MBF and I2b Notes

PEACE STUDENT MOVEMENT (PEACE STM)
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Contents
Q#what is barter system? What are inconveniences of barter system? ..................................................................................................................... 2
Q#2 Define money. What are the functions of money? ............................................................................................................................................. 6
Q#3 what are the different kinds of money? Or what are the different stages in the evolution of money? Or what is the origin and growth of
money? ...................................................................................................................................................................................................................... 8
Q#5 what are the qualities of good money? ............................................................................................................................................................. 10
Q #6 what are the merits and demerits of paper money? ......................................................................................................................................... 12
Q #7 What are the methods of note issue? ............................................................................................................................................................. 15
Q #8 What is inflation? What are different types of inflation? What are the measures to control inflation? ................. 18
Q #9 What is deflation? What are the measures to control deflation? .................................................................................................................... 22
Q10: Difference Between Inflation And Deflation? ................................................................................................................................................ 25
Q# 11 Critically examine the fishers quantity theory of money. 27
Q #12 What is trade cycle? What phases of trade cycle? ....................................................................................................................................... 30
Q #13: What are the causes/ reasons of trade cycle also explain remedies of trade cycle? ...................................................................................... 32
Q14: What is an index number? Discuss its construction, advantages, limitation as well. 36
Q15: define foreign exchange. Discuss main objectives of foreign exchange control. ............................................................................................ 40
Q #16 what are the advantages and disadvantages of nationalization of banks in Pakistan. .......................................................................... 44
Q #17. What is bank? What are the types of banks? (Or) what are the classifications of bank? .............................................................................. 48
Q#18 What is a commercial bank? What are the functions of commercial bank? ................................................................................................. 51
Q#19 Explain the role of commercial bank in economic development of country. .............................................................................................. 55
Q#20 What is the process of credit creation? What are the limitations on the powers of bank to create credit? .............. 58
Q#21 Explain the relationship between banker and customer. ............................................................................................................................... 61
Q#22 what are the circumstances under which the relationship between banker and customer comes to an end? ........ 64
Q#23 What are the rights and duties of banker and customer? Explain them in detail. .......................................................................................... 66
Q24: banking, discuss the procedure for opening current, saving and fixed deposit account with a bank? ..................... 68
Q#25 Define central bank. Explain the function of central bank. .......................................................................................................................... 70
Q#26 Differentiate central bank and commercial bank............................................................................................................................................ 73
Q#27 What are the objectives of monetary policy? Also explain the tolls of monetary policy. ............................................................................... 75
Q # 28 Explain tools of monetary policy or instruments of monetary policy? ........................................................................................................ 77
Q94(a) define cheque & bills of exchange? Discuss its features? Also point out the distinction between the two: ................................................. 79
Q.no 29 (b) define cheque & promissory note? Discuss its features also point out the distinction between the two? ....................... 81
Q29 (C) Defines promissory note and bills of exchange? Distinction between promissory note and bills of exchange? 2001. ............................... 83
Q29 (D) What Is Difference between Promissory Note, Bill of Exchange & Cheque? ........................................................................................... 85
Q#30 Describe the parties of letter of credit; also explain the procedure for opening letter of credit. .................................................................... 86
Q#31 What are the types of letter of credit? ........................................................................................................................................................... 88
Q #32 What is business finance? What are the main types of business finance? ..................................................................................................... 90
Q #33 Define owner (equity) and debt finance. What are the advantages and disadvantages of debt and equity finance? .................................... 93
Q #34 Explain the various types of interest free or non interest modes of financing .......................................................................................... 97

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Q#1: What is barter system? What are inconveniences of barter system?
Answer: Barter System
At an early stage of mans economic life, the wants were very limited in number. Man can easily
satisfy all his wants. But as time passed, his needs began to increase. He lost his self-sufficiency.
He began to produce some goods in greater quantity than he could consume himself. The
purpose was to exchange some of his products which he had in excess with those who had
surplus products with themselves.

Definition:
According To R.H. Parker:
Barter is a system in which goods or services are directly exchanged with the
goods or services without the use of money.

According To Sloan:
Direct exchange of commodity or services for another without the use of
money.
Barter, however, is possible only under extremely simple condition of exchange. A pure barter do not
exist today

Inconveniences / Difficulties/ Hindrances /Barriers / Of Barter System
Followings are the difficulties that were faced in barter system.
1. Lack of coincidence of wants
2. Lack of common measure of value
3. Lack of subdivision
4. Lack of store of value
5. Difficulty in future payments (credit)
6. Difficulty in transfer of wealth
7. Difficulty in tax collection
8. Lack of specialization
9. Difficulty in budgeting
10. Exit at small scale
11. No investment, no saving

1. Lack of coincidence of wants:
Barter is possible only when there is double coincidence of wants. The main defect of barter is
that there is lack of coincidence of wants.

Example
If a person has surplus rice and he wants to exchange it with wheat. He will have to find a person
who has surplus wheat as well as he needs rice.

2. Lack of common measure of value:
In barter system it is very difficult to measure the value of goods because there is no standard
measure for the valuation of goods.

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Example
A man who has rice may assign the value to his 1kg rice as equal to 2 kg wheat. But the other
person may assign a value to his 1 kg wheat as equal to 3 kg rice.

3. Lack of subdivision:
In barter system another problem arises when the goods that are exchanged cannot be subdivided
into small parts (units).

Example
If a person has a cow and he wants to exchange it with a goat. It is clear that a cow has more
value than a goat. The problem is what a part of cow is to be given in exchange of goat. The
transaction is impossible because cow cannot be sub-divided.

4. Lack of store of value:
In barter system it is very difficult to store the commodities like fruit, vegetables and animal
skins. It means that one cannot secure his future by storing commodities.

5. Difficulty in future payments (credit):
In barter system it is very difficult to lend goods to other people because at the time of repayment
commodities may lose their value so credit transitions are impossible.

Example
A person borrowed ( ) a goat for one month but at the time of return the goat may fall
sick and lose her value, so the payments in future under barter are difficult.

6. Difficulty in transfer of wealth:
Under barter system it is very difficult to transfer moveable and immovable property from one
place to another place.

Example
If a person has to transfer 100 goats from Faisalabad to Lahore, It would be very difficult for him
to transfer them.

7. Difficulty in tax collection:
Another difficulty which arises under barter is that the tax cannot be collected in form of goods.
If the tax is collected they will lose their value with the passage of time.

8. Lack of specialization:
Under the barter it is very difficult to attain specialization in their fields, because the people
remain busy in meeting their own needs and they do not focus on effective ( ) utilization
( ) of resources.

9. Difficulty in budgeting:
Budgeting is an art of estimating of future expenses and revenues. Under the barter system it is
very difficult to estimate future expenses and incomes.

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10. Exit at small scale:
Barter may only exist at small scale of trade. But if someone wants to expand the scale of
trade how he can do so.

11. No investment, no saving:
Under barter, there is no concept of investment and saving. Because it is very difficult to
save anything in batter system.

Elimination (Removal) Of Inconveniences Of Barter:
The introduction of money removed the above mentioned problems in the following ways:

1. Money as a Medium of Exchange:
The goods and services are now purchased and sold with the help of money. The
difficulty double coincidence of want has been removed.

2. Money as a Common Measure of Value:
Money is used as a common measure of value by which was can measure and compare
the values of different goods and services.

3. Money as a Standard of Future Payment:
In modern economy, goods and services are sold and bought on the promise to pay in
future. So it acts as the standard of future payment.

4. Money as a Store of Value:
Under barter system goods, animals and commodities cannot be stored for a longer
period. Now a days wealth is stored in the form of money.

5. Money is an Instrument of Making Loans:
People save money and deposit in the bank. The bank advances these saving to
businessmen and industrialists so savings are transferred to investment.

6. Liquidity to Wealth:
Money imparts liquidity to various forms of wealth such as land, machinery, stocks and
stores etc. These forms of wealth can easily be converted into money.

7. Establishment of Financial Institutions.
The introduction of money has made it possible to establish financial institutions like the
central bank, commercial bank etc. which deal in currency, and near money assets such as bill of
exchange, bonds, shares etc.

8. Influence of Income and Consumption.
The use of money has helped in removing difficulties of barter system. The higher the
income, the higher will be production and consumption.

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9. Instrument of Economic Policy:
In order to achieve growth, reduce unemployment, and maintain regular expansion of
economic activity, money is the most powerful factor.

10. Aids to Specialization, Production, and Trade:
The market mechanism, production of goods, specialization, and expansion of trade is
possible by use of money.

11. Circular Flow of Money.
In a monetary economy, there is circular flow money. Money flows from firms to the
households. It flows again from household to the firms as the prices of goods and services.

12. Money and Problem of Subdivision:
The problem of subdivision was also solved by the use of money. Now with the help of
money we can purchase each and every kind of goods.

13. Money as a Tool of Monetary Management:
Money is an instrument of monetary management if it is effectively used; it helps in
increasing, output, and employment,

14. Exist at Large Scale:
If someone wants to expand the scale of his business, the money removes this defect
easily.

CONCLUSION:
In conclusion we can say that barter system has many difficulties and problems so at is
better for everyone to use money. Even though at present many developing countries are using
the barter system. Even Pakistan was doing trade with Communist Countries like china and
Russia.

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Q#2 Define money. What are the functions of money? Or define money. How money has facilitated
economy? Or define money. What are the advantages of money?

Answer:
Introduction:
Everyone uses money. We all want it, work for it and think about it. If you don't know what
money is, you are not like most humans. However, the task of defining what money is, where it
comes from and what it's worth.

Definition: Money
Any circulating medium of exchange, including coins, paper money, and demand deposits.
or
A current medium of exchange in the form of coins and banknotes; coins and banknotes
collectively.
Money has facilitated economy by providing the following functions.

1. Medium of exchange
2. Measure of value
3. Future payments
4. Budgeting
5. Economic activities
6. Transfer of wealth
7. Store of wealth
8. Determination of national income
9. Liquidity of wealth
10. Promote to foreign exchange
11. Market mechanism
12. Basis of credit creation

1. Medium of exchange:
Money acts as a medium of exchange between the buyer and seller. Money is used to make
payments for goods and services. Goods can sold for money and that money can be used to
purchase goods.

2. Measure of value:
Value of different goods and services can be measured in Monterey terms, in the same as we can
measure weight in kg and distance in KM.

3. Future payments:
Future payments can be easily determined with the help of money. One can borrow loans from
banks and other financial institutions in form of money and repayment can be made as well in
form of money.

4. Budgeting:
Money helps government and companies in preparation of budgeting. Incomes and expenses are
estimated and recorded in terms of money.

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5. Economic activities:
All type of economic activities such as investments, savings, credit are made in terms of money.
Money has played a vital role in economic growth of a society.

6. Transfer of wealth:
With the help of money wealth can be transferred easily form one place to another place. One
can sold his property at one place against money and he can buy similar at some other place

7. Store of wealth:
Wealth can be stored easily in form of money. One can save his wealth by converting it in
money.

8. Determination of national income:
With the help of money, it becomes easy to determine the income generated by a nation. It also
helps in determination of Gross Domestic Product of a country.

9. Liquidity of wealth:
Liquidity means conversion of property in form of cash. Wealth or property can be converted in
liquid from with the help of money.

10. Promote to foreign trade:
Money has played a vital role in the growth of foreign trade. Foreign investments are made in
terms of money. Payments and receipts of other countries are made in terms of money.

11. Market mechanism:
Market mechanism is based on the demand, supply and price of the goods. Demand and supply
are the two major factors of market which work only because of money. Money is the only factor
which determines the price, demand and supply of goods.

12. Basis of credit creation:
Banks create credit on the basis of cash deposits in banks. So it is not possible for banks to create
credit without the help of money.

Conclusion:
We can conclude that money is very important invention of human life. Now a day all the
transactions are based on money. We can purchase and sale goods and service easily with the
help of money.

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Q#3 what are the different kinds of money? Or what are the different stages in the
evolution of money? Or what is the origin and growth of money?
Answer : Different forms of money:
On the basis of evolution the money is classified in five main types,
1. Commodity money
2. Metallic money
3. Paper money
4. Bank money
5. Electronic money

1. Commodity Money:
In commodity money, different commodities have been used as money like cattle, goats, horses,
animal skins, and arrows. Commodity money was used in barter system in which goods were
exchanged with other goods and services.

Problems of commodity money:
It was found that commodity money was not best to make payments due to the following
problems.
i. Lack of coincidence of wants
I. Lack of common measure of value
II. Lack of subdivision
III. Lack of store of value
IV. Lack of divisibility
V. Lack of transferability

2. Metallic Money:
Metallic money consists of gold coins, silver coins, and metal coins. In our country coins of Rs.
five, two and one are the metallic money. Metallic money cannot be eliminated from economy. It
is playing vital role in the economy. Metallic money is of three kinds.
i. Full bodied money
ii. Token money
iii. Tender money

i. Full bodied money:
In full bodied money, the metallic value of coin is equal to their face value. Full bodied money is
also called standard money or natural money. The gold silver and nickel are considered as full
bodied money. Now such money is not used anywhere in the world.

ii. Token money:
In token money the face value of coin is higher than the metallic value. They are usually made of
silver, copper or nickel. In Pakistan full bodied money does not exist only token is used.

iii. Tender money
Any currency which is generally acceptable in discharge of debts is called tender money it can be
made of paper or metal. If someone offers tender money against debts, nobody can refuse to take
it. Tender money has two types,

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a. Limited tender money
b. Unlimited tender money

a. Limited tender money:
Coins of small denominations are called limited tender money. Such as coins of RS 1, 2 and 5.

b. Unlimited tender money:
Money which is compulsory o accept is called unlimited tender money. Coins of large
denominations are called unlimited tender money. Notes of Rs 5, 10, 50, 100, 500, 1000, 5000
are called unlimited tender money.

3. Paper money:
Paper money consists of notes issued by the state bank of Pakistan. The paper money is of
different denominations, colors and sizes. Paper money is more convenient than any other form
of currency.

4. Bank money:
Bank money includes cheques, bills of exchange, and drafts. Bank money is playing a vital role
in the economic development. Because varies transactions are settled without the use of paper
money. Bank money is safer than any other form of money. but bank money also have some
defects.
Dishonor of cheque may delay payments.
Uneducated may not know the best use of cheque.
Cheque is not a legal tender; one can refuse to take it against the settlements of debts.

5. Electronic money:
With the development of computers and its application, the business and business transactions
are changing very fast. Now a days most of the transactions take place through electronic
money. People prefer to use debit cards and credit cards instead of paper money or bank money.
With the passage of time electronic money may diminish the use of paper money.
Credit card
Debit card

6. Mobile money:
With the help of technology, transactions are very easy. We can make and receive payments with
the help of mobile. We make a transaction and payments are made with mobile.

Conclusion:
Consequently the money at present age is the outcome of evolution of money. After passing
through above discussed stages, now it is the medium of exchange all over the world.

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Q#5 What Are the Qualities of Good Money?
Answer: Introduction
Money is the greatest discovery of modern age. The word MONEY is derived from the
LATIN word MONETA. It occupied a unique and important position in all the fields of life.
Generally speaking anything that people will accept in exchange of their goods and services and
at the same time by which they will purchase goods and formed the modern form.

Definition
(I). Walker Says:
Money Is What, Money Does.

(Ii) Prof Knap Says:
Money is anything which is declared as money by government, becomes Money.

(Iii) G.D.H. Coles:
Purchasing power something which buys things.

Qualities of Good Money:
Good money should have the following qualities.
1. Acceptability
2. Transferability
3. Stability
4. Storability
5. Recognizable
6. Malleability
7. Divisibility
8. Durability
9. Economy
10. Elasticity
11. Homogeneity

1. Acceptability:
Good money should have the quality of general acceptability. General acceptability means every
person must accept it for the settlement of payments. It should be accepted for purchase and sale
of goods.

2. Transferability:
Good money is easily transferable from one place to another for doing business and making
payments. Paper money is easy to transfer from one place to another place because it has
minimum possible weight.

3. Stability:
Value of money should remain stable. If value of money is changing or fluctuating day by day
than it would not be considered reliable.

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4. Storability:
The money should be storable. Value of money should not depreciate with time. If money
material is perishable it will lose its value in few days. Paper money has quality of storability.

5. Recognizable:
The money should be easily recognizable so that the holder of money may not confuse about the
value of money. For example if every note has the same color it will not be easily recognizable.
Paper money is easily recognizable because notes of different value have different color.

