Unit 2
Money and Banking
The average level of all prices in a country is termed the price level. There are thousands of waves in a sea, each wave having a distinct height.
Nevertheless, we will calculate the typical level of the sea and call it the sea- level. Similarly, we will calculate the price level, although there are thousands of prices, all moving in alternative ways.
When the price level rises money can purchase less goods and services. So we are saying that its purchasing power has fallen. Conversely, when the worth level falls, money can buy more and that we can say its purchasing power has gone up. Thus, the worth of cash changes inversely with the price level. In our country, the worth level increased by about 400% during war n (1939-1945). The worth of the rupee fell by the same percentage.
Why does the price Level Change?
Changes in the price index are caused by two factors:
(a) Changes in the supply of money, and
(b) Changes within the supply of goods and services.
When the quantity of money in circulation during a country is increased (e.g., by printing new notes) extra money is available to the people for making purchases, the demand for goods and services goes up and the price level tends to rise.
Conversely, if the supply of money decreases people can buy less and therefore the price level tends to go down Again, if there's a rise in the supply of goods and services, the worth level tends to fall and, within the converse case, it tends to rise.
Thus, if the supply of money increases by 25% and therefore the supply of goods and services also increase by an equivalent 25%, there'll ordinarily be no effect on the worth level. There are other factors which influence the price level (e.g., the amount of times money changes hands or the speed of circulation) but the primary two factors are the most important of all.
In India, during war II, there was a large increase within the volume of notes printed by the govt . There was, at an equivalent time, a decrease within the supply of goods (due to reduction of imports, etc.). Consequently, the worth level increased many times.
It is possible to analyse the causes of price changes during a different way. Modern writers believe that price level changes are caused by changes within the level of income, i.e., the average amount of money earned by that people when more income is earned, the demand for the products and services goes up and price rise. When income falls, less goods and services are demanded and price fall. [Changes within the level of income depend on two factors, the quantity of savings and therefore the volume of investment within the country.]
Theories
The quantity theory of money states that the quantity of money is the main determinant of the price level or the value of money. Any change within the quantity of money produces an exactly proportionate change within the price level.
In the words of Irving Fisher, “Other things remaining unchanged, because the quantity of money in circulation increases, the worth level also increases in direct proportion and therefore the value of money decreases and the other way around .”
If the number of cash is doubled, the price level also will double and the value of cash will be one half. On the opposite hand, if the number of cash is reduced by one half, the price level also will be reduced by one half and therefore the value of money will be twice.
Fisher has explained his theory in terms of his equation of exchange:
PT = MV + M’V’
Where P = price level, or 1/P = the value of money;
M = the total quantity of legal tender money;
V = the speed of circulation of M;
M’ = the total quantity of credit money;
V = the speed of circulation of M’;
T = the total amount of goods and services exchanged for money or transactions performed by money.
This equation equates the demand for money (PT) to supply of money (MV=M’V’). The entire volume of transactions multiplied by the worth level (PT) represents the demand for money. Consistent with Fisher, PT is ∑PQ. In other words, price index (P) multiplied by quantity bought (Q) by the community (∑) gives the entire demand for money.
This equals the entire supply of cash within the community consisting of the quantity of actual money M and its velocity of circulation V plus the entire quantity of credit money M’ and its velocity of circulation V. Thus the entire value of purchases (PT) during a year is measured by MV+M’V. Thus the equation of exchange is PT=MV+M’V’. So as to seek out out the effect of the quantity of money on the price level or the value of money, we write the equation as
P = MV+M’V
T
Fisher points out that the price level (P) varies directly as the quantity of money (M+M’), provided the volume of trade (T) and velocity of circulation (V, V’) remain unchanged. The truth of this proposition is evident from the fact that if M and M’ are doubled, while V, V’ and T remain constant, P is also doubled, but the value of money (MP) is reduced to half.
Fisher’s quantity theory of cash is explained with the help of Figure 1 (A) and (B). Panel A of the figure shows the effect of changes within the quantity of money on the worth level. To start with, when the number of cash is M1, the worth level is P1.
