preparing for the next.

For the sake of convenience, the book has been divided into four parts in a logical sequence. Part I containsthe subject-matter of money and banking, including Indian banking and the Reserve Bank’s monetary policy.Part II provides an exhaustive treatment of the theory of income and employment, including an analys is of tradecycles and measures of economic stabilisation. Part III deals with international trade: theory, policy and finance.Part IV elucidates the principles of public finance and fiscal policy, including a discussion on India’s FinanceCommissions. A brief review of supply side economics has also been incorporated to keep the reader abreast ofthe latest economic trends in the West. Within this, it is hoped that the book will serve as a comprehensivetextbook for the students of B.A. and B.Com. degree courses and a basic reference book for the M.A. andM.Com. degree courses at all the Indian universities in general.

Money, Banking, Finance and Trade are the dynamics of macro studies in Economics and Managementfield. The subject is fascinating and fast changing in scope and application. In view of this, the author has takenthe opportunity this time to recast, and thoroughly revise, rewrite, and update the discussion on the subject-matter. It is hoped the present new edition will have enhanced utility to the reader.

In writing a textbook of this kind, one incurs a mounting indebtedness to several writers on the subject. Itis, therefore, very difficult for me to state how greatly I am indebted to each of them. As I have drawn upon andassimilated a great amount of materials from the standard works of these well-known authorities, I acknowledgewith gratitude my debt to these authors and their publishers whose work I have referred to with ment ion orwithout mention in the course of writing this volume.

The author has taken this opportunity to update the information/data analysis included in this book. Severalnew points and sub-topics have been incorporated, in the light of new development in the subject and newofficial reports and publications of the Reserve Bank of India, International Monetary Fund, World Bank and theGovernment of India. New concepts and topics, such as new monetary aggregates, Indian capital market , WTO,etc. have been added. It is hoped that this volume will have an enhanced utility to the students and researchersin India and other developing economies. Suggestions for further improvement of the book will be gra tefullyacknowledged.

The author is grateful to the student community and teaching fraternity alike for the warm welcome theyhave accorded to this book so that it has seen the light of the Twentieth edition by now.

The author expresses his special gratitude to Prof. B.M. Peerzada, President, L.J. Institute of Managementfor his constant inspiration and encouragement. Besides, the author is grateful to Ex-Principal, A.A. Munshi andpresent principal Dr. Sirasuddin H. Chougle, Maharashtra College of Arts, Science and Commerce for their encourgementto the Author in this academic writing, then and now.

Comments and suggestions from the reviewers of the earlier editions, other adopters and friends likeDr. Rajkumar Sen, Ex-President, Indian Economic Association, Dr. B.N. Ghosh (Universiti Sains Malaysia),Dr. B.M. Jani (Saurashtra University), Prof. Devendra Awasthi (St. Andrew’s College Gorakhpur), Prof . P.S.Trivedi (Mahila College, Bhavnagar), Dr. Himanshu Desai (Nav Gujarat College, Ahmedabad), Muzafarshah Mohd.Mustafa and Lim Hock, Lecturers in Economics, College of Arts, Universiti Utara Malaysia (UUM) and my studentsespecially, Mohd. Husain Navloor, Ex-lecturer, Maharashtra College, Mumbai. Somchai and Jirapone of Thailand(DBA), Prof. Shahzad of Pakistan and Mathi of Malaysia (MBA) and Sally (Ph.D. student) at UUM have beenmost beneficial in preparing this volume. My thanks to all.

Janmashtmi2nd September 2018 D.M. MITHANI

CONTENTS

PART I

MONEY AND BANKING 1 – 366

1 . THE NATURE OF BARTER AND MONETARY ECONOMY 3 – 10

Barter Economy — Evolution of Money — Forms of Money in a Modern Economy — Nature of a MonetaryEconomy — Circular Flow of Money — Monetisation — References — Questions for Discussion — ObjectiveTest.

2 . FUNCTIONS AND SIGNIFICANCE OF MONEY 11 – 24

Definition of Money — Static Functions of Money — Dynamic Role of Money — Money as a Liquid Asset:A Link with Future — Money and Near-money — Significance of Money in Modern Economic Life — Roleof Money in a Capitalist Economy — Classical and Modern Economists’ Views on Money — References— Questions for Discussion — Objective Test.

3 . MONETARY STANDARDS 25 – 29

The Concept of Monetary Standard — Metallic Standard — Monometallism — Bimetallism — Paper Standard— Gresham’s Law — Reference — Questions for Discussion — Objective Test.

4 . THE GOLD STANDARD 30 – 43

Meaning and Characteristics of Gold Standard — Functions of the Gold Standard — Forms of Gold Standard— Domestic Gold Standard — International Gold Standard — Mechanism of International Gold Standard —Rules of Gold Standard Game — Working and Collapse of the Gold Standard — References — Questionsfor Discussion — Objective Test.

5 . THE MONEY SUPPLY 44 – 58

The Concept of Money Supply — Components of Money Supply — The Modern Approach — DifferentApproaches Regarding Measure of Money Supply — Reserve Bank of India’s Measure of Money Stock —New Monetary Aggregates — Determinants of Money Supply — The Analysis of Changes in Money Supply:Money Multiplier Theory — Money Supply Function — Velocity of Circulation of Money — Creation of Money:Changes in Money Supply — Non-bank Financial Intermediaries and Money Supply — References — Questionsfor Discussion — Objective Test.

6 . THE DEMAND FOR MONEY 59 – 72

Introduction — The Classical Approach — The Keynesian Approach — Idle Cash Balances (The SpeculativeDemand for Money) — The Liquidity Trap — Total Demand for Money — Portfolio Balance Approach toDemand for Money — Wealth Theory of Demand for Money — The Money Illusion — A Note on EmpiricalStudies of Demand for Money — References — Questions for Discussion —Objective Test.

7 . VALUE OF MONEY 73 – 78

The Concept of Value of Money — Measurement of Changes in the Value of Money — Construction ofPrice Index Number — Difficulties in Measuring the Changes in Value of Money — References — Questionsfor Discussion — Objective Test.

8 . QUANTITY THEORY OF MONEY 79 – 95

The Gist of the Quantity Theory of Money — The Cash Transactions Approach: Fisherian Version —Criticisms against Fisher’s Quantity Theory of Money — The Cash-Balances Approach: The Cambridge

Version — A Comparison between Fisherian and Cambridge Versions — Superiority of Cambridge Versionover Fisher’s Version — Shortcomings of Cash Balances Approach — General Evaluation of the QuantityTheory of Money — Keynes’ Theory of Money and Prices (Keynes’ Reformulation of QTM) — The ChicagoVersion of QTM — References — Questions for Discussion — Objective Test.

9 . THE INCOME THEORY OF MONEY 96 – 102

Basic Theme of the Income Theory of Money (ITM) — Main Postulates of the ITM (Income ExpenditureApproach) — Saving and Investment Approach — An Appraisal of ITM — References — Questions forDiscussion — Objective Test.

10. INFLATION AND DEFLATION 103 – 136

Introduction — Meaning of Inflation — Inflation as a Pure Monetary Phenomenon — Inflation as a Post-fullEmployment Phenomenon — Contemporary Views on Inflation — Features of Inflationary Economy — Typesof Inflation — Major Theories of Inflation — Demand-pull vs. Cost-push Inflation — The Keynesian Conceptof Inflationary Gap — Causes of Inflation — Effects of Inflation — Inflation in an Underdeveloped Economy— Inflation and Economic Development — The Control of Inflation — Deflation — Inflation Versus Deflation(Inflation is Unjust, Deflation is Inexpedient) — Control of Deflation — Globalisation and Inflation — GlobalInflation Rates — Inflation in India: Current Scenario — References — Questions for Discussion — ObjectiveTest.

