MODULE 6: EXCHANGE RATE DETERMINATION

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MODULE 1 – PUBLIC FINANCE
CHAPTER 1 – CONCEPT OF PUBLIC FINANCE
ORIGIN
Public finance is one of the oldest branches of the
economic theory. In fact, public finance was born when
the concept of state (government) was born.
Human Wants
Individual Wants
(Food, clothing, shelter, etc.)
Social Wants
(protection of society against
external enemies & anti social
elements, basic infrastructure etc. )
Public finance came into existence mainly to satisfy
social want.
DEFINITION
1
Sir Hugh Dalton
Public Finance is concerned with the income and
expenditure of public authorities and with the adjustment
of one to the other
2
Prof. R. R. Musgrave
The complex of problems that centre around the revenue
expenditure process of the government is referred to as
public finance
3
Prof. P. E. Taylor
Public finance deals with the finances of the public in an
organized group under the institutions of government.
SCOPE OF PUBLIC FINANCE
1. Public Revenue
 The public revenue refers to the
income of the government.
 Broadly
the
income
of
the
government can be divided into tax
revenue and non-tax revenue.
 This part explains the types of taxes,
the effect on taxes on the economy &
the people, the advantages &
disadvantage of taxes etc.
 It also includes the study of the
sources of non-tax revenue of the
government.
SCOPE OF PUBLIC FINANCE
2. Public Expenditure
 This part of public finance explains
the objectives of public expenditure,
the
classification
of
public
expenditure, causes of increase in
public
expenditure,
effects
of
spending money in different ways,
etc.
 This part also explains how the
government can influence the
production of goods and services,
through the instruments of public
expenditure.
SCOPE OF PUBLIC FINANCE
3. Public Debt
 This part explains the classification of
public debt, burden of public debt
and the causes responsible for
growth of public debt in modern
economies.
 It also explains why the government
requires loans, debt management
and the methods used by the
government for debt redemption.
SCOPE OF PUBLIC FINANCE
4. Financial administration
 This is a more practical part of public
finance.
 It studies the procedure to be followed
by the government in imposing taxes,
collecting the taxes, spending the
collected money and getting the
government income & expenditure
audited by the competent authority.
 It also explains how the government
adjusts the two sides of public finance
to each other.
SCOPE OF PUBLIC FINANCE
5. Economic stability & growth
 This part of public finance takes us to
the objectives of public finance
namely, to maintain internal and
external economic stability and to
expedite the rate of economic growth.
 The government has to maintain the
balance
between
stability
and
economic growth.
FUNCTIONS OF PUBLIC FINANCE
Public Finance is defined as a study of income and expenditure of
the government. Naturally the functions of public finance are
similar to functions of the government. the functions of public
finance have also grown, multiplied and diversified over a long
period. They can be presented as follows:
1. Defence
2. Maintenance of law and order
3. Economic growth
4. Reducing inequalities
5. Reducing regional inequalities
FUNCTIONS OF PUBLIC FINANCE
1. Defence
 The first and foremost responsibility of
the state (government) has been to
provide protection to the people
against the aggression of other
countries or extremists or other groups
of people.
 Even today the ministry of defence is
the one of the most important and
high profile ministries of any
government.
 A very large part of the budget is
earmarked for the defence of the
country.
FUNCTIONS OF PUBLIC FINANCE
2. Maintenance of law and order
 Any community is characterised by the
presence of the some anti-social
elements.
 They use other means like committing
thefts, smuggling, contract killing etc.
and earn their income.
 Hence it is the responsibility of the
government to protect the community
against such anti-social elements.
FUNCTIONS OF PUBLIC FINANCE
3. Economic growth
 The responsibility of a modern state is
not only to preserve the social order
but to improve it in all ways.
 In less developed economies, the
economic growth of the country is
given top priority after defence.
 Public finance has to provide adequate
resources for investing in different
sectors and bringing about economic
growth.
FUNCTIONS OF PUBLIC FINANCE
4. Reducing inequalities
 Extreme inequalities are bad.
 They give rise to social unrest,
revolutions and bloodshed.
 Hence one of the functions of public
finance is to reduce inequalities.
 This can be done by charging higher
taxes to people with high income and
providing aid to people with lower
incomes in the form of free or
subsidized food, free houses, medical
aid, education etc.
FUNCTIONS OF PUBLIC FINANCE
5. Reducing regional inequality
 In a vast country like India, some parts
are more developed and some parts
are less developed.
 Regional inequalities give rise to
several problems such as large scale
migrations from less developed parts
to more development parts.
 This problem is very evident in the city
of Mumbai where lakhs of people
migrate from various parts of the
country.
 Public finance helps to reduce regional
inequalities by collecting more taxes
from developed states and spending it
on less developed states.
