According to Musgrave, Public Finance deals with the economics of Public Sector. This includes not only its financing but its entire bearing on the level of and allocation of resources as well as on the distribution of income among consumers.
In his view, the importance of the public sector rests on the fact that reliance on the efficacy of market mechanism alone may lead to malfunctioning of economic activities. Hence, Public Policy is required to:
• secure adjustments in the allocation of resources,
• secure adjustments in the distribution of income
• secure economic stabilization and growth
It is thus obvious that the role and scope of Public finance is not confined to the provision of Public Services, but has now been extended to achieve effectiveness in the state of allocation, distribution, stability, growth and development.
Subject Matter of Public Finance
Public Finance is a science that deals with the revenue and expenditure operations of the Public authority. Taxation is not the only means by which a society may choose to redistribute income. A transfer payment is another means. By Transfer payments, we refer to payments which are not made in return for some productive service.
Such payments consist of payments by government that involve not direct service by the recipient and include; unemployment insurance, interest on the public debt, welfare payments, among others. This includes the effects of such revenue and expenditure activities of the government on the economy or what is paraphrased as fiscal operations.
In modern times, the major subdivisions of Public Finance which constitute its subject matter are, Public Revenue, Public Expenditure, Public Debt, and certain problems of the fiscal system as a whole such as Financial Administration.
Public Revenue; Under Public Revenue we study methods of raising public revenue, principles of taxation, and other related problems.
Public Expenditure
This part of Public Finance deals with the study of the principles and effects of Public Expenditure in the economic life of the country as a whole. That is, the effect of Public expenditure on production and distribution.
Public Debt
Here, we examine methods, causes and consequences of Public Borrowing.
Financial Administration
Under this branch of Public Finance, we analyse the methods of Administration, control and problems relating to the preparation of budget.
It has to be pointed, however, that the subject-matter of Public Finance is not static, but dynamic. This means that it is continuously widening with the change in the concept of state, functions of state and changing problems of economics.
Sources of Public Revenue
The sources of Government Revenue are broadly divided into two;
1. Tax sources
2. Non tax sources
• Commercial sources
• Administrative sources
• Administration fee
• Licence fee
Grants and Loans
Meaning of Tax
The standard definitions of a tax are reproduced below.
“Taxes are compulsory payments to government without expectations of direct return or benefit to the tax payer”. P.E. Taylor “a compulsory contribution from a person to the government to defining the expenses incurred in the common interest of all without reference to special benefits conferred”
– E.A.R. Seligman
Characteristics of Taxes
Compulsory payment
• Tax payment does not imply exlusive benefit for the payer
• Taxes are not imposed because the sate has rendered a specific service to the payer or conversely that the individuate pays the tax because he she has received a specific service from the state.
Elements of a Tax
• Taxes are compulsory contributions
• They are imposed by governments (public authorities) only
• It involves sacrifice on the part of the payer
• The purpose ot taxation is to enhance the welfare of the people
• Benefit is not a pre-condition for tax payment
• Taxes do not aim to realise the cost of services rendered
• Taxes may be assessed on income or capital but they are paid out of income.
• A tax may be imposed upon an individual or property or commodities, but they are paid by individuals.
• A tax is a legal collection and therefore imposes a personal obligation on the payer
• Tax payment does not imply exclusive benefit for the payer
• Taxes are not imposed because the state has rendered a specific service to the payer or conversely that the individual pays the tax because he /she has received a specific service from the state.
Commercial Revenues
These are received in the form of prices paid for government produced goods and services- P.F. Taylor. These are revenues which are derived by government from Public Enterprises by selling their goods and services. They are also known as prices because they come in the form of prices of goods and services provided by government.
Administrative Fees
These are payments to defray the cost of each recurring service undertaken by the government primarily in the public interest, but conferring a measurable special advantage on the fee payer.
Licence Fee
This is paid on those instances in which the government confers a permission or a privilege on people to perform a specific service. The objective of such fee may be to regulate or control certain activities.
