UNIT III.docx

UNIT III: Fiscal Policy: nature and significance – public revenues – expenditure, debt,

development activities allocation of funds – critical analysis of the recent fiscal policy of

Government of India. Balance of Payments: Nature – structure – major components – causes for

disequilibrium in balance of payments – correction measures.

Fiscal Policy

The term ‘Fisc’ in English means ‘treasury’. Hence policy concerning treasury or Government

exchequer is known as ‘Fiscal Policy’.

Fiscal policy is that part of Government policy which is concerned with raising revenues through

taxation and other means deciding on the level and pattern of expenditure it operates through

budget. However, generally the expenditure exceeds the revenue income of the Government. In

order to meet this situation, the Government imposes new taxes or increases rates of taxes, takes

internal or external loans or resorts to deficit financing by issuing fresh currency.

Thus, the collective form of policies of imposing taxation, taking loans or deficit financing is

known as fiscal policy. The authors have defined it as follows:

By fiscal policy is meant the use of public finance or expenditure, taxes, borrowing and financial

administration to further our national income objective. –Buchler

Changes in Government expenditure and taxation designed to influence the pattern and level of

activity. – J. Harry and Johnson

“Fiscal policy is a policy under which the Government uses its expenditure and revenue

programmes to produce desirable effects and avoid undesirable effects on national income,

production and employment.” - Arthur Smithies

There are mainly three constituents of the fiscal policy; these are: (i) taxation policy, (ii) public

expenditure policy, and (iii) public debt policy. All these constituents must work together to

make the fiscal policy sound and effective.

Objectives of fiscal policy

1. Development by effective Mobilization of Resources

2. Efficient allocation of Financial Resources

3. Reduction in inequalities of Income and Wealth

4. Price Stability and Control of Inflation

5. Employment Generation

6. Balanced Regional Development

7. Capital Formation

8. Reducing the Deficit in the Balance of Payment

9. Foreign Exchange Earnings

NATURE OF FISCAL POLICY

1. Rationalization of product classification codes: The rationalized standard product code

structure for indirect taxes. The change has resulted in reduced disputes and litigations

about product classification.

2. Common accounting year for income tax: Taxation policy has adopted standard

accounting year (April-March) for the purpose of income tax.

3. Long term fiscal policy: Since 1986 budget, the Government of India has introduced long

term fiscal policy to provide greater certainties in its budgetary policies and to improve

the overall environment of business.

4. Impact on rural employment: Generation of employment is the main objective of the

fiscal policy.

5. Reliance on indirect taxes:

6. Inadequate public sector contribution:

7. Introducing of Modified Value Added Tax (MODVAT):

SIGNIFICANCE OF FISCAL POLICY

1. Capital formation

2. Mobilization of resources

3. Incentives to savings

4. Inducement to private sector

5. Alleviation of poverty and unemployment

6. Reduction in inequality

PUBLIC REVENUES

Any public authority or Government needs income for the performance of a variety of functions

and meeting its expenditure. The income of the Government through all sources is called public

income or public revenue. According to Dalton, public income can be classified as Public

Revenue and Public 

Any public authority or Government needs income for the performance of a variety of functions

and meeting its expenditure. The income of the Government through all sources is called public

income or public revenue. According to Dalton, public income can be classified as Public

Revenue and Public Receipts.

Public Revenue:

Public revenue refers to income of a Government from all sources raised, in order to meet public

expenditure. Public revenue consists of taxes, revenue from administrative activities like fines,

fees, income from public enterprises, gifts and grants.

Public Receipts

It includes public revenue plus the receipts from public borrowings, the receipts from sale of

public assets and printing and issuing new currency notes. It includes other sources of public

income along with public revenue. Public Revenue can be classified as Tax Revenue and Non -

Tax Revenue.

Sources of Public Revenue

Public revenue is divided into two groups: Tax Revenue and Non - tax Revenue.

Tax Revenue:

The revenue raised by the Government through various taxes is known as tax revenue. Tax

revenue is the most important source of public revenue. A tax is a compulsory payment levied by

the Government on individuals or companies to meet the expenditure which is required for

public welfare.

