fiscal polocy

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Information about fiscal polocy

Published on March 3, 2014

Author: koppulachandra


UNIT III FISCAL POLICY 1. Fiscal policy: One of the important functions of the fiscal policy is to promote the welfare of people in general and particular the proper section for this purpose .modern govts are working in planned way. The govt mobilizes the funds from various sources like taxes, borrowings and debts. One of the popular sources is through taxes both direct and indirect .to removes the inequalities of the income and to establish socialistic of society direct taxes are important. These objectives are to produce desirable effects and avoid undesirable effects on the national income production employment and price level .the goal of the fiscal policy in developed countries is to achieve economic stability ,while in developing countries is to achieve economic development. Fiscal policy involves designing the tax structure determining tax revenue and handling public expenditure in such a way that the objective of the full employment is achieved. The fiscal policy is the part of govt policy which is concerned in raise in revenue through taxation and deciding the pattern of expenditure. The govt budget is an estimation of govt expenditure and revenue for ensuring financial year presented to the parliamentary financial ministers. The budget is divided vertically into revenues and capital again they will be divided into revenue receipts and expenditure as well as capital receipts and expenditure. The revenue expenditure includes all current expenditure of govt and capital includes all the capital transaction of govt. The revenue receipts includes revenue from taxes while capital receipts include mkt loans, income from repayments and other receipts such as income from undertakings. Fiscal policy Merits: 1) Capital Formation: The Fiscal policy of the country has been playing an important role in raising the rate of capital formation in the public and private sectors. It has created a favorable impact on public and private sector investment of the country. 2) Mobilization of Resource: the Fiscal policy of the country has been helping to mobilize a considerable amount of resources through taxation, public debt and other sources for financing its various developmental projects. 3) Incentives to savings: the fiscal policy of the country has been providing various incentives to raise the savings rate both in household and corporate sector through various budgetary policy changes viz. tax exemption, tax concession etc…, 4) Inducement to Private sector: The private sector of the country has been getting necessary inducements from the fiscal policy of the country to expand its activities. Tax concessions, tax exemptions, subsidies and so on incorporated in the budgets have been providing adequate incentives to the private sector units engaged in industry, infrastructure, and export of the country.

5) Reduction of inequality: the Fiscal policy of the country has been making constant Endeavour to reduce the inequality in the distribution of income and wealth. Progressive taxes on income and wealth tax exemption, grant and so on are making a concerted effort to reduce such inequalities. 6) Export Promotion: The Fiscal Policy has been making constant efforts to promote through its various budgetary policies in the form of concessions, subsidies and so on. 7) Alleviation of poverty and Unemployment: It makes constant efforts to alleviate poverty and unemployment through its various poverty eradication and employment generation programmes. Demerits 1. Instability: The Fiscal Policy of the country has failed to help attain stability in various fronts of the economy. The growing volume of deficit financing has created inflationary rise in price levels. 2. Defective Tax Structure: The Fiscal policy has also failed to provide a suitable tax structure for the country. The tax structure has failed to raise the productivity of direct taxes. 3. Inflation:- The fiscal policy of the country has failed to contain the inflationary rise in price level. The increasing volume of public expenditure on non-development heads and deficit financing has resulted demand-pull inflation. 4. Negative Return of the Public Sector: The negative return on capital invested in the public sector units has become a serious problem for the Government of Indian. The government has to keep huge budgetary provisions and thereby creating a huge drainage of scarce resources of the country. 5. Growing Inequality: The fiscal policy of the country has failed to contain the growing inequality in the distribution of income and wealth throughout the country. The growing trend of tax evasion has made the tax machinery ineffective for the purpose while the growing reliance on indirect taxes has made the tax structure regressive. 2.Objectives of Fiscal policy: The objectives of fiscal policy varied from country to country.they are based on eco.development of the country. The broad objectives of fiscal policy are as follows  Mobilization resources  Reduction disparities of income  Economic development of country  Expansion of employment  Price stability  Correction of disequilibrium in BOP Mobilization resources To mobilize resources for investment govt may go for voluntary as well as compulsory savings it takes place through public taxations, borrowings, cum voluntary and compulsory savings. As the per capital income is very low the developing countries voluntary savings does not take place. The govt can distribute the money to various sectors where they have scarcity. Economic development and growth

