th

BBA 4 Semester
Macroeconomics
rd
3 Unit Notes
Meaning and Definitions of Money :

Definition of Money

Money, in simple terms, is a medium of exchange. It is instrumental in the exchange

of goods and/or services.

Further, money is the most liquid assets among all our assets. It also has general
acceptability as a means of payment along with its liquid nature.

Usually, the Central Bank or Government of a country creates and issues money.
Also called cash money, this is a legal tender and hence there is a legal compulsion
on citizens to accept it.

Functions of Money:
Money performs a number of primary, secondary, contingent and other functions
which not only remove the difficulties of barter but also oils the wheels of trade
and industry in the present day world. We discuss these functions one by one.

1. Primary Functions:
The two primary functions of money are to act as a medium of exchange and as a
unit of value.

ADVERTISEMENTS:

(i) Money as a Medium of Exchange:

This is the primary function of money because it is out of this function that its
other functions developed. By serving as a medium of exchange, money removes
the need for double coincidence of wants and the inconveniences and difficulties
associated with barter. The introduction of money as a medium of exchange
decomposes the single transaction of barter into separate transactions of sale and
purchase thereby eliminating the double coincidence of wants.

This function of money also separates the transactions in time and place because
the sellers and buyers of a commodity are not required to perform the transactions
at the same time and place. This is because the seller of a commodity buys some
money and money, in turn, buys the commodity over time and place.

When money acts as a medium of exchange, it means that it is generally

acceptable. It, therefore, affords the freedom of choice. With money, we can buy
an assorted bundle of goods and services. At the same time, we can purchase the
best and also bargain in the market. Thus money gives us a good deal of economic
independence and also perfects the market mechanism by increasing competition
and widening the market.

ADVERTISEMENTS:

As a medium of exchange, money acts as an intermediary. It facilitates exchange.

It helps production indirectly through specialisation and division of labour which,
in turn, increase efficiency and output. According to Prof. Walters, money,
therefore, serves as a ‘factor of production,’ enabling output to increase and
diversify.

In the last analysis money facilitates trade. When acting as the intermediary, it
helps one good or service to be traded indirectly for others.

(ii) Money as Unit of Value:

The second primary function of money is to act as a unit of value. Under barter one
would have to resort to some standard of measurement, such as a length of string
or a piece of wood. Since one would have to use a standard to measure the length
or height of any object, it is only sensible that one particular standard should be
accepted as the standard. Money is the standard for measuring value just as the
yard or metre is the standard for measuring length.

The monetary unit measures and expresses the values of all goods and services. In
fact, the monetary unit expresses the value of each good or service in terms of
price. Money is the common denominator which determines the rate of exchange
between goods and services which are priced in terms of the monetary unit. There
can be no pricing process without a measure of value.

The use of money as a standard of value eliminates the necessity of quoting the
price of apples in terms of oranges, the price of oranges in terms of nuts and so on.
Unlike barter, the prices of such commodities are expressed in terms of so many
units of dollars, rupees, francs, pounds, etc., depending on the nature of the
monetary unit in a country.

ADVERTISEMENTS:

As a matter of fact, measuring the values of goods and services in the monetary
unit facilitates the problem of measuring the exchange values of goods in the
market. When values are expressed in terms of money, the number of prices are
reduced from n(n-l) in barter economy to (n-1) in monetary economy.

Money as a unit of value also facilitates accounting. “Assets of all kinds, liabilities
of all kinds, income of all kinds, and expenses of all kinds can be stated in terms of
common monetary units to be added or subtracted.”
Further, money as a unit of account helps in calculations of economic importance
such as the estimation of the costs, and revenues of business firms, the relative
costs and profitability of various public enterprises and projects under a planned
economy, and the gross national product. As pointed out by Culbertson, “Prices
quoted in terms of money become the focus of people’s behaviour. Their
calculations, plans, expectations, and contracts focus on money prices.”

2. Secondary Functions:
Money performs three secondary functions: as a standard of deferred payments, as
a store of value, and as a transfer of value. They are discussed below.

(i) Money as a Standard of Deferred Payments:

The third function of money is that it acts as a standard of deferred or postponed
payments. All debts are taken in money. It was easy under barter to take loans in
goats or grains but difficult to make repayments in such perishable articles in the
future. Money has simplified both the taking and repayment of loans because the
unit of account is durable.

ADVERTISEMENTS:

Money links the present values with those of the future. It simplifies credit
transactions. It makes possible contracts for the supply of goods in the future for an
agreed payment of money. It simplifies borrowing by consumers on hire-purchase
and from house-building and cooperative societies.

Money facilitates borrowing by firms and businessmen from banks and other non-
bank financial institutions. The buying and selling of shares, debentures and
securities is made possible by money. By acting as a standard of deferred
payments, money helps in capital formation both by the government and business
enterprises. In fine, this function of money develops financial and capital markets
and helps in the growth of the economy.