11. FINANCIAL MARKETS (Money and Capital Markets) 137 – 155

Nature and Functions of Financial Markets — Money Market – Its Meaning — Constituents of the MoneyMarket — Institutions of the Money Market — Characteristics of Developed and Underdeveloped MoneyMarkets — The Structure of the Indian Money Market — The Moneylenders — The Indigenous Bankers —Deficiencies of the Indian Money Market — Measures for Improvement — A Note on the Report of theWorking Group (Vaghul Committee) on Money Market — Recent Innovations in the Money Market — CapitalMarket — Structure of Interest Rates — Structure of Interest Rates in India — References — Questions forDiscussion — Objective Test.

12. THEORIES OF INTEREST 156 – 170

Concept of Interest — Classical Theory of Interest — Loanable Funds Theory of Interest — Keynes’ LiquidityPreference Theory — Comparison between Classical and Keynesian Theories of Interest — The ModernTheory of Interest (or Neo-Keynesian Theory) — References — Questions for Discussion — Objective Tes t.

13. COMMERCIAL BANKING 171 – 190

Evolution of Banking — What is a Bank? — Kinds of Banks — Functions of Commercial Banks — Structureof Banking System: Unit Banking vs Branch Banking — Merits and Demerits of Unit and Branch Banking —Functions and Services of Indian Banks — Bank’s Balance Sheet and Portfolio Management — Credit Creation— Limits to Credit Creation — The Credit Expansion Multiplier: Revisited — Leaf-Cannon Criticism of theTheory of Credit Creation — Role of Banks in a Developing Economy — Banks vs. Non-bank FinancialIntermediaries — References — Questions for Discussion — Objective Test.

14. BANKING IN INDIA 191 – 238

Introduction — Early Growth of Joint Stock Banks in India — Major Banking Developments/Reforms Duringthe Planning Era — Salient Features of Commercial Banking System in India — Growth of CommercialBanking in India — Lead Bank Scheme — Action Plans — Mobilisation of Savings: Deposit Mobilisation —Credit-Deposit Ratio of Scheduled Commercial Banks — Credit Deployment — Credit Deployment to Priori tySectors — Analysis of Recent Credit Growth — Banks’ Participation in the IRDP — Other Aspects ofCredit Deployment — Innovative Banking — Novel Credit Schemes/Facilities — Merchant Banking — IndianBanks Overseas — Customer Service in Banks — Agricultural Finance Corporation — The Problem ofBanks’ Overdues — Profitability of Commercial Banks — A Review of Current Banking Scenario — Technologyand Payment System — Virtual Banking — Report of the Working Group on Restructuring Weak PublicSector Banks — Capital Adequacy — References — Questions for Discussion — Objective Test.

15. CO-OPERATIVE AND RURAL BANKING 239 – 269

Introduction — Differences between Co-operative Banks and Commercial Banks — The Structure ofCo-operative Banking System in India — Primary Agricultural Credit Societies — Central Co-operative Banks

— State Co-operative Banks — Urban Co-operative Banks — Land Development Banks — NationalCo-operative Development Corporation — Scheduled Co-operative Banks — Rural Banks — The Schemeof Regional Rural Banks — The Organisation and Functions of the Regional Rural Banks — Progress ofthe Regional Rural Banks — The Major Problems Faced by RRBs — Suggestions for Reorganisation andImprovement in the Working of RRBs — Dantwala Committee’s Report on RRBs — National Bank for Agricul tureand Rural Development (NABARD) — Structural Reforms in Co-operative Banking — NABARD and itsRole in Rural Credit — Micro-finance — NABARD and the Co-operative Sector Revisited — References —Questions for Discussion — Objective Test.

16. THE CENTRAL BANK AND INSTRUMENTS OF CREDIT CONTROL 270 – 288

Central Bank: An Apex Financial Authority — Functions of a Central Bank — Functions of Reserve Bankof India — Central Bank and Monetary Management — Instruments of Credit Control — Bank Rate Policy(BRP) — Open Market Operations — Variable Cash Reserve Ratio (VCRR) — A Review of the GeneralInstruments of Credit Control — Selective Credit Control (SCC) — Objectives of Selective Credit Control— Measures of Selective Credit Control — Limitations of Selective Credit Control — Selective Credit Controlin a Developing Economy — References — Questions for Discussion — Objective Test.

17. DEVELOPMENT BANKS AND OTHER TERM FINANCING INSTITUTIONS IN INDIA 289 – 295

The Concept of Development Banking — Development Banks in India — The Industrial Finance Corporationof India (IFCI) — The Industrial Development Bank of India (IDBI) — The Industrial Reconstruction Bank ofIndia (IRBI) — The National Small Industries Corporation (NSIC) — The Industrial Credit and InvestmentCorporation of India (ICICI) — State Financial Corporations (SFCs) — The State Industrial DevelopmentCorporations (SIDCs) and the State Industrial Investment Corporations (SIICs) — The Export-Import Bankof India (EXIM) — Land Development Banks (LDBs) — The Life Insurance Corporation of India (LIC) — TheUnit Trust of India (UTI) — Questions for Discussion — Objective Test.

18. THE RESERVE BANK OF INDIA: ORGANISATION AND FUNCTIONS 296 – 316

Introduction — Organisational Structure and Management of the Bank — Departments of the ReserveBank — Objects and Functions of the RBI — The RBI as Currency Issuing Authority — The RBI as aBanker to Government — The RBI as a Banker’s Bank and Supervisor — Exchange Management andControl — Collection of Data and Publications — Miscellaneous Developmental and Promotional Functions—The Bill Market Scheme — The RBI and Agricultural Finance — The RBI and Industrial Finance — TheRBI and Export Finance — The Deposit Insurance Corporation — National Housing Bank — References— Questions for Discussion — Objective Test.

19. MONETARY POLICY 317 – 334

Introduction — Meaning and Content of Monetary Policy — Objectives of Monetary Policy — Neutrality ofMoney — Exchange Rate Stability and Equilibrium in the Balance of Payments — Price Stability and Controlof Business Cycles — Full Employment — Economic Growth — Choosing between Conflicting Objectives —Role of Monetary Policy in a Developing Economy — Efficacy of Monetary Policy — Limitations of MonetaryPolicy — References — Questions for Discussion — Objective Test.

20. A REVIEW OF THE WORKING AND OPERATIONS OF THE RESERVE BANK OF INDIA 335 – 354

Monetary Regulation and Credit Management of the RBI: Introduction — Objectives of Monetary Policy inIndia — Controlling Measures Adopted by the RBI — Major Issues of Indian Monetary Policy in Retrospectand Prospect — Chakravarty Report on the Working of the Indian Monetary System — The NarasimhamCommittee Report: A Review — Recent Monetary and Credit Policy Operations — Liquidity Managementby the Reserve Bank — Stance of Monetary Policy in India in 2005-06 — References — Questions forDiscussion — Objective Test.

21. INDIAN CAPITAL MARKET 355 – 364

Meaning and Functions of Capital Market — Structure of the Indian Capital Market — Capital Market forCorporate Securities — Capital Market for Government Securities — Growth Prospects of Indian CapitalMarket — Recent Developments in Indian Securities Markets — Review of Policy Development — References— Questions for Discussion — Objective Test.

