CENTRAL BANK/RESERVE BANK OF INDIA

Role/Function of Central Bank/RBI

1.Bank of Note Issue
The central bank has the sole monopoly of note issue in almost every country. The

currency notes printed and issued by the central bank become unlimited legal tender
throughout the country.
In the words of De Kock, "The privilege of note-issue was almost everywhere
associated with the origin and development of central banks."
However, the monopoly of central bank to issue the currency notes may be partial in
certain countries. For example, in India, one rupee notes are issued by the Ministry of
Finance and all other notes are issued by the Reserve Bank of India.
The main advantages of giving the monopoly right of note issue to the central bank
are given below:
(i) It brings uniformity in the monetary system of note issue and note circulation.
(ii) The central bank can exercise better control over the money supply in the country.
It increases public confidence in the monetary system of the country.
(iii) Monetary management of the paper currency becomes easier. Being the supreme
bank of the country, the central bank has full information about the monetary
requirements of the economy and, therefore, can change the quantity of currency
accordingly.
(iv) It enables the central bank to exercise control over the creation of credit by the
commercial banks.
(v) Granting of monopoly right of note issue to the central bank avoids the political
interference in the matter of note issue.

Role/Function of Central Bank/RBI

2. Banker to Government:
The Reserve Bank acts as the banker, agent and adviser to Government of India:
(a) It maintains and operates government deposits,
(b) It collects and makes payments on behalf of the government,
(c) It helps the government to float new loans and manages the public debt,
(d) It sells for the Central Government treasury bills of 91 days duration,
(e) It makes 'Ways and Means' advances to the Central and State Governments for

periods not exceeding three months,

(f) It provides development finance to the government for carrying out five year plans,
(g) It undertakes foreign exchange transactions on behalf of the Central Government,
3. Agent to the Government
As an Agent to the government, the central bank collects taxes and other payments on
behalf of the government. It raises loans from the public and thus manages public
debt. It also represents the government in the international financial institutions and
conferences. ) It acts as the agent of the Government of India in the latter's dealings
with the International Monetary Fund (IMF), the World Bank, and other international
financial institutions
4.Adviser to the Government
As a financial adviser to the lent, the central bank gives advise to the government on
economic, monetary, financial and fiscal matters such as deficit financing, devaluation,
trade policy, foreign exchange policy, etc.

Role/Function of Central Bank/RBI

5.Custodian of Cash Reserves of Commercial Bank
Central bank is the bank of banks. This signifies that it has the same relationship with

the commercial banks in the country which they have with their customers. It provides
security to their cash reserves.
The exact form of this function has varied from country to country. . In some countries,
however, the banks are compelled by law to hold deposit balances with the central
bank called as Cash Reserves and this gives it an additional tool to regulate credit
creation by them. The legal provision to this effect was first introduced in US. Later, it
was adopted in India also. RBI has found it a very effective regulatory tool and has
used it very extensively. Every Bank is under the statutory obligation to keep a certain
minimum of cash reserves with the Reserve Bank. The purpose of these reserves is to
enable the Reserve Bank to extend financial assistance to the scheduled banks in
times of emergency and thus to act as the lender of the last resort.Again, the choice of
exact percentage and its revision is left to the discretion of the RBI. The current CRR is
4% and as per the amendment to the Banking Regulation Act in September 1972 it
can be raised to 15% if the Reserve Bank considers it necessary,
Through this CRR the RBI regulates the money supply in the market and controls the
inflation . If the inflation is high RBI increases CRR (Cash Reserve Ratio). Thus Banks
have to maintain higher cash reserves with RBI and thus reduces the money available
with Banks for giving it on credit. In other words the money supply in the market
reduces which lowers the spending and ultimately the demand for goods decreases
and consequently decreases the inflation rate.
During times of recession RBI reduces CRR. Thus Banks have to maintain lower
reserves with the RBI which increases the money available with them for giving it on
credit. This increases the money supply in the market which increases spending and
ultimately demand for goods increases and this gives stimulus to economy.

Role/Function of Central Bank/RBI

6.Lender of the Last Resort:
Central bank works as lender of the last resort for commercial banks because

in the times of need it provides them financial assistance and

accommodation. Whenever a commercial bank faces financial crisis, central
bank as lender of the last resort comes to its rescue by advancing loans and
the bank is saved from being failed. Central bank helps commercial banks by
discounting their bills and securities.
7.Clearing House Function:
All the commercial banks have their accounts with the central bank.
Therefore, central bank settles the mutual transactions of banks and thus
saves all banks contacting each other individually for setting their individual
transactions, in this way; the unnecessary cash transactions between
individual banks are avoided.
The clearing house function of the central bank has the following advantages:
(i) It economies the use of cash by banks while settling their claims and
counter-claims.
(i) It reduces the withdrawals of cash and these enable the commercial banks
to create credit on a large scale.
(ii) It keeps the central bank fully informed about the liquidity position of the
commercial banks

Role/Function of Central Bank/RBI

8.Credit Control:
This is a very important function. These days, the most important

function of central bank is to control the volume of credit for bringing

about stability in the general price level or inflation and
accomplishing various other socio-economic objectives. There are
number of methods which a central bank may use for controlling the
volume of credit such as bank rate, open market operations, change
in cash reserve ratio and various selective controls.
9.Custodian of Foreign Exchange Reserves:
Central bank of a country is also a custodian of its official foreign
exchange reserves. This arrangement helps the authorities in
managing and co-ordinating the monetary matters of the country
more effectively. This is because there is a direct association between
foreign exchange reserves and quantity of money in the market. The
foreign exchange reserves are influenced by international capital
movements, international trade credits and so on. Because of the
interaction between the domestic money supply, price level and
exchange reserves, the central bank frequently faces several
contradictory tendencies which have to be reconciled.

