Central Bank

Definition: -
“It is a bank which has monopoly over issuing of currency notes; it keeps all
the reserves of foreign exchange and gold; it settles financial transactions between banks
and it controls the money supply and money market.”

Function of Central Bank

The main functions of central bank are as under:
I. Issue the Currency Notes: -
Central bank issues the currency notes in the country. It has the monopoly of issuing
currency notes in a country. There are two methods of issuing currency notes in the
country that are as under:
• Reserve Capital Method.
• Fixed Fiduciary Method.
Reserve Capital Method: -
While issuing notes by this method the central bank has to keep a certain
percentage of notes issued in the form of gold and silver etc. As in Pakistan, SBP (State
Bank of Pakistan) has to keep 30% as reserves in the form of gold against each Rs.100
issued. Such method is followed by the countries like Pakistan, India, Germany and US
(United State) etc.
Fixed Fiduciary Method: -
Under this method the parliament of a country allows to issue the currency notes
up to a specific limit without keeping any reserves against such issued notes. If more than
such notes are issued an equal amount of gold has to be kept. This system is applied in
case of UK (United Kingdom) Norway and Japan.
II. Bank of Government: -
Central Bank is also called Bank of Government because all the payments and receipts of
the govt. are made by central bank. Central bank keeps the deposits of all the govt.
departments. Central bank serves as an agent to Govt. It sells and purchase govt.
securities.
III. The Bank of Banks: -
Central bank is a banker to banks. Therefore, it is the function of central bank to establish
a suitable and proper type of banking structure in a country.
• Central bank provides loans to commercial banks.
• The central bank serves as a Clearing House for the commercial banks.
 IV. Custodian of Foreign Exchange and Gold Reserves: -
Most of the Central banks have to keep gold while issuing notes. In addition to gold the
foreign exchange reserves are also with the central bank
• The fluctuations in exchange rate will not occur when central bank interference in
foreign exchange market by selling and purchasing foreign exchange.
• The deficit in BOP can be removed in a better way.
V. Lender of last Resort: -
The central bank serves as a last resort for the commercial banks, particularly
when they do not have access to other sources. In addition to commercial banks, it also
serves as a lender of last resort for the govt.
VI. Controller of Money Market: -
The changes in money and credit do have a variety of effects on the
economy. Therefore, central bank has to control the supply of money and take some steps
for this purpose:
• Bank rate Policy: -
During Inflation central bank increases its bank rate and during deflation central bank
decreases the bank rate.
• Open Market system: -
During Inflation central bank sells the bands, securities etc. in the market to control the
inflation and during deflation purchased the bands, securities etc. to control the deflation
in the economy.
• Changes in Reserve Ratio: -
When central bank want to control the inflation in the economy increases the reserve ratio
for the commercial banks. While during deflation central bank decrease the reserve ratio
for the commercial banks.

Trade Cycle
According to Habeler
“Business cycles are just the names of prosperity and adversity; good
trade and bad trade”.
According to W. C. Mitchel
“Trade cycles are the fluctuations in the aggregate economic activity.
Any trade cycle starts from depression, enters into revival, then converts itself into boom
and finally turns into recession.”
According to J. R. Hicks
“Trade cycles represent fluctuations in the real national income of the
economy. Such fluctuations occur because of economic growth, consequent upon changes
in labor force, innovations and inventions, capital assumptions and natural resources”.
Y

Economic Activity
Boom

Revival Recession

Depression

O Time X

Phases of Trade Cycle

A Trade cycle is furnished with four phases. They are:
I. Depression: -
In this situation, the level of income and employment falls. The demand for
goods and services falls. As a result, the prices of goods and services fall. The profits of
producers decrease. In nut shell, during depression, the level of prices, consumption,
income, employment, wages and interest rate, etc. reach the lowest level.
Prices
Consumption
Income Decreased
Wages
Employment

II. Revival OR Recovery: -

Economy gradually converts itself into revival. The producers, who face big
losses during depression, leave the business. The remaining firms indulge themselves in
the replacement of existing machines. In this way, the demand for capital goods will rise
and the recovery emerges. Accordingly, the price level, wages, interest rate, rates of
profit, employment and production all starts rising gradually.

