Public Finance & the Money Market

Weightage: Chapters 7 and 8 of ICAI's Paper 4 syllabus, roughly 22 marks. These two chapters carry more examinable distinctions than any others in the paper, and almost every question is decided by knowing precisely where one term ends and its neighbour begins.

Public finance

The fiscal functions

Government intervenes in the economy for three purposes, and classifying an intervention correctly is a standard question.

The allocation function — providing goods and services the market will not supply adequately, and correcting the misallocation caused by market failure.

The distribution function — altering the distribution of income and wealth through progressive taxation, transfers and subsidies, since the market distributes according to ownership of resources and productivity rather than according to need.

The stabilisation function — using fiscal policy to moderate fluctuations in output, employment and prices, which is the Keynesian demand management of the previous chapter applied through the budget.

Market failure

A market fails when it does not allocate resources efficiently. Four sources are examined.

Public goods. A public good has two properties. It is non-rival, meaning one person's consumption does not reduce what is available to others. And it is non-excludable, meaning those who do not pay cannot be prevented from consuming it. National defence, street lighting and a lighthouse are the standard examples.

Non-excludability creates the free rider problem: since no one can be excluded, no one has an incentive to pay, so a private market would supply nothing however valuable the good. This is why public goods must be provided collectively and financed by taxation.

Distinguish a pure public good, which has both properties, from a merit good such as education or healthcare, which is rival and excludable but which government provides or subsidises because individuals would otherwise under-consume it relative to what is socially desirable.

Externalities. An externality is a cost or benefit falling on a third party who is neither the producer nor the consumer, and which is not reflected in the market price.

A negative externality — pollution from a factory — means the private cost is less than the social cost, so the good is over-produced relative to the efficient level. The remedy is to internalise the externality by imposing a tax equal to the external cost, or by regulation.

A positive externality — vaccination, education, research — means the private benefit is less than the social benefit, so the good is under-produced. The remedy is a subsidy.

Asymmetric information, where one party to a transaction knows more than the other. It produces two distinct problems, and distinguishing them is examined:

• Adverse selection arises before the transaction, from hidden characteristics. A person who knows they are in poor health is more likely to buy insurance, so the pool of insured becomes worse than average and premiums rise, driving out the healthy — the market for good risks unravels.
• Moral hazard arises after the transaction, from hidden actions. An insured person takes less care because the consequences fall on the insurer.

Imperfect competition and market power, where a monopolist restricts output and charges a price above marginal cost, producing allocative inefficiency.

The budget

A government budget is the annual statement of estimated receipts and expenditure. Its structure is examined closely.

Revenue receipts neither create a liability nor reduce an asset. They comprise tax revenue and non-tax revenue such as interest, dividends and fees.

Capital receipts either create a liability or reduce an asset — borrowings, disinvestment proceeds and recovery of loans.

Revenue expenditure neither creates an asset nor reduces a liability — salaries, interest payments, subsidies, and the ordinary running costs of government.

Capital expenditure either creates an asset or reduces a liability — construction of infrastructure, purchase of equipment, and repayment of loans.

A budget may be balanced, where receipts equal expenditure; surplus, where receipts exceed expenditure; or deficit, where expenditure exceeds receipts.

The deficits

These three definitions are among the most examined items in the entire paper, and they differ from one another by exactly one adjustment each.

Revenue deficit = Revenue expenditure − Revenue receipts

It measures the extent to which the government's current spending exceeds its current income. A revenue deficit means the government is borrowing to meet ordinary running costs, which creates no asset and is therefore regarded as unsustainable.

Fiscal deficit = Total expenditure − Total receipts excluding borrowings

It measures the government's total borrowing requirement for the year. This is the headline figure in budget commentary and the one against which fiscal targets are set.

Primary deficit = Fiscal deficit − Interest payments

It isolates the current year's fiscal position from the burden of past borrowing. A country may run a fiscal deficit consisting almost entirely of interest on old debt while having a primary deficit close to zero, which indicates that current policy is not adding to the underlying problem.

Taxation

Direct taxes are levied on income or wealth and the burden cannot be shifted — income tax, corporate tax. Indirect taxes are levied on goods and services and the burden can be shifted to the consumer — GST, customs duty.

The incidence of a tax is where the burden finally rests, and it falls more heavily on the side of the market that is less elastic, because that side has fewer alternatives and less ability to escape it.

Tax structures are classified by how the average rate changes with income:

• Progressive — the rate rises with income. Income tax with slab rates is progressive, and it advances the distribution function.
• Proportional — the rate is constant regardless of income.
• Regressive — the rate falls as income rises. Indirect taxes tend to be regressive in effect, because a given tax on necessities absorbs a larger share of a poor household's income, and this is the standard criticism of heavy reliance on them.

Adam Smith's canons of taxation — equality, certainty, convenience and economy — are examined by name.