According to Hugh Dalton, "a tax is a compulsory contribution imposed by a public authority,

irrespective of the exact amount of service rendered to the tax payers in return and not imposed

as a penalty for any legal offence."

In 2009-10, the tax revenue of Central Government was estimated at about 78% of total revenue

receipts.

Direct Taxes: - It includes:-

Personal Income Tax: Personal Income Tax is levied on the taxable income of individuals and

Hindu Undivided Families (HUFs). Here various exemptions and deductions are allowed.

Corporate Tax: Corporate Tax is levied on taxable income of registered corporate firms. Under

various sections of Income Tax Act, exemptions and deductions are allowed.

Other Direct Taxes: There are various other direct taxes & their share is negligible. For eg :-

Interest tax, wealth tax, estate duty, expenditure tax etc.

Indirect Taxes: - It includes

Customs Duty: Customs Duty is levied on imports and on selective exports. In 2009-10, customs

duty revenue to Central Government was estimated at Rs. 84,244 crore.

Excise Duty: Excise duty is levied on goods produced. Over the years the rate of Excise duty has

been reduced on most of the items. In 2009-10, excise duty revenue of Central Government was

estimated at Rs. 1,04,659 crores.

Service Tax : Service tax was introduced in 1994-95. In February 2010, service tax was reduced

to 10% from12%. About 117 services were subject to service tax. In 2009-10. Service tax of

central Government was Rs. 58,454 crore.

Non - Tax Revenue

The revenue obtained by the Government from sources other than tax is called non - tax

revenue’.

1) Administrative Revenues:

The Government gets revenue from public for administrative work in following forms :-

Fees: A fee is charged by the public authorities for rendering service to the members of public.

There is no compulsion involved in case of fees. For Eg. Fees charged for issuing licenses,

passports, registrations, filing of court cases etc.

Fines and Penalties: Fines or penalties are imposed as a form of punishment for breach of law or

non - fulfillment or failure to observe some regulations. Fines are compulsory payments without

quid-pro-quo. For Eg. Fines are imposed for rash driving, not disclosing taxable income,

travelling without tickets etc.

2)  Profits of Government Enterprises:

The Government gets revenue by way of surplus from public enterprises. For Eg: - Surplus from

railways, telephones, profits of state undertakings etc. Earnings from state enterprises depend on

prices charged by them for their goods and services and the surplus derived.

3) Gifts and Grants:                                                                                                        

Gifts are voluntary contributions by individuals or institutions to the Government. Gifts are

important source of revenue during the times of war and emergency. There is no element of

quid-pro-quo. The donor may not get anything in return.

In modern day grants from one Government to another is an important source of revenue. Grants

are provided by Central Government to State Governments or by State Governments to local

authorities to carry out their functions. Grants from foreign countries are known as foreign aid.

PUBLIC EXPENDITURE

Public Expenditure refers to Government Expenditure. It is incurred by Central and State

Governments. The Public Expenditure is incurred on various activities for the welfare of the

people and also for the economic development, especially in developing countries. In other

words The Expenditure incurred by Public authorities like Central, State and local Governments

to satisfy the collective social wants of the people is known as public expenditure.

NEED I IMPORTANCE/ SIGNIFICANCE OF PUBLIC EXPENDITURE:

In modern economic activities public expenditure has to play an important role. It helps to

accelerate economic growth and ensure economic stability. Public Expenditure can promote

economic development as follows:

1. To promote rapid economic development.

2. To promote trade and commerce.

3. To promote rural development

4. To promote balanced regional growth

5. To develop agricultural and industrial sectors

6. To build socio-economic overheads eg. Roadways, railways, power etc.

7. To exploit and develop mineral resources like coal and oil.

8. To provide collective wants and maximize social welfare.

9. To promote full - employment and maintain price stability.

10. To ensure an equitable distribution of income.

Thus public expenditure has to create and maintain conditions conducive to economic

development. It has to improve the climate for investment. It should provide incentives to save

invest and innovate.

Types of Public Expenditure

Classification of public expenditure refers to the systematic arrangement of different items on

which the Government incurs expenditure. Public expenditure can be classified as follows.

