Functions of Money

The functions of money can be conveniently divided in to three parts (A) Primary (B) Secondary and (C) Contingent functions. These functions are briefly discussed as under. (A) Primary Functions: (i) Money as Medium of exchange: In all market transactions money is used to pay for goods and services. The sale or purchase of goods is done through money. Money in other words acts as medium of exchange and helps in overcoming the difficulty of double coincidence of wants of barter economy. (2) Money as a unit of account: Another important function of money is that it provides a unit of account. The monetary unit of account is used to measure the value of goods and services in the economy. Just as we measure weights in terms of kilograms or distance in kilometres similarly we measure and compare the value of goods and services in terms of money. (3) Money as standard of deferred payments: Another function of money is that it is used as mean of setting debts maturing in the future. In modern economy most of the business is done on credit. Goods are bought and sold on the promise to pay money on a certain date in future. Debts are stated and paid in terms of units of account. (4) Money as a store of value: Money also functions as a store of value. It is a reservoir of purchasing power overtime. The money which you have today can be set aside to purchase things later on. This function of money is useful because most of us do not to spend our income immediately upon receiving it. They prefer to wait until they have the time or desire to spend it. B. SECONDARY FUNCTIONS OF MONEY Money as potential to influence the economy. It influences the price level, interest rates, utilization of resources etc. The secondary functions of money in brief are 1. Aid to specialization, production and trade: The use of money has helped in removing the difficulties of barter. The market mechanism, production of commodities, specialization, expansion and diversion of trade etc have all been facilitated by the use of money. 2. Influence on Income and consumption: The use of money has direct bearing on levels of income and consumption in the country. All production takes place for the market and the factor payments are made in money. 3. Money as an instrument of making loans: People save money and deposit it in banks. The banks and advance these saving to businessmen and industrialists. Money is thus the instrument by which saving are transferred into investment. 4. Money as a tool of monetary management: Money is an important tool of monetary management. If the money is effectively used it helps in increasing output and employment. 5. Instrument of economic policy: Money is an important instrument of economic policy. In order to achieve growth, reduce unemployment and maintain regular expansion of economic activity money is the most powerful factor. C. CONTINGENT FUNCTIONS Contingent functions are derived from primary and secondary functions. Contingent functions of money are as follows. (i) Distribution of national income: Money facilitates the distribution of national income among various factors of production.

(ii) Basis of Credit system: Banks create credit on the basis of their cash reserves. Any change in the volume of money is brought about mainly by an increase or decrease in money supply. (iii) Measure of Marginal Productivity: The marginal productivity of each factor of production is measured with the help of money. (iv) Liquidity of Property: Money gives liquid form to wealth. A property can be converted into liquid form with the use of money.

Price Stability
The general rise in the level of prices represents inflation, while the general fall in the level of prices is called deflation. Both these situations are undesirable. Therefore monetary policy is used to stablize the prices. Because of the price stability. (1) The negative effects rising in an economy will come to an end. (2) The price stability will not allow the depression or boom to occur. (3) The future value of money can easily be assessed, and everybody will accept it for future payments without any hesitation. (4) The price stability will not encourage unequal income distribution. (5) Because of the price stability the rising prices during inflation and falling prices industry deflation could be controlled. (6) The Stable prices lead to stagnation in the economy. As if producers and labour not possessing the incentives in the form of more profits and wages their efficiency will be affected. (7) Because of the changes in price level the resources allocation, investment, direction and choice of technique like issues are easily resolved. (8) Because of the constant price level the fixed income group would develop the realization that their wages, pensions, rents and interest etc will remain the same. When their incomes do not increase they will fail to avail the luxuries of life. (9) The price stability is not possible because monetary policy can not encompass the whole economy. The monetary policy can maximally influence the activities of commercial banks. The non-bank financial institutions and foreign bans have their own policies which are hardly influenced by the changes in monetary policy. Keeping above given points in for and against the price stability in view it can be concluded that it is not possible practically that the prices could remain stable or constant at a particular level. Therefore economists think that the monetary policy be devised in such a way that the rising prices and falling prices both should remain under control. It means that neither the pries should rise very sharply nor should fall very rapidly.

Money Market
Money market is a financial market for short terms loans. It is a market for short term borrowing and lending of funds. It is defined as a financial market in which only short term debt instruments having maturity of less than one year are traded. The main features of money market are given as under. (i) Money market has buyers and sellers in the form of borrowers and lenders. The borrowers are the traders, manufactures, speculators. The lenders in the money market are the Central Bank,

Commercial Banks etc. (ii) It deals with short term credit instruments such as Treasury bills of exchange etc. (iii) Money market securities are more widely traded and are liquid. (iv) Short term securities have smaller fluctuation in prices. Therefore they are considered sage investment. (v) Money market operates through various financial institutions such as Central bank, Commercial banks, non bank financial intermediaries, bill brokers. (vi) Money market is not a single homogenous market. It is composed of several sub markets. Each market deals with specific short term credit instruments e.g. call money market, trade bill market etc.

Liquidity Preference
In the words of Meyer Liquidity Preference is the preference to have an equal amount of cash rather then to claims against others. According to Keynes interest is purely a monetary phenomenon people prefer to hold a part of their incomes and wealth in liquid form. People become willing to part with liquidity only when they are offered same reward in the form of interest liquidity preference means the demand for money to hold cash. Keynes is of the view that rate of interest is determined by the demand for (liquidity preference) and supply of money. Keynes has given three motives for holding money in liquid form. 1. Transaction Motive: The transaction motive relates to the demand for money or the need for cash for the current transactions of individual and business exchanges. Individuals hold cash in order to bridge the internal between the receipt of income and its expenditure the businessmen and the entrepreneurs also have to keep a proportion of their resources in ready cash in order to meet their current needs of various kinds. In the case of individuals Keynes calls it Income motive and in case of businessmen it is called by him Business motive. 2. Precautionary Motive: Precautionary motive for holding money refers to the desire of the people to hold cash balance for unforeseen contingencies. People hold a certain amount of money to provide for the danger of unemployment, sickness, accidents and other more uncertain perils. This amount of money held under this motive will depend on the nature of the individual and the conditions in which he lives. 3. Speculative Motive: The Speculative motive relates to the desire to hold ones resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest.

Full Employment
The classical economists believed that there was always full employment. According to them full employment is a situation when there is no involuntarily unemployment, through there may be voluntarily, casual, seasonal, structural, technological and frictional unemployment. In their opinion in a free competitive economy serious unemployment was passing phase. All job seekers are able to find jobs sooner or later at the prevailing wage rate. This view however is not

accepted by economists these days. Actually there is always some unemployment. Employment will be full literally when every able bodied adult worked the number of hours considered normal for a fully employed person at the current wage level. This level of employment, however normally appears to be unattainable in private enterprise economists. For, under such economics, quite a few have enough unearned incomes to be able to afford a life of well-paid idleness. Pigou accordingly defied full employment as one when every body who at the ruling rate of wages wishes to be employed is infact employed. But even Pigovian full employment appears to be unattainable for, at any given time, there is bound to be some seasonal and frictional unemployment. This led Keynes and after him to define full employment as a level of employment which falls short of Pigovian full employment. The Economic and Social Council of the UN has accepted the same definition for it required countries to fix full employment standard in this sense. Keynesian full employment is by definition the maximum level of employment that private enterprise countries can attain without experiencing strong inflationary pressure. According to Keynes full employment is a situation in which aggregate employment is inelastic in response to an increase in effective demand for its output. But for purpose of practical policy it is necessary to reduce the concept to quantitative terms. It should be possible to say precisely when employment is less than full so that remedial measures can be adopted to achieve the full employment level.

Index Numbers
Index numbers are devices for measuring the difference in the magnitude of a group of related variables. An index number of prices is that a number which indicates the price level of any given dete as compared with the level of prices at some standard dete called the base. PREPARATION OF INDEX NUMBERS The following are the various steps in the construction of an index number. (i) Choice of the base year: The first step is to choose a year to serve as the base year i-e the year with reference to which the price changes n other years are expressed as percentages. Care must be excised in its selection. It should be an average year, neither a year of boom nor of depression. (ii) Selection of Commodities: The second step is to select commodities the prices of which have to be taken to represent the general price level. The commodities should be really representative and should be sufficiently large in number. The selection of commodities also depends on the object with which the index is prepared. (iii) Price Lists taken for each commodity: It is better to have an average of wholesale prices of the same commodity from a number of representatives markets. These prices are taken for the base year and also for the subsequent years the index number for which we want to construct. Retail prices are better because it is the retail prices which consumers actually pay. But retail prices are not taken because they differ widely from locality to locality. (iv) Price of each commodity: The next step is to represent the price of each commodity for the base year as 100 and the price of the same commodity for the subsequent year as a percentage of the price for the base year. For instance of the price of wheat in the base year is Rs. 70 per quintal and is called 100 of Rs. 154 in the subsequent year should be called 220 and so on in the case of all the commodities taken and all the years. (v) The Final step: The final step is t strike the average of the numbers thus obtained with

reference to each year. The average for the base year will to course come to 100. The other average will be higher or lower than 100 according as the general price level has risen or fallen.

International Development Association

The establishment of the International Development Association (I.D.A) was another step in the direction of increasing international liquidity in the World. The I.D.A was setup in September 1960, as a subsidiary of the World Bank to provide soft loans to the member countries. In other words the object of the I.D.A was to provide loans to the member countries on liberal terms with regard to the rate of interest and the period of repayment. The interest charged on the I.D.A loans was lower than that of the World Bank. Jurther the borrowing countries were allowed longer periods, say 50 years or so, for repayment of loans. Besides the loans taken by the member countries could be repaid in their own national currencies. They were under no obligation to repay the loans in hard currencies as was the case with the World Bank. It is on this ground that the I.D.A is often referred to as the Soft Loans Window of the World Bank. The I.D.A has its own criterion for investment in developing countries. The project to be selected for financial aid should be of a high development priority. The project should be such as to help the country in saving its foreign exchange resources during the course of its fulfilment. The I.D.A gives loans to private industrial undertakings without any guarantee from the government of that country. MEMBERSHIP, CAPITAL AND ORGANIZATION OF I.D.A The membership of the I.D.A is open to all those countries which are members of the World Bank. The I.D.A was started with an initial capital of 1,000 million dollars collected from member countries. The capital resources of the I.D.A have been increased from time to time to meet the increasing requirements of the member countries. The subscriptions from the member countries are payable to the I.D.A in five annual instalments. The I.D.A has divided its member countries into two parts. Part I comprises 21 countries and Part II includes 99 countries. The countries included in Part I happen to be rich and affluent with higher income per capita. NATURE OF I.D.A ASSISTANCE I.D.A provides soft loans to the member countries which are generally interest free. But there is a nominal service charge of 3/4 percent on the amount of outstanding loans. This charge is intended to cover the administrative expenses of the I.D.A. The I.D.A provides long term loans repayable over a period of 50 years with an initial grace period of 10 years. No repayment is to be made during the initial period of 10 years. Afterwards 1 percent of the principal amount of the loan is repayable annually for a period of 10 years and during the next 30 years the balance of the outstanding loan is to be amortized at an average rate of 3 percent per annum. The I.D.A provides loans for such projects as water supply, sanitation, health, education urban development etc, which do not make immediate contribution to the economic development of the country.

International Finance Corporation and its Objectives

The International Finance Corporation (I.F.C) is an affiliated institution of World Bank. It was established on July 20, 1956 with the object of assisting private enterprises in developing countries by providing them with risk capital. The World Bank grant loans only to member

governments or private enterprises with the guarantee of member government concerned. Again the World Bank provides only loan to private enterprises. Infact the development of private enterprises is held up for lack of adequate risk capital. Hence there was an urgent need for some international finance institution which would be willing to provide risk capital to the private industrial undertaking in developing countries. The I.F.C was set up to meet the participation requirement of private industrial undertakings. OBJECTIVES OF THE I.F.C The main objectives of the I.F.C is to accelerate the pace of economic development of the member countries in the under developed areas of the world in these ways. (i) By investing in private productive enterprises in association with private investors and without any government guarantee of repayment. (ii) By bringing together investment opportunities, private capital, both foreign and domestic and experienced management. (iii) By stimulating productive investment of private capital, both foreign and domestic, in the developing countries for productive purposes. MEMBERSHIP OF THE I.F.C As already pointed out that the I.F.C is an affiliate of the World Bank. Its membership is separate from that of the World Bank. But it is only the members of the World Bank who can become members of the I.F.C. It is not essential that all the members of the World Bank should also be the members of the I.F.C, is optional for the members of the World Bank. Total membership of the I.F.C at present is 161. ORGANIZATION OF THE I.F.C All the powers of the I.F.C have been vested in the Board of Governors. There is one Governor from ach member country nominated by government of that country. The Board of Governors normally meets once a year to chalkout the general policy of the corporation. The general business of the I.F.C is carried on by the Board of Directors which meets at least once a month. There are 21 Executive Directors who constitute the Board of Directors of the corporation. The President of the World Bank is ex-officio Chairman of the Board of the Directors of I.F.C. Subject to this over all supervision, the day-to-day routine working of the corporation is conducted by the Executive Vice-President. CAPITAL OF THE I.F.C The Corporation was started in July 1956 with an authorized capital of 100 million dollars. The capital has been increased from time to time to meet the increasing requirements of the corporation. The Board of Directors has decided to double the authorized capital of I.F.C to 1,300 million dollars. The corporation has also been borrowing funds from the World Bank to supplement its financial resources. INVESTMENT CRITERIA OF THE I.F.C While extending financial assistance to enterprises the Corporation keeps following points in view. 1. The borrowing enterprises should be expected to make profits in course of time. Infact profitability is an essential criterion for loans to be made by the I.F.C. 2. The borrowing enterprises should be such as to make a definite contribution to the economic development of the country in which it is located. 3. The corporation is prevented by its Charter to invest more than 22 million dollars in any single venture. 4. The corporation can make investment in a private enterprises only if more than 50 percent of

the capital is forth from that enterprise itself. 5. So far as the equity is concerned the Corporation cannot provide more than 25 percent of the aggregate capital of the borrowing enterprise.

International Bank for Reconstruction; its Functions and Objectives

The International Bank for Reconstruction and Development (I.B.R.D) better known as the World Bank was established at the same time as the International Monetary Fund to tackle the problem of International investment in 1944. Since the I.M.F was designed to provide temporary assistance in correcting balance of payments difficulties, there was need of an institution to assist long term investment purposes. Thus I.B.R.D was established for promoting long term investment loans on reasonable terms. The World Bank is an inter-government institution corporate informs the capital stock of which is entirely owned by its member governments. Initially only nation there were members of the I.M.F could be members of the World Bank but the restriction on membership was subsequently released. FUNCTIONS OF I.B.R.D The principal functions of the I.B.R.D are set forth in Article (1) of the Agreement as follows. 1. To assist in the reconstruction and development of the territories of its members by facilitating the investment of capital fro productive purposes. 2. To promote private foreign investment by means of guarantee of participation in loans and other investments made by private investors and when private capital is not available on reasonable terms to make loans for productive purposes out of its own resources from funds borrowed by it. 3. To promote the long term balance growth of international trade and the maintenance of equilibrium in balances of payments by encouraging international investments for development of productive resources of members. 4. To arrange loans made guaranteed by it in relation to international loans through other channels so that more useful projects, large and small alike, will be dealt with first. OBJECTIVES OF I.B.R.D The objectives of I.B.R.D as incorporated in the Articles of Agreement are as follows. 1. To help in the reconstruction and development of member countries by facilitating the investment of capital for the productive purposes, including the restoration and reconstruction of economies devastated by war. 2. To encourage the development of productive resources in developing countries by supplying them investment capital. 3. To promote private foreign investment through guarantees and participation in loans and other investment made by private investors. 4. To supplement private foreign investments by direct loans out of its own capital for productive purposes. 5. To promote long term balances growth of international trade and the maintenance of equilibrium in the balance payments of member countries by encouraging long term international investments. 6. To bring about an easy transition from a war economy to a peace time economy. 7. To help in raising productivity, the standard of living and the conditions of labour in member

countries. The World Bank advances loans to member countries primarily to help them lay down the foundation of sound economic growth. The loans made by the Bank either directly or through guarantees are intended for certain specific projects of reconstruction and development in the member countries. LENDING PROCEDURE OF I.B.R.D The I.B.R.D advances loans to member countries in the following three ways. 1. Loans out of its own Fund: As we know that the Bank collects capital contributions from its members this results in the creation of a sizeable fund out of which the Bank advances loans to the needy member countries. 2. Loans out of borrowed Capital: Sometimes the Bank does not grant loans out of its own funds. It borrows funds from another member country for the purpose of giving loans to the needy members. The Bank pays interest to the member country from which it has borrowed funds for a specific period of time. 3. Loans through Banks guarantee: Sometimes the Bank encourages the private investors of a country to lend their funds to an other country by guaranteeing the repayment of loans and interest there on. Ordinarily the Bank does not lend to the member countries out of its own funds. The Bank lends out of its funds only when private investors in member countries are not forthcoming to make loans to the concerned country.

I.M.F; Objectives and its Advantages

There was complete lack of monetary cooperation amongst the countries of the world after the First World War. A sort of economic war was going amongst the majority of the countries of the world. Infact the Second World War broke out primarily on account of these economic causes. During the closing years of war an international monetary conference was held at Bretton Woods in the U.S.A. in July 1944 to prepare a plan to root out the economic causes leading to the out break of war. The Bretton Woods Plan was divided into two parts (1) the establishment of I. M. F. and (2) the setting up of World Bank. I. M. F. started functioning on the 1st march 1947. OBJECTIVES OF I. M. F. Following are the objectives of I. M. F. 1. To bring about international monetary cooperation. 2. To ensure stability in foreign exchange rates. 3. To eliminate exchange control. 4. To establish system of multinational trade and payments system. 5. To promote international trade. 6. To help member nations to achieve balanced economic growth. 7. To eliminate of to reduce the disequilibrium in the balance of payments. 8. To promote investment of capital in backward and under developed countries. CAPITAL AND ORGANIZATION The capital of the I. M. F. consists of the aggregate of the quotas allotted to member countries. Each member pays either 20 percent of quota or 10 percent of its entire gold and dollar holdings, whichever is less, in gold. The balance of quota is paid to the I. M. F. in the national currency of the member country. The quota as of member countries of the I. M. F. are normally revised once every five years.

There are two bodies to run the management of the I. M. F. (a) The Board of Governors and (b) The Board of Directors. Every member country appoints one Governor to participate in the meetings of the Board of Governors. The Board of Governors formulates the general policy of the Fund. There are 21 members in the Board of Directors. Seven of then are permanent members, while fourteen are elected from amongst the remaining members. According to the Fund Agreement, the headquarters of the Fund are located in a country which happens to have the highest quota of capital of I. M. F. The head office of the Fund is at present located in Washington. FUNCTIONS OF THE I. M. F. There are three important functions of the Fund. They are (1) The Fund helps the member countries to eliminate or at least to minimize the short period disequilibrium in their balance of payments. (2) The Fund also helps the member countries to remove the long period disequilibrium in their balance of payments. (3) The Fund tenders advice to the member countries on economic and monetary matters, because it is in a position to do so in view of its special quota. ADVANTAGES OF THE FUND Following are the main advantages which have occurred to the world from the functions of the Fund. 1. Establishment of a Monetary Reserve Fund from which foreign exchange requirements of various are met. 2. Setting up of multilateral trade and payments system. 3. Improvements in short term disequilibrium in balance of payments. 4. Stability in foreign exchange rates. 5. Check in competitive currency devaluation. 6. No interference in domestic economic affairs. 7. Gains of Gold Standard. CRITICISM OF THE FUND The functions of the Fund is often subjected to the criticism on the following grounds. 1. Limited scope of the functioning of the Fund. 2. Quota fixation is on unscientific basis. 3. Discriminating treatment. 4. Inability to remove exchange controls. 5. No success in securing exchange stability. 6. No provision for automatic revaluation of currency. 7. No solution of the liquidity of problem. 8. Failure to tackle the problem of pertro-dollars. 9. No elimination of multiple exchange rates. 10. Free convertibility of currencies not attained. 11. Inadequate representation to developing countries. 12. Provision of inadequate resources to developing countries. Erosion of sovereignty of poor nations.

Limitations of Monitary Policy

Now we see the limitations in the ways of effective role of monetary policy in case of developing countries like. Main points about limitations are discussed as under. 1. In case of under-developed countries the money and capital markets are very immature. The banking system is backward and there operates non-monetization in the economy. Above all the major parts of transactions are made with the help of cash, where as the use of cheques and drafts are very limited. The saving schemes are not very attractive. As a result, people are bound to keep their savings in the form of gold and hoardings. 2. There exists a traditional type of banking in the poor countries where banks provide more loans to commerce while reduced loans are given over industrial and agricultural sectors. Perhaps it is due to long period of time and element of uncertainty. If Central Bank inducts cheap money policy for economic development its benefits are mostly availed by speculators a hoarders while the neglected sectors remain deprived of. It shows that easy monetary policy leads to create artificial shortages, regional imbalances and unequal income distribution, rather being helpful in economic development. Thus monetary policy aggravates the problems of developing countries. 3. In case of developing countries the money market is extremely backward. It is fragmented into organized and unorganized money markets. The organized money market is located in cities where bank and specialized institutions provide loans at concessionary rates. While the unorganised money market is located in villages where there is dearth of banks and financial institutions. The Zamindars, money lenders and merchants provide these loans at a higher rate of interest. Above all, the monetary policy will have a least influence over unorganized money market and central bank is pursuing easy monetary policy. 4. In case of poor countries there is limited business regarding stocks, shares and securities. The stock exchanges are confined to few big cities. Central Bank follows a very conservative and orthodox way regarding sale of securities. There is a limited publicity in respect of public loan. The Government security market is neither deep nor elastic. More over, so many financial institutions like co-operative banks etc are least affected by monetary policy. They have them own structure of rate of interest, rigid and inflexible even in the presence of easy monetary policy. 5. In case of under-developed countries the unemployment is not of cyclical nature, which could be removed with easy monetary policy. Rather it is concerned with disguised and underemployment. Accordingly the role of monetary policy is different in under-developed countries. Accordingly there is a need to adjust monetary policy to the circumstances prevailing in the backwards countries. In case of developing countries monetary policy can play its effective role when. (A) Such a rate of interest structure could come into being which is flexible upward as well as downward. Moreover the benefits of cheap money policy should not be taken away by speculators and hoarders. (B) If the loans provided under cheap credit money policy are transmitted over to goods sector i.e they are used for speculation a shortage goods will develop. Hence the economy may experience inflation. The inflation will sabotage the process of development. Therefore central bank will have to keep an eye over the speculative demand for money. The loans for unproductive uses will have to be encouraged. (C) The major part of bank loans is taken away by businessmen while the small traders and

agriculturists fail to get the loans. Thus to remove such disparity and proper distribution of loans the central bank should encourage the opening of new banks which could provide loans neglected persons and sectors. Co-operative banking be promoted. As a result not only the savings will increase, but the loan availability will also become possible. (D) In countries like Pakistan there always exists a danger of inflation. It is because of the reason that outputs cannot be increased to the desirable extent. There is a big population pressure. The government expenditures are far more than government revenues. The trading is carried under speculation and hoarding. In such like circumstances, the selective credit controls are more useful i.e central bank restricts the speculative and consumer credits. In the light of above mentioned cases if monetary policy is reformulated it can play an effective role in the economic development of developing countries.

