Sophiyapethuru.files.wordpress.com



The general price level The general price level is a hypothetical daily measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. Typically, the general price level is approximated with a daily price index, normally the Daily CPI. The general price level can change more than once per day during hyperinflation.QTM in a Nutshell. The quantity theory of?money?states that there is a directrelationship between?the quantity of?money?in an economy and the?level?of?pricesof goods and services sold. ... So an increase in?money supply?causes?prices?to rise (inflation) as they compensate for the decrease in?money's?marginal value.Feb 3, 2017Macro-Economic Effects and General Price Level!1. The Wealth Effect:Individuals and businesses hold money, bonds and other financial assets in their portfolio. In a world in which prices keep on changing the market value of these assets is one of the determinants of spending. It is a well known proposition of macro-economics that when the general price level rises, the value of money (or the purchasing power of money) falls.This fall in the market value of assets leads to a decline in household and business spending. This is known as the wealth effect of a change in price, a phenomenon first discovered by A. C. Pigou, one of the followers of J. M. Keynes. The wealth effect may simply be stated as follows: a change in the general price level will cause a change in spending by changing the real value of wealth.Don Patinkin has refined the concept and has given it a different name: the real-balance effect. Real values are those that have been adjusted for price level changes. Here real values indicates ‘purchasing power’ or, command over goods and services.When the price level changes, there is an automatic change in the purchasing power of financial assets. To be more specific, when the general price level rises, there is an immediate rise in the real value of financial assets and stock of wealth. And this stimulates aggregate expenditure—consumption spending of households and investment spending of businesses.2. The Interest Rate Effect:When the general price level rises, (i.e., when there is inflation in the economy), the value of money, i.e., the purchasing power of each rupee falls. This simply means that more money is now required to buy a fixed basket of goods and services. This point is illustrated in Fig. 37.1.Suppose a family of four needs Rs. 500 per week to buy food. It there is 100% inflation, i.e., if the price level gets doubled, the same amount of food will now cost Rs. 1000 per week. This means that the family or the consuming unit must now have twice as much money to buy the same quantity of food.The converse is also true. When the general price level is halved, the household requires half the money to be able to buy the same fixed quantity of good because the purchasing power of each rupee has doubled.When prices rise, people need money more to be able to buy the same amount of goods and services. How do people get this extra money? By selling other assets like bonds, or stocks and shares. This means that excess demand of money is equivalent to excess supply of bonds.This excess of bonds depresses bond prices. And this implies a rise in the market rate of interest. The rise in the rate of interest is necessary to encourage people to buy more bonds. But a rise in the interest rate will have an undesirable consequence: it will lead to a fall in investment expenditure.When the general price level tends to fall, people will require less money (or real balance) to be able to purchase the same quantity of goods and services.The money saved in the process will now appear to be surplus. This money is no longer required to buy goods and services. It will be held in the form of liquid balance. What will people do with this surplus money? In fact, excess supply of money implies excess demand for bonds.In other words, people will use their money holdings to buy bonds and other income-earning assets. The excess demand for bonds increases bond prices. This is equivalent to a fall in the rate of interest. This, in its turn, will encourage increased investment expenditures, pushing aggregate expenditures up.Fig. 37.1 shows the interest rate effect, the relationship among three crucial macro-variables, viz., the general price level, interest rates, and aggregate expenditure. When the price level rises, interest rates also rise, but aggregate expenditure falls. The converse is also true—when the price level falls, interest rates also fall and aggregate expenditure is pushed up.3. The International Trade Effect:Net export, like consumption, investment, and government spending is an important component of aggregate expenditure in an open economy. In our discussion of national income accounting we have noted that net export is a function of domestic income. Net export is also likely to be affected by the domestic price level.If prices of domestically produced goods rise while prices of foreign goods as also the foreign exchange rate remain constant, domestic goods become more expensive relative to foreign goods.When the price of domestic goods increases in relation to prices of foreign goods, export falls and import rises. This means that net export falls. The end result will be a fall in aggregate expenditure. The converse is also true.This is known as the international trade effect of a change in the domestic price level. This causes aggregate expenditure to change in the opposite direction. This means that a rise in the domestic price level will cause net expenditure on foreign goods to fall.4. The Sum of the Price Level Effect:A lower price level increases autonomous consumption (the wealth effect), autonomous investment (the interest rate effect) and autonomous net exports (the international trade effect). When the price level falls, aggregate expenditure rises.This is reflected in the upward shift of the aggregate expenditure line from AE0?to AE1?in Fig. 37.2. A higher price level generates an exactly opposite effect. In this case the aggregate expenditure schedule shifts downward from AE0?to AE1. The expression within bracket shows the price level corresponding to each level of aggregate expenditure.The relationship between?money supply?and price level lies in the fact that the amount of money in circulation in an economy has a direct impact on the aggregate price level. This is mainly because an abundance of money leads to an increase in demand for goods and services, while a scarcity of money has the opposite effect. In economic terms, this effect is explained by the?quantity theory of money, which states that the amount of money in supply in an economy has a direct bearing on the price level.A simple way of looking at the relationship between money supply and price level is to consider the fact that consumers will only spend when they have something to spend. That is to say that when there is a lot of money in the economy, people will have more to spend. This increase in demand also causes a corresponding increase in the price level. Excess liquidity leads to a situation in which a lot of cash will be vying for an often limited supply of goods. This causes the money to gradually lose its value, which consequently leads to price increases.Economists rely on the relationship between money supply and price level as one of the indicators of the state of the economy. When there is a rise in the aggregate price, one of the