Capital and Revenue Expenditure:

Capital Expenditure of the Government refers to that expenditure which results in creation of

fixed assets. They are in the form of investment. They add to the net productive assets of the

economy. Capital Expenditure is also known as development expenditure as it increases the

productive capacity of the economy. It is investment expenditure and a non-recurring type of

expenditure. For Ex. Expenditure - on agricultural and industrial development, irrigation dams,

and public -enterprises etc, are all capital expenditures

Revenue expenditures are current or consumption expenditures incurred on civil administration,

defense forces, public health and, education, maintenance of Government machinery etc. This

type of "expenditure is of recurrent type which is incurred year after year.

Development and Non - Developmental Expenditure / Productive and Non - Productive

Expenditure:

Expenditure on infrastructure development, public enterprises or development of agriculture

increase productive capacity in the economy and bring income to the Government. Thus they are

classified as productive expenditure. All expenditures that promote economic growth

development are termed as development expenditure.

Unproductive (non - development) expenditure refers to those expenditures which do not yield

any income. Expenditure such as interest payments, expenditure on law and order, public

administration, do not create any productive asset which brings income to Government such

expenses are classified as unproductive expenditures.

Plan and Non - Plan Expenditure

The plan expenditure is incurred on development activities outlined in ongoing five year plan.

In 2009-10, the plan expenditure of Central Government was 5.3% of GDP. Plan expenditure is

incurred on Transport, rural development, communication, agriculture, energy, social services,

etc.

The non - plan expenditure is incurred on those activities, which are not included in five-year

plan.

Other Classification (Mrs. Hicks)

Mrs. Hicks classified Public Expenditure on the basis of duties of Government. It is as follows.

Defense Expenditure: It is expenditure on defense equipment, wages and salaries of armed

forces, navy and air force etc. It is incurred by Government to provide security to citizens of

country from external aggression.

Civil Expenditure: Government/incurs this expenditure to maintain law and order and

administration of justice.

Development Expenditure: It is expenditure on development of agriculture, industry, trade and

commerce, transport and communication etc.

PUBLIC DEBT

Public debt refers to Government debt. It refers to Government borrowings from individuals,

financial institutions, organizations and foreign countries. If revenue collected through taxes and

other sources is not adequate to cover expenditure, the Government may resort to borrowings.

Thus public debt is one of the instruments to cover deficits in budget.

Over the years, the public debt of Central Government and that of State Government’s has

increased during the planning period. In short, public debt refers to “obligations of Governments,

particularly those evidenced by securities, to pay sums to the holders at some future date”.

Borrowed funds are utilized for development and non-development activities.

Types of Public Debt

1. Internal And External Debt

2. Short Term, Medium Term And Long - Term Debt

3. Productive And Unproductive Debt

4. Redeemable And Irredeemable Debt

5. Funded And Unfunded Debt

Internal and External Debt

Internal Debt: Government borrowings within the country are known as internal debt. Public

loans floated within the country are called internal debt. The various internal sources from which

the Government borrows include individuals, banks, business firms and others. The various

instruments of internal debt include market loans, bonds, treasury bills, ways and means

advances etc.

External Debt: Borrowings by the Government from abroad is known as external debt. The

external debt comprises of Loans from World Bank, Asian Development Bank, etc. External

loans help to take up various developmental programmes in developing and underdeveloped

countries.

Short Term, Medium Term and Long - Term Debt

Short Term Debt: Loans for a period of less than one year are known as short - term debt. For

Ex. The treasury bills are issued by RBI on behalf of the Government to raise funds for a period

of 91 days and 182 days. Interest rates on such loans are very low. To cover the temporary

deficits in budget short - term loans are taken.

Medium - Term Debt: The period of medium term debt is normally for a period above one year

and up to 5 years. One of the main forms of medium term debt is by way of market loans. The

interest rates on medium term loans are reasonable. These are preferred to meet expenditure on

health, education, relief work etc.

Long - Term Debt: Loans for a period exceeding 5 years are called long - term debt. One of the

main forms of long term loans is by way of issue of bonds. Long term debt is required for the

purpose of retirement of debts and also for the purpose of development projects.