When the quantity of cash is doubled to M2, the price level is additionally doubled to P2. Further, when the quantity of cash is increased four-fold to M4, the price level also increases by four times to P4. This relationship is expressed by the curve P=f (M) from the origin at 45°.
Assumptions of the Theory:
Fisher’s theory is based on the subsequent assumptions:
1. P is a passive factor in the equation of exchanger which is affected by the other factors.
2. The proportion of M’ to M remains constant.
3. V and V are assumed to be constant and are independent of changes in M and M’.
4. T also remains constant and is independent of other factors like M, M’, V and V’.
5. It's assumed that the demand for money is proportional to the value of transactions.
6. The supply of money is assumed as an exogenously determined constant.
7. The idea is applicable within the end of the day .
8. It's based on the assumption of the existence of full employment in the economy.
Criticisms of the Theory:
The Fisherian quantity theory has been subjected to severe criticisms by economists:
1. Truism:
According to Keynes, “The quantity theory of money may be a truism.” Fisher’s equation of exchange may be a simple truism because it states that the entire quantity of cash (MV+M’V’) paid for goods and services must equal their value (PT). But it can't be accepted today that a particular percentage change within the quantity of money results in an equivalent percentage change within the price level.
2. Other Things not equal:
The direct and proportionate relation between quantity of money and price level in Fisher’s equation is predicated on the idea that “other things remain unchanged”. But in real life, V, V’ and T aren't constant. Moreover, they're not independent of M, M’ and P. Rather, all elements in Fisher’s equation are interrelated and interdependent. As an example , a change in M may cause a change in V.
Consequently, the price level may change more in proportion to a change within the quantity of cash . Similarly, a change in P may cause a change in M. Rise within the price level may necessitate the issue of more money. Moreover, the quantity of transactions T is also suffering from changes in P.
When prices rise or fall, the volume of business transactions also rises or falls. Further, the assumptions that the proportion M’ to M is constant, has not been borne out by facts. Not only this, M and M’ aren't independent of T. a rise within the volume of business transactions requires a rise in the supply of money (M and M’).
3. Constants Relate to Different Time:
Prof. Halm criticizes Fisher for multiplying M and V because M relates to a point of time and V to a period of your time . the former is a static concept and the latter a dynamic. It is, therefore, technically inconsistent to multiply two non-comparable factors.
4. Fails to live Value of Money:
Fisher’s equation doesn't measure the purchasing power of cash but only cash transactions, that is, the quantity of business transactions of all types or what Fisher calls the volume of trade in the community during a year. But the purchasing power of cash (or value of money) relates to transactions for the purchase of goods and services for consumption. Thus the number theory fails to live the value of money.
5. Weak Theory:
According to Crowther, the quantity theory is weak in many respects.
First, it cannot explain ‘why’ there are fluctuations within the price level in the short run.
Second, it gives undue importance to the price level as if changes in prices were the foremost critical and important phenomenon of the economic system.
Third, it places a misleading emphasis on the number of money as the principal cause of changes in the price level during the business cycle . Prices might not rise despite increase within the quantity of money during depression; and that they may not decline with reduction in the quantity of money during boom.
Further, low prices during depression aren't caused by shortage of quantity of cash , and high prices during prosperity aren't caused by abundance of quantity of money. Thus, “the quantity theory is at the best an imperfect guide to the causes of the business cycle in the short period,” according to Crowther.
6. Neglects Interest Rate:
One of the main weaknesses of Fisher’s quantity theory of money is that it neglects the role of the speed of interest together of the causative factors between money and costs . Fisher’s equation of exchange is said to an equilibrium situation during which rate of interest is independent of the quantity of money.
7. Unrealistic Assumptions:
Keynes in his General Theory severely criticised the Fisherian quantity theory of cash for its unrealistic assumptions.
First, the quantity theory of money is unrealistic because it analyses the relation between M and P within the end of the day . Thus it neglects the short run factors which influence this relationship.