chief factors responsible is too much demand caused by consumers having easy access to money. The response of the government to this is often to introduce monetary or fiscal policies meant to restrict the ease with which consumers can obtain money, including bank loans and various types of credit. One method by which the government can restrict access to money is through increases in general interest rates.The effect of this restriction further illustrates the relationship between money supply and price level, because this maneuver usually forces the price level to drop. When the?central bank?of a country increases the interest rate, consumers may find the conditions attached to obtaining money to be either too prohibitively expensive or too rigorous, as other banks tighten their lending policies in response to the interest rates increase. As a consequence of the lack of easy access to funds, consumers tend to become more conservative in their spending habits, leading to a drop in the demand for goods and services. The consequence of a reduction in demand is an accompanying drop in the prices of goods and services.InflationDefinition:?Inflation?is when prices rise, and?deflation?is when prices fall. You can have both inflation and deflation at the same time in various asset classes. When taken to extreme, both are bad for economic growth, but for different reasons.?That's why the?Federal Reserve, the nation's?central bank, tries to control them. Here's how to recognize the signs of rampant inflation and deflation, and to protect your finances.How to Tell the Difference Between Inflation and DeflationThere are fives?types of inflation. The worst is?hyperinflation. That's when prices rise?more than 50 percent?a month. Fortunately, it's rare. That's because it's only caused by massive?military spending. On the other end of the scale is?asset inflation, which occurs somewhere nearly all the time.?For example, each spring?oil and gas prices?spike?because?commodities?traders bid up?oil prices. They anticipate rising demand at the pump thanks to the summer vacation driving season.?The third type, creeping inflation, is when prices rise 3 percent?a year or less. It's somewhat common. It occurs when the economy is doing well. The last time it happened was in 2007.The fourth type is walking, or pernicious, inflation. Prices increase 3-10 percent?a year, enough for people to stock up now to avoid higher prices later. Suppliers and wages can't keep up, which leads to shortages or prices so high most people can't afford the basics.The fifth type, galloping inflation, is when prices rise 10 percent?or more a year. It can destabilize the economy, drive out foreign investors, and topple government leaders. It's a result of?exchange rate?fluctuations.Deflation is when prices fall, but it can be difficult to spot. That's because all prices don't fall uniformly.During overall deflation,?you can have inflation in some areas of the economy. In 2014, there was deflation in oil and gas prices. Meanwhile, prices of housing continued to rise, although slowly. That's why the Federal Reserve measures the?core inflation rate. It?takes out the?volatile?price changes of oil and food.ExamplesThe United States had walking inflation in the late 1980s and early 1990s. Inflation reached a peak of 6.1 percent. Galloping inflation occurred in the 1970s and early 1980s.?That was due to?President Nixon's economic policies. First, he instituted wage-price controls, which created?stagflation. To curb that, he took the dollar off the?gold standard, which only spurred inflation even more as the?dollar's value?declined. For more, see?U.S. Inflation Rate History.Japan's economy?has ongoing?deflation. It began in 1989,when the Bank of Japan raised?interest rates. That?sent demand for housing downward. As prices fell in other areas, businesses cut back on expansion, and people stopped spending and started saving more. The population grew older, without enough young people to replace workers who retired. Older people bought less, since it's the young who start families, buy new homes and purchase furniture.The government tried?expansionary fiscal policies. That only doubled its debt without restoring confidence. Japan still struggles to escape this liquidity trap.Causes?There are three?causes of inflation. The first,?demand-pull inflation?occurs when demand outstrips?supply.?The second is?cost-push inflation. It's?the supply of goods or services is restricted, while demand stays the same. For example, since there is a shortage of highly skilled software engineers, their wages are skyrocketing.?The third, overexpansion of the nation's?money supply, is?when too much?capital?chases too?few goods and services. It's caused by too-expansive fiscal or?monetary policy, creating too much?liquidity.Deflation is usually caused by a drop in?demand. Fewer shoppers mean?businesses have to lower prices, which can turn into a bidding war.It's also caused by technology changes, such more efficient computer chips. Deflation can also be caused by exchange rates. For example, China keeps its currencies value low compared to the U.S. dollar. That allows it to underprice U.S. manufacturers, lowering prices on its exports to the United States.Inflation: Types, Causes and Effects (With Diagram)Article Shared by?<="" div="" style="margin: 0px; padding: 0px; border: 0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width: 100%;">Inflation and unemployment are the two most talked-about words in the contemporary society.These two are the big problems that plague all the economies.Almost everyone is sure that he knows what inflation exactly is, but it remains a source of great deal of confusion because it is difficult to define it unambiguously.1. Meaning of Inflation:Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by the additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’.Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or average of prices’. In other words, inflation is a state of rising prices, but not high prices.It is not high prices but rising price level that constitute inflation. It constitutes, thus, an overall increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other words, inflation reduces the purchasing power of money. A unit of money now buys less. Inflation can also be seen as a recurring phenomenon.While measuring inflation, we take into account a large number of goods and services used by the people of a country and then calculate average increase in the prices of those goods and services over a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may reflect the short term workings of the market.It is to be pointed out here that inflation is a state of disequilibrium when there occurs a sustained rise in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may be both slow and rapid. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sustained. That is why inflation is difficult to define in an unambiguous sense.Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was 193.6 and, in December 2008, it was 223.8. Thus, the inflation rate during the last one year was223.8- 193.6/ 193.6 x 100 = 15.6As inflation is a state of rising prices, deflation may be defined as a state of falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of money or purchasing power of money. Disinflation is a slowing down of the rate of inflation.2. Types of Inflation:As the nature of inflation is not uniform in an economy for all the time, it is wise to distinguish between different types of inflation. Such analysis is useful to study the distributional and other effects of inflation as well as to recommend anti-inflationary policies. Inflation may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation.Thus, one may observe different types of inflation in the contemporary society:A. On the Basis of Causes:(i) Currency inflation:This type of inflation is caused by the printing of currency notes.