22. MERCHANT BANKING 365 – 366

Introduction — Merchant Banking in India — Functions of a Merchant Bank — Regulation of MerchantBanking in India — Questions for Discussion — Objective Test.

PART II

THE THEORY OF INCOME AND EMPLOYMENT 367 – 481

23. NATIONAL INCOME 369 – 383

Concept of National Income — Concepts Associated with National Income Total — Other Related Conceptsand Relationships — Methods of Estimating National Income — Difficulties in National Income Estimate —Method of Deflating National Income — Importance of National Income Data — Social Accounting Method— Reference — Questions for Discussion — Objective Test.

24. EMPLOYMENT AND UNEMPLOYMENT 384 – 391

Concept of Unemployment — Full Employment — Types of Unemployment — Nature of Unemployment inUnderdeveloped Countries — References — Questions for Discussion — Objective Test.

25. THE CLASSICAL THEORY OF EMPLOYMENT 392 – 399

Introduction — Supply-oriented Classical Theory of Employment — Assumptions of Full Employment —Say’s Law of Markets — Interest Rate Flexibility — Classical Model of Employment — Wage Rate Flexibilityand Employment — Keynes’ Criticisms against Classical Theory — References — Questions for Discussion— Objective Test.

26. KEYNESIAN THEORY OF EMPLOYMENT 400 – 414

Introduction — The Principle of Effective Demand — Analysis of the Level of Effective Demand (FactorsDetermining Effective Demand) — How GNP is Determined? — Paradox of Poverty and Potential Plenty —An Outline of the Keynesian Theory of Employment — Shortcomings of Keynesian Theory — References —Questions for Discussion — Objective Test.

27. THE CONSUMPTION FUNCTION 415 – 423

Fundamental Psychological Law of Consumption — The Consumption Function — Saving Function — TechnicalAttributes of Consumption Function — Factors Affecting the Consumption Function — Significance of theConcept of Consumption Function — Measures to Increase Consumption Spending — References — Questionsfor Discussion — Objective Test.

28. THE INVESTMENT FUNCTION 424 – 434

Introduction — Meaning of Investment Function — Marginal Efficiency of Capital — Marginal Efficiency ofCapital (MEC) and Rate of Interest — MEC Schedule — Investment Demand Schedule (Function) — FactorsAffecting MEC — The Role of Expectations — Criticisms of MEC — Measures to Stimulate Investment —References — Questions for Discussion — Objective Test.

29. THEORY OF MULTIPLIER 435 – 440

Introduction — The Concept of Multiplier — Working of the Multiplier (The Process of Income Propagation)— Graphical Representation of the Multiplier Effect — Assumptions of the Multiplier Theory — Leakages inthe Multiplier Process — Shortcomings of the Multiplier Theory — Income Fluctuations in a Less DevelopedEconomy — References — Question for Discussion — Objective Test.

30. THE ACCELERATOR PRINCIPLE 441 – 445

Meaning of Accelerator — Working of the Accelerator — Limitations of the Acceleration Principle — Significanceof the Acceleration Principle — Interaction of the Multiplier and the Accelerator — References — Questionsfor Discussion — Objective Test.

31. SAVINGS AND INVESTMENT 446 – 456

The Concept of Savings — Determinants of Savings — Saving: A Virtue or a Vice? — Saving and InvestmentEquality — Underemployment Equilibrium — References — Questions for Discussion — Objective Test.

32. KEYNES’ THEORY AND UNDERDEVELOPED COUNTRIES 457 – 459

Introduction — Distinctive Nature and Typical Causes of Unemployment in Underdeveloped Countries —The Static Feature of the Keynesian Model — Failure of the Keynesian Multiplier in Underdeveloped Countries— References — Questions for Discussion — Objective Test.

33. TRADE CYCLES AND MEASURES OF ECONOMIC STABILISATION 460 – 476

Introduction — Features of a Trade Cycle — Phases of a Trade Cycle — Important Trade Cycle Theories— The Purely Monetary Theory — The Monetary Over-investment Theory — Non-monetary Over-investmentTheory — Under-consumption (Or Over-saving) Theory — The Psychological Theory — The Innovation Theory— Keynes’ MEC Theory — Hicks’ Theory of Trade Cycles — General Conclusions on the Theories of TradeCycle — Measures of Economic Stabilisation — References — Questions for Discussion — Objective Test.

34. MONETARISM AND KEYNESIANISM 477 – 481

Introduction — Monetarism — Genesis of Monetarism — Other Aspects of Friedman’s Contribution in MonetaristDoctr ine — Major Monetarist Propositions — Keynesian vs. Monetarist — Reference — Questions forDiscussion — Objective Test.

PART III

INTERNATIONAL TRADE: 483 – 605THEORY, POLICY AND FINANCE

35. THE NATURE OF INTERNATIONAL TRADE 485 – 488

Internal and International Trade — Salient Features of International Trade — Differences between InternalTrade and International Trade — Advantages of International Trade — Disadvantages of Foreign Trade —References — Questions for Discussion — Objective Test.

36. THE THEORY OF COMPARATIVE ADVANTAGE 489 – 496

The Theory of Comparative Advantages (The Classical Theory of International Trade) — ComparativeCosts Measured in Terms of Money (Taussig’s Restatement of Comparative Costs Doctrine) — A CriticalAppraisal of the Theory of Comparative Costs — Doctrine of Comparative Costs and UnderdevelopedCountries — Revealed Comparative Advantage — References — Questions for Discussion — ObjectiveTest.

37. MODERN THEORY OF INTERNATIONAL TRADE:GENERAL EQUILIBRIUM APPROACH 497 – 509

Introduction — Heckscher-Ohlin Theorem — Factor-Price Equalisation Theorem — An Appraisal and Comparisonbetween Classical and Modern Theory of International Trade — Shortcomings of Ohlin’s Theory — EmpiricalTests of the Factor Endowment Theory — Reference — Questions for Discussion — Objective Test.

38. GAINS FROM TRADE AND TERMS OF TRADE 510 – 518

Gains from Trade — Distribution of Gains — Meaning and Types of Terms of Trade — Equilibrium Termsof Trade (Theory of Reciprocal Demand) — Factors Influencing Terms of Trade — Reasons for the UnfavourableTerms of Trade of Less Developed Countries (LDCs) — Effects of Tariff on the Terms of Trade — Effectsof Devaluation on the Terms of Trade — Effects of Economic Development/Growth on the Terms of Trade— References — Questions for Discussion — Objective Test.

39. MECHANISM OF INTERNATIONAL PAYMENTS 519 – 535

Instruments of External Payments — Foreign Exchange Market and its Functions — Rate of Exchange —Determination of the Rate of Exchange — Equilibrium Rate of Exchange — Mint Parity Theory — PurchasingPower Parity (PPP) Theory — Criticisms against the PPP Theory — Balance of Payments Theory — Causesof Fluctuations in Exchange Rates — Fixed and Flexible Exchange Rates — Case for Fixed Exchange RateSystem — Case for Flexible Exchange Rates — Managed Flexibility — References — Questions for Discussion— Objective Test.