Role/Function of Central Bank/RBI

10. Regulation of Exchange Rate:
A related function, which is assigned to the central bank, is the regulation and

stabilization of the exchange rate. This task is facilitated when the central bank is also
the custodian of official foreign exchange reserves. As regards expertise and
competence central bank of the country is the best agency to which the task of
regulating and stabilizing exchange rate should be assigned. The central bank happens
to be the apex institution of the entire financial system of the country. It is in possession
of maximum data and has the expertise 'of estimating the financial trends and the type
of corrective measures needed.
11. Other Functions:
It is believed that an underdeveloped country requires an all-frontal approach in solving
its problems of poverty and growth. Though regulation of the volume of money and
credit and its other dimensions, the central bank plays a key role in its growth policy,
much more is needed to make it really effective. Viewed in this manner, the functions of
a central bank come to cover a much wider field than is conventionally considered in the
case of central banks of developed countries.
Let us consider the developmental role of a central bank with reference to our own
country. At the time of Independence, our entire financial system (including our bank
jpig sector) was very weak. Modern banking services were scarcely available in rural and
semi-urban areas. The, banking system contained several small and weak banks. There
was a need to strengthen them through amalgamations and mergers. Similarly, the
banking industry was in the grip of some unhealthy practices which risked their own
lives and Jeopardised the interest of the depositors. They were in need of better
regulation and supervision.

Role/Function of Central Bank/RBI

Under the Banking Regulation Act,1949 and its various amendments, the Reserve

Bank has been given extensive powers of supervision and control over the banking
system. These regulatory powers relate to the licensing of banks and their branch
expansion; liquidity of assets of the banks; management and methods of working of
the banks; amalgamation, reconstruction and liquidation of banks; inspection of
banks; etc.
12. Ordinary Banking Functions:
The Reserve Bank also performs various ordinary banking functions:
(a), It accepts deposits from the central government, state governments and even
private individuals without interest,
(b) It buys, sells and rediscounts the bills of exchange and promissory notes of the
scheduled banks without restrictions,
(c) It grants loans and advances to the central government, state governments, local
authorities, scheduled banks and state cooperative banks, repayable within 90 days,
(d) It buys and sells securities of the Government of India and foreign securities,
(e) It buys from and sells to the scheduled banks foreign exchange for a minimum
amount of Rs. 1 lakh,
(f) It can borrow from any scheduled bank in India or from any foreign bank,
(g) It can open an account in the World Bank or in some foreign central bank.
(h) It accepts valuables, securities, etc., for keeping them in safe custody.
(i) It buys and sells gold and silver.

Role/Function of Central Bank/RBI

13.Miscellaneous Functions:
In addition to central banking and ordinary banking functions, the Reserve Bank

performs the following miscellaneous functions:

(a) Banker's Training College has been set up to extend training facilities to supervisory staff of
commercial banks. Arrangements have been made to impart training lo the cooperative
personnel,
(b) The Reserve Bank collects and publishes statistical information relating to banking, finance,
credit, currency, agricultural and industrial production, etc. It also publishes the results of
various studies and review of economic situation of the country in its monthly bulletins and
periodicals.
14.Promotional and Developmental Functions:
Besides the traditional central banking functions, the Reserve Bank also performs a
variety of promotional and developmental functions:
(a) By encouraging the commercial banks to expand their branches in the semi-urban and rural
areas, the Reserve Bank helps (i) to reduce the dependence of the people in these areas on the
defective unorganised sector of indigenous bankers and money lenders, and (ii) to develop the
banking habits of the people
(b) By establishing the Deposit Insurance Corporation, the Reserve Bank helps to develop the
banking system of the country, instills confidence of the depositors and avoids bank failures,
(c) Through the institutions like Unit Trust of India, the (Reserve Bank helps to mobilise savings
in the country,
(d) Since its inception, the Reserve Bank has been mating efforts to promote institutional
agricultural credit by developing cooperative credit institutions.
(e) The Reserve Bank also helps to promote the process of industrialisation in the country by
setting up specialized institutions for industrial finance,
(f) it also undertakes measures for developing bill market in the country.

Role/Function of Central Bank/RBI

15.Forbidden Business:
Being the central bank of the country, the Reserve Bank:
(a) Should not compete with member banks and
(b) should keep its assets in liquid form to meet any situation of

economic crisis.
Therefore, the Reserve Bank has been forbidden to do
certain types of business:
(a) It can neither participate in, nor directly provide financial
assistance to any business, trade or industry,
(b) It can neither buy its own shares not those of other banks or
commercial and industrial undertakings,
(c) It cannot grant unsecured loans and advances,
(d) It cannot give loans against mortgage security,
(e) It cannot give interest on deposits.
(g) It cannot purchase immovable property except for its own
offices.

Monetary Policy of Central Bank (RBI)

Monetary Policy is the process by which monetary authority of a country,

generally a central bank controls the supply of money in the economy

by exercising its control over interest rates in order to maintain price
stability and achieve high economic growth.[1] In India, the central
monetary authority is the Reserve Bank of India (RBI). is so designed as
to maintain the price stability in the economy.
Types of Monetary PolicyExpansionary Monetary Policy
In times of recession when the Central Bank wants to stimulate or
increase output and demand this policy is used. This policy increases
money supply which in turn increases demand and output/production.
The tools used to increase money supply are by making use of open
market purchases of Government Securities, lowering CRR and
decreasing the Bank rate.
Contractionary Monetary Policy
In times of increasing inflation the Central Bank wants to reduce
demand . Thus this policy reduces money supply which in turn
decreases demand and inflation. The tools used to decrease money
supply are by making use of open market sale of Government
securities, increasing CRR and increasing the Bank rate.

Monetary Policy of Central Bank (RBI)

Objectives of Monetary PolicyPrice Stability

Price Stability implies promoting economic development with

considerable emphasis on price stability. The main focus to control

price level/inflation and to see that it does not go out of control.
Controlled Expansion Of Bank Credit/Money Supply
One of the important functions of RBI is the controlled expansion
of bank credit and money supply with special attention to
seasonal requirement for credit without affecting the output.
Promotion of Fixed Investment
The aim here is to increase invested in fixed assets so that
productivity can be increased..
Restriction of Inventories
Overfilling of stocks and products becoming outdated due to
excess of stock often results is sickness of the unit. To avoid this
problem the central monetary authority carries out this essential
function of restricting the inventories. The main objective of this
policy is to avoid over-stocking and idle money in the organization.

Monetary Policy of Central Bank (RBI)

Promotion of Exports and Food Procurement Operations
Monetary policy pays special attention in order to boost exports and facilitate the

trade. It is an independent objective of monetary policy.