Prices
Consumption
Income Increasing
Wages
Employment
 III. Prosperity OR Boom: -
The revival culminates into boom or prosperity. In the period of revival when
profits rise, the firms get loans from the banks. In this way prices and costs rise very
sharply. Simply, during boom, the price level, consumption expenditures, income of
people, wages, profits, employment and output reach the highest level.

Prices
Consumption
Income Increased
Wages
Employment

IV. Contraction OR Recession: -

The boom does not last for ever. The banks tighten their policy of advancing
loans. On the other hand, the firms who have produced a lot has to be sold at decreased
prices. Such as all phenomena result in great losses to the producers. Being disappointed,
there is a big cut in the output and employment. The recessionary trends develop in the
economy and the economy reaches to the depression.
Prices
Consumption
Income Decreasing
Wages
Employment

Properties of Trade Cycle

The properties of trade cycle are as under:
I. Aggregate Economic Activity: -
Fluctuations in aggregate economic activity represent trade cycles. If there are
downswing and upswing trends in a particular sector of the economy, they will not
represent trade cycles.
II. The Period of Phases: -
The period of phases with respect to their duration and intensity are not alike.
In some cycles, the period of depression is acute and prolonged as compared with the
period of prosperity. While in some cycles, the economy rapidly turns from depression to
revival while in others it may be of a slower nature. According to Clament Juggler a trade
cycle completes its all phases in the period of 9 or 10 years. While, according to
Kandretiff, a cycle lasts for 50 years.
III. The Nature of Diffusion of Effects: -
The effects of trade cycle do not remain confined to a particular segment of the
economy; rather they are spread over to all the sectors of economy. Moreover, the
changes in phases of trade cycle do have the effects on wages, prices, rents, profits,
consumption, savings and investment.
IV. International in Nature: -
 Trade cycles are international in nature. It means that the prosperity in one
country will have the effect on the other countries. As, it happened during 1930's Great
Depression when unemployment spread over to all the capitalist economies.
V. Social Effect: -
The trade cycles generate, in addition to economic, the social effect. As during
depression, suicides increase because of economic stringencies while in prosperity the
birth rate rises because of economic easiness.

How can trade cycle be reduced?

Trade cycle has always been a crucial issue for the policy makers to control the trade
cycle. Some of the measures are presented as:
I. Fiscal Policy: -
Fiscal policy is an economic policy which consists of government expenditures and
taxes. This policy can be adopted to remove boom or inflation and depression.
Accordingly, to remove boom or inflation, strict fiscal policy can be adopt. In this way,
investment, national income and prices will decrease.
On the other hand, during deflation or depression easy fiscal policy is adopted. In this
way, investment, national income and prices will increase.
II. Monetary Policy: -
Monetary policy is an economic policy which consists of open market operations,
changes in bank rate and changes in reserves etc. During inflation or boom strict
monetary policy can be followed by raising the bank rate, selling government securities
and raising the reserve ratios of banks. On the other hand, during deflation or depression
easy monetary policy can be followed by reducing the bank rate, purchasing the
government securities and decreasing the reserve ratios of banks.
III. Buffer Stock Schemes: -
Such schemes consist of official purchase and sale of food grains. During
depression when the prices of agricultural goods are falling the government should
purchase such commodities at reasonable prices. On the other hand, during boom
government should sell the products at its disposal at lower prices. In this way the boom
will not perpetuate.
Why did trade cycle appear in the economy?
Theories of Trade Cycles
There are different theories about the trade cycle. However some of them are as under:
i. Sunspot Theory: -
According to Orthodox Philosophers, trade cycles are generated due to changes
in climate and weather conditions. Such changes bring certain spot on the face of sun
which result in decreasing the heat out of the sun. In this way, the agricultural production
will be affected and will have a negative effect on industrial production.
ii. Psychological Theory: -
According to psychological theory trade cycles occur due to the business
expectations and psychological behavior of businessmen. If the business community is
optimistic about future business life, they will increase/decrease investments, production
and employment and due to this trade cycles appear in the economy.
iii. Theory of under consumption: -
According to this theory, trade cycles occur because the rich society decreases
their consumption and create over savings. As a result, they do not purchase all of the
goods produced in the economy and caused for trade cycle in the economy.
iv. Hawtrey Theory of Trade cycle: -
According to Hawtrey money and banking system is responsible for trade cycle.
As if there is prosperity in the economy, the commercial banks and other institutions
increase the supply of money. To expand their business the businessmen get loans from
banks and boom will occur in the economy.
On other hand when commercial banks pursue a tight credit policy in boom, it puts the
firms into troubles. The raw material and intermediate goods have to be sold at reduced
prices and prices fall. In this way, the economy will be in the grip of depression.
v. The Over Investment Theory: -
Over investment in the capitalist economies is responsible for economic
fluctuations/trade cycle. At lower interest rates, the producers borrow heavily and
increase investment. But when banks increase the rate of interest and it becomes
expensive to get loans and economy ultimately leads to depression.
vi. Schumpeter's Theory of Trade cycle: -
According to Schumpeter, trade cycles occur due to inventions and innovations on
the part of entrepreneurs. In other words, when there is over supply of goods, there prices
come down. Hence, the wages and incomes of people decrease and the economy enters in
the phase of depression. During depression, new inventions and innovations are adopted.
As a result, the economy will recover which ultimately converts itself into boom.
vii. Keynes Theory of Trade cycle: -
This theory is based on the theory of income & employments. Where, he explains the
behavior of a trade cycle. Consumption, investment and concept of a multiplier bring
changes in the economic activities.
viii. Samuelson's Theory/Interactive of Multiplier and
Acceleration/Modern Theory: -
Business cycles come into being because of interaction of multiplier and accelerator.
As because of multiplier effect, NI changes multiple times of change in investment.
While any change in income will affect investment through accelerator principle. In this
way, according to Samuelson, there is an endless sequence of changes in income and
output.