But there is the danger of changes in the value of money over time which harms or
benefits the creditors and debtors. If the value of money increases over time, the
creditors gain and debtors lose. On the other hand, a fall in the value of money
over time brings losses to creditors and windfalls to debtors. To overcome this
difficulty, some of the countries have fixed debt contracts in terms of a price index
which measures changes in the value of money. Such a contract over time
guarantees the future payment of debt by compensating the loser by the same
amount of purchasing power when the contract was entered into.

(ii) Money as a Store of Value:

Another important function of money is that it acts as a store of value. “The good
chosen as money is always something which can be kept for long periods without
deterioration or wastage. It is a form in which wealth can be kept intact from one
year to the next. Money is a bridge from the present to the future. It is therefore
essential that the money commodity should always be one which can be easily and
safely stored.”

Money as a store of value is meant to meet unforeseen emergencies and to pay

debts. Newlyn calls this the asset function of money. “Money is not, of course, the
only store of value. This function can be served by any valuable asset. One can
store value for the future by holding short-term promissory notes, bonds,
mortgages, preferred stocks, household furniture, houses, land, or any other kind of
valuable goods. The principal advantages of these other assets as a store of value
are that they, unlike money, ordinarily yield an income in the form of interest,
profits, rent or usefulness…,and they sometimes rise in value in terms of money.
ADVERTISEMENTS:

On the other hand, they have certain disadvantages as a store of value, among
which are the following: (1) They sometimes involve storage costs; (2) they may
depreciate in terms of money; and (3) they are “illiquid” in varying degrees, for
they are not generally acceptable as money and it may be possible to convert them
into money quickly only by suffering a loss of value.”

Keynes placed much emphasis on this function of money. According to him, to

hold money is to keep it as a reserve of liquid assets which can be converted into
real goods. It is a matter of comparative indifference whether wealth is in money,
money claims, or goods. In fact, money and money claims have certain advantages
of security, convenience and adaptability over real goods. But the store of value
function of money also suffers from changes in the value of money. This
introduces considerable hazard in using money or assets as a store of value.

(iii) Money as a Transfer of Value:

Since money is a generally acceptable means of payment and acts as a store of
value, it keeps on transferring values from person to person and place to place. A
person who holds money in cash or assets can transfer that to any other person.
Moreover, he can sell his assets at Delhi and purchase fresh assets at Bangalore.
Thus money facilitates transfer of value between persons and places.

3. Contingent Functions:
Money also performs certain contingent or incidental functions, according to Prof.
David Kinley. They are:

(i) Money as the Most Liquid of all Liquid Assets:

ADVERTISEMENTS:
Money is the most liquid of all liquid assets in which wealth is held. Individuals
and firms may hold wealth in infinitely varied forms. “They may, for example,
choose between holding wealth in currency, demand deposits, time deposits,
savings, bonds, Treasury Bills, short-term government securities, long-term
government securities, debentures, preference shares, ordinary shares, stocks of
consumer goods, and productive equipment.” All these are liquid forms of wealth
which can be converted into money, and vice-versa.

(ii) Basis of the Credit System:

Money is the basis of the credit system. Business transactions are either in cash or
on credit. Credit economises the use of money. But money is at the back of all
credit. A commercial bank cannot create credit without having sufficient money in
reserve. The credit instruments drawn by businessmen have always cash guarantee
supported by their bankers.

(iii) Equaliser of Marginal Utilities and Productivities:

Money acts as an equaliser of marginal utilities for the consumer. The main aim of
a consumer is to maximise his satisfaction by spending a given sum of money on
various goods which he wants to purchase. Since prices of goods indicate their
marginal utilities and are expressed in money, money helps in equalising the
marginal utilities of various goods. This happens when the ratios of the marginal
utilities and prices of the various goods are equal. Similarly, money helps in
equalising the marginal productivities of the various factors. The main aim of the
producer is to maximise his profits. For this, he equalises the marginal productivity
of each factor with its price. The price of each factor is nothing but the money he
receives for his work.

(iv) Measurement of National Income:

ADVERTISEMENTS:

It was not possible to measure the national income under the barter system. Money
helps in measuring national income. This is done when the various goods and
services produced in a country are assessed in money terms.

(v) Distribution of National Income:

Money also helps in the distribution of national income. Rewards of factors of
production in the form of wages, rent, interest and profit are determined and paid
in terms of money.

4. Other Functions:
Money also performs such functions which affect the decisions of consumers and
governments.

(i) Helpful in making decisions:

Money is a means of store of value and the consumer meets his daily requirements
on the basis of money held by him. If the consumer has a scooter and in the near
future he needs a car, he can buy a car by selling his scooter and money
accumulated by him. In this way, money helps in taking decisions.

(ii) Money as a Basis of Adjustment:

To carry on trade in a proper manner, the adjustment between money market and
capital market is done through money. Similarly, adjustments in foreign exchange
are also made through money. Further, international payments of various types are
also adjusted and made through money.