Other objective of physical policy is to promote echo development of country the contribution of public expenditure to growth depends on its size as well as ratio of productive expenditure to total expenditure. This investment show positive impact for development of country. Reduction of disparities of income Physical policy can be used be the govt to minimum the echo disparity in the society the disparity lead to political and social interest and generation instability in economy. Govt can reduce the economic disparity more tax from the luxury people as well as harmful goods. These taxes is also called as progressive taxation and also take low taxes from poor people. Expansion of employment After the great objective of Indian govt is to promote more employment for increasing per capita income. To increase the level of private expenditure and public expenditure and investment has to be increase thus physical policy can help in creating an atmosphere where people get more employment opportunities Price Stability Fiscal policy helps in insuring price stability where economy is experiencing deflations, budget should aim at increasing expenditure and creating income for the people who have high income to consumer and also maintain price stability of commodities at the time of inflation. This is possible because of fiscal policy contribution. 3. Features of Fiscal policy The features of fiscal policy can be explained as below Common according year for income tax: Taxation policy has adopted standard accounting year April march for the purpose of income tax. The change is intended to reduce the malpractices and raise revenue of tax. Long term fiscal policy Since 1986 budget the govt of India has introduced long term fiscal policy to provide greater certainties in its budgetary policies and to improve the overall environment of business. Impact on rural employment Generation of employment of India has introduced new employment schemes like jawahar rojgar yojna or strengthened the existing schemes like integrated rural development program or national rural employment program. Block money Unaccounted money has been a constant feature of Indians economy. Fiscal measures have generally failed to reduce the certain of block money. Reliance on indirect taxes: The tax policy is increasingly becoming regressive in nature by large dependence on indirect taxes like excise duty (or) custom duty as compared to that on direct taxes like income Taxes, corporation tax etc Inadequate public sector contribution: Contrary to repeated assertion by the govt of India, public sector continues to be a drain on the meager resources of the govt. Introduction of MODVAT: In 1986 the introduction of MODVAT has helped to reduce cumulative impact of indirect taxes on manufactured products.

4. FISCAL POLICY INSTRUMENTS The fiscal policy have three types of factors. Those are 1. Public Revenue 2. Public Expenditure 3. Public Debt PUBLIC REVENUE Meaning: The state, in the process of performing its functions and to achieve its targets and objectives, has to incur a large public expenditure. This expenditure is possible only when there is sufficient public revenue. Without the revenue, there cannot be expenditure. Revenue is as important of public finance as production to the economic system. TAXATION: Taxes are compulsory contributions paid by citizen of the country to the state without Expecting any benefits or return from the state. Every individual enjoys certain benefits, rights and privileges from the actions and performances of the state and as such, it is the responsibility of every individual to contribute the treasury a specified amount determined by the state without anticipating or expecting any benefits or returns. IMPORTANT TYPES OF TAXATION ARE AS FOLLOWS: DUTY: Imposition of tax to regulate industrial production and to control export and import of the goods is known as “Duty”. CESS: If the tax is levied for a specific purpose then it is known as “cess”.for exampleeduction cess,it is levied for promoting education in the country. SURCHARGE: Tax on tax is known as surcharge. If the objective of Fevying higher tax is for short period of time, then government, resorts to have surcharge. OCTROI: if tax is levied by municipal corporation or grama panchayat on the goods brought from other parts of the country by traders for sale into their jurisdiction limits, then it is known as “octroi”.this tax is also known as entry tax. (4)TERMINAL TAX: It is the tax levied by local bodies or municipalities on the goods leaving for sale from their boundaries into other parts of the country. (5)TOLL TAX: This tax is paid by vehicular travellers.the persons who are travelling in car,bus,jeep etc.For using the road or bridge to reach their destination have to pay the tax. Principles:  Principle of Fairness  Principle of Transparency

 Principle of Benefit  Principle of Economy  Principle of Sanction PUBLIC EXPENDITURE Nearly two hundred years ago, corresponding to the police character of the state minimum expenditure by it was considered to be good. Thus even in standard works on economics, expenditure was considered to be rather unimportant and more more so the public expenditure .much more attention was given to public revenues and taxation than to public expenditure. Principles of Expenditure These are the basic principles which should be guide or govern public expenditure in an economy. i) ii) iii) iv) v) Principle of Economy:- It lay down that un necessary and waste full expenditure. Should be avoided. Principle of Sanction: - the expenditure should be made after evading obtaining proper authorization and should be incurred of the same purpose for which the sanction or approval has been obtained. Principle of benefit:- the expenditure should be in the best interest of the economy and society, only wovth while projects should be selected on the basis or appropriate cost benefit analysis. Principle of Fairness:- expenditure should be made in such a way that there is equity economic justice and fairness. Principle of transparency:- the objectives, policy quantum and direction of public expenditure should be transparent and understandable. Classification of Public Expenditure There are a variety of ways in which public expenditure can be classified bu broadly it is classified under the following heads i) According to Authority which spends the money 1. federal or union o9r central expenditure 2. state or provincial expenditure 3. Local expenditure or expenditure of municipalities and other local bodies. ii) According to the object of Expenditure:1. Development activities like providing subsidies elective power, transport service, welfare activities employment opportunities and price stability etc. 2. Non- developmental activities like money spent on administrative machinery, law and order interest payment on public debt and defense. 3. According to the nature of Expenditure:1. Revenue expenditure: Revenue expenditure is current example, administrative and maintenance expenditure. This expenditure is of a recurring type. iii) 2. Capital expenditure:- Capital expenditure is of capital nature and is incurred once for all. It is non recurring expenditure, Ex: Expenditure in building multipurpose.

