Month: January 2021

Public finance deals with the question how the Government raises its resources to meet its ever-rising expenditure. As Dalton puts it,” public finance is “concerned with the income and expenditure of public authorities and with the adjustment of one to the other.”

Accordingly, effects of taxation, Gov­ernment expenditure, public borrowing and deficit financing on the economy constitutes the subject matter of public finance. Thus, Prof. Otto Eckstein writes “Public Finance is the study of the effects of budgets on the economy, particularly the effect on the achievement of the major economic objects growth, stability, equity and efficiency.”

Further, it also deals with fiscal policies which ought to be adopted to achieve certain objectives such as price stability, economic growth, more equal distribution of income. Economic thinking about the role that public finance is expected to play has changed from time to time according to the changes in economic situ­ation.

Before the Great Depression that gripped the Western industrialised countries during the thirties, the role of public finance was considered to be raising sufficient resources for carrying out the Government functions of civil administration and defence from foreign countries. During this period, the classical economists considered it prudent to keep expenditure to the minimum so that taxing of the people is avoided as far as possible.

Further, it was thought that Government budget must be balanced. Public borrowing was recommended mainly for production purposes. During a war, of course, public borrowing was considered legitimate but it was thought that the Government should repay or reduce the debt as soon as possible.

Economists have a strict definition of a public good, and it does not necessarily include all goods financed through taxes. To understand the defining characteristics of a public good, first consider an ordinary private good, like a piece of pizza. A piece of pizza can be bought and sold fairly easily because it is a separate and identifiable item. However, public goods are not separate and identifiable in this way.

Even though new technology typically creates positive externalities through which one-third to one-half of the social benefit of new inventions spills over to others, the inventor still receives some private return. But what about a situation where the positive externalities are so extensive that private firms could not expect to receive any of the social benefit? This kind of good is called a public good.

Instead, public goods have two defining characteristics: they are nonexcludable and nonrivalrous. The first characteristic, that a public good is nonexcludable, means that it is costly or impossible to exclude someone from using the good. If Larry buys a private good like a piece of pizza, then he can exclude others, like Lorna, from eating that pizza. However, if national defense is being provided, then it includes everyone. Even if you strongly disagree with America’s defense policies or with the level of defense spending, the national defense still protects you. You cannot choose to be unprotected, and national defense cannot protect everyone else and exclude you.

The second main characteristic of a public good that it is nonrivalrous means that when one person uses the public good, another can also use it. With a private good like pizza, if Max is eating the pizza, then Michelle cannot also eat it it the two people are rivals in consumption. With a public good like national defense, Max’s consumption of national defense does not reduce the amount left for Michelle, so they are nonrivalrous in this area.

A number of government services are examples of public goods. For instance, it would not be easy to provide fire and police service so that some people in a neighborhood would be protected from the burning and burglary of their property, while others would not be protected at all. Protecting some necessarily means protecting others, too.

Positive externalities and public goods are closely related concepts. Public goods have positive externalities, like police protection or public health funding. Not all goods and services with positive externalities, however, are public goods. Investments in education have huge positive spillovers but can be provided by a private company. Private companies can invest in new inventions such as the Apple iPad and reap profits that may not capture all of the social benefits.

Key Character

• A public good has two key characteristics: it is nonexcludable and nonrivalrous. These characteristics make it difficult for market producers to sell the good to individual consumers.
• Nonexcludable means that it is costly or impossible for one user to exclude others from using a good.
• Nonrivalrous means that when one person uses a good, it does not prevent others from using it.

It is apparent that public goods will not be adequately supplied by the private sector. The reason is plain: because people can’t be excluded from using public goods, they can’t be charged money for using them, so a private supplier can’t make money from providing them. … Because public goods are generally not adequately supplied by the private sector, they have to be supplied by the public sector.

Economists have often jumped from the observation that public goods are susceptible to underproduction to the conclusion that the government should tax people and use the revenues to provide public goods.

Public goods are regularly supplied by private actors without government coercion. For example:

• Having one’s downtown be free of impoverished beggars is a benefit that is both non-rivalrous and non-excludable, yet privately funded homeless shelters and soup kitchens are common.
• A beautiful, well-kept garden provides a vista that multiple users can enjoy without depletion (non-rivalrous) and from which passersby cannot easily be barred (non-excludable), yet many homeowners in populated areas expend significant sums, not to mention hours of hard labor, tending their yards.
• A highly educated citizenry tends to make better political decisions and to generate a richer cultural environment—both benefits that are non-rivalrous and largely non-excludable—yet people routinely spend great sums educating their children.
• Private groups regularly clean up roadsides, even though the benefit they are creating is not depleted as more drivers use the road (non-rivalrous) and cannot be limited to people who contribute to the clean-up (non-excludable).
• Millions of people make donations on “crowd-funding” websites like Kickstarter to finance projects like community theatre spaces, thereby creating the non-excludable, non-rivalrous benefit of more cultured communities.

Overcoming the Free-Rider

Direct provision of a public good by the government can help to overcome the free-rider problem which leads to market failure

• The non-rival nature of consumption provides a strong case for the government rather than the market to provide and pay for public goods.
• Many public goods are provided more or less free at the point of use and then paid for out of general taxation or another general form of charge such as a license fee.
• State provision may help to prevent the under-provision and under-consumption of public goods so that social welfare is improved.
• If the government provides public goods, they may be able to do so more efficiently because of economies of scale.

Public goods an example of market failure

• Pure public goods are not normally provided by the private sector because they would be unable to supply them for a profit.
• It is up to the government to decide what output of public goods is appropriate for society.
• To do this, it must estimate the social benefits from making public goods available.

Free Rider Problem

• Because public goods are non-excludable it is difficult to charge people for benefitting form a good or service once it is provided
• The free rider problem leads to under-provision of a good and thus causes market failure

Quasi-Public Goods

A quasi-public good is a near-public good i.e. it has many but not all the characteristics of a public good. Quasi-public goods are:

• Semi-non-rival: up to a point, extra consumers using a park, beach or road do not reduce the space available for others. Eventually beaches become crowded as do parks and other leisure facilities. Open access Wi-Fi networks become crowded
• Semi-non-excludable: it is possible but often difficult or expensive to exclude non-paying consumers. E.g. fencing a park or beach and charging an entrance fee; building toll booths to charge for road usage on congested routes
• The air waves – a public good or quasi public good?
• The airwaves used by mobile phone companies, radio stations and television companies are owned by the government.
• Do they count as a pure public good? One person’s use of the airwaves rarely limits how other people can benefit from utilising them.
• At peak times, the airwaves become crowded

Public expenditure is spending made by the government of a country on collective needs and wants such as pension, provisions (such as education, healthcare and housing), security, infrastructure, etc. Until the 19th century, public expenditure was limited as laissez faire philosophies believed that money left in private hands could bring better returns. In the 20th century, John Maynard Keynes argued the role of public expenditure in determining levels of income and distribution in the economy. Since then, government expenditures has shown an increasing trend. Sources of government revenue include taxes, and non-tax revenues.