6. Malleability:
The material which is used for making money should be malleable. The material which cannot
be melted is not fit for making coins. The gold, silver, copper and nickel coins are malleable.

7. Divisibility:
Divisibly means ability to divide into small units without losing its value. Good money should be
divisible. In barter system, commodity money was not divisible into small units. Thats why it
was replaced by the paper money.

8. Durability:
The material used in making money should be durable and long lasting. Coins do not wear
quickly, so the quality of money remains stable.

9. Economical:
Good money should be economical. Economical means low cost of printing and more value. If
there is heavy cost on issuing money that is not good money.

10. Elasticity:
Supply of money should be elastic. Elastic means whenever it is needed, supply of money can be
increased or decreased. Paper money has the quality of elasticity.

11. Homogeneity:
Homogeneity means the money should be identical, So that there is no ambiguity to the holder of
money.

Conclusion:
We can conclude that good money is acceptable easily everywhere, everyone easily accept and
recognize it. It has long life.

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Q #6 what are the merits and demerits of paper money? Or What are the advantages and
disadvantages of paper money?
Answer: Paper money:
Paper money means the Currency notes issued by central bank of country. In the present age
paper money has got a significant place in place of metallic money. Paper money is convenient
to carry and easy to handle and store. It is the most advance form of money. It fulfills nearly all
the characteristics of ideal money. It is believed that different attempts are made to introduce
paper money i.e. in china during 9
th
century, Iran 13
th
century and finally paper money was
originated by gold smith of England in early 17
th
century. Now in all developed and
underdeveloped countries of world, inconvertible paper money is used as medium of exchange
and standard of value.

Definition:
Prof. Hanson:
Paper money means the paper instrument such as bank notes,
cheque bills and other forms which act as a currency.

According to F ,Perry:
Paper money is documents representing money such as bank notes, promissory
notes, bills of exchange etc.

Money made up of paper is called paper money. It consists of the notes issued by the central
bank. In Pakistan notes of Rs 5 to 5000 are the examples of paper money.

Advantages of paper money:
Following are the advantages of paper money,
1. Economical
2. Easy handling
3. Easy counting
4. Emergency needs
5. Metal savings
6. Easy transfer
7. Easy payment
8. Uniform quality
9. High value in small bulk
10. Stability
11. Recognizable
12. Storability
13. Advantage for banks

1. Economical:
Printing cost of paper money is less than the minting charges of metallic money. Paper money is
cheaper than the metallic money. A large quantity of paper money can be issued at very low cost

2. Easy handling:
Paper money has lesser weight than metallic money. It is easy to handle paper money than coins.

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3. Easy counting:
Paper money is easy to count than the metallic money. The counting of coins in larger sum in
coins takes more time. Paper money takes lesser time than the metallic money.

4. Emergency needs:
Paper money is friend in peace and war. Central bank can increase the supply of paper money for
meeting the economic needs.

5. Metal saving:
Metal saving is possible when paper money is used rather than metallic money. Metals like gold
and silver can be used for other productive purpose.

6. Easy transfer:
Transfer of paper money is easy and cheaper than metallic money because it is light weight and
takes less space.
7. Easy payment:
Payments of larger sums are easy and cheaper than the metallic money because paper money is
easy to count and easy to transfer.

8. Uniform quality:
Paper money has an also a uniform quality and holder of the paper money does not suffer lose
because old and new notes have the same value.

9. High value in small bulk:
Paper money contains high value in small quantity as compared to the metallic money.

10. Stability:
Paper money is more stable in value but the value of coins do not remain stable due to wear and
tear. The value of coins changes with the passage of time.

11. Recognizable:
Paper money of every denomination is easily recognizable because of its different size, color and
design.

12. Storability:
Paper money is easy to store because of more value in light weight. It takes less space so that a
large sum can be stored in small space even in pockets.

13. Advantage for banks:
Banks have the great advantage of paper money they can easily count paper money buy using
counting machines.

Disadvantages of paper money:
1. Inflation
2. Limited acceptability
3. Danger of cancellation

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4. Short life
5. Instability of exchange rate
6. Less confidence

1. Inflation:
Printing of paper money is easy. In time of need government may over issue currency notes. This
over issue may cause inflation which increases the prices of goods and decreases the value of
money.

2. Limited acceptability:
Paper money has limited acceptability. It is acceptable only in the domestic country and in other
countries of the world it is not acceptable.

3. Danger of cancellation:
There is always a danger of cancellation. If government canceled the paper money then holder of
money just has the worthless piece of paper.

4. Short life:
Paper money is less durable than the metallic money. Paper money can be easily destroyed by
fire, water or heat. So life of paper money is less than coins.

5. Instability of exchange rate:
Exchange rate means the rate at which the domestic money is exchanged with the foreign money.
Value of paper money depends upon the fluctuations. The instability of exchange rate directly
affects the foreign trade.

6. Less confidence:
As value of paper money is less stable and it has no real value in it. So people have less
confidence in paper money.

Conclusion:
In conclusion we can say that paper money is very important invention. It has many merits and
demerits. But merits of paper money are more superior than its demerits.

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Q #7 What are the methods of note issue?

Answer: Introduction: In all over the world, all most all the countries have fiat standard and
fiat paper money. The management regulations and control of paper money is normally assigned
to central bank of the country. The main advantage of this single authority control and
management is that is that there is uniformity in quality, size and design of all paper currency
notes.
There are the following methods of note issue,
1. Fixed fiduciary system
2. Proportional reserve system
3. Modified proportional reserve system / exchange management
4. Minimum reserve system

1. Fixed fiduciary system:
According to this principle, central bank can issue notes up to a certain limit by keeping
government securities. If any time central bank wants to issue more notes, then the notes must be
issued by keeping 100% gold reserve.

Advantages:
Following are advantages of fixed fiduciary system.

i. No danger of over issue:
Under this system there is no danger of over issue of notes because 100% gold reserves are kept.

ii. No danger of inflation :
There are no chances of inflation because money can be converted into gold at any time.

Disadvantages:
Following are disadvantages,

i. Inelastic:
In emergency, if there is gold is not available government cannot issue notes.

ii. Unnecessary lock up of gold:
Large amount of gold is locked that can be used for other productive purposes.

2. Proportional reserve system:
Under this system central bank keeps certain percentage of note issue in form of gold reserve.
This ratio may be different in every country. In Pakistan this ratio is 30%.

Advantages:
Following are advantages.

i. Elastic:
Under this system central bank can increase the supply of money easily whenever needed.

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ii. No lock of Gold:
Under this system, a large amount of gold is not locked. Gold can be used for other productive
purposes.

iii. Emergency needs:
This system is very helpful in emergency needs of currency.

Disadvantages:

i. Danger of over issue:
There is always danger of over issue of notes.

ii. Danger of inflation:
There is always danger of inflation due to over issue of notes.

3. Modified proportional reserve system / exchange management:
Under this system, central bank keeps certain percentage of note issue in form of gold, foreign
bills of exchange, foreign currency at some other country where gold system is used. This system
is used in many countries.

Advantages:
Following are advantages,

i. Elastic system:
Central bank can increase supply of money easily.

ii. No lock of gold:
Under this system, a large amount of gold is not locked. Gold can be used for other productive
purposes.

Disadvantages:

i. Lock up of foreign exchange:
Under this system a large amount of foreign currency is locked up in unproductive sector.

ii. Over issue:
There is always danger of over issue of currency notes.

4. Fixed minimum reserve system:
Under this system central bank keeps only a fixed amount of gold or silver reserves against
whatever amount of note issue.

Advantages:
Following are advantages,

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i. Elastic:
This system is highly elastic because central bank can issue a large amount of notes by keeping
small reserve.

ii. No lock up of gold:
A large amount of gold is not locked up that can be used for productive purpose

Disadvantages:

i. Over issue:
In this system, there is a great danger of over issue.

ii. Currency value:
Under this system, central bank may fail to stable the price level.

Conclusion:
There are many principles and methods of note issue and countries use these according to their
need of time.

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Q #8 What is inflation? What are different types of inflation? What are the measures to
control inflation?

Answer: Inflation:
Inflation is a process in which there is continuous increase in general price level and there is
continuous decrease in money value. Inflation is a situation where demand of goods and services
exceeds available supply of goods.

Definitions:
According To R.P. Kent:
Inflation is nothing more than a sharp upward movement in the price level.

According To Crowther:
In the state of inflation the prices are rising c.e. the value of money is falling.

According To Ackley:
A persistent and appreciable rise in general price level.

According To Coulborn:
Too much money chasing too few goods.

Type Of Inflation:

A. On The Basis Of Rate Of Inflation:
(i) Creeping Inflation:
It is a situation where the increase. In the price level is very slow. i.e. 2% P.a. (Japan, USA,
Singapore)

(ii) Walking Inflation:
In this situation increase in price level is more than creeping inflation i.e. 5% P.a.

(iii) Trotting Inflation:
In this situation prices raise more than they are in creeping inflation i.e. 5-20% (Pakistan,
Greece, and Italy).

(iv) Galloping or Hyper Inflation:
It is situation where general price level rises rapidly within a short period of time.

B. On The Basis of Degree of Control:
(i) Open Inflation:
It is a situation when the inflation gets out of control and cannot be controlled by government
price control or similar measures.

(ii) Suppressed Inflation:
It is a situation when the inflation can be controlled by the government price control policy.

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C. On The Basic Of Causes:
i. Demand pull inflation:
Inflation that occurs due to high demand in the economy called demand pull inflation. The higher
consumption causes aggregate demand to grow, while aggregate supply lack behind.

ii. Cost push inflation:
It is the inflation that is result of higher cost of production. Production cost
consists of direct material, direct labor and factory overhead. In this situation the supply
decreases due to cost increase.

iii. Budgetary inflation:
When the government covers the budget deficit by borrowing then there will be
budgetary inflation.

iv. Monetary inflation:
When there is an expansion in the currency notes in circulation then there will
be monetary inflation.

v. Income inflation:
The inflation that is occurred form high income level. Income may increase due
to change in salary or foreign remittance.

vi. Profit inflation:
Profit inflation is the result of the greed of businessmen. It usually occur in such
economy which are dominated by monopolies.

Measures Used To Control The Inflation :
The main measures used to control the inflation are;
1. Monetary measures
2. Fiscal measures
3. Other measures

1. Monetary Measures:
Monetary measures are adopted by the central bank to control the supply of money.

i. Bank rate policy:
Bank rate or discount rate is the rate at which central bank lend loans to commercial banks.
Whenever central bank wants to control the inflation it increases the bank rate which help in
reducing borrowings from commercial banks and inflation may be controlled.

ii. Open market operation:
In open market operation central bank sales or purchases the securities in open market. If there is
inflation in the country the central bank sells the securities which reduce the supply of money. So
that inflation may be controlled.

20
iii. Variable reserve ratio:
In order to control inflation, the central bank increases the reserve ratio due to which more funds
of commercial banks are kept with the central bank. So the borrowings from commercial bank
deceases and inflation may be decreased.

iv. Credit rationing:
Under this policy central bank advices commercial banks to stop issuing loans for some time. In
this way inflation may be controlled.

v. Monetary reforms:
The government can order commercial banks to exchange old notes by new one. In this way a
large amount of money can be blocked for some time. Repayment should be made after
achieving the objective.

2. Fiscal Measures:
Fiscal measures are based on the demand management. Central bank may raise or lower down
the demand by controlling expenditures.

i. Decrease in tax rate:
In order to control inflation, central bank may decrease the tax rate. Resultantly industrialists
increase the level of production which reduces the price level.
ii. Decrease in government expenditures:
In government decreases expenditures on unproductive purposes the inflation is automatically
controlled.

iii. Deficit financing:
In order to control inflation the government should avoid from deficit financing.

3. Other Methods:

i. Increase the supply of goods:
If the supply of goods is equal to the demand in the market, Inflation will be automatically
controlled.

ii. Population planning:
Control on population by adopting different measures of family planning. It will reduce the
demand of goods which will help in controlling price level.

iii. Political stability:
If there is political stability in country, it will encourage investment and increase in production
which may help in controlling prices.

iv. Smuggling of goods:
Shortage of supply is normally due to the smuggling of goods. If govt take actions to control
smuggling it will help in controlling price level.

21
v. Price control policy:
The government should adopt strict price control policy against the profiteers and hoarders. So
that inflation can be controlled.

Conclusion:
Inflation is bad for economy and measure should be taken to stop it. There are many methods for
the control of inflation. No country can be on the way to progress unless inflation is under
control.

22
Q #9 What is deflation? What are the measures to control deflation?

Answer: Deflation:
Deflation is a situation in which prices, output and employment are falling down. Inflation and
deflation both are harmful for the economy but the deflation is more harmful. It creates hurdle on
path of economic growth.

Definition: According to the Philips deflation is a period during which level of prices declines
and the value of money increases.

According to James Phillips:
Deflation is a period during which level of prices declines and the value of money rises.

Causes of deflation:
Followings are main causes of deflation.
1. Decrease in money supply:
The main reason of deflation is decrease in money supply. Sufficient money supply is necessary
to meet the economic need.

2. Strict banking policy:
Sometimes, restriction on lending is imposed by the central bank to decrease the money supply.
This policy may decrease the investments.

3. High taxes:
Sometimes government levied high taxes due to which the purchasing power of the people is
also decreased and the result is deflation in economy.

4. Excess production:
If goods are produced more than the demand, then it also becomes the cause of deflation and
prices are decreased.

5. No storage facility:
If businessmen have no storage facility than they are bound to sell goods even at low prices,
which may cause deflation.

6. Excess saving:
In case of inflation, commercial banks promote savings but unnecessary promotion of saving
May leads towards the deflation.

7. Heavy imports:
Imports in large scale quantity are also the cause of deflation. Due to increase in imports the
supply is also increased which is the cause of deflation.

8. Decrease in exports:
If exports are decreased, the goods and services will be increased in the market, hence price will
be decreased.

23

9. Decrease in demand:
Decrease in demand of goods and services are another cause of deflation. Demand may be
decreased due to the fall in income.

10. Decrease in government expenditures:
Sometimes the government decreases expenditures due to which demand for goods is also
decreased.

11. Increasing cost:
Increasing cost of production also becomes the reason for deflation. People may not have buying
power to purchase costly goods.

12. Lower profits:
The lower profit rate is also the cause of deflation. Businessmen cut their profits to retain in the
market a stage becomes when the profit becomes zero. Business at this stage may decide to stop
production.

13. High bank rate:
An increase bank rate may also cause deflation. Increase in bank rate decreases the borrowings
which decreases the money supply. Decreases in money supply cause deflation.

14. Sale of securities:
Sale of securities (shares and bonds) is also the cause of deflation. The people may like to invest
their savings in shares due to this their purchasing power is decreased and they can buy fewer
goods.

Measure / methods to control deflation:
By taking following measures government can get easily control on deflation.

1. Increase in supply of money:
To control deflation, supply of money in the country can be increased. Central bank should issue
currency notes to meet the economic needs. When the supply is increased the demand for goods
and services is also increased.

2. Increase in wages:
Increase in wages also helps decreasing deflation. The purchasing power of the people will be
increased which will increase the demand of goods.

3. Decrease in reserve ratio:
Decrease in reserve ratio also helps in controlling deflation. It increases the borrowings from
commercial bank. Increase in borrowings increases the demand and price level.

4. Control on production:
Production of different commodities should be controlled and there should be equilibrium in
demand and supply. Control on production helps controlling production.

24

5. Decrease in interest rate:
The rate of interest on loans should be decreased. Loans should be provided to the producers to
increase the production and investment level. This will increase the incomes of people. Demand
for goods will be increased and deflation will be decreased.

6. Increase in private investments:
The government should provide facilities to the industrialists to increase investment in country.
By setting up new industries, the employment opportunities will be increased, incomes of people
will also be increased which help to control inflation.

7. Tax reduction:
Government should reduce the taxes which will increase the incomes of people. Increase in
incomes increases the demand for goods and services which helps controlling inflation.

8. Increase in exports:
The excess supply of goods can be exported to control deflation. Increase in exports encourages
producers for more production which helps in decreasing deflationary pressure.

9. Increase in investments:
Deflation can be controlled through new investments. The production and employment increases
due to new investments. The use of idle money decreases the deflation.

10. Fixed prices:
Deflation can also be controlled by fixing the price of goods and services. Government may
appoint a price commission who supervises the price level so that the producer is not
discouraged.

11. Public works:
Government may start public works to eliminate the deflation. The amount is transferred from
government to public. The demand for the goods and services is increased and there is increase
in production.

