Unit –IV
Money supply measures
Measuring India's Money Supply
One of the most important concepts to understand in economics is the concept of money. It forms the basis of overall economic research. And one of the important aspects of money is the supply of money in the economy. Learn more about the money supply and measuring the money supply in India.
Money supply
First, let's understand the meaning of money supply or money supply. Simply put, the money supply is the total inventory of money in circulation in the economy on a particular day.
This includes all banknotes, coins, and demand deposits held by the general public on that day. Money demand, money supply, etc. are also stock variables
Please note that the money supply held by the government, central banks, etc. is not considered as a money supply. This money is not actually in circulation in the economy and therefore does not form part of the money supply.
Today, our economy has essentially three major sources of money. They are a product of money and are responsible for its distribution in the economy. They are Government producing all coins and 1 rupee banknotes Reserve Bank of India (RBI), which issues all banknotes and a commercial bank that creates credits according to demand deposits
Measuring India's Money Supply
Then move on to the next logical question. How can I measure the amount of money in the economy? It's certainly neither easy nor easy. There is no only way to calculate the money supply in our economy. Instead, the Reserve Bank of India has developed four alternatives to the money supply in India.
These four alternatives to the money supply are labeled M1, M2, M3, and M4. RBI collects data and calculates and publishes the numbers for all four indicators. Let's see how they are calculated.
M1 (narrow money)
M1 includes all banknotes held by the general public on a particular day. It also includes all demand deposits, both savings and checking deposits at all banks in the country. It also includes all other bank deposits held at RBI. Therefore, M1 = CC + DD + other deposits
M2
M2 is also narrow money and includes all the contents of M1 as well as the bank savings of the post office. Therefore, M2 = M1 + postal savings savings deposit
M3 (broad money)
M3 consists of all banknotes held by the general public, all demand deposits in banks, all bank deposits in RBI, and net time deposits in all domestic banks. Therefore, M3 = M1 + bank time deposit.
M4
M4 is the broadest measure of the money supply used by RBI. This includes all aspects of M3, including savings at the national post office bank. It is the least liquid indicator of all of them. M4 = M3 + postal savings
Creating credits (money) by commercial banks
RBI makes money, commercial banks
Money by creating credits, which are also treated as credit creation.
Commercial banks generate credit in the form of secondary deposits.
There are two types of total bank deposits.
(I) Primary deposits (initial cash deposits by the general public) and (ii)Secondary deposits (deposits generated by loans from banks and expected to be re-deposited in banks) Funds generated by commercial banks are (i) primary deposits (initial cash deposits) and (ii) statutory reserves. It is determined by two factors. Ratio (LRR), the minimum ratio of deposits that a commercial bank is legally required to hold as liquid cash. Broadly speaking, when a bank receives a cash deposit from the general public, the bank holds a portion of the deposit as a cash reserve (LRR) and uses the remaining amount for lending. In the process of lending money, banks can generate credit through secondary deposits that are many times larger than the initial deposit (primary deposit).
How? It is explained below.
Money (credit) making process:
A man like X deposits 2,000 rupees in a bank and LRR
Ten%. This means that the bank holds only the minimum required Rs 200 as a cash reserve (LRR). The bank can use the remaining amount Rs 1800 (= 2000 – 200) to lend to someone. (To be on the safe side, the loan will not be offered in cash, but will be re-deposited into the bank as a demand deposit in favor of the borrower.) The bank does not actually lend, only the demand deposit account We will lend 1800 rupees to the opened Y. The name and amount will be credited to his account.
This is the first round of credit creation in the form of secondary deposits (Rs 1800), which is 90% of the primary (initial) deposits. Again, 10% of Y's deposit (ie Rs 180) is kept in the bank as a cash reserve (LRR) and the remaining Rs 1620 (= 1800 – 180) goes to Z, for example. The bank will receive a new demand deposit of Rs. 1620. This is the second round of credit creation, which is 90% of the primary round of increase of 1800 rupees. The third round of credit creation will be 90% of the second round of 1620. This is not the end of the story. The credit creation process continues until the derivative deposit
(Secondary deposit) will be zero. After all, the amount of total credit
Anything created this way will be a multiple of the initial (primary) deposit. The·
The quantitative result is called the money multiplier. If the bank successfully creates total credits, Rs 18000 means that the bank has created 9 primary deposits for Rs 2000. This is the meaning of credit creation.