In the 17th and the 18th centuries, public expenditure was considered a wastage of money. Thinkers believed government should stay with their traditional functions of spending on defense and maintaining law and order.

Causes of growth of public expenditure

There are several factors that have led to an enormous increase in public expenditure through the years

1) Defense expenditure due to modernization of defense equipment by the navy, army and air force to prepare the country for war or for prevention causes-for-growth-of-public-expenditure.

2) Population growth: It increases with the increase in population, more of investment is required to be done by government on law and order, education, infrastructure, etc. investment in different fields depending on the different age group is required.

3) Welfare activities: Welfare, mid-day meals, pension provisions etc.

• Provision of public and utility services: Provision of basic public goods given by government (their maintenance and installation) such as transportation.
• Accelerating economic growth: In order to raise the standard of living of the people.
• Price rise: Higher price level compels the government to spend an increased amount on purchase of goods and services.
• Increase in public revenue: With the rise in public revenue government is bound to increase the public expenditure.
• International obligation: maintenance of socio-economic obligation, cultural exchange etc. (these are indirect expenses of government)

4) Wars and social crises: Fighting amongst people and communities, and prolonged drought or unemployment, earthquake, hurricanes or tornadoes may lead to an increase in public expenditure of a country. This is because it will involve governments to re-plan and allocate resources to finance the reconstruction.

5) Creation of super national organizations: E.g., the United Nations, NATO, European community and other multinational organizations that are responsible for the provision of public goods and services on an international basis, have to be financed out of funds subscribed by member states, thereby adding to their public expenditure.

6) Foreign aid: Acceptance by the richer industrialized countries of their responsibility to help the poor developing countries has channelled some of the increased public expenditure of the donor country into foreign aid programmes.

7) Inflation: This is the general rise in the price level of goods and services. It increases the cost of all activities of the public sector and thus a major factor in growth in money terms of public expenditure.

Principle of maximum social advantage

The criteria and pre-conditions for arriving at this solution are collectively referred to as the principle of maximum social advantage. Taxation (government revenue) and government expenditure are the two tools. Neither of excess is good for the society, it has to be balanced to achieve maximum social benefit. Dalton called this principle as “Maximum Social Advantage” and Pigou termed it as “Maximum Aggregate Welfare”.

Dalton’s Principle of Maximum Social Advantage maximum satisfaction should be yield by striking a balance between public revenue and expenditure by the government. Economic welfare is achieved when marginal utility of expenditure = marginal disutility of taxation. He explains this principle with reference to

• Maximum Social Benefit (MSB)
• Maximum Social Sacrifice (MSS)

India’s social security system is composed of a number of schemes and programs spread throughout a variety of laws and regulations. Keep in mind, however, that the government-controlled social security system in India applies to only a small portion of the population.

Furthermore, the social security system in India includes not just an insurance payment of premiums into government funds (like in China), but also lump sum employer obligations.

Generally, India’s social security schemes cover the following types of social insurances:

• Pension
• Health Insurance and Medical Benefit
• Disability Benefit
• Maternity Benefit

The Code on Social Security, 2020

Foreign companies should note that when The Code of Social Security, 2020, one of the four new labor codes introduced by the Ministry of Labor and Employment comes into force, it will subsume the following enactments:

• The Employees’ Compensation Act, 1923
• The Employees’ State Insurance Act, 1948
• The Employees’ Provident Funds and Miscellaneous Provisions Act, 1952
• The Employment Exchanges (Compulsory Notification of Vacancies) Act, 1959
• The Maternity Benefit Act, 1961
• The Payment of Gratuity Act, 1972
• The Cine- Workers Welfare Fund Act, 1981
• The Building and Other Construction Workers Welfare Cess Act, 1996
• The Unorganised Workers’ Social Security Act, 2008

Rules for the new labor codes on industrial relations, social security, and occupational safety health & working conditions (OSH) are likely to be finalized by the end of January, according to Labor Secretary Apurva Chandra. If that is the case, it may result in implementation of the labor codes by April 1, 2021, which was the deadline put by the labor ministry. However, this timeline is subject to change, depending on interventions made by key stakeholders and lobby groups and other exigencies, such as the impact of the ongoing pandemic.

The Labor Secretary was also quoted in the media saying that the draft model standing orders for the manufacturing, mining, and service sectors will be finalized by February. These draft orders set the standards for service conditions and employees’ conduct in the respective sectors and were notified on December 31, 2020 to seek feedback (within a period of 30 days from the date of notification).

Pension or Employees’ Provident Fund

The Employees’ Provident Fund Organization (EPFO), under the Ministry of Labor and Employment, ensures superannuation pension and family pension in case of death during service. Presently, only about 35 million out of a labor force of 400 million have access to formal social security in the form of old-age income protection in India. Out of these 35 million, 26 million workers are members of the Employees’ Provident Fund Organization, which comprises private sector workers, civil servants, military personnel, and employees of State Public Sector Undertakings (PSUs).

The schemes under the EPFO apply to businesses with at least 20 employees. Contributions to the Employees’ Provident Fund (EPF) Scheme are obligatory for both the employer and the employee when the employee is earning up to INR 15,000 (US$205) per month, and voluntary, when the employee earns more than this amount. If the pay of any employee exceeds this amount, the contribution payable by the employer will be limited to the amount payable on the first INR 15,000 only.

Three schemes are supervised by the Employees’ Provident Fund Organization:

• The Employees’ Provident Fund Scheme, 1952;
• The Employees’ Pension Scheme, 1995; and,
• The Employees’ Deposit Linked Insurance Scheme, 1976.

Four main types of pension (all monthly) are offered:

• Pension upon superannuation or disability
• Widows’ pension for death while in service
• Children’s pension
• Orphan’s pension

Health Insurance and Medical Benefit

India has a national health service, but this does not include free medical care for the whole population. The Employees’ State Insurance (ESI) Act, 1948 created a fund to provide medical care to employees and their families, as well as cash benefits during sickness and maternity, and monthly payments in case of death or disablement for those working in factories and establishments with 10 or more employees. (As on March 31, 2017, the total number of ESI beneficiaries were 123.7 million.)