40. THE BALANCE OF PAYMENTS 536 – 547

Introduction — Structure of Balance of Payments — Balance of Trade and Balance of Payments — Balanceof Payments Always Balances — Equilibrium in the Balance of Payments — Types of Disequilibrium in theBalance of Payments — Fundamental Disequilibrium — Causes of Disequilibrium — Measures for CorrectingDisequilibrium — Deflation — Exchange Depreciation — Devaluation — Exchange Control — Non-monetaryMeasures — Reference — Questions for Discussion — Objective Test.

41. TRADE POLICY: FREE TRADE VS. PROTECTION 548 – 554

Free Trade Policy — Protection — Advantages of Protectionism — Role of Protection in UnderdevelopedCountries — References — Questions for Discussion — Objective Test.

42. PROTECTIVE TRADE DEVICES: TARIFFS AND QUOTAS 555 – 562

Tariffs — Effects of Tariffs — Import Quotas — Types of Import Quotas — The Effects of Quotas —Quotas vs Tariffs — References — Questions for Discussion — Objective Test.

43. EXCHANGE CONTROL 563 – 567

Meaning of Exchange Control — Objectives of Exchange Control (Merits of Exchange Control) — Techniquesof Exchange Control — Methods of Exchange Control — Indirect Methods of Exchange Regulation — Demeri tsof Exchange Control — References — Questions for Discussion — Objective Test.

44. THE IMF AND THE PROBLEM OF INTERNATIONAL LIQUIDITY 568 – 576

Introduction — Achievements of the IMF — The Problem of International Liquidity — IMF and InternationalLiquidity — Special Drawing Rights — Features of SDR Scheme — A Critical Appraisal of the SDR Scheme— The SDRs in Operation — Questions for Discussion — Objective Test.

45. INTERNATIONAL FINANCIAL INSTITUTIONS 577 – 580

The World Bank — International Finance Corporation (IFC) — International Development Association (IDA)— Questions for Discussion — Objective Test.

46. EURO-DOLLAR MARKET 581 – 583

Prelude — The Meaning of Euro-dollar — Euro-dollar Market — Benefits of the Euro-dollar Market — Effectsof Euro-dollar Market on International Financial System — Shortcomings of the Euro-dollar Market — Reference— Questions for Discussion — Objective Test.

47. EUROPEAN ECONOMIC COMMUNITY (EEC) 584 – 586

The Nature and Objective of the EEC — The Organisation of EEC — The Impact of EEC — European FreeTrade Association (EFTA) — Questions for Discussion — Objective Test.

48. GENERAL AGREEMENT ON TARIFFS AND TRADE 587 – 589

Origin of GATT — Objectives of GATT — Most Favoured Nations Clause — Tariff Negotiations — TheKennedy Round — Questions for Discussion — Objective Test.

49. UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT 590 – 597

Introduction — Organisation of the UNCTAD — Functions of UNCTAD — UNCTAD and GATT — Appraisalof Recommendations of UNCTAD-I — UNCTAD-II — UNCTAD-III — UNCTAD-IV — UNCTAD-V — UNCTAD-VI — New International Economic Order (NIEO) — Questions for Discussion — Objective Test.

50. THE WORLD TRADE ORGANISATION (WTO) 598 – 603

Introduction — Objectives and Functions of the WTO — The WTO Code/Agreements — The WTO in Action— Singapore Issues — WTO and India — Sinagapore Issues, Doha Declaration and Cancun Fiasco —WTO: What it is and What it Does? — Questions for Discussion.

51. FOREIGN DIRECT INVESTMENT AND ITS DETERMINANTS 604 – 605

References — Questions for Discussion.

PART IV

PRINCIPLES OF PUBLIC FINANCE 607 – 734

52. NATURE AND NORMS OF MODERN PUBLIC FINANCE 609 – 616

Meaning and Scope of Public Finance — Functions of Public Finance — Importance and Objects of ModernPublic Finance — Public Finance vs. Private Finance — The Principle of Maximum Social Advantage —Limitations of the Principle — Limitations of the Principle — Dalton’s Objective Tests of Social Advantage— Circular Flow of Income and Taxes — References — Questions for Discussion — Objective Test.

53. PUBLIC REVENUE 617 – 620

Meaning of Public Revenue — Tax Revenue — Non-tax Revenue — Classification of Public Revenue —References — Questions for Discussion — Objective Test.

54. CANONS OF TAXATION AND PRINCIPLES OF EQUITY 621 – 626

Canons of Taxation — Equity in Taxation — Cost of Service Principle — Benefit Principle — ObjectiveApproach of Ability to Pay Principle — Taxable Capacity — References — Questions for Discussion —Objective Test.

55. CHARACTERISTICS OF A GOOD TAX SYSTEM AND THE INDIAN TAX STRUCTURE 627 – 631

Characteristics of a Good Tax System — The Indian Tax Structure — References — Questions for Discussion— Objective Test.

56. TYPES OF TAXATION 632 – 642

Proportional, Progressive, Regressive and Digressive Taxes — Specific and Ad Valorem Taxes — Directand Indirect Taxes — Merits of Direct Taxation — Demerits of Direct Taxation — Merits of Indirect Taxation— Demerits of Indirect Taxes — Comparison between Direct and Indirect Taxes — Role of Direct and Ind irectTaxes in Developing Countries — Complementarity Aspect of Direct and Indirect Taxes — References —Questions for Discussion — Objective Test.

57. INCIDENCE OF TAXATION 643 – 649

Meaning of Incidence — Impact, Shifting and Incidence — Tax Evasion and Tax Shifting — The Processof Tax Shifting — Tax Capitalisation — Dalton’s Theory of Incidence (Demand-Supply Analysis of TaxShifting) — Incidence of Customs Duties, Income Tax and Corporate Income Tax — Reference — Questionsfor Discussion — Objective Test.

58. EFFECTS OF TAXATION 650 – 656

Introduction — Effects of Taxation on Production — Effects of Taxation on the Allocation of Resources —Effects of Taxation on Distribution — Other Macroeconomic Impacts of Taxation — References — Questionsfor Discussion — Objective Test.

59. PUBLIC EXPENDITURE 657 – 665

Introduction — Importance and Objects of Public Expenditure — Increasing Trend of Public Expenditure —Causes of Public Expenditure Growth — Canons of Public Expenditure — Effects of Public Expenditure —Reference — Questions for Discussion — Objective Test.

60. PUBLIC DEBT 666 – 676

Introduction — Necessity of Public Borrowing — Forms of Public Debt — Burden of External Debt — Burdenof Internal Debt — The Question of Shifting of the Burden of Public Debt — Redemption of Public Debt —Reference — Questions for Discussion — Objective Test.

61. FISCAL POLICY 677 – 685

Introduction — The Concept of Sound Finance (Balanced Budget Approach) — The Concept of FunctionalFinance (Unbalanced Budget Approach) — Objectives of Fiscal Policy — Fiscal Policy in Depression —Role of Fiscal Policy in Developing Countries — Instruments of Fiscal Policy — Limitations of Fiscal Policy— References — Questions for Discussion — Objective Test.

62. DEFICIT FINANCING 686 – 689

The Concept of Deficit Financing — Deficit Financing and Price Level — Limits of Deficit Financing —Questions for Discussion — Objective Test.

63. MOBILISATION OF RESOURCES FOR DEVELOPMENT 690 – 692

Introduction — Taxation and Development — Public Borrowings for Development — Profits of Public Sectorand Development — Deficit Financing for Development — Foreign Capital and Economic Development —Questions for Discussion — Objective Test.

