Chapter 1

Definition to NI

National Income and its Measurement

National income is the total sum of incomes of all individuals plus income of the government in a country. Or National income is the money or market value of all goods and services produced by the people with the economic resources of a country in addition to foreign remittances during one year.

Some important steps to be remembered:

National income is measured for one year. Only the money or market value of output is to be calculated not the physical quantity. National income does not include the income earned from illegal activities such as smuggling, kidnapping, theft etc.

Various concepts of NI
Following are the various concepts of national income which are given as under GDP or (Gross Domestic Product) GNP or (Gross National Product) NNP or (Net National Product) National income at factor cost. PI or (Personal Income) DPI or (Disposable Personal Income)

GDP or (Gross Domestic Product)

GDP shows the money value of all final goods and services produced only within the geographical boundaries of a country either by nationals of that country or foreigners during one year. GDP (Y ) is the sum of the following: Consumption (C) Investment (I) Government Purchases or spending (G) GDP = Y = C + I + G

GNP or (Gross National Product)

GNP or Gross national product is the money value of all final goods and services produced by the people within and outside the country for one year. GNP = GDP - incomes earned by the foreigners working in that country + incomes earned by nationals of that country working abroad. GNP = GDP + Foreign remittances foreigners earning GNP (Y ) is the sum of the following: Consumption (C) Investment (I) Government Purchases or spending (G) Exports (X) GNP = Y = C + I + G + (X-M)

(M) means Import

Consumption (C):
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The spending by households on goods and services

Investment (I):

The spending on capital equipment, inventories, and structures, including new housing

Government Purchases (G): Net Exports (NX):

The spending on goods and services by local, state, and federal governments Exports minus imports

NNP or (Net National Product)

NNP is the net market or money value of all output after deducting depreciation allowances from GNP. In producing GNP we consume or use up some capital like equipments and machinery, these capital goods falls in its value due to wear and tear in the production process. This wear and tear of machines is called depreciation. For keeping these machines in working order we keep an amount which is called depreciation allowance NNP = GNP Depreciation allowances

PI or (Personal Income)

Personal income = National income Corporate income tax undistributed profit + transfer payments (pension, old age benefits, unemployment fund etc) In personal income of individual direct taxes are also included such as income tax.

DPI or (Disposable Personal Income)

DPI is the amount which is left with individuals after paying direct taxes.This is the money income which individuals can either spend or save as possible as they can according to their needs and wants. DPI = Personal income Direct tax.

MEASUREMENT OF NATIONAL INCOME

There are three methods which are used to measure National Income:

PRODUCTION METHOD

The national income is calculated by adding up the net values of all production that has taken place in different sectors of economy during a year. in this method the economy is divided into various sectors such as. Agriculture industry Infrastructure Banking Health Education Transport and communication etc. The net market or money value of all these sectors is added and the result is coming as national income. Macro Economics Note, Arranged by: Habibullah Qayumi 2

Example..

Production sectors Agriculture Industry Trade Transport & communication Health & education Banking NATIONAL INCOME

Net value (billions) 340 210 290 200 250 160 1450

INCOME METHOD OR NI AT FACTOR COST

In this method the income of all individuals in a country is calculated which they earn in return of services they provide for four factors of production such as, Land, Labor, Capital and Entrepreneurship Thus national income is the sum total of Rent, Wages, Interest and profit which are received by people from four factors of production. FOPs = land + Labor + capital + Entrepreneur and N.I = Rent + Wage + Interest+ Profit Example: Source of income Wages and salaries Rent Interest Profit National income

Amount (billions) 400 300 320 450 1470

EXPENDITURE METHOD

National income can also be measured by adding the total expenditure made by the people and government on consumption of goods and services and investment in a country during a year. Example: Expenditure Amount (billions) Private consumption exp 400 Private domestic investment 200 Government consumption 350 Government investment 300 Export minus import 150 National Income 1400

Circular Flow of National Income in two Sector Economy

The modern economy is monetary economy. In the modern economy money is used as medium of exchange. While analyzing the circular flow of income in

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two sector model of the economy, we assume there are only two sectors in economy:

Household sector

The business sector hires the service of factors of production owned by household sector and pays for those services in terms of wage, rent and interest to household sector.

Business sector

The household sector buys goods and services from business sector and spends its entire income on consumption in this way the income of household sector become the revenue of business sector and national income circulates.

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Difficulties in measuring NI
Inadequate statistical data:
In under-developed countries since scientific methods of collecting data are not used, so accurate information is not obtained and NI is under estimated.

Lack of trained staff:

Most under developed countries do not have trained staff for data collection which leads to the problem of estimating exact NI.

Illiteracy:

Due to illiteracy, most of the producers do not maintain proper records of production, cost and income which lead to under estimated NI.