Multiplier:
According to Keynes theory of income, Income changes many times due to change in
investment.
Y = f (I)
When
I increase = Y increase
I decrease = Y decrease
K= Y I
Accelerator:
According to Clark, Investment changes many times due to change in Income.
I = f (Y)
When
Y increase = I increase
Y decrease = I decrease

W= I Y
Assumption of Modern Theory:
• The autonomous consumption expenditures worth Rs. 10 crore are taking
place each year, i.e., Cº = Rs. 10 crore
• The autonomous investment expenditures worth Rs. 10 crore are taking
place each year, i.e., Iº = Rs. 10 crore
• The value of MPC = 2/3
• The value of COR(accelerator coefficient) is 2, i.e., w = 2
• There is one period lag between income and expenditure which means to
say that current income generates consumption in the next year.

Per- Autonomous Autonomous Induced Induced National Income

-iod Consumption Investment Consumption Investment
T Cº Iº cY MPC (eY):w=2 Y=Cº+Iº+
=2/3 cY+eY
1 10 20 - - - 10+20+0+0=30
2 10 20 30*2/3 20-0 20*2=40 10+20+20+40
=20 =20 =90
3 10 20 90*2/3 60-20 40*2=80 10+20+60+80
=60 =40 =170
4 10 20 170*2/3 113-60 53*2=106 10+20+53+106
=113 =53 =249
5 10 20 249*2/3 166-113 53*2=106 10+20+166+106
=166 =53 =302
6 10 20 302*2/3 201-166 35*2=70 10+20+201+70
=201 =35 =301
7 10 20 301*2/3 201-201 0*2=0 10+20+201+0
=201 =0 =231
Result:
The table shows that from first period to 5th period, NI goes on to increase. The increase
in NI represents that the economy is moving towards revival. In the 5th period, NI of the
economy gets maximum, which shows boom or prosperity. In the 6th period, the trend of
fall in income starts, while in the 7th period, NI has fallen down. This represents
contraction or recession.
Balance of Payments (BOP)
Definition: -
“Balance of payments is systematic record of all economic transactions completed
between the residence of a country and the residence of the rest of the world”.
Surplus in (BOP): -
If the receipts of a country are greater than its payments the result is Surplus.
Receipts > Payments
Balance in (BOP): -
If the receipts of a country and its payments are equal the result is Balance.
Receipts = Payments
Deficit in (BOP): -
If the receipts of a country are less than its payments the result is Deficit.
Receipts < Payments
“Simply whenever, the foreign payments of a country are more than the foreign receipts
of the country, the deficit in BOP rises. In other words, whenever the demand for foreign
exchange is more than the supply of foreign exchange the deficit in BOP occurs”.
Causes of Deficit in (BOP)
The causes of deficit in BOP are as under:
I. Income Type of Disequilibrium: -
The deficit may arise because of changes in income level of a country. If in a
country the incomes are rising more than the rest of the world, because of rise in incomes
the consumption in the country will increase and the exports will decrease. In this way
foreign receipts will come down and deficit in BOP occurs.
II. Price Type of Disequilibrium: -
The changes in price level are also responsible for BOP deficit. If in a country
due to demand-pull inflation or cost-push inflation, the price level rises, the domestic
products will become expensive. In this way, the exports of a country may fall and the
imports of a country may increase. In this way, receipts will come down and payments
will increase and caused for deficit in BOP.
III. Capital Movement: -
The capital movement is also responsible for deficit in BOP. As due to political
instability the domestic capital is flowing out then the foreign payments of a country may
increase. If the foreign capital is not coming to the country, the receipts of a country may
also go down. Thus the changes in capital movement at capital accounts of BOP are also
responsible for deficit in BOP.
 IV. Structural Changes: -