64. FEDERAL FINANCE 693 – 703

Introduction — Principles of Federal Finance — The Problem of Distribution and Adjustment of FinancialResources — Methods of Adjustments — Inter-governmental Financial Relations in India — Finance Commissions— References — Questions for Discussion — Objective Test.

65. SUPPLY-SIDE ECONOMICS: AN OUTLINE 704 – 706

Introduction — Keynes vs. Classicists — The Gist of SSE (The Laffer Curve) — Tenets of SSE — References— Questions for Discussion — Objective Test.

APPENDIX 707 – 734

True happiness comes when money isshared than acquired

MONEY AND BANKING

PARTI

1

Money matters muchin modern times

3

Money confers inestimable benefits to our commerciallife in a modern society. We can appreciate the significanceand role of money in a modern economy straightawaywhen we look at the difficulties and inconveniencesexperienced in a primitive society’s moneyless economycalled “Barter Economy.”

1. BARTER ECONOMYBarter system was prevalent in the earliest stages

of man as a commercial animal. Even today, in someof the interior parts of African countries and even inbackward regions of India, especially in the non-monetisedsubsistence sector of some rural and Adivasi areas,barter exchange in some degree is in operation.

There is no use of money or any medium of exchangein a barter economy. “Barter” means direct exchangeof goods — goods exchanged against goods. Corn maybe exchanged for ox hides, house for horses, pigs forpoultry, lemons for oranges, baskets for bananas, shoesfor shirts and so on. In the barter system, thus, onehas to give some kind of goods to get some other kindof goods.

The barter system is not as simple and smooth asystem of exchange as its meaning shows. Many difficultiesand inconveniences are inherent in a simple barter.As a society becomes more civilised and the complexitiesof economic organisation begin to multiply, exchangethrough barter tends to become more difficult andcomplicated.

Difficulties of Barter SystemA few major difficulties of the barter system may

be traced below:1. Want of Coincidence. The first difficulty in

the barter system of exchange is that there has to be

a double coincidence of wants. Two persons can havebarter exchange only if their disposable possessionsmutually suit each other’s needs. In barter trading,thus, two parties must agree on their mutual exchange,which is possible only if there exists a double coincidenceof wants. That is, one party must be wanting a commoditywhich the other party wants to dispose of and the formermust have disposable possession of the commodity thatis desired in exchange by the latter. In a barter, therefore,a person who wants to exchange his goods for someother goods has not only to find another person whopossesses what he needs but who, at the same time,has a desire for what he has to offer. In practice, it isdifficult always to have such double coincidence ofwants and, therefore, there are delays in transactions,and a considerable amount of time and effort is wastedin effectuating the exchanges. Clearly, trade and businesscannot develop rapidly in a barter economy for wantof coincidence. Barter as such is a high barrier to economicprogress.

2. Lack of a Common Measure of Value. Anotherserious difficulty of the barter is that it lacks any commonmeasures of value or unit of account. In the absenceof a well-defined unit of account, in a barter, the valuesof goods are measured in a relative sense; hence thereis no absolute measurement of value. Since the valueof each commodity can be expressed in terms of everyother commodity, one has to remember a large numberof cross relations of values in exchange for differentgoods which is physically impossible to do when thereare an infinite number of commodities. Under suchconditions, no meaningful accounting system can beevolved.

3. Want of a Means of Subdivision. Barterexchange also suffers from a severe inconvenience onaccount of indivisibility of many kinds of goods. Onecan easily portion out a bag of foodgrains, a basket

THE NATURE OFBARTER ANDMONETARYECONOMY

1

4 MONEY, BANKING, INTERNATIONAL TRADE AND PUBLIC FINANCE

of fruits, etc. which are divisible goods and can givemore or less in exchange for what is wanted. But, thereal difficulty arises in the process of exchange betweenindivisible and divisible goods.

For instance, a horse is not divisible and cannotbe exchanged in parts against different divisible goodslike rice, sugar, potatoes, etc. Thus, barter trade betweendivisible and indivisible goods in small values cannotbe carried on without a loss of value.

In a barter system, smooth exchange operationsare impossible for want of a means of subdividingand distributing values according to people’s varyingrequirements.1

4. Lack of Standard of Deferred Payments.Another drawback of barter is that it lacks a standardof deferred payments, so that contracts involving futurepayments or loan transactions cannot take place withease in such a system. Credit transactions cannot bepromoted smoothly under barter trading. Chance ofcontroversy about the quality of goods or services tobe repaid can arise. There will be no easy agreementon the mode of repayment. Credit transactions wouldalso involve high risks to both parties as the real valueof a commodity to be repaid may drastically increaseor decrease in future.

5. Lack of Efficient Store of Value. Perhaps,a major inconvenience of barter is the lack of facilityto store value or the lack of existence of a generalisedpurchasing power. Under barter, people can store valuefor future use by storing wealth, but the difficulty ariseswhen wealth consists of perishable goods. Moreover,the store of value in terms of real wealth involves costand further, the problem of storing the goods arises.In addition, bulky goods cannot be easily exchangedfor other goods as and when required. A quick exchangesometimes involves a heavy loss, too.

Chart 1 pinpoints the shortcomings of a barter economyas have been discussed above.

To recapitulate, the main difficulties experiencedin a barter economy are:l requirement of double coincidence of wants;l absence of a unit of account;l indivisibility of bulky goods and lack of a means

of subdivision;l lack of a standard of deferred payments; andl lack of generalised purchasing power as a store

of value.

It follows that the barter economy is a highly inefficienteconomy of exchange. With the progress of civilisationand economic expansion, these difficulties and inconveniencesof the barter system becomes more pronounced. Toovercome these drawbacks, some kind of money wasinvented and evolved in every society.

2. EVOLUTION OF MONEYGrowing inconvenience of barter in the complex

economic societies necessitated the invention of money.Writers like Spalding, however, opine that money seemsto have been discovered rather than invented in theprogress of economic civilisation of mankind.2 Accordingto Crowther, money was undoubtedly an invention;“it needed the conscious reasoning power of man totake the step from simple barter to money accounting.”3

Whatever it may be, the fact remains that with theincreased volume of trade and growing process of divisionof labour and specialisation, barter became more andmore difficult in its direct exchange phenomenon. Hence,to overcome the basic difficulties of barter such aswant of double coincidence, want of means of subdivision,etc., it was thought that exchange of goods should bemade indirect by using some medium in between. Thus,money came into the picture as a medium of exchange.

Crowther4 observes that, in the beginning, in asimple exchange of goods for goods, the terms of exchange

CHART 1

SHORTCOMINGS OF BARTER ECONOMY

WANT OF COINCIDENCE LACK OF UNIT OF ACCOUNT

WANT OF A MEANS OF SUBDIVISION LACK OF STANDARD OF DEFERRED PAYMENTS

LACK OF EFFICIENT STORE OF VALUE

THE NATURE OF BARTER AND MONETARY ECONOMY 5

were fixed with reference to one standard commodity.Values of different goods being measured in terms ofthis standard commodity, in the exchange process, itcame to be accepted as a medium of exchange. Thisstandard commodity used as a medium of exchangewas known as money.