Desired Distribution of Credit
Monetary authority has control over the decisions regarding the allocation of credit
to priority sector and small borrowers. This policy decides over the specified
percentage of credit that is to be allocated to priority sector and small borrowers.
Equitable Distribution of Credit
The policy of Reserve Bank aims equitable distribution to all sectors of the
economy and all social and economic class of people
To Promote Efficiency
It is another essential aspect where the central banks pay a lot of attention. It tries
to increase the efficiency in the financial system and tries to incorporate structural
changes such as deregulating interest rates, ease operational constraints in the
credit delivery system, to introduce new money market instruments etc.
Reducing the Rigidity
RBI tries to bring about the flexibilities in the operations which provide a
considerable autonomy. It encourages more competitive environment and
diversification. It maintains its control over financial system whenever and
wherever necessary to maintain the discipline and prudence in operations of the
financial system.

Monetary Policy of Central Bank (RBI)

Tools of Monetary Policy
Open Market Operations
An open market operation is an instrument of monetary policy which involves buying or

selling of government securities from or to banks and financial institutions. This

mechanism influences the reserve position of the banks, yield on government securities
and cost of bank credit. The RBI sells government securities to contract/reduce the flow
of credit(Contractionary Monetary Policy) and buys government securities to increase
credit flow (Expansionary Monetary Policy). Open market operation makes bank rate
policy effective and maintains stability in government securities market.
Cash Reserve Ratio
Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to
keep with RBI in the form of reserves or balances .Higher the CRR with the RBI lower will
be the money supply/liquidity in the system (Contractionary Monetary Supply) and lower
CRR will increase money supply (Expansionary Monetary Supply)RBI is empowered to
vary CRR between 15 percent and 3 percent. But as per the suggestion by the
Narshimam committee Report the CRR was reduced from 15% in the 1990 to 5 percent
in 2002. As of today the CRR is 4 percent.
Statutory Liquidity Ratio
Every financial institution has to maintain a certain quantity of liquid assets with
themselves at any point of time of their total time and demand liabilities. These assets
can be cash, precious metals, approved securities like bonds etc. The ratio of the liquid
assets to time and demand liabilities is termed as the Statutory Liquidity Ratio. There
was a reduction of SLR from 38.5% to 25% because of the suggestion by Narshimam
Committee. The current SLR is 23%.[5]

Monetary Policy of Central Bank (RBI)

Bank Rate Policy[6]
Bank rate is the rate of interest charged by the RBI for providing funds or
loans to the banking system. This banking system involves commercial and
co-operative banks, Industrial Development Bank of India, EXIM Bank, and
other approved financial institutes. Funds are provided either through lending
directly or rediscounting or buying money market instruments like commercial
bills and treasury bills. Increase in Bank Rate increases the cost of borrowing
by commercial banks which results into the reduction in credit volume to the
banks and hence declines the supply of money/liquidity. Increase in the bank
rate is the symbol of tightening/contractionary monetary policy. Bank rate is
also known as discount rate. The current Bank rate is 9%.
Credit Ceiling
In this operation RBI issues prior information or direction that loans to the
commercial banks will be given up to a certain limit. In this case commercial
bank will be tight in advancing loans to the public. They will allocate loans to
limited sectors. Few example of ceiling are agriculture sector advances,
priority sector lending.
Credit Authorization Scheme
Credit Authorization Scheme was introduced in November, 1965 when P C
Bhattacharya was the chairman of RBI. Under this instrument of credit
regulation RBI as per the guideline authorizes the banks to advance loans to
desired sectors.[7]

Monetary Policy of Central Bank (RBI)

Moral suasion:
Moral suasion means persuasion and request. To arrest inflationary situation central

bank persuades and request the commercial banks to refrain from giving loans for
speculative and non-essential purposes. On the other hand, to counteract deflation
central bank persuades the commercial banks to extend credit for different purposes.
Central bank also appeals commercial banks to extend their wholehearted co-operation
to achieve the objectives of monetary policy. Being the monetary authority directions of
the central bank are usually followed by commercial banks.
Prescription of margins requirements:
Generally, commercial banks give loan against stocks or securities. While giving loans
against stocks or securities they keep margin. Margin is the difference between the
market value of a security and its maximum loan value. Let us assume, a commercial
bank grants a loan of Rs. 8000 against a security worth Rs. 10,000. Here, margin is Rs.
2000 or 20%.
If central bank feels that prices of some goods are rising due to the speculative activities
of businessmen and traders of such goods, it wants to discourage the flow of credit to
such speculative activities. Therefore, it increases the margin requirement in case of
borrowing for speculative business and thereby discourages borrowing. This leads to
reduction is money supply for undertaking speculative activities and thus inflationary
situation is arrested.
On other contrary, central bank can encourage borrowing from the commercial banks by
reducing the margin requirement. When there is a grater flow of credit to different
business activities, investment is increased. Income of the people rises. Demand for
goods expands and deflationary situation is controlled.
Thus, margin requirement is a significant tool in the hands of central bank to counter-act
inflation and deflation.

Monetary Policy of Central Bank (RBI)

Repo Rate and Reverse Repo Rate
Repo rate is the rate at which RBI lends to commercial banks generally against

government securities. Reduction in Repo rate helps the commercial banks to get
money at a cheaper rate and increase in Repo rate discourages the commercial banks
to get money as the rate increases and becomes expensive.. The increase in the Repo
rate will increase the cost of borrowing and lending of the banks which will discourage
the public to borrow money and will encourage them to deposit. As the rates are high
the availability of credit and demand decreases resulting to decrease in inflation.
Reverse Repo rate is the rate at which RBI borrows money from the commercial banks.
This increase in Repo Rate and Reverse Repo Rate is a symbol of tightening of the
policy. As of December 2012, the repo rate is 8% and reverse repo rate is 7%.
Consumer credit regulation:
Now-a-days, most of the consumer durables like T.V., Refrigerator, Motorcar, etc. are
available on installment basis financed through bank credit. Such credit made
available by commercial banks for the purchase of consumer durables is known as
consumer credit.
If there is excess demand for certain consumer durables leading to their high prices,
central bank can reduce consumer credit by (a) increasing down payment, and (b)
reducing the number of installments of repayment of such credit.
On the other hand, if there is deficient demand for certain specific commodities
causing deflationary situation, central bank can increase consumer credit by (a)
reducing down payment and (b) increasing the number of installments of repayment
of such credit.