Money multiplier:
This means a multiple that increases total deposits due to initial deposits
(Primary) deposit. The money multiplier (or credit multiplier) is the reciprocal of the statutory reserve ratio (LRR). If the LRR is 10%, that is, 10/100 or 0.1, then the money multiplier = 1 / 0.1 = 10.
The smaller the LRR, the larger the size of the money multiplier deposited in his account. He is only given a checkbook to draw a check when he needs money. Again, 20% of Sohan's deposit, which is considered a safe limit, is held for him by the bank and the remaining Rs 640 (= 80% of 800) is remitted to Mohan, for example. Therefore, the credit creation process goes on and on, and the final volume of the total credits created this way will be a multiple of the first cash deposit. Bank loans only make deposits (or credits) for the borrower, so banks can lend money and claim interest without letting go of cash. If a bank succeeds in creating a credit of, for example, 15,000 rupees, it means that the bank has created 15 times as many credits as a primary deposit of 1,000 rupees. This is the meaning of credit creation. Similarly, banks buy securities and create credits when they pay the seller their own check. Checks are deposited in some banks and deposits (credits) are created for the seller of securities. This is also called credit creation. As a result of credit creation, the money supply in the economy will be higher. Because of this credit creativity of commercial banks (or banking systems), they are called credit factories or money manufacturers.
The limits of the credit creation process are explained as follows:
(A) Cash amount:
It affects the creation of credit by commercial banks. Cash is high Commercial banks in the form of public deposits, more will be credit Created. However, the amount of cash held by commercial banks it is managed by the central bank. Central banks have the potential to increase or decrease cash in commercial banks, purchase or sale of government securities. In addition, credit Creation ability depends on the rate of increase / decrease in CRR.
(B) CRR:
Refers to the cash reserve rate that needs to be stored in a central bank. According to a commercial bank, the main purpose of maintaining this reserve is meet depositors' trading needs, ensure security, Liquidity of commercial banks, Credit creation when the ratio goes down more and vice versa.
(C) Leakage:
It means the outflow of cash. The credit creation process is Cash leak.
The different types of leaks are described as follows:
(D) Excessive preparation:
It generally happens when the economy is heading into a recession. In such cases, the bank may decide to keep the reserve instead of using it. Funds for lending. Therefore, in such situations, the credits created by Commercial banks will be small, as large amounts of cash are indignant.
(II) Currency outflow:
It means that the public does not deposit all the cash. Customers are possible to hold with them cash that affects the credit creation of banks. Therefore, banks' ability to generate credit is diminished.
(A) Borrower availability:
It affects the credit creation of banks. Credits are created by lending money in the form of a loan to the borrower. No credit creation if there is no borrower.
(B) Availability of securities:
A security is what that a bank lends. Therefore, the availability of securities is required to grant a loan. Otherwise, credit creation will not occur. According to Clauser, "Banks do not generate money from thin air. It turns other forms of wealth into money."
(C) Business conditions:
Credit creation means being influenced by the cyclical nature of the economy. For example, when the economy enters a recession, credit creation becomes smaller. This is because during the depression stage, businessmen do not like to invest in new projects. On the other hand, during the prosperous period, businessmen ask banks for loans, which leads to credit creation.
Despite that limitation, we create that credit Commercial banks are an important source of income.
The basic conditions for creating a credit are as follows:
- Accept fresh deposits from the public
- Banks willing to lend money
- Willingness to borrow the borrower.
RBI is the governing body of India's monetary policy. They control the flow of money to the market through various means of monetary policy. This helps the RBI manage inflation and liquidity in the economy. Let's take a look at the monetary policy tools used by the RBI.
Reserve Bank of India
RBI is the Central Bank of India. It was founded in 1935 under the special law of Parliament. The RBI is a major authority on national monetary policy. The main function of the RBI is to maintain economic stability and the required level of liquidity.