It is on the basis of these functions that money guarantees the solvency of the payer
and provides options to the holder of money to use it any way, he likes.
Dynamic Functions of Money:

These functions are:

 Money can activate idle resources and put them into productive channels.
 Therefore, it helps in increasing output, employment, and also income levels.
 Further, it helps in converting savings into investments.
 The creation of new money governments of modern economies can spend
more than what they earn.

Value of Money

The value of money simply implies its exchange value. It means the number/amount
of goods and/or services that you can obtain in exchange for a single unit of money.

Further, the value of money is inversely proportional to the price of goods/services.

Therefore, if the price level increases, the value of money decreases and vice-versa.

Forms of Money

We can classify the total money supply of an economy into two broad groups – Cash
Money and Credit Money, including all other financial assets. The degree of money-
ness of different assets is different.

The Components of Money Supply

The components of the money supply are as follows:

 Paper Money and Coins – The Central Bank or Government issues these as
Currency. Further, they have a 100% acceptance as a means of payment. The
acceptance is based on a ‘promise to pay the bearer’ gold and/or foreign
exchange in return.
 Demand Deposit – A bank has a legal obligation to pay money on demand.
The money-ness is highest in currency and demand deposits.
 Near Money or Money Substitute – A commonly used Near Money is a
bank cheque. many people accept it as a means of payment. However, there is
no legal compulsion behind their acceptance.
 Term deposit – This is less liquid than a demand deposit as the individual
cannot use it before a fixed period of time.
 Other Financial Assets – Many non-banking financial intermediaries issue
these assets.
 Evolution of Money:
 As barter system was an inconvenient method of exchange, people were
compelled to select some commodity which was most commonly accepted
in that area as a medium of exchange. Thus, a large variety of goods came to
be used as money; gradually the most attractive metals, like gold, silver, etc.,
were adopted as money almost everywhere.
 Money has now taken the place of all these commodities. Later coins were
replaced or supplemented by paper currency for the reasons of economy and
convenience. The bank cheques, drafts and promissory notes came into use
in addition of currency to serve as the most important type of money.
However, today each country has its own monetary system and the money of
one is not usually acceptable outside its borders.
 In fact, this is one of the reasons which makes international trade different
from internal trade. Money was not invented overnight. The development of
money was rather slow. It is the result of a process of evolution through
several hundred years.
 The different types of money indicate the different stages of the
development of money. Wheat, corn, tobacco, skins, beads, gold, etc. Even
live animals served as a medium of exchange at different times in different
parts of the world. Rulers in all lands found that making coins is a profitable
business and took it into their own hands.
 According to Prof. Walker, “Money is what money does”. It is associated
with the functions performed/roles played by money.

 However, a suitable definition must be comprehensive and must emphasise

not only on the important functions of money but also on its basic
characteristics, namely general acceptability. Looking from this criterion, we
find Crowther’s definition to be the most suitable.

 “Anything that is generally acceptable as a means of exchange (i.e., as a

means of settling debts) and that at the same time, acts as a measure and as a
store of value.” — Crowther
  This definition covers all the three important functions of money and also
stresses its basic characteristic, namely general acceptability.

 Legal Tender Money and fiduciary Money:

 Legal tender money is issued by the monetary authority of a country. It has
legal sanction of the Government. Every individual is bound to accept legal
tender money in exchange for goods and services, and in the discharge of
debts.

Quantity Theory of Money

Cambridge Cash Balance Approach

Cambridge Cash Balance equation is a modified version of Fisher's equation
because this theory is linked with that quantity of money which people hold back
with them in the form of cash balances.

Marshall’s Equation:-

He said, “in every society, there is some fraction of income which people keep in
the form of currency, it may be a 5th or a 10th.......

M = KY + K'A

Where,

M = money with people

Y = total real income

K = part of annual income which people want to keep with them as purchasing
power

A = value of assets

K' = part of total property which people want to keep back as cash balance.

The supporters of Marshall removed the property part, then

M = KY
Or M = K.P.O ....... since Y = PO

Thus,P = M / KO

Where,

P = price level

O = total production

M = total supply of money

K = part of income which people want to keep with them.

Result :-

According to Marshall it is the value of K and not M which influences the price.

Pigou'sEquation :-

Marshall’s cash balance approach was further developed by his student, A.C.
Pigou

P = KR / M

Where,

P = purchasing power of one unit of money

K = ratio of money which is kept in the form of cash money

R = real income

M = total quantity of active money

He improved his equation :-

P = KR / M [ C + h(1-C) ]
Where,

C = part of total money which is held back in the form of cash balance

(1-C) = part of total money which is deposited in banks

h = part of bank deposits which banks keep with them in the form of cash balance

Result:-

If K and R are considered as static then any increase in the quantity of money will
bring down the value of money proportionately.

Robertson’s Equation :-

M = KPT

Thus, P = M / KT

Where,

M = quantity of money

K = part of T which people want to keep with them in the form of cash balance

P = price level

T = total transactions in one year

According to Robertson, the demand for money is for store of value or hoarding
value.