Fiscal Policy of India

In economics fiscal policy is the use of government revenue collection

(taxation) and expenditure (spending) to influence the economy (GDP). [1]

The two main instruments of fiscal policy are government taxation and
changes in the level and composition of taxation and government
spending can affect the following variables in the economyAggregate demand and the level of economic activity;
The distribution of income;
The pattern of resource allocation within the government sector and
relative to the private sector.
Fiscal policy refers to the use of the government budget to influence
economic activity.
GDP= C+I+G+(X-M)
C- Consumption
I-Investment
G-Government Purchases (Spending)
(X-M)- Exports-Imports.
Thus if Government Purchases(Spending )G is increased then GDP will
automatically increase.

Fiscal Policy of India

Types of Fiscal PolicyNeutral fiscal policy- It is usually undertaken when an economy is in equilibrium.

Government spending is fully funded by tax revenue and overall the budget outcome has
a neutral effect on the level of economic activity.
Expansionary fiscal policy- It involves government spending exceeding tax revenue,
and is usually undertaken during recessions. Let's say that an economy has slowed
down. Unemployment levels are up, consumer spending is down and businesses are not
making any money. A government thus decides to fuel the economy's engine by
decreasing taxation, giving consumers more spending money while increasing
government spending in the form of buying services from the market (such as building
roads or schools). By paying for such services, the government creates jobs and wages
that are in turn pumped into the economy In the meantime, overall unemployment levels
will fall.
With more money in the economy and less taxes to pay, consumer demand for goods
and services increases. This in turn rekindles businesses and turns the cycle around from
stagnant to active.
If, however, there are no reins on this process, the increase in economic productivity can
cross over a very fine line and lead to too much money in the market. This can cause
inflation.

Fiscal Policy of India

Contractionary fiscal policy It occurs when

government spending is lower than tax revenue,

and is usually undertaken to pay down government
debt or reduce inflation.
When inflation is too strong, the economy may need
a slow down. In such a situation, a government can
use fiscal policy to increase taxes in order to suck
money out of the economy. Fiscal policy could also
dictate a decrease in government spending and
thereby decrease the money in circulation. Of
course, the possible negative effects of such a
policy in the long run could be a sluggish economy
and high unemployment levels.

Balance of Payment
Balance of payments is a systematic record of all economic

transactions ,visible as well as invisible, in a period, between one

country and the rest of the world. It shows the relationship between one
country's total payments to all other countries and its total receipts from
them. Balance of payments thus is statement of payments and receipts
on international transactions.
Payments and receipts on international account are on 3 accounts:
(a) the current account;
(b) the capital account; and
(c) reserve account.
Kindleberger defines balance of payments as "a systematic record of all
economic transactions between the residents of the reporting country
and the residents of foreign countries during a given period of time.
In the words of Benham, "Balance of payments of a country is a record

of the monetary transactions over a period with the rest of the world.
Balance of Payment= Current Account +Capital Account+
Reserve
Account

Balance of Payment
Features of Balance of Payments
Balance of Payments has the following features:
(i) It is a systematic record of all economic transactions between

one country and the rest of the world.

(ii) It includes all transactions, visible as well as invisible.
(iii) It relates to a period of time. Generally, it is an annual
statement.
(iv) It adopts a double-entry book-keeping system. It has two
sides: credit side and debit side. Receipts are recorded on the
credit side and payments on the debit side.
(v) When receipts are equal to payments, the balance of payments
is in equilibrium; when receipts are greater than payments, there
is surplus in the balance of payments; when payments are greater
than receipts, there is deficit in the balance of payments.
(vi) In the accounting sense, total credits and debits in the balance
of payments statement always balance each other.

Balance of Payment
Features of Balance of Payments
Balance of Payments has the following features:
(i) It is a systematic record of all economic transactions between

one country and the rest of the world.

(ii) It includes all transactions, visible as well as invisible.
(iii) It relates to a period of time. Generally, it is an annual
statement.
(iv) It adopts a double-entry book-keeping system. It has two
sides: credit side and debit side. Receipts are recorded on the
credit side and payments on the debit side.
(v) When receipts are equal to payments, the balance of payments
is in equilibrium; when receipts are greater than payments, there
is surplus in the balance of payments; when payments are greater
than receipts, there is deficit in the balance of payments.
(vi) In the accounting sense, total credits and debits in the balance
of payments statement always balance each other.

Balance of Payment
Current Account- It is sum of Balance of trade of Visible item (Merchandise) , Balance of

trade of Services, Investment income and Net transfer payments.

Balance of Trade
Visible Items/Merchandise-This includes exports and imports of goods. While the export
earn foreign exchange for the nation and are a credit item on the current account, the
imports use up foreign exchange and are a debit item.
Services- Services are another important constituent of the current account. Most nations
buy services from and sell services to other nations. These services are consultancy,
transportation, warehousing, travel & tourism etc. They are either using up or earning
foreign exchange.
The difference between a nations exports of goods and services and its imports of goods
and services is its balance of trade.
If the exports of goods and services (Credit Side) are less than imports of goods and
services (Debit Side), a nation is said to have a trade deficit.
A trade surplus on the other hand occurs when the exports of goods and services of a
nation are more than their imports.
Investment Income:
The 3rd item in the current account is the investment income. The citizens of a nation hold
foreign assets (stocks, bonds and real assets like buildings and factories. Dividend,
interest, rent and profits paid to such asset holders are a source of foreign exchange.
Conversely when foreigners earn dividends, interest and the profits on the assets held by
them in the nation foreign exchange is used up. Thus . Income received on capital invested
abroad is the credit item and income paid on capital borrowed from abroad is the debit
item. The net amount from this is also added to current account.

Balance of Payment
Net Transfer Payments- Transfer payments from a

nation to the foreigners are use of foreign exchange

(debit)and transfer payments from foreigners to a nation
are source of foreign exchange (credit). Some of this
transfer payments are from private citizens in the form
of gifts and donations and some are from Government in
form of payment of salaries to ambassadors and high
commissioners etc). The term net transfers refers to the
difference between payments from the nation to the
foreigners and payments from foreigners to the nation.
If we add net exports and imports of goods, net exports
and imports of services, net investment income and net
transfer payments we get the balance on current
account.