Productive and Unproductive Debt

Productive Debt: Public debt is said to be productive when it is raised for productive purposes

and is used to add to the productive capacity of the economy. These loans are normally long -

term in nature. These loans are utilized on development activities such as infrastructure

development like roadways, railways, airports, seaports, power generation, telecommunications

etc.

Unproductive Debt: An unproductive debt is one which does not yield any income. It does not

add to the productive assets of the country. For Ex. debts utilized for transfer payments in form

of subsidies, old age pension, special incentives to weaker sections etc.

Redeemable and Irredeemable Debt

Redeemable Debt: Loans which Government promises to pay off at some future date are called

redeemable debts. Their maturity period is fixed. The Government has to make arrangements to

repay the principal and interest on due date.

Irredeemable Debt: Loans for which no promise is made by the Government regarding their

exact date of repayment are called irredeemable debts. Such debt has no maturity period. The

Government may pay interest regularly. Normally, Government does not resort to such

borrowings.

Funded and Unfunded Debt

Funded Debt: Funded debt is normally obtained on long - term basis. The interest on funded

debt must be paid regularly. But the Government has the option to repay the principal. If market

conditions are favorable Government may repay it before maturity.

Unfunded Debt: Unfunded debts are of short term. They are also known as floating debt.

Unfunded debts are incurred to meet temporary needs of the Government. The rate of interest is

low. There is no special fund created to repay this debt.

DEVELOPMENT ACTIVITIES ALLOCATION OF FUNDS

Announcement of long term fiscal policy was in the direction of determining the relationship

between planning in India and the process of making the budget. During the course of this

budget speech 1985-86, the finance Minister and promised to adopt such long term fiscal policy

which will be co-terminus with the period of plan.

The first long-term fiscal policy was announced on 27 December, 1985.

The objectives of long term fiscal plan are to achieve all those objectives which are directly

related to the alleviation of poverty. The main objectives of fiscal policy are

1. To accelerate the process of economic growth

2. Removal of poverty

3. To prepare Indian economy for the 21st century

4. Better coordination of plans and impart uniformity to the policies

5. To provide direction and coordination to annual budget

CRITICAL ANALYSIS OF THE RECENT (2015-16) FISCAL POLICY OF

GOVERNMENT OF INDIA

Taxation

• Abolition of Wealth Tax. 

• Additional 2% surcharge for the super-rich with income of over Rs. 1 crore. 

• Rate of corporate tax to be reduced to 25% over next four years.

• No change in tax slabs

• 100% exemption for contribution to Swachch Bharat, apart from CSR. 

• Service tax increased to14 per cent.

Agriculture

• Rs. 25,000 crore for Rural Infrastructure Development Bank.

• Rs. 5,300 crore to support Micro Irrigation Programme

• Farmers credit - target of 8.5 lakh crore.

Infrastructure

• Rs. 70,000 crores to Infrastructure sector.

• Tax-free bonds for projects in rail road and irrigation

• PPP model for infrastructure development to be revitalised and Govt. to bear majority of the risk.

• Atal Innovation Mission to be established to draw on expertise of entrepreneurs, and researchers to foster scientific innovations; allocation of Rs. 150 crore.

• Govt. proposes to set up 5 ultra-mega power projects, each of 4000MW.

Education

• AIIMS in Jammu and Kashmir, Punjab, Tamil Nadu, Himachal Pradesh, Bihar and Assam.

• IIT in Karnataka; Indian School of Mines in Dhanbad to be upgraded to IIT.

• PG institute of Horticulture in Amritsar.

• Kerala to have University of Disability Studies

• Centre of film production, animation and gaming to come up in Arunachal Pradesh.

• IIM for Jammu and Kashmir and Andhra Pradesh.

Defence

• Allocation of Rs. 2,46,726 crore; an increase of 9.87 per cent over last year.

• Focus on Make in India for quick manufacturing of Defence equipment.

Welfare Schemes

• JAM trinity (Jan Dhan Yojana, Aadhaar and Mobile) to improve quality of life and to pass benefits to common man.