Many sources of income:

Some people get their incomes from many other sources It is very difficult to compute their income from different sources and in this way the exact figure of NI is mislead.

No-cooperation of the people:

In most of under-developed countries, people do not cooperate with data collecting staff.

Non-marketed goods and services:

In estimating the national income, only those goods and services are included for which the payment is made the unpaid or non-marketed goods and services are excluded such as production for self consumption, help or volunteer etc

Under-ground economy:

In under-developed countries, about 30% of the economy is under-ground the officially declared incomes are less than the actual incomes.

Significance of NI
It seeks to measure the level of production in the country in one year. We can know whether the economy is growing, stagnant or declining by comparing it with the previous years. National income shows contributions by various sectors of economy. Living standard and economic welfare of the people can be compared with other countries.

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CHAPTER 2

Aggregate Consumption and Saving

Concept to Consumption
That part of consumers disposable income which is used to spend on the general utilization of goods and services is by definition called consumption. Generally income can be divided into two parts, consumption and saving & it can be shown as: Y=C+S C shows aggregate consumption which involves both all private as well as government consumption expenditures in a country.

Propensity to consume or consumption function

A consumption function is a positive or direct relationship between consumers disposable income and consumption. In other words, consumption function indicates that consumption of consumers depend on their level of income, more is the income, higher will be the rate of consumption and vice versa. Consumption function is also known as propensity to consume which is shown as.. C = f (Y)

Two concept of consumption function

An American economist J.M Keynes developed two concepts for propensity to consume or consumption function these are..

1- Average propensity to consume (APC)

(APC) is defined as a ratio of total consumption to total disposable income at different levels. It is calculated by dividing the amount of consumption by disposable income for any given level of income. For example, when nation's disposable income is Afs. 2000 billion and consumption expenditure is Afs. 1500 billion therefore, 1500/2000 = 0.75. this means that out of 2000 billion income , 75% will be used for consumption. APC declines as income increases because the proportion of income spent on consumption decreases as people tend to save more out of increased income. APC = C/Y

2- Marginal propensity to consume or (MPC)

The concept of MPC is very important in macroeconomics , J.M Keynes has defined marginal propensity to consume as the relationship between a change in consumption (C) that resulted from a change in disposable income (Y). It is found out by dividing change in consumption to a given change in disposable income. MPC shows that how much of change in income is being consumed. Thus MPC = C/ Y

Tabular explanation of APC and MPC

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Concept of Saving
That part of households income which is not spent on consumption is defined as saving. In other words, saving is the act of not consuming all of one's current income or whatever is not consumed out of disposable income is called saving. The economy's saving equation is Saving = Disposable income consumption or S=YC

Motive for saving

The motive for saving is divided into two major consideration..

1. Subjective considerations

Foresight: people save money as a provision against some unforeseen circumstances which might arise in the future. A few other accumulate wealth for their dependents, all such consideration can be constituted under the heading foresight. Social considerations: wealth gives power over others in the economic sphere and also political and social influence. The desire of prestige ,power and respect in social life actuates human being to save

2. Objective considerations

Security of life and property: if there is security of life and property in a country, the saving is encouraged. Facilities for investment: if facilities of profitable investment are available, then saving is stimulated.

Saving function
Saving function or propensity to save is the direct or positive relationship between saving and disposable income of individuals. In other words saving is the function of income, as much as income is increasing saving will also tend to increase and vice versa. Both consumption and savings are positively correlated with the levels of income. Higher is the income, more will be the tendency for consumption and saving. Thus S = f (Y)

Concepts of saving function.

APS (Average Propensity to save) MPS or (Marginal Propensity to save) Average propensity to Save (APS): the ratio of savings to income APS = S / Y Marginal propensity to Save: the ratio of change in saving to change in income. MPS = change in saving/ change in income Note : MPC + MPS = 1

Keynesian Psychological Law of Consumption

J.M. Keynes in his book General Theory analyzed the consumption behavior of the community on the basis of human behavior. He presented a Law which is known as Psychological Law of Consumption. According to this Law, the level of consumption in a community depends upon the level of disposable income, as income increases, consumption also increases but at a decreasing rate or it increases not as fast as income. According to J.M. Keynes that as a psychological behavior of people the increase in consumption is less than the increase in income and this is what given as a Psychological Law of consumption. Macro Economics Note, Arranged by: Habibullah Qayumi 8

Properties to the Law of Consumption

The level of consumption is directly functionally related to the level of disposable income. C = f ( Y ). The rise in the level of consumption is less than the rise in the level of income or consumption is increasing but at decreasing rate. C < Y. As the level of income increases, the household s devote a part of incremental income to increase in consumption and the other part to increase saving. Symbolically Y = C + S

Chapter 3

Investment
The word investment in economics is used as a process which refers to all those expenditure made by individuals, businesses and Government on the purchase of new plant, machinery, the building of new houses, factories, schools and construction of roads etc. in other words, It is the process of increasing the existing assets, capital, properties, and wealth of private as well as government sectors in a country.