Role of Monitary Policy

Now-a-days the monetary policy is very important both for the developed as well as for the developing countries. We can have the idea about the role of monetary policy for the developing countries like Pakistan from the points explained below. 1. The under-developed countries are aimed at a balanced economic growth, particularly they want to develop their backward regions and utilize the labour, capital and other natural resources at their disposal in a best way. For this purpose monetary policy can be helpful to us. As the loaning facilities to backward regions can be extended, the cheaper credit may be made available to the preferred regions and sectors, and more loans at cheaper rates for neglected areas can also be provided to start the process of economic development. 2. The economic development of a country depends upon technical changes, inventions and innovations and discovery of new models etc whether they have been imported of formulated at domestic level. Accordingly, monetary policy has to play its role for the sake of technical progress and inventions etc. As the producers who want to produce new goods can be provided the credit at soft conditions. In this way the process of development can be started. 3. The economy which is engaged in the process of economic development is in need of more capital so that the transaction of goods and services could easily be facilitated. The availability of more money will put to an end the non-monelized sector in the poor countries. The backward and self sufficient life of villages will come to an end. 4. Economic growth and industrial growth are compulsory to each other. The industrial growth can be possible if loans are provided in a greater amount. The entrepreneurs with greater funds would utilize the resources and produce more goods. The availability of loans can be made possible through money and capital market. The monetary policy can be helpful in establishing the monetary institutions.

Price Stability and Balance of Payments

There appears to be no conflict between the objectives of price stability and balance of payments in country. Monetary policy aims at controlling inflation to discourage imports and encourage exports and thus it helps in attaining balances of payments equilibrium. However if the government tries to remove unemployment and allows some inflation with in the economy, there appears a conflict between these two objectives. For a rise in the price level will discourage

exports and encourage imports, thereby leading to disequilibrium in the balance of payments. But this may not happen if prices also rise by the same rate in other countries of the world.

Full Employment and Balance of Payments

There is a major policy conflict between full employment and balance of payments. Full employment is always related to balance of payments deficit. Infact the problem is one of maintaining either internal balance or external balance. If there is balance of payments deficit, then a policy of reducing expenditure will reduce imports but it will lead to increase in unemployment in the country. If the government raises aggregate expenditure in order to increase employment, it will increase the demand for imports there by creating disequilibrium in the balance of payments. It is only when the government adopts expenditure-switching policies such as devaluation that this conflict can be avoided but that too temporarily.

Full Employment and Price Stability

One of the objectives of monetary policy in 1950s was to have full employment with price stability. But the studies of Phillips, Samuelson Solow and others in the 1960s established a conflict between two objectives. They suggest that full employment can be attained by having more inflation and that price stability can be achieved by having unemployment to the extent of 5 to 6 percent. Economists do not find any conflict between unemployment and price stability. They hold that so long as there are unemployed resources, there will be price stability. Prices start rising only when there is full employment of resources.

Economic Growth and Price Stability

There is a conflict between the goals of economic growth and price stability. The rise in prices is inherent in the growth prices. The demand for goods and services rises as a result of stepping up of investments on a large scale and consequent rise in prices especially when the level of full employment is reached. In the long run when new resources are developed and growth leads tot eh production of more commodities, the inflationary rise in prices will be checked. But the rise in prices will be there with the growth of the economy and it will be moderate and gradual.

Full Employment and Economic Growth

The majority of the economists hold the view that there is no inherent conflict between full employment and economic growth. Full employment is consistent with 4 percent unemployment in the economy. So the relationship between full employment and economic growth boils down to trade-off between unemployment and growth. Periods of high growth are associated with low level of unemployment and periods of low growth with rising unemployment. In 1961 Aurther Okun established relationship between real GNP and changes in the unemployment rate. This relation has come to be known as Okuns law. This law states that for every three percentage points growth in real GNP, unemployment rate declines by one percentage point every year. However certain economists argue that unemployment rate increases as the growth rate rises.

Economic growth leads to reallocation of resources in the economy where by there is change in the type and quantity of labour demanded. There is a shift in the demand for labour from one sector of the economy to the other. As workers are trained for specific jobs, they are displaced when the demand for the products of particular industries falls. This creates unemployment. This is particularly so when growth is the result of technological innovations which are labour saving and require more qualified and skilled workers. Thus unskilled workers are worst sufferers because they are thrown out of jobs with automation. Employment can however increase with growth if demand is increasing at 3 percent per annum and the productivity is increasing at 4 percent per year, thou put will expand by employment will decline. Under the circumstances the government should adopt such monetary policy which should increase the overall demand in the economy.

Instruments and Techniques of Monetary Policy

Monetary policy mainly aims at controlling the volume of credit in the country and sometimes also the direction of its use. It is not possible to describe in detail the methods by which this is done, for which reference may be made to any good book on the theory of money and banking. A brief mention of them, however must be made for completeness of our discussion. Monetary policy may achieve credit control in various ways depending upon whether the control desired is quantitative control or qualitative control. The former refers to the volume of purchasing power and latter to the use to which it may be put. (a) QUANTITATIVE CONTROL The methods of quantitative control include the following. (i) Bank Rate Policy: The Central Bank of the country raises or lowers as needed, its Bank Rate (discount rate) for first calls paper thus influencing other interest rate sin the money market. A higher rate discouraged and lower rate encourages bank loans ad hence credit expansion. Thus is regulates and controls the volume of purchasing power in the economy for carrying on economic activities. (ii) Open Market Operations: The Central Bank buys or sells, as the need may be, Government securities in the open market. By purchasing the securities it adds to the balances of commercial banks with itself and by selling them it reduces such balances. Balances with the Central Bank being as good as cash, such operations expand and restrict respectively the power of commercial banks to create credit when they sell of buy such securities. (iii) Variable Reserve Ratios: The Central Bank requires a certain percentage of the liabilities of commercial banks (or member banks) to be kept in form of reserves with it under the law. This ratio can be increased when credit contraction is desired and decreased when the object is to expand credit. (iv) Credit Rationing: The Central Bank may put limits on the issue of credit (overall or for particular purposes) on the part of the member banks. These limits may be increased or decreased as needed by the monetary situation in the country. (b) QUALITATIVE CONTROL It includes following. (i) Moral Suasion: Central Bank through direct advice or persuasion may influence the banks to follow particular lines of policy considered necessary to meet a particular situation. (ii) Consumer Credit Regulation: In times of inflationary pressure the Central Bank may put restrictions on loans to consumers. If consumption needs encouragement the Central Bank may

allow commercial banks to advance loans for consumption. (iii) Publicity: This method is used usually accelerating the pace of economic development. This implies issuing of weekly statistics, periodical reviews about money market conditions, public finance, trade, industry, weekly balance sheet etc for the information of commercial banks, this convincing them of the desirability of following particular lines of policy. (iv) Variable Margin Requirements: Margin requirements may be increased if the object is to discourage, and decreased if the aim is to encourage credit only for speculative activities in the stock exchange. (v) Direct Action: This method is used by Central Bank usually to rediscount bills of banks following policies which are inconsistent with the Central Banking policy. This method is rarely used and only as last resort. To be fully effective in achieving their aims these methods pre-suppose a well-developed money market which is sensitive to the actions taken by the Central Bank. If there is a large nonmonelised sector and net of banking institutions is not wide enough to cover the country, or there is absence of organised banks prepared to cooperate in the national interest monetary policy will face difficulties in achieving its objectives.

Monetary Policy and its Objectives

The monetary policy of a country consists of various measures usually taken by its Central Bank but ultimately reflecting Government policy to seek to influence the supply of and demand for money and the various uses to which loanable funds may be put. The objectives of monetary policy are achieved through influencing the lending policies of banks which affect the flow of purchasing power and its direction in the country. The main objectives of monetary policy may be divided into two broad categories. (i) Those of minor scope: This category includes such objectives as stabilisation of money market, protection of the monetary standard, elimination of undesirable fluctuations in foreign exchange rates, maintaining stability of inter prices, avoidance of undue fluctuations in interest rates etc. These objectives, however remain in the background of the monetary policies of the present day economies and are subordinated to the major objectives, and hence are given comparatively small importance. (ii) Those of major scope: The major objectives of monetary policy have varied under difference monetary systems, under the gold standard, safeguarding the gold reserve from internal and external drains was given the chief importance. During the thirties of the present century the major objective of monetary policy was considered to be achievement and maintainance of full employment. This was natural in view of the universal phenomenon of unemployment prevailing during the Great Depression. During World War II and the post war period control of inflation become a major task. One may say that some thing out of business fluctuation has remained one of the major objectives of monetary policy, particularly in the industrially developed countries. Closely connected with this has been the objective of Cheoxing the tendency towards that is called secular stagnation and to impart a healthy buoyancy to the economy. At present the problem of inflation dominates the scene almost everywhere outside the socialist world. For less developed world the major objectives of monetary policy has been to promote activities resulting in economic development or optimum utilisation of their material and human resources. In Pakistan monetary policy must be geared to the needs of her planned economic development in addition to tackling the current problem of high inflationary pressure.

Selective Credit Control

Qualitative or Selective credit control is a recent development in monetary management by the Central Bank. The objective of qualitative control is to divert the flow of credit into particular uses or channels in the economy. Infact the objective of selective credit control is to encourage the flow of credit into those uses or channels which help the growth of economy. The following are the main types of selective credit controls exercised by the Central Bank. 1. Fixation of Margin Requirements on secured loans. 2. Regulation of Consumer Credit. 3. Control through Directives by Central Bank. 4. Rationing of Credit. 5. Moral Suasion. 6. Publicity. 7. Direct Action. All the above mentioned types of selective credit control are discussed as under. 1. Fixation of Margin Requirements: The margin is the difference between the loan value and the market value of securities offered by borrowers against secured loans. By prescribing the margin requirements on secured loans, the Central Bank does not permit the commercial banks to lend their customers the full value of the securities offered by them, but only a part of their market value. To start with, this method was applied to stocks and shares only. But now its scope has been extended to cover goods stored in authorized godowns. At present, this method is being extensively used by developing as well as developed countries to check the flow of credit into undesirable speculative activities. 2. Regulation of Consumer Credit: As we are aware that, durable consumer goods such as T.Vs, refrigerators, washing machines, motor vehicles etc are purchased in Western countries by the consumer on instalment credit. According to this system, a certain percentage of the price is paid by the consumers in downright cash. The remaining part of the price is financed by bank credit which is repayable by the consumer in instalments spread over a specified period of time. The objective of this method is to curb the consumption of durable consumer goods which happen to be in short supply in the economy. This method controls excessive consumer demand for durable goods. This method was first introduced by the Federal Reserve System in the U.S.A. in August 1941 to regulate the terms and conditions under which credit repayable in instalments could be extended to the consumers for purchasing durable goods. Later on the method of consumer credit regulation was adopted by Central Banks in other countries, such as those of Britain, Canada, Australia and New Zealand. 3. Control through Directions: Sometimes, selective credit controls may be enforced on the commercial banks through directives issued by the Central Bank from time to time. These directives may be in the form of written orders, appeals or warnings by the Central bank addressed to the commercial banks. These directives are issued to the commercial banks in order to realize the following objectives. i) To divert credit less urgent uses to more urgent uses. Or from less productive uses to more productive use. ii) To prohibit lending for certain purposes altogether. iii) To fix maximum limits of credit for certain purposes. The commercial banks generally decide by the directives issued to them by the Central Bank from time to time. These directives generally supplement the traditional weapons of control, such

as, the bank rate and open market policy. 4. Rationing of Credit: This is another weapon in the armoury of the Central Bank. Rationing of credit as an instrument of credit control was first used by the Bank of England in the closing years of the eighteenth century. The term rationing of credit implies two things, first it means that the Central Bank fixes a limit upon its rediscounting facilities for any particular banks. Second it means that the Central Bank fixes the quota of every affiliated bank for financial accommodation from Central Bank. This method of rationing of credit has a historical background. Due to the operation of the usuary law, the Bank of England could not raise its rate of discount beyond maximum limit of 5 percent. It was not possible for the bank to discourage excessive borrowing from it by the banks during periods of monetary stringency. The Bank of England was thus compelled to ration credit among the member banks. But after the repeal of usuary law, the method of rationing of credit lost its importance in Britain. Central Banks in other countries such as Germany, France, and Mexico also make use of this method to check excessive borrowing by the commercial banks from Central Bank. The rationing of credit as a method of credit control occupied a prominent place in Soviet Economic planning. 5. Moral Suasion: The moral suasion method is frequently employed by the Central Bank to exercise control on the commercial banks. This method involves advice, request and persuasion with commercial banks to cooperate with the Central Bank in implementing its credit policies. If the commercial banks do not abide by the advice or request of the Central Bank, no punitive action is taken against them. The Central Bank merely uses its moral influence with the commercial banks to prevail upon them to accept its policies. For example, the Central Bank may request the commercial banks not to extend credit for speculative purposes or it may request the member banks not to press with the demand for additional financial accommodation from it. The Central Bank under this method can only appeal to the patriotic and nationalistic sentiments of the commercial banks. The Central Bank may even hold occasional conferences with the commercial banks to make its policies known to them. Anyway, the method of moral suasion is a purely informal method with no legal sanction. The method of moral suasion has also its limitations. The main drawback of this method is that it lacks legal sanction. As such, it fails to be effective at a line when the forces of credit expansion in the economy happen to be very strong and powerful. Nevertheless, this method has its uses and can serve as useful supplement to other methods of credit control. 6. Publicity: Central Banks have adopted publicity as an instrument of credit control. They use this instrument not only for influencing the credit policies of commercial banks but also to educate and influence public opinion in the country. Infact publicity is an essential instrument to ensure the effectiveness of the monetary policy of The Central Bank. Under this method the Central Bank gives wide publicity to what is good and what is bad in credit system of the country. The Central Bank gives wide publicity to its thinking in the field of bank credit. The commercial banks, in their turn are guided by the ideas of the Central Bank in matters relating credit creation. Publicity as a method of credit control has been very extensively used in the U.S.A. when the Federal Reserve System regularly publishes reports regarding the credit creating activities of the member banks. The method is also widely used by the Central Bank in Germany and Sweden. The State Bank of Pakistan also periodically published returns and statements about the affairs of commercial banks. There is some controversy going on amongst the economists with regard to effectiveness of publicity as a method of credit control. While some economists feel that publicity is useful instrument of credit control, there are others who are of the opinion that it is at

best only a minor instrument of credit policy. 7. Direct Action: The method of direct action is most extensively used by the Central Bank to implement their credit policies. This methods can be used to enforce both quantitative as well as qualitative credit controls by the Central Banks. This method is not used in isolation, it is used as a supplement to other methods of credit control. This method of direct action implies the use of coercive measures against those commercial banks whose credit policies do not confirm to the declared objectives of the Central Bank. This method also involves the issuing of general instructions by the Central Bank to all the commercial banks. It may also take the form of special instructions by the Central Bank issued to erring banks. It should however by remembered that the method of direct action is sued only as last resort when other methods fail to yield the desired result. The method of direct action can prove effective only when the Central Bank is armed with sufficient Legal powers to enforce its directives on the commercial banks. Hence the Central Banks in several countries have been given statutory powers to take drastic action against the defaulting banks. According to recent Central Banking legislation, the Central Banks in different countries have been given extensive powers under the law to formulate the general credit policy to be followed by the commercial banks. They have also been authorized to prescribe rates of interest to be charged on different types of loans and advances.

Quantitative Credit Control

The important quantitative or the general methods of credit control are as follows. (i) Bank Rate or Discount Rate Policy (ii) Open Market Operations (iii) Variable Cash Reserve Ratios These methods are discussed in brief as under. (i) Bank Rate or Discount Rate Policy: The bank rate policy is one of the principal methods of general credit control. It is the earliest method of credit control which was used by the Bank of England till the out break of the First World War. But later on with the change in economic conditions in Great Britain, the bank rate policy became rather ineffective and the Bank of England was compelled to advise other methods of credit control which were more effective than bank rate policy. The Central Bank, thus tries to control credit (through Bank Rate Policy) by influencing both the cost as well as the availability of credit. The cost of credit is influenced by changing the bank rate. By raising the bank rate or the discount rate, the Central Bank raises the cost of credit and by lowering the bank rate or the discount rate, it lowers down the cost of credit. The bank rate policy also affects the availability of credit by changing the conditions under which the Central Bank grants loans to the commercial banks. Thus the bank rate policy influences both cost as well as the availability of credit. (ii) Open Market Operations: Open market operations as a method of credit control developed only after the First World War. The term Open Market Operations is used in two senses. In the narrow sense open market operations imply the purchase and sale by the Central Bank of government, securities in the money market. Bank in the broad sense this term implies the purchase and sale by the Central bank not only of government securities but also of other eligible papers like bills and securities of private concerns. (iii) Variable Cash Reserve Ratio: This method of credit control requires variations in the cash

reserve ratio of commercial banks. It was first suggested by Lord Keynes who did much to popularize it as a method of credit control by the Central Bank. The theory underlying the method of Variable Cash Reserve Ratio is that by changing the cash reserve ratio, the cash reserves of the commercial banks can be directly changed, affecting thereby their ability to create credit in the economy. This can be illustrated by an example. Let us suppose that the commercial banks have excessive cash reserves on the basis of which they are creating too much credit. The Central Bank considers this over expansion of credit as harmful for the larger interests of the economy. So it will raise the cash reserve ratio which the commercial banks are required to maintain with the Central Bank. This will automatically sterilize a part of the cash reserves of the commercial banks and force them to curtail the creation of credit in the economy. In this way by raising the cash reserve ratio of the Commercial Banks, the Central Bank will be able to put an effective break on the inflationary expansion of credit in the economy.

Credit Control and its Objectives

The present day economy is referred as the credit economy because credit has come to play a predominant role in modern economic system. The over whelming majority of business transactions particularly in western countries are settled through the use of credit instruments by the parties concerned. Infact it would not be wrong to say that credit is the lift-blood of modern business. We are already aware of the fact that credit plays the same role in the economy as money. As such exchanges in the volume of credit have exactly the same effect on the internal price level as changes in the supply of money. It therefore becomes necessary to exercise some control on the creation of credit for the smooth functioning of the economy. A free and unlimited creation of credit by the commercial banks possesses a serious threat to the national economy. Hence it becomes necessary to keep the creation of credit under the control of Central bank. The central bank is the most appropriate body to control the creation of credit in view of its functions as the bank of issue and the custodian of cash reserves of member banks. OBJECTIVES OF CREDIT CONTROL The important objectives of credit control are given below. 1. STABILITY IN THE INTERNAL PRICE LEVEL As is well known, the economy of a country suffers a good deal as a result of violent fluctuations in the internal price level. Hence the main objective of credit control is to establish stability in the internal price level. If the supply of credit is less than the commercial requirements, there is sure to be decline in the price level. If on the contrary the supply credit exceeds the commercial requirements the internal prices are bound to rise up. Hence the commercial banks should try to bring about a proper adjustment between the supply of credit and the commercial requirement of the country. 2. CONTROL OF THE BUSINESS CYCLE As is well known, the operation of the business cycle causes an atmosphere of economic stability in a capitalist country. Hence the objective of credit control policies of the central bank should be to eliminate or at least to reduce the havoc caused by business cycle. By varying the supply of credit, the Central Bank can, to some extent, control the operation of the business cycle. 3. STABILITY IN EXCHANGE RATES Introducing stability in the foreign exchange rates can also be an objective of the credit control policy of the central bank. The instability in exchange rates can have harmful repercussions on the foreign trade of the country. Hence central bank in those countries whose foreign trade is

important should pay special attention to the elimination of violent fluctuation in foreign exchange rates through credit control policy. 4. STABILIZATION OF THE MONEY MARKET According to some economists, the credit control policy of the central Bank should aim at the stabilization of the money market in the country. To achieve this objective, the Central Bank should neutralize seasonal variations in the demand for funds. It should for example provide extra credit in times of emergencies. Infact the control on credit should be exercised by the Central Bank in such a manner as to bring about an equilibrium in the demand and supply of money at all times. 5. PROMOTION OF ECONOMIC GROWTH The objective of credit control policy is backward and under developed countries should be able to promote economic growth within the shortest possible time. Generally speaking the economic development in these countries is retarded an account of lack of financial resources. Hence the Central Bank in these countries should try to solve the problem of financial stringency through planned expansion of bank credit. 6. PREPARATION OF WAR Sometimes, the objective of the Central Bank is to prepare the country for war through expansion of credit to enable the government to meet its financial requirements. Modern wars are so expensive that it is not possible to meet their costs without adequate expansion of bank credit. During the Second World War almost every country resorted to expansion of credit on large scale to meet the rising war expenditure.