Projects or a setting up big factors like steel plant, money spent on land, machinery and equipment. Developmental activities financed by Public expenditure i) ii) iii) iv) v) vi) vii) viii) Development of infrastructure:Development of infrastructural facilities which include development of power project, railways road, transportation system, bridges, dams, irrigation projects, hospitals, educational institutions and so on. Involves huge expenditure by the government because private investors are reluctant to invest in these areas considering their low rate of profitability and high risk. Development of Public enterprises:The development of heavy and basic industries is very important for the development of an underdeveloped country. But the establishment of these industries involves huge investment and a considerable proportion of risk. Naturally the private sector can’t take the responsibility to develop these industries. The development of these industries has become a responsibility of the government of India. Particularly since the introduction of the industrial policy of 1956. a significant portion of the public expenditure has been utilized for the establishment and improvement of these public enterprises. Support to private sector:Providing the necessary support to the private sector for the establishment of industry and other projects is another important objective of the public expenditure policy formulated by the government of India. Social Welfare and employment programmes:Public expenditure policy pursued by the government of India is its growing involvement in attaining various social welfare programmes and employment generation programmes. Increase Production:Public expenditure contributes to production through a large number of public enterprises both in industries and agriculture. Promote price stability:Increases in public expenditure relieves the economy from the dilemma of depression and conversely public expenditure can be scaled down when there is a fear of inflationary rise in prices Promote balanced growth:There is a tendency to use economic resources for the further development of already developed regions. Reduce inequality of income:- Public expenditure is to reduce the inequality of income. Public Debt: Public debt in the India context refers to the borrowings of the central and state government. Gross public debt is the gross financial liability of the government. Types of public debt:1) short term debt i) Maturity up to one year ii) Common instruments are treasury bills 2) Floating debt: i) No specific date of maturity ii) Repayable subject to different terms and conditions’ 3) Funded debt:i) cheated by the sale of government securities issued to pay floating obligations ii) Maturity exceeds on one year and in actual practice may even go up to 30 years 4) Refunded debt:

5) i) replacing maturing securities with new securities ii) Internal debt:- The different types if internal debts are Market Loans: these are the loans with the maturity of 1 year or more at the time of issue and general interest. Market loans are raised by central government almost every year for open market by sale of securities. Bonds: the central government raises funds by issue of specific types of bond as and when required like gold bond 1998. Treasury Bill:- These have been major sources of short term funds for the governments to bridge the gap between revenue and expenditure . Treasury bills have a maturity of 91 or 182 or 364 days. Special Floating and other loans: they represent the contribution of Govt. of India towards the capital of International Financial Institution such as IMF and World Bank Special Securities issued to RBI: Issue of special security is a means of which government takes loans of temporary and short term nature from the RBI . Securities against small savings: these are the national savings fund converted into central government securities. Small Savings raised by such schemes as national small savings certificates into central government securities. Provident Funds: State and public provident funds are important sources of public debt. 6) External debt is raised in foreign currency and a substantial part of it is also repayable in foreign currency. This is because of NRI’. Principles:i) ii) iii) iv) v) vi) vii) fairness cost flexibility objective orientation expediency timing transparency Role of Debt:- Public debt plays an important role in the economy. The net effect of the borrowing also depends upon the sources from which they come. If the government reduces its borrowings from the market and the public reduces its own consumption and lends its savings to the government the result will be a net increase in the rate of saving. If money is borrowed from the central bank it results in an addition to aggregate money supply in the country.