Keynes's Equation :-

Keynes has laid more stress on consumer goods. In his opinion, people want to
keep cash balance to purchase consumer goods. This equation is called Real
Balance Approach.
n = P ( K + rK' )

Or P = n / ( K + rK' )

Where,

n = total quantity of money

P = price level

K = part of money kept for purchasing consumer goods

r = ratio of cash balances out of bank deposits with banks

K' = quantity of money in banks to purchase consumer goods and which people
want to keep in bank.

If K, K' and r assumed to be static then P will change according to changes in n.

Features of Keynes Equation :-

 It considers the demand for money from practical point of view.

 It analyses the value of money in short period.
 The demand for money in short period is static.
 This equation combines both legal tender money and credit money.

Criticism :-

 It is difficult to measure K, K' and r.

 The equation ignores the velocity of real money and credit money
 Present consumption has been given preference whereas demand for money
in the fields of speculation and investment is more important.
 Effect of the changes in the rate of interest and bank rate on the ratio of
different types of deposits has not been explained.
2) Milton Friedman's Quantity Theory of

Money :-

It is a mixture of Keynesian and post Keynesian theories. It is also known as

“Restatement of Quantity Theory of money”.

He asserted that :-

 Demand for money can be determined just like demand for commodity.
 Two types of people holding money – business firm and wealth holders.He
deals with those who hold money in the form of money, bonds, shares etc.
 Ratio of human to non- human wealth should also be considered as
subsidiary variable in the money demand function. Expectation :- higher the
human component, greater will be the demand for money.

M / P = f ( Rb,Re,Rm,Pe,w,Yp,u )

Where,

M/P = demand for real cash balances

Rb = rate of return from bonds

Re = rate of return from equity shares

Rm = rate of return from money

Pe = rate of return from physical goods

W = ratio of non-human to human wealth

Yp = permanent income

u = individual tastes and preferences

The equation was reduced to :-

 M/P = f ( r, Yp, u )

Where, r = rate of return

Features of Friedman’s Theory :-

 Money is considered as a luxury good.

 He attempts to show that there is a predictable relationship between change
in the money stock and changes in Gross National Product.

Criticism :-

The theory failed to find any role for rate of interest in determination of demand
for money.

What is Demand for Money?

 In economics, demand for money is commonly associated with cash or bank

demand deposits. In general, the nominal demand for money increases
withthe level of nominal output and decreases with the nominal interest rate.
 The demand for money is influenced by a variety of factors, including
income level, interest rates, inflation, and future uncertainty.
 The impact of these factors on money demand is typically explained in
terms of the three motives for demanding money:
o Transaction motive – It refers to the demand for money to meet the
current needs of individuals and businesses.
o Precautionary motive – It refers to people's desire to save money for
various contingencies that may arise in the future.
o Speculative motive – It refers to the motivation of individuals to hold
cash in order to profit from market movements regarding future
changes in theinterest rate.
 Monetary policy can help to stabilise an economy when the demand for
money is stable. When the demand for money is not stable, real and nominal
interest rates change, and economic fluctuations occur.
 The demand for money explains people's desire for a specific amount of
money.
 Money is required to manage transactions, and the value of the transactions
determines how much money people wish to keep.
 o The greater the number of transactions, the greater the amount of
money demanded.
 Since the quantity of transactions is determined by earnings, it should be
obvious that an increase in earnings leads to an increase in the demand for
money.
 When people save their money rather than putting it in a bank where it earns
interest, the money they save is also subject to the rate of interest.
 People become less focused on stockpiling money when interest rates rise,
because holding money leads to holding less interest-earning deposits. As a
result, at high interest rates, the amount of money demanded decreases.

What is the Supply of Money?

 Money supply is a stock variable, just like money demand. Money supply
refers to the total stock of money in circulation among the general public at
any given time.
 The RBI publishes figures for four different measures of money supply,
namely M1, M2, M3, and M4. They are defined as below:
o M1 = CU + DD
o M2 = M1 + Savings deposits with Post Office savings banks
o M3 = M1 + Net time deposits of commercial banks
o M4 = M3 + Total deposits with Post Office savings organisations
(excluding National Savings Certificates)
 where, CU is public currency (notes and coins) and DD is net demand
deposits held by commercial banks. The term 'net' implies that only public
deposits held by banks are to be included in the money supply.
 Interbank deposits held by a commercial bank in other commercial banks are
not considered part of the money supply.
 M1 and M2 are referred to as narrow money. M3 and M4 are referred to
as broad money.
 The gradations are listed in decreasing order of liquidity. M1 is the most
liquid and easiest to transact with, whereas M4 is the least liquid.
 M3 is the most commonly used money supply measure. It's also referred to
as aggregate monetary resources.
 Credit control policies imposed by a country's banking system aid in
determining the total supply of money.
 The money supply is solely determined by the central bank and is
unaffected by interest rates. As a result, the money supply curve is vertical
at the quantity of money supply, rather than upward or downward sloping.
  Since the central bank has control over the money supply, it can take actions
to increase or decrease the money supply. Changes in the money supply
cause interest rates to fluctuate.
 The monetary base and the money multiplier ultimately determine the
money supply.
o In most countries, the size of the monetary base is determined by the
central bank.
o The monetary base includes vault reserves as well as currency in
circulation outside of banks.
o Central banksmay alter reserve requirements in order to alter the
monetary base.
 Monetary policy has an effect on the money supply as well.
o Expansionary policy raises the total supply of money in the economy
faster than usual, while contractionary policy raises the total supply
of money more slowly than usual.
o Expansionary policies are used to combat unemployment, whereas
contractionary policies are used to slow inflation.