(ii) Credit inflation:Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.(iii) Deficit-induced inflation:The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may the be called the deficit-induced inflation.(iv) Demand-pull inflation:An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull inflation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggregate demand to money supply. If the supply of money in an economy exceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods.”Keynesians hold a different argument. They argue that there can be an autonomous increase in aggregate demand or spending, such as a rise in consumption demand or investment or government spending or a tax cut or a net increase in exports (i.e., C + I + G + X – M) with no increase in money supply. This would prompt upward adjustment in price. Thus, DPI is caused by monetary factors (classical adjustment) and non-monetary factors (Keynesian argument).DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal axis and price level on the vertical axis. In Range 1, total spending is too short of full employment output, YF. There is little or no rise in the price level. As demand now rises, output will rise. The economy enters Range 2, where output approaches towards full employment situation. Note that in this region price level begins to rise. Ultimately, the economy reaches full employment situation, i.e., Range 3, where output does not rise but price level is pulled upward. This is demand-pull inflation. The essence of this type of inflation is that “too much spending chasing too few goods.”(v) Cost-push inflation:Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation (henceforth CPI). Cost of production may rise due to an increase in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not completely market-determinded. Higher wage means high cost of production. Prices of commodities are thereby increased.A wage-price spiral comes into operation. But, at the same time, firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins. Thus, we have two important variants of CPI wage-push inflation and profit-push inflation.Anyway, CPI stems from the leftward shift of the aggregate supply curve:?B. On the Basis of Speed or Intensity:(i) Creeping or Mild Inflation:If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed of annual price rise is a creeping one has not been stated by the economists. To some, a creeping or mild inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a rate of price rise is kept at this level, it is considered to be helpful for economic development. Others argue that if annual price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of no danger.(ii) Walking Inflation:If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of inflation may be described as ‘moderate inflation’.Often, one-digit inflation rate is called ‘moderate inflation’ which is not only predictable, but also keep people’s faith on the monetary system of the country. Peoples’ confidence get lost once moderately maintained rate of inflation goes out of control and the economy is then caught with the galloping inflation.(iii) Galloping and Hyperinflation:Walking inflation may be converted into running inflation. Running inflation is dangerous. If it is not controlled, it may ultimately be converted to galloping or hyperinflation. It is an extreme form of inflation when an economy gets shattered.”Inflation in the double or triple digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”.(iv) Government’s Reaction to Inflation:Inflationary situation may be open or suppressed. Because of anti-inflationary policies pursued by the government, inflation may not be an embarrassing one. For instance, increase in income leads to an increase in consumption spending which pulls the price level up.If the consumption spending is countered by the government via price control and rationing device, the inflationary situation may be called a suppressed one. Once the government curbs are lifted, the suppressed inflation becomes open inflation. Open inflation may then result in hyperinflation.3. Causes of Inflation:Inflation is mainly caused by excess demand/ or decline in aggregate supply or output. Former leads to a rightward shift of the aggregate demand curve while the latter causes aggregate supply curve to shift leftward. Former is called demand-pull inflation (DPI), and the latter is called cost-push inflation (CPI). Before describing the factors, that lead to a rise in aggregate demand and a decline in aggregate supply, we like to explain “demand-pull” and “cost-push” theories of inflation.(i) Demand-Pull Inflation Theory:There are two theoretical approaches to the DPI—one is classical and other is the Keynesian.According to classical economists or monetarists, inflation is caused by an increase in money supply which leads to a rightward shift in negative sloping aggregate demand curve. Given a situation of full employment, classicists maintained that a change in money supply brings about an equiproportionate change in price level.That is why monetarists argue that inflation is always and everywhere a monetary phenomenon. Keynesians do not?find any link between money supply and price?level causing an upward shift in aggregate demand.According to Keynesians, aggregate demand may rise due to a rise in consumer demand or investment demand or government expenditure or net exports or the combination of these four components of aggreate demand. Given full employment, such increase in aggregate demand leads to an upward pressure in prices. Such a situation is called DPI. This can be explained graphically.Just like the price of a commodity, the level of prices is determined by the interaction of aggregate demand and aggregate supply. In Fig. 4.3, aggregate demand curve is negative sloping while aggregate supply curve before the full employment stage is positive sloping and becomes vertical after the full employment stage is reached. AD1?is the initial aggregate demand curve that intersects the aggregate supply curve AS at point E1.The price level, thus, determined is OP1. As aggregate demand curve shifts to AD2, price level rises to OP2. Thus, an increase in aggregate demand at the full employment stage leads to an increase in price level only, rather than the level of output. However, how much price level will rise following an increase in aggregate demand depends on the slope of the AS curve.(ii) Causes of Demand-Pull Inflation:DPI originates in the monetary sector. Monetarists’ argument that “only money matters” is based on the assumption that at or near full employment excessive money supply will increase aggregate demand and will, thus, cause inflation.An increase in nominal money supply shifts aggregate demand curve rightward. This enables people to hold excess cash balances. Spending of excess cash balances by them causes price level to rise. Price level will continue to rise until aggregate demand equals aggregate supply.Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate demand may rise if there is an increase?in consumption expenditure following a tax cut. There may be an autonomous increase in business investment or government expenditure. Government expenditure is inflationary if the needed money is procured by the government by printing additional money.In brief, increase in aggregate demand i.e., increase in (C + I + G + X – M) causes price level to rise. However, aggregate demand may rise following an increase in money supply generated by the printing of additional money (classical argument) which drives prices upward. Thus, money plays a vital role. That is why Milton Friedman argues that inflation is always and everywhere a monetary phenomenon.There are other reasons that may push aggregate demand and, hence, price level upwards. For instance, growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of the exporting countries. Additional purchasing power means additional aggregate demand. Purchasing power and, hence, aggregate demand may also go up if government repays public debt.Again, there is a tendency on the part of the holders of black money to spend more on conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.(iii) Cost-Push Inflation Theory:In addition to aggregate demand, aggregate supply also generates inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usually associated with non-monetary factors. CPI arises due to the increase in cost of production. Cost of production may rise due to a rise in cost of raw materials or increase in wages.However, wage increase may lead to an increase in productivity of workers. If this happens, then the AS curve will shift to the right- ward not leftward—direction. We assume here that productivity does not change in spite of an increase in wages.Such increases in costs are passed on to consumers by firms by raising the prices of the products. Rising wages lead to rising costs. Rising costs lead to rising prices. And, rising prices again prompt trade unions to demand higher wages. Thus, an inflationary wage-price spiral starts. This causes aggregate supply curve to shift leftward.This can be demonstrated graphically where AS1?is the initial aggregate supply curve. Below the full employment stage this AS curve is positive sloping and at full employment stage it becomes perfectly inelastic.Intersection point (E1) of AD1?and AS1?curves determine the price level (OP1). Now there is a leftward shift of aggregate supply curve to AS2. With no change in aggregate demand, this causes price level to rise to OP2?and output to fall to OY2. With the reduction in output, employment in the economy declines or unemployment rises. Further shift in AS curve to AS3?results in a higher price level (OP3) and a lower volume of aggregate output (OY3). Thus, CPI may arise even below the full employment (YF) stage.(iv) Causes of Cost-Push Inflation:It is the cost factors that pull the prices upward. One of the important causes of price rise is the rise in price of raw materials. For instance, by an administrative order the government may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pressure on cost of production.Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC compels the government to increase the price of petrol and diesel. These two important raw materials are needed by every sector, especially the transport sector. As a result, transport costs go up resulting in higher general price level.Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher money wages as a compensation against inflationary price rise. If increase in money wages exceed labour productivity, aggregate supply will shift upward and leftward. Firms often exercise power by pushing prices up independently of consumer demand to expand their profit margins.Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of production. For instance, an overall increase in excise tax of mass consumption goods is definitely inflationary. That is why government is then accused of causing inflation.Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion of natural resources, work stoppages, electric power cuts, etc., may cause aggregate output to decline. In the midst of this output reduction, artificial scarcity of any goods created by traders and hoarders just simply ignite the situation.Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus, inflation is caused by the interplay of various factors. A particular factor cannot be held responsible for any inflationary price rise.4. Effects of Inflation:People’s desires are inconsistent. When they act as buyers they want prices of goods and services to remain stable but as sellers they expect the prices of goods and services should go up. Such a happy outcome may arise for some individuals; “but, when this happens, others will be getting the worst of both worlds.”When price level goes up, there is both a gainer and a loser. To evaluate the consequence of inflation, one must identify the nature of inflation which may be anticipated and unanticipated. If inflation is anticipated, people can adjust with the new situation and costs of inflation to the society will be smaller.In reality, people cannot predict accurately future events or people often make mistakes in predicting the course of inflation. In other words, inflation may be unanticipated when people fail to adjust completely. This creates various problems.One can study the effects of unanticipated inflation under two broad headings:(a) Effect on distribution of income and wealth; and(b) Effect on economic growth.(a) Effects of Inflation on Distribution of Income and Wealth:During inflation, usually people experience rise in incomes. But some people gain during inflation at the expense of others. Some individuals gain because their money incomes rise more rapidly than the prices and some lose because prices rise more rapidly than their incomes during inflation. Thus, it redistributes income and wealth.Though no conclusive evidence can be cited, it can be asserted that following categories of people are affected by inflation differently:(i) Creditors and debtors:Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms. When debts are repaid their real value declines by the price level increase and, hence, creditors lose. An individual may be interested in buying a house by taking loan of Rs. 7 lakh from an institution for 7 years.The borrower now welcomes inflation since he will have to pay less in real terms than when it was borrowed. Lender, in the process, loses since the rate of interest payable remains unaltered as per agreement. Because of inflation, the borrower is given ‘dear’ rupees, but pays back ‘cheap’ rupees. However, if in an inflation-ridden economy creditors chronically loose, it is wise not to advance loans or to shut down business.Never does it happen. Rather, the loan-giving institution makes adequate safeguard against the erosion of real value. Above all, banks do not pay any interest on current account but charges interest on loans.(ii) Bond and debenture-holders:In an economy, there are some people who live on interest income—they suffer most. Bondholders earn fixed interest income: These people suffer a reduction in real income when prices rise. In other words, the value of one’s savings decline if the interest rate falls short of inflation rate. Similarly, beneficiaries from life insurance programmes are also hit badly by inflation since real value of savings deteriorate.