Balance of Payment
The balance on current account shows how much a nation has

spent on foreign goods, services, investment income and

transfer payments relative to how much it has earned from
other nations.
When the balance on current account is negative then a
nation has spent more on foreign goods and services,
investment income payments and transfers than it has earned
through sales of its goods and services, investment income
and transfer payment received.
If a nations current account net balance for a particular year is
negative that means its net wealth position vis-a vis the rest
of the world must decrease. In such a situation it is said that
there is deficit balance of payment on current account.
If a nations current account net balance is positive credit is
more than debit we say that their surplus balance of payment
on current account.

Balance of Payment
Capital Account- It reflects changes in foreign assets

and foreign liabilities of the nation. This includes

investments, loans and bank capital.
The capital inflow is credit and capital outflow is -debit.
The main elements of Capital Account are as followsInvestments
1.Foreign Direct Investment (FDI)- It is relatively for
long term. When FDI flows into the nation foreign
exchange increases and it will be on credit side. For eg
Allianz picks up 26% stake in life insurance arm of Bajaj
Auto Ltd and forms Bajaj Allianz Life Insurance Co. Ltd.
But when a nations citizens/firm make such
investments abroad foreign exchange goes out and it is
a debit entry. For eg Tata Tea buying out Tetley.

Balance of Payment
2. Portfolio Investment- Portfolio investment
represents sales and purchase of foreign financial
asset such as Shares and bonds. Unlike FDI, they
dont involve management control in the companies
in which investment is made.
Whenever a foreign investor or FII buys shares of
companies listed on Indian exchanges BSE or NSE it
involves a foreign investment in Indian shares and
this is foreign exchange inflow and it will be on credit
side. But when an Indian investor makes an
investment in companies listed on foreign stock
exchanges like Dow Jones, NASDAQ, Hang Sang then
there is outflow of foreign exchange and it will be
debit entry.

Balance of Payment
Private Capital flows- These are the loans received/given by

the Private residents from/to the Private non-residents. A loan

with less than 1 year is called short term capital flow and loan
with term greater than 1 year is called long term capital flow.
Loan received by Indian from foreigners are capital inflows and
are credits and loan given to foreigners by Indians are capital
outflows and hence debits.
Officials- This refers to changes in foreign assets and liabilities
of the Government of domestic country. A loan taken by the
Government from a foreign country will mean increase in
liabilities. But this result in foreign exchange inflow and hence it
represents credit entry. But when Government of domestic
country gives loan to a foreign country it represents foreign
exchange outflow and hence it appears on debit side. If the
domestic country purchases asset in the foreign country it will
result in increase of asset of the country but this will result in
foreign exchange outflow and will be a debit entry.

Balance of Payment
Banking Capital: Banking Capital includes changes in

foreign assets and liabilities of the foreign branch of an

Indian Bank. Foreign assets are loan given by the foreign
branches of Indian Banks and as this result in outflow of
foreign exchange it is a debit entry. Foreign liabilities are
the deposits held by the foreign branches of Indian
banks and as this results in inflow of foreign exchange it
is a credit entry.
Thus Capital account balance is net balance between
credit and debit entries of Foreign Direct Investment,
Portfolio investment, Private Capital flows, Officials,
Banking Capital. It may be surplus or deficit. If the net of
foreign exchange inflow(credit) is more than net of
foreign exchange outflow (debit)t then it will be surplus
and viceversa..

Balance of Payment
Official ReservesThese are government owned international assets. These are

held/owned by the Monetary Authority or Central Bank of the

Country like RBI.
These reserves are composed of
A)Gold
B) Convertible foreign currencies like Dollars, Euros, Japanese
Yen, U.K.s Pound etc.
C)Special Drawing Rights.
These reserves are used to account for deficit or surplus.
For examples of the home country BOP is in deficit then that
deficit has to be financed from this reserves by selling Gold,
SDRs or foreign exchange assets or even borrow from IMF or
Central Banks of other countries.
Similarly if the home country has a surplus BOP then it means
there will be increase in reserves of the country.

Exchange Rates

Exchange rate is the rate at which one countrys currency can be exchanged

for another.
For eg 1 USD= 54 INR
Increase in the value of exchange rate is appreciation of exchange rate and
decrease in value of exchange rate is depreciation or devaluation of exchange
rate.
For eg if 1 USD= 55 INR then USD has appreciated and INR has depreciated.
If 1 USD = 53 INR then USD has depreciated and INR has appreciated.
Initially we started with fixed exchange rate system but finally gave way to
floating or market determined exchange rate system.
While Governments in most nations still intervene to ensure that exchange rate
movements are orderly, the exchange rates today are by and large determined
by the unregulated forces of supply and demand.
Exchange rates play an important role in determining the performance of an
economy.
If the exchange rate of a country depreciates then the exports of that country
become more attractive and cheaper than the other country and consequently
the export increases. At the same time the imports becomes more expensive.
So the imports decrease and demand for domestic goods rises. As a result of
increase in exports and demand for domestic goods output increases and GDP
also increases.

Exchange Rates

Factors on which the Exchange Rates

depend/Determinants of Exchange Rates

1. Inflation
If inflation in the India is relatively lower than elsewhere, then
Indian exports will become more competitive and there will be an
increase in demand for Rupee to buy Indian goods. Also foreign
goods will be less competitive and so Indian citizens will buy less
imports.
Therefore countries with lower inflation rates tend to see an
appreciation in the value of their currency.
2. Interest Rates
If Indian interest rates rise relative to elsewhere, it will become
more attractive to deposit money in the India. You will get a
better rate of return from saving in Indian banks, Therefore
demand for Rupee will rise. Higher interest rates cause an
appreciation in the currency. This is known as hot money
flows and is an important short run factor in determining the
value of a currency.