Second, Fisher’s equation holds good under the idea of full employment. But Keynes regards full employment as a special situation. The overall situation is one among the underemployment equilibrium.
Third, Keynes doesn't believe that the relationship between the number of cash and the price level is direct and proportional. Rather, it's an indirect one via the speed of interest and the level of output.
According to Keynes, “So long as there's unemployment, output and employment will change in the s.ame proportion as the quantity of money, and when there's full employment prices will change within the same proportion because the quantity of money.”
Thus Keynes integrated the idea of output with value theory and monetary theory and criticised Fisher for dividing economics “into two compartments with no doors and windows between the theory of value and theory of money and prices.”
8. V not Constant:
Further, Keynes acknowledged that when there's underemployment equilibrium, the speed of circulation of money V is very unstable and would change with changes in the stock of money or money income. Thus it was unrealistic for Fisher to assume V to be constant and independent of M.
As an alternate to Fisher’s quantity theory of money, Cambridge economists Marshall, Pigou, Robertson and Keynes formulated the cash balances approach. Like value theory, they regarded the determination of value of money in terms of supply and demand.
Robertson wrote during this connection: “Money is only one among the various economic things. Its value, therefore, is primarily determined by precisely the same two factors as determine the value of the other thing, namely, the conditions of demand for it, and the quantity of it available.”
The supply of money is exogenously determined at a point of time by the banking system. Therefore, the concept of velocity of circulation is altogether discarded within the cash balances approach because it ‘obscures the motives and decisions of people behind it’.
On the other hand, the concept of demand for money plays the main role in determining the value of money. The demand for money is that the demand to hold cash balances for transactions and precautionary motives.
Thus the cash balances approach considers the demand for money not as a medium of exchange but as a store useful . Robertson expressed this distinction as money “on the wings” and money “sitting”. It's “money sitting” that reflects the demand for money within the Cambridge equations.
The Cambridge equations show that given the supply of money at a point of time, the value of money is decided by the demand for cash balances. When the demand for money increases, people will reduce their expenditures on goods and services so as to have larger cash holdings. Reduced demand for goods and services will bring down the price level and raise the value of money. On the contrary, fall within the demand for money will raise the worth level and lower the value of money.
The Cambridge cash balances equations of Marshall, Pigou, Robertson and Keynes are discussed as under:
Marshall didn't put his theory in equation form and it was for his followers to explain it algebraically. Friedman has explained Marshall’s views thus: “As a primary approximation, we may suppose that the amount one wants to carry bears some reference to one’s income, since that determines the quantity of purchases and sales in which one is engaged. We then add up the cash balances held by all holders of money within the community and express the entire as a fraction of their total income.”
Thus we will write:
M = kPY
Where M stands for the exogenously determined supply of money, k is that the fraction of the real money income (PY) which people wish to hold in cash and demand deposits, P is the price level, and Y is that the aggregate real income of the community. Thus the price level P = M/kY or the value of money (the reciprocal of price level) is
1/P = kY/M
Pigou was the primary Cambridge economist to express the cash balances approach in the form of an equation:
P = kR/M
Where P is that the purchasing power of cash or the value of money (the reciprocal of the price level), k is that the proportion of total real resources or income (R) which people wish to hold in the form of titles to legal tender, R is that the total resources (expressed in terms of wheat), or real income, and M refers to the number of actual units of tender money.
The demand for money, consistent with Pigou, consists not only of legal money or cash but also bank notes and bank balances. So as to incorporate bank notes and bank balances within the demand for money, Pigou modifies his equation as
P = kR/M {c + h(1-c)}
Where c is the proportion of total real income actually held by people in legal tender including token coins, (1-c) is that the proportion kept in bank notes and bank balances, and h is that the proportion of actual tender that bankers keep against the notes and balances held by their customers.
Pigou points out that when k and R in the equation P=kR/M and k, R, c and h are taken as constants then the two equations give the demand curve for legal tender as a rectangular hyperbola. This implies that the demand curve for money features a uniform unitary elasticity.