Conclusion:
Deflation is bad for economy and measure should be taken to stop it. Production of goods is
decrease in time of deflation. No country can be on the way to progress unless inflation is under
control.

25
Q10: Difference between Inflation and Deflation?
ANSWER:
Definition of inflation:
Inflation is nothing more than a sharp upward movement in the price level.

Definition of deflation:
Deflation is a reduction in the general price level due to a decrease in the economic activity of a
nation.
Inflation Deflation
1. Prices:
The general price level goes up due to inflation in
the economy.

The general price level comes down due to
deflation in the economy.
2. output:
The output of goods and services increases
due to inflation in a free market economic system

The output of goods services decrease due to
deflation. In a free market economic system.
3. Employment:
The rate of employment increases due to ever
increasing a activities in the country.

The rate of employment decreases due to
decreasing activities in the country.
4. Business:
The business earns higher profits due to rising
prices. The production factors are paid at old
rates but goods are sold at current market prices.

The business earning is disturbed due to
deflation. The prices come down. the unsold
stock become a problem for the business person
during deflation.
5. Investment:
The shareholders feel comfort due to
inflation. The share prices and dividend increases
due to expanding business activities

The shareholders feel sorry due to deflation. The
investment is unable to generate reasonable
income for them due to low activities.
6. Income:
Inflation does not reduce the national income
of the country. The business works do not shrink
the size of income.

Deflation reduces national income of the country.
The low business activities shrink the size of
income.
7. Agriculture:
Inflation is a friend of agriculture. The prices
of goods and services go up. The farmers are
happy due to it.

Deflation is an enemy of agriculture. The prices
of goods and services come down. The farmers
feel burden due to it.
8. Saving:
The saving is looted by inflation due to
decreasing value of money. The savers are
discouraged due to increasing prices.

The savers are encouraged due to deflation. They
can buy more goods with their saving due to
decreasing prices.
9. Hoarding:
The boarding of goods is profitable during
inflation.

The hoarding of goods becomes unprofitable due
to decreasing prices.

26
10. Quality:
The Quality of output is adversely affected
by inflation. The producers pay attention to
quantity rather than quality.

The quality of output is maintained during
deflation. The producers can attract customers
due to better quality of goods.
11. Exports:
The demand for goods in overseas markets
comes down due to rising prices. The foreign
customers can buy goods form elsewhere.

The exports become necessary during deflation.
The goods are cheaper for overseas customers the
demand for exports increases due to decreasing
prices.
12. Payments:
The balance of payments position becomes
unfavorable due to inflation.

The balance of payments position can be
improved by exporting goods abroad.
13. Control:
It is easy to control inflation the governments
can fix the prices of goods and services for some
time.

It is difficult to control deflation. The
government has to do a lot of work through fiscal
and monetary measures.
14. Time:
The time period of inflation is short. It is
easy to fall. The government can take measure to
regulate the activities.

The time of deflation is longer. It takes a long
time to go up. The government can regulate the
activities through various measures.
15. Speculation:
Inflation helps the speculation activities. The
businessmen put their energies to make quick
profits. They do not take care of genuine
productive work.

Deflation cannot help speculators to earn profits.
Artificial demand cannot attract investor to
indulge in non-productive activities.
16. Government:
The government is in trouble due to
inflation. The revenue raised loses its value. The
ongoing projects remain incomplete due to high
prices.

The govt. revenue can be used to complete the
projects
17. Real Estate:
The real estate owners lose their purchasing
power due to high prices. They collect rent at old
rates according to the agreements already made.

The real estate owners feel happy as they receive
rent at old rates but now prices are low so they
can buy more goods with the same income.

Conclusion:
In conclusion we can conclude that both inflation and deflation is not good for a country. Both
are harmful for public and economy. It is duty of government to get control on inflation and
deflation.

27
Q# 11 Critically examine the fishers quantity theory of money. (Or) Explain and criticize
the fishers equation of exchange.

Answer: Statement of theory:
The quantity theory of money was presented by jean Bodin in 1568 for the first time. Afterward
John Law, David Hume and J.S. Mill have also worked on this theory. But it was popularized by
Professor Irving Fisher with the help of an equation in his book purchasing power of money in
1911.
The quantity theory of money states that the quantity of money is the main determinant of the
price level or value of money.

Definition:
Other things remaining unchanged, as the quantity of money in circulation increases, the price
level also increases in direct proportion and value of money decreases and vice versa

Fisher equation of exchange

PT= MV+M
1
V
1

P= General price level.
M= Quantity of legal tender money.
M
1
= quantity of bank/ credit money.
V= velocity of circulation of legal tender money.
V
1
= velocity of circulation of bank money.
T= total transaction.
The above equation shows that a proportional change in quantity of money brings of money
brings proportional change in prices.

NUMERICAL EXAMPLE:
Let M=100, M
1
=200, V=3, V
1
=3 T=90.
Putting the values in the equation of exchange.
P= (100x3) + (200x3)
P = 300+600 =10

In order to prove that variation in money supply produces proportional change in price, we now
double the supply of money by keeping other variables

Constant:

P= (200x3) + (400x3) = 600+1200 = 1800 =20
90 90 90
The general price level has doubled by doubling the supply of money. Now we half the supply of
money and keeping V, V
1
and T constant.

P2= (50x3) + (100x3) = 150+300 = 450 =5
90 90 90

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The price is now one half what it was before and value of money is double now.

Assumptions of theory:
Followings are main assumption of fisher`s theory.

1. Full employment:
Theory assumes that there is full employment in the economy. It states that all the factors of
production are fully utilized no resource are idle.

2. Velocity of money is constant:
It is assumed that the velocity of circulation of money remains unchanged in short run.

3. Volume of trade:
It is also assumed that the volume of trade remains constant in the short period because method
of production and habits of consumer remain unchanged.

4. Constant relationship between M and M:
There must be constant relationship between M and credit money M.

5. Price level is passive factor:
P should be affected by the other factors but should not affect other factors.

6. Short period:
This theory applied to the changes in price level only in short period.

Criticism on theory:
Followings are main critics on fisher`s theory.
1. Other things may not remain same:
The drawback of this theory is that other things are assumed to be unchanged. But in reality it is
not possible that the factors in an economy remain unchanged.

2. Variables are not independent:
The various variables in the equation are not independent. The factors have great influence on
each other. In this equation p is assumed to be passive factors which do not affect other factors
but in reality when price level is increased, it increases the profit rate and promotes trade

3. No proportionate change:
This theory assumes that if quantity of money is doubled, the prices are also doubled, this
assumption is wrong. There is no proportionate change in the money and prices.

4. Ignores the rate of interest:
This theory ignores the influence of rate of interest on the quantity of money. An increase in the
quantity of money is due to the decrease in interest rates.

29
5. Fails to explain trade cycle:
This theory is failed to explain the trade cycle. According to this theory, if the quantity of money
is doubled the price level will also be doubled. During 1929 1933 the quantity of money was
increased but it fails to increase price level. The depression was not eliminated. So theory has
failed to explain the causes of trade cycle.

6. Full employment:
This theory assumes full employment in an economy which is not possible at all.

7. Static theory:
The quantity theory of money is a static theory. The world is dynamic and things are changing at
fast speed. The ups and down in an economy cannot be explained with the help of this theory.

Conclusion:
Thus it is clear that if the supply of money is doubled, the price level will also be doubled and
the value of money is one halved. Similarly if the supply of money is halved, the price level of
money is doubled. All modern theories accept that change in the quantity of money is one of the
factors affecting price level.

30
Q #12 What is trade cycle? What phases of trade cycle?
Answer: Trade cycle:
Fluctuations (ups and down) in economic activities of a country is called trade cycle. These
changes or ups and down may be positive or negative. The duration of trade cycle may vary from
5 years to ten years or above.

ECONOMIC ACTIVITY

Phases of trade cycle

Trade cycle is composed of four phases which are given below,
1. Depression / slum / trough
2. Recovery
3. Boom / peak
4. Recession

1. Depression:
Depression is the most fearful stage of trade cycle. In the period of depression there is fall in
national income, employment, prices, and production. Cost of production is higher than the sale
price. During this phase of trade cycle factories are closed and workers become jobless.

Features of depression:
Low production
Low prices
Low employment
Low profit margin
Decrease in demand
Low interest rate
Low borrowings

2. Recovery:
Recovery is a stage of economy where demand of goods starts increasing. Profit margin start
rising because cost of production fall below the general price level. New investments are made in
different productive activities or businesses. At this stage unemployment level start decreasing.

Features of recovery:
There is increase in level of production
Increase in demand
There is decrease in cost of production
Increase in public borrowings

31
Improvement in level of employment
Rise in Investment opportunities
Improvement in business profit

3. Boom / peak:
It is a stage of economy where business activities attain maximum best level. After some time
economy moves from recovery to boom, At this stage national income, demand of goods, level
of production and employment level is growing rapidly. This is an ideal stage of an economy.

Features of boom:
High level of profit
Ideal level of national income
Maximum production
Low cost of production
Rapid increase in demand of goods
Growth in public borrowings
Low rate of unemployment
Ideal investment opportunities

4. Recession:
This is the level of economy where economic activities starts falling down. At this stage
economy moves from boom to recession and investments, employment, production starts
reducing. There is shrinkage in profit margin because cost of production exceeds the sale price,
due to this poor firms close their business while other reduce their production.

Features of recession:
Decrease in production
Fall in employment level
Shrinkage in profit margin
Decrease in public borrowings
Decrease in demand
Decrease in price of product
Cut down in national income

Conclusion:
In a nutshell, trade cycle means the whole course of business activities which passes through all
phases of prosperity and difficulty. Business cycle generally refers to those fluctuations which
take place in the business enterprise and occurs with a fair degree of regularity.

32
Q #13: What are the causes/ reasons of trade cycle also explain remedies of
trade cycle?
Answer: Causes of trade cycle:
Trade cycle is affected by the two factors that are;

A. Internal factors:
Following are internal factor of trade cycle.

1. under consumption:
There is too much saving in the boom period. This reduces the price level. The price start
increasing but wages do not increase proportionately. The income of rich start increasing at
higher rate but incomes of poor do not increase as compared to the price level; the result is that
the demand for consumption goods decreases.

2. Unsold stock:
Trade cycle is the result of inventories (closing stock). There is excess of goods and services but
people are unable to buy goods of their own choices due to their low incomes. Unsold stock
results in depression.

3. Imports
Imports are also the reason for depression. When the goods are imported, it increases the supply
of goods. Increase in supply of goods decreases the price level.

4. Liquid assets:
Liquid assets are includes coins, paper money, bonds and shares. Increase in liquid assets leads
economy toward boom. The increase in liquid assets increases the investments, in this way the
stock exchange activities will flourish and economy leads towards prosperity.

5. Unfilled orders:
Unfilled orders means the demand of goods is higher and the supply is low the manufacturers are
unable to meet the demand of customers. Increase in demand encourages the manufacturers to
produce more which leads toward boom.

6. Reserves / Excessive profits:
The retained profits are the source of capital but excessive reserves or profits are kept idle that is
the wastage of funds. During the boom period, this policy is bad because it leads towards the
depression.

7. Over capitalization:
The capitalization of profits is desirable for meeting emergency needs. if all the profit of the
company is capitalized and company do not pay dividend on shares. It may discourage
investment which causes the depression.

8. Trade union:
Trade union also becomes the cause of depression. They demand more wages which increases
cost and resultantly price level rise. The increase in price level decreases the demand of product.

33

9. Investments:
The changes in investment rates affects the trade cycle. High investment rate increase brings
boom in economy. If investment rate is low it will cause depression.

External factors:
Following are external factor of trade cycle.
1. War:
War is a major factor which affects trade cycle. The war brings damages to the country; fall in
investments and incomes, employment and price level. War becomes the reason of depression.

2. Population:
Population increases the aggregate demand of products which raises the price level higher. High
price brings the inflation. Investment and income level falls. There will be depression in the
economy.

3. Migration:
The increase and decrease in migration affects the demand. Decreases in population due to
migration, deceases the demand of products. The supply of goods exceeds the demand which
brings depression
On the other hand if there is increases in population due to migration. The demand of goods is
high and the supply is low. More demand encourage investors to produce more which brings
boom in the economy

4. Innovations:
Innovations brings boom in the economy. When a new business is started or a new product is
introduced, it increases the demand for that product. This may encourage the investments in new
business which brings boom in the economy.

5. Invention:
Invention means discovery of new methods of productions, new machinery or material.
Inventions reduce the cost of production which increases the competition and investment. That
results boom.

6. Weather:
The weather also affects the produce of agriculture sector. In bad weather conditions there is low
yield of crops. The demand is the same but the output is low so the price level goes up.

7. Government purchases:
When government purchases goods from supplier it increases the demand which leads towards
the boom and if government do not purchases goods, it reduces the demand of goods which
result in depression.

8. Export surplus:
Exports surplus is then, when exports are more than the imports. Exports surplus brings the
prosperity in economy.

34

REMEDIES TO CONTROL CYCLE:
Trade cycle can be controlled by applying following methods:
A. Monitory policy
B. Fiscal policy
C. International measures

A: Monetary Policy:
1. Bank Rate:
The central bank can increase bank rate when there is prosperity. The bank rate can be
reduced in case of depression. The borrowing and lending is made according to bank rate. The
commercial banks help the central bank to control trade cycle.

2. Market Operation:
The central bank can buy and sell bills and government securities. When money supply is
less as compared to its demand the central bank buy the securities and vice versa. The purpose is
the regulate supply.

3. Reserve Ratio:
The central bank can increase or decrease the reserve ratio. The rate of reserve is
decreased during depression, and increase in expansion.

4. Selective Control:
The central bank can provide credit to one sector at low rates and at high rate for another
sector. The central bank can check the loans granted by commercial banks, to control trade cycle.

B. Fiscal Policy:
5. Public Work:
The government can start public works programs during depression and stop construction
of various projects during good trade period. Public works programs help to control trade cycle.

6. Taxes:
The state can increase or decrease rates of taxes. The government can raise more taxes for
contraction of money supply. The tax rates may be lowered to provide excess money supply.

7. Budget:
The government can prepare surplus budget during boom period. There is need of deficit
budget during deflation. The government can use budge teary measure alone with other methods
to control trade cycle.

8. Public Debt:
The government must take loans during depression to meet various needs. In case of
boom the debt should be repaid. The government can overcome the difficulties of low business
activity through public debt.

35
9. Imports:
The government can allow import of goods, which are needed by public. during
depression there is no need to import the items, but when there is boom period the supply of
goods can be maintained through imports.

C. International Measures:
10. Production control:
The production control measures can be made at international level. The goods produced
in excess of demand create problems. The producers can fix quota for production at world level.
In this way trade cycle can be controlled.

11. Buffer Stock:
Buffer stock can be kept in warehouses. When production is low the suppliers can meet
the demand from such stock. In case of excess production they hold surplus stock. Control over
supply means control over trade cycle.

12. Investment Control;
The government may allow investment in an area where there is low investment. Excess
investment in any sector may lead towards depression. There is need for balanced investment in
all economic sectors.

Conclusion:
In conclusion we can say that there are many causes of trade cycle and by take appropriate
measure a country can get control on it.

36
Q14: What is an index number? Discuss its construction, advantages, limitation as well. Also
explain and construct the simple index number and weighted index number? 2003
ANSWER:
A large number of commodities are offered for sale in every country of the world. The
prices of commodities sometimes fall or rise. So in order to find the relative changes in prices
level we use index number.

DEFINITION:
D. Greenwald: index number is a measure of relative changes occurring in a series of values
compared with base year.

According To A. Haber:
An index number is a ratio, usually expressed as a percentage of prices, quantities, or
values that relates a given period with a comparison period

STEPS FOR CONSTRUCTION OF INDEX NUMBER:
1. Selection of Base Year: (Period):
One year is selected from past as base. Changes in prices are expressed in percentage (%)
from the base year.

2. Selection of Commodities:
A number of commodities are selected. The class of consumers must be decided to select
the goods. The selection depends on the purpose for which the index number is prepared.

3. Price Quotations:
The price quotations are obtained from selected markets only, and then the price of each
commodity is noted.

4. Weighting:
Each commodity is a weight. The weight shows the impotence, people give to different
commodities.

5. Percentages Changes:
The percentage changes in prices are calculated.

6. Calculation of Average:
The average of individual Indices ( ) is calculated. The individual indices are added
up and divided by no of weights. This average figure is called index number.