5. Critical analysis of the recent policy of government of India. One important aspect of new economic policy (1991) adopted by government of India is fiscal reforms. Main objective of fiscal reforms is to bring down the fiscal deficit. Simplification of Taxation: With a view to simplifying the taxation system as recommended by Rajachelliah taxation reforms committee, ex- finance minister Dr. Manmohan Singh and finance minister Sh.Chidhambaram have taken several steps. Improving tax to GDP rates: In year 2002-03 this ratio was 14.4. in the year 2007-08 it improved to 17.8. Reduction in rates of direct taxes: In 1997-98 budget, the maximum rate of income tax had been reduced to 30%. In the budget for the year 2008-09, maximum rate of income tax is 30%. Rate of corporation tax has also been reduced. As a result tax revenue has increased. In 1991-91 direct tax revenue was 1.9%. It rises to 5.1% in 1990-91 year it increase to 19% in 2007-08 it rise to 48.8%. Reforms in indirect taxes: Under reforms concerning customs, import duties were reduced so as to bring down the cost of production. It is for the benefits of customers. In year 2001-02, government adopted central added value tax (CENVAT) vat is charged on value additions at each stage of production or distribution. Introduction of service tax: In the year 1994-95, service tax has been started in India. In year 2007-08 rate of service tax was 12%, in 2009 it reduce to 10%.Intially this was applicable for few sectors but now many services have been covered under this tax. Reduction in subsidies: Central government has to make huge payments by way of subsidies, for instance, fertilizer subsidies etc. in 1991-91 subsidies constituted 2.3% of GDP but in 2007-08 fall to 1.1% in 2008-09 it again increased to 2.4% of GDP. Improvement in tax collection For improving tax collection and to check tax evasions various schemes have been launched by government from time to time wise allotting permanent account, permanent account number (PAN) e- payment facilities etc. Closure of sick public sector companies: Government has been closing loss making and sick public sector companies. This step has been taken to reduce the burden of these loss making units on government. Disinvestment of public sector units:

Disinvestment here refers to selling the share of public sector units to private hands. Through disinvestment government gets huge funds. This has enabled the government to overcome financial crunch. Efforts to reduce government administration expenses: For this government has offered attractive voluntary retirement scheme to its employees to overcome the problem of over staffing.governament has banned or reduced sanctioning new posts in some of its departments. Reduction in central tax: Government has reduced CST from 3%to 2%from April 1,2009.this tax has been reduced to 1%and from April 2010 CST would be abolished. Introduction to goods service tax: Central government is gradually reducing central sales tax, excise tax on goods and is increasing service tax rate.governament is moving towards imposing a uniform tax on goods and services named GST with effect from April 1,2010. Enactment of fiscal responsibility and budget management act: Government has enacted fiscal policy responsibility and budget management act ,2003.the purpose of this act is to reduce fiscal deficit. “Talk less think more act wisely”

STRUCTURE OF BALANCE OF PAYMENTS:The Balance of Payment (BOP) of a country is a systematic account of all economic transactions between a country and the rest of the world, undertaken during a specific period of time. BOP is the difference between all receipts from foreign countries and all payments to foreign countries. If the receipts exceed payments, then a country is said to have favourable BOP, and vice versa. According to Charles Kindle Berger "The BOP of a country is a systematic recording of all economic transactions between residents of that country and the rest of the world during a given period of time". The Balance of payments record is maintained in a standard double - entry book - keeping method. International transactions enter into record as credit or debit. The payments received from foreign countries enter as credit and payments made to other countries as debit. The following table shows the elements of BOP. BALANCE OF PAYMENTS ACCOUNT Receipts (Credits) 1. Export of goods. Payments (Debits) Imports of goods. Trade Account Balance 2. Export of services. Import of services. 3. Interest, profit and dividends Interest, profit and dividends paid. received. Current Account Balance 4. Unilateral receipts. (1 to 4) 5. Foreign investments. Investments abroad. 6. Short term borrowings. Unilateral payments. Short term lending. 7. Medium and long term borrowing. Capital Account Balance (5 to 7) 8. Errors and omissions. 9. Change in reserves. (+) Total Reciepts Total payments. Errors and omissions. Medium and long term lending. Change in reserve (-) = Total Payments