In conclusion Public Finance is a branch of Economics that deals with how government generates revenue and how it spends it. Such revenue and expenditure activities of the State are easily understandable through the three theories of Public Finance – Classical, Keynesian and Modern (Musgrave’s) theories. These theories basically explain the meaning and development in the scope of Public Finance over the years. In this session we have also noted that Public Finance addresses issues that revolve around Public Revenue, Public Expenditure, Public Debt and Public Financial Administration.
Theory of Money and Monetary Policy
From the primitive system of exchange, the quest had always been there to case the process of transaction as economic activities grew in complexities. Starting from a subsistence economy, where there was no exchange, through barter system of swapping and into a monetary medium of exchange system, all these has improved transactions over time In the modern-day economy, money has come to be an interesting financial asset.
While it is fascinating phenomenon to some, it is confusion to some others who do not think of money as an item that is bought and sold, but rather as the item that does the buying and is received in the selling of other goods.
Definition of Money
Money is anything that is generally accepted as a means of payment and in exchange of goods and services or in settlement debts. Anything that serves as money must fulfill the following related functions:
a. Medium of Exchange: money in its capacity as a medium of exchange facilitates transactions i.e. it makes exchange of goods and services possible. In other words, money helps to speed up the rate of business transactions; it serves as an intermediary between parties in any transaction. With this function of money, parties involved in the transaction are mutually satisfied. It is this role of money that helps in solving the problem of exchange created by trade by barter.
b. Store of Value: Money serves as a cheap means of storage, because it is highly liquid. This implies that money can be stored or saved for as long as the owner so wishes without physical deterioration or any extra cost.
c. Unit of Account or Measure of Value: In performing this role money serves as a measure of value that is the medium through which values of goods and services can be measured. Here, money performs the role of resource allocation
d. Standard of Deferred Payments; the introduction of money now makes it possible to take possession of goods and services now and their payment postponed
To perform these functions, money must have the following characteristics:
i. Acceptability; anything used as money must be generally acceptable and recognized. General acceptability is conferred on money by the law of the land by declaring it as a legal tender
ii. Portability; this is the ease with which money can be carried i.e. it must be capable of being moved from one place to the other. this implies that it must not be heavy so that large amount can be carried at a time
iii. Divisibility; good money must be divisible into smaller unit or have smaller denomination in order for small business transaction to be undertaken
iv. Fool-proof; a good money not being non-counterfeit-able
v. Durability; good money must be durable in the sense that it must be able to withstand the pressure of being transferred from one person to the other without any form of destruction or defacing, as well as been capable of being used for relatively a long period of time. It is this particular characteristic that makes money to perform the store of value function.
vi. Stability; the value of good money must be relatively stable; value refers to the purchasing power of money over goods and services in a country.
vii. Relative Scarcity; any material used as money must not be such that its supply is without limit, it must not be pick-able along the street. This is because its value is derived from its relative scarcity.
viii. Homogeneity; each unit of good money must be the same in terms of size, color, quality and face value.
• What are the roles of money in any economy?
Ans: Medium of exchange, unit of account, store of value and measure of deferred payment
Demand for Money
Demand for money refers to the situation of withholding money rather than spending money, i.e. demand to hold. The demand for money arises from two important functions of money; the medium of exchange and store of value functions. Thus, individuals and businesses wish to hold money partly inform of cash and partly in-form of assets.
Demand for money is at times referred to as motives of money. Keynes suggests three motives for the demand for money in an economy i.e. 3 reason why people hold money rather than other assets. These are:
Transactionary Motive
This motive relates to the need of cash for current transaction, that people at times demand for money (hold money) to be partakers of business transaction or exchange. This motive arises from the medium of exchange function of money in making regular payment for goods and services.
This motive is dependent on the expectation of income of the consumer, i.e. change in business transaction is a function of consumer’s income, this is denoted as LT = F(Y).
Precautionary Motive
This relates to the desire of the consumer to provide for unforeseen contingencies, requiring sudden or urgent expenditures and for unforeseen opportunities of advantageous purchases. Individuals’ keep money in reserve to meet unexpected needs or situation such as unemployment or sack, accident etc.
Firms on their part keep funds in reserve to take advantage of purchases or buying i.e. taking advantage of unexpected deals. Precautionary motive is dependent on the level of Consumers income and level of business activities is denoted as Lp = F(Y).