APPROPRIATE FORMULA:
Construction of Simple and Weighted Index No:
According to simple index number all items are equally important for the people.
But in practical life it is not so. The commodities should be given due importance according to
their consumption.

37

Simple Index Number:
Commodity Price in 1990 (Po) Base
1990=100
Price in 2000
(P1)
Relative price
(R)
A 20/ Kg 100 Rs. 25 125
B 5/ Kg 100 10 200
C 15 Kg 100 30 200
D 40 Kg 100 50 125
E 200/ Quintal 100 450 225
N=5 R= 875
Formula: R= price in current year P
1
x 100
Price in base period x 100 or P
o
1. 25 x 100= 125
20
2. 10 x 100 = 200
5
3. 30 x 100 = 200
15
4. 50 x 100 = 125
40
5. 450 x 100 = 2250
200
Price index in 200 = R = 875 = 175
N 5
As the index is 175 which means that the price level rose 75% in 2000 over 1990.

Weighted Index Number:
Now we assign high weights to commodities of greater importance to consumers and
lesser weights to commodities of lesser importance.
Commodity Weight
(w)
Prices in
1990 (P
o
)
Base year
1990= 100
Prices in
2000 (P
1
)
Price
relative
(R)
WxR
A 5 20 100 25 125 625
B 4 5 100 10 200 800
C 2 15 100 30 200 400
D 3 40 100 50 125 375
E 10 200 100 450 225 2250
w=24 WR=4450

The weighted index in 200 = WR = 4450 = 181.2
W 24
The weighted price index number is more accurate than the simple index number. The index
181.2 shows that there is 81.2% rise in prices in 2000 as compared to 1990.

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Advantages (Uses) Of Index Number:

1. Comparison:
Index number is very useful for comparing the values of things over two periods.

2. Forecasting:
Index numbers are very helpful for forecasting economic and business conditions.

3. Policy Making:
Many economic policies are formulated with the help of index number.

4. Price Index Number:
Index numbers are used to compare the prices of two periods. It serve as a guide for
framing monetary and fiscal policy and other policies.

5. Cost Of Living Index Number:
It is very important in order to know the economic welfare of the people. Cost of living
index numbers are very helpful in adjusting wages and in the settlement of wage disputes. It
must be taken into account while revising wages & salaries.

6. Production:
Index numbers are useful for measuring the change in production level. The goods and
services produced during one year are compared with the goods and services output level. The
government can decide to import or export goods for welfare of people.

7. Investment:
Index number is helpful to note the changes in investment. The stock exchange prepares
index numbers to show the investment made by people from period the period.

8. Sales:
Index of sales is prepared to find out the quantities and value of total sale between times.

9. Changes in Employment Level:
Index numbers are useful to note the changes in employment level. The state can try to
increase the rate of employment, by creating new job opportunities.

10. Performance of Students:
Index numbers are useful to measure the intelligence and performance of students. The
teachers can check their efficiency through such index.

Limitations (Difficulties) Of Index Number:
1. Selection of Base Year:
The base year must be accurate otherwise the results achieved will be misleading.

39
2. Selection of Commodity:
The pattern of consumption of all categories of people is not the same. So selection of
commodities is a difficult job.

3. Price Quotations:
An index number may be for wholesale or retail prices. Whole sale prices are easy to
obtain, but they do not show the real cost of living.

4. Weighting:
The weight (preference, importance) people give to different commodities in base year
may be changed, in current period due to change in taste and income etc.

5. Average:
An index number is an average. An average cannot give a complete picture of the
situation.

Conclusion
Index numbers are very important for economic analysis. They summarize movements in a group
of related variables. The consumer Price index is one of the most commonly used forms of index
number. It measures the changes in the retail prices.

40
Q15: define foreign exchange. Discuss main objectives of foreign exchange control. Also point
out the methods employed for exchange control? (2000, 2001, 2002, 2002(s).

ANSWER:
INTRODUCTION:
The term foreign exchange denotes either a converted into another or means and
methods by which one currency is exchanged for another.
It is related to the exchange methods and with international trade are made.

According To Ency Brit:
The system by which commercial nations discharge their debts to each other.

According To Hartley:
Foreign exchange is a mechanism by which international indebtedness is settled
between two countries.

According: To H.E. Evitt:
The means and methods by which rights of wealth expressed in terms of the currency of
one country are converted into rights to wealth in terms of the currency of another country are
known as foreign exchange.

In Simple Words, the term foreign exchange is used
1. It is the currency of the other country.
2. It is the procedure by which international payments are made.
3. It is the rate at which foreign currency is bought and sold.

Exchange Control:
Exchange control refers to restrictions put by the government on the private foreign
exchange dealings. In Pakistan foreign exchange regulation act 1947 is used to control and
regulate foreign payments, import and export of currency, bullion and foreign exchange.

According To G.V. Labeler:
The state regulation excluding the free play of economic forces forms the foreign
exchange market.

According To G.N. Helm:
Exchange control refers to measure which replace part of the equilibrating functions of
the foreign exchange market by regulation alien to the pricing process.

OBJECTIVES Of EXCHANGE CONTROL:
Exchange controls are basically implemented to safe guard the interest of whole of the
economy.
The main objectives are as under:

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1. to Correct Adverse Balance of Payments (Bop):
One of the main objectives is the correction of adverse BOP. This objective is achieved
by curtailing the volume of import.

2. to Conserve Foreign Exchange:
A country may introduce exchange control for conserving hard earned foreign exchange.
There reserves are exclusively used for, (i) payment of external debt (ii) import essential goods.
(iii) Purchase of defense material.

3. To Protect Home Industry:
Exchange control is also employed to protect home industry. If some industries face
competition from abroad and the govt. desires to protect them, then foreign exchange control is
employed.

4. To Stabilize Exchange Rate:
The fluctuation in exchange rate cause disequilibrium in the economy. In the government
officially fixes the exchange rate.

5. To Promote Economic Growth:
Exchange controls are used by low_ income countries for promoting economic growth.
They are very useful for allocating resources according to development plans.

6. Payment of Foreign Debts:
Exchange controls are also adopted for the purpose of acquiring foreign exchange to pay
foreign debts.

7. Substitute for Tariffs:
Exchange controls may be employed as a substitute for tariffs and other restrictions on
imports for the purpose of protecting home industries form foreign competition.

8. To Increase The Foreign Exchange Reserves:
Every government wants to increase foreign exchange reserves, so to get this objective
exchange control policy is adopted.

9. Control over Flight of Capital:
Exchange control may be used to check capital fights to foreign countries. Capital flights
in and out of the country are of vital importance. This is very serious problem for those
underdeveloped countries which are experiencing political instability.

10. Source of Income:
Exchange controls are also source of income for the government. Since during exchange
controls the government directly retains the foreign exchange and as foreign exchange is directly
sold by govt. so difference between buying and selling rate goes income to govt.

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11. Under-Valuation:
It means to fix a rate, lower than it would be in a free floating exchange system. The
basic aim of this to protect local industry and favour of local exporters.

12. Over Valuation:
It means exchange rate is fixed over and above its normal level. This policy is adopted in
following cases:
1. When supply of local currency is extra ordinary.
2. When country is facing high inflation.
3. When a country has a massive foreign debts.

METHODS OF EXCHANGE CONTROL:
1. Exchange Pegging:
Exchange pegging means the act of fixing the exchange rate (value) of a currency to
some chosen rate. When exchange rate is fixed (pegged) higher than the market rate, it is called
pegging up
When exchange rate fixed lower than market rate it is called pegging down (under
valuation). This is a temporary measure to remove fluctuations in the foreign exchange rate,
England adopted it during WWI

2. Import Quotas and Licenses:
For maximum effectiveness import quotas and licenses are used. The govt. fixes quotas
for the importation of goods.

3. Blocked Accounts:
If a country prohibits the transfer of funds of foreigners held in its banks, the accounts are
said to be locked and funds to be frozen. The account holders cannot draw cheques without the
permission of the central bank of the blocking country.

4. Clearing Agreements:
Under this system, the governments of two countries agree to clear the accounts in home
currency through their central banks.

5. Stand Still Agreement:
This is also a method to control exchange the short term debt is converted to long term
debt or gradual payments in (installments) is allowed.
Germany adopted it in 1931.

6. Exports Bonus Scheme:
To encourage the exporters, a certain (specific) part of foreign exchange is given to the
exporter for their personal use.

7. Compensation Agreements:
According to this agreement the two countries import and export the commodities of
equally valued. Since no payment is made to foreign exchange. Problem of foreign exchange
doesnt arise.

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8. Payment Agreement:
The payment agreements are made between a debtor and creditor country. This method is
used in such a way that debtor country makes more & more exports to creditor country and
imports less and less quantity forms it. In this way the transactions are settled and cleared.

9. Rationing Of Foreign Exchange:
The government requires that all foreign exchange receipts should be handed over to the
central bank then the govt. through the central bank rations or allocates this foreign exchange
among the importers.

10. Exchange Equalization Account:
Exchange equalization account is the device adopted for smoothing out temporary or
short term fluctuations in the rate of exchange as a result of any abnormal movement of capital.
England adopted it in 1932. France and USA in 1936. So a fund is created for the purpose
of buying & selling foreign currencies to control exchange rate fluctuations.

11. Multiple Exchange Rate Practice:
Sometimes two or more exchange rates are employed for buying and selling foreign
currencies. The major objective of this multiple exchange rate is to encourage or discourage
certain types of imports and exports.

CONCLUSION

44
Q #16 what are the advantages and disadvantages of nationalization of banks in
Pakistan.
Answer:
Nationalization:
Nationalization means the transfer of ownership, management and control to the state. In 1974,
13 banks were nationalized under nationalization of banks act 1974.

Definition:
According to Alan Isaacs; nationalization is the process of bringing the assets of a company into
the ownership of state.

According to the Robert Millard; nationalization is the act of converting the privately owned
resources into the one owned by the central government.

Advantages of Nationalization:
1. Distribution of credit:
Nationalized helped in the fair distribution of credit. Before nationalization the credit was
concentrated in few hands. Nationalization ensured the fair distribution of wealth.

2. Banking management:
The government has setup and executive board to look after the administrative work of the
banks. The business of banking has improved due to better management.

3. End of monopoly:
There was complete control of few industrialists over the banking system. They used bank assets
and deposits of public for their personal interest. With the nationalization of banks their
monopoly comes to an end.

4. Benefit to employees:
Before the nationalization the rights of employees were not protected. Employees rights are
protected by the nationalization of banks. They are promoted on merit basis nationalization
increased the job security and job satisfaction.

5. Control over expenses:
Nationalization of banks has controlled non- development expenses to a large extent. The useless
expenses on entertainment and advertisement have been reduced which improved the rate of
profit for commercial banks

6. Increase in employment:
Nationalization resulted in creation of jobs opportunities for talented and educated people in the
banks. As far as new branches are opened, hundreds of people got employment.

1. Rural bank branches:
The nationalized banks have opened many branches in rural areas. It is due to the rural branches
that the idle funds are being used into the productive sectors.

45
8. Foreign bank branches:
The performance of foreign bank branches has also increased; the employees are posted on the
merit basis. Number of branches has also increased to promote banking at international level.

9. Increase in government income:
Before nationalization the income of the bank was gone into the hands of their owners. Now the
income of the banks is transferred to the government treasury which can be used for the common
interest of the nation.

10. Increase in public confidence:
Nationalization helped in increasing the public confidence. They do not feel hesitation in
depositing their savings in banks because they know that the banks are working under the
supervision of government.

11. Black money:
Before the nationalization the corrupt officers and traders were used to keep their black money in
banks. But now the protection to black money is not possible because the government can check
the amounts of bank at any time.

12. Control over credit:
Commercial bank can create credit, but unnecessary expansion of credit can create inflation.
Nationalization enables the state bank of Pakistan to control the activities of commercial banks.

13. Economic development:
Nationalization increased the resources of the government. The government was in a position to
start long term projects which leads towards the economic development.

14. Development of agricultural sector:
Before the nationalization, considerable attention was not given to the agricultural sector.
However after nationalization special attention was given to the agricultural credit, which helped
in development of agricultural sector.

Disadvantages of nationalization:

1. Lack of competition:
Healthy competition is necessary for the development and promotion. Nationalized banks were
run by the state so less attention was given to effective policies and competition.

2. Corruption and bad debts:
Nationalization resulted in high level of corruption by the top management. Credit was generally
misused and in some cases the amount of loan was not returned.

3. Favoritism:
Nationalization has resulted in favoritism, incompetent and unqualified staff is appointed. The
favoritism has badly affected the performance of banks.

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4. Political pressure:
After nationalization the political interference has increased in the bank management has
increased. Loans are granted on political pressure rather than on merit basis.

5. Low efficiency of employees:
Nationalization transferred the bank officials into the government officials. Their jobs were fully
secured which reduces the efficiency of employees.

6. Unfair distribution of credit:
It was announced at the time of nationalization that the unfair distribution of credit should be
eliminated. But in actual, the big capitalist have obtained loan by using their powerful resources.

7. Complex procedures:
After nationalization the procedure of getting loan became complicated, due to which the needy
people and business community could not get loans and the country remained underdeveloped in
many sectors.

Causes of nationalization of banks:
1. Credit control:
Commercial bank can create credit, but unnecessary creation of credit can create problems. State
bank of Pakistan keeps an eye on the credit creation but it has an indirect link. Commercial banks
were creating credit for their personal benefit.

2. Distribution of loan:
Loans were advanced to the rich people and. The middle class and low class was greatly ignored
which created the class conflicts.

3. Discrimination of sectors:
The commercial banks had been advancing most of the loan to the big importers and exporters. It
was ignoring small but important sectors of economy.

4. Loan to relatives:
The high ranking bank officials used the bank reserves for their personal benefit. They issued a
large amount to their relatives and the major amount of loan was not returned.

5. Lack of uniformity in rules:
There were no consistent and uniform service rules. The promotion and increments were given
on the personal liking and disliking and there was no job security.

6. Misuse of credit:
The commercial bank issued loans almost blindly. The loans issued were used for speculation
and black marketing.

7. Central bank control:
There was ineffective control of state bank of Pakistan for providing loans. They did not care for
the rate of margin requirement and other policies of state bank of Pakistan.

47

8. Banking profit:
Earning of high profit was the first propriety of every bank. Banks were not focusing on the
economic growth. The savings of the people were used for the personal interests of banks not for
the national interest.

9. Overseas branches:
The performance of overseas branches was poor; most of them were even working at loss.

10. Wasteful competition:
Banks were busy in wasteful competition. They were spending huge amount on the
advertisement and entertainment. There was rush of braches in trading centers but no branches in
rural areas.

11. Protection of black money:

The private banks protected the black money; this resulted in the contraction of funds in few
hands. It was failed to check the unfair means of income, even the government was not allowed
to check the balance of such account. Tax collection was not possible on such accounts.

Conclusion:

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Q #17. What is bank? What are the types of banks? (Or) what are the classifications of
bank?

Answer: Bank:
The word bank is derives from Italian word BANCO and French word BANQUE which
means a bench. It is also derive from German word bank which means a heap and stock of
money.
Generally, it is said that A financial institution which deals in money and credit. It borrows and
lends money and credit. It borrows money and lends money and in this way acts as financial
intermediary between the lender and borrower
Bank is a financial institution which borrows savings from general public at lower rate and lends
it to the other people at higher rate of interest.

DEFINITIONS:
According to Prof-Kinley:
A bank is an institution which receives deposits and advances loans

According to H.L.Hart:
A banker is one who, in, the ordinary course of his business, honors cheques
drawn upon him by persons from or for whom he receives money or current account

According to Prof-Crowther:
A bank collects money from those who have it spare or who are saving it out of
their incomes. It lends money to those who require it

Kinds of bank:
Banks can be classified on the basic of:
A) Functions:
B) Ownership
C) Registration

A. Functional Classification:
1. Central bank:
A bank which supervises the activities of banking in Pakistan is called central bank. In Pakistan
state bank of Pakistan is the central bank. Main purpose of the central bank is not to earn profit
but it work for the welfare of the society. Central bank has the right to issue notes. Central bank
is also called bank of banks.

2. Commercial bank:
A bank which accepts deposits from general public and lends them to the other people to earn
profit is called commercial bank. The main aim of commercial bank is to earn profit. It also
provides the services of agency to his clients. Examples of commercial banks are; national bank
of Pakistan, Habib bank limited, Allied bank limited, united bank limited etc.

49
3. Industrial bank:
The main purpose of industrial bank is to provide credit facility for setting up and running
industries in country. In Pakistan, Industrial development bank and other financial institutions
are providing loans to the different industries.