Role and Functions of State Bank of Pakistan

Immediately after partition the newly born stat was faced with a serious banking situation due to the who sale immigration of banking staff to India. The Reserve Bank of India showed reluctance in solving the banking crisis in Pakistan. It rather created further difficulties by refusing to give Rs. 55 Crore which Pakistan was entitled to share the cash balance of the undivided India. The Govt. of Pakistan then realised that the Reserve Bank of India cannot be relied upon and further dependence on it would endanger the very existence of Pakistan. It therefore decided to establish its own currency authority. The Governor General of Pakistan Quaid-e-Azam Muhammed Ali Jinnah issued order of establishment State Bank of Pakistan on 1st July 1948. According to State Bank order of 1948, the bank is entrusted with the duty of regulating the issue of bank notes and keeping of reserve with a view to seeking monetary stability in Pakistan and generally to cooperate currency and credit system of the country to its advantage. The order of 1948 has been substituted by State Bank of Pakistan Act 1956 which requires the bank to regulate monetary and credit system of Pakistan and to foster its growth in the best national interest with a view to secure stability and full utilization of the countrys productive resources. The functions of State Bank of Pakistan are governed by the State Bank of Pakistan Act 1956 State Bank of Pakistan will continue performing its four basic functions. (i) Framing and operation of monetary policy (ii) Regulations and supervision of banks and financial institutions (iii) Foreign exchange management (iv) Settlements of payment and accounts. The basic functions performed by State Bank of Pakistan are now discussed in brief as under. 1. STATE BANK AS A BANK OF ISSUE

The State Bank of Pakistan has the role right to issue notes except subsidiary coins which are issued by the Government. The Bank adopted the Proportional Reserve System for the issue of notes upto December 1965. The level of currency banking by gold bullion, foreign securities is now fixed 1200 million through an ordinance in December 1965. This system of note issue is known as minimum Reserve System. The size of notes issue reflects the public demand for money. The amount of notes in circulation can be increased to meet the public demand and are adjusted according to the general level of prices and economic activity in the country. The assets of the Issue Department are always equal to liabilities. 2. FRAMING AND OPERATION OF MONETARY POLICY The State Bank of Pakistan frames and operators the monetary policy. Monetary policy is conducted by the State Bank of Pakistan to regulate and control the volume of money and credit supply in the country in order to achieve specific economic objectives such as price stability, reducing unemployment, etc. The main instruments of monetary policy are (i) Open market operations (ii) Changing the reserve requirement and (iii) Changing the discount rate. (i) Open market Operations: Open market operations technique is used for expanding or contracting the money supply in the country. By buying the Govt. securities in the open market, the State Bank of Pakistan expands the money supply and by selling securities it contracts the money supply in the country. (ii) Changing the reserve requirements: The state bank of Pakistan also controls the money supply in the country by changing cash reserve requirements of the commercial banks. An increase in the cash reserve ratio reduces the excess reserves of the bank and curtails the powers of the banks to advance loans. The decrease in the cash reserve ratio increases the cash reserves of the commercial banks which increase the capacity of the banks to advance more loans. The State Bank of Pakistan now requires the scheduled banks to maintain at least 35% of demand and time liabilities with it. (iii) Changing Discount rate: The bank rate is the rate of interest at which the State Bank of Pakistan discounts the first class bills of exchange. The rise in the bank rate pushes up the cost of borrowing of commercial banks and reduces money supply in the country. A decrease in the bank rate works in the opposite direction. 3. REGULATION AND SUPERVISION OF BANKS The State Bank of Pakistan has full powers to supervise and control the banking system in the country. The regulatory powers relate to the licensing of banks, and their branch, expansion, liquidity of assets of banks, management and methods of working of the banks amalgamation and reconstruction and liquidation of banks, inspection of banks etc. 4. FOREIGN EXCHANGE MANAGEMENT The State Bank of Pakistan acts as custodian of foreign exchange reserves manages exchange control and external value of the rupee and acts as the agent of the government in respect of Pakistans membership of IMF. An important aspect of foreign exchange management is that all foreign exchange transactions are made at the official rate of exchange. It also maintains the exchange value of the rupee in terms of other major currencies of the world. 5. STATE BANK AS A CLEARING HOUSE The State Bank of Pakistan acts as Clearing House for the commercial banks. A clearing house is a place where representatives of commercial banks meet each day to exchange cheques drawn on each other and then settle the differences owed to each other. State Bank thus helps the commercial banks in making millions of payments by a minimum of transactions. 6. ADVISOR TO GOVERNMENT

The State Bank of Pakistan also acts as advisor to government in all financial matters. Since State Bank of Pakistan is directly involved in the money and foreign exchange markets, it, therefore, tenders advice on all economic matters. It also provides advice to commercial banks and other financial institutions and to commerce and industry in general. 7. LENDER OF LAST RESORT The State Bank of Pakistan is the lender of last resort for the commercial banks. It at any time the banks are short of cash reserves, the State Bank of Pakistan comes to their rescue. It provides cash to commercial banks by rediscounting bills of exchange and treasury bills. The State Bank of Pakistan thus helps and maintain liquidity ad solvency of the commercial banks. 8. STATE BANK AND ECONOMIC GROWTH The State Bank of Pakistan is playing a significant role in facilitating and fostering economic development and growth of banking system and other financial institutions in the country. The main development promotional activities of the Bank are as follows. (a) The development of the capital market in the country owes a great deal to the efforts made by the State Bank of Pakistan. (b) Under the State Banks Export Finance Scheme, the commercial banks provide finance to the exporters at the concessional rate. (c) The State Bank of Pakistan has helped in the establishment of specialized credit institutions for meeting the medium and long term credit needs of the various sectors of the economy. These institutions include IDBP, NIT, EPF (Equity Participation Fund), HBFC, ICP (Investment Corporation of Pakistan) Bankers Equity Limited, Pakistan Industrial Credit and Investment Corporation, Small Business, Finance Corporation etc. The following functions which the State Bank of Pakistan hade been performing and which involved public dealings have been transferred to the State Bank of Pakistan Banking Services corporation. The new corporation has started functioning from January 2, 2002 as a subsidiary organization of State Bank of Pakistan.

Bank of England as Mother of all Central Banks

After the abandonment of barter system the development in the monetary system started taking place. According to G. Growther the present day banker has three ancestors (1) the merchants (2) the gold smiths (3) the money lenders. When every money lender of gold smith issued receipts and most of them allowed the overdraft, there was then too much confusion in the banking system. The money lenders and gold smiths in order to earn profits could not keep adequate reserves for meeting the demands of the customers for cash. The failure on the part of the money lenders and gold smiths to return money caused wide spread distress among the people. In order to create confidence among the people, steps were taken to regulate the banking organization. A conference was held in Nuremburg in 1548. It was decided that a bank should be setup by the state which should streamline the banking organization. Accordingly central bank came into being. The central banks were of two types in the beginning (1) They were joint stock banks and later on they were aimed economic stability (2) They were setup for the implementation of the monetary policy so that purpose of economic stability could be attained. Accordingly the oldest central bank of the world the Risks Bank of Sweden was setup in 1668. The central bank of Britain the Bank of England was established in 1694 on modern lines, so that it could provide loans to govt. Hence it is called the mother of all enteral banks. It is called sp

because all the central banks of the world followed the same basic principles on which the Bank of England was established. In 1844 the notes issued by the Bank of England got the legal status. In this way it really became a central bank, because it got the power to issue notes (2) It assumed the role of governments bank (3) It obtained the power to control foreign trade and foreign transactions. Then later on it was accorded as last resort for the banks and bankers bank. These are the main functions which the central banks of the world performing at present. By assuming these powers and functions the Bank of England became the authority in money transactions and regularization of monetary policy. It became chief of money and banking system in England. The main objective before it was to attain economic stability of Great Britain. Therefore it was entrusted with complete monopoly powers regarding monetary control. After the establishment of the Bank of England the people of Great Britain started trusting the banking system. The confidence in banking system came into them. These are the reasons for which the Bank of England is being called the mother of all central banks of the world.

Central Bank
According to Prof. Shaw Central Bank is an institution which controls credit. While Prof. Hawtry says The main function of Central Bank is that it should serve as a last resort for commercial banks. In the words of R. P Kent Central Bank is an institution which perform the function of expansion and contraction of money supply. Prof. M. H De-Kock who wrote his esteemed book Central Banking defines central bank and its functions as Central Bank is a chief of money and banking system of a country. Therefore it possesses different types of powers to control money and banking of the country. In this respect it performs the following functions. 1. To control money supply in such a way that the needs of business enterprises and general public could be met. For this purpose it has complete or partial monopoly over issuing of notes. 2. It provides the same services to the govt. which are provided by commercial banks to their customers. 3. It supervises the cash reserves of commercial banks. 4. It is a custodian of foreign exchange and gold reserves of the country. 5. It is bankers bank it discounts the bills of exchange serves as last resort of banks, particularly when they do not have any source to get the loan. 6. It settles the accounts between commercial banks. 7. It controls credit in accordance with the needs of the country that the monetary policy could effectively be used. Keeping all these definition in view the central Bank may be defined as the apex banking and monetary institution whose main function is to control regulate and stabilize the banking and monetary system of the country in the national interest.

Functions of the Central Bank

The functions of the Central Bank differ from country to country in accordance with the prevailing economic situation. But there are certain functions which are commonly performed by the Central Bank in all countries. We have mentioned above such functions of the Central Bank narrated by De-Kock. Now let us discuss all these functions in detail. 1. Monopoly Over issuing Notes: The main objective of a Central Bank is to attain economic

stability. Therefore, it has been entrusted with complete or partial monopoly powers regarding issuance of notes. This is the basic function of Central Bank. Because of this function they have been accorded as Bank of Issue for a long time. 2. Banker, Agent and Advisor to the Government: Central Bank provides same services to govt, which are provided by the commercial banks to their customers. As Central Bank keeps the deposits of all the govt. departments. Again the govt. expenditure is made through Central bank. As the salaries, pensions are paid to govt. employees from the State Bank of Pakistan in our country. Central Bank advances short term loans (for 3 months) to govt, so that during such period govt may be able to have revenues in the form of taxes etc. Again Central bank helps govt. during wars and emergencies however central bank advances govt. for commodity operations where govt. has to purchase goods in bulk of amount. To have the public debt central bank serves as an agent to govt. It sells and purchases govt. securities it provides advisory services to govt. It guides govt. regarding different economic issues like devaluation of currency, adoption of fixed or flexible exchange rate system etc. It keeps a close link with the money market of a country. It helps govt. in making the decisions regarding amount of credit, targets of credits and allocation of credit in different sectors and regions. It is central bank which coordinates between fiscal and monetary policies so that the broader economic objectives could be realized. 3. Custodian of Foreign Exchange and Gold Reserves: Most of central bank has to keep gold while issuing notes. As a result all the gold reserves of a country are placed with the central bank. In addition to gold the foreign exchange reserves are also with central bank because most of countries have to exercise exchange control whereby the citizens of a country can not keep foreign exchange with themselves. Moreover the citizens of a country who are need of foreign exchange have to get it from central bank. All this means that whole of the foreign exchange reserves are in the possession of central bank. 4. Banker to Commercial Banks: Central bank is a banker to banks. Therefore it is the function of a central bank to establish a suitable and proper type of banking structure in the country. In this way, not only credit requirements of different sectors could be met, but the central bank could also be able to have a greater control over the activities of a commercial banks. Therefore all the commercial have to keep a certain proportion of demand and time deposits with central bank. With such reserves the central bank can influence the credit activities of commercial banks. The central bank recounts the bills of exchange offered by the commercial banks. In this way it provides loans to commercial banks. It also serves as a clearing house for the commercial banks. 5. Lender of the last Resort: The central bank serves as last resort for the commercial banks particularly when they do not have access to other sources. In addition to commercial banks, it also serves as lender of last resort for govt. 6. Controller of Money Market: The utmost function of central bank is to control money and credit, particularly it has to peek an eye on credit expansion. The changes in money and credit do have a variety of effects on the economy. Whenever the supply of money and credit exceedingly increase the purchasing power of money will decrease, leading to create inflation. Therefore, the central bank ahs to control credit for the sake of controlling inflation. For this purpose it exercises the monetary management. While during inflation central bank has to follow an easy monetary policy for the sake of removal of deflation.

Importance of Central Bank

Basically the central bank of govt. therefore it improves exchange control which leads to efficient allocation of foreign exchange. When foreign exchange is opimally allocated, all such will have a positive effect on agri and industrial outputs. Thus output and employment will increase. Consequently, central bank will be helpful in taking the economy on the path of economic development. It is the central bank which controls and regulates the foreign exchange and foreign exchange rates, if central bank realises that the countrys balance of payment is deficit it can suggest to the govt to devalue the currency. Because of the devaluation the exports of the country will be cheaper while imports expensive. In this way, export surplus could be used for economic development. Central bank gives suggestions and opinions to govt. regarding different economic issues. It issues reports regarding sectors of economy. It keeps the deposits of govts foreign exchange and gold reserves of countries. It makes the training of banking personnels, acquaints them with modern trends of banking, it arranges for seminars, refresher courses and work shops. Such all may be accorded as investment in man which will contribute to the economic growth.

Importance of Industrial Development Bank

The Industrial Development Bank of Pakistan is one of the leading financial institutions of Pakistan. It was established in 1961. Prior to nationalization of banks in January 1974 the IDBP had a paid up capital of Rs. One billion of which 51% was held by the Federal Government and rest by provincial governments, commercial banks, insurance companies and other Pakistan private investors. On nationalization of banks, the entire share capital previously held by private individuals and other institutions was transferred to Federal Government. A unique feature of IDBP now is that it is also a scheduled bank and an authorized dealer of foreign exchange. The IDBP thus operates as a full fledged commercial bank in addition to its role as a developmental financial institution. In 1989 the IDP began to provide universal banking fascilities to its clients. As a universal bank IDBP is committed to diversification of its banking business. It is providing combination of commercial banking and investment banking services to its clients. It is maintaining close links and having extensive consultations with its customers in private sector. The IDBP operates in frame work of the development programme for the private sector. Its prime objective is wide diffusion of credit and broad based ownership for creating middle class of industrial entrepreneurs. In order to obtain its objectives, the IDBP, it performs the following functions. (i) Provides medium and long term loans in local and foreign currency for the establishment of new industrial units and for modernization and replacement of existing units in the private sector. (ii) Guarantee loans, debts and credits raised or incurred by an industrial concern. (iii) Undertakes complete commercial banking business. (iv) Undertakes merchant banking business (under writing of public issue of shares, leasing etc.) (v) Administers the Equity Participation Funds. (vi) Acts as refinancing agency in respect of the world. Bank and Asian Development Bank, Credit to small scale industrial units. (vii) Extends consultancy and technical assistance service to clients in the execution and management of projects.

The financial health of the IDBP is not satisfactory at present. It is facing serious problems of non-payment of loans. This has adversely affected the profitability and liquidity of the Bank. The major factors contributing to its low performance are (i) inadequate legal and judicial system (ii) deteriorating culture system (iii) general slow down of the economy (iv) adverse impact of sanctions, etc. The IDBP had equity of Rs.907 million as on June 2003 against which the total losses stood at about Rs.24 billions. The bank has also failed to maintain the required paid up capital up Rs. 1 billion. The new focus of Bank is to shift the operational emphasis to commercial banking operations. Emphasis is also being laid on providing export finance and meeting the sunning financial needs of the existing industrial projects.

Agriculture Development Bank

Zarai Taraqiati Bank formerly known as Agriculture Development Bank of Pakistan is now one of the main credit supplier to the agriculture sector in the country. It was established in 1961 by the merger of Agriculture Development Finance Corporation (ADFC) and the Agriculture Bank of Pakistan (ABP). The Zarai Taraqiati Bank (ZTBL) or Agricultural Development Bank of Pakistan has its head office in Islamabad. It concentrates on modernization of agriculture, increased farm productivity with emphasis on the provision of credit to small farmers and rural women. The credit is provided to the farming community for the purchase of primary inputs like fertilizers, pesticides, machinery, poultry farming, dairy farming etc. It aims at rural selfemployment and poverty reduction of the farmers in the villages. The ZTBL advances short, medium and long term loans to the farmers. The short term loans are given for financing the cost of raising, processing and marketing of crops and other agro based industries. The medium term loans are provided for the purchase of agricultural implements, levelling of land and setting up of agro-based industries. The long term loans are provided for the purchase of tractors, installing of tube-wells, construction of ware houses etc. The various loan operation of given below. 1. DISBURSEMENT OF LOANS Total agricultural loans amounting to Rs. 93 Billion were disbursed to the farming community for the purchase of primary inputs, tractors, poultry and live stock sector in 2004-05. Its share in the supply of total agricultural credit was 34.1%. 2. ROLE IN POVERTY REDUCTION ZTBL is supplementing the Governments programme for poverty alleviation. It is providing financial assistance to rural poor in (i) Credit programme for women and (ii) Micro credit scheme. 3. FARM MECHANIZATION AND WATER RESOURCE DEVELOPMENT The ZTBL is helping the Government for increasing farm productivity and achieving selfsufficiency in food production. For achieving this objective, the Bank has played a Key role in providing finance for the purchase of tractors, installation of tube-wells, threshers, combine harvesters and other farm implements which help in increasing farm yields. 4. ONE WINDOW OPERATIONS The provision of loans to the farmers at one place is the most successful scheme of the Bank. The small farmers holding 26 acres of irrigated land or 50 acres of un-irrigated land are getting benefit under this scheme. 5. CREDIT TO WOMEN PROGRAMME

The main object of this scheme of ZTBL is to make credit available rural women through female Mobile credit officers. The Bank under this scheme has disbursed very large amount in rural women for farming and non-farming activities such as poultry, fishery, orchard, forestry etc. 6. MICRO CREDIT SCHEME The ZTBL has launched Micro Credit Scheme since 2000 to engage rural poor in increasing income through engagement in cottage industries. 7. REVOLVING FINANCE SCHEME This scheme is operational since 1999. Under this scheme the loan is provided to the credit worthy of farmers for meeting the seasonal agricultural requirements.

Causes of the Failure of Banking System

If we look into the banking system of Pakistan, we find several causes of its failure. The main causes of the failure of the system are discussed below. The number of bank office in Pakistan is yet not adequate. For this reason people can not enjoy the fascilities which banks can offer. In the absence of banks, people do not get encouragement for saving and capital of country does not grow. The credit Inquiry commissions report in Pakistan revealed the in adequate banking fascilities in the country. It revealed that there is only one bank office per 1,50,000 people. But in USA and the UK there is one bank office per 7,000 and 4,000 population respectively. The scheduled banks in Pakistan advance loans in greater number. This difference in the distribution of banking fascilities is a sign of defect in our banking system. There should be adequate number of banks in the country to encourage people to saving habit and to extend credit to the industrialists, agriculturists, traders, and other needy people for the development of the country. The banks of Pakistan must launch campaign to popularize, the banking habit. Because our people do not have the banking habit, i.e. they are not acquainted with the valuable services that banks can render them. Secondly Pakistan has no developed money market. The money market in Pakistan is undeveloped due to the absence of the bill market. Without a developed bill market, the central bank cannot effectively control the credit system adopting open market operation. Besides the bank rate policy of central bank cannot be operative if the money market is not well-developed and well integrated. Thirdly the large concentration of credit with a limited number of industrialists of bigger means is another defect in our banking system. According to the report of the Credit and Inquiry Commission banks advance loans only to the bigger industrialists. So credit is inadequate to small business industries. Fourthly the seasonal fluctuation in the volume of credit is another defect which is the cause of failure of our banking system. Lastly seasonal variation and wide fluctuation in the rate of interest is another important problem of our banking system. During excessive demand for accommodation in the busy season of sowing and harvesting associated with festival and marriage season has been invariably followed by higher rate of interest. It is obvious from the above points that our banking system has some defects due to which it is failed. These defects may be removed if the following measures are taken. (i) Adequate number of banks should be opened in the rural areas of the country. If banks are opened in rural areas, villagers will get fascilities to save their small income depositing the same in the banks. At present National Bank of Pakistan is being given subsidy with a view to encouraging it to open branches in backward areas of the country. Other banks should also be

given such subsidy. (ii) To give loans to small industrialists the branches of specialized financial institutions should be set up and the State Bank of Pakistan should adopt such policies which will help the flow of credit from undesirable to desirable channels. (iii) To avoid the seasonal fluctuations of the volume of credit the State Bank of Pakistan in cooperation with the other banks should try to solve this seasonal stringency. It should be noted that the present banking structure of Pakistan stands on stronger footing. The Government of Pakistan and State Bank of Pakistan are trying to improve the banking system of the country. It may be hoped that within a very short period the banking system of our country will be able to keep pace with the banking system of developed countries.

Capital Market
As the name denotes the capital market is a market of capital funds. Accordingly by capital market we mean such a market where the transactions for new capital are made. Therefore the capital market is consisted of people and institutions which become helpful in raising new capital. The financial institutions provide loans to those sectors of the economy where their capital is protected and the income from such advancing is sure and well estimated. The capital market is sub-divided into (1) Primary Market and (2) Secondary Market The primary capital market is concerned with the sale and purchase of new securities. The new securities are issued for the first time. While the secondary capital market is concerned with the sale and purchase of even the old and already issued securities. The financial institutions which are the components of money market make the transactions regarding monetary assets, monetary instruments and near monics. The purpose of such all instruments is to raise funds directly and indirectly. In this way capital market not only becomes a source of capital availability but it also leads to a better allocation of capital. Thus it serves as a ready market for those who wish to borrow or who wish to supply funds. The borrowers and lenders do not have to search out each other. Thus though money market a better relationship comes into being amongst the borrowers and lenders. In this way gap between demand for money and supply of money gets shortened. According the capital market promotes investment in a country. MAIN INSTRUMENTS OF CAPITAL MARKET The capital market instruments are debt and equity instruments. These instruments are not liquid in nature and have maturities more than one year. The principal capital market instruments are (1) Shares (2) Debentures (3) Mortgages and (4) Securities of the government. These instruments used in the capital market are discussed as under. (1) Shares: Finance is essential to any business. The larger the business grows, the wider the sources of finance should be available to it. A public company raises capital through the sale of shares called equity financing and by borrowing named as debt de-financing. Shares are the equity claims on the net income and assets of a company. The holders of ordinary shares or equity shares are the real owners of the company. In case of bankruptcy claims of share holders are paid only after the other claims have been paid. (2) Debentures: Debenture is a long term loan to the company with a very strong credit rating. Each year debenture holders receive a fixed rate of interest whether a company is making profit or not if the company goes bankrupt, the debenture holders must be paid before any other claim is met.

(3) Mortgages: Mortgages are long term loans provided to individuals, firms against tangible security. When the loan is not paid in accordance with the terms of loan the title of the property is transferred to the creditors. The commercial banks and specialised financial institutions are actively engaged in providing long term loans to business in Pakistan. (4) Federal Investment Bonds: The Government of Pakistan mobilizes long term loans by the sale of Federal Investment Bonds having a maturity of 15 to 20 years. The objective of introducing this debt instrument is to mobilize private savings, contain inflationary pressure in the economy by absorbing funds of the financial sector and also to provide investment opportunities to the financial institutions.

What is Money Market?

