Inflation and Monetary Policy

Inflation
Inflation is defined as a sustained increase in the price level or a sustained fall in the value of money. Rate of inflation t = Pt Pt-1 /pt-1 X100 Where, Pt is the price level in year t, Pt - 1 is the price level in year t-1, the base year. If there is a decline in the rate of inflation, such a situation is called DISINFLATION.

Types of Inflation
Open inflation and suppressed Inflation When the government does not try to prevent a rise in prices, inflation is called as open inflation. Thus, prices grow without any time-out. Suppressed inflation occurs in a controlled economy where the upward pressure on prices is not allowed to influence the quoted or managed prices. Inflation here reveals itself in other forms. For example, government may introduce rationing of goods leading to long queues in front of ration shops. There is very likely to be a black market for such good whose prices are far above the quoted prices. In India, suppressed inflation manifests itself in the prices of essential goods sold through PDS. The ration prices are deliberately maintained at a certain level while the open market prices are above this level.

Creeping Inflation, Galloping Inflation and Hyper Inflation Recognized on the basis of severity of inflation, as measured in terms of rate of rise in prices.
Creeping Inflation/ moderate inflation :There is moderate rise in prices of 2-3 per cent per annum. It is generally considered good for a growing economy. Mildly rising prices result in faster growth of output The profit margins of firms are raised which encourages them to produce more. Creeping inflation does not severely distort relative prices nor does it destabilize price expectations.

Galloping inflation : Prices rise at double or treble digit rates per annum (20-100%). It tends to distort relative prices . Results in disquieting changes in distribution of purchasing power of different groups of income earners. There is often a flight of capital from the country since people tend to send their investment funds abroad and domestic investment withers away. Hyper inflation or run-away inflation is of a severe type in which prices rise a thousand or a million or even a billion per cent per year. It seriously cripples the economy. Prices and money supply rise alarmingly. It is generally a result of war, political revolution or some other catastrophic event.

Demand pull inflation Such an inflation occurs when aggregate demand rises more rapidly than the economy's productive potential, pulling prices up to equilibrate aggregate supply and demand. It is characterized by a situation in which there is "too much money chasing too few goods".

Factors on demand side

On the demand side, the major inflationary factors are: money supply disposable income and consumer expenditures Increase in business outlays Increased foreign demand.

Cost push / Supply shock inflation

This inflation occurs due to an increase in the cost or supply price of goods caused by increases in the prices of inputs. Rapidly rising money wages with no corresponding rise in labour productivity in certain key sectors of the economy result in higher prices in these same sectors, particularly as demand rises. This leads to further erosion of real wages forcing organized labour, to seek a further rise in money wages. This is what is commonly referred to as wage price spiral.

Cost push inflation occurs due to non-wage factors also. For instance, monopolistic or oligopolistic firms often attempt to maintain their profit margins steady by raising the prices of their products in proportion to the rise in other cost elements. Such a cost push inflation is sometimes called "mark-up" inflation.

Causes of cost push inflation

Wage-push Pressures Profit-Push and Mark-up Pricing Import Prices Exchange rates

Measurement of Inflation
The GNP deflator The GNP deflator measures the average level of the prices of all goods and services that make up the GNP. It is the ratio of nominal GNP in a given year to real GNP and it is a measure of inflation from the period for which the base prices for calculating the real GNP are taken to the current period.

The Consumer Price Index (CPI) It measures the cost of buying a fixed basket of goods and services representative of the purchases of urban consumers. The basket represents the actual consumption pattern of a typical family from a specific group for which the CPI is being constructed.

Whole sale price index The items included in WPI include items like fertilizers, minerals, industrial raw materials and semi-finished goods, machinery and equipment, etc., apart from items in the food group and in the fuel, light and power group. The WPI can be interpreted as an index of prices paid by producers for their inputs. Wholesale prices rather than retail prices are used.

Deflation
Deflation is a sustained general reduction in the level of prices, or of the prices of an entire kind of asset or commodity. There is a fall in how much the whole economy is willing to buy, and the going price for goods. Since this idles capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral.

 Deflation is generally regarded negatively, as it is a tax on borrowers and on holders of illiquid assets, which accrues to the benefit of savers and of holders of liquid assets and currency. Deflation also occurs when improvements in production efficiency lowers the overall price of goods. Though improvements in production efficiency are motivated by a promise of increased profit margins, competition in the market place often prompts reduction in prices. Consequently deflation has occurred, since purchasing power has increased.

 Deflation raises real wages, which are both difficult and costly for management to lower. This frequently leads to layoffs and makes employers reluctant to hire new workers, increasing unemployment. In modern economies, deflation is caused by a collapse in demand (usually brought on by high interest rates), and is associated with recession and (more rarely) long-term economic depressions.

Monetary policy
The policy concerned with changes in the supply of money. The central bank (RBI in India), administers the Monetary and Credit policy. Traditionally announced twice a year, through which the Reserve Bank of India seeks to ensure price stability for the economy. RBI also announces norms for the banking and financial sector and the institutions which are governed by it.