Investment function
Investment function is broadly categorized into two main types: Induced & Autonomous

I- Induced Investment

Induced Investment is the change in Investment which is induced by the change in National Income, which means that such type of Investment is influenced by the change in income. Induced investment is the direct or positive function of national income which signifies that as much as the real national income rises, the level of investment also rises and vice versa. Thus I = f (Y) Schedule to Induced Investment Income (Billion AFN) Investment (Billion AFN)
200 300 400 500 600 30 50 70 90 110

II- Autonomous Investment

The Investment which is not influenced by the changes in national income is called autonomous investment. In other words, an autonomous investment is independent of the level of national income. When investment is influenced not by national income but by other factors such as, increase in population, level of technology, rate of interest and by the expectation of future economic growth then such type of investment is known as autonomous investment. Thus: Autonomous Investment is the function of following factors Rate of interest Level of population Level of technology Expected rate of profit Macro Economics Note, Arranged by: Habibullah Qayumi 9

I = f ( Y, i, P, Tech, Ep ) In the graph it is shown that autonomous investment curve Ia is a horizontal straight line which shows no relation to income level. For example, when national income is 200(b), the autonomous investment is 10(b). If national income increases to 500(b), the autonomous investment remains same as 10(b) and so on. In case, there is an introduction of new technology, or the rate of interest falls, or if the businessmen expect the sales to grow more. All such factors induced people to increase investment more and the autonomous investment curve shifts upward from 10(b) to 15(b).

Determinants of Investment

Rate of interest Expected rate of return or marginal efficiency of capital (MEC). Rate of interest: The rate of interest that commercial banks offer if it is high people don't invest just put their money in the bank but if the interest rate is low people invest their money to get more profit. Thus investment is an indirect or inverse function of rate of interest, higher is the rate of interest lower will be the level of investment and vice versa. I = f ( I ) Marginal efficiency of capital Expected rate of return or MEC is a Keynesian concept. According to J.M Keynes marginal efficiency of capital is the expected annual rate of return (profit) which the investor expects from investment during specific period of time. MEC or expected rate of return is obtained from dividing expected profit by investment made multiplied by 100. For example a businessman invests 10000 in a capital asset or project and he expects 1000 as a return or profit per year. Then MEC = 1000/10000 100 = 10% MEC and Rat of interest. Marginal efficiency of capital and rate of interest are the two important factors which affect the volume of new investment in a country. A new investment can take place if MEC is greater than the prevailing rate of interest, as long as the MEC is higher than the rate of interest, the investment will be made till the MEC and the rate of interest are equalized. But, if MEC is coming less than (i) then no investment will take place. For example: If MEC is 10% and i is 8% MEC > i = Investment MEC = i = Depends MEC < i = No Investment Factors effecting MEC The MEC is influenced by various factors, such factors are given as under.. Demand for the product Current rate of investment Rate of growth of population Technological development Rate of taxes Macro Economics Note, Arranged by: Habibullah Qayumi 10

Investment Multiplier Multiplier is a Keynesian concept. According to J.M Keynes, when an investment take place in the country, the national income rises many times of its own size or a change in investment brings about multiple change in national income such process of multiple change in income to change in investment is known as investment multiplier. Thus it is the ratio of the total change in income to the initial change in investment, which is shown as K=Y/I K = change in income / change in investment Where K is the multiplier. Example: If the national income increases by Afs. 1000 billion as a result of an increase in the level of investment by Afs. 100 billion the numerical size of multiplier would be K = 1000 / 100 = 10
Initial investment (I)
100

Change in income
100 90 80 60 50 40 20

Change in consumption
90 80 60 50 40 20 20

Change in savings
10 10 20 10 10 20 0

100

440

360

80

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CHAPTER 4

Theory OF Public Finance

Concept to Public Finance

Public Finance is a particular branch of economics which studies how the state collects its revenue and how it makes expenditure to perform its various functions. Thus in macroeconomics the study of government income and expenditure is called public finance.

Division of Public FINANCE

Public finance can be divided into two main following headings. Public expenditure and Public revenue

PUBLIC EXPENDITURE

The government of every country is taking active part in the organization of its country. To improve and develop social, economic and political conditions of a country the government makes some expenses on defense, police, courts, civil administration, public education, public health, transport and communication, energy irrigation etc. all such expenses of the government is known as public expenditure.