Trade Balance :Trade balance is the difference between export and import of goods, usually referred as visible or tangible items. If the exports are more than imports, there will be trade surplus and if imports are more than exports, there will be trade deficit. Developing countries have most of the time suffered a deficit in their balance of payments. The trade balance forms a part of current account. In 2008-09, trade deficit of India was 118.6 US $ billion. Current Account Balance :It is the difference between the receipts and payments on account of current account which includes trade balance. The current account includes export of services, interest, profits, dividends and unilateral receipts from abroad and the import of services, profits, interest, dividends and unilateral payments abroad. There can be either surplus or deficit in current account. When debits are more than credits or when payments are more than receipts deficit takes place. Current account surplus will take place when credits are more and debits are less. The current account The current account records the movement of all goods and services into and out of the UK. Some of you may be thinking, "what happened to the visibles and invisibles?" While some examiners might let you get away with using these terms, these old terms have not been used officially for almost five years! Trade in goods The visible section is now called the trade in goods section. Both names are equally easy to remember. This section records all trade in goods, hence the name! Another way of thinking about it is that all goods are visible, hence the old name. Trade in services In the days of 'visible' and 'invisible', services, investment income and transfers were all lumped in together in the 'invisibles' section. The current account only had two sections: visible and invisible. Investment income This also used to be under the old 'invisibles'. You may know it as 'IPDs' or interest, profit and dividends. The new title of investment income makes sense because interest, profit and dividends are all forms of income earned on investments. Interest is earned on bank deposits and government bonds, profit is earned from investments in a business enterprise and dividends are earned annually on shares. Transfers

This also used to be under the old 'invisibles'. Transfers are now separated into a separate section because they are different in the sense that they do not reflect any actual trade. This section is split into two; government transfers and transfers made by other sectors Capital Account Balance :It is the difference between receipts and payments on account of capital account. The transactions under this title involves inflows and outflows relating to investments, short term borrowings I lending, and medium term to long term borrowings / lending. There can be surplus or deficit in capital account. When credits are more than debits surplus will take place and when debits are more than credits deficit will take place. In 2009-10. India’s capital account surplus was 51.8 US $ billion. Direct investment This refers to money that flows across national boundaries for the purpose of investing in a business enterprise. Essentially, it records the transfer of ownership of UK or foreign businesses. It also records money invested abroad for a new business venture. When Marks & Spencer build a new store in, say, Hong Kong, this will count as an outflow of money from the UK (-) in the direct investment section of the capital account. When Nissan built its factory in Sunderland, this counted as an inflow of money (+) in the same section. Portfolio investment This is money that flows across national boundaries for the purpose of investing in shares and bonds. If someone in the UK buys some shares in an American company, this will count as an outflow of money from the UK (-) in the portfolio investment section of the capital account. If an American buys some shares in a British company, this will count as an inflow of money into the UK (+) in the same section Other investment This section can be quite hectic because it includes short-term 'hot money' banking flows. It also includes net government borrowing from foreigners. Official reserves This refers to the reserves of gold and foreign currencies held by the Bank of England for use by the government. The government might use some of their reserves to artificially manipulate the value of the pound; although this rarely happens any more because the pound is freely floating and the government do not seem particularly keen to intervene in currency markets Errors and Omissions :The double entry book - keeping principle states that for every credit, there is a corresponding debit and therefore, there should be a balance in BOP as well. In reality BOP may not balance, due to errors and omissions. Errors may be due to statistical discrepancies (differences) and omissions may be due to certain transactions may not get recorded. For Eg.,

remittance by an Indian working abroad to India may not get recorded etc. If the current and capital account shows a surplus of 20,000 $, then the BOP should show an increase of 20,000 $. But, if the statement shows an increase of 22,000 $, then there is an error or omission of 2,000 $ on credit side Foreign Exchange Reserves :The balance of foreign exchange reserve is the combined effect of current and capital account balances. The reserves will increase when:a) The surplus capital account is much more than the deficit in current account. b) The surplus in current account is much more than deficit in capital account. c) Both the current account and capital account shows a surplus. In 2009-10 India’s foreign exchange reserves increased by 13.4 US $ billion. INDIA’S BALANCE OF TRADE:Balance of trade is the difference between exports and imports. India’s Balance of trade is mostly in deficit. This is due to low share off Exports in world market. Imports are high due to petroleum, oil and lubricant products. INDIA’S BALANCE OF TRADE (US $ Billion) _______________ I Year 1990-91 2004-05 2009-10 Exports 18.5 85.2 182.2 Imports Trade Balance 27.9 118.9 300.6 -9.4 - 33.7 -118.4 India’s export performance is poor. At present, India’s share off world export trade is 1%. The share of exports of other developing countries is much more than India. B. REASONS FOR POOR PERFORMANCE OF INDIA’S EXPORT TRADE There are Several reasons for India’s Poor performance. Some off them are: Export - Related Problems :- 1 High Prices :As compared to other Asian Countries the price of Indian goods is high. Prices are high due to documentation formalities, high transaction costs & also to make higher profits. Poor - Quality :-