Objectives
High level of output (or national income) High rate of economic growth. High employment. Price stability (or optimal rate of inflation). Low inequality in the distribution of income and wealth (equity objective). External stability or healthy balance of payment position (stability of external value of domestic currency).

INSTRUMENTS OF MONETARY POLICY

(A) Quantitative Instruments The Quantitative Instruments are designed to regulate or control the total volume of bank credit in the economy. These tools are indirect in nature . (B) Qualitative Instruments or Selective Tools These tools are used for discriminating between different uses of credit. It can be discrimination favoring export over import or essential over non-essential credit supply. This method can have influence over the lender and borrower of the credit.

Quantitative Instruments
1. Bank Rate Policy (BRP) Influences the volume or the quantity of the credit in a country. The bank rate refers to rate at which the central bank (i.e RBI) rediscounts bills of commercial banks or provides them advance against approved securities. The Bank Rate affects the actual availability and the cost of the credit. If the RBI increases the bank rate, it deters banks from further credit expansion as it becomes a more costly affair. On the other hand, if the RBI reduces the bank rate, borrowing for commercial banks will be easy and cheaper. This will boost the credit creation.

2. Open Market Operation (OMO)

The open market operation refers to the purchase and/or sale of short term and long term securities by the RBI in the open market. The OMO is used to wipe out shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc. Thus under OMO there is continuous buying and selling of securities taking place leading to changes in the availability of credit in an economy.

3. Variation in the Reserve Ratios (VRR) Commercial Banks have to keep a certain proportion of their total assets in the form of Cash Reserves. These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR). Any change in the VRR (i.e. CRR + SLR) brings out a change in commercial banks reserves positions. Thus by varying VRR commercial banks lending capacity can be affected. RBI increases VRR during inflation to reduce the purchasing power and credit creation. But during recession it lowers the VRR making more cash reserves available for credit expansion.

Cash Reserve Ratio

CRR, or cash reserve ratio, refers to a portion of deposits (as cash) which banks have to keep/maintain with the RBI. During Inflation RBI increases the CRR due to which commercial banks have to keep a greater portion of their deposits with the RBI .

Statutory Liquidity Ratio

Banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements . If SLR increases the lending capacity of commercial banks decreases thereby regulating the supply of money in the economy. SLR also refers to some percent of reserves to be maintained in the form of gold or foreign securities

Qualitative methods
(B) Qualitative Instruments or Selective Tools. They are used for discriminating between different uses of credit. 1. Consumer Credit Regulation If there is excess demand for certain consumer durables leading to their high prices, central bank can reduce consumer credit by (a) increasing down payment, and (b) reducing the number of installments of repayment of such credit.

2. Fixing Margin Requirements The margin refers to the "proportion of the loan amount which is not financed by the bank". A change in a margin implies a change in the loan size. This method is used to encourage credit supply for the needy sector and discourage it for other non-necessary sectors. This can be done by increasing margin for the non-necessary sectors and by reducing it for other needy sectors. Example:- If the RBI feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given.

3. Publicity This is yet another method of selective credit control. Through it Central Bank (RBI) publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors 4. Credit Rationing Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit exposure to unwanted sectors.

5. Moral Suasion It implies to pressure exerted by the RBI on the indian banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the central bank through a monetary policy. Under moral suasion central banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes.

6. Control Through Directives Under this method the central bank issue frequent directives to commercial banks. These directives guide commercial banks in framing their lending policy. Through a directive the central bank can influence credit structures, supply of credit to certain limit for a specific purpose.

7. Direct Action Under this method the RBI can impose an action against a bank. If certain banks are not adhering to the RBI's directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are in excess to their capital. Central bank can penalize a bank by changing some rates. At last it can even put a ban on a particular bank if it dose not follow its directives and work against the objectives of the monetary policy.

Fiscal Policy
Acts of a government to influence the direction of nations economy by using its financial and regulatory powers. The two main important instruments are government spending and taxation. These are also known as financial powers. By regulatory powers we mean the ability of government to influence or require its people to change their behavior. E.g. Indian government might ask all the industries to conform to universal environmental standards to reduce global warming.

Stances of Fiscal Policy

A neutral stance of fiscal policy implies a balanced budget where Government spending (G) is equal to Tax revenue (T) i.e. G=T. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus. Expansionary fiscal policy is usually associated with a budget deficit. Hence, when government decides to adopt expansionary fiscal policy, it actually decides to spend more than what it did earlier.

 A contractionary fiscal policy occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two i.e. G < T. This would lead to a lower budget deficit or a larger surplus. Contractionary fiscal policy is usually associated with a surplus.

Objectives of fiscal policy

1. Development by effective mobilisation of resources Ensure rapid economic growth and development by mobilisation of Financial Resources. The financial resources can be mobilised by : Taxation : direct taxes as well as indirect taxes. Public Savings : reducing government expenditure and increasing surpluses of public sector enterprises. Private Savings : effective fiscal measures such as tax benefits, can help the government raise resources from private sector and households. Resources can be mobilised through government borrowings by ways of treasury bills, issue of government bonds, etc., loans from domestic and foreign parties and by deficit financing.