Etymologically, the term “money” is derived fromthe Latin word Moneta, the name of the Roman goddessJuno, in whose temple coins were being minted. Useof money as a medium of exchange and a unit of accountis, however, much older than coinage. Numerous thingslike shells and sheep, grains and stones, tea and tobacco,ivory and iron, gold and silver have been used as moneyat different times and different places before the inventionof modern-day’s metallic and paper money. The originof money as such is difficult to trace for want of record.Lord Keynes puts it as the origin of money is deep-rooted in antiquity, and it is a far more ancient institution.“Its origins are lost in the mists when the ice was melting,and may well stretch back into the paradisical intervalsin human history of the inter-glacial periods, when theweather was delightful and the mind free to be fertileof new ideas — in the islands of the Hesperides orAtlantis or some Eden of Central Asia.”5 Indeed, moneyis the epitome of the history of human civilisation.

No doubt, the evolution of money has been asecular process. Like several other economic institutions,money, in its present form, has passed through severalphases and developed through the centuries.

Development of Money in Different Stages

The development of money has passed throughvarious stages in accordance with time, place andcircumstances with the progress of economic civilsationof mankind. Economists have recognised five such stagesin the evolution of money:

I. Animal MoneyII. Commodity Money

III. Metallic MoneyIV. Paper MoneyV. Credit MoneyI. Animal Money. Animals were being used as

a common medium of exchange in the primitive huntingstage. History records that cattle occupied a place ofpride as money in the earliest period of human civilisation.In temperate regions of Europe, Asia and Africa, cattlewas regarded as the most standard unit of barter forquite a long time in the primitive era. In the ancientIndian civilisation, the concept of Go-Dhan (cattle wealth)as a form of money is also referred to in Arth-Veda.In the fourth century B.C., the Roman State had officiallyrecognised crows and sheep as money to collect finesand taxes.

II. Commodity Money. In certain communities,early primitive money, in its crudest sense, also tookthe form of commodity money. A large number ofcommodities from axes to yarn have been adoptedas money. The particular commodity chosen to serveas money depended upon various factors like locationof the community, climatic environment of the region,cultural and economic standard of society, etc. Forexample, people living by the seashore adopted shellsand dried fish as money. People of the cold regionsin Alaska and Siberia preferred skins and furs as amedium of exchange. African people used ivory andtiger jaws as money. Besides, commodities such asprecious stones, rice, tea, tobacco, etc. also servedas money during the primitive days of human civilisation.Professor Paul Einzig6 has recorded some 172 commoditiesin the list of primitive money.

Animal and commodity money, however, sufferedfrom such drawbacks as:

1. Lack of uniformity and standardisation;2. Inefficient store of value due to the problem

of storing and loss of value with the lapse oftime;

3. Lack of easy transferability due to difficultiesof portability; and

4. Indivisibility.III. Metallic Money. Commodity money gradually

transformed into metallic money when precious metalslike gold, silver, copper, bronze, etc. were discoveredand used as a medium of exchange with the growthof economic civilisation from the pastoral to the commercialstage of society. Use of metals as money in the courseof time paved the way for the development of coinagesystem in the economy.

As historian Toynbee narrates, the coin age beganaround 700 B.C. in Lylia, a Greek city state. Imperfectionsof the metallic money in size, shape and weight, etc.have been removed with the minting of coins by states.

Metallic money had, however, the following drawbacks:1. On account of its bulkiness, a large sum of

money in terms of coins was not easily portable.2. It was unsafe to carry and could be easily lost

or stolen.3. Rapid transactions were not feasible by using

coins as a mode of payment.The coin era, however, lasted till the 17th century.IV. Paper Money. In the 17th and 18th centuries,

paper currency emerged as “token money.” In modernera, paper money has become popular. It originallycame as paper receipts against metallic money whichwas found unsafe to carry by itinerant merchants. Thenwith the shortage of metals, state authorities thought

6 MONEY, BANKING, INTERNATIONAL TRADE AND PUBLIC FINANCE

of introducing paper currency — a representative papermoney — which was convertible. In the later stages,however, it became “fiat money”, i.e., inconvertiblelegal tender. Being a representative money, paper currencies,thus, economise the use of standard coins or metals.

V. Bank Money. In the final stage, along withpaper money, another form of convertible money developedin the form of credit money or bank money, owing tothe growth of banking institutions and credit creationactivities and cheque system of payments in modernera. In modern commerce, large transactions are carriedon through cheques and only small transactions aremanaged through currency money.

In modern economy, coins, paper notes and bankmoney, i.e., cheques issued against demand deposit,all serve as money. But even today, sometimes otherthings have also served as money. In Germany, forexample, in the post-war period (1945-46), cigarettesand cognac were used as money when its financialand economic condition had greatly deteriorated. Sometimeago, due to shortage of token coins in India, couponsand stamps were used as money.

In short, anything and everything can serve andhas served as money provided it is generally recognisedand accepted as means of payment. But all things cannotserve as a good money. Good money should possessthe attributes of general acceptability, cognisability,portability, divisibility, maleability, durability, uniformity,adequacy and stability of value.

3. FORMS OF MONEY IN AMODERN ECONOMY

In the modern monetary systems, there are threeforms of money in actual use: (i) Metallic Money,(ii) Paper Money, and (iii) Credit Money.

The first two kinds of money are in the form ofcurrency money and the last one is credit or bank money.

Metallic Money

Metallic money refers to coins made out of variousmetals like gold, silver, bronze, nickel, etc. A coin isa piece of metal of a given size, shape, weight andfineness whose value is certified by the State. The rightof minting coins is the monopoly of the State. Thedepartment of government minting coins is called theMint.

Coins are of two types: (i) Standard or full-bodiedcoins and (ii) Token Coins.

A coin is regarded as a standard coin or full-bodiedcoin if its “face value” (i.e., the exchange value fixedby the issuing authority and embossed on it) is equal

to its “intrinsic value”, i.e., the worth of the metalliccontent of the coin. In the past, coins made from preciousmetals like gold and silver were regarded as standardcoins and the monetary systems adopting them werereferred to as “gold and silver standards.”

On the other hand, a token coin refers to a coinhaving the face value of more than its intrinsic value.Token coins are usually made of cheap metals likenickel, copper or bronze. They are generally of lowerdenominations. Token coins are issued primarily as aform of subsidiary money which is to be used for smallchange only. They are useful as a convenient meansfor the payment of small sums.

Since all types of coins are issued by the Stateauthorities — either the Treasury or the Central Bankof the country — they are regarded as legal tender.Legal tender money’s acceptability is sanctioned or backedup by law; hence, a refusal to accept it is a punishableoffence. Standard coins are, however, unlimited legaltender in the sense that they are acceptable as a meansof payment of up to any amount, while token coinsare limited legal tender as payments can be made upto a small sum only.

Paper Money

Paper money consists of currency notes issued bythe State Treasury or the Central Bank of the country.In India, one rupee notes are issued by the Ministryof Finance of the Government of India, while all othercurrency notes of higher denominations are issued bythe Reserve Bank of India.

In modern era, the use of paper money is widespreadowing to its following advantages:

1. Paper money is economical. Obviously, paperis much cheaper than any metal.

2. Paper money economises the use of preciousand scarce metals by serving as representativemoney.

3. It is very convenient to carry paper moneyfrom place to place.

4. It is also easy to store paper notes. Currencynotes of lakhs of rupees can be stored in asmall vault.

5. It is easier to count paper notes than metalliccoins.

6. Supply of paper money is easily adjustable asper the need of the economy. Thus, paper moneyis of great monetary and fiscal advantages tothe government.