Many Indian exporters do not give much importance to quality control, so their products are of poor quality. Due to low quality many times Indian goods are rejected & sent back to India by foreign buyers. Poor Negotiation Skills :Indian exporters lack Negotiation Skills due to poor training in Marketing. They fail to Convince & induce the foreign buyers to place orders. Inadequate Promotion :For Export Marketing, Promotion is important. Many Indian Exporters do not give much importance to promotion. A good no. of Indian exporters are not professional in advertising & Sales promotion. They do not take part in trade fairs & exhibitions. Poor follow-up of sales :Indian exporters are ineffective in providing after-sale-service. They do not bother to find out the reactions of buyers after sale. This results in poor performance of India’s export trade. General Causes 1. Good Domestic Market Sellers find a ready market for their goods within the country, so they do not take patns to get orders from overseas markets. 2. Number of formalities There are number of documentation & other formalities due to which the some rnarketers do not enter the export field. So there is a need to simplify formalities. 3. Problem of Trading Blocs Trading blocs reduce trade barriers on member nations, but they impose trade barriers on non-members. As India is not a member of some powerful trading blocs, it has to face some problems. 4. Negative Attitude Some of the overseas buyers have a negative attitude towards Indian goods. They feel that Indian goods are inferior goods. Thus there is a need to correct this attitude. 5. Poor Infrastructure Indian infrastructure is poor. Indian exporters find it difficult to get orders & also to deliver them at time. EQUILIBRIUM AND DISEQUILIBRIUM IN BOP :-

Balance of payments is the difference between the receipts from and payments to foreigners by residents of a country. In accounting sense balance of payments, must always balance. Debits must be equal to credits. So, there will be equilibrium in balance of payments. Symbolically, B = R - P Where : - B = Balance of Payments R = Receipts from Foreigners P = Payments made to Foreigners When B = Zero, there is said to be equilibrium in balance of payments. When B is positive there is favourable balance of payments; When &. B is negative there is unfavourable or adverse balance of payments.' When there is a surplus or a deficit in balance of payments there is said : to be disequilibrium in balance of payments. Thus disequilibrium refers to imbalance in balance of paymen TYPES OF DISEQUILIBRIUM IN BOP The following are the main types of disequilibrium in the balance of payments:1. Structural Disequilibrium :Structural disequilibrium is caused by structural changes in the economy affecting demand and supply relations in commodity and factor markets. Some of the structural disequilibrium are as follows :a. A shift in demand due to changes in tastes, fashions, income etc. would decrease or increase the demand for imported goods thereby causing a disequilibrium in BOP. b. If foreign demand for a country's products declines due to new and cheaper substitutes abroad, then the country's exports will decline causing a deficit. c. Changes in the rate of international capital movements may also cause structural disequilibrium. d. If supply is affected due to crop failure, shortage of raw-materials, strikes, political instability etc., then there would be deficit in BOP. e. A war or natural calamities also result in structural changes which may affect not only goods

but also factors of production causing disequilibrium in BOP. f. Institutional changes that take place within and outside the country may result in BOP disequilibrium. For Eg. if a trading block imposes additional import duties on products imported in member countries of the block, then the exports of exporting country would be restricted or reduced. This may worsen the BOP position of exporting country. 2. Cyclical Disequilibrium :Economic activities are subject to business cycles, which normally have four phases Boom or Prosperity, Recession, Depression and Recovery. During boom period, imports may increase considerably due to increase in demand for imported goods. During recession and depression, imports may be reduced due to fall in demand on account of reduced income. During recession exports may increase due to fall in prices. During boom period, a country may face deficit in BOP on account of increased imports. Cyclical disequilibrium in BOP may occur because a. Trade cycles follow different paths and patterns in different countries. b. Income elasticities of demand for imports in different countries are not identical. c. Price elasticities of demand for imports differ in different countries. 3. Short - Run Disequilibrium :This disequilibrium occurs for a short period of one or two years. Such BOP disequilibrium is temporary in nature. Short - run disequilibrium arises due to unexpected contingencies like failure of rains or favourable monsoons, strikes, industrial peace or unrest etc. Imports may increase exports or exports may increase imports in a year due to these reasons and causes a temporary disequilibrium exists. International borrowing or lending for a short - period would cause short - run disequilibrium in balance of payments of a country. Short term disequilibrium can be corrected through short - term borrowings. If short - run disequilibrium occurs repeatedly it may pave way for long - run disequilibrium. 4. Long - Run I Secular Disequilibrium :Long run or fundamental disequilibrium refers to a persistent deficit or a surplus in the balance of payments of a country. It is also known as secular disequilibrium. The causes of long - term disequilibrium are a. Continuous increase in demand for imports due to increasing population. b. Constant price changes - mostly inflation which affects exports on continuous basis. c. Decline in demand for exports due to technological improvements in importing countries, and as such the importing countries depend less on imports.