4. Agricultural bank:
These banks provide short term and long term loans to the farmers so that they can purchase
seeds, fertilizers, tractor and other agricultural equipments.

5. Exchange bank:
A bank which buys and sells foreign currency to facilitate imports and exports is called exchange
bank. In Pakistan commercial bank deals in foreign exchange.

6. Savings bank:
A bank which collects the savings of the people having low income and pay interest on it is
called saving bank. Such bank is formed to encourage saving habits of people. In Pakistan no
such bank exists but saving account can be opened in post office

7. Investment banks:
Bank which buys and sells shares, debentures and bonds is called investment bank. Investment
banks also grant loan for the purchase of shares and other securities. Investments Corporation of
Pakistan are national investment trust are the examples of investment banks.

8. Consumers bank:
The main purpose of these banks is to provide credit facility to the consumers to purchase goods.
City bank is performing services of consumer bank in Pakistan.

9. Mortgage bank:
This provides loan against land and building for short and long period. House building Finance
Corporation is working as mortgage bank in Pakistan.

10. School banks:
These banks provided the banking facility to the schools students. No bank in Pakistan is
providing facility to the students of school. However in European countries these banks are
providing banking facility to the students.

11. Cooperative bank:
These banks are formed to work for the welfare of society. Their aim is not to earn profit. These
banks provide credit facility to the farmers of small income.

12. Consortium bank:
A bank which is formed and run by some other banks is called consortium bank. These banks
provide long term loan loans to large scale companies. In Pakistan no such bank exists.

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13. Labor bank:
These banks are opened by trade unions of laborers. The main purpose of this bank is to manage
workers fund, like pension fund, provident fund etc. in a better way.

14. Islamic bank:
It is an interest free bank which is working under the principles of Islam. Islamic banks are
working under the profit &loss sharing principle. Meezan bank is the example of the Islamic
bank in Pakistan.

B: On The Basis Of Ownership:
(1) Public Sector Bank:
Such banks are owner by government & works under the direct control of the
government. The chief executive of such banks is appointed by federal government. HBL &
NBP are example of public sector bank.

(2) Private Sector Bank:
These banks are under the direct ownership of the private organization of co-
operative societies. The banks are controlled by the individuals or Private Organization MCB,
ABL are the examples.

C: On The Basis Of Registration:
(1) Scheduled Bank:
These are the banks which are registered in the list of central bank. They are
bound to follow the instructions and policies of central bank.

(2) Non Scheduled Banks:
These are the banks which are not registered in list and policies, policies, instructions of
central bank.

Conclusion:
There are different type of bank and these different type are based on the purpose and goal of
their business.

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Q#18 What is a commercial bank? What are the functions of commercial bank?
ANSWER:
COMMERCIAL BANK:
Commercial bank is the most popular form of bank. They are established for the purpose of
earning profit. Commercial bank receives deposits from the individuals, firms and companies at
lower rate and lends it to those people who have need it at higher rate of interest. The difference
of rate is the profit of bank.
A commercial bank is something with which every one of us is familiar. Commercial bank plays
very important role in economic development of the country. It is often called the HEART of
financial system of an economy.

DEFINITIONS:
According to Cairn Cross:
Bank is a financial intermediary, a dealer in loans and debts.
According to Sayers:
Banks is an institution whose debts are widely accepted in settlement of other
peoples debts to each other.
According to Prof Gilbert:
A banker is a dealer in capital, or more properly a dealer in money. He is an
intermediate party between the borrowers and the lender. He borrows of one party
and lends to another.
According to Crowther:
Bank is a dealer in debt of its own and other people.

FUNCTIONS OF COMMERCIAL BANK
A commercial bank performs various functions that are classified into;
A) Primary functions
B) Secondary functions
C) General utility functions

A) Primary functions:
Primary or main function of commercial bank is of accepting deposits and making loans to needy
people

1. Accepting deposits:
This is the main function of commercial bank to collect surplus money from the people and
businessman. For this purpose commercial bank has introduced following types of accounts

i. Saving account:
Commercial banks offer saving account for the people who have small savings. Interest is paid
on saving deposits from 6% to 11%. Account holder is not allowed to made frequent
withdrawals.

52
ii. Current account:
Current account is usually offered to the businessmen because they can withdraw and deposit
money several times a day. Interest is not allowed by bank on this account. Traders and
businessmen maintain such type of account.

iii. Fixed deposit account / term deposit account:
In term deposit account the amount cannot be withdrawn before the expiry of specified (fixed)
time. High rate of interest is paid on fixed deposit account. Such type of account is usually
maintained by the people who have surplus money.

iv. Foreign currency account:
This account is opened in foreign currency. Account holder cannot deposit local currency in this
account. Foreign currency account can be opened in form of saving account, current account or
fixed deposit account.

v. Profit and loss account:
Those people who do not want to earn interest on their deposit, they can deposit their money in
profit and loss account. Bank pays profit or loss on the amount of deposit that may be different
from one period to other period.

2. Advancing loans:
Advancing loans is the main function of the commercial bank. The amount of deposits is used to
advance loans to other people. Bank charges high rate of interest on the amount of loan. These
loans can be of short, medium and long period.
Bank provide loan in the following ways,

i. Loan:
Commercial bank offer short medium and long term loans against the securities.

ii. Cash credit:
Cash credit is an agreement between bank and its client to borrow money up to a specified limit.
The period of cash credit may consist of days and months. Interest is charged only on the amount
withdrawn.

iii. Overdraft:
Overdraft is a very short term credit facility. Bank allows his trustworthy customers to draw
more than the deposit. Bank charges higher interest rate on the amount of overdraft.

iv. Discounting of bill:
Bank provides money to the holder of bill of exchange after deducting charges of discounting of
bill. Amount of discount is the income for bank.

B) Secondary functions:
These functions can be divided in agency function and general utility function.

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1. Agency function:
Bank works for his customer as his agent. As an agent bank provide following customers to his
customers.
i. Collection and payment of cheque:
This is important function of commercial bank to collect and make payment of cheques.

ii. Purchase and sale of public securities:
Commercial bank also buys and sells securities (shares and debenture) on the behalf of his
customer. Bank charge his commission for providing such services.

iii. Financial advisor:
Bank gives on demand valuable advices to his customer on various financial matters

iv. Execution of standing orders:
Bank also executes the instructions and settles those transactions that are of regular nature. For
example payment of rent, insurance and utility bills etc.

v. Transfer of funds:
Bank also transfers money from one place to another place by means of bank draft, telephonic
transfer and cheques. Bank performs this function on the orders of his customer.

vi. Deduction of zakat:
Bank deducts amounts of zakat from customers account on the behalf of government. Such
amount is transferred to the general zakat fund.

2. General utility function:
Bank also provide general utility function to his customers some of them are given below

i. Locker facility:
Bank also provides locker facility to his customer for the safe custody of valuable goods like
jewelry, shares, securities etc. bank charges his services charges.

ii. Foreign exchange:
Bank also deals in foreign exchange. It converts local currency in to foreign currency and vice
versa on customer demand.

iii. Relief fund:
Bank performs the function of collecting money as a charity from general for the relief of victims
of earthquake and war effected people.

iv. 24 hour cash services:
In this modern money economy commercial banks provide the facility of 24 hour cash services.
Customer can withdraw money from ATM machines at any time.

54
Conclusion:
Commercial banks are very important in a country, their basic function is borrowing and lending
of loan. And they also provide many useful functions for customer.
Banks play a dominant and useful role in promoting economic development by mobilizing the
financial resources of the country. In past activities of commercial bank were very limited but
now commercial banks are Multi Services Organization

55
Q#19 Explain the role of commercial bank in economic development of country Or
Explain the importance of commercial bank.

Answer: Commercial bank:
Commercial bank is the most popular form of bank. They are established for the purpose of
earning profit. Commercial bank receives deposits from the individuals, firms and companies at
lower rate and lends it to those people who need it at higher rate of interest. The difference of
rate is the profit of bank.

Role of bank in economic development:
Commercial banks are playing vital role in the economic development of country. Few of them
are given below,

1. Promoting savings:
Commercial bank are playing vital role in the promotion savings. They are offering different
types of deposit accounts with attractive interest rates to increase savings.

2. Promoting investments:
Commercial banks do not keep the collected money idle with them; they lend it to the
businessmen for investment purpose which increases the production and employment level.

3. Transfer of funds:
Commercial bank also provides the facility to transfer money from one place to another place
which makes the transactions safer and leads to the growth of trade.

4. Industrial development:
Commercial bank provides short and long term loans to the industrialist. Bank also gives
valuable advices to them.

5. Increase in employment:
Commercial bank grants loans to different sectors of business, such as Trade, commerce,
agriculture and transport to expand the business activities which increases the level of
employment in country.

6. Construction of houses:
Bank provides credit facility to their customer for the construction or purchases of house. Bank
provide short term loan for repairing and long term loans for the purchase of land and
constriction of houses.

7. Credit creation:
Commercial banks are called the factories of credit. They create credit from the deposits.
Through the credit creation process commercial bank provides funds to the various sectors of
economy.

56
8. Capital formation:
Capital formation means increase in number of production units. Capital formation depends upon
the amount of investment and savings. Commercial bank can increase the capital formation by
granting loans to the productive sectors.

9. Export promotion cell:
Commercial banks are also playing an important role in the growth of export. It has established
exports promotion cells for the guidance and information to the exporters.

10. Agricultural development:
Economic development is not only based on the development of industry but it also depends on
the agricultural. Commercial banks are advancing loans to the farmers on small medium and
long terms to purchase seeds, machinery, and other equipment.

11. Development of transport:
The commercial bank financed the transport scheme through Punjab ministers scheme. It has
reduced the unemployment on one hand and increased the transportation facility on the other
hand.

12. Financial advices:
Commercial bank also gives financial advices to their customers to promote their business,
besides credit facility.

13. Construction of houses:
Commercial bank provides loans for the construction projects. It grants short term loans for
repairing and long term loans for the construction of houses.

14. Assistance to government:
It also grants loans to the government for the development projects. The commercial banks
provide assistance to the government for the economic stability.

15. Economic prosperity:
Economic growth depends upon the development of banking system. A sound banking system
promotes economic status of people by providing loans on the lenient terms and conditions.

16. Development of foreign trade:
Commercial bank help the importers and exporters by providing them foreign exchange, it also
issues letter of credit to ensure the payment.

17. More production:
A good banking system increases the production capabilities of the country by growing capital
formation and proper labour division.

18. Modern technology:
The use of modern technology is possible only when the banking system is developed as it is the
main source of their funds.

57

19. Collection of zakat:
Commercial deducts amount of zakat from depositor account on the behalf of government and
distribute the same among the deserving people.

20. Use of idle funds:
The idle funds of individuals and firms are get utilized through the commercial bank. This helps
in expansion of production capacity of a country.

Conclusion:
Commercial banks are very important for the development of a country. They provide financial
assistant to country, and it is better to say that commercial banks are back bone of a country.

58
Q#20 What is the process of credit creation? What are the limitations on the powers of bank to
create credit? (Or) Commercial banks are the factories of credit, explain. (Or) How does the
commercial bank create credit what are its limitations? (Or) Loans are the children of deposits
and deposits are the children of loans. Discuss

Answer:
Credit creation:
Commercial banks are the factories of credit. It is the most important function of the commercial
bank. Commercial banks create credit by providing loans. The amount of loan is not paid directly
to the customer. The amount is deposited in the borrower account. The borrower can withdraw
amount by issuing cheque. Thus loans create deposit and deposit create loan.

Definition:
In Simple Word:
The tendency on the part of commercial banks to expand their demand deposits as a
multiple of their excess cash reserves is known as creation of credit

According To Prof Crowther:
The important work of bank is to provide easy. Medium of exchange for this payment
and receipt to people. Banks are considered as manufacturer of credit. It means they are not only
the dealer of money but in actual meaning they are creator of credit.

A single bank cannot create credit. It is the banking system as a whole which can make loans
more than their excess cash reserves.

Assumptions:
1. Many banks:
It is assumed that there are many banks that are working in the country and they are cooperating
with each other for the purpose of credit creation.

2. Same cash ratio:
It is assumed that the cash reserve ratio is the same for every bank that may be 20%.

3. Bank transaction:
It is also assumed that the money taken as loan must be deposited in the same or other bank. The
loan given by the second bank must be deposited into the third bank and so on.

4. Initial deposit:
There must be initial deposit in every bank by the customer. This initial deposit is the basis of
credit creation.

5. Many borrowers:
It is assumed that there are many borrowers and the bank gives them loan against the securities.

59
Process of credit creation:
The process of credit creation can be explained with the help of examples. Suppose, Bank A
receives RS 1000 as a deposit from customer, the bank keeps 20% of deposit and lends 80% of
deposit to Mr. X.

The position of Bank A after credit creation is as follows

Balance sheet of Bank A

Liabilities Amount Assets Amount

Deposits 1000 Cash reserve 200

Loan to Mr. X 800

Total 1000 Total 1000
We now assume that the Mr. X makes Payment of Rs 800 to Mr. Y by cheque. Mr. Y deposited
his cheque in his account in Bank B. Bank B receives Rs. 800 as deposit and after keeping 20%
reserve he lends the remaining 80% as loan to Mr. Z. The balance sheet of Bank B after giving
loan is as follows.

Balance sheet of Bank B

Liabilities Amount Assets Amount

Deposits 800 Cash reserve 160

Loan to Mr. Z 640

Total 800 Total 800

The process is not yet completed, it will continue further. The whole process can be explained as
follows.

Bank Primary deposit Reserves 20% Credit creation
A 1000 200 800
B 800 160 640
C 640 128 512
D 512 102 409
Total 2952 590 2351

This table shows that if the bank have initial deposit of 1000 and reserve ratio is 20% then bank
create credit of Rs 4000 and the total demand deposit is Rs 5000 which is equal to the initial
deposit of Rs 1000 and credit creation of Rs 4000.

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Limitation of credit creation:
The capacity of bank to create credit depends upon the following factors,

1. Withdrawals:
Credit creation depends on the deposits. If a borrower withdraws a part or entire amount loaned
to him the bank will not be able to create credit.

2. Cash reserve:
The commercial bank keeps a large portion of cash as reserve for making the payment of cheque.
If the reserve ratio is high the bank cannot crate much credit.

3. Proper securities:
Bank grants loan against a proper security, if the proper security is not available the commercial
bank cannot create credit.

4. Business conditions:
People only borrow loans when there are good business conditions. In worst business condition
people hesitate to take loan, thus it becomes the hurdle in credit creation.

5. Willingness to borrow:
Commercial bank can create credit only if customers are willing to borrow but if they are not
willing to borrow commercial bank cannot create credit.

6. Policy of lending:
Commercial banks are not independent in connection with lending. They have to follow the
policies of central bank. The central bank imposes restriction on the commercial bank to create
credit.

7. Primary deposit:
Credit creation depends upon the primary deposit. If people are not in habit to deposit their
savings in bank, then the central bank cannot create credit.

Conclusion:
In conclusion we can say that commercial banks provide financial assistant to a county. They
utilize the saving of people and provide the funds as loan to business.

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Q#21 Explain the relationship between banker and customer. (Or) What are the types of
relationship between banker and customer? (Or) explain the nature of relationship between the
banker and customer.

Answer:
When a person deposits money in bank, he creates a relation with banker. Banker or bank means
any company which transacts the business of banking. A customer is a person who maintains an
account with the banker. The relationship is created due to contract between the banker and
customer. A banker is debtor for deposits and creditor for loans and advances.

Banker:
J.W Gilbert says that A banker is a dealer in capital or, more properly, a dealer in money.
He is an intermediate party between the borrower and the lender. He borrows from one party and
lends to another.
In simple words banker can be defined as a person who receives money and accepts the cheque
drawn upon him by customer. A banker also collects and pays drafts, dividend and bill of
exchange.

Customer:
Justice Lindley says customer is a person who has some sort of account either deposit or current
account or some sort of similar relation with a banker.

Relationship:
The relationship of banker and customer is primarily of debtor and creditor with a super-added
obligation on the part of banker to accept the customers cheque, if the account is in credit.

Relationship of debtor and creditor:

1. Debtor and creditor:
The relationship of banker and customer is of debtor and creditor. When an account is opened,
banker becomes the debtor of is customer. And customer becomes the creditor of his banker.
When the account of customer is out of credit the relationship ends.

2. Principal and agent:
The relationship between banker and customer is of principal and agent. The customer is
principal and banker is agent at the time of collection of cheque and bill of exchange. Moreover
banker also purchases and sale shares as an agent.