RBI also controls and regulates the monetary system of our economy. This is the only banknote issuer in India. RBI is the central bank that manages all other commercial banks, financial institutions, financial companies and more. The RBI oversees the country's entire financial sector.
Monetary policy means
Monetary policy is the way the RBI manages the money supply in the economy. Therefore, these credit policies help control inflation and thus help the country's economic growth and development. Let's take a look at the various monetary policy tools that RBI has at its disposal.
1] Open market operations
Open market operations are the direct involvement of the RBI in buying and selling short-term securities in the open market. This is a direct and effective way to increase or decrease the money supply in the market. It also has a direct impact on the market's ongoing interest rates.
Let's say the market is in equilibrium. The RBI then decides to sell the short-term securities in the market. The money supply in the market will decrease. And after that, the demand for credit lines will increase. Therefore, interest rates will rise accordingly.
On the other hand, if RBI buys securities from the open market, it has the opposite effect. The money supply to the market will increase. As a result, the demand for credits declines and interest rates fall.
2] Bank interest rates
One of the most effective means of monetary policy is bank interest rates. Bank interest rates are basically the interest rates at which RBI lends funds to commercial banks with or without collateral. This is also the standard rate at which RBI purchases or discounts bills of exchange and other such products.
Therefore, if RBI raises bank interest rates, commercial banks also need to raise lending rates. And this helps manage the money supply in the market. And vice versa will obviously increase the money supply in the market.
3] Variable reserve requirements
This monetary policy instrument has two components: the cash reserve ratio (CLR) and the statutory liquidity ratio (SLR). Let's understand both.
The Cash Reserve Rate (CRR) is part of a commercial bank deposit that must be deposited with the RBI. Therefore, CRR is the percentage of deposits that a commercial bank must hold in RBI. The RBI adjusts the above percentages to control the money supply available at the bank. Therefore, the loans offered by banks will be cheaper or more expensive. CRR is a great tool for controlling inflation.
The statutory liquidity ratio (SLR) is the percentage of total deposits that a commercial bank must hold in the form of cash reserves or gold. Therefore, increasing SLR means that banks provide less money as loans and control the money supply in the economy and vice versa.
4] Liquidity adjustment facility
The Liquidity Adjustment Facility (LAF) is an indirect means of managing currencies. Control the flow of funds through repo rates and reverse repo rates. Repo rates are actually the rates at which commercial banks and other institutions obtain short-term loans from central banks.
Reverse repo rate is the rate at which RBI deposits funds in a commercial bank in a short period of time. Therefore, RBI constantly changes these rates to control the flow of funds in the market according to economic conditions.
5] Moral appeal
This is an informal method of money management. The RBI is the central bank of the country and therefore enjoys a supervisory position in the banking system. If necessary, banks can be encouraged to exercise credit control from time to time in order to maintain a balance of funds in the market. This method is actually very effective, as banks tend to follow the policies set by the RBI.
The central bank is responsible for protecting the financial stability and economic development of a country. Apart from this, the central bank also plays an important role in avoiding cyclical fluctuations by controlling the money supply in the market. In Hawtrey's view, a central bank should primarily be the "lender of last resort."
On the other hand, Kisch and Elkins believed that "maintaining the stability of the monetary standard" as an essential function of the central bank. The functions of the central bank are broadly divided into two parts, namely traditional functions and development functions.
The different functions of a central bank (as discussed in Figure-3) are explained as follows
Traditional Functions:
Check out the functions that ar common to any or all central banks within the world. The normal functions of the financial organisation embrace the following:
(a) Issuing bank: Has the exclusive right to issue banknotes (currency) in all countries of the world. In the early years of banking, all banks enjoyed the right to issue promissory notes. However, this led to a number of problems, such as excessive banknote issuance and disorganization of the monetary system. Therefore, the governments of different countries authorized the central banks to issue banknotes. The issuance of notes by a bank has resulted in uniformity in the circulation of notes and the equilibrium of the money supply.