Causes of Growth of Public Expenditure

Public expenditure has now-a-days enormously increased due to expansion of the state activities. The main factors which have contributed to the increase in the government expenditure are as under:

Defense: The foremost duty of govt. of every country is to defend its

country from external aggression. For this purpose, the state has to spend huge sums on establishment and maintenance of Army, Navy and Air Force which increase the state expenditure

Police: To maintain internal peace and to protect the life and property of

its citizens, the government maintains police. Traffic police is needed to regulate traffic in big towns and highways. Thus higher maintenance of police leads to increase state expenditure.

Courts: in order to settle disputes among people and punish those who

violate laws of the country, courts are established. The state has to provide funds for such courts and in this way state expenditure go high.

Public Education and Health: Modern governments have the

responsibility to provide good quality education and health facilities to their people. To achieve this objective, the state spends money on schools, colleges, universities, research organizations, dispensaries and hospitals which boost up state expenditure.

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Infrastructures: To construct roads, highways, motorways, bridges and

railway tracks the government spends a very huge amount of money which leads to increase state expenditure.

Energy and Irrigation: Energy is the key to all industrial and social
progress. So the government provides funds for the development of energy resources. It explores oil, gas, and coal reserves. It also establishes power houses. Apart from energy to develop Agriculture sector it also undertake irrigation schemes in terms of Dams, rivers and canals which are built through public expenditure.

Classification of Public Expenditure

Non developmental or Unproductive Expenditures Developmental or Productive Expenditures

Non developmental Expenditures

Non developmental or non productive expenses of the state are those expenses from where the revenue or income to the government is not generated. In other words, the socio-economic development is not taking place by such expenditure. The non productive expenditures of the state are broadly divided into the following factors. Further it could be explained as follows: Debt Repayment or Debt Servicing Defense Expenditures Administrative Expenses Subsidies and Grants

Debt Repayment
Debt servicing includes the expenses made by the government in terms of repayment of public loans including the principal amount and the rate of interest. Repayment of internal and external loans with particular interest rates contributes about 20% to 30% of the total state expenditures in under developed countries.

Defense expenditures
The foremost duty of govt, of every country is to defend its country from external aggression. For this purpose, the state has to spend huge sums on establishment and maintenance of Army, Navy and Air Force which increase the state expenditures to the outstanding rates. Major amount round about 40% of the total state budget is allocated for defense purposes each year.

Administrative Expenses
The government has to maintain Law and order in the country so that life and property of the people may be protected. In order to achieve such objective, the government has to make outstanding expenses on the maintenance of police , administration of courts for justice to enforce the policies of the state. All such expenditures contribute about 5% to 10% of the government budget in a fiscal year of LDC.

Subsidies and Grants

The government offers a lot of subsidies each year to various sectors of the economy particularly to agriculture and industrial sectors. Here the price is lowered through concessions where some part is paid by the government and some by the buyer. Government subsidies are assigned about 2 to 3% of the total public expenditures. Each year Federal State also has to give certain Macro Economics Note, Arranged by: Habibullah Qayumi 13

grants to provincial government which leads to increase the overall spending of central government. Money spent on various developmental projects of the country by the government to stimulate and strengthen the overall economic growth and is productive in nature to generate revenue to the state, such as, spending on irrigation and power, rail and roads, transport and communications, agricultural and industrial improvement, health and education etc. All such spending on the mentioned projects by the public authorities are known as Developmental or Productive Expenditures.

Developmental or productive expenditures

Principles of public expenditure are some rules and regulation under which the government of a country makes spending on the performance of its various functions. A prudent State must follow the following principles in the best utilization of public expenditures. Principle of maximum social benefit Principle of Economy Principle of Elasticity Principle of Productivity Principle of Equality According to this principle the public expenditure must be made on those items which are more important and beneficial for all citizens or which could lead to maximization of utility. In other words, the state expenditure should aim at benefiting so many people, instead of few people. The government should bring more welfare to its citizens through expenditures. Thus, this principle is in accordance with Maximum General Benefit.

Principles of Public Expenditures

Principle of maximum Benefit

Principle of Economy

This principle requires that government should spend money in such a way that all wasteful expenditure is avoided. By economy is meant that public expenditure must be increased without any extravagances and misuse. If the hard-earned money of the people collected through taxes, is thoughtlessly spent, the public expenditure will not confirm to the principle of economy.

Principle of Elasticity
According to this principle the government expenditure policy should be such like that State could bring change in the size and direction of its expenditures in accordance with its needs. In other words, public expenditure policy must be elastic, rather than rigid.

Principle of Productivity
According to this principle the public expenditures should promote productive activities in the country. In other words, the government expenses should be devised in such a way that they could promote and improve the developmental activities of the economy rather than non developmental.