Money market consists of all those institutions which raise short term funds. The short term borrowers consist of businessmen, whole-sellers, investors and firms. Thus money market is a market of short term transactions and the activities of this market comprise of discounting houses, commercial banks and central bank. Short run money market is concerned with the running and existing business. It is so because that the small firms borrow for short term loans to run their business. The short term funds are obtained from organised money market and unorganised money market. The organised money market consists of commercial banks while the unorganised money market consist of money lenders, Artihiyas, relatives and friends. In short run the funds are raised against financial documents, bills of exchange and short term securities. The commercial banks not only discount the bills of exchange, but also advance loans against mortgages. Thus the money market consist of govt. commercial banks, money lenders, brokers, businessmen firms etc. In money market the resources are raised from the whole economy and then are channelized into different sectors of the economy. INSTRUMENTS OF MONEY MARKET The main short term debt instruments traded in the money market are as follows. (i) Treasury Bills: The treasury bills are the short term debt instruments issued by the central bank of a country. They are always issued on discount basis and the period of maturity ranges from 3 months to 12 months. The government of a country pays a set amount at the maturity of the bill and have no interest payment. The state Bank of Pakistan has been actively engaged in the market oriented monetary policies it is pursuing open market operations in order to manage government debt and the reserve money. Since 1998 the State Bank of Pakistan has introduced market treasury bills of 3, 6 and 12 months maturity. Treasury bills are the most liquid of all the money market instruments. They are also the safest among all of them as there is no possibility of default in them. The federal Govt: is always able to meet its debt obligations. (ii) Bill of Exchange: Bill of exchange is another important short term debt instrument. The commercial banks advance loans by discounting bills of exchange of their client. These loans are granted to meet the working capital requirements of the firms. (iii) Call Loans: Call loans are loans which are granted for a very short period not exceeding 15 days in any case. Bill brokers and dealers in the stock exchange generally borrow money at call from the commercial banks. The borrowers have to repay the money immediately whenever the banks call these loans back. No collateral securities are needed against these loans. Some times the lenders and borrowers of call loans are commercial banks only. The banks with

surplus funds lend to the banks with credit funds for a day and are renewable on day to day basis. (iv) Bankers Acceptance: A bankers acceptance is a draft issued by a firm upon a bank and accepted by it. The bank here is required to pay to the order of a specific party or to the bearer a specific sum of money at some future date. Banker s acceptances are used mostly in financing the commercial transactions both drafts can be sold or discounted in the money market named acceptance market. (v) Repurchase Agreement (Repos): Repos re short term loans which usually mature within less than two weeks. Here the treasury bills serve as security for the loans. Repos are important source of bank funds.

Remedies to Remove Defects of Money Market

1. Uniformity be brought in the policies of all financial institutions of the country and they be brought under the complete control of State Bank of Pakistan. 2. Activities of saving institutions FCP and NIT by published widely. The share holders be exempted from income tax. The people be acquainted with the securities, shares and stocks etc. 3. Branches of Banks and financial institutions be opened in the small towns and villages so that the villagers could borrow. Moreover to promote savings different schemes be introduced. 4. The banking system be modernized, the conservative banking be replaced by modern banking, and the inefficient personnel be replaced by efficient bankers and financial experts. 5. While recommending and approving the cases the feasibility of projects be entertained, rather considering the political will and affiliation. The strict policy be followed regarding recovery of old debts. 6. The cheap credit policy be followed in organised money market. In this way the unnecessary demand for loans will come to an end, the savings will be promoted end inflow of foreign capital will increase.

Defects of Money Market

Our money and capital market is prey to financial dualism. It means that we have two types of money market. (1) Organised money market (2) Unorganised money market The organised money market consists of (i) State Bank of Pakistan (ii) Commercial Banks (iii) Cooperative banks (iv) Financial institution (v) Insurance companies. While unorganised money market consist of (i) Money Lenders (ii) Brokers (iii) Businessmen and merchants (iv) Friends and relatives (v) Land lords. Following are the major properties of our unorganised money market. (a) There is direct link between borrowers and lenders. (b) The account system is very simple and crude. (c) The repayment of the loan is also made in the form of grains. (d) Financial deals are often kept secret. (e) The rate of interest is high. (f) It deals with the small businessmen and agriculturists. It means that the major share of domestic population is out of jurisdiction of organised money market. (g) There is meagre transfer of resources from both markets.

Because of the problems mentioned above our money market is highly fragmented and it has led to create the following problems. (1) There is reduced use of cheques. People do not know much about the modern financial documents like cheques, drafts, securities and debentures. (2) The transactions particularly in the villages are non-monetary rather than monetary. (3) Because of difference in markets there prevail centuries old methods of savings i-e people make their savings in the form of silver, gold and land etc. People hardly know the investment opportunities. The villagers have never heard the name of stock exchanges which are confined to just Lahore, Karachi and Islamabad. The villagers keep their monks with the land lords, money lenders and such other people and get back whenever they are in need of it. The money lenders, land lords and arthiyas do not pay any interest against such deposits. On the other hand, the charge heavy interest against the loans borrowed from them y the poor peasants and tenants. (4) The stock exchange, ICP, NIT like financial institutions are confined to big cities only. In addition to them commercial banks and specialized credit institutions are also situated in big cities. The urban residents deposit their amount and borrow from these institutions. Where as there are reduced banking fascilities in the village, they neither have the inspiration ot save nor they can avail the opportunity to borrow from banks. (5) Because of the separate markets there exists a big difference in the rate of interest. In the organised money market the rate of interest is low, the borrowers has the greater opportunities to borrow, the commercial banks can enhance their resources by borrowing from Central Bank, World Bank or selling their shares, the commercial banks follow the bank rate while setting their interest rate, and the central Bank is a chief organised money market, on the other hand, the rate of interest is very high in case of unorganised money market, the lenders provide the loans in a very limited amount, the loans are advanced under very strict conditions and the mortgages are hardly offered by the borrowers. (6) The arthiyas, money lenders and land lords have monopoly power in unorganised money market. The poor peasants and small traders are at their money. The poor farmers are found very much weak when we find the element of uncertainty in agriculture sector. The uneconomic holdings, big families, disguised unemployment and the natural clamities greatly torture the farmers. In such state of affairs who will lend them? No to talk of commercial banks, the agricultural and cooperative banks are found hesitant in advancing the loans to farmers. (7) The poor businessmen and farmers not only have to pay heavy interest rate, but also they do not have any share in the foreign exchange reserves of the country where as the small farmers and traders greatly contribute to the earnings of foreign exchange through exportation of cotton and rice etc. Such foreign exchange is allocated to big businessmen who are concerned with organised money market. (8) Despite shortage of foreign exchange in the country and deficit in the Balance of Payment, the cheap credit money policy is adopted. The exchange rate is artificially kept at low level by following exchange controls. In this way the divergence between organised and unorganised money market widens. The policy of lower rate of interest benefits the big businesses and industrialists, which promotes the unequal income distribution in the country. But because of lower interest rate, the level of savings remain low, demand for loanable funds remain high and the inflow for foreign capital also remains low. The rate of interest deliberately kept at lower level of the organised money market, even below the bank rate. (9) After 1959s credit commission recommendations 1974s nationalization of Commercial banks and establishment of NCCC is was hoped that agri sector will be able to have a greater

share in the distribution of credit. But statistics reveal that the major share of agri loans is taken away big the big land lords while the small farmers have a meagre share in agri credit. (10) All the specialised credit institutions in the organised money market are directly or indirectly government controlled. But these institutions and corporations are furnished by official formalities. People are hardly aware with the modern concepts of money and savings. The broker class is hardly available which could create a link between the saves and investors. The Commercial bank and Corporation follow discriminatory policies. They are kind to big businesses because they think that this class makes the productive investment. While the poor farmers and traders spend the borrowed money on unproductive fields like marriages, liligation and social taboos. According to Prof. Hala Mynt the banking procedure and rigid law of banks serve as big obstacle in the way of advancing to backwards sector. To provide loans to agri sector the banks have to face heavy expenses and they are not hoped to get them back.

Nature and Functions of Commercial and Specialized Banks

Banking system in Pakistan can not be said to be highly developed. Before the partition of British India, the area which is now Pakistan had a well organized banking system. But after partition all banks transferred their head offices to India. Pakistan at first had no Central Bank. The Reserve Bank of India acted as the Central Bank of Pakistan. In 1948 the State Bank of Pakistan was established and it has been serving since then as the Central Bank of Pakistan. Now the country has many commercial banks. There are several specialized banks also. Following is the outline of banking system in Pakistan. 1. CENTRAL BANK OR STATE BANK OF PAKISTAN At the top of banking system of Pakistan stands the State Bank of Pakistan. The State Bank of Pakistan is the guardian of the Monetary and Banking system of Pakistan. It is the pivot around which the whole banking system evolves. It controls the money and credit of the country with a motive of security and the stability of prices. It acts as bankers bank and Governments bank. It regulates the banking activities of Pakistan. 2. SCHEDULED BANK In Pakistan there are two types of scheduled banks namely (i) Pakistan scheduled banks and (ii) Foreign scheduled banks. A Pakistani scheduled bank is one which is owned by Pakistan and is incorporated in Pakistan. Again Pakistan scheduled banks are of two types (a) banks which are owned by private individuals e.g. Habib Bank Ltd, the Muslim commercial bank ltd, United Bank Ltd etc. and (b) The banks owned by Government e.g. the National Bank of Pakistan. A foreign scheduled Bank is one which is incorporated in a foreign country, such the city Bank and American express Bank etc. These banks usually collect the floating capital of the public and finance the short term needs of commercial transactions. They not only deal in commercial transactions, they have also wide field beyond this scope. They advance loans for investment purposes and often they advise the public in purchasing and selling shares, properties and securities. They lend money to the businessmen, manufacturers etc, by way of discounting bills and creation of overdraft. They also play an important role in the economic development of the country and render valuable services to the community. 3. SPECIALIZED BANKS Some specialized financial institutions have been setup in Pakistan with a view to provide the credit requirements to different sectors of economy. Agriculture Development Bank of Pakistan,

Industrial Development Bank of Pakistan, House building Finance Corporation of Pakistan etc are such specialized institutions which have been established to provide credit for agriculture, industry, housing and settlement respectively. There are also some co-operative and land mortgage banks in Pakistan which provide credit to the agriculturists. 4. EXCHANGE BANKS There are some exchange banks in Pakistan. They play a vital role in financing the foreign, trade of the country. The facilitate the export and import by selling and buying bills of exchange. They also help in liquiding the international indebtedness of the country by exporting and importing metals and securities. 5. SAVING BANKS Saving banks are no more separately existing in the real sense, there are Post Office Saving and National Saving Centre which operate as saving banks in Pakistan. They accept deposits from public and invest them in various Government projects. Its operation therefore is very limited. 6. SPECIALIZED CREDIT INSTITUTIONS Specialized credit Institutions are generally the Government sponsored corporations. These provide medium and long term finance to various public sector organizations. In these institutions are Investment Corporation of Pakistan (ICP), Equity Participation Fund (EPF), Bankers Equity Limited (BEL), National Investment Trust (NIT) etc.

Kinds of Credit Instruments

Some of the important and country used credit instruments are discussed here in brief. 1. Cheque: A cheque is defined by Section 6 of the Negotiable Instrument Act as a bill of exchange drawn on a specified banker and not expressed to be payable otherwise than on demand. In other words it is a bill of exchange drawn on a banker which is payable on demand. 2. Bills of Exchange: A bill of exchange has been defined under section 5 of the Negotiable Instrument Act as an instrument in writing containing an unconditional order, signed by the banker directing a certain person to pay certain sum of money, only to or to the order of the certain person or to the bearer of instrument. A bill of exchange may be (a) inland (b) external or foreign bill. The former bill is a bill which is payable in Pakistan. The latter means a bill payable either to foreigner or by foreigner. It is very important instrument. Without making actual payment, goods can be purchased. Secondly in foreign trade, it enables an exporter to get value for his export in his own currency. Thirdly it saves cost of transporating precious metals, only the different being transferred. 3. Promissory Note: A promissory note is defined by Section 4 of the Negotiable Instrument Act as an instrument in writing (not being a bank note or currency note) containing an unconditional undertaking signed by the maker to pay a certain person or to the bearer of the instrument. Promissory notes are commonly used and these may be termed as credit instrument A businessmen borrowing from a bank customarily gives the bank such a note. Sellers of goods and services may accept such a note instead of cash Individuals who borrow for person needs usually give promissory notes to tenders. 4. Drafts: These are bills of exchange issued by a banker on his branch office. Same rules are applicable as are applicable to the cheques. Bank drafts like bills of exchange are of great in pretence in the financing of trade, especially foreign trade. 5. Hundies: These are bills of exchange in Vernacular Language, which have been in common use in our country for purpose of business from at least the 10th century A.D and which have

been recognised by law as valid and effective negotiable instrument. 6. Letters of Credit: IT is a letter written by one person or bank to another requesting the latter to pay any amount of money up to certain limit to the person named in the letter or in whose favour the letter is written. In this letter generally a date is fixed up to which only advances should be made by the addresses. Thus a letter of credit remains in force up to a certain date only. Generally these letters are issued by banks. 7. Circular Letters of Credit: This letter is different from the letter of credit for it is addressed to several branches of the issuing banker. The amount of credit can be taken in cash or against bill of exchange drawn, which depends upon the condition of letter. The addresses are required to inscribe on the bank of the letter all advances that they make. 8. Travellers Cheque: Such cheques are very useful to tourists or travellers, for against delivery of these, holders can obtain funds from any branch. Every cheque is of a fixed amount already printed on it. The cheque form has a place where the grantee has to sign in the presence of the payee banks. When these cheques are granted by issuing banker, the grantee is asked to sign all these cheques in his presence. This enables the paying banker to compare the signatures and ascertain that the payment is made to the sight person. 9. Treasury Bills: In sub-continent, for the first time, these bills were issued by the Government on 5 November 1790 to raise money for war purposes and are issued even now. Then they were made also legal tender for all payments to the Government. 10. Book Credit: Book credit are effected when a tradesman sells on credit or a bank advances money, the sale or advance being entered into the account books for the tradesman or of the bankers.

Functions of Commercial Banks

Commercial Banks act as intermediaries between those who have surplus money and those who need it. To receive deposits and advance loans are thus two main functions of all commercial banks. In short they borrow to lend. They borrow in the form of deposits and lend in the form of advances. Besides there are other incidental functions which have developed according to the needs of society. We discuss all of them below. 1. ACCEPTING DEPOSITS Banks attract the idle savings of people in the form of deposits. These deposits may be of any of the following types. (a) Demand Deposits or Current Accounts: There are repayable on demand without any notice. Usually no interest is paid on them; because the banks cannot utilize short term deposits and must keep almost cent percent reserve against them. On the other hand a little commission is charged for the service rendered. Occasionally, however a small interest is paid to the people who keep large balances. (b) Fixed deposits or time deposits: These deposits can only be withdrawn after the expiry of the period for which these deposits are made. Higher interest is paid on them, the rate rising with the length of the period and the amount of deposit. (c) Savings Bank Deposits: These deposits stand midway between current and fixed accounts. One or two withdraws up to a limit of one fourth of the deposit is allowed in a weak. The rate of interest is less than on fixed deposits. 2. GIVING LOANS Receiving of deposits is not the whole story about a banks function. It that were so, how could a

bank pay interest? Hence after collecting money, a bank invests it or lends it out. Money is lent to businessmen and traders usually for short periods only. This is so because the bank must keep itself ready to meet the demand of the depositors who have deposited money for short periods. Money is advanced by banks in any one of the following ways. (a) By allowing an Overdraft: Customers are given the right to over-draw their accounts. In other words they can get more than they have deposited, but they have to pay interest on extra amount which has to be repaid within a short period. The amount of permisable over draft varies with the financial position of the borrower. (b) By Creating a Deposit: Cash-credit is another way of lending by banks. When a person want a loan from a bank, he has to satisfy the manager about his ability to repay, the soundness of his venture and his honesty of purpose. After that the bank may require a tangible security, or it may be satisfied with borrowers personal security. Usually such security is accepted as can be easily disposed of in the market e.g. government securities or shares of approved concerns. The details of time and rate of interest are settled and the loan is advanced. A borrower rarely wants to draw the whole amount of his loan in cash. Usually he opens a current account with that amount in bank, if he has already not got an account with this bank. Now it is exactly as if that sum had been deposited by him. This is how a deposit is created by a bank. That is why it is said every loan creates a deposit. After the period for which the money has been borrowed is over, the borrower returns the amount with interest to the bank. Banks make most of their profits thus by giving loans. (c) Discounting Bills: Discounting of bills is another way of lending money. The banks purchase these bills through bill brokers and discount companies or discount them directly for the merchants. These bills period a very liquid asset (i.e. asset which can easily be turned into cash). The banks immediately pay cash for the bill after deducting the discount (interest) and wait for the bill to mature when they got back their full value. The investment in the bills is quite safe, because a bill bears the security of two businessmen the drawer as well as drawer, so that if one proves dishonest or fails, the bank can claim money from other. This is regarded as the best investment by the banks. It is liquid, lucrative and safe. This is why it is said that a good bank manager knows the difference between a bill and mortgage. 3. REMITTING FUNDS Banks remit funds for their customers through bank drafts to any place where they have branches or agencies. This is the cheapest way of sending money, it is also quite safe. Funds can also be remitted to foreign countries. 4. MISCELLANEOUS FUNCTIONS Beside these main functions, the banks perform several other functions as given below. (a) Safe Custody: Ornaments and valuable documents can be kept in safe deposit with a bank, in its strong room fitted with lockers, on payment of a small sum per year. Thus risk of theft is avoided. (b) Agency Functions: The banks works as an agent of their constituents. They receive payments on their behalf. They collect rents, dividends on shares etc. They pay insurance premia and make other payments as instructed by their depositors. They accept bills of exchange on behalf of the customers. They pass bills of lading or railway receipts to the purchasers of goods when they pay for them. The amount is passed on to the suppliers. Banks also collects the amount of utility bills from customers of different utility agencies. (c) References: They give references about the financial position of their customers. When required they supply this information confidentially. This is done when their customers want to

establish business connections with some new firms within or out side the country. (d) Letters of Credit: In order to help the travellers, the banks issue letters of credit. A man who is going abroad takes with him a letter of credit from his bank. It is mentioned these that he can be paid sum up to a certain limit. He shows this letter to banks in other countries which make the payment to him and debt the bank which has issued the letter of credit. (e) Collection of Statistics: The modern bank collects statistics about money, banking, trade and commerce and publishes them in the form of pamphlets and hand outs. This helps the banks customer in acquiring knowledge about the latest economic situation on the basis of which they can formulate their business policy. (f) Under writing Services: Some time private companies issue debentures for public sale. But the public may hesitate in buying these debentures unless they are under written by the banks. The public has full confidence in the banks. If debentures carry the signatures of a bank, the public would not hesitate in buying them. For under writing these debentures, the bankers charge a small underwriting commission from the companies. (g) Advice of Financial Letters: Since the bank is fully acquainted with the economic situation in the county, it is in a position to render useful advice to its customers on financial matters. UTILITY OF BANKS An efficient banking system is absolutely necessary for a country. It is to prosper commercially the services that an efficient banking system can render a county cannot be exaggerated. The banking system can be useful in the following ways in addition to what has been mentioned above in the functions of banks. 1. The banks create instruments of credit: The banks create instruments of credit which serve as very convenient substitutes for money. This means a great saving. 2. The Banks increase the mobility of capital: They bring the borrowers and the lenders together. They collect money from those who can not use it and give it to those who can. They thus help the movement of funds from place to place and form person to person in a very convenient and inexpensive manner. 3. The bank encourage the habbit of thrift: One of the requisite conditions of saving is that there should be channels of investment so long as money is kept in one pocket, the chances are that it will be spent and not saved. But if it is put in the bank, it is out of sight and to be out of sight is to be out of mind. The chances are that it will remain in the bank. 4. Accumulation of Capital: By encouraging savings, the banks bring about accumulation of large amounts of capital in the country from small individual savings. In this way they add to productivity of the resources of the country and contribute to the general prosperity and welfare. In a word banks are indispensable not only to maintain economic activity i.e. consumption, production, exchange distribution but also for promoting economic development.

Bank and its Types

Every thing with which we are much familiar, is difficult to be defined. The paradox applies to the bank also. We are much familiar with bank in our daily life, but when it comes to definition, one is bound to keep silent. Different people have defined bank in different ways. In simple and direct words, we think of a bank as an institution which accepts deposits from public and lends money. People either for the sake of safety, or for the sake of income in the form of interest or for both, like to deposit their money with the banks. Banks accept their deposits on interest and lend it to other people on a higher rate of interest, thereby earning profit for themselves. In this

contex we may refer to the following definitions. According to code of exchange Bills (1892) of England In a bank we include every person, firm or company having a place of business where credits are opened by deposits or collection of money or currency, subject to be paid or remitted on drafts or cheques or orders or money as advanced or loaned on stocks etc. According to Kinley Bank is an establishment which makes to individuals such advance of moey as may be required and safely made and to which individual entrust money when not required by them for use. As per Sayer ordinary banking business consists of changing cash or bank deposits and bank deposits for cash, transferring bank deposits from one person or corporation (one depositor) to another, giving bank deposits in exchange for bills of exchange, government bonds, the secured or unsecured promises of businessmen to repay etc. Gantur Says The word Bank express the business which consist in efficient an account of others receipts and payments buying and selling, either money or gold and silver or letters of exchange and drafts, public securities and shares in industrial enterprises - in a word all obligations whose creation has resulted from the use. Thus in simple words we may say that bank is an institution dealing in money and credit. It is an institution which receives money as deposits, lend money on credit. IOU promises to pay on its customers, orders and there are accepted by other people in payment of their debts. A bank buys the credit off their customers and it sells its own credit too its customers. Since people deposit their money with the bank, the other people who know it, regard them credit worthy and if bank promises to pay his customers debt to them, they accept it. All these definitions define bank in the form of the function what the bank does. They narrate the functions of a bank in one or the other way and say that whoever may do all this is a banker or bank. In the end we come to the conclusion that A bank is that which does banking i.e. any person, firm or company performing banking functions. Since the definitions of bank given by different scholars are only functional and narrative in character, we must understand the banking rather than bank. Banking is the sum of the functions of a bank. Although primary business of bank is to receive deposits and give loans, yet some banks are specialised in one task. While others are in other tasks on the basis of this specialisation the banks are classified under the following heads. 1. CENTRAL BANK The Central Bank is the principal bank in a country. It is the head of the banking system in a country. It is the bankers bank. It is the banker of the government. The deposits of the government are maintained with it, it lends money to the government and has the responsibility of adjusting all the responsibilities in monetary and financial metters which the government bestows upon it. In addition to this Central Bank has the role authority of controlling the credit and money supply of the country. It controls the value of currency by its role right of issuing notes. It controls commercial banks through the various techniques such as discount rate, manipulations, open market operations, changes in the reserve ratio and the selective credit control. 2. COMMERCIAL BANKS The main function of commercial banks are accepting deposits, lending money through over draft, loans, discounting of bills etc, working as an agent of its customers in the tasks assigned by their customers and financing of trade and industry. But it must be noted that these banks lend money on short term basis. Besides doing the function of commercial banking they also deal in foreign exchange and may do some other banking functions also.