(b)Banker, agent and consultant to the govt: It implies that a financial organization performs totally different functions for the government. As a banker, the financial organization performs banking functions for the govt even as industrial banks do for the general public by acceptive government deposits and creating loans to the govt. As agent, the financial organization manages the general public debt, assumes the payment of the interest on this debt and provides all different debt-related services. As associate consultant, the financial organization advises the govt on matters of policy, securities industry, capital markets, and government loans. Except for this, the financial organization formulates and implements business enterprise and financial policies to {control} the money provide within the market and control inflation.
(c) Steward of the money reserves of economic banks: Government banker, agent and consultant: It implies that a financial organization performs totally different functions for the government. As a banker, the finance organization performs banking functions for the government, just as industrial banks do for the general public, by accepting deposits from the government and creating loans for the government. As an agent, the financial institution manages the general public debt, assumes the payment of interest on this debt and provides all the different services related to the debt. As an associate consultant, the finance organization advises the government on policy, securities industry, capital markets, and government loans. Except for this, the finance organization formulates and implements business and financial policies to {control} the money provided within the market and to control inflation.
(d) Manager of the money reserves of economic banks: It implicit that the central bank keeps a minimum deposits of international currency. The main objective of this reserve is to meet emergency foreign exchange requirements and overcome adverse deficit requirements in the balance of payments
(e)Rediscount bank: Meet the money wants of people and firms by rediscounting bills of exchange through business banks. This can be associate indirect manner of loaning cash to business banks by the financial organization. Discounting a bill of exchange implies deed the bill by shopping for it for a add but its face price. Rediscount involves discounting a antecedently discounted bill of exchange. Once house owners of bills of exchange want money, they approach the banking concern to discount these bills. If the business banks themselves want money, they approach the financial organization to rediscount the bills.
(f) Investor of last resort: see the foremost crucial role of the financial organization. The financial organization conjointly lends cash to business banks. Rather than rediscounting bills, the financial organization makes loans against treasury bills, government securities, and bills of exchange.
(g)Central clearing, settlement and transfer bank: It implies that the central bank helps to settle the mutual indebtedness between commercial banks. Bank depositors deliver checks and money orders from other banks. In such a case, it is not possible for banks to approach each other for clearing, settlement or transfer of deposits. The central bank facilitates this process by establishing a clearinghouse under its responsibility. The clearinghouse acts as an institution where mutual indebtedness between banks is settled. Representatives of different banks meet at the clearinghouse to settle interbank payments. This helps the central bank to know the liquidity status of commercial banks.
(h) Credit controller: It implies that the central bank has the power to regulate the creation of credit by commercial banks. Credit creation depends on the amount of deposits, cash reserves, and interest rate given by commercial banks. All of these are controlled directly or indirectly by the central bank. For example, the central bank can influence commercial bank deposits by conducting open market operations and making changes to the CRR to control various economic conditions.
(b) Developmental Functions:
Refer to the functions related to the promotion of the banking system and the economic development of the country. These are not mandatory functions of the central bank. These are treated as follows:
(i) Development of specialized financial institutions: See the main functions of the central bank for the economic development of a country. The central bank establishes institutions that serve the credit needs of the agricultural sector and other rural businesses. Some of these financial institutions include the Industrial Development Bank of India (IDBI) and the National Bank for Agriculture and Rural Development (NABARD). They are called specialized institutions because they serve specific sectors of the economy.
(ii) Influence the money market and the capital market: It implies that the central bank helps to control the financial markets. Money market operations in short-term credit and capital market operations in long-term credit. The central bank maintains the economic growth of the country by controlling the activities of these markets.
(iii) Compilation of statistical data: It compiles and analyzes data related to the banking, monetary and exchange position of a country. The data is very useful for researchers, politicians and economists. For example, the Reserve Bank of India publishes a magazine called the Reserve Bank of India Bulletin, whose data is useful for formulating different policies and making decisions at the macro level.
Important Promotional Functions of Reserve Bank of India
Reserve Bank of India promotion function
The various promotional features implemented by the Federal Reserve Bank of India are listed below.