Principle of Equality
Such principle refers to the equal distribution of wealth to remove the gap between rich and poor class of the society. If due to unwise public spending, Macro Economics Note, Arranged by: Habibullah Qayumi 14

wealth gets concentrated in a few hands, then its purpose is not served . The money really goes waste then.

Effects of Public Expenditures

Following are the various effects of pubic expenditures on the economy. Effect on production Effect on Employment Effect on Wealth Distribution Effect on Economic Stability and Growth

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PUBLIC REVENUE

Public revenue means government income. For the performance of multifarious functions by the State, money is needed. Therefore, every state tries to meet its annual expenditure from taxes and other sources other than taxation, such collecting of money funds by the government from different Tax and non Tax sources are known as Public Revenue.

Sources of public Revenue

The revenue of the state can be classified under the following headings. Revenue from private income Irregular revenue Revenue from state ownership

1- Revenue from private income

Under this heading the government derives revenue from citizens by Taxation Fees (The interest of Govt. is social welfare, so the cost of the service is less then actual service) Prices (the interest of Govt. is benefit)

Taxes
A tax is a compulsory contribution by the people to the public authority to cover the cost of services rendered by the state for the general benefit of its people. It is the first major source of state income to meet its expenditure

Fees
Fee is also a compulsory payment made by those who get a particular government service in return. The fee is intended to cover a part of the cost of service rendered. It is less than the cost of service provided by the State. Educational fees, court fees, driving license fees and medical fees etc, are the best examples of the State fees. All such type of fees are sources of revenue to the state. The difference between a fee and price is that in a fee public interest is prominent, whereas, price is a payment for a service of business character.

Price as a Revenue
Price is a second major source of state revenue after the tax. Price is charged on the provision of specific goods and services to the people by the State Owned Enterprises. When public authority sells goods or renders a service, such as railway, buses and airlines fares, postal, telephone, hydroelectric, gas and water charges, charges on iron, steel, coal, oil, salt and other minerals are the best examples of price. The price paid by the buyer is equal to the value of good or service he receive.

2- Irregular Revenue.
Under this heading Grants or Donations and Penalties or Fines are included. a. Grants or Donations. which are given by the state of one country to another country or by the high level government to the lower level government ( central government to local government ) in the times of some natural disaster or War. Such donations are used by the state for the redevelopment and economic growth of that region.

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b. Penalties or Fines: Fines are imposed by the government as a penalty for violating the Laws of the state. it is also a compulsory payment. For example, violation of traffic rules is punished through fines. All such other fines are being collected as a revenue to the state and used for its economic development.

3- Revenue from state ownership

A government also obtains income from the different assets it owns. For example, it gets revenue through the rent or sale of state land, sales of forest wood, and from other productive government owned enterprises such as railways, postal and banking services, transport and communication services etc.

Taxation
A tax is compulsory contribution or payment by earned people to the public authority to cover the cost of services rendered by state for the general benefits of its people. Two main points from the above definition: Compulsory payment No claim for specific service in return.

Types of taxes
Direct Tax
A direct tax is that in which the incidence (final burden) and impact (initial burden) is on the same person. It is called direct because the government gets amount directly from the same person on whom it imposes tax. Income tax, wealth or property taxes are the example of direct tax.

Indirect Tax

An indirect tax is that in which the impact on one person and the incidence is on some other person. For example, in the case of saleable articles, firstly the tax is paid by the seller. But the seller shifts the burden to the customer. He raises the price of commodity and in this way the final burden of tax goes to the person who finally buys the commodity. Sale tax, custom duty and excise duties are the examples of indirect taxation.

Tax system
Proportional system of tax
The proportionate system of taxation was presented by classical economists. Under this system the individuals are required to pay tax in proportion to their income. The rate of tax remains same as the base changes. If for instance, the rate of tax is 5%, a man with an income of 1200 Af will pay 60 Af and another person with an income of 5000 Af will pay 250 Af to the state.

Progressive tax

The tax system is said to be progressive when the rate of tax increases as the tax base increase. For example, the monthly income of a person is 9000 Af and he is asked to pay 2% of his income to the government suppose further that his income rises from 9000 Af to 15000 Af per month, the government instead of taking 2% of his income in a tax asks him to pay 6%in the form of tax. Digressive tax :It is the combination of proportionate tax and progressive tax . Macro Economics Note, Arranged by: Habibullah Qayumi 17

Regressive tax : if the tax rate is decreasing for the improvement of a special class of the society .