(iii) Investors:People who put their money in shares during inflation are expected to gain since the possibility of earning of business profit brightens. Higher profit induces owners of firm to distribute profit among investors or shareholders.(iv) Salaried people and wage-earners:Anyone earning a fixed income is damaged by inflation. Sometimes, unionised worker succeeds in raising wage rates of white-collar workers as a compensation against price rise. But wage rate changes with a long time lag. In other words, wage rate increases always lag behind price increases. Naturally, inflation results in a reduction in real purchasing power of fixed income-earners.On the other hand, people earning flexible incomes may gain during inflation. The nominal incomes of such people outstrip the general price rise. As a result, real incomes of this income group increase.(v) Profit-earners, speculators and black marketers:It is argued that profit-earners gain from inflation. Profit tends to rise during inflation. Seeing inflation, businessmen raise the prices of their products. This results in a bigger profit. Profit margin, however, may not be high when the rate of inflation climbs to a high level.However, speculators dealing in business in essential commodities usually stand to gain by inflation. Black marketers are also benefited by inflation.Thus, there occurs a redistribution of income and wealth. It is said that rich becomes richer and poor becomes poorer during inflation. However, no such hard and fast generalisation can be made. It is clear that someone wins and someone loses during inflation.These effects of inflation may persist if inflation is unanticipated. However, the redistributive burdens of inflation on income and wealth are most likely to be minimal if inflation is anticipated by the people. With anticipated inflation, people can build up their strategies to cope with inflation.If the annual rate of inflation in an economy is anticipated correctly people will try to protect them against losses resulting from inflation. Workers will demand 10 p.c. wage increase if inflation is expected to rise by 10 p.c.Similarly, a percentage of inflation premium will be demanded by creditors from debtors. Business firms will also fix prices of their products in accordance with the anticipated price rise. Now if the entire society “learn to live with inflation”, the redistributive effect of inflation will be minimal.However, it is difficult to anticipate properly every episode of inflation. Further, even if it is anticipated it cannot be perfect. In addition, adjustment with the new expected inflationary conditions may not be possible for all categories of people. Thus, adverse redistributive effects are likely to occur.Finally, anticipated inflation may also be costly to the society. If people’s expectation regarding future price rise become stronger they will hold less liquid money. Mere holding of cash balances during inflation is unwise since its real value declines. That is why people use their money balances in buying real estate, gold, jewellery, etc. Such investment is referred to as unproductive investment. Thus, during inflation of anticipated variety, there occurs a diversion of resources from priority to non-priority or unproductive sectors.(b) Effect on Production and Economic Growth:Inflation may or may not result in higher output. Below the full employment stage, inflation has a favourable effect on production. In general, profit is a rising function of the price level. An inflationary situation gives an incentive to businessmen to raise prices of their products so as to earn higher volume of profit. Rising price and rising profit encourage firms to make larger investments.As a result, the multiplier effect of investment will come into operation resulting in a higher national output. However, such a favourable effect of inflation will be temporary if wages and production costs rise very rapidly.Further, inflationary situation may be associated with the fall in output, particularly if inflation is of the cost-push variety. Thus, there is no strict relationship between prices and output. An increase in aggregate demand will increase both prices and output, but a supply shock will raise prices and lower output.Inflation may also lower down further production levels. It is commonly assumed that if inflationary tendencies nurtured by experienced inflation persist in future, people will now save less and consume more. Rising saving propensities will result in lower further outputs.One may also argue that inflation creates an air of uncertainty in the minds of business community, particularly when the rate of inflation fluctuates. In the midst of rising inflationary trend, firms cannot accurately estimate their costs and revenues. That is, in a situation of unanticipated inflation, a great deal of risk element exists.It is because of uncertainty of expected inflation, investors become reluctant to invest in their business and to make long-term commitments. Under the circumstance, business firms may be deterred in investing. This will adversely affect the growth performance of the economy.However, slight dose of inflation is necessary for economic growth. Mild inflation has an encouraging effect on national output. But it is difficult to make the price rise of a creeping variety. High rate of inflation acts as a disincentive to long run economic growth. The way the hyperinflation affects economic growth is summed up here. We know that hyper-inflation discourages savings.A fall in savings means a lower rate of capital formation. A low rate of capital formation hinders economic growth. Further, during excessive price rise, there occurs an increase in unproductive investment in real estate, gold, jewellery, etc. Above all, speculative businesses flourish during inflation resulting in artificial scarcities and, hence, further rise in prices.Again, following hyperinflation, export earnings decline resulting in a wide imbalances in the balance of payment account. Often galloping inflation results in a ‘flight’ of capital to foreign countries since people lose confidence and faith over the monetary arrangements of the country, thereby resulting in a scarcity of resources. Finally, real value of tax revenue also declines under the impact of hyperinflation. Government then experiences a shortfall in investible resources.Thus economists and policymakers are unanimous regarding the dangers of high price rise. But the consequence of hyperinflation are disastrous. In the past, some of the world economies (e.g., Germany after the First World War (1914-1918), Latin American countries in the 1980s) had been greatly ravaged by hyperinflation.The German inflation of 1920s was also catastrophic:During 1922, the German price level went up 5,470 per cent. In 1923, the situation worsened; the German price level rose 1,300,000,000 (1.3 billion) times. By October of 1923, the postage in the lightest letter sent from Germany to the United States was 200,000 marks. Butter cost 1.5 million marks per pound, meat 2 million marks, a loaf of bread 200,000 marks, and an egg 60,000 marks! Prices increased so rapidly that waiters changed the prices on the menu several times during the course of a lunch!! Sometimes, customers had to pay the double price listed on the menu when they observed it first!!! A photograph of the period shows a German housewife starting the fire in her kitchen stove with paper money and children playing with bundles of paper money tied together into building blocks!Currently (September 2008), Indian economy experienced an inflation rate of almost 13 p.c.