3. INDUSTRIAL BANKS Industrial banks arrange long term loans for industry. These banks accept long term fixed deposits. These banks mainly deal in the financing of industry for long periods. Such loans are also given for specific purposes which are productive and expected to yield return after the allowed time. 4. AGRICULTURAL BANKS Agriculture has its own problems and hence there are separate banks to finance it. They advance long term and short term loans to agriculturists. Long term credit is needed for making permanent improvements in land, buying more lands and introducing better methods and costlier implements. Short term credit is meant to supply funds for day-to-day operation of the agriculturists. These include buying of seeds and manures, personal and Labour expenses and payment of water rates and taxes etc. the nature of securities offered by the agriculturists and the length of time for which capital is required, make it impossible for commercial banks, exchange banks and industrial banks to make up this finance. 5. LAND-MORTGAGE BANKS These banks provide loans to the cultivators by mortgaging their land whenever the cultivator has to do some permanent reforms in his land viz making boundary around the field, purchase of machine, digging of well on for any other work. He can borrow money from land mortgage bank by mortgaging his land such banks arrange short, medium and long term loans. 6. EXCHANGE BANKS These banks mainly deal in foreign exchange. They purchase foreign currencies and sell then to those people who have to make payments abroad. Though commercial banks deal in foreign exchange as their specific function, yet these banks are specific in the task. Exchange banks besides financing foreign trade, also finance the internal trade. 7. CO-OPERATIVE BANKS These types of banks are nothing else then commercial banks, but their organization is carried on co-operative lines. The principles of co-operation are different from all other forms of the Joint Stock Organizations. They are treated on different stand due to some peculiarities in regard to their fund and character. 8. SAVING BANKS Though all commercial banks have saving accounts with them, there may be some specialised banks which deal in the small amounts of the savings of the people. 9. PRIVATE BANKS While different kinds of banks described above are banks run on modern lines, there are some private bankers who combine trading and carry on their business in the most antiquated form. Such bankers are present in England, their number is sufficiently large even in the country. Almost the whole of the agriculture industry and a considerable portion of the internal trade is financed by them. 10. MISCELLANEOUS BANKS There are certain other kinds of banks which have arisen in due course to meet the specialised needs of people. In England and America, we have got investment banks whose object is to control the distribution of capital into several uses. American trade unions have also got labour banks where the savings of the labourers are pooled together. Some of the colleges in this country have started student banks to receive the deposits of the student community. The merchant bankers or Accepting Houses of London perhaps represent another highly specialised development of the financial structure.

11. INDIGENOUS BANKERS In the Indo-Pak sub-continent, these bankers are known by different names in different places. These are known as Shahukar, Khatri, Multani, Shareef, Mahajer Bhal wana etc. These indigenous bankers serve a substantial part of financial need of the country particularly in the rural area.

Says Law of Market

According to J. B Say, an early nineteenth century French economists, Supply creates its own demand. In Says words It is production which creates market for goods; for selling is at the same time buying and more of production, more of creating demand for other goods. Every producer finds a buyer. In other words, every supply of output creates an equivalent demand for output, so that there can never be a problem of general over-production. Says law thus denies the possibility of the deficiency of aggregate demand. Says law so conceived describes an important fact about the working of free exchange economy that the main source of demand is the sum of incomes earned by the various productive factors from the process of production itself. The employment of hither to unutilised labour and other resources pays its own way, because it enlarges the market demand for goods by an amount equivalent to the income created and the value of output produced. A new productive process by paying out income to its employed factors, generates demand at the same time that it adds to supply. It is thus production which creates market for goods. It is the cause and sole cause of demand. David Ricardo, the chief among the classical economists said No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity which may be useful to him or while contributes to future production. In the words of James Mill Consumption is co-extensive with production. Thus supply creates its own demand not only at the same time but also to an equal extent. Demand is generated simultaneously through the act of supply because supply creates income in the form of wages, interest and profit suppose 1,000 metres of cloth are produced. The value of cloth has been distributed in the form of wages, rent interest and profit as reward to the participating factors of production. The purchasing power so generated will be spent either on the purchasing cloth or some other commodity. The factors of production producing the other commodity will receive purchasing power as reward which may be spent on the purchase of cloth or again some other commodity. Thus the circle of production as well as of purchase goes on widening till the supply of no commodity remains unsold in the market. Hence the total or aggregate supply of commodities in the economy would be exactly equal to aggregate demand. There being no deficiency of demand, general over production is out of the question. It may be that at any given time, the supply of commodity may exceed the demand for it, but it will be only a temporary disequilibrium, ultimately demand will equal supply and the entire production will be taken off the market, provided of course, there is no interference in the working of the free market forces. In brief Says law of market is denied of the possibility of general over production that is a denied of the possibility of a deficiency of aggregate demand. Therefore the employment of more resources will always be profitable and will take place to the point of full employment, subject to the limitations that the contributors of the resources are willing to accept rewards no greater than their physical productivity justifies. There can be no general unemployment, according to the view, if workers will accept what they are worth.

BASIC ASSUMPTIONS OF SAYS LAW It is clear from the statement of the Says law given above that it is based on certain assumptions. The main assumptions are as follows. (i) The law can operate only in a free exchange economy, where there is perfect freedom for the buyers to buy and sellers to sell. There prevails perfect competition and there are no restrictions imposed either on the producers or on the consumers and there is no price control. (ii) There is free flow of money incomes. As these incomes are received they are immediately spent. Even savings must be invested and spent on acquiring producers goods. (iii) Savings are equal to investment and this equally is brought about by flexible interest rate. (iv) The Government follows the policy of laissez-faire and does not interfere in any manner with the operation of the market forces. (v) The size of the market is limited by the volume of production, only then will demand equal supply or supply creates its own demand. IMPLICATIONS OF SAYS LAW Following are the main implications of Says law (i) One of the implication of Says law is that the economic system is self adjusting and functions automatically without being directed by any controlling authority. If there is any disequilibrium, it will be only temporary and there is a persistent tendency for the equilibrium to be restored. For instance, there is over production. Prices will fall, demand will increase and the extra supply will be cleared. Similarly if there is unemployment, wages would fall and it would become worth while to employ more labour so that unemployment disappears that is how there is automatic adjustment in the economic system. There is built in flexibility. (ii) An important policy conclusion that follows from Says law is that the government should act on the policy of Laissez-afire (let alone) or of non-interference in economic activities. Any interference by the government in automatic working of the economic system will simply create imbalances and disequilibrium. In the absence of government interference, the disequilibrium will be temporary and will tend to be rectified by the free operation of market forces. Hence government should not raise barriers in the way of smooth working of the economy and economic forces. Owing to the built in flexibility in the economic system prices, wages and interest rates and the volume of production keep changing as the economic situation may require and there is no need for the government to interfere. (iii) Another important conclusion that follows from Says law is that general over-production is not possible. That is so because will fall and increased demand under the impact of fall in prices will clear the surplus stock. At, times there may be over-production in a particular industry as distinguished from general over-production but this would also be temporary because automatically adjustments would come about. But in a free and fully competitive system general over production is simply out of the question. What ever the amount of annual products, it can never exceed the amount of annual demand. (iv) Similarly, under free and perfectly competitive economic system, general unemployment is impossible, it follows from Pigovian for mutation of Says law that a general reduction in wages would create enough demand for labour to remove unemployment. Only there would be no wage regulation by government and no trade union pressure to resist reduction in wages. There will thus be persistent tendency to full employment. There may be sometimes unemployment in a particular, industry but no general unemployment is possible. Whatever the state of demand, there will always be, via wage adjustment tendency towards full employment. CRITICISM OF SAYS LAW OF MARKET

The Says law has been by Keynes on the following grounds. (i) Keynes refused to accept the classical theory that economic system was self-adjusting and that it worked automatically without any extraneous aid. Says law laid down that the supply and demand would always be in equilibrium with each other and further this process of equilibrium was automatic and self-adjusting Keynes refused to accept Says law, due to non-egalitarian structure of capitalist society, there are two principal classes the rich and the poor and wealth is unequally distributed between them. The result is that national consumption can not keep pace with national production because the propensity to consume of the richer classes is very low. This leads to deficient aggregate demand or in other words, to over production and general unemployment. In Keynes view State interference is necessary to bring about adjustment between supply and demand. (ii) According to Keynes the general wage cut applied to all industries shall fail to bring about an expansion in the volume of employment, the reason being that a general cut in money wages would reduce the volume of purchasing power in the hands of workers. This will result in a reduction in aggregate effective demand which would have the effect of reducing the volume of employment in the community. Keynes was of the opinion that employment depend upon the level of effective demand which could be maintained by leaving wages intact. Keynes was thus bitter opponent of wage-cuts as a method of expanding employment opportunities. (iii) The fundamental fallacy in Says law is that partial equilibrium analysis which could apply to a particular industry, has been extended to the economy as a whole. Lowering of wage rate in a particular industry, may increase employment there without decreasing demand. But if wages are reduced all around, it will reduce income and so effective demand and the volume of employment. Difference between the Pigovian and Keynesian view on Says law is fundamental. While Pigou is of the view that employment depends upon the level of money wages and can be increased by lowering wages. Keynes contended that the volume of employment is determined by the level of aggregate effective demand which may be adversely affected by cuts in money wages. In Keynes view if wages rates were perfectly flexible unemployment could still exist if the aggregate demand was deficient. Hence it is wrong to assert as the classical economists did, that wage adjustment ensures full employment and interest rate adjustment tends to solve the saving investment problem.

Importance of Multiplier
Keynes multiplier is looked upon as an important contribution to economic thought. It is not only a theoretical concept but also an important instrument of economic prices. It has emerged as an important theoretical concept because it ahs focused attention on investment as the major dynamic element in the economy of a country. It has also strengthened the case for public investment, particularly at a time of depression and unemployment, because even small increment in public investment at such a time leads to large increment in income, output and employment. The concept of the multiplier also helped the government in formulating an appropriate employment policy during depression. It has not only inflicted that employment was directly created by investment but also revealed that income was generated through out the economic system like a stone causing ripples in a pond. Besides a knowledge of multiplier is of supreme importance not only in analysing the course of the business cycle but also in devising an anti-cyclical policy to smoothen business fluctuations in the working of economy. The concept

of the multiplier has thus brought about a revolution not only in economic theorizing but also in policy making at a state-level.

Criticism of Liquidity Preference Theory

Keynes theory has also met with criticism. Firstly it has been pointed out that rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest. Secondly Keynes makes the rate of interest independent of demand for investment funds. Actually it is not so. The cash balances of the businessman are largely influenced by their demand for savings for capital investment. Thirdly liquidity preference is not only factor governing the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of money. Fourthly liquidity preference theory does not explain the existence of different rate of interest prevailing in the market at the same time. Owing to the perfect homogeneity of cash balance, the rate of interest have to be uniform. Actually is it not so. Fifthly Keynes ignores saving or waiting as a means or source of investible fund. To part with liquidity without there being any saving is meaningless. Sixthly Keynes theory of interest is of limited value from the supply side. It is not always possible to reduce the rate of interest by increasing the supply of money. If the liquidity preference of people also increases in the same proportion in which the supply of money increase then the rate of interest shall remain unaffected.

Liquidity Preference Theory

Keynes expounded his own theory of interest which many be called the monetary theory of interest as opposed to the classical theory which might be termed as the Real Theory of Interest. According to Professor Keynes, interest is purely a monetary phenomenon, because the rate of interest is calculated in terms of money. It is also monetary phenomenon in the sense that it is determined by the demand for and the supply of money. Professor Keynes defines interest as the reward paid for parting with liquidity for a specified time. Money is the most liquid asset and people generally like to keep their assets in cash. Therefore if they are asked to surrender this liquidity, they must be paid a reward. This reward is paid in the form of interest. Greater the desire for liquidity higher shall be the rate of interest demanded for parting with liquidity. The rate of interest, like the price of an ordinary commodity is determined by the demand for and supply of money. The rate of interest on the demand side, is governed by the liquidity preference of the community. The liquidity preference of the community arises due to the necessity of keeping community. Keynes discusses these requirements under three heading. (i) Transaction Motive (ii) The precautionary Motive and (iii) Speculative Motive. The demand for money arising under these three motives constitutes the aggregate demand for money. It must be keep in mind that the demand for money in Keynesian sense the demand to hold money. Money under these three motives is actually held in cash in hands of the public, and

the communitys demand for money shell increase or decrease, according to the communitys desires to hold more or less cash in hands. An increase in the demand for money (i.e. an increase in liquidity preference) shall lead to arise in the rate of interest. A decrease in the demand for money (i.e. decrease in liquidity preference) shall lead to fall in the rate of interest. An increase in the demand for money is not always followed by a rise in the rate of interest. If for instance, an increase in the demand for money is followed by an increase in the quantity of money in the same proportion, the rate of interest shall not be affected at all. While the liquidity reference governs the rate of interest, in it own town, it is also governed by the rate of interest. Higher the rate of interest, the lower shall be liquidity preference, lower the rate of interest, the higher shall be the liquidity preference. The rate of interest on supply side is determined by the supply of money in the economy. The supply of money is different from the supply of commodity. While the supply of commodity is a flow, the supply of money is a stock. Further supply of money is the supply of money to hold and the aggregate supply of money in community at any time is the sum of all money holdings of all members of the community. Unlike the demand for money, the supply of money is completely amenable to government control. The liquidity preference of the community cannot be directly controlled by the sale. But supply of money is the factor which is always in the hands of the state. In most countries the control of supply of money has been entrusted to the Central bank. The Central Bank may not be able to influence liquidity preference directly. But through its control of supply of money, it can influence the rate of interest which in its turn affects the liquidity preference. Higher the supply of money, the lower shall be the rate of interest, lower the supply of money higher shall be the rate of interest. An increase in supply of money is not always followed by a fall in the rate of interest. If for instance an increase in the supply of money is also followed by an equivalent increase in the demand for money, the rate of interest shall not be affected at all. While the supply of money affect the rate of interest, it is in turn not affected by the rate of interest unless the monetary authority issues more money to counter the high rate of interest, because the supply of money is in hands of the government.

Supply of Money and its Demerits

The term the supply of money is synonymous with such terms as money stork, Stock of money, money supply and quantity of money. The supply of money at any moment is the total amount of money in the economy. There are three alternative views regarding the definition or measures of money supply. The most common view is associated with the traditional and Keynesian thinking which stresses the medium of exchange function of money. According to this view, money supply is defined as currency with the public and demand deposits with commercial banks. Demand deposits are savings and current accounts of depositors in commercial banks. They are the liquid form of the money because depositors can draw cheques for any amount lying in their accounts and bank has to make immediate payment on demand. Demand deposits with commercial banks plus currency with the public are together denoted M1, the money supply. This is regarded as a narrower definition of the money supply. The second definition is broader and is associated with the modern quantity theorists headed by Friedman. Friedman defines the money supply at any moment of time as literally the number of dollars people are carrying around in their pockets, the number of dollars they have to their credit at banks or dollars they have to their credit at banks in the form of demand deposits and also

commercial bank time deposits. Time deposits are fixed deposits of customers in commercial bank. Such deposits earn a fixed rate of interest varying with the time period for which the amount id deposited. Money can be with drain before the expiry of that period by paying a penal rate of interest to the bank. So time deposits possess liquidity and are included in the money supply by Friedman. Thus the definition includes M2 plus time deposits of commercial banks in the supply of money. This under definition is characterised as M2 in America and M3 in Britain. It stresses the store of value function of money or what Friedman says a temporary abode of purchasing power. The third definition is the broadest and is associated with Gurley and show. They include in the supply of money M2, plus deposits of savings banks building societies, ban associations and deposits of other credit and financial institutions. The choice between these alternative definitions of the money supply depends on two considerations. One a particular choice of definition may facilitate of blur the analysis of the various motives of holding cash and two form the point of view of monetary policy. An appropriate definition should include the area over which the money authorises can have direct influence. If these two criteria are applied, none of three definitions is wholly satisfactory. The first definition of money supply may be analytically better because M1 is a sure medium of exchange. But M1 is an inferior store of value because it earns no rate of interest, as is earned by time deposits. The second definition that includes time deposits (M2) in the supply of money is less satisfactory analytically because in a highly developed financial structure it is important to consider separately motives for holding means of payment and time deposits. Unlike demand deposits, time deposits are not a perfect liquid form of money. This is because amount lying in them can be withdrawn immediately by cheques. Normally it cannot be withdrawn before the due date of expiry of the deposit. Thus time deposits lack perfect liquidity and cannot be included in money supply. But his definition is more appropriate from the point of view of monetary policy because the central bank can exercise control over wider area that includes both demand and time deposits held by commercial banks. The third definition of money supply that includes M2 plus deposits of non bank financial institution is unsatisfactory on the both criteria. Firstly they do not serve the medium of exchange function of money. Secondly they almost remain outside the area of the control of central bank. The only advantage they possess is that they are highly liquid store of value. Despite this merit deposits of non bank financial institutions are not included in the definition of money supply. From the above discussion we can conclude that the quantity supplied of all the kinds of money put together will make the supply of money in the country. DETERMINANTS OF MONEY SUPPLY There are two theories of determinants of the money supply. According to the first view, the money supply is determined exogenously by the central bank. The second view holds that the money supply is determined endogenous by changes in the economic activity which affect peoples desire to hold currency relative to deposits, the rate of interest etc. Thus the determinants of money supply are both exogenous and endogenous which can be described broadly as the minimum cash reserve ratio, the level of bank reserves and the desire of people to hold to hold currency relative to deposits. 1. The Required Reserve Ratio: The required reserve ratio of the minimum cash reserve ratio of the reserve deposit ratio is an important determinant of money supply. An increase in the required reserve ratio reduces the supply of money with commercial banks and a decrease in

required reserve ratio increases the money supply. The RR1 is the ratio of cash to current and time deposit liabilities which is determined by law. Every commercial bank is required to keep a certain percentage of these liabilities in the form of deposits with the central bank of the country. But notes or cash held by commercial banks in their tills are not included in the minimum required reserve ratio. 2. The level of Bank Reserves: The level of bank reserves is another determinant of the money supply. Commercial banks reserves consist of reserves on deposits with the central bank and currency in their tills or values. It is the central bank of the country that influences the reserves of commercial banks in order to determine the supply of money. The central bank requires all commercial banks to hold reserves equal to fixed percentage of both time and demand deposits. These are legal minimum or required reserves. Required reserves (RR) are determined by the required reserve ratio (RRr) and the level of deposit (D) of a commercial bank RR = RRr D. If deposits amount of Rs. 20 lacs and required reserve ratio is 20 percent, then the required reserves will be 20% 80 = Rs. 16 Lacs. If the reserve ratio is reduced to 10 percent, the required reserves will also be reduced to Rs. 8 lacs. Thus higher the reserve ratio the higher the reserves to be kept by bank and vice versa. But it is excess reserves (ER) which are important for the determination of money supply. Excess reserves are the difference between total reserves (TR) and required reserves (RR) ER = TR RR. It is excess reserves of a commercial bank which influence the size of its deposits liabilities. A commercial bank advances loans equal to its excess reserves which are an important component of money supply. To determine the supply of money with a commercial bank, the central bank influences its reserves by adopting open market operation and discount rate policy. 3. Publics Desire to Hold Currency and Deposits: Peoples desire to hold currency relative to deposits in commercial banks also determines the money supply. If people are in habit of keeping less in cash and more in deposits with commercial banks, the money will be large. This is because banks can create more money with larger deposits. On the contrary, if people do not have banking habits and prefer to keep their money holdings in cash, credit creation by banks will be less and the money supply will be at a low level. 4. Other Factors: The money supply is a function not only of the high powered money determined by the monetary authorities, but of interest rates, income and other factors. The latter factor change the proportion of money balances that the public holds as cash. Changes in business activity can change the behaviour of bank and the public and thus affect the money supply. Hence the money supply is not only an exogenous controllable item but also an endogenously determined item.