Canons or principles of taxation

A good tax system by the state based on given certain principles Canon of equality Whenever govt. is imposing the tax on income basis of the people, according to their income. Canon of certainty Whenever govt. is imposing tax clearly when to pay , where to pay , and how much to pay etc. Canon of convenience Whenever govt. is imposing tax and service is in the bank and having clear area to pay . Canon of economy Whenever govt. is imposing tax in such policy that should be as least as possible it means effective and efficient. Canon of productivity Whenever govt. is imposing tax it should target that classes from whom govt. can collect more and more tax , from business class . Canon of elasticity Whenever govt. is imposing tax it should impose the tax policy in such way that will be flexible for the people .

Public Debts
The summation of all those loans which are raised by Government in the past time to cover its deficit in the federal budget over a given period of time is known as Public debts.

Types of Public Debts

1- Dead weight Debt Those loans which are taken by government for unproductive expenditures are known as Dead Weight Debt. In other words the debt utilization which has no real assets to cover the cost of loan is Dead Weight debt. 2- Active or Reproductive Debt The loans which are raised by the state for the reproduction of the economy, or developmental expenses are known as reproductive or Active Loan. 3- Passive Debt All those loans which are raised by the state neither for some economic improvement nor for any revenue generating objectives, but some sought of entertainment purposes (Zoo, libraries, museums, Parks etc.) are know as Passive Debts.

Sources of Public Debts

Two sources from which the government can get loans: a. Internal Sources When there is a deficit in the government current budget, then the govt. starts raising loan from inside the country through individuals & by banking sector by issuing some govt. securities (Prize bond, treasury bill and some other state securities) such loan raising inside the country is known as internal debt. This type of loans is short term. Macro Economics Note, Arranged by: Habibullah Qayumi 18

b. External Sources The loan taken from outside the country like World Bank, IMF, ADB, friend countries etc. are known as external source of debt.

Repayment of loan
i. Redeemable loan (Sinking Fund) These are the loans which are raised by govt. for a certain period, and the principle amount is paid lumsum at one after completion of that period, but the interest is paid by regular basis. The govt. makes a type of reserve fund in which regularly a portion of principle amount is kept for repayment of principle amount after the loan period is over is known as Sinking Fund. ii. Irredeemable loan (Funded loan) It is in very rear cases maybe only 2%, in this type of loans the interest rate is paid regularly, but due to inability of debtor the principle amount is not paid. iii. Budget Surplus It is the situation that the govt. expenditure is less then its revenue or budget. The excess amount could be kept aside for future planning and recovery of deficits or the govt. can repay the debts. iv. Rescheduling loan It show request for extension of loan period. It means when the govt. is not in the position of repayment as per the schedule. v. Writing off loan It is a sought of Bad Debts when the debtor is not in the position of repayment to the creditor, so the debtor requests for writing off the loan, with the willingness of creditor. vi. Repudiation loan It is writing off the loan or rejecting the repayment of loan to creditor but not with willingness of creditor. Like Afghanistan repudiate the loan claim of Russia.

Chapter 5

Money and Banking

Introduction to Money Money is one of the most wonderful and important inventions of man in economic sciences. It is defined from different angles by different economists Money is anything that is widely used and accepted legally in payments for goods and services. (Robertson) Money is anything which is generally acceptable as a medium of exchange and the standard unit in which prices and debt are expressed. (Samuelson) Barter system (16-17 Century) There was a time when money was not existed , people used to exchange goods for goods or services for the satisfaction of needs and wants without money as a medium of exchange , such system of direct exchanging of goods for other goods is known as Barter System. But later on with the passage of Macro Economics Note, Arranged by: Habibullah Qayumi 19

time, human needs and wants began to increase and such system brought a list of difficulties to man. To overcome all those difficulties money came into being. Now a days is monetary economic system. Inconveniences of barter system Before the introduction of money, the following difficulties and inconveniences were experienced in the barter system. Lack of Double co-incidence (Mutual Satisfaction) of wants Indivisibility of goods Difficulty in storing of value (specially perishable Goods) Lack of common measure of value Difficulty in transfer of wealth Difficulty in state Taxes and payments

Evolution of Money
In the earlier stages of human civilization, to satisfy man needs, barter system took place, after that with the passage of time man used so many other ways of satisfying its needs and wants which led to various stages of use of money as a medium of exchange in terms of Commodity money, Metallic money, Paper currency, Credit money, Electronic money etc. All such stages of money are used as a medium of exchange to solve the difficulties of barter economic system.