To determine the value of money or its reciprocal the price level, Robertson formulated an equation almost like that of Pigou. The sole difference between the two being that rather than Pigou’s total real resources R, Robertson gave the volume of total transactions T. The Robertsonian equation is M = PkT or
P = M/kT
Where P is that the price level, M is that the total quantity of money, k is that the proportion of the entire amount of goods and services (T) which individuals wish to carry in the form of cash balances, and T is the total volume of products and services purchased during a year by the community.
If we take P as the value of money instead of the price level as in Pigou’s equation, then Robertson’s equation exactly resembles Pigou’s P = kT/M.
Keynes in his A Tract on Monetary Reform (1923) gave his Real Balances Quantity Equation as an improvement over the opposite Cambridge equations. Consistent with him, people always want to have some purchasing power to finance their day to day transactions.
The amount of purchasing power (or demand for money) depends partly on their tastes and habits, and partly on their wealth. Given the tastes, habits, and wealth of the people, their desire to carry money is given. This demand for money is measured by consumption units. A consumption unit is expressed as a basket of standard articles of consumption or other objects of expenditure.
If k is that the number of consumption units within the form of cash, n is that the total currency in circulation, and p is that the price for consumption unit, then the equation is
n= pk
If k is constant, a proportionate increase in n (quantity of money) will cause a proportionate increase in p (price level).
This equation are often expanded by taking into account bank deposits. Let k’ be the number of consumption units in the form of bank deposits, and r the cash reserve ratio of banks, then the expanded equation is
n=p (k + rk’)
Again, if k, k’ and r are constant, p will change in exact proportion to the change in n.
Keynes regards his equation superior to other cash balances equations. The opposite equations fail to point how the worth level (p) can be regulated. Since the cash balances (k) held by the people are outside the control of the monetary authority, p are often regulated by controlling n and r. It's also possible to manage bank deposits k’ by appropriate changes within the bank rate. So p will be controlled by making appropriate changes in n, r and k’ so on offset changes in k.
There are certain points of similarities between Fisher’s transactions approach and the Cambridge cash balances approach. These are discussed as under:
1. Similarities:
The two approaches have the subsequent similarities:
1. Same Conclusion:
The Fisherian and Cambridge versions lead to an equivalent conclusion that there's a direct and proportional relationship between the quantity of money and the price level and an inverse proportionate relationship between the quantity of money and the value of money.
2. Similar Equations:
The two approaches use almost similar equations. Fisher’s equation P = MV/T is similar to Robertson’s equation P = M/kT. However, the sole difference is between the 2 symbols V and k which are reciprocal to every other.
Whereas V = |1/k| k = |1/V|. Here V refers to the rate of spending and k the amount of money which people wish to carry in the kind of cash balances or don't want to spend. As these two symbols are reciprocal to every other, the differences within the two equations can be reconciled by substituting 1/V for k in Robertson’s equation and 1/k for V in Fisher’s equation.
3. Money as the Same Phenomenon:
The different symbols given to the entire quantity of money within the two approaches ask the same phenomenon. Intrinsically MV+M’V of Fisher’s equation, M of the equations of Pigou and Robertson, and n of Keynes’ equation ask the entire quantity of money.
2. Dissimilarities:
Despite these similarities the 2 approaches have many dissimilarities:
1. Functions of Money:
The two versions emphasize on different functions of money. The Fisherian approach lays emphasis on the medium of exchange function while the Cambridge approach emphasises the store useful function of money.
2. Flow and Stock:
In Fisher’s approach, money may be a flow concept while within the Cambridge approach it's a stock concept. The former relates to a period of time and therefore the latter to a point of time.
3. V and k Different:
The meaning given to the 2 symbols V and k within the two versions is different. In Fisher’s equation V refers to the rate of spending and in Robertson’s equation k refers to the cash balances which people wish to carry . The former emphasises the transactions velocity of circulation and the latter the income velocity.
4. Nature of Price Level:
In Fisher’s equation, P refers to the average price level of all goods and services. But within the Cambridge equation P refers to the prices of final or consumer goods.