However, paper money has also some disadvantagessuch as:

THE NATURE OF BARTER AND MONETARY ECONOMY 7

1. There is the danger of overissue of notes asthey can be easily printed and their supply dependsupon the whim of the government. An excessivemoney supply may lead to rising prices or inflationthereby reducing the value (purchasing power)of money.

2. Paper money lacks general acceptability if thepeople lose confidence in the government forone reason or the other.

3. Durability of paper money is much less thanmetallic money.

4. Paper money can circulate within the domesticeconomy only. For making foreign exchangepayments, paper money is not acceptable unlessit is a key currency like the dollar.

But these disadvantages are surmountable andcontrollable by a proper check. Therefore, paper moneyis in wide circulation.

Credit Money

In modern economic societies, with the developmentof banking activity, along with paper money, anotherform of convertible money has developed in the formof credit money or bank money. Bank demand deposits,withdrawable by issuing cheques, have started functioningas money, and cheques are now conventionally acceptedas a mode of payment by the business community ingeneral. It must be noted that a cheque by itself isjust a credit instrument. Actually, it is the bank depositbehind the cheque that serves as money.

Bank money today constitutes a major part ofmoney supply in advanced countries. In many countriessuch as America, it amounts to nearly 90 per cent ofthe total money supply. In poor countries, the proportionof currency money widely exceeds that of bank money.

Indeed, in a modern economy, currency moneyand bank money together constitute the total stock ofmoney or money supply. Currency money is a legaltender and has general acceptability, whereas bankdeposits are conventional money and lack generalacceptability.

In fact, though the use of money has become all-pervasive throughout the world, certain backward areasare still non-monetised. Barter is, therefore, not completelyobsolete. In India, for instance, some Adivasi areasare still unfamiliar to the use of money.

4. NATURE OF A MONETARYECONOMY

A monetary economy is one in which money iswidely used and accepted as a medium of exchange.It is a monetised economy.

Unlike in barter economy, in an organised marketof a monetary economy, money buys goods and goodsbuy money — but goods do not buy goods directly. Inshort, in a money economy, goods are exchanged indirectly— goods are sold for money and money purchases goods.

In a monetary economy, money serves as a meansof payment. It is the general and permanent abodeof purchasing power. Thus, all transactions are measuredand recorded in terms of money. Money serves as aunit of account in a monetary economy. Money beinga common denominator of value, the price system hasemerged as a distinct characteristic of monetary economy.

As compared to the barter system, exchange processis more efficiently organised in a monetary economywhen money is used as a medium of exchange. Theuse of money in the process of exchange has far-reachingconsequences when it reduces the amount of informationrequired in concluding a transaction. All the inconveniencesof barter like want of double coincidence, want of ameans of subdivision, want of efficient store of wealthetc., are automatically eliminated in a monetary economy,cost and time involved in searching for a double coincidenceis saved. Further, the use of money and consequentemergence of the price mechanism simplifies the processof transactions by condensing the complex signallingmechanism of prices into simple assimilable forms ofinformation.7

Money serves as an indispensable factor of productionin a monetary economy for enabling its output to increaseand diversify.8 A higher level of output and more varietiesof goods and services are enjoyable by the people ina monetary economy as compared to a barter economy.Indeed, the flow of money and credit enables and encouragesentrepreneurs to innovate and accelerate the processof growth.

The institution of money is a valuable socialresource of a monetary economy. Money servesas a pivot around which all economic activ itiesmove. It is the key to all the wealth. Peoplework for the sake of money, since money is regardedas a prominent means to buy formal happinessin a modern money economy.

Monetary economy has a greater degree of liquiditythan a barter economy. Money being the most liquidasset, it serves as a link between the present and thefuture in a monetary economy. There is an absenceof any such link in a barter economy. Further, unlikethe barter system, a monetary economy contains bankinginstitutions. There are commercial banks and the CentralBank as the apex financial institution. There exists acapital market too for long-term credit activities. Creditis the edifice of modern commerce which rests on theinstitution of money, especially bank money.

8 MONEY, BANKING, INTERNATIONAL TRADE AND PUBLIC FINANCE

A distinguished feature of a monetary economy isthat it is covered with a veil of money. There is a circularflow of money side by side and corresponding to thereal flow of economic transactions. In fact, there is acontinuous flow of money payments and spendings amonghouseholds and the government sector of a modern monetaryeconomy.

Money matters much in a modern capitalist economy.It is the embodiment of Adam Smith’s “Invisible Hands”.Money is the bloodstream of the organic compositionof a modern monetary economy. It serves as a greatwheel of circulation and a great instrument of commerce.9

Every fabrication of the modern economic society inits present complex form may be attributed to moneythat has served as a means of valuing, distributingand contracting for commodities of various kinds.10

No doubt, money has conferred inestimable benefitsto modern man’s living and progress.

5. CIRCULAR FLOW OF MONEYA money economy is basically characterised by

the circular flow of money. It involves a continuousflow of money payments in its economic activities. Moderneconomic life is interdependent. Thus, in the want-satisfying activity, goods produced by one are exchangedfor the consumption of the other. There are, thus, twomajor classes in the economic process. These are: producers(or firms) and consumers (or households). The portionof money income, which the consumers spend on thepurchases of goods and services in a economy, passesthrough the hands of many people — the retailers,wholesalers and manufacturers, i.e., the producer class.These producers then again use money in investmentsand it thus passes to the consumers in the form ofwages, salaries, interest, rent, profit, etc. In short, thereis a circular flow of money between firms and households(in a closed economy).

A simple model of such type of circular flow isillustrated in Fig. 1.

As a matter of fact, there are real flows and monetarycounter-flows. In a simple two-sector (firms and households)closed economy model, thus, the real flows constitutethe movement of productive factor resources from thehouseholds sector to firms, while real output (finishedproducts) of the firms move to the household. In abarter economy, money being used as a medium ofexchange, there are monetary payments involved behindreal transactions. Thus, there are “monetary counter-flows” to the “real flows”, which being circular in movementconstitute the “circular flow of money”. Thus, moneyflows from firms to households, when firms purchasefactor services and, to that extent, firms’ spendingsdetermine the income of the owners of factors of productioncomprising the household sector. To state in elaborateterms, the firm pays the prices to the factors of productionwhile employing them into the productive channels.This constitutes the cost of production which in turnbecomes the income of households. Thus, in an aggregatesense, the value of national income can be viewed interms of factor cost or factors’ earnings in total. Similarly,when households spend on real output produced byfirms, real goods and services flow from firms to householdswhile money flows from households to firms. What householdsspend on firms’ products is equivalent to the pricesof products which indicate the value of real outputturned out by the firms. Thus, the value of nationalproduct can be measured by aggregating their marketprices.

Continuous or unchanged real flows and moneyflows in an economy would imply that the same amountof goods and services are produced at constant pricesover a period of time. Thus, the main condition ofconstant prices is that the flow of goods and servicesshould remain intact and there should be no leakageof money in its circular flows, i.e., whatever has beenpaid out to households by the firms should come backthrough their consumption expenditure.

In the above given very simple model of circularflow, we may now incorporate a saving element (whichimplies a sort of leakage from the flow of income-expenditure).Saving is the unconsumed part of income or unspentmoney left with households. If the savings of householdsare not hoarded but made available to the loanablefunds market, i.e., capital market, the businessmen (firms)can borrow them for investment purposes. When savingtends to be equal to investment or vice versa and thecircular flow of money remaining undisturbed, economicactivity and the price level would remain constant inthe economy. Fig. 2 illustrates such a circular flow.