Coverage under the ESI scheme has extended to hotels, shops, cinemas and preview theaters, restaurants, newspaper establishments, and road-motor transport undertakings. The scheme has also been extended to private educational and medical institutions that have employed 10 or more employee. This is applicable in certain states and union territories only.

The ESI (Central) Amendment Rules, 2016 – notified on December 22, 2016 – expanded coverage to include employees earning INR 21,000 (US$287) or less in a month from January 1, 2017; previously, the wage limit for ESI subscribers was INR 15,000 per month.

An employee who earns less than INR 21,000 per month contributes 1.75 percent of their salary towards the ESI while the employer pays 4.75 percent making a total contribution of 6.5 percent. The company or establishment can apply for an ESI registration within 15 days from the time the ESI Act becomes applicable to that entity. The Employees’ State Insurance (Central) Amendment Rules, 2017 was notified on January 20, 2017 detailing new maternity benefits for women who have insurance.

Sickness benefit under ESI coverage is 70 percent of the average daily wage and is payable for a maximum of 91 days in a year. To qualify for sickness benefit, the insured worker is required to contribute for 78 days in a contribution period of six months. There are provisions for extended sickness benefits and corresponding eligibility criteria.

ESI also provides disablement benefit, which is applicable from day one of entering insurable employment for temporary disablement benefit. In case of permanent disablement benefit, it is paid at the rate of 90 percent of wage in the form of monthly payment, depending upon the extent of loss of earning capacity as certified by a Medical Board.

Besides sickness and disability pay outs, the ESI provides for dependents’ benefits (DB). The DB paid is at the rate of 90 percent of the wage in the form of monthly payment to the dependents of a deceased insured person – in cases where the death has occurred due to employment injury or occupational hazards.

Other benefits that are offered with ESI are:

• Medical benefits;
• Maternity benefits;
• Unemployment allowance;
• Confinement expenses;
• Funeral expenses;
• Physical rehabilitation;
• Vocational training; and
• Skill upgradation training under Rajiv Gandhi Shramik Kalyan Yojana (RGSKY).

A one-time relaxation has been extended to employers who could not file the return of ESI contribution for the contribution period from April 1, 2020 to September 30, 2020 due to the extenuating circumstances faced by enterprises last year. The new deadline to file this return is January 15, 2021. This does not impact employees contributing to and receiving benefits from the ESI. Also, no further relaxations have been provided for older or newer contribution periods.

Disability Benefit

The Employee’s Compensation Act, 1923, formerly known as the ‘Workmen’s Compensation Act, 1923’, requires the employer to pay compensation to employees or their families in cases of employment related injuries that result in death or disability.

In addition, workers employed in certain types of occupations are exposed to the risk of contracting certain diseases, which are peculiar and inherent to those occupations. A worker contracting an occupational disease is deemed to have suffered an accident out of and in the course of employment, and the employer is liable to pay compensation for the same. Injuries resulting in permanent total and partial disablement are listed in parts I and II of Schedule I of the Employee’s Compensation Act, while occupational diseases have been defined in parts A, B, and C of Schedule III of the Employee’s Compensation Act.

Last year, the central government changed the wage amount to be considered for calculation of compensation to workers under the Employee’s Compensation Act, 1923 vide notification S.O.71 (E) dated January 3, 2020. Now, it will be INR 15,000 (US$205), according to the notification by the Ministry of Labor and Employment. The previous wage amount considered for the calculation of compensation was just INR 8,000 (US$109).

Compensation calculation depends on the situation of occupational disability:

(a) Death

50 percent of the monthly wage multiplied by the relevant factor or an amount of INR 120,000 (US$1,640), whichever is more.

(b) Total permanent disablement

60 percent of the monthly wage multiplied by the relevant factor or an amount of INR 120,000 (US$1,640), whichever is more.

The relevant factor for computation is mentioned in Schedule IV of the Employee’s Compensation Act.

Maternity Benefit

The Maternity Benefit (Amendment) Act, 2017 came into force on April 1, 2017, and increases some of the key benefits mandated under the previous Maternity Benefit Act of 1961. The amended law provides women in the organized sector with paid maternity leave of 26 weeks, up from 12 weeks, for the first two children. For the third child, the maternity leave entitled will be 12 weeks. India now has the third most maternity leave in the world, following Canada (50 weeks) and Norway (44 weeks).

The Act also secures 12 weeks of maternity leave for mothers adopting a child below the age of three months as well as to commissioning mothers (biological mothers) who opt for surrogacy. The 12-week period in these cases will be calculated from the date the child is handed over to the adoptive or commissioning mother.

In other provisions, the law mandates that every establishment with over 50 employees must provide crèche facilities within easy distance, which the mother can visit up to four times a day. For compliance purposes, companies should note that this particular provision will come into effect from July 1, 2017.

The Maternity Benefit (Amendment) Act introduces the option for women to negotiate work-from-home, if they reach an understanding with their employers, after the maternity leave ends.

Under the pre-existing Maternity Benefit Act of 1961, every woman is entitled to, and her employer is liable for, the payment of maternity benefit at the rate of the average daily wage for the period of the employee’s actual absence from work. Apart from 12 weeks of salary, a female worker is entitled to a medical bonus of INR 3,500.

The 1961 Act states that in the event of miscarriage or medical termination of pregnancy, the employee is entitled to six weeks of paid maternity leave. Employees are also entitled to an additional month of paid leave in case of complications arising due to pregnancy, delivery, premature birth, miscarriage, medical termination, or a tubectomy operation (two weeks in this case).

In addition to the above, the 1961 Act states that no company shall compel its female employees to do tasks of a laborious nature or tasks that involve long hours of standing or which in any way are likely to interfere with her pregnancy or the normal development of the fetus, or are likely to cause her miscarriage or otherwise adversely affect her health.

Gratuity

The Payment of Gratuity Act, 1972 directs establishments with 10 or more employees to provide the payment of 15 days of additional wages for each year of service to employees who have worked at a company for five years or more.

Gratuity is provided as a lump sum payout by a company. In the event of the death or disablement of the employee, the gratuity must still be paid to the nominee or the heir of the employee.

The employer can, however, reject the payment of gratuity to an employee if the individual has been terminated from the job due to any misconduct. In such a case of forfeiture, there must be a termination order containing the charges and the misconduct of the employee.