5. Nature of T:
In Fisher’s version, T refers to the entire amount of goods and services exchanged for money, whereas within the Cambridge version, it refers to the final or consumer goods exchanged for money.
6. Emphasis on Supply and Demand for Money:
Fisher’s approach emphasises the availability of cash , whereas the Cambridge approach emphasises both the demand for money and therefore the supply of cash .
7. Different in Nature:
The two approaches are different in nature. The Fisherian version is mechanistic because it doesn't explain how changes in V bring about changes in P. On the other hand, the Cambridge version is realistic because it studies the psychological factors which influence k.
It is on account of those differences that Hansen wrote: “It isn't true as is usually alleged that the cash balance equation is simply the quantity theory in new algebraic dress.”
The Cambridge cash balances approach to the quantity theory of money is superior to Fisher’s transaction approach in many respects.
They are discussed as under:
1. Basis of Liquidity Preference Theory of Interest:
The cash balances approach emphasises the importance of holding cash balances rather than the supply of money which is given at a point of time. It thus led Keynes to propound his theory of liquidity preference and of the speed of interest, and to the integration of monetary theory useful and output.
2. Complete Theory:
The cash balances version of quantity theory is superior to the transactions version because the previous determines the value of money in terms of the demand and supply of money. Thus it's a complete theory. But within the transactions approach, the determination useful of money is artificially divorced from the theory of value.
3. Discards the Concept of Velocity of Circulation:
The cash balances approach is superior to the transactions approach because it discards the concept of the velocity of circulation of money which ‘obscures the motives and decisions of individuals behind it.
4. Related to the Short Period:
Again the cash balances version is more realistic than the transactions version of the quantity theory, because it's associated with the short period while the latter is said to the long period. As acknowledged by Keynes, “In the long run we may all be dead.” therefore the study of the relationship between quantity of money and price level during the long run is unrealistic.
5. Simple Equations:
In the cash balances equations, transactions concerning final goods only are included where P refers to the extent of ultimate goods. On the other hand, within the transactions equation P includes all kinds of transactions. This creates difficulties in determining the true price level. Thus the former equations are simpler and realistic than the latter.
6. New Formulation in Monetary Theory:
Further, the Cambridge equation regards the cash balances held by the people as a function of the extent of income. The introduction of income (f or R or T) in this equation as against V (the velocity of circulation of money) within the transaction equation has made the cash balances equation realistic and led to new formulations in monetary theory. “It points out that changes in the level of money income can happen through changes within the price level, through changes in real output or through both at once.”
7. Explains Trade Cycles:
Hansen regards k within the Cambridge equation superior to Fin Fisher’s equation for understanding cyclical fluctuations. Consistent with him, “Drastic and sudden shifts within the desire to hold money, reflected during a change in k, may produce large and quickly moving changes within the level of income and prices.
In the Cambridge analysis, a shift in k may start an upward or downward movement.” as an example , when k (the fraction of total real income that people wish to hold in cash balances) increases because of low business expectations, the price level falls, and vice versa.
8. Study of Subjective Factors:
As a corollary to the above, V in Fisher’s equation is mechanistic while k within the Cambridge equation is realistic. The subjective factors behind variations in k have led to the study of such factors as expectations, uncertainty, motives for liquidity, and therefore the rate of interest in modern monetary theory. During this sense, it can be justifiably said that, “the Cambridge equation moves us on from the tautology represented by the equation of exchange to a study of economic behaviour.”
9. Applicable under All Circumstances:
Fisher’s transactions approach holds true only under full employment. But the cash balances approach holds under all circumstances whether there's full employment or less than full employment.
10. Based on Micro Factors:
The Cambridge version is superior to the Fisherian version because it's based on micro factors like individual decisions and behaviours. On the opposite hand, the Fisherian version relies on macro factors like T, total velocity of circulation, etc.
Inflation is a quantitative measure of the speed at which the average price level of a basket of selected goods and services in an economy increases over a period of time. It's the constant rise within the general level of prices where a unit of currency buys but it did in prior periods. Often expressed as a percentage, inflation indicates a decrease within the purchasing power of a nation’s currency.