The long run disequilibrium can be corrected by making constant efforts to increase exports and to reduce imports. 5. Monetary Disequilibrium Monetary disequilibrium takes place on account of inflation or deflation. Due to inflation, prices of products in domestic market rises, which makes exports expensive. Such a situation may affect BOP equilibrium. Inflation also results in increase in money income with people, which in turn may increase demand for imported goods. As a result imports may turn BOP position in disequilibrium. 6. Exchange Rate Fluctuations :A high degree of fluctuation in exchange rate may affect the BOP position. For Eg. if Indian Rupee gets appreciated against dollar, then Indian exporters will receive lower amounts of foreign exchange, whereas, there will be more outflow of foreign exchange on account of higher imports. Such a situation will adversely affect BOP position. But, if domestic currency depreciates against foreign currency, then the BOP position may have positive impact. CAUSES OF DISEQUILIBRIUM IN BOP Any disequilibrium in the balance of payment is the result of imbalance between receipts and payments for imports and exports. Normally, the term disequilibrium is interpreted from a negative angle and therefore, it implies deficit in BOP. The disequilibrium in BOP is caused due to various factors. Some of them are I. 1. Import - Related Causes The rise in imports has been the most important factor responsible for large BOP deficits. The causes of rapid expansion of imports are :Population Growth Population Growth may increase the demand for imported goods such as food items and non food items, to meet their growing needs. Thus, increase in imports may lead to BOP disequilibrium. 2. Development Programme Increase in development programmes by developing countries may require import of capital goods, raw materials and technology. As development is a continuous process, imports of these items continue for a long time landing the developing countries in BOP deficit. 3. Imports Of Essential Items

Countries which do not have enough supply of essential items like Crude oil or Capital equipments are required to import them. Again due to natural calamities government may resort to heavy imports, which adversely affect the BOP position. 4. Reduction Of Import Duties When import duties are reduced, imports becomes cheaper as such imports increases. This increases the deficit in BOP position. 5. Inflation Inflation in domestic markets may increase the demand for imported goods, provided the imported goods are available at lower prices than in domestic markets. 6. Demonstration Effect An increase in income coupled with awareness of higher living standard of foreigners, induce people at home to imitate the foreigners. Thus, when people become victims of demonstration effect, their propensity to import increases. II. Export Related Causes :- Even though export earnings have increased but they have not been sufficient enough to meet the rising imports. Exports may reduce without a corresponding decline in imports. Following are the causes for decrease in exports 1. Increase In Population :Goods which were earlier exported may be consumed by rising population. This reduces the export earnings of the country leading to BOP disequilibrium. 2. Inflation :- When there is inflation in domestic market, prices of export goods increases. This reduces the demand of export goods which in turn results in trade deficit. 3. Appreciation Of Currency :- Appreciation of domestic currency against foreign currencies results in lower foreign exchange to exporters. This demotivates the exporters. 4. Discovery Of Substitutes :- With technological development new substitutes have come up. Like plastic for rubber, synthetic fibre for cotton etc. This may reduce the demand for raw material requirement. 5. Technological Development :-

Technological Development in importing countries may reduce their imports. This can be possible when they start manufacturing goods which they were exporting earlier. This will have an adverse effect on exporting countries. 6. Protectionist Trade Policy :- Protectionist trade policy of importing country would encourage domestic producers by giving them incentives, whereas, the imports would be discouraged by imposing high duties. This will affect exports. III. Other Causes :- 1. Flight of Capital Due to speculative reasons, countries may lose foreign exchange or gold stocks. Investors may also withdraw their investments, which in turn puts pressure on foreign exchange reserves. 2. Globalisation Globalisation and the rules of WTO have brought a liberal and open environment in global trade. It has positive as well as negative effects on imports, exports and investments. Poor countries are unable to cope up with this new environment. Ultimately they become loser and their BOP is adversely affected. 3. Cyclical Transmission International trade is also affected by Business cycles. Recession or depression in one or more developed countries may affect the rest of the world. The negative effects of trade cycle (low income, low demand, etc.) are transmitted from one country to another. For eg. The current financial crisis in U.S.A. is affecting the rest of the world. 4. Structural Adjustments Many countries in recent years are undergoing structural changes. Their economies are being liberalised. As a result, investment, income and other variables are changing resulting in changes in exports and imports. 5. Political factors The existence of political instability may result in disrupting the productive apparatus of the country causing a decline in exports and increase in imports. Likewise, payment of war expenses may also serious affect disequilibrium in the country’s BOP. Thus political factors may also produce serious disequilibrium in the country’s BOPs. MEASURES TO CORRECT DISEQUILIBRIUM IN BOP :-