3. Financer and financee:
The banker is called financer and customer is known as financee. Banker grants loans to his
customer to meet the cash requirements.

4. Bailor and Bailee:
The customer becomes Bailor at the time of delivery of valuable goods for the safe custody. The
banker acts as Bailee when he receives goods from customer.

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5. Pledger and pledgee:
The customer can become Pledger at that time of providing security of moveable property for
obtaining loan. And banker becomes pledgee when he grants loans against security.

6. Mortgager and mortgagee:
The customer becomes mortgager at that time when he obtains loan against immovable property
and banker becomes mortgagee when he grants loan against immovable property.

7. Author and trustee:
Banker acts as trustee for a customer who keeps valuable & documents for the safe custody. The
customer becomes the author.

8. Reference and referee:
The customer becomes reference and banker becomes referee when banker is asked to comment
on financial position of customer. The banker as referee can submit favorable and unfavorable
reports to other bank.

9. Lessor and lessee:
When the bank provides finance to his customer on the basis of lease, the relationship becomes
of Lessor and lessee. The bank is Lessor and customer is lessee.

10. Adviser and advisee:
The banker becomes advisor and customer becomes advisee. Bank gives valuable advices to his
customer about the financial matters of business.

11. Licenser and licensee / banker as a trustee:
Banker works as licensor / trustee when he keeps the valuable or document of customer for the
safe custody.

12. Banker as beneficiary:
When banker receives money from customer and uses it in various sectors for his benefit he
becomes beneficiary.

13. Modarab and Amal:
When banker provides finance to his customer on the agreement of Modaraba, the relationship
becomes that of Modarab and Amal. The banker is Modarab and customer is Amal.

14. Hirer and owner:
When goods are delivered to the customer on hire purchase agreement, the banker becomes the
owner and customer becomes the hirer of the same.

15. Pawnor and Pawnee:
When a customer keeps his goods or documents with banker as security for the payment of debt
or the performance of promise, the relationship becomes of Pawnor and Pawnee. The customer
becomes Pawnor and banker becomes Pawnee.

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16. Correspondent and respondent:
Bank issues traveler cheque, letter of credit and credit cards to customer that can be used in
international market for making payments. Banker becomes correspondent and customer
becomes respondent.

17. Indemnifier and indemnity holder:
When the banker promises his customer to compensate for the loss suffered by him, the banker
becomes indemnifier and customer becomes indemnity holder.

18. Testator and executor:
When a banker is asked to execute the will of his customer after his death, the banker becomes
executor and banker becomes executor.

Conclusion:
There are many kinds of relations exist between banker and customer. This relationship is based
on the kind of contract between banker and customer. And right and duties are based on this
relationship.

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Q#22 what are the circumstances under which the relationship between banker and customer
comes to an end? Or what are the reasons of termination of relationship between banker and
customer?
Answer:
Followings are circumstances in which relationship between banker and customer may be come
to an end.

1. Insanity of customer:
When a customer loss his senses permanently or in other words when a person becomes of
unsound mind the banker closes his account and the relationship comes to an end.

2. Insolvency of customer:
When a customer is declared insolvent and he is unable to pay his debts. The relationship comes
to an end and banker stops withdrawals from account.

3. Death of customer:
The relationship is atomically terminated on the death of customer. Credit in account is paid to
the heir of customer.

4. Unsatisfactory working of bank:
The customer may close his account, if he is not satisfied with the working of bank.

5. Order of court:
A court may order to stop withdrawals from account. Due to breach of contract, other part is
compensated by court.

6. Notice by banker:
A banker can terminate the relationship by sending a notice to customer, if he finds that his
customer is involved in illegal activities.

7. Notice by customer:
A customer can send notice to the banker about the termination of relationship, when he is not
satisfied with the performance of banker.

8. Unsatisfactory operation:
A banker may close the account, if the customer is not obeying the rules of operating account.

9. Assignment of account:
A customer may assign the whole amount in the account to the other party by giving notice to the
banker. When the amount is transferred the relationship between banker and customer comes to
an end.

10. Loss of confidence:
If a customer is not satisfied with the financial position of bank he may close his bank account to
avoid any type of loss.

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11. Low profit:
If banker pays low profit or interest and charges more interest than a customer may choose to
close his account.

12. Change of residence:
A customer may terminate his relationship due to change of residence. Customer may shift his
account to the nearest branch of his destination.

13. Insufficient balance:
When a customer used to draw cheque and does not have credit in his account, banker may close
his account after giving notice.

14. Banking hours not observed:
When a customer used to present his cheque after banking hours, banker may close his account
after giving notice.

15. Winding up of company:
When a company is wounded up by the order of court, no payment of cheque is made. Thus
relationship between banker and company comes to an end.

Conclusion:

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Q#23 What are the rights and duties of banker and customer? Explain them in detail.
Answer:
Rights of customer:
Followings are rights of a customer of a bank,
1. Right to draw cheque:
A customer has right to issue cheque for taking money if he has sufficient balance in his account.
Customer can also withdraw cheque against debit balance if agreement of overdraft is made.

2. Right to receive bank statement:
Every customer has a right to receive bank statement containing details about the withdrawals
and deposits.

3. Right to receive cheque book:
A customer has right to receive cheque book at the time of opening bank account so that he can
withdraw cash from account.

4. Right to Claim for damages:
Customer has right to claim for the damages from bank when he dishonors cheque without any
reason.

5. Right to Claim for damages for not maintaining privacy:
Privacy of customer account must be maintained, if banker do not maintain the privacy the
customer has right to claim for the damages.

6. Right of correction:
A customer has right of rectification of errors made by the banker while debiting and crediting
his account.

Duties of customer:
Followings are duties of a customer of a bank,

1. Banking hours:
A customer should present cheque during the banking hours. If he present cheque after banking
hours, banker is not responsible for making payment.

2. Presentation of cheque:
It is the duty of customer to submit his cheque within the time. The life of cheque is six months
from the date of issue.

3. Protection of cheque book:
It is the duty of customer to keep the cheque book in safe custody so that no one can misuse it.

4. Report about theft:
It is the duty of customer to inform banker, when cheque book or a cheque is lost to avoid
misuse.

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5. Filling of cheque book:
It is the duty of customer to fill the cheque with care. If any error or mistake is made the banker
may refuse to make the payment.

Rights of banker
Followings are rights of a banker,
1. Right to claim charges:
Banker has right to claim charges and commission for the services provided to the customer.

2. Right to Charge compound interest:
It is the right of bank to charge compound interest on the amount of overdraft according to the
terms and conditions agreed between the parties.

3. Right to retain securities:
It is the right of bank to retain the securities until the customer pays amount of debt. If customer
fails to pay the amount of debt, the banker has right to sell the securities.

4. Right to adjust debit balance:
It is the right of banker to adjust the amount of overdraft as soon as the customer deposits some
cash in his account.

Duties of banker
Followings are duties of a banker,
1. Payment of cheque:
It is the duty of banker to make the payment of cheque drawn on him. The cheque must be drawn
properly and presented within the time.

2. Secrecy:
It is the duty to banker to maintain the privacy of customers account.

3. Standing orders:
It is the duty of banker to obey the standing orders in making payments. Such as rent rate and
taxes that are paid after the regular intervals.

4. Safe custody:
It is the duty of banker to take reasonable care of goods that are deposited for the safe custody.

5. Trustee:
While acting as trustee, a banker must work according to the terms and conditions of agreement.

Conclusion:

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Q24: banking, discuss the procedure for opening current, saving and fixed deposit account
with a bank?
Answer:
Formalities For Opening Current & Saving Account With A Bank:
There are certain formalities which to be observed for opening a current and saving
account with a bank. These formalities are as under:

1. Formal application:
The customer is required to fill in account opening form. It is a formal request to the
bank to allow him to operate the account. This form is then signed and name of introducer is also
mentioned.

2. Introduction:
Introduction is very much important in order to open an account with the bank. The
introducer may be old account holder or responsible person etc. a current account opener must be
introduced by the person who has current account with the bank.

3. Specimen signature:
When the banker is satisfied about the customer, he agrees to open the account. The
banker of the branch takers specimen signatures on the specimen signature card

4. Declaration:
The signature of account opener is obtained on a declaration by which he binds himself
to follow the rules and regulation of the bank which are read by him or read to him.

5. Deposit of initial money:
In Pakistan the current account can be opened with a minimum of Rs.500 and PLS
saving account with a minimum of Rs.100. The account opener fills in the pay-in-slip and
deposit the initial deposit of money.

6. Account is opened:
After the deposit of initial money, the account is opened by the banker in his books.

7. Issuance of account no and documents:
After making necessary inquires, the banker opens account and account number is
allotted to the customer and following documents are given:

i. Pay-in-slip:
Pay-in-slip is given to the customer in order to deposit the cash or cheque in the bank.

ii. Cheque book:
When the account is opened, the banker give cheque book which contains cheques for
withdrawing money from the bank.

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iii. Pass-book
A pass-book is issued to the account holder. This is a copy of entries of amount deposited
and withdrawn and then the net-balance.

Formalities for opening fixed deposit:

Account:
The following procedure is usually adopted for opening and operation of fixed deposit
account.

1. Submission of application:
The person will submit the form available from the concerned bank. In this from the
person will write his name, period and amount of deposit. He will put his signatures and provide
a copy of identity card also.

2. Issue of FDR (fixed deposit receipt):
The bank after making inquiry will issue a receipt called FDR. In this receipt all the terms
and conditions of the account. The amount of deposit and rate of interest etc are mentioned.

3. Payment of interest:
The bank normally pays the interest after the expiry of the period. However if the
customer desires the interest can be paid quarterly, half yearly, and on yearly basis.

4. Payment before the date of maturity:
If the customer wants to withdraw his money before maturity, he will have to forgo
(sacrifice) the interest received on that amount.

5. Time of deposit:
The customer can decide time of deposit. It may be very form 03 months to 05 years

6. No need of introduction:
The bank accepts fixed deposits account without introduction. A copy of identity card is
sufficient to open such account. The banker is free from risk of loss.

CONCLUSION

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Q#25 Define central bank. Explain the function of central bank.
Answer:
Introduction:
Central bank has the central position in the banking system. It controls the activities and system
of other banks. Main purpose of central bank is not to earn profit. It works for the welfare of
society. Central bank has sole authority to issue notes. It works as banker of banks and banker to
government. In Pakistan, state bank of Pakistan is acting as central bank.

Definition
An institution which is charged with the responsibility of managing the expansion and
contraction of the volume of money in the interest of welfare of economy.

Functions of commercial bank
1. Monopoly of note issue:
Central bank has the sole authority to issue currency notes. No other bank has authority to issue
notes. In Pakistan, state bank of Pakistan issues currency notes.

The purpose of sole authority is;
i. To bring uniformity in currency notes
ii. To control over printing of notes
iii. To regulate currency according to the demand

2. Banker to the government:
Central bank performs several functions on the behalf of government. It gives all those facilities
to government that commercial gives to the public.
Following are the functions that are performed by the central bank to facilitate government,

i. Keeping deposits:
Central bank keeps deposits of federal and provincial government. It makes payments on the
behalf of government. Central bank does not pay interest on government deposits.

ii. Fiscal agent:
As a fiscal agent the central bank grants loans to the government and makes investments in the
treasury bills and other long term securities.

iii. Foreign loans:
Central bank also makes arrangement to get foreign loans on the behalf of government.

iv. Financial advisor:
It advices government on all financial matters such as controlling the inflation or deflation and
valuation of currency.

v. Transfer of capital:
Central bank is also responsible for transferring the funds of government form one place to
another place.

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3. Bankers bank:
Central bank is the banker of commercial banks and performs the followings functions to
facilitate commercial banks.

i. Custodian of cash reserve:
Central bank keeps a certain percentage of deposits of commercial bank as cash reserve; the
amount is kept in safe custody

ii. Clearing house:
Central bank acts as the clearing house for commercial banks. All scheduled banks have their
accounts with central bank so the mutual obligation of banks are settled simple by passing debit
and credit entries in their accounts.

iii. Lender of last resort:
Central bank is the supreme bank of a country if a commercial bank is suffering from crises,
central bank grants loans to the commercial banks.

iv. Opening of new bank:
New bank or branch cannot be opened without the permission of central bank.

v. Growth of bank:
Central bank is responsible for the growth of banking system in country.

4. Control of foreign exchange:
Central bank is responsible for the management of foreign exchange. Central bank maintains the
silver, gold and foreign currency reserves in country.

5. Controlling of credit:
It is the duty of central bank to maintain and regulate the supply of money according to the
economic needs. If there is depression in economy, central bank expands the supply of money. If
there is inflation in country, central bank aims at contracting the supply of money.

6. Exchange rate stability:
Central bank fixes the exchange rate of domestic currency in terms of foreign currency. It tries to
bring stability in exchange rates.

7. Development role:
Sometimes the central bank takes the responsibility to enhance economic growth. Central bank
develops money markets and capital markets. It introduces the export promotion schemes to
increase the volume of exports. Facilities are provided to promote investment in various sectors
of economy.

8. Miscellaneous functions:
i. Staff training:
The central bank establishes training institutes and also provides modern training of banking to
the staff.

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ii. Saving habits:
Central bank makes and plans and adopts the various methods to promote the habits of savings
among the people of country.

iii. Representative of government:
Central bank acts as the representative of government for international institutions, like IMF and
World Bank.

iv. Membership fee:
If the government wants to be the member of international institutions, central banks pays
membership fee on the behalf of government.

v. Financial reports:
Central bank publishes various reports which give the real picture of economy.

Conclusion:
We can say that central bank is most important bank of a country. There is only one central bank
in country. It works for the welfare if country and its main function is to issue currency notes.

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Q#26 Differentiate central bank and commercial bank.
Answer:
DEFINITION:
Central bank:
An institution which is charged with the responsibility of managing the expansion and
contraction of the volume of money in the interest of welfare of economy.

Commercial bank:
A bank is an institution which receives deposits and advances loans

Difference between central bank and commercial bank
Central bank Commercial bank
1. Formation
Central bank is formed under an act of
parliament or ordinance.
Commercial bank is formed under companies
ordinance 1984.

2. Ownership
share capital of central bank may be owned by
state,
The share capital of the commercial bank is
owned by the people.
3. Management
The management and employees of central
bank is appointed by the government.
Employees of commercial bank are appointed
by the board of the directors.
4. Object
The main object of the central bank is welfare
of society and economic development of
country.
The main object of commercial bank is to earn
profit.
5. Issuance of notes
It has only authority of issue notes. Commercial bank cannot issue currency notes.
It can issue plastic money like debit cards,
credit cards.
6. Branches
Central bank only has inland branches it
cannot form its branches in other countries.
Commercial bank has both foreign and
national branches.

7. Number of bank
There is only one central bank in every
country.
There are many commercial banks in every
bank.
8. Account
Government and commercial bank can open
their account in central bank.
General public, companies and firms can
open account in commercial bank.
9. Winding up
Central bank cannot closed up even if it is
working on loss
The commercial bank can be closed if it is
continuously suffering losses.
10. Transfer of funds
Central bank transfer funds of commercial
banks and government.
Commercial bank transfer funds of their
customers.

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11. Discounting of bill
It discounts the bill of commercial bank It discounts the bills of the customer
12. Advisor
It gives advices the commercial bank and
government on financial matter.
The commercial bank gives advices to
their on financial matters customers on
financial matters.
13. Nature of account
Central bank opens account of government
under the various heads of accounts.
Commercial bank opens account of their
customer under heads of saving, current, PLS,
and fixed deposit account.
14. money market
Central bank is the leader of money market . It is the member of money market.
15. credit controller
It controls credit by using various methods. The commercial bank creates credit according
to money available.
16. Foreign payments
It makes the foreign payment on the behalf of
government.
It makes foreign payments on the behalf of his
Customer.
17. Discount of bill
It discounts the bill of commercial banks. It discounts the bill of customers.
18. Evening Banking
Central bank does not provide evening banking

The commercial banks provide evening
banking services to customers.

CONCLUSION:
According to above discussion we can conclude that central bank is main bank and
commercial bank is subordinate of central bank. Central bank make policies and commercial
bank implement this polices.

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Q#27 What are the objectives of monetary policy? Also explain the tolls of monetary policy.