Gratuity is calculated through the formula mentioned below:

Gratuity = Last Drawn Salary × 15/26 × Tenure of Service, where:

• The ratio 15/26 represents 15 days out of 26 working days in a month.
• Last Drawn Salary = Basic Salary + Dearness Allowance.
• Tenure of Service is rounded up or down to the nearest full year. For example, if the employee has a total service of 10 years, 10 months and 25 days, 11 years will be factored into the calculation.

The budget is an estimate of income and expenditure for a definite duration. In economics, budget is a systematic list of revenue and expenditure or we can say it’s a plan for income and expenditure.

The word ‘budget’ has been borrowed from the English word “Bowgette” which traces its origin from the French word “Bougette”.  Word “Bougette” has arrived from the word, ‘Bouge’ which means a leather bag.

The Union Budget of India, also referred to as the Annual Financial Statement in the Article 112 of the Constitution of India, is the annual budget of the Republic of India. The Government presents it on the first day of February so that it could be materialised before the beginning of new financial year in April. Until 2016 it was presented on the last working day of February by the Finance Minister in Parliament. The budget, which is presented by means of the Finance bill and the Appropriation bill has to be passed by Lok Sabha before it can come into effect on 1 April, the start of India’s financial year.

An interim budget is not the same as a ‘Vote on Account’. While a ‘Vote on Account’ deals only with the expenditure side of the government’s budget. An interim budget is a complete set of accounts, including both expenditure and receipts. An interim budget gives the complete financial statement, very similar to a full budget. While the law does not disqualify the Union government from introducing tax changes, normally during an election year, successive governments have avoided making any major changes in income tax laws during an interim budget.

As of September 2017, Morarji Desai has presented 10 budgets which is the highest count followed by P Chidambaram’s 9 and Pranab Mukherjee’s 8. Yashwant Sinha, Yashwantrao Chavan and C.D. Deshmukh have presented 7 budgets each while Manmohan Singh and T.T. Krishnamachari have presented 6 budgets.

Reason OF Union Budget

The Government performs two important functions by making a budget every year:

1. The Government estimates the expected expenditures for developmental works in different sectors of the economy e.g. Industry, Manufacturing, Education, Health, Transport, etc.
2. To meet the expenditures for the coming financial year, the Government tries to work out the sources of revenue. ( i.e. by imposing new taxes or increasing or decreasing the previous rates of taxes, or to remove or impose subsidy on any commodity.

Components of the Union (Central) Budget of India:

The budget is divided into two parts:

(i) Revenue Budget and

(ii) Capital Budget.

The Revenue Budget comprises revenue receipts and expenditure met from these revenues. The revenue receipts include both tax revenue (like income tax, excise duty) and non-tax revenue (like interest receipts, profits). Capital Budget consists of capital receipts {like borrowing, disinvestment) and long period capital expenditure (creation of assets, investment).

Capital receipts are receipts of the government which create liabilities or reduce financial assets, e.g., market borrowing, recovery of loan, etc. Capital expenditure is the expenditure of the government which either creates assets or reduces liability. Capital budget is an account of assets and liabilities of the government which takes into consideration changes in capital.

Structure or components of a government budget broadly consists of two parts Budget Receipts and Budget Expenditure as shown in the following chart with their classification.

Types of Budget

1. Traditional or General Budget: The initial structure of the present-day general budget is known as the Traditional Budget. The main aim of the General Budget is to set up financial control over the Executive and the Legislative. This budget contains the details of income and expenditure of the Government.

This budget contains the details of the expenditure in different sectors done by the Government. However, the result of this expenditure is not explained in this budget. Thus, the main idea behind the traditional budget that is to solve the problems of independent India and to achieve the developmental targets was defeated.

As a result, the need and importance of drafting a ‘Performance Budget was accepted and it was presented as a complimentary budget to the earlier Traditional budget.

2. Performance Budget: When the outcome of any activity is taken as the base of any budget, such a budget is known as ‘Performance Budget’. For the first time in the world, the performance budget was made in the USA. An Administrative Reforms Commission was set up in 1949 in America under Sir Hooper. This commission recommended for making a ‘Performance Budget’ in the USA. In the Performance Budget, it is the compulsion of the government to tell that ‘what is done’, ‘how much done’ by it for the betterment of the people. In India, the Performance Budget is also known as the ‘Outcome Budget’.
3. Zero Based Budget: There are two primary reasons for adopting this type of Budget in India.

(i) The continuous revenue deficit in the budget of the country.

(ii) Poor implementation of the Performance Budget.

In the zero-based budget, neither expenses incurred during the previous financial years are not considered nor the expenditure of the last financial year used for the coming years.

Under Zero-based budgets, every activity is decided based on Zero basis i.e. the previous expenditures are not considered. This budget is also known as ‘Sun Set Budget’ which means the finance department has to present the zero-based budget before the end of the financial year.

Outcome Budget: In India, development-related schemes such as MGNREGA, NRHM, Mid Day Meal, PMGSY, Digital India, Prime Minister Skill Development Council, etc. are started every year. The large sum of money is spent on these schemes every year. However, at present, the government doesn’t have any parameters to measure the results of these schemes.

Budget Deficit

A budget deficit occurs when government expenditures exceed revenues from taxes and other sources. Although the concept of a budget deficit applies to any organization with operating revenues and expenses, the term is most commonly applied to government budgets.

Components

1. Revenues

For national governments, a majority of revenue comes from income taxes, corporate taxes, consumption taxes, and social insurance taxes. For non-governmental organizations and companies, revenues come from the sale of goods and services.

2. Expenses

For governments, expenses include government spending on healthcare, infrastructure, defense, subsidies, pensions, and other items that contribute to the health of the overall economy. For non-governmental organizations and companies, expenses include the amount that is spent on daily operations and factors of production, including rent and wages.

Implications

Contrary to what it may sound like, a budget deficit is not always a negative indicator of economic health. Some of the implications of a budget deficit are described below:

1. Increase aggregate demand

A budget deficit implies a reduction in taxes and an increase in government spending, which results in an increase in the aggregate demand of the country and subsequent economic growth, ceteris paribus.

2. Boost the economy during a recession

During a recession, the economy tends to experience a decrease in investment spending from the private sector, along with lower aggregate consumption and demand. A government may choose to borrow and run a deficit to combat the situation by taking measures to spend effectively.

3. Increase government spending

Government spending serves many purposes, including investments in infrastructure, healthcare, human capital, unemployment benefits, pension programs, and so on. A nation’s government may choose to spend more than its revenues allow by running a deficit.

4. Fiscal policy

A budget deficit may be used to finance an expansionary fiscal policy, which involves lowering income and corporate taxes (therefore reducing revenue for the government) and increasing government spending on infrastructure and investments to attract foreign capital and boost economic growth.