1. Promote banking habits
The Federal Reserve Bank of India helps mobilize people's savings for investment. We've expanded our banking industry nationwide by establishing various institutions like UTI, IDBI, IRCI and NABARD. This promoted people's banking habits.
2. Offering refinancing for export
The Federal Reserve Bank of India offers refinancing to market exports. Credit and Guarantee Corporation (ECGC) and Export Import Bank were originally established by the Federal Reserve Bank of India to fund India's foreign trade. They lend to foreign trade the shape of insurance covers, long-term loans and foreign currency-denominated credit. However, it's currently working individually.
3. Granting credit to agriculture
The Federal Reserve Bank of India has institutional arrangements for rural or agricultural finance. For instance , banks have found out special agricultural credit cells. It promoted local regional banks with the assistance of economic banks. NABARD is additionally promoted.
4. Providing credit to small industrial units
Commercial banks lend to the tiny industrial sector in accordance with the occasional directive issued by the Federal Reserve Bank of India. The Federal Reserve Bank of India encourages commercial banks to supply guarantee services to the tiny industry sector also . The Federal Reserve Bank of India considers the progress given to the tiny sector as progress within the priority sector. He also instructed commercial banks to open specialized branches to supply adequate financial and technical assistance to the tiny industrial sector.
5. Providing indirect finance to the co-operative sector
The RBI has instructed NABARD to lend to the state co-operative banks, which are lending to the co-operative sector. Therefore, the Federal Reserve Bank of India provides indirect financing to the Indian co-operative sector.
6. Exercise control over the national financial and banking industry
The Federal Reserve Bank of India has enormous and broad authority over the supervision and control of economic banks, co-operative banks, and non-bank institutions that receive deposits. Banking Regulations provide a minimum of a good range of requirements for paid-in capital, reserves, cash reserves and current assets.
Bank operations, management, mergers, reconstructions, liquidations, etc. are thoroughly overseen by Federal Reserve Bank of India staff. All planned banks are required to submit a weekly report back to the Federal Reserve Bank showing key items of India's liabilities and assets.
7. Creating an industrial agreement for industrial finance
The Federal Reserve Bank of India has institutional arrangements for industrial finance. For instance , several development banks are created to supply long-term finance to industry, like the economic Finance Corporation of India and therefore the Industrial Development Bank of India.
According to A.C. Pigou (Cambridge University), inflation comes in existence “when money income is expanding more than in proportion to income activity”. An increase in general price level takes place when people have more money income to spend against less goods and services.
G. Crowther (British economists) brings out the meaning precisely when he says, “inflation is a state in which the value of money is falling i.e. prices rising”.
Inflation, according to Harry G. Johnson (Canadian economist), “is a sustained rise in prices”.
Paul Samuelson (American economist) defines inflation as “a rise in the general level of prices”.
According to Milton Friedman (American economists), ‘inflation is taxation without representation’.
Causes of Inflation
Demand- Pull Inflation
- Increase in Money Supply: When the monetary authorities increase the money supply in excess of the supply of goods and services it results in additional demand and consequent increase in price level. As Milton Friedman put it “inflation is always and everywhere a monetary phenomenon”.
- Deficit Finance: As increase in money supply also takes place when the government resorts to deficit financing to incur the public expenditure. Deficit financing undertaken for unproductive investment or expenditure becomes purely inflationary. Even when it is used on productive activities, prices would still increase during the gestation period.
- Credit Creation: Commercial banks increase the quantity of money in circulation when they advance loans through credit creation. Credit creation is similar to that of deficit financing in its effects.
- Exports: Exports reduce the goods available in domestic market. Export earnings enhance the purchasing power of the exporters and others linked with export. An increase in exports would aggravate the situation by reducing the supply of goods and at the same time pushing up the demand because of additional income.
- Repayment of Public Debt: Public debt is a common feature of modern governments. When such debts are repaid, people will have more income at their disposal. Additional disposable income tends to raise the demand for goods and services.
- Black Money: Social and economic evils like corruption, tax evasion, smuggling and other illegal activities give rise to unaccounted (for tax payment) or black money. People with black money indulge in extravanza, affecting demand and thus the price level.