Monetary policy:
The primary function of central bank is to control money and credit supply. Central bank can
increase and decrease the money supply according to the economic needs of country. In Pakistan
the state bank of Pakistan is controlling the supply of money. The management of the flow of
money is called monetary policy or credit policy.
Monetary policy is formulated and implemented by the central bank of the country. The
central bank is responsible of monetary system. The commercial banks increase total money
supply in the country by creating credit. The ups and downs in the volume of credit affect the
purchasing power of money.

Definition
According to the prof. Spencer: monitory policy is the purposeful exercise of the monetary
authoritys power to make expansion or contraction in the money supply.

According To H.G.Jhonson:
It is a policy of central bank in control the supply of money with the aim of achieving
macroeconomic stability.

Objectives of monetary policy:
Objectives of monetary policy may vary from one country to other country depending upon the
economic needs.

Following are the main objectives of monetary policy.

1. Employment:
The main objective of monetary policy is to raise the level of employment in country. It create
more opportunities of employment in less developed countries.

2. Price stability:
The main objective of monetary policy is to maintain the price level at reasonable level. Inflation
and deflation can be avoided by controlling price level. Central bank can control inflation by
decreasing the supply of money and deflation can be controlled by increasing supply of money.

3. Increase in investment:
Investment level can be increased with the help of monetary policy. Central bank can aim to
promote both foreign and domestic investments.

4. Increase in production:
Central bank can increase level of production by granting loans to manufacturers at low interest
rates.

5. Exchange stability:
Monetary policy aims to maintain the exchange rate at stable level. Exchange rate stability is
essential for the smooth flow of international trade.

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6. Control on inflation:
The main objective of monetary policy is to control inflation. Excess money supply is one of the
reasons of inflation. Central bank can control inflation by controlling the supply of money.

7. Control on deflation:
Deflation can be controlled by expanding the supply of money. Unnecessary contraction of
supply of money is one of reasons of deflation. Central bank can increase money supply with the
help of monetary policy.

8. Stability in capital market:
The development of country depends upon the development of capital market. Central bank can
create stability in capital market with the help of monetary policy.

9. Foreign value of currency:
Foreign value of currency can be maintained at stable level with the help of monetary policy
which leads towards growth in international trade.

10. Control on trade cycle:
Trade cycle exists when there are fluctuations in the production, employment and price level.
Trade cycle can be controlled by controlling credit in economy with the help of monetary policy.

11. Economic growth:
Monetary policy aims to promote rapid growth in national income and per capita income. It
requires the best utilization of resources.

12. Control on speculation:
The commodity and stock markets are the speculation places. An artificial demand is cratered
due to which small investor suffers lose. Speculation increases the price level that can be
controlled with the help of monetary policy. Central bank imposes restriction on giving loans to
the speculators.

13. Living standard:
Living standard of people can be improved with the help of monetary policy by increasing the
purchasing power of money.

Conclusion:

77
Q # 28 Explain tools of monetary policy or instruments of monetary policy? Or how central
bank control credit Or what are the methods to control credit?
Answer:
Tools of monetary policy
Tools of monetary policy can be divided in to two main parts.

Bank Rate Policy: Consumer Credit Control
Credit Rationing Direct Action.
Discount Rate Policy. Marginal Requirement.
Open Market Operation. Moral Persuasion.
Varying Reserve Ratio. Publicity.

A. Quantitative methods:

a. Bank rate policy:
The bank rate or the discount rate is the rate of interest at which central bank lends loan to the
commercial bank. When central wants contraction in supply of money it may increase the
interest rate due to which the borrowings from the commercial bank decrease. When the central
bank wants to increase the supply of money it decreases the interest rate which encourage the
borrowings.

2. Open market operation:
The buying and selling of government securities by central bank in market is called open market
operation when central bank wants the contraction in supply of money, it sells securities. When
central bank wants expansion in supply of money it buys government securities.

3. Reserve ratio:
The portion of the reserves that is to be kept with the central bank is called reserve ratio. When
the reserve ratio is increases the supply of money is decreased. When the reserve ratio is
decreased the supply of money is increased.

4. Credit limit:
Under this scheme, central bank limits the maximum amount of landings of commercial bank.
Commercial banks are not allowed to grant loan more than the fixed limit.

TOOLS OF MONETARY
POLICY:
(1)QUANTITATIVE CONTROL
(2)QUALITATIVE CONTORL

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5. Credit rationing:
The method of credit control is applied by the central bank in times of financial crises. The
central bank rations the credit of every commercial bank. It fixes the amount that each member
bank can draw by rediscounting the bills of exchange.

6. Discount rate policy:
This method refers to the varying of the rate at which the central bank rediscounts the
bills of exchange of banks. In case of inflation the central bank increases the discount rate but in
case of deflation central bank decreases the bank rate.

B. Qualitative methods:

1. Margin requirement:
Central bank can control credit by changing margin. if the margin requirement is increased, then
people cannot take more loans. But if margin requirement is decreased people can take more
loans.

2. Direct action:
Central can take direct action if the commercial banks are not following the monetary policy. It
may refuse to grant loans or impose penalty on them.

3. Control on consumer credit:
According to this technique, the central bank may apply some strict restrictions on consumers
credit. It may increase the interest rate or may shorten the period of repayment.

4. Publicity:
The central bank may convince the borrowers and lenders through publication of annual reports
and weekly statements about the specific policy.

5. Moral persuasion:
The central bank can use this method of moral persuasion as leader of commercial bank.
It regularly advises and guides commercial banks to follow a particular policy for loans, avoid
mal practices and to adopt the right ways.

Conclusion:
Central bank can control supply of money with different ways. They can adopt any above policy
to get control on credit supply for the welfare of country.

79
Q94(a) define cheque & bills of exchange? Discuss its features? Also point out the distinction
between the two cheque & bill of exchange.
Answer:
Definition:
Cheque: (according to N.I act 1881.)
Under section 6 cheque has been defined as
a cheque is a bill of exchange drawn on a specified bank and not expressed to be
payable otherwise than on demand.

Bills of exchange:
Under section 5 bills of exchange has been defined:
In instrument in writing containing an unconditional order, signed by the marker directing a
certain person to pay a certain sum of money only to or to the order of a certain person or to the
bearer of the instruments.

DISTINCTION BETWEEN CHEQUE & BILL OF EXCHANGE:
CHEQUE BILLS OF EXCHANGE
1. Drawer:
A cheque is always drawn on a bank.

Bills of exchange can be drawn on any person.
2. Acceptance:
A cheque does not require any acceptance.

A B/E must be accepted by the drawee before it
is presented for payment.
3. Cancellation:
Payment of cheque can be cancelled by the
notices of customer.

Payment of bills of exchange can be cancelled.
4. Crossed:
A cheque can be crossed for the purpose of
safety.

Bills of exchange cannot be crossed.
5. Circulation:
A Cheque is not intended for circulation.

A B/E circulates from hand to hand freely.
6. Discount:
A cheque con not be discounted from any bank

A B/E can be discounted.
7. Grace Days:
Cheque is always payable on demand, so there is
no question of allowing grace days.

A grace days allowed in this case is of 3 days.
8. In Sets:
A cheque is never drawn is sets.

A B/E, specially a foreign bill is drawn in sets.
9. Noting Or Protest:
There is no system of noting or protest in case of
cheque

There is a system of noting or protest in case of
dishonor of a bill.
10. Purpose:
The main purpose of a cheque is to minimize the
use of metallic money.

A B.E is drawn for the purpose of receiving &
giving credit.

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11. Payable On Demand:
A cheque is always payable on demand

A B/E may be drawn payable on demand or at a
fixed time.
12. Payable to Bearer On.
A cheque drawn payable to bearer on demand is
valid.

A B/E can be drawn to bearer on demand is void
13. Printed Form:
It must be drawn in printed form, issued by the
particular bank.

A B/E can be drawn on any person and there is
no printed from.
14. Stamp.
A cheque does not require any stamp.

A B/E must be stamped.
15. Condition of Discharge.
The drawer of a cheque is discharged only if he
suffers any damage by delay in presentiment for
payment.

The drawer of bill is discharged, if it is not
presented for payment.
16. Notice Of Dishonor:
Notice of dishonor is not required in cheque.

The notice of dishonor is required in bill.

CONCLUSION

81
Q.no 29 (b) define cheque & promissory note? Discuss its features also point out the distinction
between the two?

ANSWER:
Definition
Cheque:
Under section 6 of negotiable instrument act:
a cheque is a bill of exchange drawn on a specified bank and not expressed to be
payable otherwise than on demand.

Promissory Note:
According to section 4 of n.i. act 1881:
a promissory note is an instrument in writing (not being a bank note or a currency note)
containing an unconditional undertaking, signed by the maker, to pay a certain sum of money
only to, or to the order of a certain person, or to the bearer of the instrument.

Distinction:

CHEQUE PROMISSORY NOTE.
1. Parties.
There are three parties in cheque i.e. drawer,
drawee, & payee.

There are two parties in promissory note i.e.
marker and payee.
2. Printed Form:
It is drawn on a printed form, provided by bank.

It can be drawn on any paper and does not need
any printed form.
3. Drawer:
Drawer is the receiver of payment.

Maker is payable of certain amount
4. Crossing:
Crossing is allowed in cheque

Crossing is not allowed in pro-note.
5. Stamping Duty:
No stamp duty is to be payable.

Payment is not stopped in case of pro-note
6. Stopping Of Payment:
Drawer can stop the payment.

Payment is not stopped in case of pro-note.
7. Payable To Maker:
Cheque can be drawn PAYABLE TO MAKER.

It cannot be drawn Payable to Maker
8. Promise And Order:
It is an unconditional order.

It is an unconditional promise.
9. Maker And Payee:
Drawer of cheque can be payee.

Maker of note cannot be payee.
10. Makers Position:
Drawer of cheque stands in an immediate relation
with drawee not payee.

The liability of maker of promissory note is
primary.

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11. Nature of Liability.
The liability of drawer of cheque is secondary. He
is liable only when the drawee. Does not honor the
cheque.

The liability of maker of promissory note is
primary.
12. Payable To Bearer:
Cheque can be drawn payable to bearer.

Promissory note cannot be draw Payable to
Bearer
13. Issuance Of Instrument:
Cheque can only be drawn promissory note can be
drawn on any person inducing bank.

Promissory note can be drawn on any person
including bank.
14. Protest:
Where a cheque has been dishonored then drawer
can protest on solid grounds.

A promissory note need not be protested.
15. Not Of Contracts:
There are three contracts i.e.
B/W drawer & Drawee
B/W Drawee & payee
B/W payee & Drawer.

There is only one contract
i.e. B/W.
Maker & Payee.

CONCLUSION

83
Q29 (C) Defines promissory note and bills of exchange? Distinction between promissory
note and bills of exchange? 2001.

ANSWER: Definition:
According to section 4 of N.I. Act 1881:
A promissory note is an instrument in writing (not being a bank note or a currency note)
containing an unconditional undertaking, signed by the maker, to pay a certain sum of money
only to, or to the order of a certain person, or to the bearer of the instruments.

Distinction between Bills Of Exchange & Promissory Note:

PROMISSORY NOTE BILLS OF EXCHANGE.
1. Number of Parties.
There are two parties in a promissory note name the
maker and the payee.

In a bill there may be three parties, the drawer, the
drawee, and the payee.
2. Maker.
A promissory note is written by principal debtor
who has to make payment of the note.

But a bill of exchange is written by the creditor
who has to receive payment.
3. Nature Of Control
A promissory note is an unconditional promise to
pay.

But a bill of exchange is an unconditional order by
the drawer to the drawee.
4. Nature Of Liability:
The liability of marker of a promissory note is
primary.

The liability of drawer of a bill is secondary and
unconditional. The drawer is liable only when the
acceptor does not honor it.
5. Acceptance:
A note requires no acceptance as it is signed by
the person who is liable to pay.

The bill must be accepted by the drawee before it
is presented for payment.
6. Notice Of Dishonor:
In case of promissory note, no notice is necessary
to the maker in case of dishonor.

In bill of exchange notice of dishonor must be
given by holder to all prior parties who are liable
to pay.
7. Marker And Payee:
In a promissory note the marker cannot be the
payee because the same person cannot be both the
promisor and promise.

In a bill the drawer and payee may be the same
person when bill is drawn pay to me or my
order.
8. Promise And Order:
In a promissory note there is a promise to make
the payment.

In a bill of exchange there is an order for making
the payment.
9. Makers Position:
The maker of a pro-note stands in immediate
relation with the payee.

The drawer of an accepted bill stands in an
immediate relation with the acceptor and not the
payee.
10. Payable To Bearer:
A pro-note cannot be drawn payable to bearer.
A bill can be so drawn provided it is not drawn
payable to bearer on demand.

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11. Copies:
A note cannot be drawn in sets.

A foreign bill can be drawn in sets.
12. Protest:
A note need not be protested.
A foreign bill must be protested for dishonor,
when it is required by law.
13. Payable To Maker:
A note cannot be made payable to the marker
himself.

A bill can be made payable to the maker himself
as one person may become both drawer & payee.
14. Certain Provisions:
The provisions relating to presentment for
acceptance, or acceptance for honor are not
applicable.

These provisions are applicable to a bill of
exchange.
15. Possibility Of Conditional:
A pro-note cannot be made conditional.
The acceptance of a B/E may be conditional with
the consent of the holder.

CONCLUSION

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Q29 (D) What Is Difference between Promissory Note, Bill of Exchange & Cheque?

ANSWER:
PROMISSORY NOTE BILL OF EXCHANGE CHEQUE
1. Maker:
A promissory note is written
by debtor.

A bill of exchange is written
by the creditor.

A cheque is written by the
person who has account in the
bank.
2. Number Of Parties:
There are two parties in the
promissory note i.e. the maker
and the payee.

There are three parties i.e. the
drawer, the drawee and payee

In cheque also the drawer and
payee may be the same person.
3. Maker & Payee:
The maker and payee are
different persons in promissory
note.

The drawer and payee may be
the same person.

In cheque also the drawer and
payee may be the same person.
4. Drawer:
There is no drawee of a
promissory note.

Drawee of a bill of exchange
may be anyone including bank.

Drawee of a cheque is always
a bank.
5. Promise Of Order:
A promise or order contains an
unconditional promise to pay.

A bill of exchange contains an
unconditional order to pay.

A cheque also contains an
unconditional order to pay.
6. Acceptance:
A promissory note needs no
acceptance as it written and
signed by the person who is
liable to pay.

A bill must be accepted by the
drawee.

A cheque does not require
acceptance of the drawee
before its payment.
7. Nature Of
Responsibility:
The responsibility of a maker
of a promissory note

The responsibility of a drawer
of bill of exchange

The responsibility of the
drawer of a cheque to the

CONCLUSION

86
Q#30 Describe the parties of letter of credit; also explain the procedure for opening letter
of credit.
Answer:
Letter of credit
According to the Mr. Frank letter of credit is a written document issued by the buyers bank
authorizing the seller to draw in accordance with the certain terms and conditions.

Parties of letter of credit

1. Importer / Applicant:
Applicant is the importer of goods. He requests his bank to issue letter of credit in the favour of
exporter.

2. Issuing bank:
The bank which issues letter of credit in favour of exporter is called issuing bank. It is also called
importers bank.

3. Exporter:
The person who exports goods to the importer is called exporter. In other words the person in
whose favour the letter of credit is opened is called exporter.

4. Paying bank:
It is bank which makes the payment to the exporter after receiving the letter of credit.

Procedure of opening letter of credit

1. Sales contract:
Importer of one country makes an agreement with exporter of other country to purchase goods.
When the terms and conditions about the price, quantity and quality are decided the contract
between the parties takes place. The importer then informs his bank to open letter of credit.

2. Performa invoice:
The banker may ask importer to provide the Performa invoice which contains the details about
the goods that are to be imported.

3. Import license:
The banker may ask applicant to provide import license. Import license is issued by the
government.

4. Application form:
Application form is also known as application and agreement for L.C. It contains all necessary
details about the terms and conditions of sale. It is signed by the applicant.

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5. Margin requirement:
Margin requirement is generally fixed by the state bank of Pakistan. It is from 10% to 40% of the
total amount for which the L.C is opened. Importer will have to deposit this amount to the
issuing bank. It is refundable amount.

6. Issuance of L.C:
The issuing bank informs paying bank that the letter of credit has been issued. Three copies are
prepared one copy is kept buy the issuing bank for its own record. The remaining two copies are
sent to the paying bank. The paying bank keeps the second copy and sends the third copy to the
exporter.

7. Information to the seller:
The paying bank informs the seller that the letter of credit has been issued. The seller than sends
goods to the importer and provide the shipping documents to the paying bank. The bank checks
the documents and sends them to the issuing bank.