The structural changes which occur in an economy are also responsible for
deficit in BOP. They are as:
• If in a country, the population increases, the exports will decrease and imports
will increase.
• If in a country, the natural resources are depleted the exports may come down.
• If in the world, the substitutes are developed, they may have the effect of
reducing the exports of a country.
• If a country is engaged in the process of economic development, it has to import
machinery, raw material and a variety of goods. In this way the country will
have to spend foreign exchange on their importation.
Measures to Remove Deficit in BOP
Simply to remove deficit in BOP, a country should increase its exports and decrease its
imports. They are discussed below:
I. To Give Subsidies to Exporters: -
Any country which faces deficit in BOP should give subsidies to the exporters. They
may also consist of granting of loans at reduced rates to the exporters as well as providing
insurance facilities and shipment services etc. Moreover, if countries follow the policy of
subsidizing the other countries may also follow it. In this way the benefits of subsidies
will not be availed.
II. Restrictions on Imports: -
Any country which faces deficit in BOP may also impose restrictions on imports by
increasing the import duties, imposition of exchange control etc. In this way the imports
will decrease.
III. Deflation: -
The country which is facing deficit in BOP should follow the policy of deflation.
This policy can be adopted with the help of tight fiscal policy by decreasing Govt.
expenditures and increasing taxes. This will have the effect of decreasing the incomes
and expenditures of the people. In this way, there will be a deflation in the economy. As a
result the imports will decrease and exports will increase
IV. Devaluation: -
In 1994, the World Monetary Conference was held at Brettonwoods. In this conference it
was decided that Pound Sterling (₤), Dollar ($) and gold will be used for international
transaction. The rate of exchange so determined would remain fixed. However, a country
which faces deficit in BOP was allowed to devaluate its currency up to 10% without
permission of International Monetary Fund (I.M.F) and more than this with the
permission of IMF. In this way the exports will increase and imports will decrease.
Accordingly, the deficit will be cured.
V. International Monetary Fund (I.M.F): -
As the international level, the institution named as IMF has been set up. This institution
has been assigned to perform the following functions:
•To serve as a pool of international reserves.
•To keep an eye on exchange rates of currencies.
 •To provide assistance to those countries who face persistent deficit in their BOP.
In this respect IMF has initiated a lot of and with the help of these farcicalities the
member of IMF who faces deficit in BOP, can get loan from IMF and use it to remove its
deficit.
VI. Depreciation: -
Under Brettonwood System it was decided that the rate of exchange between
currencies will remain fixed. But in 1971, American President Nixon suspended the
convertibility of Dollar into gold. Thus, since 1973, the world is having the managed
Flexible Exchange Rate of System. Under Flexible System, the deficit in the BOP is
automatically washed through the policy of Depression.
VII. Appreciation: -
The policy of appreciation is opposite to that of depreciation. It comes into being
when the country faces surplus in BOP under the flexible exchange rate system.
Balance of Trade
“The record of only visible goods transaction completed between the residence of a
country and the residence of the rest of the world”, is known as Balance of Trade.”
Terms of Trade (TOT)
Ratio between the value of exports and value of imports is known as terms of trade.
Value of X
TOT=
Value of M