—an unprecedented one over the last 16 or 17 years. However, an all-time record in price rise in India was struck in 1974-75 when it rose more than 25 p.c. Anyway, people are ultimately harassed by the high dose of inflation. That is why, it is said that ‘inflation is our public enemy number one.’ Rising inflation rate is a sign of failure on the part of the government.What Causes Deflation?Deflation can be caused by a number of factors, all of which stem from a shift in the supply-demand curve. Remember, the prices of?all?goods and services are heavily affected by a change in the supply and demand, which means that if demand drops in relation to supply, prices will have to drop accordingly.?Also, a change in the supply and demand of a nation’s currency plays an instrumental role in setting the prices of the country’s goods and services.Although there are many reasons why deflation may take place, the following causes seem to play the largest roles:1. Change in Structure of Capital MarketsWhen many different companies are selling the same goods or services, they will typically lower their prices as a means to compete. Often, the capital structure of the economy will change and companies will have easier access to debt and equity markets, which they can use to fund new businesses or improve productivity.There are multiple reasons why companies will have an easier time raising capital, such as declining?interest rates, changing banking policies, or a change in investors’?aversion to risk. However, after they have utilized this new capital to increase productivity, they are going to have to reduce their prices to reflect the increased supply of products, which can result in deflation.2. Increased ProductivityInnovative solutions and new processes help increase efficiency, which ultimately leads to lower prices. Although some innovations only affect the productivity of certain industries, others may have a profound effect on the entire economy.For example, after the Soviet Union collapsed in 1991, many of the countries that formed as a result struggled to get back on track. In order to make a living, many citizens were willing to work for very low prices, and as companies in the United States outsourced work to these countries, they were able to significantly reduce their operating expenses and bolster productivity. Inevitably, this increased the supply of goods and decreased their cost, which led to a period of deflation near the end of the 20th century.3. Decrease in Currency SupplyAs the currency supply decreases, prices will decrease so that people can afford goods. How can currency supplies decrease? One common reason is through central banking systems.For instance, when the Federal Reserve was first created, it considerably contracted the money supply of the United States. In the process, this led to a severe case of deflation in 1913. Also, in many economies, spending is often completed on credit. Clearly, when creditors pull the plug on lending money, customers will spend less, forcing sellers to lower their prices to regain sales.4. Austerity MeasuresDeflation can be the result of decreased governmental, business, or consumer spending, which means government spending cuts can lead to periods of significant deflation. For example, when Spain initiated austerity measures in 2010, preexisting deflation began to spiral out of control.5. Deflationary SpiralOnce deflation has shown its ugly head, it can be very difficult to get the economy under control for a number of reasons. First of all, when consumers start cutting spending, business profits decrease. Unfortunately, this means that businesses have to reduce wages and cut their own purchases. In turn, this short-circuits spending in other sectors, as other businesses and wage-earners have less money to spend. As horrible as this sounds, it continues to get worse and the cycle can be very difficult to break.Effects of DeflationDeflation can be compared to a terrible winter: The damage can be intense and be experienced for many seasons afterwards. Unfortunately, some nations never fully recover from the damage caused by deflation. Hong Kong, for example, never recovered from the deflationary effects that gripped the Asian economy in 2002.Deflation may have any of the following impacts on an economy:1. Reduced Business RevenuesBusinesses must significantly reduce the prices of their products in order to stay competitive. Obviously, as they reduce their prices, their revenues start to drop. Business revenues frequently fall and recover, but deflationary cycles tend to repeat themselves multiple times.Unfortunately, this means businesses will need to increasingly cut their prices as the period of deflation continues. Although these businesses operate with improved production efficiency, their profit margins will eventually drop, as savings from material costs are offset by reduced revenues.2. Wage Cutbacks and LayoffsWhen revenues start to drop, companies need to find ways to reduce their expenses to meet their bottom line. They can make these cuts by reducing wages and cutting positions. Understandably, this exacerbates the cycle of inflation, as more would-be consumers have less to spend.3. Changes in Customer SpendingThe relationship between deflation and consumer spending is complex and often difficult to predict. When the economy undergoes a period of deflation, customers often take advantage of the substantially lower prices. Initially, consumer spending may increase greatly; however, once businesses start looking for ways to bolster their bottom line, consumers who have lost their jobs or taken pay cuts must start reducing their spending as well. Of course, when they reduce their spending, the cycle of deflation worsens.4. Reduced Stake in InvestmentsWhen the economy goes through a series of deflation, investors tend to view?cash?as one of their best possible investments. Investors will watch their money grow simply by holding onto it. Additionally, the interest rates investors earn often decrease significantly as central banks attempt to fight deflation by reducing interest rates, which in turn reduces the amount of money they have available for spending.In the meantime, many other investments may yield a negative return or are highly volatile, since investors are scared and companies aren’t posting profits. As investors pull out of stocks, the?stock market?inevitably drops.5. Reduced CreditWhen deflation rears its head, financial lenders quickly start to pull the plugs on many of their lending operations for a variety of reasons. First of all, as assets such as houses decline in value, customers cannot back their debt with the same?collateral. In the event a borrower is unable to make their debt obligations, the lenders will be unable to recover their full investment through foreclosures or property seizures.Also, lenders realize the financial position of borrowers is more likely to change as employers start cutting their workforce. Central banks will try to reduce interest rates to encourage customers to borrow and spend more, but many of them will still not be eligible for loans.Tools to Fix DeflationFortunately, it is possible to reduce the impact of deflation. However, fighting deflation requires a disciplined approach, as it will not fix itself.?Prior to the Great Depression, it was commonly believed that deflation would eventually run