• Six crore toilets across the country under the Swachh Bharat Abhiyan.

• MUDRA bank will refinance micro finance organisations to encourage first generation SC/ST entrepreneurs.

• Housing for all by 2020.

• Up gradation 80,000 secondary schools.

Welfare Schemes

• New scheme for physical aids and assisted living devices for people aged over 80

• Govt. to use Rs. 9,000 crore unclaimed funds in PPF/EPF for Senior Citizens Fund.

• Govt. to create universal social security system for all Indians.

Renewable Energy

• Rs. 75 crore for electric cars production.

• Renewable energy target for 2022: 100K MW in solar; 60K MW in wind; 10K MW in biomass and 5K MW in small hydro

Tourism

• Development schemes for churches and convents in old Goa; Hampi, Elephanta caves, Forests of Rajasthan, Leh palace, Varanasi , Jallianwala Bagh, Qutb Shahi tombs at Hyderabad to be under the new tourism scheme.

• Visa on Arrival for 150 countries.

Gold

• Sovereign Gold Bond, as an alternative to purchasing metal gold.

• New scheme for depositors of gold to earn interest and jewellers to obtain loans on their metal accounts.

Financial Sector

• NBFCs registered with the RBI and having asset size of Rs 500 crore and above to be considered as ‘financial institution’ under Sarfaesi Act, 2002, enabling them to fund SME and mid-corporate businesses

BALANCE OF PAYMENTS

The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year.

The Balance of Payments is the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping.

It is a double entry system of record of all economic transactions between the residents of the country and the rest of the world carried out in a specific period of time.

It takes into account the export and import of both visible and invisible items.

“The balance of payment of a country is a systematic record of all economic transactions between its residents and residents of foreign countries” - Kindlebereger

“Balance of payments of a country is a record of the monetary transactions over a period with rest of the world.” -Benham

NATURE OF BOP

1. Systematic Record: It is a systematic record of receipts and payments of a country with other countries.

2. Fixed Period of Time: It is a statement of account pertaining to a given period of time, usually one year.

3. Comprehensiveness: it includes all the three items. (Visible, invisible and capital transfers)

4. Double Entry System: Receipts and payments are recorded on the basis of double entry system.

STRUCTURE OF BOP

The structure of BOP has two aspects

Credit Side: Credit side of all those values received or likely to be received form abroad.

Debit Side: Debit side comprises all the payments made.

I. Current Account: The current account records all the income-related flow. This flow could arise on account of trade in goods and services and transfer payments among countries.

a. Merchandise Trade: Trade in goods consists of export and import is called as merchandise trade. Merchandise export are those exports in a country i.e., sales of goods to resident of another country, are a source of reserves.

b. Invisible Export: The invisible exports are those exports where sales of service are credit and purchases of services are debited.

II. Capital Account: The capital account record movements on account of international purchase or sale of assets. Assets include any form in which wealth may be held money

held as cash or in the form of bank deposits, shares, debentures, other debt instruments, real estate, land, factories, antiques.

III. Official Reserves: Official reserves include gold, reserves of convertible foreign currencies, which are the means of international payments. Foreign currencies may be held in the form of balances with foreign central banks or foreign Govt. securities.

IV. Unilateral Transfer Account: These refer to one sided transfer from one country to the other. It terms as a gift which include private remittances, Government grants etc. These are not trading transactions.

CAUSES OF DISEQUILIBRIUM IN BOP

Though the credit and debit are written balanced in the balance of payment account, it may not remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an imbalance in the balance of payment account. Such an imbalance is called the disequilibrium. Disequilibrium may take place either in the form of deficit or in the form of surplus.

Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment to foreigners. It arises when the effective demand for foreign exchange of the country exceeds its supply at a given rate of exchange. This is called an 'unfavorable balance'.

Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a situation arises when the effective demand for foreign exchange is less than its supply. Such a surplus disequilibrium is termed as 'favorable balance'.

Various causes of disequilibrium in the balance of payments or adverse balance of payments are as follows:

1. Population Growth

Most countries experience an increase in the population and in some like India and China the population is not only large but increases at a faster rate. To meet their needs, imports become essential and the quantity of imports may increase as population increases.