High Powered Money (H Theory of Money)

According to them, the single-most factor determining money supply is the high-
powered money (H), defined as money produced by the central bank and the
government and held by the public and the banks. It consists of

(i) Currency, C, including coins and notes in circulation with the public;

(ii) Cash reserves, R, held by commercial banks as vault cash;

(iii) Other Deposits, OD, of the central bank

Money supply is thus directly proportional to the high-powered money, H.

Differentiating the expression for M with respect to H, we have (dM/dH) = m,
defined as the ratio of increase in money supply (M) per unit increase in high-
powered money (H) and known as the money multiplier.

Instruments of Monetary Policy

The instruments of monetary policy are of two types:

1. Quantitative: General or indirect (CRR, SLR, Open Market Operations, Bank

Rate, Repo Rate, Reverse Repo Rate)
2. Qualitative: Selective or direct (change in the margin money, direct action,
moral suasion)

Both methods affect the level of aggregate demand through the supply of money,
cost of money and availability of credit. Of the two types of instruments, the first
category includes bank rate variations, open market operations and changing
reserve requirements (cash reserve ratio, statutory reserve ratio).

Policy instruments are meant to regulate the overall level of credit in the economy
through commercial banks. The selective credit controls aim at controlling specific
types of credit. They include changing margin requirements and regulation of
consumer credit.

Monetary Policy is discussed under:

1. General Credit Controls:

These are designed to control and adjust the size of a volume of deposits created
and the cost of bank credit in general without regard to the particular field of an
enterprise or economic activity in which the credit is used.

a. Bank Rate Policy:

The bank rate is the minimum lending rate of the central bank at which it
rediscounts first-class bills of exchange and government securities held by the
commercial banks. When the central bank finds that inflation has been increasing
continuously, it raises the bank rate so borrowing from the central bank becomes
costly and commercial banks borrow less money from it (RBI).

The commercial banks, in reaction, raise their lending rates to the business
community and borrowers who further borrow less from the commercial banks.
There is a contraction of credit and prices are checked from rising further. On the
contrary, when prices are depressed, the central bank lowers the bank rate.

It is cheap to borrow from the central bank on the part of commercial banks. The
latter also lower their lending rates. Businessmen are encouraged to borrow more.
Investment is encouraged and followed by rising output, employment, income and
demand and the downward movement of prices is checked.

List of Public Sector Banks in India and their Headquarters

b. Open Market Operations:

Open market operations refer to the sale and purchase of securities in the money
market by the central bank of the country. When prices start rising and there is a
need to control them, the central bank sells securities. The reserves of commercial
banks are reduced and they are not in a position to lend more to the business
community or general public.

Further investment is discouraged and the rise in prices is checked. Contrariwise,

when recessionary forces start in the economy, the central bank buys securities.
The reserves of commercial banks are raised so they lend more to the business
community and the general public. It further raises Investment, output,
employment, income and demand in the economy hence the fall in price is
checked.

c. Changes in Reserve Ratios:

Under this method, CRR and SLR are two main deposit ratios, which reduce or
increase the idle cash balance of commercial banks. Every bank is required by law
to keep a certain percentage of its total deposits in the form of a reserve fund in its
vaults and also a certain percentage with the central bank.

When prices are rising, the central bank raises the reserve ratio. Banks are required
to keep more with the central bank. Their reserves are reduced and they lend less.
The volume of investment, output and employment are adversely affected. In the
opposite case, when the reserve ratio is lowered, the reserves of commercial banks
are raised. They lend more and the economic activity is favourably affected.

2. Selective Credit Controls:

Selective credit controls are used to influence specific types of credit for particular
purposes. They usually take the form of changing margin requirements to control
speculative activities within the economy. When there is a brisk speculative
activity in the economy or in particular sectors in certain commodities and prices
start rising, the central bank raises the margin requirement on them.

Structure of Banking Sector in India

a. Change in Margin Money:

The result is that the borrowers are given less money in loans against specified
securities. For instance, raising the margin requirement to 70% means that the
pledger of securities of the value of Rs 10,000 will be given 30% of their value, i.e.
Rs 3,000 as a loan. In case of a recession in a particular sector, the central bank
encourages borrowing by lowering margin requirements.

b. Moral Suasion: Under this method, RBI urges commercial banks to help in
controlling the supply of money in the economy.