Value of X = Prices of goods Export * Q of goods export

Value of M = Prices of goods Import * Q of goods import
Surplus/Favorable TOT: -
If value of X is greater than value of M the terms of trade is favorable. In
other words when the receipts of a country is more than its payments the result is surplus
in TOT.
Value of X > Value of M
OR
Receipts > Payments
Deficit/Unfavorable TOT: -
If value of M is greater than value of X the terms of trade is unfavorable. In
other words when the payments of a country is more than its receipts the result is deficit
in TOT.
Value of M > Value of X
OR
Payments > Receipts
Causes of Deficit/ Unfavorable of TOT
The causes of deficit/unfavorable of TOT are as under:
I. Export of Agri Goods: -
Unlikely the exports of Pakistan are agri. goods like cotton and rice etc. In
international markets there are heavy fluctuations in the prices of these goods. If the
prices of such goods fall, as such goods can’t be stored and they have to be sold even at
lower prices. Accordingly, TOT goes deficit.
II. Low Income and Price Elasticities of Demand: -
There is very low income and price elasticities of demand for the exports of
Pakistan. Therefore, even at lower prices our exports do not increase. Thus when we have
poor income and price elasticities of demand the TOT is going deficit.
III. Desire for Industrialization: -
The poor countries have the desire to industrialize themselves as soon as possible.
For this purpose they have to import raw material, machinery and automobiles. It means
that under developing countries sold at lower prices and purchased at higher prices. In
such situation TOT is going deficit.
IV. Increase in Population: -
In the poor countries there is a big population pressure and major part of increase in
population is comprised of unskilled labor. There, the wages because of such rising labor
are going down. And the exports of poor countries are also getting cheaper with the result
that TOT is going deficit.
V. Lack of Trade Unions: -
In under developing countries the trade unions have always been weak and ineffective.
As a result the wages can be depressed down. With this the domestic goods will be
produced cheaper and exported at lower prices. In this way, the TOT will remain deficit.
VI. Supply of goods and Market Structure: -
The competitive conditions prevail in the export sectors of under developing countries.
As a result, the prices of export goods are low. Thus when the exports of under
developing countries command lower prices and imports at higher prices the TOT goes
deficit.
Measures to Improve TOT
The TOT can be improved by doing this:
• The country should export manufactured goods, rather agri. goods and primary
goods.
• In order to industrialize their economies the under developing countries should
depend upon their own resources. They should reduce their dependence on imports.
• The population of the country should be controlled so that the demand for imports
could decrease.