Exchange Rates

3.Change in Competitiveness
If Indian goods become more attractive and competitive this will also cause the

value of the Exchange Rate to rise as foreigners will need more Indian rupee to
purchase Indian goods. This is important for determining the long run value of
the Rupee. This is similar factor to low inflation.
4. Balance of Payments
A deficit on the current account means that the value of imports (of goods and
services) is greater than the value of exports. If this is financed by a surplus on
the financial / capital account then this is OK. But a country who struggles to
attract enough capital inflows to finance a current account deficit, will see a
depreciation in the currency. (For example current account deficit in US of 7%
of GDP was one reason for depreciation of dollar in 2006-07)
5. Government Debt.
Under some circumstances, the value of government debt can influence the
exchange rate. If markets fear a government may default on its debt, then
investors will sell their bonds causing a fall in the value of the exchange rate.
For example, Ireland debt problems in 2008, caused a rapid fall in the value of
the Ireland currency and Greece crisis.
For example, if markets feared the India would default on its debt, foreign
investors would sell their holdings of Indian bonds. This would cause a fall in
the value of the rupee.

Exchange Rates

6.Government Intervention
Some governments attempt to influence the value of their currency. For example,

China has sought to keep its currency undervalued to make Chinese exports
more competitive. They can do this by buying US dollar assets which increases
the value of the US dollar to Chinese Yuan.
7.Price of Oil
A large portion of Indias import payment is mainly for payment of oil.
Internationally, crude prices are named as BRENT, NYMEX, and Dubai Crude.
Whenever there is any hike in the oil price per barrel, the Indian Rupee
depreciates against the US Dollar. As such, the Indian Government buys more
USD against INR to honour the import liability, resulting in heavy demand for
USD. Consequently, the Indian rupee depreciates against USD.
8.Natural Calamities
Natural calamities may also affect the currency market for a short period of time.
In August 2005, Hurricane Katrina affected the entire region around the Gulf of
Mexico. This region contributes around one-third of US oil production and
accounts for around half of the nations refining capacity. Besides, a large part of
US oil imports reaches ports in this area. The hurricane caused a huge loss in
production of crude oil and natural gas. It affected the prices of crude oil and
prices shot up to around USD70 per barrel in a very short time. Automatically,
the oil price increased globally and at the same time affected the exchange rate.
Since India had to buy more USD to honour its import liability, the Rupee became
weaker by around 60-65 paise against the USD.

Taxation

The most important source of revenue of the government is taxes. The act of

levying taxes is called taxation. A tax is a compulsory charge or payment

imposed by government on individuals or corporations. The persons who are
taxed have to pay the taxes irrespective of any corresponding return from
the goods or services by the government. The taxes may be imposed on the
income and wealth of persons or corporations and the rate of taxes may
vary.
Canons of Taxation
Canons of Taxation are the main basic principles (i.e. rules) set to build

a 'Good Tax System'.

Canons of Taxation were first originally laid down by economist Adam
Smith in his famous book "The Wealth of Nations".
In this book, Adam smith only gave four canons of taxation. These
original four canons are now known as the "Original or Main Canons of
Taxation".
As the time changed, governance expanded and became much more
complex than what it was at the Adam Smith's time. Soon a need was
felt by modern economists to expand Smith's principles of taxation and
as a response they put forward some additional modern canons of
taxation.

Taxation

Adam Smith's Four Main Canons of Taxation

A good tax system is one which is designed on the basis of an

appropriate set of principles (rules). The tax system should strike a

balance between the interest of the taxpayer and that of tax
authorities. Adam Smith was the first economist to develop a list of
Canons of Taxation. These canons are still regarded as characteristics
or features of a good tax system.
1. Canon of Equity
The principle aims at providing economic and social justice to the
people. According to this principle, every person should pay to the
government depending upon his ability to pay. The rich class people
should pay higher taxes to the government, because without the
protection of the government authorities (Police, Defence, etc.) they
could not have earned and enjoyed their income. Adam Smith argued
that the taxes should be proportional to income, i.e., citizens should
pay the taxes in proportion to the revenue which they respectively
enjoy under the protection of the state.

Taxation

2. Canon of Certainty
According to Adam Smith, the tax which an individual has to pay should

be certain, not arbitrary. The tax payer should know in advance how
much tax he has to pay, at what time he has to pay the tax, and in what
form the tax is to be paid to the government. In other words, every tax
should satisfy the canon of certainty. At the same time a good tax
system also ensures that the government is also certain about the
amount that will be collected by way of tax.
3. Canon of Convenience
The mode and timing of tax payment should be as far as possible,
convenient to the tax payers. For example, land revenue is collected at
time of harvest & income tax is deducted at source. Convenient tax
system will encourage people to pay tax and will increase tax revenue.
4. Canon of Economy
This principle states that there should be economy in tax administration.
The cost of tax collection should be lower than the amount of tax
collected. It may not serve any purpose, if the taxes imposed are
widespread but are difficult to administer. Therefore, it would make no
sense to impose certain taxes, if it is difficult to administer.

Taxation

Additional Canons of Taxation

Activities and functions of the government have increased significantly since

Adam Smith's time. Government are expected to maintain economic

stability, full employment, reduce income inequality & promote growth and
development. Tax system should be such that it meets the requirements of
growing state activities.
Accordingly, modern economists gave following additional canons of
taxation.
5. Canon of Productivity
It is also known as the canon of fiscal adequacy. According to this principle,
the tax system should be able to yield enough revenue for the treasury and
the government should have no need to resort to deficit financing. This is a
good principle to follow in a developing economy.
6. Canon of Elasticity
According to this canon, every tax imposed by the government should be
elastic in nature. In other words, the income from tax should be capable of
increasing or decreasing according to the requirement of the country. For
example, if the government needs more income at time of crisis, the tax
should be capable of yielding more income through increase in its rate.

Taxation

7. Canon of Flexibility
It should be easily possible for the authorities to revise the tax structure

both with respect to its coverage and rates, to suit the changing
requirements of the economy. With changing time and conditions the tax
system needs to be changed without much difficulty. The tax system must
be flexible and not rigid.
8. Canon of Simplicity
The tax system should not be complicated. That makes it difficult to
understand and administer and results in problems of interpretation and
disputes. In India, the efforts of the government in recent years have been
to make the system simple.
9. Canon of Diversity
This principle states that the government should collect taxes from
different sources rather than concentrating on a single source of tax. It is
not advisable for the government to depend upon a single source of tax, it
may result in inequity to the certain section of the society; uncertainty for
the government to raise funds. If the tax revenue comes from diversified
source, then any reduction in tax revenue on account of any one cause is
bound to be small.

Taxation

Classification of Taxes on basis of degree of progression

of tax

Proportional tax
A tax is called proportional when the rate of taxation

remains constant as the income of the tax payer increases.