Objectives of the Monetary Policy of India

1. Price Stability: Price Stability implies promoting economic development with

considerable emphasis on price stability. The centre of focus is to facilitate the
environment which is favourable to the architecture that enables the developmental
projects to run swiftly while also maintaining reasonable price stability.

2. Controlled Expansion Of Bank Credit: One of the important functions of RBI

is the controlled expansion of bank credit and money supply with special attention
to the seasonal requirements for credit without affecting the output.

3. Promotion of Fixed Investment: The aim here is to increase the productivity of

investment by restraining non-essential fixed investment.

4. Restriction of Inventories: Overfilling of stocks and products becoming

outdated due to excess stock often results in the sickness of the unit. To avoid this
problem the central monetary authority carries out this essential function of
restricting the inventories. The main objective of this policy is to avoid over-
stocking and idle money in the organization

5. Promotion of Exports and Food Procurement Operations: Monetary policy

pays special attention in order to boost exports and facilitate trade. It is an
independent objective of monetary policy.

6. Desired Distribution of Credit: Monetary authority has control over the

decisions regarding the allocation of credit to priority sector and small borrowers.
This policy decides over the specified percentage of credit that is to be allocated to
the priority sector and small borrowers.

7. Equitable Distribution of Credit: The policy of the Reserve Bank aims

equitable distribution to all sectors of the economy and all social and economic
classes of people
8. To Promote Efficiency: It is another essential aspect where the central banks
pay a lot of attention. It tries to increase the efficiency in the financial system and
tries to incorporate structural changes such as deregulating interest rates, easing
operational constraints in the credit delivery system, introducing new money
market instruments etc.

9. Reducing the Rigidity: RBI tries to bring about the flexibilities in the
operations which provide considerable autonomy. It encourages a more
competitive environment and diversification. It maintains its control over the
financial system whenever and wherever necessary to maintain the discipline and
prudence in operations of the financial system.

What is Inflation? Inflation refers to the rise in the prices of most goods and
services of daily or common use, such as food, clothing, housing, recreation,
transport, consumer staples, etc. Inflation measures the average price change in a
basket of commodities and services over time. The opposite and rare fall in the
price index of this basket of items is called ‘deflation’. Inflation is indicative of the
decrease in the purchasing power of a unit of a country’s currency. This is
measured in percentage.

What are the effects of Inflation?

The purchasing power of a currency unit decreases as the commodities and

services get dearer. This also impacts the cost of living in a country. When
inflation is high, the cost of living gets higher as well, which ultimately leads to a
deceleration in economic growth. A certain level of inflation is required in the
economy to ensure that expenditure is promoted and hoarding money through
savings is demotivated.

Causes of Inflation

What causes inflation?

Inflation can be caused by multiple factors with demand-pull and cost-push

inflation among the most common. However, the causes of inflation in 2021 are a
bit more complex and have been caused in part because of the government's
response to the pandemic, in addition to sudden increases in demand as
coronavirus lockdown restrictions faded and as labor shortages occurred across the
country.
Here are the major causes of inflation:

1. Demand-pull inflation

Demand-pull inflation happens when the demand for certain goods and services is
greater than the economy's ability to meet those demands. When this demand
outpaces supply, there's an upward pressure on prices — causing inflation.

A practical example of this would be tickets to see Hamilton live on Broadway.

Because there were a limited number of seats and the demand for the live show
was far greater than capacity, the price of tickets skyrocketed approaching $2,000
on third party sites, well above the standard ticket price of $139 and premium
ticket price of $549 at the time.

2. Cost-push inflation

Cost-push inflation is the increase of prices when the cost of wages and materials
goes up. These costs are often passed down to consumers in the form of higher
prices for those goods and services. An example of this would be lumber, as
lumber is an input good for houses. When the cost of lumber spiked as much as
400% earlier in 2021 it had an impact on the increase in housing prices resulting in
inflation.

3. Increased money supply

Increased money supply is defined as the total amount of money in circulation,

which includes cash, coins, and balances and bank accounts according to the
Federal Reserve . If the money supply increases faster than the rate of production,
this could result in inflation, particularly demand-pull inflation because there will
be too many dollars chasing too few products. An increase in money supply is
usually created by the Federal Reserve through a process called Open Market
Operations (OMO).

4. Devaluation

Devaluation is downward adjustment in a country's exchange rate, resulting in

lower values for a country's currency.

The devaluation of a currency makes a country's exports less expensive,

encouraging foreign nations to buy more of the devalued goods. Devaluation also
makes foreign products for the devaluing country more expensive which
encourages citizens of the devaluing country to buy domestic products over foreign
imports.

China is perhaps most known for this tactic as the United States and other nations
have frequently accused China of working to devalue the Yuan over the years.