5. Higher taxes in the future

A current budget deficit that runs persistently often implies that the government will need to increase taxes in the future to pay off the accumulated debt since taxes are one of the primary sources of revenue for the government.

6. Higher interest rates and bond yields

In order to borrow large amounts, governments often offer higher interest rates to investors and international banks that lend them money. Increased government borrowing results in higher interest rates and bond yields since investors and banks require compensation for the risk through interest payments.

Theories

1. Ricardian Equivalence Theory

The Ricardian Equivalence Theory argues that using budget deficit or borrowing to stimulate the economy exerts no effect. It relies on many assumptions, including one that states that the government will increase taxes to pay off the current deficit.

According to the theory, households take it into account while making investment and saving decisions and choose to save more to compensate for the future increase in taxes. Therefore, consumption in the economy decreases, and the increase in government spending financed by a deficit does not impact the economy.

2. Crowding Out Theory

The Crowding Out Theory states that an increase in government spending and borrowing leads to a decrease in investments from the private sector. It is because governments borrow by selling bonds to the private sector and by borrowing from foreign sources, such as other countries and international banks.

However, it often results in higher interest rates, as well as higher spending on bonds by the private sector which leads to lower funds for private sector investments and a higher cost of borrowing (due to higher interest rates).

Therefore, the increase in government spending is often met with a relatively smaller decrease in private sector investments, which offsets the overall effect of the expansionary move.

Types of Budget Deficit

There are three types of budget deficit, which are explained below

• Fiscal Deficit
• Revenue Deficit
• Primary Deficit

Fiscal Deficit

Fiscal deficit is defined as the excess of total expenditures over the total receipts excluding the borrowings in a year. In other words, this can be defined as the amount that the government needs to borrow in order to meet all expenses.

The more the fiscal deficit more will be the amount borrowed. Fiscal deficit helps in understanding the shortfall that the government faces while paying for the expenditures in the absence of lack of funds.

The formula for calculating fiscal deficit is as follows

Fiscal deficit = Total expenditures – Total Receipts excluding borrowings.

Impact of Fiscal Deficit

The following impacts of fiscal deficit can be seen

• Unnecessary expenditure: A high fiscal deficit leads to unnecessary expenditure done by the government that leads to potential inflationary pressure on the economy.
• Printing more currency by RBI for meeting the deficit, also called deficit financing leads to the availability of more money in the market, leading to inflation.
• Borrowing more will hinder the future growth of the economy as most of the revenue will be utilised towards meeting debt payments.

Remedial measures for Fiscal Deficit

• Reduced public expenditure
• Reduction in bonus, leave encashments and subsidies
• Increase tax to generate revenue
• Disinvestment of public sector units

Revenue Deficit

Revenue expenditure is defined as the excess of total revenue expenditure over the total revenue receipts. In other words, the shortfall of revenue receipts as compared to the revenue expenditure is known as revenue deficit

Revenue deficit signals to the economists that the revenue earned by the government is insufficient to meet the requirements of the expenditures required for the essential government functions.

The formula for revenue deficit can be expressed as

Revenue Deficit = Total Revenue expenditure – Total Revenue receipts

Impact of Revenue Deficit

• Reduction in assets: For meeting the shortfall in the form of revenue deficit, the government has to sell some assets.
• It leads to conditions of inflation in the economy
• A large number of borrowing leads to a greater debt burden on the economy.

Remedial measures for Fiscal Deficit

• By reducing unnecessary spending.
• By raising the rate of taxes and applying new taxes, wherever possible.

Primary Deficit

Primary deficit is said to be the fiscal deficit of the current year minus the interest payments that are pending on previous borrowings, or it can be said that primary deficit is the requirement of borrowing without the interest payment.

Primary deficit, therefore, shows the expenses that government borrowings are going to fulfil while not paying for the income interest payment.

A zero deficit shows that there is a requirement for availing credit or borrowing for clearing the interest payments pending.

The formula for the primary deficit is expressed as follows

Primary Deficit = Fiscal Deficit – Interest Payments

Measures to reduce the primary deficit can be similar to the steps taken to reduce the fiscal deficit as the primary deficit is any borrowings that are above the existing deficit or borrowings.

Velocity of Circulation refers to the average number of times a single unit of money changes hands in an economy during a given period of time. It can also be referred to as the velocity of money or velocity of circulation of money. It is the frequency with which the total money supply in the economy turns over in a given period of time.

If the velocity of money is increasing, then the velocity of circulation is an indicator that transactions between individuals are occurring more frequently. A higher velocity is a sign that the same amount of money is being used for a number of transactions. A high velocity indicates a high degree of inflation.

Factors Affecting the Velocity of Circulation

• Money Supply:

Money supply and the velocity of money are inversely proportional. If the money supply in an economy falls short, then the velocity of money will rise, and vice versa.

Velocity of money depends upon the supply of money in the economy. If the supply of money in the economy is less than its requirements, then the velocity of money will increase and if the money supply is less than its requirement, the velocity of money will fall.

• Frequency of Transactions:

As the number of transactions increases, so does the velocity of circulation.

With the increase in the frequency of transactions, the number of payments and receipts increases and, as a result, velocity of money increases. Similarly, with the decrease in the frequency of transactions, the velocity of money decreases.

• Regularity of Income: Regularity of income enables people to spend their money more freely, leading to a rise in the velocity of circulation.
• Payment System: It is also affected by the frequency with which labor is paid (weekly, monthly, bi-monthly) and how fast the bills for various goods and services are settled. The velocity of money is also determined by the frequency with which the labour force is paid (i.e., weekly or monthly) and the speed with which the bills for goods are settled.
• Regularity of Income: If people receive income at regular intervals, they will spend their income more freely and the velocity of money will increase. But, if people receive their income at irregular intervals, they will prefer to hold more cash balances to meet the uncertain conditions in future and the velocity of money will fall.
• Propensity to Consume: Greater the tendency of the people to consume, other things remaining the same, higher will be the velocity of money. On the contrary, lower the propensity to consume, lesser will t3 the velocity of money. Saving, or not consuming, has an adverse effect on the velocity of money.

There are several other factors involved, including the value of money, the volume of trade, credit facilities available in the economy, business conditions, etc.

Monetarism and Keynesian Economics

There is a conflict of belief between Monetarists and Keynesian economists regarding the concept. Monetarists believe in the stability of the velocity of circulation and argue that there is a direct relationship between money supply and price levels, and between the rate of growth of money supply and rate of inflation. On the other hand, Keynesian economists believe that the velocity of circulation is an unstable concept that can change rapidly, leading to changes in the money supply.