PUNJAB
RAJASTHAN
SIMILARITY BETWEEN PUBLIC AND PRIVATE FINANCE
1. The Economic Problem
 Both, an individual and a community face the economic problem.
 Both, the society as well as an individual have to arrange the wants in an
order of importance and satisfy them.
 An individual would first pay attention to acquiring food, clothing and
shelter.
 The society, under the leadership of the government has to pay attention
first to defence of the country, maintenance of law and order and then go
to satisfy the other wants in order of importance.
SIMILARITY BETWEEN PUBLIC AND PRIVATE FINANCE
2. The aim
 The aim of the government is to get
maximum
satisfaction
to
the
community.
 Similarly the aim of an individual in
earning the income and spending it,
is to get maximum satisfaction for
himself and his family members.
SIMILARITY BETWEEN PUBLIC AND PRIVATE FINANCE
3. The procedure to achieve the aim
 With the objective of getting maximum satisfaction from the limited
resources available, the government distributes its income on different
items of expenditure in such a way that the marginal utility of money
spent on different items to the community is equal.
 An individual also follows the same procedure in distribution of his
income.
 Thus, the law of equi-marginal utility enables both the government
and the individual to obtain maximum satisfaction from the total
amount of money spent.
SIMILARITY BETWEEN PUBLIC AND PRIVATE FINANCE
4. Balancing
expenditure
income
&
 The income and expenditure of an
individual need not balance every month.
 Similarly, the income and expenditure of
the government need not balance every
year.
DIFFERENCES BETWEEN PUBLIC AND PRIVATE FINANCE
1. Sources of income
 The government can depend upon
taxation, borrowings and creation
of new money as sources of its
income.
 An individual depends upon salary,
rent, interest, profit which are
sources of his income. He can also
take a loan.
 The government can print paper
currency against certain assets and
use that currency as its income.
This source is not open to an
individual.
DIFFERENCES BETWEEN PUBLIC AND PRIVATE FINANCE
2. Source and size of borrowing
 The government can take an internal loan i.e. loan from its own
citizens or an external loan i.e. loan from some other state or citizens
of some other states.
 An individual can take a loan from some other individuals.
 Further, the capacity of the government to borrow is much larger than
the capacity of any individual to borrow.
 Also, the government can get loans more easily and on easy terms and
conditions as compared to an individual.
DIFFERENCES BETWEEN PUBLIC AND PRIVATE FINANCE
3. Balancing
income
and expenditure
 Government – Adjusts income
as per the expenditure
 Individual
–
Adjusts
expenditure as per the income
DIFFERENCES BETWEEN PUBLIC AND PRIVATE FINANCE
4. Budget principle
market principle
and
 The government does not enquire
about getting a proper price for
its services. Whether the cost of
service is covered or not covered,
the
government
goes
on
rendering the services to the
citizens if they are necessary.
 An individual is guided by the
market principle. He would
produce a commodity or a service
and render it to someone else
only if the price received covers
the cost of production.
DIFFERENCES BETWEEN PUBLIC AND PRIVATE FINANCE
5. Perspective
 A society has a very long life,
it is almost eternal. Therefore
the government can take a very
long term view of its finances.
It may incur some expenditure
at present even though, the
returns may be reaped after a
considerably long time.
 The vision of an individual is
limited. A person can look to
at the most the next generation
but not beyond that.
DIFFERENCES BETWEEN PUBLIC AND PRIVATE FINANCE
6. Motive
 The government works for
social welfare. It takes up a
particular
project
without
consideration of profit or loss
to itself.
 An individual looks at the
profit motive. A person
produces a commodity or a
service and sells it only if the
price earned covers the cost of
production
and
leaves
something for the producer of
the service.
RECAP OF SIMILARITY AND DIFFERENCES BETWEEN
PUBLIC AND PRIVATE FINANCE
Sr No
Similarity
Differences
1
The economic problem
Sources of income
2
The aim
Source and size of borrowing
3
The procedure to achieve aim
Balancing income and expenditure
4
Balancing income and expenditure
Budget principle and market principle
5
Perspective
6
Motive
SOUND FINANCE
 The concept of sound finance was based upon the belief that in economic
activities, the private sector is always more efficient and careful than the
public sector.
 The private sector is careful about keeping the cost of production at the
lowest level.
 The private sector uses resources most efficiently and effectively.
 The private sector can earn a profit only if the commodity is produced at
the lowest cost and is sold at the lowest price.
 Hence, it was maintained that government should not interfere in the
working of the economy which was called the market economy.
SOUND FINANCE
This belief gave rise to following principles:
 The government should undertake only two functions namely the defence
of the country and maintenance of law & order.
 Government should keep its expenditure at its lowest level.
 The government budget should always be balanced.
 A deficit budget should be avoided at any cost.