5. Rising wages

Rising wages is exactly what it sounds like — an increase in what's being paid to
workers. "Wages are a cost of production," adds Baker. "If wages rise a large
amount, businesses will either have to pass the cost on, or live with lower margins.
The exception is if they can offset wage growth with higher productivity."

However, economists remain mixed on the impact of gradual increases in wages,

like raising the minimum wage, compared to faster, more sudden wage growth
seen in places like Silicon Valley. Some believe that an increase in wages could
result in cost-push inflation due to the higher cost to businesses, while others
believe that higher wages across the board (not just concentrated in certain sectors)
will also increase demand enough to offset a spike in prices.

"Rising wages should allow consumers to combat inflation, especially if the wages
are rising at the same or a faster rate than the inflation rate," adds Susane L. Toney,
Ph.D, endowed chair of Business and Economics at Hampton University. "The
rising wages allow consumers to pay higher prices without impacting their
purchasing power."

6. Policies and regulations

Certain policies can also result in either a cost-push or demand-pull inflation.

When the government issues tax subsidies for certain products, it can increase
demand. If that demand is higher than supply, costs could rise. Additionally,
stringent building regulations and even rent stabilization policies could
inadvertently increase costs and create an inflationary environment by passing
those costs to residents or artificially reduce the supply of housing.

Anti-inflationary fiscal policy involves adjustments in government expenditures,

taxation and borrowing and debt management policies. Borrowing and debt
management policies are related to the central bank’s monetary policy and is
treated as a third type of stabilisation policy distinct from either monetary policy or
fiscal policy.

Aims:

If fiscal policy is to control inflation, there is need to curtail the volume of

spending in such a manner that costs of production are not increased. In other
words, for fiscal policy to control inflation there is need for a maximum reduction
in government expenditures and increase in taxes so as to achieve a balance
between aggregate expenditure and output.

Since excessive aggregate spending is the root cause of inflation, a reduction in

government spending, which is one major components of total spending, is likely
to lessen inflationary pressures. During inflation it is necessary to eliminate
wasteful public expenditure or those public works programmes which may be
justifiable in periods of low employment, but are not warranted in full
employment.

Secondly, inflationary pressures can be reduced by postponing public construction

of various types, such as the building of new post offices, bridges, or highways.

One type of government expenditure, namely, government subsidies, if used

judiciously, may aid in checking inflationary pressures. Prima facie, if a critical
item like steel is in short supply, subsidies to marginal producers may help raise
output and thus eliminate specific inflationary (cost + push) pressures because steel
is used as input by many industries.

Secondly, subsidies may be provided to producers of essential items of

consumption to offset cost increases, so that these firms will not have to raise
prices and thus increase the cost of living and set off general wage increases.

However, subsidy payments themselves are inflationary, since they result in

increased purchasing power in the hands of the public. But if they bring about
significant increases in output of very scarce goods, the increased supply will more
than offset net excess demand pressure.

In fact, the most effective type of subsidy from the inflationary point of view is one
applied to imports. Such a subsidy increases the domestic supply of subsidised
commodities without adding to domestic purchasing power. However, the gains
may partly be lost due to the ability of other countries to buy our products.
Taxes seem to have the greatest anti-inflationary effects. However, the
effectiveness of taxes depend not only on the individual taxes but also on the
overall tax structure.

A tax on personal income reduces inflationary pressures by reducing people’s

disposable income. It does have a minimum effect on business cost, except to the
extent that reductions in disposable income lead trade unions to demand wage
increases.

On the contrary, it does not place a burden on persons who do not fall under the tax
net or who are able to evade taxes or who spend huge sums from accumulated
wealth. Moreover, a major portion of the tax may be absorbed from savings and
thus it may give no direct incentive to curtail spending. Thus, its anti-inflationary
effect will be less per rupee than that of a tax on spending.

Consequently, “if given inflationary pressures are to be checked by the use of

income-tax increases, the tax rates must be higher than they would need to be
with a tax having a greater effect in curtailing spending. Accordingly, the
adverse effect on incentives to work and produce will be somewhat greater.”

Excise duty and sales tax affect inflationary pressures in a different way. Demand-
shifting excise are designed to discourage persons from buying particularly scarce
commodities. The tax acts as an alternative to the rationing system. The policy will
prove to be effective only if the demand for the product is fairly elastic.

Contrarily, demand-absorbing excise are levied upon commodities having inelastic

purchasing power that would otherwise be used for inflationary spending.
However, the fact is that most commodities of inelastic demand are of widespread
use and the burden of tax will be distributed in a regressive manner (i.e., the poor
will pay more than the rich).

However, income-tax on companies may be raised to control inflation. Such a tax

is deflationary in two ways. First, to the extent that dividends are reduced,
individual spending is curtailed, at least partly. Secondly, business firms are left
with less funds for expansion and so they must reduce their investment spending.