Formula:

The GDP equation is as follows:

Gross Domestic Product (GDP) = Money Supply x Velocity of Circulation

Therefore, the formula for velocity is the following:

Velocity of Circulation = Gross Domestic Product (GDP) / Money Supply

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable holdings), or for money in the broader sense of M2 or M3.

Money in the sense of M1 is dominated as a store of value (even a temporary one) by interest-bearing assets. However, M1 is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money for near-future expenditure and the interest advantage of temporarily holding other assets. The demand for M1 is a result of this trade-off regarding the form in which a person’s funds to be spent should be held. In macroeconomics motivations for holding one’s wealth in the form of M1 can roughly be divided into the transaction motive and the precautionary motive. The demand for those parts of the broader money concept M2 that bear a non-trivial interest rate is based on the asset demand. These can be further subdivided into more microeconomically founded motivations for holding money.

Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve.

The magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its choice of a nominal anchor.

Types of demand for money

• Transaction demand: Money needed to buy goods; this is related to income.
• Precautionary demand: Money needed for financial emergencies.
• Asset motive/speculative demand: When people wish to hold money rather than buy assets/bonds/risky investment.

Asset motive

The asset motive states that people demand money as a way to hold wealth. This may occur during periods of deflation or periods where investors expect bonds to fall in value.

Precautionary demand for money

 Precautionary demand for money, the money we may need for unexpected purchases or emergencies.

Money Balances Held for Precautionary Reasons

Precautionary money balances are held to moderate the impact of unexpected spending needs that can occur in the future. The factors that drive the demand for precautionary money balances are similar to those analyzed for transaction money balances.

• As the level of economic activity and GDP rises, companies and consumers will increase the level of precautionary money balances for unforeseen spending needs. it is a natural consequence of trends, such as increasing consumer spending habits and rising inflation.
• The availability of credit and level of interest rates affect the level of precautionary money balances. Other conditions held equal, when credit is easily (hardly) available and interest rates are low (high), such money balances are expected to rise (decline).
• The balances held for precautionary reasons must be consistent with the level of spending of a company, family, or individual. For example, a precautionary balance of $500 would not be enough for a family that is spending $5,000 per month.

Transaction demand for money

The money we need to purchase goods and services in day-to-day life.

In the classical quantity theory of money. The demand for money is a function of prices and income (assuming the velocity of circulation is stable.) If income rises, demand for money will rise.

In an inventory model, the demand for holding money depends on the frequency of getting paid, and the cost of depositing money in a bank. When employees are paid, they will hold some money to buy goods. If they are paid once a month, they may deposit half to benefit from interest payments, and then withdraw after two months. However, electronic transfers and debit cards have made this less relevant.

Money Held for Transactions

The amount of money held for such a reason is called transaction money balances. Transaction money balances depend on several factors, but mainly:

• The overall conditions in the economy analyzed. When macroeconomic conditions improve, in the form of higher nominal GDP growth, lower unemployment, or higher salaries, it’s reasonable to assume that spending in the economy will improve. The conditions determine an increase in the demand for money needed to finance the purchase of goods and services.
• The citizens’ propensity to spend. Regardless of the overall macroeconomic conditions, the citizens of an economy may possess a higher propensity to spend on goods and services than another economy with similar characteristics, which would create, other conditions held equal, higher demand for money.

Money Held for Speculative Reasons

Money held for speculative reasons is also known as the portfolio demand for money. The money is held to take advantage of speculative opportunities or for covering/offsetting risks in other assets or the economy. There are several cases in which money is used as a speculative instrument:

• When there is deflation or when it is expected in the future. If prices decline, the money stored today will be more valuable tomorrow.
• When conditions in other markets are not favorable and are expected to deteriorate. For example, if the bond market doesn’t offer good returns, investors may prefer holding speculative cash balances to wait for better market conditions. In addition, if the prices of certain assets are expected to go down, investors may increase their cash positions for speculative purposes.
• When people want to speculate on changes in currency rates. For example, if somebody expects its domestic currency to depreciate significantly against a foreign currency, they can buy the foreign currency and store it and wait for its appreciation against the domestic currency.

Speculative Demand for Money and Asset Prices

We said that speculative demand also depends on the conditions in other markets, such as the bond market and the expectations of returns in those markets.

In general, an investor who chooses to hold money instead of financial instruments, such as bonds, is giving up the return he/she can earn holding such instruments.

That is why:

• The demand for money tends to increase when the potential returns in other asset classes decline or when the perceived risk of such investments increases.
• The demand for money tends to decline if the potential returns in other asset classes increase or when the perceived risk of such investments declines.

As a general rule, we can say that there is:

• A direct relationship between speculative demand for money and returns in other financial assets.
• An inverse relationship between speculative demand for money and risks in other financial assets.

The Classical Approach:

The classical economists did not explicitly formulate demand for money theory but their views are inherent in the quantity theory of money. They emphasized the transactions demand for money in terms of the velocity of circulation of money. This is because money acts as a medium of exchange and facilitates the exchange of goods and services. In Fisher’s “Equation of Exchange”,

MV = PT

Where M is the total quantity of money, V is its velocity of circulation, P is the price level, and T is the total amount of goods and services exchanged for money.

The right-hand side of this equation PT represents the demand for money which, in fact, “depends upon the value of the transactions to be undertaken in the economy, and is equal to a constant fraction of those transactions.” MV represents the supply of money which is given and in equilibrium equals the demand for money. Thus, the equation becomes MV = PT

This transactions demand for money, in turn, is determined by the level of full employment income. This is because the classicists believed in Say’s Law whereby supply created its own demand, assuming the full employment level of income. Thus, the demand for money in Fisher’s approach is a constant proportion of the level of transactions, which in turn, bears a constant relationship to the level of national income. Further, the demand for money is linked to the volume of trade going on in an economy at any time. Thus, its underlying assumption is that people hold money to buy goods.

But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events. It is, therefore, not possible to say that V will remain constant when M is changed. The most important thing about money in Fisher’s theory is that it is transferable. But it does not explain fully why people hold money. It does not clarify whether to include as money such items as time deposits or savings deposits that are not immediately available to pay debts without first being converted into currency.