Kinds of Money
The money came into being from different stages in different time periods. Following are the different kinds or stages of money: 1- Commodity money A large number of commodities or items has served as commodity money at different time and places. Such as, cattle like goats, horses, cows, sheep, etc and other precious items were used as money. There were some problems in storing, transportability, durability and divisibility of such items as money, which led to an other stage of money in terms of some precious metals like gold, silver and copper which is known as metallic money. 2- Metallic Money (coins) The next form of money was the use of some precious metals such as gold, silver and copper as a medium of exchange. Such coins had an intrinsic value (value in themselves), which was reflected in their face value these coins were also known as full bodied coins. But again there were some problems in such kind of money which led to establishment of paper money. Token coins (face value is greater than intrinsic value). Full bodied coins (face value is equal to the intrinsic value of coin). 3- Paper Money After metallic money the next development in the payment and transaction system was paper money which includes currency notes issued by the central bank of country. Paper currency has the advantage that it is lighter than coins. Paper currency is legal tender by the state. The drawback of paper currency is that payment in large amount is difficult to count and it is also difficult to carry a huge amount of paper currency from one place to another place, such drawbacks are overcame by the use of credit or bank money. 4- Credit or Bank Money Macro Economics Note, Arranged by: Habibullah Qayumi 20

With the passage of time banking system is introduced in the economic sphere of life which brought about an easier and modern system of payment in transactions in terms of credit money. Now a days the transactions are made through the payment and receipts of bank cheques, draft and credit cards etc. all such means for making payments and receipts in transactions is known as credit or bank money. Cheque is not a legal tender because it is itself not money it can not be enforced in payment of debt. Although in most of the developed countries most of the businesses done through credit money. 5- Electronic Money With the development of computers and advanced communication technology, transactions became easier. Through advanced computerized banking system new ways of payments and receipts for transactions are introduced such as, ATM cards, credit cards. Such means of computerized transactions are known as electronic or plastic money.

Functions of Money
To fully understand the nature and importance of money, we have to consider the various functions it perform. Following are the important functions of money 1. Money as Medium of Exchange As a medium of exchange it solves the double coincidence of wants problem in barter system.with a money a person can buy anything he like. 2. Money as a measure of value In money economy value of all goods and services are expressed in terms of price .like ( price for wheat in Kg and Cloth in meter etc). 3. Standard of differed payments In a money economy the contracts are made for future payments in money terms, with a promise to repay the loan in money. 4. Money as a store of value Money acts as a store of value without loss in its value over period of time. in barter system much difficulty was faced in storing value in terms of goods. 5. Source of Govt. receipts Government can collect taxes from the people with the help of money easily. On the other hand Govt. gives salaries and pensions to the people without any difficulty. 6. Money as unit of account We count the amount with the help of money. Different countries have different unit of account such as USD for America, Pond for UK, Yen for Japan, Rupee for Pak, Afs for Afghanistan etc. in this way the figure of National income, Wealth assets are expressed in terms of money.

Introduction to Banking
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A Bank is an institution which deals with money . Commercial banks receive deposits and advances loans to earn maximum profits. According to Crowther, A bank is a firm which collects money from those who have it spare. It lends money to those who require it. According to Mr. Parking, A bank is a firm that takes deposits from households and firms and makes loans to other households and firms Commercial bank accepts deposits from individuals, firms and companies at a lower rate of interest and gives it at higher rate of interest to those who need it. The difference between the terms at which it borrows and those at which it lends forms the source of its profit

Functions of Commercial Bank

A Commercial banks performs a variety of functions, these functions are classified as under: Basic Functions Secondary Functions

1- Basic Functions
The basic functions of commercial banks are Accepting of deposits and Advancing of money.

A - Accepting of deposits

The bank accepts or collects money from the people by the following three ways or accounts... 1. Current Account (Demand Deposit): Customers withdraw money at any time he wishes to draw, or Money is withdrawn able at any time by the customers. Banks usually do not pay interest on current deposits. Current account holders receive a Cheque book and regular statements containing details of money paid in and paid out. The businessmen and traders usually maintain their funds in current account 2. Saving Account (Saving Deposit): Saving account is generally opened by persons of small income. The aim of this account is to encourage and mobilize saving of the people. The bank pays a certain interest on this type of deposit. Customers can withdraw money with in certain limit decided by the bank. 3 Fixed Deposit Account: Fixed deposits are kept by the bank for a specified period of time, the time period is fixed for withdraw. The rate of interest of fixed deposits is fairly high. The longer the period, the higher is the interest rate.

B Advancing of Money loan

The second major function of a commercial bank is to make loans to businessmen, traders, exporters, households etc. These loans are made against any securities. The strength of a bank is primarily judged by the soundness of its advances or loans. The lending or advancing of money may be in any of the following forms. Macro Economics Note, Arranged by: Habibullah Qayumi 22

Loans: The commercial banks grant short & long term loans to individuals, firms, companies mostly against securities. The amount of loan is credited to the borrowers account, who can withdraw it as per his/her requirements. Overdraft: The bank allows the facility of over drafting to their reliable and well reputed customers. It is a short term loans, provided by the banks to the current account holders. Under this system the banks allows the customers to overdraw his/her account up to certain limit. For example: A person has 20000AFS in bank and the bank allows him/her to over draw up to 30000. Small interest is charged on overdraft. Discounting of bills: A very important function of the modern banks is to discount bills of exchange, the bank makes loans to their customers by discounting the bill of exchange. Discounting bill of exchange refers to making the payment of bill before its maturity. The discount charged is the earning of the bank