In this system all incomes are taxed at a single uniform rate,
irrespective of whether tax payers income is high or low.
The tax liability increases in absolute terms, but the
proportion of income taxed remains the same.

Progressive tax
When the rate of taxation increases as the tax payers

income increases, it is called a progressive tax. In this

system, the rate of tax goes on increasing with every
increase in income.

Taxation

Regressive taxation
A regressive tax is one in which the rate of taxation

decreases as the tax payers income increases. Lower income

is taxed at a higher rate, whereas higher income is taxed at a
lower rate. However absolute tax liability may increase.

Degressive taxation
A tax is called degressive when the rate of progression in

taxation does not increase in the same proportion as the

increase in income. In this case, the rate of tax increases up
to a certain limit, after that a uniform rate is charged. Thus
degressive tax is a combination of progressive and
proportional taxation. This type of taxation is often used in
case of income tax. This is the case of income tax in India as
well.

Taxation

Taxes can be classified into various types on the basis of

form,nature,aim and method of taxation. the most common and

traditional classification is to classify into direct and indirect taxes .

Direct taxes
A direct tax is that tax whose burden is borne by the same person

on whom it is levied. The ultimate burden of taxation falls on the

person on whom the tax is levied. It is based on the income and
property of a person. Thus income tax, corporation tax on
companys profits, property tax, capital gains tax, wealth tax etc are
examples of direct taxes.

Indirect taxes
An indirect tax is that tax which is initially paid by one individual,

but the burden of which is passed over to some other individual

who ultimately bears it. It is levied on the expenditure of a person.
Excise duty, sales tax, custom duties etc are examples of indirect
taxes.

Taxation

Direct Taxes
Individual Income Tax: Income Tax Act,

1961 imposes tax on the income of the

individuals or Hindu undivided families Tax
rates are prescribed by the government in the
Finance Act, popularly known as Budget, every
year.
Taxable Income Slab for AY 2013-14

Rate %

For Individual below 6o years- Income Up Nil

to 200000
For Individual from 60 to 80 yearsIncome Up to 250000

Nil

For Individual from 0 to 60 years-Income- 10 %

2000001- 500000

Taxation

Corporation Tax: The companies and business organizations in

India are taxed on the income from their worldwide transactions

under the provision of Income Tax Act, 1961. A corporation is
deemed to be resident in India if it is incorporated in India or if its
control and management is situated entirely in India. Current
Corporate tax is 30 % with 3 % education cess on tax amount.
Wealth Tax-Wealth tax, in India, is levied under Wealth-tax Act,
1957. Wealth tax is a tax on the benefits derived from property
ownership. The tax is to be paid year after year on the same
property on its market value, whether or not such property yields
any income. Similar to income tax the liability to pay wealth tax
also depends upon the residential status of the assessee. The
assets chargeable to wealth tax are Guest house, residential
house, commercial building, Motor car, Jewelry, bullion, utensils of
gold, silver, Yachts, boats and aircrafts, urban land, cash in hand
(in excess of INR 50,000 for Individual & HUF only),etc. Wealth tax
is charged @ 1% of the amount by which the net wealth exceeds
Rs. 30,00,000 Lakhs.

Taxation

Capital Gains Tax

The central government also charges tax on the capital gains that is derived

from the sale of the assets. The capital gain is the difference between the
money received from selling the asset and the price paid for it.
Capital gain also includes gain that arises on transfer (includes sale,
exchange) of a capital asset and is categorized into short-term gains and longterm gains. The Long-term Capital Gains Tax is charged if the capital assets
are kept for more than three years or 12 months in the case of securities and
shares that are listed under any recognized Indian stock exchange or mutual
fund. Short-term Capital Gains Tax is applicable if the assets are held for less
than the aforesaid period.
In case of the long term capital gains, they are taxed at a concession rate.
Normalcorporate income tax rates are applicable for short term capital gains.
In case of the short term and long term capital losses, they are allowed to be
carried forward for 8 consecutive years.
For shares or equity oriented mutual fund short term is 15 % and long term is
nil .
For other assets for individuals STCG is progressive slab rates and for a firm or
company it is 30%. LTCG is 20% with indexation and 10 % without indexation
for both individuals and firms.

Taxation

INDIRECT TAXES
Central Government
Excise Duty
The central government levies excise duty under the Central Excise act of 1944

and the Central Excise Tariff Act of 1985. Central Excise duty is an indirect tax
levied on goods manufactured in India and meant for domestic consumption. The
Central Board of Excise and Customs under the Ministry of Finance, administers
the excise duty. Central Excise Duty arises as soon as the goods are
manufactured. It is paid by a manufacturer, who passes on its incidence to the
customers.
Customs Duty
Customs duty in India falls under the Customs Act 1962 and Customs Tariff Act of
1975. Customs duty is the tax levied on goods imported into India as well as on
goods exported from India. Taxable event is import into or export from India.
Additionally educational cess is also charged. The customs duty is evaluated on
the value of the transaction of the goods. The Central Board of Excise and
Customs under the Ministry of Finance manages the customs duty process in the
country. The rate at which customs duty is applicable on the goods depends on
the classification of the goods determined under the Customs Tariff. It should be
noted that preferential/concessional rates of duty are also available under the
various Trade Agreements.

Taxation

Service Tax
Service tax was introduced in India way back in 1994

and started with mere 3 basic services viz. general

insurance, stock broking and telephone. Subsequent
Budgets have expanded the scope of the service tax as
well as the rate of service tax. More than 100 services
are subjected to tax under this provision. An education
cess is also charged on the tax amount. The Central
Board of Excise and Customs under the Ministry of
Finance manages the administration of service tax.
Securities Transaction Tax (STT)
Transactions in equity shares, derivatives and units of
equity-oriented funds entered in a recognized stock
exchange attract Securities Transaction Tax. Service Tax,
Surcharge and Education Cess are not applicable on STT

Taxation

State Taxes
Value Added Tax (VAT)
Sales tax charged on the sales of movable goods has been

replaced with VAT in most of the Indian states since 2005.