It was the Cambridge cash balances approach which raised a further question: Why do people actually want to hold their assets in the form of money? With larger incomes, people want to make larger volumes of transactions and that larger cash balances will, therefore, be demanded. The Cambridge demand equation for money is Md = kPY

where Md is the demand for money which must equal the supply of money (Md=Ms) in equilibrium in the economy, k is the fraction of the real money income (PY) which people wish to hold in cash and demand deposits or the ratio of money stock to income, P is the price level, and Y is the aggregate real income. This equation tells us that “other things being equal, the demand for money in normal terms would be proportional to the nominal level of income for each individual, and hence for the aggregate economy as well.”

Its Critical Evaluation:

This approach includes time and saving deposits and other convertible funds in the demand for money. It also stresses the importance of factors that make money more or less useful, such as the costs of holding it, uncertainty about the future and so on. But it says little about the nature of the relationship that one expects to prevail between its variables, and it does not say too much about which ones might be important.

One of its major criticisms arises from the neglect of store of value function of money. The classicists emphasized only the medium of exchange function of money which simply acted as a go-between to facilitate buying and selling. For them, money performed a neutral role in the economy. It was barren and would not multiply, if stored in the form of wealth.

This was an erroneous view because money performed the “asset” function when it is transformed into other forms of assets like bills, equities, debentures, real assets (houses, cars, TVs, and so on), etc. Thus, the neglect of the asset function of money was the major weakness of the classical approach to the demand for money which Keynes remedied.

The Keynesian Approach: Liquidity Preference:

Keynes in his General Theory used a new term “liquidity preference” for the demand for money. Keynes suggested three motives which led to the demand for money in an economy: (1) the transactions demand, (2) the precautionary demand, and (3) the speculative demand.

The Transactions Demand for Money:

The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. According to Keynes, it relates to “the need of cash for the current transactions of personal and business exchange” It is further divided into income and business motives. The income motive is meant “to bridge the interval between the receipt of income and its disbursement.”

Similarly, the business motive is meant “to bridge the interval between the time of incurring business costs and that of the receipt of the sale proceeds.” If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa. There will, however, be changes in the transactions demand for money depending upon the expectations of income recipients and businessmen. They depend upon the level of income, the interest rate, the business turnover, the normal period between the receipt and disbursement of income, etc.

Given these factors, the transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as

L1 = kY

Where L1 is the transactions demand for money, k is the proportion of income which is kept for transactions purposes, and Y is the income.

Interest Rate and Transactions Demand:

Regarding the rate of interest as the determinant of the transactions demand for money Keynes made the LT function interest inelastic. But the pointed out that the “demand for money in the active circulation is also the some extent a function of the rate of interest, since a higher rate of interest may lead to a more economical use of active balances.” “However, he did not stress the role of the rate of interest in this part of his analysis, and many of his popularizes ignored it altogether.” In recent years, two post-Keynesian economists William J. Baumol and James Tobin have shown that the rate of interest is an important determinant of transactions demand for money.

They have also pointed out the relationship, between transactions demand for money and income is not linear and proportional. Rather, changes in income lead to proportionately smaller changes in transactions demand.

Transactions balances are held because income received once a month is not spent on the same day. In fact, an individual spreads his expenditure evenly over the month. Thus a portion of money meant for transactions purposes can be spent on short-term interest-yielding securities. It is possible to “put funds to work for a matter of days, weeks, or months in interest-bearing securities such as U.S. Treasury bills or commercial paper and other short-term money market instruments.

The problem here is that there is a cost involved in buying and selling. One must weigh the financial cost and inconvenience of frequent entry to and exit from the market for securities against the apparent advantage of holding interest-bearing securities in place of idle transactions balances.

Among other things, the cost per purchase and sale, the rate of interest, and the frequency of purchases and sales determine the profitability of switching from ideal transactions balances to earning assets. Nonetheless, with the cost per purchase and sale given, there is clearly some rate of interest at which it becomes profitable to switch what otherwise would-be transactions balances into interest-bearing securities, even if the period for which these funds may be spared from transactions needs is measured only in weeks. The higher the interest rate, the larger will be the fraction of any given amount of transactions balances that can be profitably diverted into securities.”

The Precautionary Demand for Money:

The Precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and businessmen keep cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies.

Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. Therefore, “money held under the precautionary motive is rather like water kept in reserve in a water tank.” The precautionary demand for money depends upon the level of income, and business activity, opportunities for unexpected profitable deals, availability of cash, the cost of holding liquid assets in bank reserves, etc.

Keynes held that the precautionary demand for money, like transactions demand, was a function of the level of income. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates. The transactions and precautionary demand for money will be unstable, particularly if the economy is not at full employment level and transactions are, therefore, less than the maximum, and are liable to fluctuate up or down.

The Speculative Demand for Money:

The speculative (or asset or liquidity preference) demand for money is for securing profit from knowing better than the market what the future will bring forth”. Individuals and businessmen having funds, after keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing in bonds. Money held for speculative purposes is a liquid store of value which can be invested at an opportune moment in interest-bearing bonds or securities.

Bond prices and the rate of interest are inversely related to each other. Low bond prices are indicative of high interest rates, and high bond prices reflect low interest rates. A bond carries a fixed rate of interest. For instance, if a bond of the value of Rs 100 carries 4 per cent interest and the market rate of interest rises to 8 per cent, the value of this bond falls to Rs 50 in the market. If the market rate of interest falls to 2 per cent, the value of the bond will rise to Rs 200 in the market.

The Fisher equation is a concept in economics that describes the relationship between nominal and real interest rates under the effect of inflation. The equation states that the nominal interest rate is equal to the sum of the real interest rate plus inflation.

The Fisher equation is often used in situations where investors or lenders ask for an additional reward to compensate for losses in purchasing power due to high inflation.

Inflation + Real Interest Rate = Nominal Interest Rate

The concept is widely used in the fields of finance and economics. It is frequently used in calculating returns on investments or in predicting the behavior of nominal and real interest rates. One example is when an investor wants to determine the actual (real) interest rate earned on an investment after accounting for the effect of inflation.

One particular significance of the Fisher equation is related to monetary policy. The equation reveals that monetary policy moves inflation and the nominal interest rate together in the same direction. On the other hand, monetary policy generally does not affect the real interest rate. American economist Irving Fisher proposed the equation.

Fisher Equation Formula

The Fisher equation is expressed through the following formula:

(1 + i) = (1 + r) (1 + π)

 Where:

I: The nominal interest rate

r: The real interest rate

π: The inflation rate

However, one can also use the approximate version of the previous formula:

i ≈ r + π

In the words of Irving Fisher, “Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa.” If the quantity of money is doubled, the price level will also double and the value of money will be one half. On the other hand, if the quantity of money is reduced by one half, the price level will also be reduced by one half and the value of money will be twice.