1- Secondary Functions
The bank also performs some other special financial functions which are known as secondary functions, such functions are stated as below Exchange of foreign currency Utility services on behalf of the customers Custodian of valuable properties to customers Letters of credit ATM (Automated Teller Machine) EFT (Electronic Fund Transfer) Types of Banks The banking system is classified on the basis of its various functions in the economic sphere of country. Following are the different kinds bank Central Bank Commercial Banks Agriculture Banks Industrial Banks Central Bank Central bank is the head of banking system in the country. A central bank is an institution which is responsible for safeguarding the financial stability of the country through performance of it manifold functions. The primary function of the central bank is to regulate the flow of money and credit in order to promote efficiency, stability and growth in the economy of country. Every civilized country now has its own central bank Da Afghanistan Bank of Afghanistan, The reserve Bank of India State Bank of Pakistan, The Federal Reserve System of America, The Bank of England Functions of Central Bank The main functions of Central Bank are as follows Note issuing Authority Banker to the state Bankers bank Guardian of money market through control of credit Lender of last resort Macro Economics Note, Arranged by: Habibullah Qayumi 23

Monetary Policy by Central Bank The change in money supply by the central bank to influence interest rate and achieve some other economic objectives is called the monetary policy. Monetary policy is implemented by the central bank to control overall credit system in economy of a country. The objective of monetary policy is to Regulate money supply Stabilize interest rates Increase investment rate Increase employment opportunities and To control general price level Tools of monetary policy The central bank uses the following methods or tools to control money supply or overall credit system in economy Discount rate policy Open market operation (OMO) Variation in Reserve Requirements

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Chapter

Inflation and Unemployment Inflation

A process of rising prices OR persistent rise in the general price level in a country over a period of time is called inflation.

Kinds of Inflation
Cost push inflation: It is a situation where a rise in the general price level is initiated and sustained by rising cost due to which prices go up. When the cost of raw material goes up the price of goods also go up which leads to inflation Demand pull inflation: It is a situation where the aggregate demand persistently exceeds the available supply of output at a current price which once again causes the general price level to go up. Means the demand is high in the market but supply is less so it the sellers would increase the price of products Suppressed Inflation This is a temporary measure of preventing inflation but eventually leads to inflation. The government fixes the prices of basic essentials like agriculture products very much below the equilibrium price. This is suppressed inflation i.e. suppressed through price control. Stagflation This is a combination of two words i.e. stagnation of the economy and inflation in the economy. Stagflation is a situation where both unemployment and the rate of inflation are higher as compared to the accepted standard.

Causes of Inflation
Policy of deficit financing Backwardness of agricultural and industrial sector of the economy: Devaluation of currency: Political instability: Private sector does not get involved in the production. Undesirable activities: like black marketing, smuggling, hoarding etc. (the shortage of supply leads to inflation) Growth of population:

Inflation rates
It is a particular rate at which the level of inflation in the economy is measured or evaluated in a specific time period. Such rate is found by the given following formula CPI = Current price level previous price level 100 Previous price level

Inflation

Based on Rates
Creeping inflation A situation in which the rise In general price level is at a very slow rate up to 2%. Macro Economics Note, Arranged by: Habibullah Qayumi 25

Walking inflation A situation in which the rise in price level in around 5% Running inflation In this type of inflation the price rises from 8 to 10%. Hyper inflation This is known as final stage of inflation where the prices go up very high from 10 % to onward

Control over Inflation

Inflation can be controlled by two sorts of Policies Fiscal Policy (increase in tax rates and decrease in state expenditure) Monetary Policy Raising bank rates Varying reserve ratio

Unemployment
By employment is meant an engagement of a person in some occupation, business, trade or any other profession etc. whereas, unemployment is an economic problem which refers to a situation where an able-bodied person seeks a job but is unable to find one at current wage rate.

Types of Unemployment
Voluntary unemployment: This means unemployment by ones own choice. This also means that people simply do not want to do productive work. Instead, they want to remain unemployed. Involuntary Unemployment This is a real form of unemployment. Individual who fall in this category are those who possess high qualifications but do not find any job commensurate with the qualification they possess. Frictional Unemployment This form of unemployment takes place as a result of imperfections in the labor market. These imperfections occur due to seasonal nature of jobs. e.g accidental breakdown of machinery, natural calamities, shortage in the supply of raw material. Technological Unemployment This occurs as a result of change in the production technology. replacement of workers by machines. e.g

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