It is obvious that the circular flow of money wouldremain undisturbed if the flow of funds into the capitalmarket (i.e., savings) and the flow of funds out of thecapital market (i.e., investments) are equal. Any disequilibrium

Fig. 1. The Circular Flow of Money — A Simple Model

CONSUMPTION EXPENDITURE

CIRCULAR FLOW OF MONEY

PRODUCTION EXPENDITURE

(FACTOR PAYMENTS)

FIRMS HOUSE- HOLDS

THE NATURE OF BARTER AND MONETARY ECONOMY 9

in the savings and investments, of course, will reflectitself either in the decrease or increase in the circularflow of money.

6. MONETISATIONA well organised system of exchange in an economy

based on the use of money is described as monetisation.Under monetisation, money is introduced as a mediumfor the smooth operation of transactions of goods andservices for the mutual satisfaction of wants.

A barter economy is non-monetised. Monetisationis a process under which the barter and subsistencesectors of an economy are brought and tied up withits monetary exchange sector. Monetisation processimplies extension of monetary exchange to the bartersystem. Monetisation, in essence, means conversionof barter into the monetary economy.

Existence of non-monetisation in a modern economyreflects the stage of its economic backwardness. Thedegree of monetisation is, thus, an index of a country’smonetary development and general economic advancement.In a backward economy, usually, a large part is non-monetised. The non-monetised sector is subsistenceand stagnant. This sector is, by and large, self-sufficient— where production is just meant for self-consumption.There is little marketable surplus. And, a very limitedexchange, if any, takes place on a barter basis. Useof money is unfamiliar to the people in the sector. Asper an estimate made by Dr. Madalgi, during the mid-seventies, about 15 per cent of Indian economy’s outputin rural hinterland and Adivasi areas was non-monetised.11

This non-monetised output includes: (i) partly bartertransactions, (ii) partly output for self-consumption, and(iii) payment of wages to workers in kind.

Expansion of money supply in such successivestage of economic development spreads the processof monetisation in the economy. With economic progress,

when exchange complexities tend to multiply, when agriculturebecomes more and more commercialised with an increasingamount of marketable surplus, diversified consumptionpattern and varied production pattern, the need forintermediation of money to effectuate smooth and rapidtransactions becomes more and more intense which pavesthe way for the expansion of the monetised sector bybringing the barter sections under its purview.

Factors Affecting Monetisation

The pace of monetisation in an economy is affectedby a multitude of factors:

1. Difficulties of Barter. The difficulties andinconveniences of the barter system tend to be morepronounced and intense with the growth of trade andincreased overdependence of a progressive economiccommunity which work as a propelling force to introduceand use money as a medium of exchange.

2. Extent of Division of Labour andSpecialisation. With the increased application of complexdivision of labour in the process of production andmore diversified output through growing specialisationand integrated system of production, the need for increasedmonetisation is felt in the economy.

3. Transition of Subsistence Economy intoExchange Economy. When a self-sufficient villageeconomy is lifted up from its subsistence level throughrural industrialisation process and commercialisationof agriculture, monetisation automatically occurs.

4. Development of Banking. Extension of bankingactivities and other financial institutions in unbankedareas and backward regions obviously lead to an increasedavailability and use of money which helps rapid monetisationof the economy.

5. Development of Trade, Transport andCommunication. Size of market, volume of trade andcommerce and consequent growth of exchange transactions

HOUSE- HOLDS

CIRCULAR FLOW OF MONEY

PRODUCTION EXPENDITURE (FACTOR PAYMENTS)

CONSUMPTION EXPENDITURE

FIRMSBORROWINGS

(INVESTMENT)CAPITALMARKET

SAVINGS

Fig. 2. The Circular Flow of Money — An Extended Model

10 MONEY, BANKING, INTERNATIONAL TRADE AND PUBLIC FINANCE

are facilitated and encouraged by the increased networkof transport, infrastructure and development of communicationsystem in the country which goes a long way in acceleratingthe process of monetisation.

6. Industrialisation. With the growth ofindustrialisation and capital formation, the pace of economicdevelopment increases which leads to a rapid growthof the secondary and tertiary sectors of the economywith diversified occupational structure and rapidity oftransactions calling for a greater degree of monetisationin the economy as a whole.

7. Demonstration Effect: With the increasedcontacts between urban and rural population, whenthe latter is impressed by the consumption pattern ofthe former and when due to this demonstration effect,the rural folk is induced to produce more marketablesurplus of their goods for selling it to the urban areasand earning money to buy urban goods, monetisationis automatically accelerated.

8. Government Sector. With the extension andintensification of the functions of the government ina welfare state, the budget is enlarged and more andmore tax revenues are collected and increased publicexpenditure is incurred. This necessitates increased useof money. Further, under the technique of deficit financing,the government resorts to the injection of more andmore money into the supply stream which is also absorbedby the non-monetised sector to some extent and thepace of monetisation is accelerated as a result.

9. Degree of Development. In general, degreesof development and monetisation are interconnected.Monetisation is the cause of, as well as the consequenceof, economic advancement. Monetisation facilitates morespecialisation and rapid economic transactions andenlargement of the size of market and consequentlyrapid and smooth economic development. So also, economicdevelopment needs more and more use of money asa more sophisticated instrument of exchange and createsscope for monetisation.

REFERENCES

1. Jevons, W.S.: Money and the Mechanism of Exchange,p. 5.

2. Spalding, W.F.: A Key to Money and Banking, p. 13.

3. Crowther, G.: An Outline of Money, p. 3.

4. Ibid., p. 3.

5. Keynes, J.M.: A Treatise on Money, Vol. I, p. 3.

6. Einzig, Paul: Primitive Money, pp. 507-509.

7. Walters, A.A. (ed.): Money and Banking, p. 9.

8. Ibid., p. 9.

9. Chandler, L.V.: The Economics of Money and Banking,p. 5.

10. Jevons, W.S.: Money and Mechanism of Exchange,p. 2.

11. Madalgi, S.S.: “Trends in Monetisation in the IndianEconomy,” Reserve Bank Staff Occasional Papers, June,1976.

I. QUESTIONS FOR DISCUSSION

1. (a) What is a barter?

(b) What are the inconveniences of barter exchange?

2. Trace the evolution of money, in brief.

3. What are the forms of money in a modern economy?

4. Describe briefly the nature of a monetary economy.

5. Write a note on: Circular Flow of Money.

6. (a) What is monetisation?

(b) Enumerate the factors determining the extent ofmonetisation in an economy.

II. OBJECTIVE TEST

1. Which of the following is an essential characteristic ofbarter economy?(a) Goods exchanged against goods.(b) Simple and a smooth system.(c) Lack of civilisation.(d) Inconvenience.

2. Barter exchange is not possible when:(a) a standard commodity is used in intermediation.(b) two persons have no mutual agreement on their

wants.(c) there is no money.(d) there is no common measure of value.

3. Invention of money is the outcome of:(a) people’s reasoning power.(b) the banking system.(c) difficulties of barter.(d) none of the above.

4. The Metallic Money contains:(a) token coins only.(b) all money.(c) standard coins plus token coins.(d) gold and silver only.

5. Token coin means:(a) coin having face value more than its intrinsic value.(b) coin having face value the same as intrinsic value.(c) coin given as bank’s token against cheque.(d) none of the above.

6. Standard coin means:(a) a full-bodied coin.(b) silver standard.(c) legal tender.(d) RBI coin.