Causes of Inflation
One of the most important factors influencing poverty in the country is inflation. Inflation is defined as a situation where general price level is persistently moving upward in a country. In Pakistan the general price level is persistently rising since its establishment. The prices remained volatile during the decade of 1990s ranging from 5.7 % to 13 % mainly because of declining economic growth, expansionary prices, output set backs, higher taxes and a depreciation of Pakistan rupee. The inflation rate started declining from 1998 onward due to improved supply position of goods and strict budgetary measures. The inflation rate was 5.7 % in 1998-99. It was brought down to 3.6 % in 1999-2000 and further to 3.1 % in 2002-2003. The inflation rate based

on CPI (Consumer Price Index) has averaged 4.6 % during 2003-2004. The slight rise in prices was due to increase in price of wheat. The inflation rate reached as high as 9.3% in the year 2004-2005 mainly due to rise in price of wheat and increase in the international oil price. CAUSES OF INFLATION IN PAKISTAN The causes of general rise in prices are usually grouped under the following two main heads. 1. Demand-pull inflation and (2) Cost-push-inflation. These two types of inflation are now discussed in the context of Pakistans economy. 1. DEMAND-PULL INFLATION Demand-pull inflation is generated when aggregate demand for goods for all purposesconsumption, investment and government exceeds the supply of goods at current prices. The main factors which have led to demand induced inflation in Pakistan are as follows. (i) Demand for non-development expenditures: The elected and non-elected governments in Pakistan since 1947 have not been able to curb the non-development expenditures. The lavish expenditures by the elected representatives and the government functionaries have contributed to the inflationary rise in the general prices. (ii) Rapid monetary expansion: During the last three years the growth in monetary assets has outstripped the rise in nominal GDP. The easy monetary policy adopted to kick start the stagnant economy has led to the rise in general price level. (iii) Deficit Financing: Due to lack of resources for economic development, the government has been resorting to deficit financing (bank borrowing, creation of new currency) over the years. The excessive growth in money supply compared to increase in output has resulted in inflation. (iv) Increase in Workers remittances: During the last three years there is a rapid increase in the flow of workers remittances in the country. During the year 2001-02 the workers remittance were $2.389 billion which now in the year 2004-05 have crossed $3.90 billion dollars. The workers remittances no doubt a boon for the country, has also resulted in the expansion in aggregate demand for goods and so a factor in the general rise in prices. (v) Foreign Economic assistance: For rapid economic development, Pakistan has been receiving foreign and since early 50s. The foreign debt outstanding is 36.6 billion dollars by 2005. The tied and untied aid is mostly invested in the projects having long gestation. The output of goods, therefore does not increase correspondingly with the rise in income. Foreign economic assistance is thus also a contributory factor in pulling up the general level of prices in the country. (vi) Consumption habits: Pakistanis living in Urban and rural areas are mostly send thrift. They are proud of spending money on the goods which are used by the people in the advanced countries of the world. The increased expenditure on clothes, foods, cosmetics etc. have added much to the inflationary pressure in the country. (vii) Construction of houses: Since 1970 people are spending their savings mostly on the purchase of land and construction of houses. The unproductive expenditure on the construction of houses, plazas etc. has also contributed to the rising trend in prices. (viii) Excessive speculation and hoarding: The investor class since the nationalization of industries is generally shy of investing money in capital intensive projects. They are mostly spending their resources on speculation and hoarding of goods. The abrupt rise I demand of goods also results in the rise of price level of goods. (ix) Increase in Wages: The rise in wages, salaries, dearness allowances, bonuses etc. in the annual budget increase the purchasing power of the employees. With the increase in the disposable income of the workers, the prices of the commodities go up. The workers gain press for higher wages. The wages and prices thus chess each other at a very rapid speed and have

accelerated the trend of price rise in the country. (x) Population explosion: The population is increasing at the rate of about 1.9% in Pakistan, the pressure of population has increased the aggregate demand for commodities thus pulling up the general level of prices in the country. (xi) Black Money: Black money is the unaccounted money receipts. It is generated through smuggling, tax evasion, price control etc. It is estimated that annual generation of black money is about 25% of GNP of the country. This huge amount pushes up the prices of land, houses, cars, air conditioners and other expensive items. 2. COST-PUSH INFLATION The rise in the general price level is also caused by the rising costs of the factors of production, it is called cost push inflation. In Pakistan the cost push inflation has occurred in the following ways. (i) Increase in Wages: In Pakistan one of the factors leading to cost-push inflation in the rise in wage not backed by increase in productivity. The compensatory wage increase and the rise in prices are chasing each other at quite a rapid speed causing personal rise in the level of prices. (ii) Rising prices of imported goods: The import prices of POL chemicals, fertilizers, nonelectrical machinery etc have gone up in the world market. The cost and so the price of commodities using the imported items has gone up in the country. (iii) Increase in Indirect taxes: For increasing the revenue the Government is heavily relying on indirect taxes. The increase in the indirect taxes every year has given the general price level an inflationary push. (iv) Depreciation of Rupee: The Pakistani rupee is depreciating vis--vis the US dollar. The repeated and higher devaluations of Pakistani rupee has increased the cost and prices of imported goods. Depreciation of the currency thus is an important factor for the rise in the average level of prices in Pakistan. (v) Rise in POL, Gas, and Excise Duty: The multiplier effect of the rise in POL, gas prices, and levying of excise duty, sales tax on a number of items has greatly contributed to the cost push effect. (vi) Sick Industrial Units: The increase in number of sick industrial units, fall in industrial production due to strikes, electricity breakdown etc cause decrease in production and lead to higher cost, thus pushing up inflationary pressure. (vii) Increase in Utility Tariffs, excise duty: The government in the budgets considerably increase the rates of sales tax, excise duty on a large number of items. A rise in utility tariffs, has also kicked a new round of inflation in the country. (viii) Rise in support price of agriculture crops: The Government raises the support prices of cotton, wheat, sugar cane to protect the interests of farmers. This also has an inflationary impact on the currency. MEASURE TAKEN TO CONTROL THE INFLATION IN PAKISTAN The inflation was well under control from the fiscal year 2000 to 2004. However it shoot up to 9.3% in the year 2005 mainly due to the rise in support price of wheat and a surge in international price of oil. The Government of Pakistan being well aware of the adverse effect of inflation is taking following measures to bring down the inflationary pressure in the economy. 1. Increase in the supply of essential goods: The Government is regularly monitoring the domestic stock of essential goods and their prices in the market. The supply of essential goods is being improved through the import of these commodities. 2. Establishment of high level committee: A high level committee is established which is to

monitor the price situation on daily basis. It will keep a close watch on the supply and demand conditions of essential goods. 3. Rise in the price of oil: During the year 2004-05 there was a rapid increase in the oil prices at international level. The Government has only partly shifted the burden of rise in oil prices to the consumers. 4. Tightening Monetary policy: In the past three years there is a rising level of economic activity in the country. The state Bank of Pakistan is effectively using monetary policy to put down pressure on general price level. 5. Import of Wheat: There is a record production of wheat of 21.1 million tones in 2004-05. The Government is building up reserves of wheat to stabilize prices of wheat in the market by import of wheat also. 6. Supply of flour and other items of utility through Utility Stores: The Government is supplying flour, sugar on reduced prices to the in the country through the utility stores.

Keynesian Theory of Inflationary Gap

In his pamphlet How to pay for the war Keynes explained the concept of the inflationary gap. It differs from his views on inflation given in the General Theory. In the General Theory he started with unemployment equilibrium. But in How to pay for War he began with situation of full employment in the economy. He defined an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base prices. According to Lipsey The inflationary gap is amount by which aggregate expenditure would exceed aggregate output at the full employment level of income. The classical economists explained inflation as mainly due to increase in the quantity of money, given the level of full employment. Keynes on the other hand ascribed it to the excess of expenditure over income at the full employment level. The larger the aggregate expenditure the large the gap and the more rapid the inflation. Given a constant average propensity to save, rising money incomes at full employment level would lead to an excess of demand over supply and to a consequent inflationary gap. Thus Keynes ased the concept of the inflationary gap to show the main determinant that cause an inflationary rise of prices. Inflationary gap arises when consumption and investment spending together are greater than full employment GNP level. This means that people are demanding more goods and services that can be produced. In other words, the implications of inflationary gap is that national income, output and employment cannot rise further. The only consequence of increased demand for goods and services on the part of the people will be to raise the price level. Or we may say that there will e an inflationary gap, if scheduled investment tends to be greater than full employment saving. In situation like this more goods will be demanded than the economic system can produce. The result will be that the prices will begin to rise and an inflationary situation will emerge. Thus if full employment saving falls short of scheduled investment at full employment (which means peoples propensity to spend is higher than the propensity to save) there will an inflationary gap. HOW CAN THE INFLATIONARY GAP BE ELIMINATED The inflationary gap can be wiped out by increase in savings so that the aggregate demand is reduced. But this may lead to deflationary tendencies. Another solution is to raise the value of available output to match the disposable income. As aggregate demand increases, businessmen hire more labour to expand output. But there being

full employment at the current money wage, they offer higher money wages to induce more workers to work for them. As there is already full employment, the increase in money wages leads proportionate rise in prices. More over output cannot be increased during the short run because factors are already fully employed. So the inflationary gap can be closed by increasing taxes and reducing expenditure. Monetary policy can also be used to decrease the money stock. But Keynes was not in favour of monetary measures to control inflationary pressure within economy.

Difference between Demand-pull Inflation and Cost-push Inflation

INFLATION In ordinary sense inflation mean a general rise in prices. A rise in prices is the indication of inflation. Basically inflation represents a situation whereby the aggregate demand for goods and services exceeds the available supply of output. As Fisher defines The inflation rate is the percentage rate per period that prices are increasing. Keynes says Any rise in price level after the level of full employment has been achieved is inflation. According to Kent Inflation is nothing more than a sharp upward movement in the price level. DEMAND-PULL INFLATION Basically, inflation represents a situation whereby the pressure of aggregate demand for goods and services exceeds the available supply of output (both being counted at the prices ruling at the beginning of a period) in such a situation, the rise in price level is the natural consequence. Now this excess of aggregate demand over supply may be the result of more than one force at work. As we know aggregate demand is the sum of consumers spending on current goods and services, government spending on current goods and services and net investment being contemplated by the entrepreneurs. At times, however the government, the entrepreneur or the households may attempt to secure a large part of output than would thus accrue to them. Inflation is thus caused when aggregate demand for all purpose-consumption, investment and government expenditure-exceeds the supply of goods at current prices. This is demand pull-inflation. COST-PUSH INFLATION OR WAGE INDUCED INFLATION We can visualise a situation where even though here is no increase in aggregate demand, prices may still rise. This may happen if costs particularly the wage costs go on rising. Now as the level of employment rises, the demand for workers also rises so that the bargaining position of the workers becomes stronger. To exploit this situation, they may ask for an increase in wage rates which are not justifiable on grounds either of a prior rise in productivity or of cost of living. The employers in a situation of high demand and employment are more agreeable to concede these wage claims because they hope to pass on these rises in costs to the consumers in the shape of rise in prices. If this happened we have another inflationary factor at work and the inflation thus caused is called the wage induced or cost-push inflation. WAGE-PRICE SPIRAL But that will not be the end of the story. A rise in prices reduces the real consumption of wage earners. They will therefore pres for higher money wages to compensate themselves for the higher cost of living. Now an increase in wages, if granted, will raise the cost of production and therefore entrepreneurs will be tempted to raise the prices. This adds to the inflationary fire. A further rise in prices raises the cost of living still further and the workers ask for still higher wages. In this way wages and prices chase each other and the process of inflationary rise in

prices gathers momentum. If unchecked this may lead to hyper-inflation which signifies a state of affairs where wages and price chase each other at a very quick speed. This is a state of galloping inflation. Thus inflation starts with aggregate demand for goods and services exceeding the supply there of (demand induced inflation) and it is further fed and strengthened by rising cost through wage-price spiral (cost induced inflation). There is increase in money supply without a corresponding increase in production so that there is case of too much money chasing too few goods.

Inflation in Under Developed Countries

Developing countries sin their bid to raise the standard of living of their people through development plans have often found themselves in the grip of inflation. But the nature of inflation in under developed countries like Pakistan is quite different from that found, in advanced or developed countries. In advanced countries true inflation starts after the level of full employment is attained. But in under-developed countries like Pakistan huge unemployment and inflation exist side by side. In other words in underdeveloped countries serious inflation is in evidence long before the level of full employment is reached. This is so because the nature of unemployment in under-developed countries differs from that which prevails in developed countries during time of depression. In order to get the economy out of depression governments in advanced countries take various steps to increase the level of investment. The additional investment expenditure leads to an increase in effective demand depending upon the magnitude of the multiplier. But his increase in investment and effective demand des not generate serious inflationary pressure because of the elastic nature of the supply curve of output. Instead increase in investment and effective demand helps a great deal in removing depression and unemployment. Which are caused by the lack of effective demand. This is the case of developed economics. In advanced countries during depression there is a lot of excess capacity in the system so that an increase in output presents no difficult problems. Thus when the supply of output can be increased easily so as to match increase in effective demand, there need be no inflationary pressure. The situation in under developed countries is however different. Here an increase in investment does create additional demand but a corresponding increase in the supply output cannot be taken for granted. Unemployment in under developed economies is not due to the lack of effective demand but due to the death of real capital. In these countries level of national income can be increased and the unemployment can be removed accumulating more real capital. But increase in the rate of capital formation requires stepping up the level of investment. Now under-developed countries, under their development plans, are making huge investment expenditure to increase the rate of capital formation and thus to obtain rapid economic growth. This huge investment expenditure leads to a sharp increase in aggregate demand for consumer goods, especially the agricultural products. Since in underdeveloped countries, there is no excess capacity in the system, the supply of consumer goods cannot be increased sufficiently and rapidly to match the increase in demand for them. This leads to inflationary rise in prices. It is worth noting that it is the food prices which first start rising rapidly in the developing economy. Rise in food prices is followed by the rise in the prices of other consumer goods. This is so because a greater part of the increase in demand generated by the investment expenditure is

spent on the food produces such as wheat and rice. But the supply of these food products cannot be sufficiently increased in the short run due to the tiny size of the farms, lack of irrigation fascilities of superior seeds, fertilizers and owing to inefficient techniques of cultivation. Income elasticity of demand for food is very high, because the vast majority of the people are under nourished. Thus as a result of huge investment expenditure there is a sharp rise in demand for food grains, leading to increase in food prices. In under-developed countries like Pakistan, which are predominantly agricultural countries, the prices of agricultural commodities, especially of food crops, hold the key position in the price structure of the country. Any distortion in agricultural prices leads to a distortion in the whole price structure. A steep rise in food prices increases the cost of living of the people. Consumers are hit hard, as their income do not increase so easily to offset the increase in prices. Workers whose cost of living rises, press for higher wages. When wage increased are conceded, the cost of production of manufactures articles rises and this in turn increases their prices and soon. More over some agricultural producers are raw material for industries and increase in their prices will directly increase the cost of production of industrial goods. Hoarding of, and speculation in, both agricultural and industrial products add fuel to the inflationary fire. Thus once the prices of agriculture (goods rise) they are likely to cause an inflationary spiral in the economy. A factor which deserves special mention in this connection is the mode of financing development plans. The developing countries are not in position to finance their plans fully from voluntary savings of the people and taxes by the government. They have often to resort to deficit financing (i.e. the creation of new money) as a method of financing their development plans. Deficit financing to some extent is good and can be absorbed by the economy without experiencing inflation. This is so because, as the economy grows its monetary sector expands and also there is an increase in production for which extra money is needed. But owing to acute shortage of finance, the underdeveloped countries have often indulged in deficit financing to an excessive degree. Sharp increase in the money supply with the public as a result of excessive deficit financing adds greatly to the level of aggregate demand for consumers goods, on the other hand the supply of consumers goods, especially of food products, can not be increased rapidly and sufficiently. The pressure of demand therefore leads to an inflationary rise in prices. It may however be pointed out that investment expenditure made by the government under the development plans do not only generates he additional demand for goods, it also increases the productive capacity. Investment has a duel effect. On the one hand it generates demand or income on the other it increases the productive capacity. As a result of increase in productive capacity more output of goods can be obtained, which will counter act inflationary tendencies. But in the earlier stages of development, investment expenditure is largely made on huge dams, steel plants and other heavy and basic industries. In other words the long term projects can help in increasing the supply of consumers goods only in the long run. In the short run prices generally shoot up under the pressure of excessive demand for goods. And one inflationary spiral starts operating, it is difficult to control it.

Economic Effects of Suppressed Inflation

Inflation is often open and suppressed. Inflation is open when markets for goods or factors of production are allowed to function freely, setting of prices of goods and factors of production without normal interference by authorities. Thus open inflation is the result of the uninterrupted

operation of the market mechanism. There are no checks or controls on the distribution of commodities by the government. Increase in demand and shortage of supplies persist which tend to lead open inflation. Unchecked open inflation ultimately leads to hyper inflation. On the contrary when government imposes physical and monetary controls to check open inflation; it is known as repressed or suppressed inflation. The market mechanism is not allowed to function normally by the use of licensing price controls and rationing in order to suppress extensive rise in prices. According to Friedman governments themselves are often producers and sellers of wide range of commodities and they want to keep their own prices low by price restriction and controls. This lead to the breakdown of the free price system, further suppressed inflation also results when efforts are made to increase domestic production and reduce import demand by tariffs, import restrictions, limits on foreign loans, voluntary import agreements etc. So long as such control exists, the present demand is post poned and there is division of demand from controlled to uncontrolled commodities. But as soon as these controls are removed there is open inflation. ECONOMIC EFFECTS OF SUPPRESSED INFLATION Suppressed inflation adversely affects the economy of a country. These are mentioned as under. 1. When the distribution of commodities is controlled the prices of uncontrolled commodities rise very high. 2. Suppressed inflation reduces the incentive to work because people do not get the commodities which they want to have. 3. Controlled distribution of goods also leads to mal-allocation of resources. This results in the diversion of productive resources from essential to non essential industries. 4. Frictions increase in the labour market when high inflation is associated with higher unemployment. 5. Suppressed inflation leads to black marketing, corruption, hoarding and profiteering. It invites extra-legal powers of control. Finally it reduces the prospect of anti-inflationary policy being tried at all.

Inflation and its Causes

INFLATION In ordinary sense inflation mean a general rise in prices. A rise in prices is the indication of inflation. Basically inflation represents a situation whereby the aggregate demand for goods and services exceeds the available supply of output. In the Keynesian sense, true inflation begins when the elasticity of supply of output in response to increase in money supply has fallen to zero or when output is un-responsible to changes in money supply. When there exists a state of full employment the conditions will be clearly inflationary, if there is increase in the supply of money. But since we do not subscribe to the classical view that there is full employment we can say that when money supply increase it results partly in the increase of output (GNP) and it partly feeds the rise in prices. And when the supply of output lags for behind, the rise in prices is described as inflationary. In Coulborns words, it is a case of too much money chasing too few goods thus inflation is generally associated with an abnormal increase in the quantity of money resulting in abnormal rise in prices. CAUSES OF INFLATION There are so many causes of inflation in the less developed countries like Pakistan. Inflation may

occur due to any one of the following reasons or causes. 1. Increase in Demand: Due to increase in population or due to change in certain other factors, the demand for goods and services measures supply remaining the same, expenditure will increase and inflation occur. 2. Lack of Supply: Due to some unfavourable climatic situations, political, social, national or international situation production remains low (small) in any particular year and supply will also decrease, prices will go up and inflation will occur. 3. Increase in the Cost of Production: In certain cases cost of production increases due to rise in the prices of factors of production, producer rises price level and due to excessive expenditure inflation occur. 4. Over Population: Inflation also occurs due to the increasing rate of growth of population. As Pakistan is an over populated country and the rate of growth of her population is about 3% per year, while the rate of production of goods is very low and due to this prices of commodities rise and inflation occur. 5. Development Expenditure: In under developed countries like Pakistan major amount of money is spent on the development programmes and due to increase in the income of the individuals, their expenditure is the basic cause of the inflation. 6. Food Problem: Pakistan is basically an agricultural country. Near about 30% of national income is had by agriculture sector. But unfortunately there is an acute shortage of food grain in Pakistan and so is the case with other developing and under developed countries of the world. The prices of other commodities are influenced by the continuous rise food grain prices and thus inflation occurs. 7. Financial Position of Common Man: In under developed countries, the financial position of a common man is very poor and there is a lock of saving because the major portion of income is spent on the purchase of only consumer goods. 8. Import of Machinery: Under developed countries spent lot of amount on the import of machinery. So the cost of production increase and inflation occur this price of goods also increase and inflation occur. 9. Expenditure on Defence: Of course defence is very important for every country. A huge amount of budget is spent on defence requirements in all countries of the world. Like other countries Pakistans major part of budget is spent on defence requirements. As we only produce 5% of total defence requirements within country and the remaining requirements are imported from abroad. Due to this reason inflation occurs. 10. Natural Climate: Natural climate play an important role in the economy of any country. Pakistan is basically an agricultural country we earn near about 30% of national from agriculture sector. Agricultural products wholly depend upon natural climate. Due to unfavourable natural climatic conditions when agricultural cross are destroyed or decreased as a result of this supply decrease and prices increase and inflation occur. 11. Deficit Financing: By deficit financing we mean that there is deficit created in budget when budget is announced. Expenditure is more than income in actual sense by deficit financing mean to issue new currency when this new currency came into the market it increases the demand of goods and services but on the other hand supply remain the same as a result of this price increase and inflation occur. 12. Decrease in Production: Inflation may occur if production decreases. There are many reasons of decrease of production e.g. natural climate, political, social conditions, competition, national and international problems etc which are cause of inflation.

MEASURES TO CONTROL INFLATION The methods which are adopted to remove inflation, they are called anti-inflation measures. These measure may be of the following three kinds. 1. Monetary Measures 2. Fiscal Measures 3. Non-Monetary Measures or General Measures. Let us discuss these turn be turn 1. MONETARY MEASURES Monetary measures mean those measures which are taken by the Central Bank of the country. Anti-inflationary measures of pure monetary nature are largely a matter of Central Bank policy. These are discussed as under. (i) Bank Rate Policy: In the time of need the people may discount the bills from commercial banks. When there is inflation in the country then banks should increase the rate so that people can not get cash by discounting the bills. This is the bank rate policy and is major weapon of controlling the inflation. (ii) Open Market Operation: When Central Bank sales or purchases the securities in open market, it is called open market operation. If there is inflation in the country then central Bank should sell the securities so that the inflation may be controlled. (iii) Higher Reserve Requirements: Higher reserve requirements are also necessary to control the inflation. Because of reserves are increased then purchasing power of people is also decreased. (iv) Monetary Reforms: The Government can order to exchange old notes by new ones in this way a large part of money may be blocked. Money should be repaid to people after achieving the purpose. (v) Marginal Requriement: Marginal requirements means the value of securities against which banks agree to advance loans. If banks increase the marginal requirement then people can not get more loans and inflation may be controlled. (vi) Credit Rationing: Sometimes Central Bank advises to commercial banks to stop the advancing loans for one month or two months or more. In this way inflation may also be controlled. 2. FISCAL MEASURES (i) Cut on Expenditure: If government decreases her expenditure on unproductive activities then inflation is also automatically controlled. (ii) Change in Taxation System: Tax system should be reorganised to encourage investment and productive activities in the country. It may help to increase production and to control the general price level. (iii) Restriction on Exports: Government may control inflation by applying restriction on the export of those goods which other wise may create shortage in the country. (iv) Managing Public Debt: Public debt should be managed in such a systematic way that money supply is reduced and consequently the inflation may be removed. (v) De-nationalization: To control the inflation government should de-nationalize sick public industries. The experience of nationalization of industries in Pakistan has been quite bitter for economy. (vi) Protection to Infant Industries: To control inflation, increase in domestic production is required. So government should protect the domestic infant industries by applying import duties. 3. GENERAL MEASURES (i) Population Planning: The demand of goods and services may be controlled by control of

population growth. So effective population planning may also help to control inflation. (ii) Co-operation between Monetary and Fiscal Policies: Government may control inflation, if there is a proper co-operation between fiscal and monetary policies. (iii) Effective Planning: Administration and politician may help to control inflation by making policies for the interest of the whole nation and by sacrificing their personal benefits. (iv) Increase in Output: Steps should be taken to increase the output, so that the shortage problem of goods can be removed. If there are sufficient products in the market in sufficient quantity. Then the too much money will not chase too few goods and in this way the inflation will automatically be controlled. (v) Political Stability: Government should take the steps to remove the political crisis so that business sectors are encouraged to invest in the country. This is very positive and natural way of controlling inflation. (vi) Discipline: There should be discipline in factories and offices so that output of the country may increase and inflation is controlled. (vii) Hoarding and Smuggling: Hoarding and Smuggling should be controlled because if hoarding and smuggling are controlled then inflation is also controlled.