Fisher has explained his theory in terms of his equation of exchange:

PT=MV+ M’ V’

Where P = price level, or 1 IP = the value of money;

M = the total quantity of legal tender money;

V = the velocity of circulation of M;

M’: The total quantity of credit money;

V’: The velocity of circulation of M;

T = the total amount of goods and services exchanged for money or transactions performed by money.

This equation equates the demand for money (PT) to supply of money (MV=M’V). The total volume of transactions multiplied by the price level (PT) represents the demand for money.

According to Fisher, PT is SPQ. In other words, price level (P) multiplied by quantity bought (Q) by the community (S) gives the total demand for money. This equals the total supply of money in the community consisting of the quantity of actual money M and its velocity of circulation V plus the total quantity of credit money M’ and its velocity of circulation V’. Thus, the total value of purchases (PT) in a year is measured by MV+M’V’. Thus, the equation of exchange is PT=MV+M’V’. In order to find out the effect of the quantity of money on the price level or the value of money, we write the equation as

P= MV+M’V’

Fisher points out the price level (P) (M+M’) provided the volume of tra remain unchanged. The truth of this proposition is evident from the fact that if M and M’ are doubled, while V, V and T remain constant, P is also doubled, but the value of money (1/P) is reduced to half.

Assumptions of the Theory:

Fisher’s theory is based on the following assumptions:

1. P is passive factor in the equation of exchange which is affected by the other factors.
2. The proportion of M’ to M remains constant.
3. V and V are assumed to be constant and are independent of changes in M and M’.
4. T also remains constant and is independent of other factors such as M, M, V and V.
5. It is assumed that the demand for money is proportional to the value of transactions.
6. The supply of money is assumed as an exogenously determined constant.
7. The theory is applicable in the long run.
8. It is based on the assumption of the existence of full employment in the economy.

Criticisms of the Theory:

The Fisherian quantity theory has been subjected to severe criticisms by economists.

1. Truism:

According to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of exchange is a simple truism because it states that the total quantity of money (MV+M’V’) paid for goods and services must equal their value (PT). But it cannot be accepted today that a certain percentage change in the quantity of money leads to the same percentage change in the price level.

2. Other things not equal:

The direct and proportionate relation between quantity of money and price level in Fisher’s equation is based on the assumption that “other things remain unchanged”. But in real life, V, V and T are not constant. Moreover, they are not independent of M, M’ and P. Rather, all elements in Fisher’s equation are interrelated and interdependent. For instance, a change in M may cause a change in V.

Consequently, the price level may change more in proportion to a change in the quantity of money. Similarly, a change in P may cause a change in M. Rise in the price level may necessitate the issue of more money. Moreover, the volume of transactions T is also affected by changes in P. When prices rise or fall, the volume of business transactions also rises or falls. Further, the assumptions that the proportion M’ to M is constant, has not been borne out by facts. Not only this, M and M’ are not independent of T. An increase in the volume of business transactions requires an increase in the supply of money (M and M’).

3. Constants Relate to Different Time:

Prof. Halm criticises Fisher for multiplying M and V because M relates to a point of time and V to a period of time. The former is a static concept and the latter a dynamic. It is therefore, technically inconsistent to multiply two non-comparable factors.

4. Fails to Measure Value of Money:

Fisher’s equation does not measure the purchasing power of money but only cash transactions, that is, the volume of business transactions of all kinds or what Fisher calls the volume of trade in the community during a year. But the purchasing power of money (or value of money) relates to transactions for the purchase of goods and services for consumption. Thus the quantity theory fails to measure the value of money.

5. Weak Theory:

According to Crowther, the quantity theory is weak in many respects. First, it cannot explain ’why’ there are fluctuations in the price level in the short run. Second, it gives undue importance to the price level as if changes in prices were the most critical and important phenomenon of the economic system. Third, it places a misleading emphasis on the quantity of money as the principal cause of changes in the price level during the trade cycle.

Prices may not rise despite increase in the quantity of money during depression; and they may not decline with reduction in the quantity of money during boom. Further, low prices during depression are not caused by shortage of quantity of money, and high prices during prosperity are not caused by abundance of quantity of money. Thus, “the quantity theory is at best an imperfect guide to the causes of the trade cycle in the short period” according to Crowther.

6. Neglects Interest Rate:

One of the main weaknesses of Fisher’s quantity theory of money is that it neglects the role of the rate of interest as one of the causative factors between money and prices. Fisher’s equation of exchange is related to an equilibrium situation in which rate of interest is independent of the quantity of money.

7. Unrealistic Assumptions:

Keynes in his General Theory severely criticised the Fisherian quantity theory of money for its unrealistic assumptions. First, the quantity theory of money for its unrealistic assumptions. First, the quantity theory of money is unrealistic because it analyses the relation between M and P in the long run. Thus it neglects the short run factors which influence this relationship. Second, Fisher’s equation holds good under the assumption of full employment. But Keynes regards full employment as a special situation. The general situation is one of the under-employment equilibrium. Third, Keynes does not believe that the relationship between the quantity of money and the price level is direct and proportional.

Rather, it is an indirect one via the rate of interest and the level of output. According to Keynes, “So long as there is unemployment, output and employment will change in the same proportion as the quantity of money, and when there is full employment, prices will change in the same proportion as the quantity of money.” Thus, Keynes integrated the theory of output with value theory and monetary theory and criticised Fisher for dividing economics “into two compartments with no doors and windows between the theory of value and theory of money and prices.”

8. V not Constant:

Further, Keynes pointed out that when there is underemployment equilibrium, the velocity of circulation of money V is highly unstable and would change with changes in the stock of money or money income. Thus it was unrealistic for Fisher to assume V to be constant and independent of M.

9. Neglects Store of Value Function:

Another weakness of the quantity theory of money is that it concentrates on the supply of money and assumes the demand for money to be constant. In order words, it neglects the store-of-value function of money and considers only the medium-of-exchange function of money. Thus, the theory is one-sided.

10. Neglects Real Balance Effect:

Don Patinkin has critcised Fisher for failure to make use of the real balance effect, that is, the real value of cash balances. A fall in the price level raises the real value of cash balances which leads to increased spending and hence to rise in income, output and employment in the economy. According to Patinkin, Fisher gives undue importance to the quantity of money and neglects the role of real money balances.

11. Static:

Fisher’s theory is static in nature because of its such unrealistic assumptions as long run, full employment, etc. It is, therefore, not applicable to a modern dynamic economy.