- Increase in Population: The size of the population is one of the important determinants of demand In many developing countries population is large in size and still increasing. India provides an example where demand outstrips supply due to the large and increasing population.
Cost- Push Inflation
Inflation need not necessarily be due to an increase in demand but increase in cost. Increase in the prices of inputs including labour, increase in profit margin by the business firms and monopsony in factor market may push up prices as they influence the supply price.
The important cost push factors are:
- Increase in wages: When prices increase due to increase in wages it is called wage-push inflation. Wages are influenced by many factors besides the demand and supply forces. Trade unions play an important role in deciding the wage rate. Strong and powerful trade unions succeed in securing higher wages for their members. Higher wages granted in the organised sector influencing the wage rate in the unorganised sector too, resulting in an increase in cost everywhere.
- Increase in Material cost: Prices of materials used in producing goods constitute a significant part of the cost. Prices of the materials may increase either due to an increase in demand for these materials or independently owing to national and international developments. Increase in crude oil price till recently is an example in this context. When the prices of basis inputs like energy, cement, steel, etc. increase, the effect is felt throughout the economy. An increase in the prices of materials especially the basic inputs alters the cost structure of all goods and services. Higher the cost of production leads to upward revision of final prices.
- Increase in Profit Margin: Firms operating under oligopoly or enjoying monopoly power (petroleum firms in public sector) may have ‘administered prices’ with higher profit margins. Such administered prices though imposed by few firms, have their impact on other firms too. The desire to have higher profit margins by all those who have the power to do so becomes the cause for inflationary trend.
- Other factors: Cost of production may increase when input prices go up due to scarcity – natural or artificial. Natural calamities like draught or floods adversely affect supplies of raw materials thus making them dearer. Firms operating with excess capacity either because of monopolistic competitive market or any other reasons, produce at a higher cost.
Remedies to Inflation in the economy
.
The fiscal measures are
(i) taxation
(ii) public borrowing
(iii) compulsory saving and
(iv) Public expenditure.
Direct and Indirect taxes are levied to reduce the disposable income of the people. While imposing the tax, care should be taken to avoid the adverse effects of taxation on savings, investment and production. Inflation must be controlled at an appropriate level. Uncontrolled inflation may turn into hyper inflation. Since inflation occurs due to disequilibrium in aggregate demand and aggregate supply, it would be controlled by correcting the forces which causes such disequilibrium. Control of inflation requires a combination of monetary, fiscal and other measures.
Monetary Measures
An increase in money supply without the corresponding increase in supply of goods and services creates excess demand causing inflation. Monetary and services creates excess demand causing inflation Monetary authorities through monetary instruments could increase the cost of credit and reduce the money supply. At the same time monetary measures may encourage the production and supply of essential commodities by supplying the required amount of credit at concessional terms. For this purpose the central bank of the country applies quantitative and qualitative methods.
The Quantitative Methods Are:
- Bank Rate: Inflation compels the Central Bank of the economy to increase the Bank Rate. Bank rate is the rate at which the central bank lends money to the member banks. An increase in bank rate makes borrowing costlier thus discourages borrowing, leading to a check on increase in supply. Similarly lowering bank rate makes borrowing cheaper, increases money supply along with decrease in cost. Cost push inflation may require to bring down the cost of borrowing. A change in bank rate brings changes in other interest rates in market in the same direction.
- Open Market Operation (OMO): Under this method a central bank sells or purchases government securities in the market. Any body can participate in this purchase or sale, hence it is called open market operation. The central bank reduces quantity of money in circulation through the sale of securities and increases the quantity of money by purchasing them. During inflation it is expected to sell the securities, bringing down the money in circulation, hence the aggregate demand in the economy for goods and services.
- Variable Reserve Ratio (VRR): Variable reserve ratio has two components: (i) Cash reserve ratio (CRR) and Statutory Liquidity Ratio (SLR). An increase in these ratios, reduces the ability to create credit. A reduction in CRR and SLR increases the reserves with banks and consequently their ability to expand credit. During inflation these ratios are usually increased. In recent decades many central banks have introduced some additional quantitative measures. They are in the form of repo rate and liquidity adjustment facility (LAF). They influence the cost of borrowing (higher cost during inflation) affecting total money in circulation.