Any disequilibrium (deficit or surplus) in balance of payments is bad for normal internal economic operations and international economic relations. A deficit is more harmful for a country’s economic growth, thus it must be corrected sooner than later. The measures to correct disequilibrium can be broadly divided into four groups MEASURES Monetary Measures :1) Monetary Policy :The monetary policy is concerned with money supply and credit in the economy. The Central Bank may expand or contract the money supply in the economy through appropriate measures which will affect the prices. A. Inflation :- If in the country there is inflation, the Central Bank through its monetary policy will make an attempt to reduce inflation. The Central Bank will adopt tight monetary policy. Money supply will be controlled by increase in Bank Rate, Cash Reserve Ratio, Statutory Ratio etc. The monetary policy measures may reduce money supply, and encourage people to save more, which would reduce inflation. If inflation is reduced, the prices of domestic market will decrease and also that of export goods. In foreign markets there will be more demand for export goods, which would correct BOP disequilibrium. B. Deflation :- During deflation the Central Bank of the country may adopt easy monetary policy. It will try to increase money supply and credit in the economy, which would increase investment. More investment leads to more production. Surplus can be exported, which in turn may improve BOP position. 2) Fiscal Policy Fiscal policy is government's policy on income and expenditure. Government incurs development and non - development expenditure,. It gets income through taxation and non - tax sources. Depending upon the situation governments expenditure may be increased or decreased. a) Inflation

During inflation the government may adopt easy fiscal policy. The tax rates for corporate sector may be reduced, which would encourage more production and distribution including exports. Increased exports will bring more foreign exchange there by making the BOP position favourable. b) Deflation During deflation the government would adopt restrictive fiscal policy.It may impose additional taxes on consumers or may introduce tax saving schemes. This may reduce the consumption of citizens, which in turn may enable more export surplus. To restrict imports the government may also impose additional tariffs or customs duties which may improve the BOP position. 3) Exchange Rate Policy Foreign exchange rate in the market may directly or indirectly be influenced by the Government. a) Devaluation When foreign exchange problem is faced by the country, the government tries to reduce imports and .increase exports. This is done through devaluation of domestic currency. Under devaluation, the- government makes a deliberate effort to reduce the value of home country. If devaluation is carried out, then the exports will become cheaper and imports costlier. This is turn will help to reduce imports and increase exports. b) Depreciation Depreciation like devaluation lowers the value of domestic currency or increases the value of foreign currency. Depreciation of a country's currency takes place in free or competitive foreign exchange market due to market forces. Depreciation and devaluation have the same effect on exchange rate. If there is high demand for foreign currency than its supply, it will appreciate and vice versa. However, in several countries the system of managed flexibility is followed. If there is more demand for foreign exchange, the central bank will release the foreign currency in the market from its reserves so as to reduce the appreciation of foreign currency. If there is less demand for foreign exchange, it will purchase the foreign currency from market so as to reduce the depreciation of foreign country and appreciation of domestic currency. Due to devaluation and depreciation of domestic currency, the exports become cheaper and imports become expensive. This helps to increase exports. I) Non-Monetary / General Measures :

A deficit country along with monetary measures may adopt the following nonmonetary measures too, which will either restrict imports or promote exports. 1) Tariffs :- Tariffs refer to duties on imports to restrict imports. Tariff is a fiscal device which may be used to correct an adverse balance of payments. The imposition of import duties will raise the prices of imports. This will lead to a reduction in demand for imports thereby improving the balance of payments position. 2) Quotas :- Under Quota System, the government may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through quota system, the deficit is reduced and the balance of payments position is improved. 3) Export Promotion :- The government may introduce a number of export promotion measures to encourage exporters to export more so as to earn valuable foreign exchange, which in turn would improve BOP Situation. Some of the incentives are Subsidies, Tax Concessions, Grants, Octroi refund, Excise exemption, Duty Drawback, Marketing facilities etc. 4) Import Substitution Governments, especially, that of the developing countries may encourage import substitution so as to restrict imports and save valuable foreign exchange. The government may encourage domestic producers to produce goods which were earlier imported. The domestic producers may be given several incentives such as Tax holiday, Cash Subsidy, Assistance in Research & Development, Providing technical assistance, Providing Scarce inputs etc. CONCLUSION :From the above measures it is clear that more exports with import substitution based on economic strength of the country are the real effective solutions to correct the disequilibrium in the balance of payments

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