 The only objective of public finance is to satisfy the wants of the state.
FUNCTIONAL FINANCE
 The concept of sound finance was strongly challenged by the Great
Depression, 1929. The principles of sound finance failed to provide a
solution to the problems associated with the Great Depression.
 Economists like J. M. Keynes and A. P. Learner tried to find out some new
principles which would help the countries caught in the Great Depression.
 Principles evolved out of thinking of these people during the Great
Depression is together called as functional finance.
FUNCTIONAL FINANCE
Functional finance gave rise to following principles:
 During inflation, a surplus budget is recommended.
 Deficit budget is recommended during depression.
 Public finance has to discharge several responsibilities like developing
infrastructure, setting up basic and heavy industries etc.
 Public finance can also be used for social purposes such as removal of
poverty, reducing inequality and reducing regional imbalance.
REDISTRIBUTIVE TAXATION
 Inequality exists in every society
 To a certain level inequalities are necessary because then it acts as an
incentive for people to work harder. To a certain level inequalities are
necessary because then it acts as an incentive for people to work harder.
 However, extreme inequalities are bad.
 They give rise to social unrest, revolutions and bloodshed.
 Hence, it is the responsibility of the government to reduce inequalities by
re-distributing income in favour of the poor.
 One of the method to reduce inequality is by way of taxation.
TAXATION AS A TOOL OF REDUCING INEQUALITY
 The direct taxes are more useful in
reducing inequalities in income &
wealth and re-distribute income in
favour of the poor.
 The Indirect taxes are taxes on
goods. The poor people spend a
larger part of their incomes on
consumption and save a smaller
part. Therefore the taxes on goods
fall more heavily on the poorer
section of the community.
TAXATION AS A TOOL OF REDUCING INEQUALITY
 For re-distributing incomes and
wealth, the direct taxes are imposed
at progressive rates.
 In Indirect taxes like the excise duty
and the customs duty, the necessaries
of life like foodgrains, cheaper
clothing, cheaper footwear are
exempted from the indirect taxes. The
costly durable consumer goods like
automobiles, expensive TV, watches,
cameras etc. are subject to heavy
taxes.
TAXATION AS ANTI-INFLATIONARY MEASURE
 Meaning
Inflation is defined as a fall in the
value of money i.e. a rise in the price
level. In simple words, commodities
which were available at Rs. x are now
available at Rs. 1.5x or Rs. 2x.
 How inflation takes place
Inflation takes place when people
have more purchasing power in their
hands. They show a tendency to
spend more. As a result, there is an
increase in demand. So when the
expenditure rises, the demand also
rises. If the rising demand is not
balanced by a rise in supply, the price
level shows a tendency to rise.
Earlier
Now
Rs. 5 – 13 grams
Rs. 5 – 10.5
grams
TAXATION AS ANTI-INFLATIONARY MEASURE
 Taxation as a tool of controlling inflation
 During inflation, the government increases the rates of the direct
taxes like the income tax wealth tax etc.
 When the income is reduced, the expenditure is reduced.
 When expenditure is reduced, the demand is reduced.
 A cut in demand is helpful in preventing a rise in prices and bringing
the price level down to a lower level.
Tax Rate
Income in
hand
Expenditure
Demand
Inflation
TAXATION AS ANTI-INFLATIONARY MEASURE
 Taxation as a tool of controlling inflation
 For controlling inflation the government reduces the taxes on raw
materials and on intermediate goods.
Prices of raw material
& intermediate goods
Prices of final
goods
Inflation
 Government imposes heavy taxes on exports. The demand for
exported goods falls in the foreign countries and thus the exports fall.
This leads to an increase in internal supply and as a result the price
level comes down
Prices of
export goods
Export
sales
Internal supply
of goods
Inflation
CONCEPT OF MAXIMUM SOCIAL ADVANTAGE
INTRODUCTION
 The concept of sound finance maintained that government expenditure
should be kept at the lowest level.
 However, this concept was criticized by various economists.
 It was maintained that the effect of public expenditure is more important
and not its size.
 The aim of all government activities is to increase the welfare of the
community.
 Public finance is an instrument which can help the government in
increasing the welfare of the community.
 So that public finance which creates “Maximum Social Advantage” is
good.
CONCEPT OF MAXIMUM SOCIAL ADVANTAGE
THE PROCESS
 Public finance has two sides namely taxation (i.e. public revenue) and
public expenditure.
 A tax is a compulsory payment to be made by an individual to the
government and for which the tax-payer does not get any direct and
proportionate return.
 The money taken away by the government is spent by it on satisfying
collective wants such as defence of the country, maintenance of law and
order, economic development and social welfare etc.
 This expenditure creates some satisfaction or utility on the part of the
community.