Public Finance
“All Policies, all measurements, Govt. loans and Govt. expenditures are related to
N.I is known as Public Finance.”
Financial Policy: -
“Collecting of taxes that are known as revenues, the policy of getting loans inside
and outside of the country and how spent it? Is known as financial policy.”
Difference between Private and Public Finance
The difference between private and public finance is as under:
 I. The order of Income and Expenditure: -
Each person first arrange/estimate his income and than spend according to his income.
While, Govt. first arrange/estimate its expenditures and than get its income by applying
taxes during a financial year.
II. Period of the Budget: -
Each person may arrange his budget daily, weekly, monthly and yearly But Govt. budget
is always for one year. Financial year of Pakistan is 1st July – 31st June.
III. Internal and External Resources: -
Each person gets his income only internal resources while govt. gets its income with both
internal and external resources.
IV. Deficit OR Surplus Finance: -
Usually the govt. budget is deficit but common person’s budget is always surplus. Their
budget can never be deficit.
V. Extraordinary Changes: -
The changes occurred in govt. budget are extra ordinary and it is more than common
person’s budget. It effect on the economic condition of the state. While, common person’s
budget do not effects on the economic condition of the state.
VI. Provision for Future: -
Common persons save their income for problem which may arise in the future. While,
Govt. not save its income.
VII. Secret and Open Budget: -
Private budget is always secret but govt. budget is always open and advertised and
discussed in Assembly.
Sources of Federal Government
1) Tax Revenues: -
Through direct& indirect taxes, wealth tax, property tax, gift tax, sales tax and
excise duty etc.
i. Fees: -
The money which people paid to govt. in return of some govt. services is known as fees.
ii. Prices: -
The money is paid in return of goods & services which are provided by the govt. to the
people according to the prices of the goods & services is known as Prices.
2) Non Tax Revenues: -
i. State Property: -
Govt. has its state property, by selling its property to the public at low prices get income.
For Example: Coal, Salt and Iron etc.
ii. Productive & Enterprise: -
Govt. is also investment in productive works and gets income For Example: Telephone
and Post office etc.
 Principles/Canons of Taxation
The principles of taxation are as under;
I. Canon of Equality: -
Every person had to pay tax according to his income not on a fixed rate of tax.
Poor persons had to pay less tax according to their incomes and rich persons had to pay
more tax according to their incomes.
II. Canon of Certainty: -
The payee must be sure that how much tax he had to pay? Where he pay? And when he
pays? The payee must have the knowledge of tax and its procedure.
III. Canon of Convenience: -
The tax must take when the payee has the income. He had to pay nearby areas.
IV. Canon of Economy: -
The expenditures which are paid to collect the taxes must be less than taxes that mare
taxes are collected.
V. Canon of Simplicity/Procedure of Tax: -
The procedure of tax must be easy that every person can easily know and understand its
procedure.
VI. Canon of Productivity: -
The system of tax must be according to the needs of the govt. and the income which is
collected from taxes must be use there where from more income come.
VII. Canon of Elasticity: -
The govt. should keep Progressive/Proportional tax in mind to applying tax on the
persons.
VIII. Canon of Flexibility: -
The govt. should give the flexibility to the persons according to their income that when
income increase than tax increase and when income decrease than tax decrease.
IX. Canon of Development: -
The money which is collected by taxes must be use there where from more income come
and increase development in the country.
Taxes
“The amount which is paid to govt. by the people and firms is known as taxes. But
against such payments the people and firms can not expect any direct return from
government”.
Types of Taxes
The taxes are divided into following types:
I. Direct Tax: -
“Direct tax is such a tax which has to be paid by the person whom upon it has been
imposed. For Example: Income tax, Wealth tax and property tax in Pakistan.
The payee can not shift the burden of such tax to somebody else.’
 II. Indirect Tax: -
“Indirect tax is such a tax which has to be paid by the person whom upon it has not
been imposed. The payee can shift the burden of the tax to somebody else. For Example:
Customs duty, Sales tax and Excise duty in Pakistan.”
III. Progressive Tax: -
“The progressive tax is a tax which changes along with change in income of the
persons. The rate of tax on higher incomes is more while it is low in case of low income.”
IV. Proportional Tax: -
“Under proportional taxes a uniform tax rate is imposed on all the incomes of people.
If in a country the income tax rate is 10%, all the persons will have to pay 10% tax.’
V. Regressive Tax: -
“It is a tax whose rate falls along with increase in incomes of the people. Thus, it is
opposite to progressive tax. It also denotes that the poor have to sacrifice more as
compared with the rich.”
Why did Government Apply Taxes?
Government Expenditures
The govt. applies taxes to complete the following:
I. Defense: -
The govt. spends its much income on the defense of its country. Pakistan spends 20% of
its budget on its defense. The most income is spent on defense in Today’s world.
II. To Maintain Discipline: -
It is government’s duty to maintain discipline in the country and for this purpose govt.
spends its income to maintain the discipline in the country.
III. Education: -
It’s government’s duty to provide education to every citizen. For this purpose govt.
established school, college and universities to provide education and spends its income
for this purpose.
IV. Health: -
The govt. is also spends its income to provide health facilities to the people and for this
purpose built new hospitals and provide modern machinery.
V. Public works: -
The govt. is also spent its income for public works as like build public parks and public
libraries for the people
VI. Communication and Transportation: -
The govt. is also try to provide the best resources of communication and transportation to
the people and for this purpose spend its income and builds new roads and airports etc.