Devaluation, its Merits and Demerits

Devaluation means to increase in the value of domestic currency in terms of foreign currencies. For example if the rate of one US dollar was equal to rupees 50. Now government of Pakistan decided to devalue her currency and new rate may be fixed as one US dollar equal to 60 rupees. This process is known as devaluation. In case of the devaluation the currency becomes cheaper from the point of view of other countries. OBJECTS OF DEVALUATION 1. BALANCE OF PAYMENTS Devaluation may be used to correct the balance of payment position, because when a country devaluates her currency then its exports are increased. 2. ENCOURAGE THE EXPORTS Devaluation policy is also adopted to encourage the exports of the country. Because when the currency is devalued then commodities become cheap for other countries and they increase their demand. 3. DISCOURAGE IMPORTS Another object of devaluation is to discourage the imports. Because when the currency is devalued then imported goods become costly, so people reduce their demand for imported goods. 4. FOREIGN LOANS If the value of home currency is higher then foreign countries are not agreed to give loans. So then main object of devaluation is to get the foreign loans for economic development of the country. 5. PRICE STABILITY Price stability is an other object of devaluation. When government finds that prices are decreasing then government devalues the currency for stability in price. 6. RETALIATION Some times one country devalues her currency to increase the exports but other countries also devalues their currencies so that the former can not get benefits. 7. OVER VALUATION

Some times value of currencies is artificially higher than its true value. So the main object of devaluation is to correct the over valuation of the currencies. MERITS OF DEVALUATION 1. FOREIGN INVESTMENT With the help of devaluation the foreign investment is increased. Because foreigners find it more cheaper to invest in devaluing country. 2. FOREIGN LOANS When the currency is devalued then foreign countries are agreed to give loans at lower rate. These loans may be utilised for the development of the country. 3. CONTROL ON SMUGGLING Due to devaluation the smuggling becomes unprofitable because the foreign goods become costly. 4. BALANCE OF PAYMENT With the help of devaluation the level of exports is increased while the level of imports is decreased. So in this way the balance of payment position is improved. 5. ECONOMIC DEVELOPMENT With the help of devaluation the foreign investment is encouraged. When the investment increased then economic development is increased. 6. EXCHANGE RATE Devaluation is helpful weapon to set up new exchange rate which is more practical and realistic. When the currency is over valued devaluation brings equilibrium in extreme and internal values of currency. 7. FOREIGN RECEIPTS When the currency is devalued then the living in foreign countries sent more foreign currency to home land because they can get more home currency. In this way the foreign exchange is also increased. 8. ENCOURAGEMENT TO INDUSTRY When the currency is devalued then the demand of goods produced by domestic industries is increased in international market. In this way the sales volume of domestic industries rise up. DEMERITS OF DEVALUATION 1. RETALIATION Some times one country devalues her currency to increase the exports but other countries also follow the same policy. So devaluation becomes useless. 2. FOREIGN DEBTS Devaluation increases the burden of foreign debts in the term of home currency because the amount of loan increases in relation to home currency. 3. PRICE LEVEL INCREASE Due to the devaluation prices of imported goods become high which bring the inflation. The prices of imported raw materials and machines become also high due to which goods manufactured in domestic industry also become costly. 4. TERMS OF FOREIGN TRADE If the currency is devalued then country has to pay the large amount of money for imports. So the foreign trade is adversely affected. 5. SHORTAGE OF CAPITAL If the currency is devalued then goods and machines become costly. So large amount of capital is required for starting business.

6. TEMPORARY TREATMENT Devaluation is a temporary treatment for the correction of adverse balance of payment. But it is not useful in long run.

Friedmans Restatement of Quantity Theory of Money

Milton Friedmans restatement of the quantity theory of money has already become a modern classic. He says that his quantity theory of money is especially a theory of demand for money. Hence his analysis is this connection is primarily concerned with exploring and explaining the nature of the demand function for money. Its objective is to discover the relatively more significant variables which determine the demand for money and to find out whether this function is stable or not. The traditional quantity theory of money was based on the assumption of a constant velocity of money. Friedman draws a distinction between the velocity and velocity function. He says that while velocity of money may and does fluctuate, the velocity function is stable. Thus the modern quantity theories like Friedman draw a distinction between demand for money and demand function for money or between velocity of money and velocity of money function. The velocity of money function is highly stable, much mor stable than the Keynesian Consumption function. Friedman therefore prefers economic analysis in terms of changes in money supply and a money multiplier derived from velocity relationship rather than use autonomous expenditures and the multiplies which emerge from consumption function as emphasised in the Keynesian theory. The modern quantity of money theories regard the money demand function not only stable but also of vital importance in determining the variables which are very important for the economy as a whole e.g. the level of national income, employment and price level. Friedman is of the opinion that the demand function and the money supply function as the independent of each other. That is, there are some important variables which determine the supply of money but which do not affect the demand the demand for money. The nation of stable demand function is useful in order to trace out the effect of changes in supply, but it is useful only if supply is influenced by at least some factors other than those regarded as affecting demand. Thus the modern quantity theories would reject the notion that the supply f money expands or contracts according to the needs of trade. We can also say that the modern quantity theories reject the concept of Keynesian liquidity trap or infinite elasticity of demand for money. Friedman makes out a strong case for the quantity theory if the elasticity of demand for money is approximately zero. Without going into how Friedman derives or expound the version of the Quantity Theory, it may suffice to give his restatement of Quantity Theory of Money this is set out below. Y=M.V(ebre1/p.dp/dt.w.R/ByU) Friedmans above equation is equivalent to the Equation of Exchange of the traditional Quantity Theory i.e. M = PY. However with the difference that Y is the real income in the traditional equation instead of the money income that Y represents in Friedmans equation given above. It is very necessary to berv in mind that the traditional quantity theory is only superficially equivalent to Friedmans restatement of it. The fundamental difference between the two approaches is that Friedman has substituted the velocity function. V(rbre1/p.dp/dt.w.y/pv) in place of the velocity constante V, or its reciprocal K in the traditional statement of the Quantity Theory. This is by no means a mere formal difference, it is unstead a very significant difference of substances.

Keynes Contribution to the Quantity Theory of Money

The modern theorists, especially the Keynesians lay emphasis that the value of money or the price level is infact a consequence of the total income rather than quantity of money. The real cause of fluctuation in prices is to be found in fluctuations in the level of aggregate income or expenditure. Therefore changes in the quantity of money can bring about changes in the level of prices only if they change aggregate spending in relation to the supply of output. Unless spending increases there can be no increase in demand for goods. And if demand for goods does not increase, the question of price rise does not arise. However eve if aggregate spending does not increase prices may still not rise. If the supply curve of output is fairly elastic. Therefore the effects of a change in quantity of money on the price level depends on the following factors. (i) Effect of change in money supply on the level of aggregate demand or spending. (ii) Relation between aggregate spending and the volume of production. As regards the volume of spending, it depends on the following. (i) The Consumption function (ii) The investment demand schedule (iii) Liquidity preference schedule (iv) Supply of money An increase in the quantity of money in the Keynesian system will lower the rate of investment. But if the rate of interest is already very low, further increase in the quantity, of money will not be able to reduce it still further. And we know that a fall in the rate of interest encourages now investment. Thus if the rate of interest is reduces as a result of an increase in money supply, the rate of investment will rise and the increase in investment will lead to increase in income via the multiplier. If this happens there will be an increase in the quantity of money i.e. we are operating along the perfectly elastic part of the liquidly preference curve, the rate of investment will not increase, and if investment does not increase, income and spending cannot increase. Thus there are circumstances when an increase in the quantity of money may fail to increase the level of aggregate spending. If this is the case, prices will not rise at all, even though the quantity of money has increased. Even if aggregate sending does increase because of an increase in the rate of investment, it is not necessary that prices must rise at all, much less proportionately to the increase in money supply. If we have less than fall employment and there are idle capital and labour resources, the supply curve of output will be fairly elastic, and increases in aggregate spending will lead to an increase in production without much increase in prices. On the hand if there is full employment an increase in aggregate spending will largely result in an increase in the level of prices rather than output.

Social Significance of Money

SOCIAL IMPORTANCE OF MONEY Money plays an important part in the daily life of a person whether he is a consumer, a producer, a businessman, an academician, a politician or an administrator. Besides it influences the economy in number of ways. (1) To the Consumer: Money possesses much significance for the consumer. The consumer receives his income in the form of money rather than in goods and services. With money in hands, he can get any commodity and service he likes, in whatever quantities he needs, and at

any time he requires. The money enables a consumer to make rational distribution of his income on various commodities of his choice. (2) To the Producer: Money is of equal importance to the producer. He keeps his account of the values of inputs and outputs in money. The raw materials purchased, the wages paid to the workers, the capital borrowed, the rent paid, the expenses on advertisement etc are all expenses of production which are entered in his account books. The sale of products in money terms are his sale proceeds. The difference between the two gives him profit. Thus a producer easily calculates not only his costs of production and receipts but also profit with the help of money. Further money helps in the general flow of goods and services from agricultural, industrial and tertiary sectors of the economy because all these activities are performed in terms of money. (3) In Specialization of Division of Labour: Money plays an important role in large scale specialization and division of labour in modern production. Money helps the capitalist to pay wages to large number of workers engaged in specialised jobs on the basis of division of labour. Each worker is paid money wages in accordance with nature of work done by him. Thus money facilitates specialisation and division of labour in modern production. These in turn help in growth of industries. It is infact through money that production on large scale is possible. (4) As the Basis of Credit: The entire modern business is based on credit and credit is based on money. All monetary transactions consist of cheques, drafts, bills of exchange etc. These are credit instruments which are not money. It is the bank deposits which are money. Banks issue such credit instruments and create credit. Credit creation in turn plays a major role in transferring funds from deposits to investors. Thus credit expands investment on the basis of public savings lying in bank deposits and helps in maintaining a circular flow of income within the economy. (5) As a Means to Capital Formation: By transforming savings into investment, money acts as means to capital formation. Money is liquid asset which can be stored and storing of money implies savings and savings are kept in bank deposits to earn interest on them. Banks in turn lend these savings to businessman for investment in capital equipment, buying of raw materials, labour etc. From different sources and places. This makes capital mobile and leads to capital formation and economic growth. (6) As an Index of Economic Growth: Money is also an index of economic growth. The various indicators of growth are national income, per capita income and economic welfare. These are calculated and measured in money terms. Changes in the value of money or prices also reflect the growth of an economy. Fall in the value of money (or rise in prices) means that the economy is not progressing in real terms. On the other hand a continuous rise in the value of money (or fall in prices) reflects retardation of the economy. Somewhat stable prices imply a growing economy. Thus money is an index of economic growth. (7) In the Distribution and Calculation of Income: The rewards to the various factors of production in modern economy are paid in money. A worker gets his wages, capitalist his interest, a landlord his rent and an entrepreneur his profit in terms of money. An organiser is able to calculate the marginal productivity of each factor in terms of money and pay it accordingly. For this, he equalises the margin productivity of each factor with its price. Its price is, infact its marginal productivity expressed in terms of money. As payments are made to various factors of production in money, the calculation of national income becomes easy. (8) To the Government: Money is of immense importance to the government. Money fadcilitates the buying and collection of taxes, fines, fees and prices of services rendered by the government to the people. It simplifies the floating and management of public debt and government expenditure on development and non development activities. It would be impossible for modern

government to carry on their functions without the use of money. Not only this but modern governments are welfare states which aim at improving the standard of living of the people by removing poverty, inequalities and unemployment and achieving growth with stability. Money helps in achieving these goals of economic policy through its various instruments. (9) To the Society: Money confers many social advantages. It is on the basis of money that the super structure of credit is built in the society which simplifies consumption, production, exchange and distribution. It promotes national unity when people use the same currency in every nook and corner of the country. It acts as lubricant for the social life of the people and oils the wheels of material progress. Money is at the back of social prestige and political power. ROLE OF MONEY IN A CAPITALISTIC ECONOMY In a capitalistic economy money is the pivot around, which all economic activities cluster. Money is an indicator as well as a surveyor or wealth. The importance of money can be judged from the powerful influence which it exercises on the volume of production, direction of production, pattern of consumption, method of distribution, direction and volume of exchange and rate of saving and investment in the country, these all powerful effects of money are discussed as under. (i) Production Pecisions: Production has been greatly fascilitated by the introduction of money. Money makes possible the accumulation of wealth in those hands which are able to organise the production. Production without the use of money cannot be organised on large scale and run efficiently and economically. The decision of what, where, when and how much to produce are guided by the amount of money offered in exchange of goods and services. The cost of production is also estimated in terms of money. The profit or loss which is the difference between the sale proceed and the total money cost is also expressed in terms of money. With the introduct of money, the consumption easily be postponed and the assets can be stored for use to future date. People also deposit their savings in banks which lent to the business firms and industrialists for further production of wealth. (ii) Pattern of Consumption: According to Adam Smith Consumption is the sole end and purpose of economic activity. Under the primitive conditions of human existence the wants were limited in number and could easily be satisfied. With the introduction of money, the exchange of goods has become easy. People can sell their goods and services for money and can obtain the assortment of goods which they need by parting with money. Money thus has considerably increased the flow of commodities from producer to consumer and thus had led to the maximum satisfaction of the human being. In the absence of money a great variety to things would never have entered in our consumption list and so our satisfaction would have been at the lowest level. (iii) Exchange of Transactions: In money less economy; exchange of goods was a very inconvenient process. People used to face difficulties of double coincidence of wants. There was also no common measure of value. The use of money has successfully removed the awkwardness of barter. Money by acting as a medium of exchange, has greatly stimulated, the exchange of goods. It splits up exchange process into two parts, sale and purchase and thus fascilitates flow of goods and services from producer to consumer. (iv) Distribution of National Dividend: The four factors of production, combining together, produce a net aggregate of commodities every year. The share of each factor of production i.e. rent of land, wages of labour, interest on capital and profit to entrepreneur is paid in terms of money. If the share of each factor of production was to be paid by dividing joint products, it would have caused much inconvenience to each distributor. As money is generally acceptable as

a medium of exchange and the same time acts as a measure and store of value, therefore the distribution of national dividend through the medium of money greatly fascilitates the process of distribution. (v) Money in the Field of Public Finance: Money renders a valuable service in the field of public finance. Public finance in recent times aims at increasing the rate of economic activities and reducing inequalities of income. It also acts an instrument of economic and social justice in a country. Money helps the state in the achievement of these objectives. The government can easily raise revenue through the medium of money and can spend it for the betterment of the people. (vi) Money in the Sphere of Banking: We know it very well that money serves as standard of deferred payments. The general confidence in the purchasing power of money makes it the chief form of credit. The debtor can safely borrow money for consumption or for production purposes. This has led to the building up of gigantic super structure of banking and credit system. (vii) Attainment of High Level of Production and Employment: The introduction of money in the economy has fascilitated exchange. It has led to the high degree of specialization and interdependence of economic units. If the money is properly managed, it ensures rising level of Production, employment and real income in the country. In case the delicate instrument is not properly handled, it leads to decline in the prices, output and job opportunities. We thus find that the behaviour of employment, rate of output, level of price and distribution of national income are directly related to the monetary forces in the capital economy.

Essentials of Good Monetary System

Various monetary systems or standards have been adopted in practice from time to time. Broadly speaking a good monetary system must fulfil the following conditions. (i) It must maintain a reasonable stability of prices in the country. This means that its internal value (or purchasing power in terms of goods and services in the country concerned) must not fluctuate too violently. This involves regulation of amount of money in circulation to suit the requirements of trade and industry in the country. (ii) A good monetary system must maintain stability of the external value of the currency. This means that its purchasing power over goods and services in foreign countries, thought its command over a definite amount of foreign currency, should remain constant. This is the problem of foreign exchange. (iii) The monetary system must be economical. A costly medium of exchange is a nation waste. It is unnecessary that is why all countries use mostly paper money. (iv) The currency must be elastic and automatic so that it expands or contracts in response to the requirements of trade and industry. (v) The monetary system must be simple so that an average man can understand it. A complicated system can not inspire public confidence. In modern times metallic money is supplemented or replaced by paper money altogether. Paper money has been very useful. It economises the use of precious metals. It is convenient to carry and easy to store. Its value can be kept stable by properly controlling its issue. It is of great fiscal advantage to the government. A government can tide over a period of difficulty by the issue of paper money. In early times when notes were introduced, they were backed by an exactly equal amount in gold or silver exchanged for coins whenever needed and did nothing more than represent coins. They

were called representative paper money. American gold certificates (Green backs) were of this type. This practice was very expensive and is no more current now. Paper money is not wholly backed by specie (i.e. precious metal) now. Only proportional reserves are maintained and a good deal of paper money rests on peoples confidence in the world of the issuing authority, be it Government or the Central Bank of the country. Paper money can be convertible or inconvertible. If the issuing authority promises to convert notes into standard money on demand, it is called convertible paper money. But something after an over issue of paper money in an emergency like war, the authority feels unable to convert its notes into coins. Then it breaks its promise of converting notes into standard money and there by makes the money inconvertible or fiat money (money by order). When the link with metal is broken there is tendency to over issue paper money. Its value then depreciates. Prices shoot up, which results in suffering for people with fixed incomes. Essentials of good monetary system found in Paper currency standard are mentioned below. 1. ECONOMICAL Practically paper money costs nothing to the Government currency notes, therefore are the cheapest media of exchange. If a country uses paper money, it need not spend anything on the purchase of gold or silver for minting coins. The loss which a country suffers from the wear and tear of metallic money is also avoided. 2. CONVENIENT The paper money is most convenient form of money. A large amount can be carried conveniently in the pocket without any body knowing it. 3. FISCAL ADVANTAGE TO THE GOVERNMENT Fiscal advantages of the paper currency to the Government are undoubtedly very great especially in the times of national emergencies like a war. A modern war cannot be prosecuted by taxes or loans alone. All governments have to resort to printing press. 4. ELASTICITY The paper standard is highly useful monetary system because it possesses great elasticity. The monetary authority can easily adjust the money supply in accordance with the requirements of the economy. The supply of money can be increased by printing more notes in times of financial emergency, war and for economic development. It can also be reduced when situation demand so. 5. PRICE STABILITY As a corollary to above, the paper standard ensures the price stability. The monetary authority can stabilise the price level by maintaining equilibrium between demand and supply of money by an appropriate monetary policy. 6. FREE FROM CYCLICAL EFFECTS The paper standard is free from the effect of business cycles arising in other countries. 7. FULL UTILISATION OF RESOURCES The gold standard had a deflationary bias, whereby the resources of the country remained utilised. Whenever there was gold in outflow, the prices fell and resources became unemployed. But this is not the case under the paper standard in which the necessary authority can manipulate the monetary policy in order to ensure full utilization the countrys resources. 8. EQUILIBRIUM IN EXCHANGE RATE One of the advantages of the paper currency standard is that it immediately restores equilibrium in the exchange rate of a country, whenever disequilibrium occurs in the demand and supply of its currency in the foreign exchange market.

9. REPLACEABLE Paper notes of one type and denomination can be easily replaced by printing notes of different types of the same denomination.

Advantages and Disadvantages of Paper Currency Standard

Paper currency standard consists of paper money which is unlimited legal tender and token coins of cheap metals. Paper money may be either convertible of inconvertible. Convertible paper money is convertible into gold or silver coins or bullion of specified weight on demand. Paper money is not convertible into coins of a precious metal of bullion nowadays. Therefore it is inconvertible. People accept it because it is legal tender. Since it has the command of the government, people have to accept it. That is why it is also known as fiat money or standard. It is also referred to as managed standard because the issue of paper money and token coins is managed by the central bank of the country. ADVANTAGES OF THE PAPER CURRENCY STANDARD The paper currency standard which is universally used, has a number of merits. Some of these are stated below. 1. Economical: The paper currency standard is cheaper than the gold or silver for coinage purpose. Rather precious metals can be used for productive purposed and for making payments for foreign countries. As paper money is not convertible, there is no need to keep gold in the form of reserves. The money authorities keep only a fixed quantity of gold in reserve for reasons of security. Thus paper standard is cheap and economical and even a poor country can easily adopt it. 2. Elastic: The paper standard is a highly useful. Monetary system because it possesses great elasticity. The monetary authority can easily adjust the money supply in accordance with the requirements of the economy. This was not possible under the gold standard. The supply of money can be increased by printing more notes in times of financial emergency, war and for economic development. It can also be reduced when the economic situation so demands. Thus there is also freedom in the management of the money supply in the economy. 3. Price Stability: The paper standard ensures price stability in the country. The monetary authority can stabilise the price level by maintaining equilibrium between demand and supply of money by an appropriate monetary policy. 4. Free from Cyclical Effects: The paper standard is free from the effects of business cycle arising in other countries. This merit was not available to other monetary standards, especially the gold standard, where cyclical movements in one country were automatically passed on to other countries through gold movements. 5. Full Utilisation of Resources: The gold standard had a deflationary bias where by the resources of the country remained unutilised. Whenever there was gold out of flow, the prices fell and resources became unemployed. But this is not the case under the paper standard in which the necessary authority can manipulate the monetary policy in order to ensure full utilization the countrys resources, 6. Equilibrium in Exchange Rate: One of the merits of the paper standard is that it immediately restores equilibrium in the exchange rate of a country whenever disequilibrium occurs in the demand and supply of its currency in the foreign exchange market. 7. Portable: It is very convenient to carry large sums of paper money from one place to another. 8. Easy to count: It is easier count paper money than metallic money.