CONCEPT OF MAXIMUM SOCIAL ADVANTAGE
BALANCE BETWEEN SATISFACTION AND DIS-SATISFACTION
TAXATION –
SATISFACTION
PUBLIC
EXPENDITURE SATISFACTION
 Satisfaction and Dis-satisfaction can be compared to each other and can
be balanced with each other.
 The dis-utility created by taxation can be balanced against utility created
by public expenditure.
CONCEPT OF MAXIMUM SOCIAL ADVANTAGE
MARGINAL PRINCIPLE
 A comparison between sacrifice and satisfaction can be made by using
the marginal principle. We can take the sacrifice and benefit separately.
MARGINAL SOCIAL SACRIFICE
 As a person or the community pays more and more units of money
(rupees) in the form of taxes, every additional rupee paid imposes more
and more sacrifice on the community.
 This is derived from the principle of Diminishing Marginal Utility.
 When a person pays more and more rupees, the marginal dis-uitility
imposed upon him is higher and higher.
Tax paid
First unit
Second unit
Third unit
Fourth unit
Fifth unit
Marginal Social Sacrifice (MSS)
19
20
21
22
23
CONCEPT OF MAXIMUM SOCIAL ADVANTAGE
MARGINAL SOCIAL BENEFIT
 As the government spends more and more units of money (rupees), the utility
derived by the community from every additional rupee spent by the government
is less and less.
 It is subject to the principle of Diminishing Marginal Utility.
Tax paid
First unit
Second unit
Third unit
Fourth unit
Fifth unit
Marginal Social Sacrifice (MSS)
25
24
23
22
21
CONCEPT OF MAXIMUM SOCIAL ADVANTAGE
BALANCE BETWEEN MARGINAL SOCIAL BENEFIT AND MARGINAL
SOCIAL SACRIFICE
 The government has to balance the effects of taxation and public expenditure at
every rupee collected and spent.
 At a particular rupee collected and spent, the MSB becomes equal to MSS.
 This is the point where the net social benefit (Social Benefit - Social Sacrifice) is
the maximum.
Tax / Public
Expenditure
First unit
Second unit
Third unit
Fourth unit
Fifth unit
MSB
MSS
NSB
Total NSB
25
24
23
22
21
19
20
21
22
23
6
4
2
0
-2
6
10
12
12
10
CONCEPT OF MAXIMUM SOCIAL ADVANTAGE
GRAPH OF MAXIMUM SOCIAL ADVANTAGE
PUBLIC EXPENDITURE AND LAW OF SUBSTITUTION
 The government distributes its income on different items in such a way that the
community gets maximum benefit.
 Similarly the government imposes different taxes in such a way that the social
sacrifice suffered by the community should be the minimum.
MARGINAL PRINCIPLE
 The government uses the marginal principle for ensuring that the total benefit
derived by the community from different items of public expenditure should be
maximum.
 This is possible when the marginal social benefit derived from different items of
public expenditure is equal.
1
Expenditure
1
2
3
4
2
Item A
20
19
18
17
3
Item B
18
16
14
12
TAXATION AND LAW OF SUBSTITUTION
 The government has to collect a certain amount of money through taxes.
 The government can use different taxes.
 The total amount is collected through different taxes in such a way that
the marginal sacrifice imposed by different taxes on community is equal.
Tax
1
2
3
4
MSS of Tax A
16
17
18
19
MSS of Tax B
18
20
22
24
• If the government wants to collect a total amount of ` 4/- through taxes, it
will collect ` 3/- through Tax ‘A’ and 1 through Tax ‘B’.
RULES FOR IMPLEMENTING MSA
1.
The total amount of taxation and public expenditure are arranged in
such a way that the Marginal Social Benefit of public expenditure is
equal to Marginal Social Sacrifice of taxation.
MSB = MSS
2.
The total amount of public expenditure is distributed over different
items in such a way that the marginal social benefit derived from all of
them should be equal.
3.
The different taxes should be arranged in such a way that the Marginal
Social Sacrifice of all of them should be equal.
EVALUATION OF PRINCIPLE OF MSA
1.
Not measurable
The principle of Maximum Social
Benefit is developed on the
assumption that the Marginal
Social Sacrifice of taxation and
Marginal Social Benefit of public
expenditure are measurable in
quantity. In practice, they are not
measurable.
EVALUATION OF PRINCIPLE OF MSA
2.
Inevitable expense
Every time the government imposes a tax or spends public money, it
is not possible to compare sacrifice imposed on the community and
benefit derived by the community. Certain expenses like expenses on
defence, maintenance of law and order have to be incurred without
social benefit.
3.
Small units
The application of marginal principle assumes that taxation and
public expenditure can be increased by small units. In practice, it is
not possible to increase them by small units. They are imposed and
increased in lumpy amounts.
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