Inflation – its concepts and causes of inflation.
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.
Inflation must be controlled at an appropriate level. Uncontrolled inflation may turn into hyperinflation. 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 requires 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 quantitive 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 for goods and services and encourage production of essential commodities through incentives to private sector in addition to its own expenditure on production and distribution of goods ad services.
The fiscal measures are (i) taxation (ii) public borrowing (iii) compulsory saving and (iv) public expenditure.
Direct and Indirect taxes are leived 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. Essential commodities should not be taxed, lest inflation be aggravated.
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 difficultto 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 specially 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.
Built-In Inflation
Built-in inflation is that the third cause that links to adaptive expectations. Because the price of goods and services rises, labor expects and demands more costs/wages to maintain their cost of living. Their increased wages end in higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.
Theoretically, monetarism establishes the relation between inflation and money supply of an economy. For instance , following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and particularly silver flowed into the Spanish and other European economies. Since the cash supply had rapidly increased, prices spiked and the value of cash fell, contributing to economic collapse.
Deflation may be a general decline in prices for goods and services, typically related to a contraction within the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time.
Deflation is that the general decline of the price level of goods and services.
Deflation is usually related to a contraction within the supply of money and credit, but prices also can fall due to increased productivity and technological improvements.
Whether the economy, price level, and money supply are deflating or inflating changes the appeal of various investment options.
Understanding Deflation
Deflation causes the nominal costs of capital, labor, goods, and services to fall, though their relative prices could also be unchanged. Deflation has been a popular concern among economists for many years. On its face, deflation benefits consumers because they will purchase more goods and services with the same nominal income over time.
However, not everyone wins from lower prices and economists are often concerned about the consequences of falling prices on various sectors of the economy, especially in financial matters. In particular, deflation can harm borrowers, who are often sure to pay their debts in money that's worth more than the money they borrowed, also as any financial market participants who invest or speculate on the prospect of inflation .
Causes of Deflation
By definition, monetary deflation can only be caused by a decrease within the supply of money or financial instruments redeemable in money. In times , the money supply is most influenced by central banks, like the federal reserve. When the supply of money and credit falls, without a corresponding decrease in economic output, then the prices of all goods tend to fall. Periods of deflation most ordinarily occur after long periods of artificial monetary expansion. The first 1930s was the last time significant deflation was experienced within the us . The main contributor to this deflationary period was the fall within the money supply following catastrophic bank failures. Other nations, like Japan within the 1990s, have experienced deflation in modern times.
World-renowned economist Friedman argued that under optimal policy, during which the central bank seeks a rate of deflation equal to the real rate of interest on government bonds, the nominal rate should be zero, and therefore the price index should fall steadily at the real rate of interest. His theory birthed the Friedman rule, a monetary policy rule.
However, declining prices are often caused by a number of other factors: a decline in aggregate demand (a decrease within the total demand for goods and services) and increased productivity. A decline in aggregate demand typically leads to subsequent lower prices. Causes of this shift include reduced government spending, stock market failure, consumer desire to increase savings, and tightening monetary policies (higher interest rates).
Falling prices also can happen naturally when the output of the economy grows faster than the availability of circulating money and credit. This occurs especially when technology advances the productivity of an economy, and is usually concentrated in goods and industries which benefit from technological improvements. Companies operate more efficiently as technology advances. These operational improvements cause lower production costs and cost savings transferred to consumers within the sort of lower prices. This is often distinct from but similar to general price deflation, which may be a general decrease within the price level and increase within the purchasing power of money.
Price deflation through increased productivity is different in specific industries. For instance , consider how increased productivity affects the technology sector. Within the last few decades, improvements in technology have resulted in significant reductions within the average cost per gigabyte of knowledge . In 1980, the average cost of one gigabyte of data was $437,500; by 2010, the average cost was three cents. This reduction caused the prices of manufactured products that use this technology to also fall significantly.
Control of Inflation:
It is, therefore, clear that inflation can't be allowed to go unchecked and the various monetary and fiscal measures need to be adopted to combat it.