During inflation it is also necessary to reduce budgetary deficit or to increase

budgetary surplus. This is more so in developing countries like India where the
root cause of inflation is governmental deficit on current account. The pertinent
question here is: to what extent is a balanced budget surplus required if inflationary
pressures are to be eliminated?
What is the Phillips Curve?

The Phillips curve is an economic concept developed by A. W. Phillips stating that

inflation and unemployment have a stable and inverse relationship. The theory
claims that with economic growth comes inflation, which in turn should lead to
more jobs and less unemployment. However, the original concept has been
somewhat disproven empirically due to the occurrence of stagflation in the 1970s,
when there were high levels of both inflation and unemployment.

 The Phillips curve states that inflation and unemployment have an inverse
relationship. Higher inflation is associated with lower unemployment and
vice versa.
 The Phillips curve was a concept used to guide macroeconomic policy in the
20th century, but was called into question by the stagflation of the 1970's.
 Understanding the Phillips curve in light of consumer and worker
expectations, shows that the relationship between inflation and
unemployment may not hold in the long run, or even potentially in the short
run.

What is 'Phillips Curve'

Definition: The inverse relationship between unemployment rate and inflation

when graphically charted is called the Phillips curve. William Phillips pioneered
the concept first in his paper "The Relation between Unemployment and the Rate
of Change of Money Wage Rates in the United Kingdom, 1861-1957,' in 1958.
This theory is now proven for all major economies of the world.

Description: The theory states that the higher the rate of inflation, the lower the
unemployment and vice-versa. Thus, high levels of employment can be achieved
only at high levels of inflation. The policies to induce growth in an economy,
increase in employment and sustained development are heavily dependent on the
findings of the Phillips curve.

However, the implications of Phillips curve have been found to be true only in the
short term. Phillips curve fails to justify the situations of stagflation, when both
inflation and unemployment are alarmingly high.
Understanding the Phillips Curve

The concept behind the Phillips curve states the change in unemployment within
an economy has a predictable effect on price inflation. The inverse relationship
between unemployment and inflation is depicted as a downward sloping, concave
curve, with inflation on the Y-axis and unemployment on the X-axis. Increasing
inflation decreases unemployment, and vice versa. Alternatively, a focus on
decreasing unemployment also increases inflation, and vice versa.3

The belief in the 1960s was that any fiscal stimulus would increase aggregate
demand and initiate the following effects. Labor demand increases, the pool of
unemployed workers subsequently decreases and companies increase wages to
compete and attract a smaller talent pool. The corporate cost of wages increases
and companies pass along those costs to consumers in the form of price increases.

This belief system caused many governments to adopt a "stop-go" strategy where a
target rate of inflation was established, and fiscal and monetary policies were used
to expand or contract the economy to achieve the target rate. However, the stable
trade-off between inflation and unemployment broke down in the 1970s with the
rise of stagflation, calling into question the validity of the Phillips curve.

The Phillips Curve and Stagflation

Stagflation occurs when an economy experiences stagnant economic growth, high

unemployment and high price inflation. This scenario, of course, directly
contradicts the theory behind the Philips curve. The United States never
experienced stagflation until the 1970s, when rising unemployment did not
coincide with declining inflation.6 Between 1973 and 1975, the U.S. economy
posted six consecutive quarters of declining GDP and at the same time tripled its
inflation.7

Expectations and the Long Run Phillips Curve

The phenomenon of stagflation and the break down in the Phillips curve led
economists to look more deeply at the role of expectations in the relationship
between unemployment and inflation. Because workers and consumers can adapt
their expectations about future inflation rates based on current rates of inflation and
unemployment, the inverse relationship between inflation and unemployment
could only hold over the short-run.
Phillips curve, graphic representation of the economic relationship between the
rate of unemployment (or the rate of change of unemployment) and the rate of
change of money wages. Named for economist A. William Phillips, it indicates
that wages tend to rise faster when unemployment is low.

In “The Relation Between Unemployment and the Rate of Change of Money Wage
Rates in the United Kingdom, 1861–1957” (1958), Phillips found that, except for
the years of unusually large and rapid increases in import prices, the rate of change
in wages could be explained by the level of unemployment. Simply put, a climate
of low unemployment will cause employers to bid wages up in an effort to lure
higher-quality employees away from other companies. Conversely, conditions of
high unemployment eliminate the need for such competitive bidding; as a result,
the rate of change in paid compensation will be lower.

The main implication of the Phillips curve is that, because a particular level of
unemployment will influence a particular rate of wage increase, the two goals of
low unemployment and a low rate of inflation may be incompatible. Developments
in the United States and other countries in the second half of the 20th century,
however, suggested that the relation between unemployment and inflation is more
unstable than the Phillips curve would predict. In particular, the situation in the
early 1970s, marked by relatively high unemployment and extremely high wage
increases, represented a point well off the Phillips curve. At the beginning of the
21st century, the persistence of low unemployment and relatively low inflation
marked another departure from the Phillips curve.