The above mentioned quantitative methods may not be very effective in controlling inflation. Increase in prices which bring more profits and prevailing optimism will not deter business firms from borrowing at a higher costs.
An uniform monetary policy- dear or cheap- throughout the economy does not bring the required result. The central banks, therefore, apply the selective credit control measures too. These measures comprise margin requirements, consumer credit controls, directives, rationing of credit and any other method whereby a selective approach can be adopted in supplying credit. Selective credit controls discriminate in favour of essential activities and discourage demand for credit for non-essential uses. In developing countries selective credit controls are more popular as they help the monetary authorities to have a ‘controlled – expansion’ of credit. Quantitative measures in these countries are less effective due to the underdevelopment of the money market. Monetary measures by themselves are not enough to control inflation. They become more helpless if inflation is due to cost- push.
In extreme cases the central bank/ government, may resort to demonetisation of currency. This measure is usually applied to higher denomination currency. It helps to bring out black money and check excess demand. Hypher inflation may even compel the government to issue new currency and replace the existing one in a given ratio, for example 100: 1. India demonetised its higher value currencies on 8 November 2016, to flush out black money and check the price level.
Fiscal Measures
Inflation cannot be controlled by monetary measures alone. They should be supported by fiscal measures. Broadly speaking, the government manipulates the budget to reduce the private as well as the public expenditure to check demand ial commodities should not be taxed, lest inflation be aggrevated.
Public borrowing can be undertaken to reduce the disposable income of the people. It is to reduce the quantity of money with the public. It is a costly instrument since the government has to pay interest on public loans. Repayment of public loans during inflation should be avoided. This would prevent additional money supply and consequent additional demand.
Compulsory saving or any other forced saving scheme and deferred payment (a part of the payment is credited to the employees provident fund accounts, thus blocking its current use) are some other instruments to reduce excess demand.
Public expenditure is the major source of injecting money into the economy. Modern welfare states spend huge amounts of money through public projects and welfare schemes. Public expenditure should be reduced during inflation. Though it is difficult to cut down public expenditure the government should attempt to avoid all unproductive expenditure Direct (Administrative) Measures
Some of the direct measures are:
Price control or ceiling on price especially of essential commodities.
- Public distribution system (PDS) to supply or distribute essential consumer goods. Rationing and fair price shops are the channels through which the pubic distribution system is operated.
- Imports of essential consumer commodities may be required to maintain the supply.
- Control or freezing of wages, profits, dividends and bonus may also be introduced. Such controls aim at limiting the income of the people and thereby reducing the demand for goods and services. These measures being drastic are likely to create social and political tension.
Increase in supply: If inflation is due to shortage of goods and services, controlling demand through monetary and fiscal measures is not of much use. Here the solution lies in increasing the supply of goods and services by improving the working of supply chains. The long-run solution lies in increasing production by creating a positive and conducive environment. This may involve improving infrastructure, providing incentives and effective implementation of various measures which enable more production.
Indexation: Inflation affects all sections of people. Among the different sections, wage/ salary earners and other fixed income group suffer the most. To compensate against inflation, a method of indexation of their income can be introduced. Indexation, according to Samuelson and Nordhaus, “is a mechanism of wages, prices and contracts that are partially or wholly compensated for changes in the general price level”. Under this system, payment received by the above mentioned groups can be increased to the extent of rate of inflation, so that their real income remains the same. In India the practice of periodical increase in dearness allowance is one of the methods of compensation against inflation.
Control of inflation is a must and should be attempted before it crosses a moderate limit. Attempts to control inflation by any particular types of measures are bound to fail. A judicious combination of all methods is a must to achieve success. A dear monetary policy must be supported by a surplus budgetary (or reduced deficit) policy along with necessary direct measures.
Success of the measures to control inflation depends on effective implementation which requires efficient and honest administration.