This was introduced to counter the rampant double taxation
issues and resultant cascading tax burden that occurred due
to the flaws inherent in the previous sales tax system.
VAT, chargeable only on goods and does not include services,
is a multi-stage system of taxation, whereby tax is levied on
value addition at each stage of transaction in the supply
chain. The term value addition implies the increase in value
of goods and services at each stage of production or transfer
of goods and services. VAT is a tax on the final consumption
of goods or services and is ultimately borne by the consumer.
VAT comes under the state list. Tax payers can claim credit
for the taxes paid at earlier stages and purchases

Taxation

Stamp Duty
It is a tax that is levied on the transaction performed by means

of a document or instrument as per the regulations of Indian

Stamp Act, 1899. It is collected by the government of the state
where the transaction is carried out. Stamp duty rates vary
between the states.
Stamp duty is paid on instruments, which are essentially a
document to create, transfer, limit, extend, extinguish or
record a right or liability. Document acquires legality once it is
stamped properly after the payment of the requisite stamp
duty charges. Stamp duty is payable for transfer of shares,
share certificate, partnership deed, bill of exchange, shares,
share transfer, leave and license agreement, debentures, gift
deed, bank guarantee, bonds, demat shares, development
agreement, demerger, power of attorney, home loans, houses
& house purchase, lease deed, loan agreement and lease
agreement.

Taxation

State Excise
Power to impose excise on alcoholic liquors,

opium and narcotics is granted to States

under the Constitution and it is called State
Excise. The Act, Rules and rates for excise on
liquor are different for each State.
In addition to the above taxes by the Central
and State Governments the local bodies have
the authority to levy tax on properties,
octroi/entry tax on utilities like water etc.

Budget Deficit, Fiscal Deficit and Deficit Financing

Budget is prepared by the Government showing the expected

income/receipts and expenditure for the coming financial year.

Receipts comes from taxes (both direct and indirect), profits from
Government owned Public Sector Undertakings like HPCL, BPCL, SBI,
BSNL, LIC etc, interest from loan given to other country Governments
or local bodies.
The expenditure of Government are on developmental projects such
as construction of roads, railways, production of utilities like energy,
water etc and non developmental expenditure on large number of
activities like Defense, Law, Police, Subsidies, Administration etc.
If the receipts are equal to expenditure then budget is said to be
balanced. If the receipts are more than expenditure then budget is
said to be in surplus. If the receipts are less than expenditure then
budget is said to be in deficit. But deficit is always neutralized by
borrowings and this is called as deficit financing.
Fiscal deficit measures that part of Government expenditure which is
financed by borrowings. It is the excess expenditure over
Governments own income or receipt.

Budget Deficit, Fiscal Deficit and Deficit Financing

Deficit Financing
Deficit financing is defined as financing the budgetary deficit through public loans and

creation of new money. Deficit financing in India means the expenditure which in
excess of current revenue and public borrowing, the government may cover the deficit
in the following ways.
1. By running down its accumulated cash reserve from RBI.
2. Issue of new currency by government it self.
3. Borrowing from reserve bank of India and RBI gives the loans by printing more
currency notes.
Objectives of deficit financing :
1. To finance war:- Deficit financing has generally being used as a method of financing
war expenditure. During the war time through normal methods of raising resources. It
becomes difficult to mobilize adequate resources. Therefore government has to adopt
deficit financing.
2. Remedy for depression :- In developed countries deficit financing is used as on
instrument of economic policy for removing the conditions of depression. Prof. Keynes
has also advocated for deficit financing as a remedy for depression and unemployment

Budget Deficit, Fiscal Deficit and Deficit Financing

3. Economic development:- The main objective of deficit financing in an under developed country

like India is to promote economic development. The use of deficit financing in fact becomes
essential for financing the development plan especially in underdeveloped countries.
4. Mobilization of Resources :- deficit financing is also used for the mobilization of surplus, ideal
and unutilized resources in the country.
5. For granting subsidies :- In a country like India government grants subsidies to the producers to
encourage them to produce a particular type of commodity, granting subsidies is a very costly
affair which we cannot meet with the regular income this deficit financing becomes must for it.
6. Increase in aggregate demand :- Deficit financing loads to increase in aggregate demand
through increased public expenditure. This increase the income and purchasing power of the
people as a consequence there is an increase availability of goods and services and the
production and employment level also increase.
7. For payment of interest:- Loan which are taken by the govt. are supposed to be repaid with
their interest for that government needs money deficit financing is an important tool to get the
income for the repayment of loan along with the interest.
8. To overcome low tax receipts.
9. To overcome the losses of public sector enterprises
10. For implementing anti poverty programme.

Budget Deficit, Fiscal Deficit and Deficit Financing

ADVERSE EFFECTS OF DEFICIT FINANCING

Deficit financing is not free from its deffects. It has its adverse effect on
economy. Important evil effects of deficit financing are given below.
1. Leads to inflation :- Deficit financing may lead to inflation. due to
deficit financing money supply increases & the purchasing power of the
people also increase which increases the aggregate demand and the
prices also increase.
2. Adverse effect on saving:- Deficit financing leads to inflation and
inflation affects the habit of voluntary saving adversely. Infact it is not
possible for the people to maintain the previous rate of saving in the
state of rising prices.
3. Adverse effect on Investment ;- deficit financing effects investment
adversely when there is inflation in the economy trade unions make
demand for higher wages for that they go for strikes and lock outs which
decreases the efficiency of Labour and creates uncertainty in the
business which a decreases the level of investment of the country.

Budget Deficit, Fiscal Deficit and Deficit Financing

4. Inequality :- in case of deficit financing income distribution becomes unequal.

During deficit financing deflationary pressure can be seen on the economy which
make the rich richer and the poor, poorer. The fix wage earners are badly effected
and their standard of living detoriates thus no gap b/w rich & poor increases.
5. Problem of balance of payment :- Deficit financing leads to inflation. A high price
level as compared to other countries will make the exports more expensive and thus
they start declining. On the other hand rise in domestic income and price may
encourage people to import more commodities from abroad. This will create a deficit
in balance of payment and the balance of payment will become unfavorable.
6. Increase in the cost of production :- When deficit financing leads to the rise in the
price level the cost of development projects also rises this means a larger dose of
deficit financing is required on the port of government for completion of these
projects.
7. Change in the pattern of investment:- Deficit financing leads to inflation. During
inflation prices rise and reach to a very high level in that case people instead of
indulging into productive activities they start doing speculative activities.