Fiscal policy

Fiscal policy is the use of government expenditure and taxation to influence aggregate demand.

Expansionary fiscal policy — increased expenditure or reduced taxation — raises aggregate demand and is used to close a deflationary gap. Contractionary fiscal policy does the reverse and is used against an inflationary gap.

Automatic stabilisers operate without any decision being taken: progressive taxation collects proportionately more as incomes rise and less as they fall, and unemployment benefits rise automatically in a downturn. They moderate the cycle without requiring a policy response.

The money market

Functions of money

The primary functions are as a medium of exchange, solving the double coincidence of wants that makes barter impractical, and as a measure of value or unit of account.

The secondary functions are as a store of value, a standard of deferred payment, and a means of the transfer of value.

The demand for money

The classical or Fisher approach is the quantity theory of money:

$MV=PT$

where $M$ is the money supply, $V$ its velocity of circulation, $P$ the price level and $T$ the volume of transactions. Assuming $V$ and $T$ are stable in the short run, the price level varies proportionately with the money supply — which is the classical explanation of inflation.

The Keynesian approach is liquidity preference, under which people hold money for three motives:

• The transactions motive — to meet day-to-day expenditure. It depends on income.
• The precautionary motive — to meet unforeseen contingencies. It also depends on income.
• The speculative motive — to take advantage of expected changes in asset prices. It depends inversely on the rate of interest, because a high interest rate means a high opportunity cost of holding idle money, and because bond prices are expected to rise when interest rates are high and expected to fall.

The first two motives make money demand a function of income; the third makes it a function of the interest rate, which is Keynes's distinctive contribution.

The supply of money

The Reserve Bank publishes four measures of increasing breadth:

• M1 — currency with the public, demand deposits with banks, and other deposits with the RBI. This is narrow money, the most liquid measure.
• M2 — M1 plus savings deposits with post office savings banks.
• M3 — M1 plus time deposits with banks. This is broad money and the measure most commonly cited in policy.
• M4 — M3 plus all post office deposits other than National Savings Certificates.

High-powered money or the monetary base is currency held by the public plus bank reserves — the money the central bank directly controls.

Credit creation. Commercial banks create money by lending. A bank receiving a deposit retains a fraction as reserves and lends the rest; the borrower spends it; it is redeposited in the banking system; and the process repeats. The total deposit created from an initial deposit is:

$\text{Money multiplier}=\frac{1}{\text{Reserve ratio}}$

So with a reserve ratio of 20%, an initial deposit of 1,000 can support total deposits of 5,000 in the banking system as a whole. The multiplier is smaller in practice because of currency leakage and excess reserves held voluntarily by banks.

Monetary policy

The Reserve Bank of India conducts monetary policy under a flexible inflation targeting framework, with the target set by the Central Government in consultation with the RBI and decisions taken by the Monetary Policy Committee.

Quantitative instruments affect the total volume of credit:

• Repo rate — the rate at which the RBI lends to commercial banks against securities. It is the policy rate, and raising it makes borrowing dearer and contracts credit.
• Reverse repo rate — the rate at which the RBI borrows from commercial banks, absorbing liquidity. Note the direction carefully: repo is lending by the RBI, reverse repo is borrowing by it.
• Cash Reserve Ratio (CRR) — the proportion of net demand and time liabilities that banks must keep as cash reserves with the RBI. Raising it reduces lendable resources.
• Statutory Liquidity Ratio (SLR) — the proportion that banks must maintain in liquid assets held with themselves, principally government securities, cash and gold. The distinction from CRR is where the funds are held and in what form.
• Open market operations — the purchase or sale of government securities by the RBI. Buying injects liquidity; selling absorbs it.
• Bank rate and the marginal standing facility, being rates at which banks may borrow from the RBI in other ways.

Qualitative instruments affect the direction of credit rather than its total: margin requirements on loans against securities, moral suasion, credit rationing, and direct action against errant banks.

Inflation. Demand-pull inflation arises from excess aggregate demand; cost-push inflation from rising input costs. The remedies differ, which is why the diagnosis matters: contractionary policy addresses demand-pull inflation but worsens the output loss under cost-push inflation.

How this chapter is examined

Expect questions distinguishing the three fiscal functions; identifying a public good by its two properties, or distinguishing it from a merit good; distinguishing adverse selection from moral hazard by whether the problem arises before or after the transaction; classifying receipts and expenditure as revenue or capital; computing or distinguishing the three deficits; classifying a tax as direct or indirect and a structure as progressive or regressive; identifying the motives for holding money; ordering the measures of money supply; and identifying what each monetary policy instrument does.

The recurring errors are confusing repo with reverse repo, confusing CRR with SLR, treating a merit good as a public good, and computing the fiscal deficit without excluding borrowings from receipts. Every one of these is a boundary between two adjacent terms — which is exactly why a written distinctions list is the highest-return preparation for this chapter.