Speculative Motive
This motive relates taking advantage or securing profit from knowing better than the market, what future will bring forth. Individuals and firms who have funds after keeping enough for transactionary and precautionary purpose like to make a speculative gain by investing in capital market.
This motive hinged on store of value function of money which can be invested at an opportune period and it is a function of income and interest rates.
Graphically demand for money is depicted as Demand for money for the demand for money: it slopes from the let to right indicating that there exists an inverse relationship between stock of money and interest rate.
• What are determinants of demand for money?
Ans: Interest rate and income level.
Supply of Money
Supply of money refers to the total quantity of money in circulation in a country for all purpose at any time. It is considered to be exogenously fixed or determined by the monetary authority, its curve is taken to be perfectly inelastic because nobody m can influence its supply.
The supply of money curve; it is infinitely inelastic because supply of money is exogenously determined.
• Why is supply of money graph perfectly inelastic?
Ans: Because it is exogenously determined by the government
The Theories of Money
The works of the classicalist, Keynesian and monetary economist will be looked at The Classical Contribution (Quantity Theory of Money)
The classical theorist are of the opinion that money is just a veil, that money can not affect real factors in the economy i.e. once it is introduced; it is consumed or used up by the system.
The classical theorist sees money performing medium or exchange function. The quantity theory of money states that the quantity of money is the main determinant of the price level or value.
The quantity theory emphasizes the view that money is used only as MEDIUM OF EXCHANGE to settle transactions involving the demand and supply of goods and services.
The relative value of goods and services is expressed in term of money value, i.e. any change in the quantity of money produces an exactly or proportionate change in price level. The theory believes that money is held for transaction purpose alone.
The theory talks about the relationship between the amount of money in an economy and the level of prices. It is often referred to as the Fisherian Equation of Exchange. It is written as;
MV = PQ
Where M = money stock
V = velocity of money (rate at which money changes hands)
P = price level
T = Q = volume of output/quantity of goods produced
PT = PQ = value of money of goods and services
MV = money in circulation
The adherent of the theory believes that there is a direct proportional relationship between price level and money stock such that an increase in money stock leads to an increase in price level i.e. 1:1 relationship called equi-proportionate relationship exists between money stock and price. Graphically.
Cambridge Version
It is for the limited function assumed for money in the Fisherian equation, that Alfred Marshal of the Cambridge school integrated the role of money as a store of wealth into the quantity theory of money.
This approach incorporates function of money as medium of exchange and as store of value or wealth the cambridge suggest that the cash balance held (i.e. demand for money) by the public is a fraction of their total income. It is given as:
Md = kPY
K=1/V
K = constant i.e. fraction of real money y (Py) people wish to hold in cash and demand deposit or the ratio stock to income
P= Price level
Y= Aggregate real income
The equation tells us that “other things being equal” the demand for money in normal terms will be proportional to the nominal level of y for each individual, and hence for aggregate economy as well. The value of money implies the purchasing power of money over goods and services in a country: the value of money is a relative concept which expresses the relationship between a unit of money and the goods and services which can be purchased with it.
This shows that the value of money is related to price level in an inverse manner. If V represents the value of money and the price level therefore v = 1/p. When price rises, the value of money falls and vice versa. Thus, in order to measure the value of money we have to find out the general price level.
• What exactly is the import of the Cambridge school to the quantity theory of money?
• Store of value function of money
• Irving Fisher worked on two functions of money, what are these functions?
• Medium of exchange function and unit of account function.
Keynesian Contribution
Keynes holds the view in contrast with classicist view, they believe money is an asset and like other asset, it can be held for its own sake, money is held in order to facilitate transactions and not just temporary above of purchasing power. It is also the view of the Keynesian that changes in supply of money will only have effect on the economy, if the change is Money Supply can influence or lead to change in interest rate, and demand in interest rate can lead to or influence investment level, and thus investment can lead to or influence the income level.
Liquidity Trap
This refers to the time in which the economy is so liquid that an increase in money supply will not have effect on the interest rate and subsequent increase in Money supply will be trapped down in the liquidity trap and the additional increase will be hoarded as speculative balance.