its course. However, economists suggested government intervention was necessary to break a deflationary spiral.During the Great Depression, the government attempted different methods to fight deflation, most of which proved ineffective. For example, President Franklin D. Roosevelt believed that deflation was caused by an oversupply of goods and services, so he attempted to reduce the supply of resources on the market. One way he tried to do this was to purchase farmland so farmers could not produce as many crops to sell in the marketplace. However, these kinds of “solutions” only further damaged the economy, possibly worsening the deflationary spiral.Central banks have a considerable influence over the direction of inflation and deflation by changing the nation’s monetary supply. For example, the Federal Reserve has engaged in?quantitative easing?as a means to prevent deflation. Although increasing the nation’s monetary supply too much could create excessive inflation, a moderate expansion in the nation’s monetary base could be an effective means of fighting deflation.The central banks’ efforts to fight deflation are effective in some instances, but not in others. The biggest limitation with central bank policies is that they can only decrease interest rates until they are near 0%. After reducing interest as much as possible, central banks no longer have a large bevy of solutions available to them. In fact, there still exists no clear-cut, foolproof way to address deflation.Historical Examples of DeflationAlthough deflation is a rare?occurrence?in the course of an economy, it is a phenomenon that has occurred a number of times throughout history. Among others, these are incidences in which deflation has occurred:1. Expansion of Industrial RevolutionDuring the late 19th century, manufacturers took advantage of new technology that allowed them to increase their productivity. As a result, the supply of goods in the economy increased substantially, and consequently, the prices of those goods decreased. Although the increase in the level of productivity after the Industrial Revolution was a positive development for the economy, it also led to a period of deflation.2. Great DepressionThe Great Depression was the most financially trying time in American history. During this dark era in history, unemployment spiked, the stock market crashed, and consumers lost much of their savings. Also, employees in high production industries such as farming and mining were producing a great amount, but not getting paid accordingly. As a result, they had less money to spend and were unable to afford basic commodities, even in spite of how much vendors were forced to reduce prices.3. Depression of 1920-1921About eight years prior to the onset of the Great Depression, the United States underwent a shorter depression while recovering from the aftermath of World War I. During this time, a million members of the Armed Forces returned to civilian life, and employers hired a number of returning troops at reduced wages. The labor market was already very tight before they returned, and due to the expansion in the workforce, unions lost much of their bargaining power and were unable to demand higher wages, which resulted in reduced spending.4. European Debt CrisisThe debt crisis in Europe is causing a number of complications for the global economy. In response to this crisis, governments have implemented austerity measures, such as cutting government assistance to needy families. However, these measures have reduced GDP considerably. Also, the banks have contracted their credit, which has reduced the money supply within the country. As a result, Europe is undergoing massive deflation.Inflation: Meaning, Causes and Effects Effects of InflationArticle shared by?Inflation: Meaning, Causes and Effects Effects of Inflation!Inflation is a highly controversial term which has undergone modification since it was first defined by the neo-classical economists. They meant by it a galloping rise in prices as a result of the excessive increase in the quantity of money. They regarded it “as a destroying disease born out of lack of monetary control whose results undermined the rules of business, creating havoc in markets and financial ruin of even the prudent.”But Keynes in his General Theory’ allayed all such fears. He did not believe like the neo-classicists that there was always full employment in the economy which resulted in hyper-inflation with increases in the quantity of money. According to him, there being underemployment in the economy, an increase in the money supply leads to increase in aggregate demand, output and employment.Starting from a depression, as the money supply increases, output at first rises proportionately. But as aggregate demand, output and employment rise further, diminishing returns start and certain bottlenecks appear and prices start rising. This process continues till the full employment level is reached. The rise in the price level during this period is known as bottleneck inflation or “semi-inflation”. If the money supply increases beyond the full employment level, output ceases to rise and the prices rise in proportion with the money supply. This is true inflation, according to Keynes.Keynes’s analysis is subjected to two main drawbacks. First, it lays emphasis on demand as the cause of inflation, and neglects the cost side of inflation. Second, it ignores the possibility that a price rise may lead to further increase in aggregate demand which may, in turn, lead to further rise in prices.However, the types of inflation during the Second World War, in the immediate post-war period, till the middle of the 1950s were on the Keynesian model based on his theory of excess demand. “In the latter 1950s, in the United States, unemployment was higher than it had been in the immediate post-war period, and yet prices still seemed to be rising, at the same time, the war time fears of postwar recession had belatedly been replaced by serious concern about the problem of inflation.The result was a prolonged debate…On the one side of the debate was the ‘cost-push’ school of thought, which maintained that there was no excess demand…On the other side was the “demand-pull” school…Later, in the United States, there developed a third school of thought, associated with the name of Charles Schultz, which advanced the sectoral ‘demand-shift theory’ of inflation… While the debate over cost-push versus demand- pull was raging in the United States, a new and very interesting approach to the problem of inflation and anti-inflationary policy was developed by A. W. Phillips.”We shall study all theories mentioned here, besides Keynes’s theory of the inflationary gap. But before we analyse them, it is instructive to know about the meaning of inflation.Contents1. Meaning of Inflation2. Demand-Pull Inflation3. Cost-Push Inflation4. The Inflationary Gap5. Phillip Curve in Economics: The Relation between Unemployment and Inflation6. Causes of Inflation7. Measures to Control InflationMonetary MeasuresFiscal MeasuresOther Measures8. Effects of InflationEffects on Redistribution of Income and WealthEffects on ProductionOther Effects1. Meaning of InflationTo the neo-classical and their followers at the University of Chicago, inflation is fundamentally a monetary phenomenon. In the words of Friedman, “Inflation is always and everywhere a monetary phenomenon…and can be produced only by a more rapid increase in the quantity of money than