2. Development Programmes

Developing countries which have embarked upon planned development programmes require importing capital goods, some raw materials which are not available at home and highly skilled and specialized manpower. Since development is a continuous process, imports of these items continue for the long time landing these countries in a balance of payment deficit.

3. Demonstration Effect

When the people in the less developed countries imitate the consumption pattern of the people in the developed countries, their import will increase. Their export may remain constant or decline causing disequilibrium in the balance of payments.

4. Natural Factors:

Natural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in the balance of payments by adversely affecting agriculture and industrial production in the country.

5. Cyclical Fluctuations

Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in the country's balance of payments. For example, if there occurs a business recession in foreign countries, it may easily cause a fall in the exports and exchange earning of the country concerned, resulting in a disequilibrium in the balance of payments.

6. Inflation

An increase in income and price level owing to rapid economic development in developing countries, will increase imports and reduce exports causing a deficit in balance of payments.

7. Poor Marketing Strategies

The superior marketing of the developed countries have increased their surplus. The poor marketing facilities of the developing countries have pushed them into huge deficits.

8. Flight of Capital

Due to speculative reasons, countries may lose foreign exchange or gold stocks People in developing countries may also shift their capital to developed countries to safeguard against political uncertainties. These capital movements adversely affect the balance of payments position.

9. Globalization

Due to globalization there has been more liberal and open atmosphere for international movement of goods, services and capital. Competition has been increased due to the globalization of international economic relations. The emerging new global economic order has brought in certain problems for some countries which have resulted in the balance of payments disequilibrium.

CORRECTION MEASURES

Solution to correct balance of payment disequilibrium lies in earning more foreign exchange through additional exports or reducing imports. Quantitative changes in exports and imports require policy changes. Such policy measures are in the form of monetary, fiscal and non-monetary measures.

The monetary methods for correcting disequilibrium in the balance of payment are as follows:-

1. Deflation

Deflation means falling prices. Deflation has been used as a measure to correct deficit disequilibrium. A country faces deficit when its imports exceeds exports.

Deflation is brought through monetary measures like bank rate policy, open market operations, etc or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our items cheaper in foreign market resulting a rise in our exports. At the same time the demands for imports fall due to higher taxation and reduced income. This would build a favorable atmosphere in the balance of payment position. However Deflation can be successful when the exchange rate remains fixed.

2. Exchange Depreciation

Exchange depreciation means decline in the rate of exchange of domestic currency in terms of foreign currency. This device implies that a country has adopted a flexible exchange rate policy.

Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an adverse balance of payments with regard to U.S.A, the Indian demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in external value. The new rate of exchange may be say $1 = Rs. 50. This means 25% exchange depreciation of the Indian currency.

Exchange depreciation will stimulate exports and reduce imports because exports will become cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off the deficit.

Limitations of Exchange Depreciation :-

Exchange depreciation will be successful only if there is no retaliatory exchange depreciation by other countries.

It is not suitable to a country desiring a fixed exchange rate system.

Exchange depreciation raises the prices of imports and reduces the prices of exports. So the terms of trade will become unfavourable for the country adopting it.

It increases uncertainty & risks involved in foreign trade.

It may result in hyper-inflation causing further deficit in balance of payments.

3. Devaluation

Devaluation refers to deliberate attempt made by monetary authorities to bring down the value of home currency against foreign currency. While depreciation is a spontaneous fall due to interactions of market forces, devaluation is official act enforced by the monetary authority. Generally the international monetary fund advocates the policy of devaluation as a corrective measure of disequilibrium for the countries facing adverse balance of payment position. When India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the value of Indian currency has been reduced by 18 to 20% in terms of various currencies. The 1991 devaluation brought the desired effect. The very next year the import declined while exports picked up.

When devaluation is effected, the value of home currency goes down against foreign currency, Let us suppose the exchange rate remains $1 = Rs. 10 before devaluation. Let us suppose, devaluation takes place which reduces the value of home currency and now the exchange rate becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is because, after devaluation, dollar is exchanged for more Indian currencies which push up the demand for exports. At the same time, imports become costlier as Indians have to pay more currencies to obtain one dollar. Thus demand for imports is reduced.