8. Payment to the seller:
When the paying bank is satisfied with the documents provided by the exporter he makes the
payment to the exporter.

9. Collection of documents:
The issuing bank collects shipping documents from paying bank. The issuing bank examines the
documents before giving it to the importer.

10. Collection of money:
The issuing bank collects money from the importer before giving him shipping documents.

11. Receipt of goods:
After making the payment the importer collects documents from issuing bank. He submits these
documents to the shipping company to receive goods. Then he can receive goods from the
shipping company, in this way the transaction of import is completed.

Conclusion:
Latter of credit is very important for fee of financial risk trade because risk of money is
guaranteed by banks. Bank provides assistance to importer and exporter but issuing L/C.

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Q#31 What are the types of letter of credit?

Answer:
There are many types of L.C. These are followings.

1. Revocable letter of credit:
A letter of credit that can be cancelled by importer or bank at any time due to any reason is called
revocable letter of credit. This type of letter of credit is not usually acceptable by the
businessmen.

2. Irrevocable L.C:
A letter of credit that cannot be cancelled before payment is called irrevocable letter of credit.
This types of letter of credit gives full protection to both the parties. Irrevocable L.C is more
popular than the revocable L.C.

3. Confirmed L.C:
If the exporters bank confirms the L.C and takes the liability to make payment to the exporter in
case of nonpayment by importers bank, it is called confirmed L.C.

4. Unconfirmed L.C:
If the exporters bank does not takes the liability of payment in case of nonpayment by the
importers bank. It is called unconfirmed L.C. it is suitable when the financial position of
importer is poor and exporter do not know the issuing bank.

5. Documentary L.C:
The L.C in which there is condition that the exporter will submit shipping documents for
receiving money, is called documentary L.C.

6. Clean L.C:
The L.C in which there is no condition that the exporter will submit shipping documents for
receiving money, is called clean L.C.

7. Fixed L.C:
A fixed L.C is that which is issued for a particular transaction. This L.C is automatically
cancelled after the completion of transaction.

8. Revolving L.C:
Revolving L.C is issued for the payment of fixed amount but after the completion of
transaction it is automatically cancelled.

9. Transferable L.C:
The L.C, in which the exporter (beneficiary) has the right to transfer it to the third party, is called
transferable L.C.

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10. Nontransferable L.C:
The L.C which cannot be transferred by the exporter to any other person is called nontransferable
L.C.

11. Red clause L.C:
In this L.C, the exporters bank provide loan to the exporter for packing and transportation of
goods before the shipment of goods. The statement containing the details of order is written with
the red ink.

12. Green clause L.C:
In this L.C, the exporters bank provide loan to the exporter for not only packing and
transportation but also for the storage of goods as well. The statement containing the details of
order is written with the green ink.

13. Freely negotiable L.C:
Under this letter of credit the exporter can get the money by showing the concerned documents
to any bank.

14. Back to back L.C:
Under this L.C there are two separate credits the first document is issued in the favour of seller
who is middleman. On the basis of first L.C the middleman requests his bank to issue second
letter of credit in favour of actual supplier.

15. Omnibus L.C:
Under this L.C the exporter can get the funds just after the shipment of goods for further dealing.
The movable and immovable property of exporter is given to banker as security against loan.

Conclusion:

90
Q #32 What is business finance? What are the main types of business finance?
Answer:
Business Finance:
Business finance is the flow of capital and credit that makes the business possible. Finance
includes raising of funds through debt or equity finance.

Business finance is the life blood of every business. In sole proprietorship and partnership less
amount of finance is needed. Due to small scale of business, but in companies large amount of
finance is required because of large size of business activities.

Definition:
According to B.O wheeler business finance is the concerned with the acquisition and utilization
of capital funds in meeting the financial needs and overall objectives of the business.

Types of business finance:
Business finance can be categorized into the two main heads,
1. On the basis of time
2. On the basis of source

1. ON THE BASIS OF TIME

A. Short term finance:
Short term finance is obtained for the period of one year or less than one year. it is obtained to
meet the day to day operating expenses of business such as payment to creditors, wages, salaries,
utility bills etc.
Following are some forms of short term finance,

a. Bank overdraft:
Bank allows its customer who has current in the bank to withdraw more than the credit in the
account. This loan facility is given to meet the daily cash needs. The bank charges interest on
overdraft.

b. Cash credit:
It is very common form of short term finance. Borrower can obtain loan against the security of
goods. The borrower is allowed to withdraw cash within the limit specified by the bank. The
interest is charged on the amount withdrawn.

c. Discounting of bills:
Another form of short term loan is the discounting of bill. The bank purchases the bill of
exchange and provides finance to the customer. The bank gets back the amount of loan on the
maturity of bill.

d. Trade credit:
Trade credit is allowed by the seller to the buyer. The goods and services are supplied on the
credit and the amount is collected as per agreement.

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e. Advances from customers:
Sometimes the business gets advance payments from their customers and agents. These advances
are not loan, yet they are a source of finance.

B. Medium term finance:
Medium term finance is obtained to meet medium term needs that can be from 1 year to 5 year.
The following are the sources of medium term finance.

a. Commercial banks:
Commercial banks are the main source of medium term loan. Loans are generally provided
against the security of assets. Businessman can use the amount of loan to meet the business
needs.

b. Loan from financial institutions:
Businessman can obtain loan from financial institutions other than bank, IDBP, ICP, NDFC are
proving credit facility to the businessmen.

c. Debentures:
Joint stock companies can obtain loan by issuing debentures. Debenture is an instrument issued
by company to obtain loan from general public.

d. Life insurance policy:
The insurance companies provide medium term loan to its policyholders out of premium
received.

C. Long term finance
Long term finance is obtained to invest in the fixed asset like land, building, plant and
machinery. Long term loan can be for a period longer than ten years. Following are the main
source of business finance.

a. Equity shares:
The equity share is the most important source of long term finance. Joint Stock Company can
issue shares for fund raising. Amount of shares is paid back only on the winding up of the
company.

b. Use of profits:
Every company maintains reserve out of its profit that can be used for the development and
expansion of business. It is a useful source of getting extra capital for building and expansion of
business.

c. Issue of right shares:
A public company can increase its capital by issuing right shares. Existing shareholders are
offered to buy shares in proportion to the shares held.

d. Loan from financial institutions:
Company can obtain loan from financial institutions like IDBP, NDFC etc.

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e. Leasing:
Leasing is now a popular form of long term finance. A business may get plant equipment, land.
The business in this way uses the asset which it does not own. Businessman has to pay the
regular installments.

2. ON THE BASIS OF SOURCE
On the basis of source, the business finance has two types,

A. Equity finance:
Equity finance is also known as the owner finance. The finance which is provided by the owner
from his personal source is called equity finance. Owner may provide long term or short term
finance.

B. Debt finance:
The second source of fund raising is the credit financing or debt financing. Most of the business
is not in a position to finance all the funds from personal sources, so they can obtain loan from
financial institutions and banks. Loans can be obtained for short medium and long terms.

Conclusion:

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Q #33 Define owner (equity) and debt finance. What are the advantages and disadvantages of
debt and equity finance? (Or) What are the sources of business finance? Explain the merits and
demerits.

Answer: Sole proprietorship and partnerships forms of organization are run on small scale basis.
They no doubt, need funds but are mostly financed from the proprietors or partners owned
capital. It is the only company organization, which is managed on a large scale basis. It requires
vast amount of funds for fixed assets, as well as working capital.

There are two main sources of business finance,
A. Equity / owner finance
B. Debt finance

A. Equity finance:
Equity finance is also known as the owner finance. The finance which is provided by the owners
from their personal resources is called equity finance. It is also known as internal equity or
internal finance. This finance is generally provided for meeting the short term and long term
financial needs.

Merits of Equity Finance
1. Long term capital:
The equity finance is a long term capital available to the business. Repayment of capital is made
only on the winding up of the business.

2. No interest:
Equity finance is free from the payment of interest. The business concern has not to pay the
interest charges on equity capital.

3. Repayment of funds:
There is no need of repayment as the finance is provided by the owner from his personal
resources.

4. High rate of profit:
Equity finance provide high rate of profit as there is no fixed interest payment so the rate of
profit is high.

5. Minimum losses:
There is minimum loss to owners during depression. The interest on loan increases the losses. In
case of equity finance there is no interest so losses remain low.

6. Freedom of control:
The owners of business enjoy the freedom of control because one man can claim his right on the
assets of the company.

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7. Full profit:
In case of equity finance, the owners of business enjoy and share full profit of business they are
free from the loan payment and interest payment.

8. Low operating cost:
In case of equity of finance the operating cost is low as there is no burden of interest.

9. Financial base:
The equity finance provides a sound financial base to the capital structure of a business by
reducing the financial risk.

10. Liquidation of business:
In case of liquidation of business, the assets of the business remain with the owners.

11. Financial worries:
It is a benefit of equity finance that there are no financial worries of borrowing when the supply
of money is short and interest rate is high.

12. Attention to business:
In case of equity finance, the owner of the business enjoy the freedom of control because they
are free from the tension of interest an repayment of loan, so they can pay full attention to the
business.

Demerits of Equity Finance
1. High rate of tax:
The rate of profit is high as interest is not charged. When profit is high, the rate of tax is also
high. The government earns more income.

2. No innovation:
The owner do not invests his money in risky business. They work on the basis of their
experience; they do not start the new and risky business, so there is no innovation.

3. No advantage of debt:
If a company only invests equity finance it cannot enjoy the benefit of debt finance. Owner may
loss the opportunity to obtain the loan at low interest rate.

4. Deficiency of capital:
There is possibility of deficiency of capital because owner invests from his limited resources.
Business may feel problem in making payments due to the shortage of capital.

5. Low rate of return:
When owner uses their own capital for the investment in business, it avoids taking risky projects.
The return on safe investment is normally low.

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6. No aggressiveness of management:
A firm without management shows aggressiveness in managing the business affairs, which result
in low return on investment.

7. over capitalization:
If a company issues more equity shares than actually required by it, then it is likely to result in
over capitalization, which may create problem for the company.

B. Debt Financing
Debt financing is the second main source for the fund raising. Amount of capital can be
borrowed from creditors. It is also known as credit financing. Most of the businesses are not able
to finance all of the capital from their own resources, so they can enter into an agreement with
the lenders and banks to obtain loans.

Merits of debt financing

1. Expansion of business:
The business activities can be expanded easily due to the large capital. Borrowed amount helps
the business to start the production at large scale which results in low cost of production.

2. No interference of creditors:
Creditors cannot interfere in the affairs of business. The owners of business design policies for
the utilization of the borrowed amount.

3. More profit:
The business concern with the help of borrowed capital can earn more profit, as the rate of return
on borrowed amount is higher than the rate of interest.

4. Urgent cash requirement:
The business can take the short term loans for meeting the urgent funds requirement.

5. Solvency of business:
The debt financing provides the solvency to the business. The funds are available to meet the
obligations on due date.

6. More innovation:
Innovation demands huge funds. Debt financing provide funds for innovation.

7. Low interest:
In case of debt financing the interest charged on debt is lower than the rate of return paid to the
shareholders in form of dividend.

8. Flexible finance policy:
Debt financing enable the management to frame a flexible financing policy. Whenever they want
to expand the business they can raise funds by obtaining loan.

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Demerits of debt financing

1. Payment of interest:
Businessman has to pay the amount of interest on this type of finance, regardless of the financial
position of the business.

2. Business can be sued:
If the amount of interest and borrowed amount is not paid at the maturity date, the creditors may
sue the business.

3. Losses:
In case of loss, the business concern even than has to pay the interest. This increases the losses of
business.

4. Repayment of loan:
Repayment of loan is the liability of the business that is to be paid on the due date. Repayment of
loan may put the business into the financial difficulty.

5. Dissatisfaction of shareholders:
If the company decides to repay the amount of loan out of profits, the payment of dividend to
shareholders is reduced. It creates dissatisfaction among them.

6. Winding up of business:
In case of winding up of business, the creditors have the prior claim on the assets of the business,
so the shareholders may suffer loss.

7. Attraction of funds:
In times of depression, the rate of return on investment is lower than the rate of interest on loan.
Therefore the new investors will not contribute their funds in the business.

Conclusion:

97
Q #34 Explain the various types of interest free or non interest modes of financing (or)
explain the Islamic mode of financing.
Answer:
Interest Free Mode Of Financing:
Interest free mode of financing means the financing free from the interest. In Islamic mode of
financing interest in all fields and all ways is prohibited. There are 12 Islamic modes of
financing. These have been approved by State Bank of Pakistan from July, 1985. a brief
description of Islamic instruments of financing is as under:

A. Lending mode of financing
B. Trade related mode of financing
C. Investment mode of financing

A. Lending mode of financing:

1. Interest free loan with service charges:
Under this mode of financing, the bank provides funds free from the interest. The bank charges
only the service charges from the borrower. The rate of service charges is fixed by the state bank
of Pakistan. Interest free loans are generally provided to the small farmers, small businessmen
and salaried persons.

2. Qarze Husna:
Under this scheme the loan is provided to the poor people for medical treatment and to the
students who are less than 35 years of age. The students are allowed a grace period of two years
after the completion of studies to repay the amount of loan.

C. Trade related mode of financing:
The state bank of Pakistan has approved five trade related mode of financing that are given
below,

1. Mark up:
Mark up is the purchase of goods by the bank and their sale to the client at some mark up (profit)
on differed payment basis. The bank purchases the required goods on the request of the client
and sells these goods to him on the price mutually agreed between the bank and the client. The
agreed price contains the cost plus mark up (profit margin).

2. Mark down:
It is the purchase of property by bank from customer with buy back agreement. Under this
scheme, the customer sells his property to the bank with a promise to buy back the same property
from bank on future date. The difference between the purchase price and sale price is the profit
of bank.

3. Hire purchase:
The bank purchases the specified goods on the request of customer and hires them to the
customer on the payment of periodical installments. The installments are calculated in such a
manner that the actual price plus bank charges are covered during the fixed period.

98

4. Leasing:
In this mode of financing, one person (lessee) acquires an asset from the other person (Lessor)
for a fixed agreed period of time. The period of lease range from 5 to 20 years, depending upon
the useful life of asset. The lessee will have to pay fixed amount after regular intervals. The
ownership of the property remains with the Lessor.

5. Development charges:
In this trade related mode of financing the bank advances money to the customer for the
development of land and property. The bank takes a share in the developed property. The share
in the developed property is named as development charges.

C. Investment modes of financing:
Following are the five types of investment modes of financing.

1. Musharika:
Musharika is an agreement between the bank and his client to participate in the business as a
temporary partner to share profit and losses of the business during a specified period of time. In
this agreement the, business is run by the client and the profits are shared in an agreed ratio.

Features of Musharika:
The funds of the banks on the basis of Musharika are secured.
A certain portion of the profit is paid to the client as management fee.
The profit is shared according to the agreed ratio.
In case of loss, it is shared by the bank and client according to the financee provided by
them.

2. Modaraba:
Modaraba is an agreement in which one part invests his funds and the other party with his
knowledge and skills. Profits are shared between the parties in an agreed ratio. In case of loss the
bank which supplies capital bears full loss.

Features of Modaraba:
Modaraba must be registered under Modaraba ordinance.
Profit is shared in agreed ratio.
Modaraba certificate is transferable.
Modaraba may be for specific purpose or multipurpose.

3. Participation term certificate:
The participation term certificate was designed to replace debenture financing in the financing of
industrial investment.

Features Participation term certificate:
Participation term certificates are transferable.
Only joint stock company can issue such certificate.
Profits are shared in agreed ratio.

99
Losses are shared in the ratio of investment.
Certificate holder has right to participate in the meetings of the company.
These certificates provide medium and long term finance.

4. Equity finance:
The bank can participate in equity by purchase of shares of limited companies. The bankers can
become the shareholders instead of creditors.

Features of equity finance:
The investors purchase the shares to participate in equity.
The profits are distributed as dividend.
The banks and financial institutions may become the shareholders.

5. Rent sharing:
Rent sharing system provides the finance for the purchase or construction of houses. The
financer becomes the joint owner of the property. The principal amount and profit in shape of
rent is received for fixed period.

Features of Rent sharing:
The bank and customer both contribute their funds.
The period of joint ownership is stated in the agreement.
The rental value of house is determined on the base of locality and quality of construction.
The gain on sale of house is shared proportionately.

Conclusion:

100

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PEACE STUDENT MOVEMENT (PEACE STM)

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