2. Efficient allocation of Financial Resources Financial resources allocated for development activities which includes expenditure on railways, infrastructure, etc. While non-development activities includes expenditure on defence, interest payments, subsidies, etc. Resource allocation for generation of goods and services which are socially desirable. 3. Reduction in inequalities of income and wealth Achieving equity or social justice by reducing income inequalities among different sections of the society. The direct and indirect taxes are more on rich people and luxury/ semi luxury items. The government invests a significant proportion of its tax revenue in the implementation of poverty alleviation programmes to improve the conditions of poor in society.

4. Price Stability and Control of Inflation The government always aims to control inflation by reducing fiscal deficits, introducing tax savings schemes, productive use of financial resources, etc. 5. Employment Generation Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generates more employment. Various rural employment programmes undertaken by the Government to solve problems in rural areas. Similarly, self employment scheme is taken to provide employment to technically qualified persons .

6. Balanced Regional Development There are various incentives from the government for setting up projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax holidays, Finance at concessional interest rates, etc. 7. Reducing the Deficit in the Balance of Payment Fiscal policy attempts to encourage more exports by way of fiscal measures like exemption of income tax on export earnings, Exemption of central excise duties and customs, Exemption of sales tax and octroi, etc. The foreign exchange is also conserved by Providing fiscal benefits to import substitute industries, Imposing customs duties on imports, etc.

8. Capital Formation Aims at increasing the rate of capital formation so as to accelerate the rate of economic growth. To increase the rate of capital formation, the fiscal policy must be efficiently designed to encourage savings and discourage and reduce spending. 9. Increasing National Income This is because fiscal policy facilitates the capital formation. This results in economic growth, which in turn increases the GDP, per capita income and national income of the country.

10. Development of Infrastructure A part of the government's revenue is invested in the infrastructure development. Due to this, all sectors of the economy get a boost. 11. Foreign Exchange Earnings Fiscal policy attempts to encourage more exports and reduce dependence on imports.

Instruments of Fiscal Policy:

1. Public expenditure 2. Taxes 3. Public debts The above mentioned instruments are used by the public authorities to achieve desirable level of production , consumption and National Income.

 During inflationary trend more and more taxes are levied on the community. In this way, purchasing power of the people can be decreased and desirable price level is achieved. During inflation public expenditure is decreased so that aggregate demand decreases decreasing high prices and increase the value of money . During deflationary period taxes are reduced and public expenditure is increased. In this way incentives to invest are increased and national income begins to rise. For economic development public debts are necessary. In under developed countries, due to insufficient resources economic development is not possible. Public loans are drawn internally and externally.

Fiscal deficit
Fiscal deficit is defined as the difference between government expenditure and its revenue i.e. Fiscal deficit = Government spending Government revenue It is expressed in terms of percentage of GDP

Effects of fiscal policy

Changes in the level and composition of taxation and government spending can impact on the following variables in the economy: Aggregate demand and the level of economic activity The pattern of resource allocation The distribution of income Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. This is generally done during recession to boost spending and demand.

Deficit financing
Deficit financing is an approach to money management that involves spending more money than is collected during the same period. When used properly, this financing method helps to launch a chain of events that ultimately enhances the financial condition rather than simply creating debt that may or may not be repaid.

By establishing a specific plan of action that involves using borrowed resources to make purchases, the government can increase the demand for output from various sectors of the business community. This in turn motivates businesses to hire additional employees and helps to fight unemployment. The renewed vigor in the marketplace helps to restore consumer confidence, making it more likely for consumers to buy more goods and services. A carefully crafted and closely monitored plan will restore a measure of stability to the national economy over a period of months or years.

Government spending
Government expenditure or spending can be categorized in three ways: 1. Spending on goods and service 2. Transfer payments- It involves payments to individuals by the government under several welfare schemes such as unemployment benefits, elderly pensions, healthcare benefits or food coupons. 3. Net interest payments- Governments pay interest rates to people who hold government bonds or debt. Hence, any increase or decrease in the interest rate will directly affect the income from these bonds. By changing its spending, government can influence aggregate demand in the economy.

Government Revenue
Government generates revenue by collecting taxes from its people and businesses. Across the globe, maximum tax is collected as payroll taxes i.e. income taxes, followed by corporate taxes. The next largest category is sales taxes and import duties. By changes in tax rates government can influence demand. For example lowering of income tax rate will increase the disposable income of people. With more money in hand people will spend those money on goods and service; hence, creating a demand for the same.

Fiscal policy in the short-run

The idea of fiscal policy in the short-run is very simple- if aggregate demand is too low, the government would: Buy more goods and service Increase transfer payments Reduce tax rates on income Reduce imports and excise duties

Buying more Increase goods and transfer services would: payments would:

Reducing tax rates on household income would:

Reducing taxes or changing regulations that influence corporate income would: Increase business spending depending on the overall sentiments in economy

Directly increase Increase spending and disposable AD income and generally increased spending by households

Increase disposable income due to lower taxes would increase spending power of individuals and hence increase in AD