Generally devaluation is resorted to where there is serious adverse balance of payment problem.

Limitations of Devaluation :-

Devaluation is successful only when other country does not retaliate the same. If

both the countries go for the same, the effect is nil.

Devaluation is successful only when the demand for exports and imports is elastic.

In case it is inelastic, it may turn the situation worse.

Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country.

Devaluation may bring inflation in the following conditions :-

Devaluation brings the imports down, When imports are reduced, the domestic supply of such goods must be increased to the same extent. If not, scarcity of such goods unleash inflationary trends.

A growing country like India is capital thirsty. Due to non availability of capital goods in India, we have no option but to continue imports at higher costs. This will force the industries depending upon capital goods to push up their prices.

When demand for our export rises, more and more goods produced in a country would go for exports and thus creating shortage of such goods at the domestic level. This results in rising prices and inflation.

Devaluation may not be effective if the deficit arises due to cyclical or structural changes.

4. Exchange Control

It is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings. Under such a measure, the central bank directs all exporters to surrender their foreign exchange to the central authority. Thus it leads to concentration of exchange reserves in the hands of central authority. At the same time, the supply of foreign exchange is restricted only for essential goods. It can only help controlling situation from turning worse. In short it is only a temporary measure and not permanent remedy.

squareNon-Monetary Measures for Correcting the BoP ↓

A deficit country along with Monetary measures may adopt the following non-monetary measures too which will either restrict imports or promote exports.

1. Tariffs

Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports would increase to the extent of tariff. The increased prices will reduced the demand for imported goods and at the same time induce domestic producers to produce more of import substitutes. Non-essential imports can be drastically reduced by imposing a very high rate of tariff.

Drawbacks of Tariffs :-

Tariffs bring equilibrium by reducing the volume of trade.

Tariffs obstruct the expansion of world trade and prosperity.

Tariffs need not necessarily reduce imports. Hence the effects of tariff on the balance of payment position are uncertain.

Tariffs seek to establish equilibrium without removing the root causes of disequilibrium.

A new or a higher tariff may aggravate the disequilibrium in the balance of payments of a country already having a surplus.

Tariffs to be successful require an efficient & honest administration which unfortunately is difficult to have in most of the countries. Corruption among the administrative staff will render tariffs ineffective.

2. Quotas

Under the 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 the quota system, the deficit is reduced and the balance of payments position is improved.

Types of Quotas :-

the tariff or custom quota,

the unilateral quota,

the bilateral quota,

the mixing quota, and

import licensing.

Merits of Quotas :-

Quotas are more effective than tariffs as they are certain.

They are easy to implement.

They are more effective even when demand is inelastic, as no imports are possible above the quotas.

More flexible than tariffs as they are subject to administrative decision. Tariffs on the other hand are subject to legislative sanction.

Demerits of Quotas :-

They are not long-run solution as they do not tackle the real cause for disequilibrium.

Under the WTO quotas are discouraged.

Implements of quotas is open invitation to corruption.

3. Export Promotion

The Government can adopt export promotion measures to correct disequilibrium in the balance of payments. This includes substitutes, tax concessions to exporters, marketing facilities, credit and incentives to exporters, etc.

The Government may also help to promote export through exhibition, trade fairs; conducting marketing research & by providing the required administrative and diplomatic help to tap the potential markets.

4. Import Substitution

A country may resort to import substitution to reduce the volume of imports and make it self-reliant. Fiscal and monetary measures may be adopted to encourage industries producing import substitutes. Industries which produce import substitutes require special attention in the form of various concessions, which include tax concession, technical assistance, subsidies, providing scarce inputs, etc.

Non-monetary methods are more effective than monetary methods and are normally applicable in correcting an adverse balance of payments.

Drawbacks of Import Substitution :-

Such industries may lose the spirit of competitiveness.

Domestic industries enjoying various incentives will develop vested interests and ask for such concessions all the time.

Deliberate promotion of import substitute industries go against the principle of comparative advantage.