9. Easy to store: It is easier to store large sums of paper money in a small space. 10. Cognisable: It is easy to recognise paper notes of different denomination. 11. Replaceable: Paper notes of one type and denomination can be easily replaced by printing notes on different types of the same denomination. DISADVANTAGES OF THE PAPER CURRENCY STANDARD Despite above mentioned merits, the paper currency standard has certain disadvantages, these disadvantages are mentioned below. 1. Inflationary Bias: One of the serious defects of the paper standard is that it has an inflationary bias. As paper notes are inconvertible, there is every likely hood of the government printing note in excess of requirements. Or the government may deliberately resort to the printing press to meet a financial emergency or war or even to need ordinary budget deficits. This leads to excess of money supply and to inflation in the country. 2. Price Stability a Myth: In the merits of the paper currency standard it has been pointed out that it leads to price stability. Actually price stability is a myth as has been experience of the majority of the countries on the paper standard. 3. Exchange Instability: Another disadvantage of this system is that it leads to instability in exchange rates whenever there are large fluctuations in external prices an against internal prices. Such wide and violent fluctuations in exchange rates are harmful for the growth of international trade and capital movements among countries. These have led governments to adopt exchange control measures. 4. Lacks Confidence: Paper money lacks confidence as it is not backed by gold reserves. 5. Lacks Durability: Paper money has less durability than metallic coins. It can be easily destroyed by fire or insects. 6. Unstable: Paper money lacks stability because its supply can be changed easily. 7. Uncertainty: Instability in the value of paper money leads to uncertainty in the economy which adversely affects business and economic progress of the country, 8. Token Money: Paper money is token money and in the event of demonetisation of notes they have no intrinsic value and are simply like wrote papers. 9. Not Automatic: The paper currency standard does not operate automatically. It is highly managed standard which requires much care and caution on the parts of the monetary authority. A little carelessness may bring disaster to the economy. ESSENTIALS OF A SOUND CURRENCY SYSTEM Broadly speaking, a sound currency system must fulfil the following conditions. (i) It must maintain reasonable stability of the prices in the country. This means that its internal value (or purchasing power in terms of goods and services in country concerned) must not fluctuate too violently. This involves regulation of amount of money in circulation to suit the requirements of the trade and industry in the country. (ii) A sound currency system must maintain stability of the external value of the currency. This means that its purchasing power over goods and services in foreign countries, through its command over definite amount of foreign currency should remain constant. This is the problem of foreign exchange. (iii) The system must be comical. A costly medium of exchange is a national waste. It is unnecessary. That is why all countries use mostly paper money. (iv) The currency must be elastic and automatic so that it expands or contracts in response to the requirements of trade and industry.

(v) The currency system must be simple so that an average man can understand it. A complicated system cannot inspire public confidence.

Nature and Evolution of Monetary Standards

The history of Monetary Standards in Pakistan can be traced back to the history of coinage in the undivided Indian subcontinent. Alexander Del Man in his book A History of Money in Ancient Countries has stated that metals like gold, silver, copper, iron in the shape of lanives, axes, pots, fish hooks etc were used in India in ancient times. The un-standardized metals of over 5000 years old have recently been discovered din India. The search in stupa area of Mohen-jo-Daro has led to the discovery of much worm out gold coins whose history runs far back into antiquity. The old gold coins were named as Nishka. In the early civilization in India, the chief metals used as coins were gold, silver, bronze and iron. The use of iron and bronze metals was steadily discarded; probably those base metals were discovered in abundance and also required in large quantity for ordinary transactions. The use of gold and silver metals in un-coined forms continued for a long time as a media of exchange, because these metals possessed intrinsic value and were also required for ornamentals. In the beginning symbols were impressed on the face of coins by means of punches. Then as time passed on and technology developed, the shape and execution of the coins was improved considerably. In the region of Guptas the coins had some shape and fineness in them. An attempt was made by King Altamash, the great, to introduce round shape silver coins weighing 173 grains each. Muhammad Tughlaq further brought revolutionary changes in the coinage system by introducing token currency of copper coins in the country. Sher Shah Suri got the instruments of exchange better designed and introduced silver rupee weighing 172.5 grains as standard coin. He also issued a copper coin of small denomination which was named as Dam. King Akher made slight improvements in the coinage system. Aurangzeb too had his share in the standardization of coinage. The collection of state revenue was done in the currency of the country named as Dam. With the fall of Mughal Empire the country was spilt up into small states. They had their own coins of different sizes, shapes, fineness and impression on them. When the East India Company came to the sub-continent, there were over 1000 different coins of various denominations. The mers was cleared by the company by standardizing the currency. It introduced a rupee silver coin in 1818 weighing 180 grams having 11/12 fineness as the standard coin of country. The act of 1835 finally got approval of the silver rupee as the standard coin. The coinage of gold standard also continued in the country but they ceased to exist as legal tender money. The ratio of exchange of one gold coin named as Molar was equal to 15 silver rupees for all transaction purposes. In the year 1866, the Coinage Act was amended and the government was allowed to mint other metals bronze and nickel in addition to silver for coins of various denominations. During the Second World War people began to hoard and melt the silver coins as the intrisic value of the rupee exceeded its face. The government then demonelized Victoris and King Edward VII standard silver rupee and half rupee in 1941, and 1942, and King George V and King George VI silver rupee and half rupee in May 1943. Government introduced pure nickel rupee, half rupee and quarter rupee in 1946. There was no central bank at the time of partition in 1947 in Pakistan. The government of Pakistan authorized the Reserve Bank of India to issue currency notes and coins till June 30, 1948. The Indian coins remained legal tender for

one year after partition in Pakistan. The new coins issued by the Government of Pakistan are pure nickel rupee half rupee and quarter rupee.

Origin and Growth of Money

The word money has been taken from Latin word Moneta which denotes godess Juno in whose temple money was minted in Rome. At present the Latin word pecunia is used for money. It is generally believed that pecunia is derived from pecus meaning cattle which have served at one time or another as a medium of exchange and a measure of value. People think that man done nothing to discover money but it appeared at its own according to the needs of circumstances. This idea is known as theory of spontaneous growth. According to some people money was discovered to overcome the defects of barter system. This idea is known as theory of evolution. Some people think that money arose as unit of account from customary ratios of exchange. There are others who hold that money originated as medium of exchange. This theory is more widely held and is generally believed that some articles general utility began to serve as a medium of exchange and became money. This was due to its general acceptability. Throughout the history of civilization money has passed through different stages. Historically the development of money in the present form has evolved through the following stages. These stages are discussed as under. 1. COMMODITY MONEY The earliest money which came into use and was accepted in the exchange of goods was commodity money. A large number of item such as wheat, cotton, skins, arrows, bows, camels, goats etc have served as commodity money at different times and places depending upon the stage of development in that country. As time passed on it was found that these commodities were not best suited as general means of making payments. The main problems with commodity money were that they lacked (a) durability (b) portability (c) divisibility (d) uniformity and standardization (e) regularity in supply (f) and had high opportunity cost, so search was made to find more suitable and convenient mean which is generally acceptable in payments for the goods and services. The search led to the discovery of precious metals like copper, silver and gold. 2. METALLIC MONEY The next form of commodity money was the use of metals such as gold, silver, copper as medium of exchange. Such coins had in intrinsic value. Which was reflected in their face value? The use of un-coined metals as a medium of exchange created further difficulties; it became difficult for people to known the weight and value of the peiece of bullion at sight. The discovery of mines of gold and silver and their exhaustion caused fluctuations in the supply of money. Transaction and storage of precious metals also became dangerous. Debasement of metal further caused inconvenience and complications in exchange further advancement in the evolution of commodity money was the replacement of un-standardized metal ingnots with a standardized coinage. The metallic coins had a guaranteed weight of value by a competent authority. They had also the intrinsic value and so commanded a universal respect. With the passage of time these full bodied coins also proved a failure as a good medium of exchange. Coins were clipped abraded and melted down. They were also debased with the discovery or exhaustion of mines the intrinsic worth of the coins begins to depart from their face value efforts were made to find out a better unit of account. 3. CONVERTIBLE PAPER MONEY

In the evolution of money the next stage was the discovery of convertible paper money as a commodity money substitute. The convertible paper money is paper money that may be redeemed for a specific commodity at a rate of specialized on the currency. Before 1914 the bulk of bank notes were convertible into gold. The bank notes of various denominations had a promise by the bank to pay to the bearer as specific amount of gold on demand. The practice of exchanging paper currency for gold was eliminated after 1914 in England and in 1933 in USA. In todays economy the paper notes are inconvertible notes. They are neither fully nor fractionally convertible into gold. The paper money developed into inconvertible money is called flat money. 4. FLAT MONEY Flat money consists of paper money that derives its status as money from the power of the state. That money is money because government says it is money. It is not backed by promise to pay something of intrinsic value. It is accepted because government declares it legal tender. The creditors must accept it as a medium of exchange and as a payment for debts. 5. CREDIT MONEY Another most important component of money supply is the deposit money or credit money. Deposit money consists of deposits at bank and the financial institutions which are subject to withdrawal by cheques. In developed countries of the world 95% transactions are carried on with cheques. Cheques are a safe way of transferring the ownership of deposits in financial institutions. They are normally acceptable as medium of exchange. 6. ELECTRONIC BANKING In all the developed and many developing countries of the world including Pakistan the commercial banks have entered into an era of electronic banking. The customers of banks having deposits in their accounts can make purchase, pay bills, transfer money simple by electronic signals. 7. NEAR MONEY The final stage in evolution of money has been the use of bills of exchange, treasury bills, debentures, saving certificates etc. They are known as near money. They are close substitute for money and are liquid assets. The final stage of its evolution has become intangible. Its ownership ins now transferable simply by book entry.

Demerits of Money
Money do doubt has played a very significant role in the economic development of a country. It is infact blessing to mankind but this blessing has also a darker side. Money is a good servant, but, bad master means that money is good so long it remains under control but then it is not efficiently managed; it is then a source of peril and confusion. Money has proved dangerous in several ways. The major evils of money are as under. (i) ECONOMIC INSTABILITY Some economists are of the view that money is responsible for economic instability that is to be found in capitalist economics. When there was no money, saving was not divorced from investment. Those who saved also invested. But in monetised economy, saving is done by certain people and investment by some other people. Hence it does not follow that saving and investment should be equal. When saving is a community exceeds investment than national income, output and employment decrease and the economy is engulfed in depression. On the contrary, when investment exceeds saving (i.e.

investment financed not by genuine savings but through deficit financing) then national income, output and employment increase and there is spell of prosperity. But if the process of money creation and investment continuous beyond the point of full employment inflationary situation will be created. Hence disparity between savings and investment resulting from the creation of money is said to be the main cause of economic fluctuations. (ii) DANGER OF OVER-ISSUE The main changer of money lies in its liability of being over-issued in the case of inconvertible paper money. The over issue of money may result in hyper-inflation. Excessive rise in prices hits hard the consuming public and the fixed incomists. It engenders speculation and inhibits productive enterprises. If also upsets detor-creditor relationship. If adversely affects distribution of income and wealth in the community so that the gulf between rich and poor widens. (iii) ECONOMIC INEQUALITIES Money has proved to be very convenient tool far amassing wealth and of the xploitation of the poor by the rich. It has created a yawning gulf between the haves and have nots. The misery and degradation of poor is, thus, to no small measure due to the existence of money. (iv) MORAL DEPRAVITY Money has weakened the moral fibre of ma. The evils to be found in the affluent society are only too obvious. The wealthy monopolise all the social evils like corruption, the wine and the woman. In their case money has proved to be soul killing weapon. In the words eminent German economist Von Mises money is regarded as the cause of theft and murder, of deception and betrayed. Money is blamed when the prostitute sells her body and when the bribed judge perverts the law. It is money against which the moralists declaims when he wishes to oppose excessive materialism. Significantly enough avarice is called the love of money and all evils is attributed to it. Money in itself may not be had, but its possession no doubt fascilitates corruption and crime. Thus money which is a source of so many blessings to mankind becomes unless we control it, a source of peril and confusion.

Importance of Money in Our Modern Society

Money is considered as the King of the free market economy. Every work starts and ends with money. Money occupies in important place in all economic activities. All businessmen, traders and individuals depends upon money for meeting their expenses. In the words of Marshall Money is the pivot round which the whole economic system clusters. The truth is that money is one of the greatest inventions of mankind. In money economic every branch of economic activity is different from what it was in barter economy. There is no doubt that money facilitates and motivates all economic activity relating to consumption, production, exchange and distribution. Money enables a consumer to maximise his satisfaction. Money measures the intensity of desire and utility of commodity to a consumer. Money fascilitates production by stimulating saving and investment. It gives molnlity to capital and helps in capital formations. It enables the harnessing of various factors or production so that the entrepreneur is able to maximise his profit. Introduction of money facilitates exchange and helps in the development of trade and commerce, both national and international. Money functions as a common denominator for the distribution of social product. It is in terms of money that wages, rent interest and profits are determined. Money helps the price mechanism to operate and serve as an instrument for the allocation of resources among competing uses. Money is extremely valuable social instrument which has largely contributed to the growth of national wealth and social welfare. It has ensured

the smooth functioning of the modern economic system. It has accelerated the process of industrialisation. In money economy there is continuous flow of money payments. This circular flow is essential for promoting economic welfare of society. Whatever the type of economic system exists money is found to be of great service. In a capital economy, money plays an important role because capitalism basically depends on price mechanism which operates through the medium of money. As Professor Robertson observes the existence of monetary economy helps society to discover what people wand and how much the want. and to decide what shall be produced and in what quantities and to make the best use of its limited productive power. And it helps each member of society to ensure that the means of enjoyment to which he has access, yield him the greatest amount of actual enjoyment which is with in his reach. Even in a socialist economy, price tags are essential for its smooth efficient and economical working. It is said while money is a master in a capitalist economy, it is a servant in a socialist economy. Money also plays a significant role in a mixed economy. It plays a circular role in determining employment, output and income in the private sector. In the public sector is helpful in the allocation of resources and for changing the pattern of income distribution. It is powerful instrument for capital formation and economic development in a developing economy.

Inconveniences of Barter System

Barter means direct exchange of goods for good. Barter system was prevalent at an early stage of mans economic life when the wants were limited in number. Man could easily satisfy all his wants he produced himself. But as time passed his needs began to increase. He lost the 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. For instance if a fisherman wanted to have skins, he could get them by giving fish to the hunter. Similarly if a weaver wanted a pair of shoes, he could receive that by giving surplus cloth to cobbler. This divert exchange of surplus commodity with another person without the use of money is termed as Barter in Economics. INCONVENIENCES OF BARTER SYSTEM The following difficulties and inconveniences were experienced in the Barter System. 1. Double Coincidence of Wants: The direct exchange of one commodity for another required direct satisfaction of both the parties in the bargain. The exchange can only be effective if a person is able to spare what the other person wants and at the same time needs what the other can spare. For instance a person has surplus wheat with him and wished to exchange with cloth. He will have to find a person who not only possesses sufficient cloth but also desires wheat. This double coincidence as in obvious is very difficult to attain in this civilized world especially where the range of human wants is very wide. The transactions of cost double coincidence of wants are very high. 2. Lack of Common Measure: Another difficulty which arises under the Barter system is absence of common measure which can help in the estimation of relative values of the two commodities. For instance a man has horse with him and other a cow and tooth are willing to trade. A man who has a horse assigns the value of one horse as two cows. The other who has a cow assigns the value of one cow as one horse and both stick to their respective valuations. In the absence of common measure of value the exchange between the two parties cannot take place unless both of them assign the same value to different commodities which they possess.

3. Lack of Sub-divisions: One serious draw back of Barter system is that even when double coincidence of wants exists between the two parties, the exchange may not take place even then. This is the particularly cause in those commodities which cannot be sub-divided. For instance a person has a cow with him and wishes to get 40 kilograms of wheat. It is clear that the value of the cow is much more than the value of 40 kilograms of wheat. What part of the cow should be given in exchange of 40 kilograms of wheat? Just imagine if the cow is cut into pieces, wheat value can it command? 4. Lack of Store of Value: Another serious inconvenience which arises under Barter that the goods particularly perishable ones cannot be stored for a longer period. They lose their value as time passes on. 5. Specialization not possible: Under Barter economy each person is jack of all trades and master of one. A high degree of specialization cannot be achieved under it. 6. Payment in Future: Under the Barter system, it is very inconvenient to lend goods to other people. With the lapse of time, the value of commodities may fall. So it becomes difficult to make payments in future. 7. Difficulties of Transfer of Wealth: There is great difficulty in transferring of wealth from one place to another under Barter system. For instance if a person has to take one hundred heads of cattle from Kashmore to Karachi show much difficulty he would feel? The risk and inconvenience of transportation is major difficulty of Barter system. 8. Difficulties in Tax collection: Another difficulty which arises under Barter system is that the tax cannot be collected, in the form of goods. If commodities are collected from the tax payers, they will not only lose value as time passes on but are difficult to store also. HOW INCONVENIENCES OF BARTER SYSTEM HAVE BEEN REMOVED BY MONEY The use of money has converted a Barter economy into monetary economy. The money has overcome difficulties and inconveniences of the barter system in the following ways. 1. Use of Money: Money is now used as (i) medium of exchange, now goods and services are purchased and sold with the help of money. (ii) Money now serves as common measure of value, the problem of comparing the prices of goods and services in the market is now simplified. (iii) With the help of money the exchange of present goods on credit has been made easier. The problem of deferred payments has been satisfactory solved with the help of money. (iv) Money as liquid store of value has facilitated its possessor to purchase any other asset at any time. (v) Though money value can be easily and quickly transferred from one place to another. 2. Liquidity of Wealth: Money imparts liquidity to various forms of wealth such as land, machinery, stocks store etc. These forms of wealth can be easily converted into money. 3. Establishment of financial institutions: The introduction of money has made it possible to establish financial institutions like central bank, commercial banks etc, which deal in currency and near money assets such as bills of exchange, bonds, shares etc. 4. Market mechanism: In monetary economy market mechanism operates. The demand and supply are brought into balance by movement of prices. The decision of what wow and for who to produce are determined in accordance with the market conditions or dictates of price mechanism. 5. Circular flow of money: In a monetary economy there is circular flow of money. Money flows from firm (as a payment for factor services) to the households. It flows from households to firms as the price of goods and services. 6. Process of development: In a Barter economy the process of economic development is slow. With the use of money division of labour has taken place, technology has developed, researches

are being carried out, trade has expanded etc. In monetary economy, there is thus an all round economic progress.

Money and its Functions

Money has been defined in various ways. Walz Ken says Money is what money does. In other words, any thin that performs the function of money is money. In the widest sense, the term money includes all media of exchange-gold, silver, copper, cheques, commercial bills of exchange etc. but this definition is too wide; cheques, bills etc have been called representative money as they are only convenient representatives of the standard of value. Some writers narrow down the definition to include only the commodity such as gold that may serve the purpose of money. This excludes bank notes or government currency notes from the category of money. These instruments cannot, logically speaking, be excluded because they possess all the attributes of money. The most commonly agreed view on the definition of money is that anything which is widely accepted in payment for goods, or in discharge of other kinds of obligations is money. In Growthers words The only essential requirement is general acceptability. Money need not itself be valuable. It must indeed be relatively scare, since it would hardly do if money could be plucked off every tree. Pout provided precautions are taken to keep it relatively scare and it may be added comparatively in variable in amount of money can consist of things as worthless as a scare of paper or the scratch of Clerks pen in the books of a bank. FUNCTIONS OF MONEY The functions of money can be conveniently divided into three parts. (A) Primary (B) Secondary (C) Contingent functions. These functions are discussed as under. A. PRIMARY FUNCTIONS OF MONEY (1) Money as a Medium of Exchange: In all market transactions, money is used to pay for goods and services. The sale or purchase of goods is done through money. Money other words acts as medium of exchange and helps in overcoming the difficulty of double coincidence of wants of the barter economy. The use of money as a medium of exchange has helped in promoting efficiency in the economy. It has reduced much of the time spent in exchange goods and services. It has also promoted efficiency of allowing people to specialize in any area in which they have comparative advantage and receive no money payments for labour. The use of money as medium of exchange has permitted more specialization by lowering transactions cost and encouraging division of labour. (2) Money as a unit of account: Another important function of money is that it provides a unit of account. The monetary unit of account is used to measure the value of goods and services in the economy. Just as we measure weights in terms of grams or kilograms, and distance in kilometres, similarly we measure and compare the value of goods and services in terms of money. Money is the yardstick that allows the individuals to measure the relative value of goods and services. The use of money as unit of amount has greatly reduces transaction costs i.e. the time, effort and expenses that go into purchase or sale of goods. (3) Money as a standard of deferred Payments: Another function of money is that it is used as mean of setting debts maturing in the future. In modern economy, most of the business is done on credit. Goods are brought and sold on the promise to pay money on a certain date in future. Debts are stated and paid in terms of units of account. (4) Money as a store of value: Money also functions as a store of value. It is reservoir of

purchasing power overtime. The money which we have to day can be set aside to purchase things later on. This function of money is useful because most of us do not to spend our income immediately upon receiving it. We prefer to wait until we have the time or desire to spend it. Money held in the form of cash is considered highly liquid asset. B. SECONDARY FUNCTIONS OF MONEY Money as potential to influence the economy. It influences the price level, interest rates, utilization of resources etc. The secondary functions of money in brief are as under: 1. Aid to specialization, production and trade: The cese of money has helped in removing the difficulties of barter. The market mechanism, production of commodities, specialization, expansion and diversion of trade etc have all been facilitated by the use of money. 2. Influence on income and consumption: The use of money has direct bearing on the levels of income and consumption in the country. All production takes place for the market and the factor payment (rent, wages, interest and profits) are made in money. The higher the production the higher are the remunerations to the factors and vice versa. 3. Money as an instrument of making loans: People have money and deposit it in banks. The banks and advance these saving to businessmen and industrialists. Money is thus an instrument by which saving are transferred into investment. 4. Money as a tool of monetary management: Money is an important tool of monetary management. If the money is effectively used, it helps in increasing output and employment. Money is also an important factor in determining the distribution of income and health among members of the society. 5. Instrument of economic policy: Money is an important instrument of economic policy of the government. In order to achieve growth, reduce unemployment and maintain regular expansion of economic activity, money is the most powerful factor. C. CONTINGENT FUNCTIONS Contingent functions are derived from primary and secondary functions. According to Kinley, the contingent functions of money are as follows: (i) Distribution of National Income: Money facilitates the distribution of national income among various factors of production. It also helps in bringing justice in distribution. (ii) Basis of Credit system: Banks create credit on the basis of their cash serves. Any change in the volume of money is brought about mainly by an increase or decrease in money supply. (iii) Measure of Marginal Productivity: The marginal productivity of each factor of production is measured with the help of money. Money also helps in equalization of marginal utility in expenditures. (iv) Liquidity of Property: Money gives liquid form to wealth. A property can be converted into liquid form with the use of money.