Since it's caused by an excess of effective demand, measures to regulate it imply a reduction within the total effective demand.
Amongst the monetary measures we include higher bank rate, open-market operations, higher reserve requirements, consumer credit control, higher margin requirements, compulsory saving etc.
Fiscal measures with reference to inflation include government spending, taxes, public borrowing, saving, debt management etc. Besides monetary and fiscal measures, there are important non-monetary anti-inflation measures which include output adjustment, suitable wage policy, price control, rationing, etc. These measures are, however, supplementary to main monetary and fiscal measures.
Control of Deflation:
Deflation adversely affects the level of production, business activity and employment and, therefore, it's equally essential to regulate it. During deflation the bank rate is lowered and securities are purchased through the open market operations and the volume of money and credit is expanded in every possible way. This policy is known as cheap-money policy. The idea is that with a rise within the quantum of money and credit, there'll be increase in investment, production and employment. But these monetary measures alone may prove inadequate.
Mere expansion of cash and credit may fail to revive economic activity, for the entrepreneurs may not be willing to expand investment (as anticipated) for want of necessary optimism. So, these monetary measures to combat deflation have to be combined with the fiscal measures like increased expenditure through deficit financing, tax concession and public works programmes, thereby providing jobs to unemployed people and generating the necessary effective demand needed for recovery.
These monetary and fiscal measures will prove simpler if combined with other measures, like the price support programmes, (i.e., to prevent the prices from falling below a certain level), lowering of wages and other costs to cause adjustment between the price-cost structure. The best remedy to fight deflation is to possess a ready programme of public works to be resorted to, as and when unemployment appears.
Some of the main ways to regulate deflation are as follow: 1. Monetary Policy 2. Fiscal Policy!
Deflation are often controlled by adopting monetary and fiscal measures in only the opposite manner to regulate inflation.
However, we discuss these measures in short .
1. Monetary Policy:
To control deflation, the central bank can increase the reserves of commercial banks through a cheap money policy. They will do so by buying securities and reducing the rate of interest . As a result, their ability to increase credit facilities to borrowers increases. But the experience of the good Depression tells us that during a serious depression when there is pessimism among businessmen, the success of such a policy is practically nil.
In such a situation, banks are helpless in bringing a few revival. Since business activity is nearly at a standstill, businessmen don't have any inclination to borrow to build up inventories even when the speed of interest is very low. Rather, they need to reduce their inventories by repaying loans already drawn from the banks.
Moreover, the question of borrowing for long-term capital needs doesn't arise during deflation when the business activity is already at a really low level. An equivalent is the case with consumers who faced with unemployment and reduced incomes don't wish to purchase any durable goods through bank loans.
Thus all that the banks can do is to form credit available but they can't force businessmen and consumers to simply accept it. Within the 1930s, very low interest rates and therefore the piling from unused reserves with the banks didn't have any significant impact on the depressed economies of the world. Thus the success of monetary policy in controlling deflation is severely limited.
2. Fiscal Policy:
Fiscal policy through increase in public expenditure and reduction in taxes tends to raise national income, employment, output, and prices. a rise publicly expenditure during deflation increases the aggregate demand for goods and services and results in a large increase in income via the multiplier process, while a discount in taxes has the effect of raising income thereby increasing consumption and investment expenditures of the people.
The government should increase its expenditure through deficit budgeting and reduction in taxes. The general public expenditure includes expenditure on such structure as roads, canals, dams, parks, schools, hospitals and other buildings, etc. and on such relief measures as unemployment insurance, pensions, etc.
Expenditure on public works creates demand for the products of private construction industries and helps in reviving them while expenditure on relief measures stimulates the demand for consumer goods industries. Reduction in such taxes as corporate profits tax, tax , and excise taxes tends to leave more income for spending and investment.
Borrowing by the govt to finance budget deficits utilises idle money lying with banks and financial institutions for investment purposes. But the effectiveness of public expenditure primarily depends upon the public works programme, its importance within the economic system, the volume and nature of public works and their planning and timing.