output.’” But economists do not agree that money supply alone is the cause of inflation.As pointed out by Hicks, “Our present troubles are not of a monetary character.” Economists, therefore, define inflation in terms of a continuous rise in prices. Johnson defines “inflation as a sustained rise”4?in prices. Brooman defines it as “a continuing increase in the general price level.”5?Shapiro also defines inflation in a similar vein “as a persistent and appreciable rise in the general level of prices.” Demberg and McDougall are more explicit when they write that “the term usually refers to a continuing rise in prices as measured by an index such as the consumer price index (CPI) or by the implicit price deflator for gross national product.”However, it is essential to understand that a sustained rise in prices may be of various magnitudes. Accordingly, different names have been given to inflation depending upon the rate of rise in prices.1.?Creeping Inflation:When the rise in prices is very slow like that of a snail or creeper, it is called creeping inflation. In terms of speed, a sustained rise in prices of annual increase of less than 3 per cent per annum is characterised as creeping inflation. Such an increase in prices is regarded safe and essential for economic growth.2.?Walking or Trotting Inflation:When prices rise moderately and the annual inflation rate is a single digit. In other words, the rate of rise in prices is in the intermediate range of 3 to 6 per cent per annum or less than 10 per cent. Inflation at this rate is a warning signal for the government to control it before it turns into running inflation.3.?Running Inflation:When prices rise rapidly like the running of a horse at a rate or speed of 10 to 20 per cent per annum, it is called running inflation. Such an inflation affects the poor and middle classes adversely. Its control requires strong monetary and fiscal measures, otherwise it leads to hyperinflation.4.?Hyperinflation:When prices rise very fast at double or triple digit rates from more than 20 to 100 per cent per annum or more, it is usually called runaway ox galloping inflation. It is also characterised as hyperinflation by certain economists. In reality, hyperinflation is a situation when the rate of inflation becomes immeasurable and absolutely uncontrollable. Prices rise many times every day. Such a situation brings a total collapse of monetary system because of the continuous fall in the purchasing power of money.The speed with which prices tend to rise is illustrated in Figure 1. The curve С shows creeping inflation when within a period of ten years the price level has been shown to have risen by about 30 per cent. The curve W depicts walking inflation when the price level rises by more than 50 per cent during ten years. The curve R illustrates running inflation showing a rise of about 100 per cent in ten years. The steep curve H shows the path of hyperinflation when prices rise by more than 120 per cent in less than one year.5.?Semi-Inflation:According to Keynes, so long as there are unemployed resources, the general price level will not rise as output increases. But a large increase in aggregate expenditure will face shortages of supplies of some factors which may not be substitutable. This may lead to increase in costs, and prices start rising. This is known as semi-inflation or bottleneck inflation because of the bottlenecks in supplies of some factors.6.?True Inflation:According to Keynes, when the economy reaches the level of full employment, any increase in aggregate expenditure will raise the price level in the same proportion. This is because it is not possible to increase the supply of factors of production and hence of output after the level of full employment. This is called true inflation.The Keynesian semi-inflation and true inflation situations are illustrated in Figure.2.Employment and price level are taken on vertical axis and aggregate expenditure on horizontal axis. FE is the full employment curve. When with the increase in aggregate expenditure, the price level rises slowly from A to the full employment level B, this is semi-inflation. But when the aggregate expenditure increases beyond point В the price level rises from В to T in proportion to the increase in aggregate expenditure. This is true inflation.7.?Open Inflation:Inflation is open when “markets for goods or factors of production are allowed to function freely, setting prices of goods and factors without normal interference by the authorities. Thus open inflation is the result of the uninterrupted operation of the market mechanism. There are no checks or controls on the distribution of commodities by the government. Increase in demand and shortage of supplies persist which tend to lead to open inflation. Unchecked open inflation ultimately leads to hyperinflation.8.?Suppressed Inflation:Men the government imposes physical and monetary controls to check open inflation, it is known as repressed or suppressed inflation. The market mechanism is not allowed to function normally by the use of licensing, price controls and rationing in order to suppress extensive rise in prices.So long as such controls exist, the present demand is postponed and there is diversion of demand from controlled to uncontrolled commodities. But as soon as these controls are removed, there is open inflation. Moreover, suppressed inflation adversely affects the economy.When the distribution of commodities is controlled, the prices of uncontrolled commodities rise very high. Suppressed inflation reduces the incentive to work because people do not get the commodities which they want to have. Controlled distribution of goods also leads to mal-allocation of resources. This results in the diversion of productive resources from essential to non-essential industries. Lastly, suppressed inflation leads to black marketing, corruption, hoarding and profiteering.9.?Stagflation:Stagflation is a new term which has been added to economic literature in the 1970s. It is a paradoxical phenomenon where the economy expedience’s stagnation as well as inflation. The word stagflation is the combination of‘ stag’ plus ‘flation’ taking ‘stag’ from stagnation and ‘flation’ from inflation.Stagflation is a situation when recession is accompanied by a high rate of inflation. It is, therefore, also called inflationary recession. The principal cause of this phenomenon has been excessive demand in commodity markets, thereby causing prices to rise, and at the same time the demand for labour is deficient, thereby creating unemployment in the economy.Three factors have been responsible for the existence of stagflation in the advanced countries since 1972. First, rise in oil prices and other commodity prices along with adverse changes in the terms of trade, second, the steady and substantial growth of the labour force; and third, rigidities in the wage structure due to strong trade unions.10.?Mark-up Inflation:The concept of mark-up inflation is closely related to the price-push problem. Modem labour organisations possess substantial monopoly power. They, therefore, set prices and wages on the basis of mark-up over costs and relative incomes. Firms possessing monopoly power have control over the prices charged by them. So they have administered prices which increase their profit margin. This sets off an inflationary rise in prices. Similarly, when strong trade unions are successful in raising the wages of workers, this contributes to inflation.11.?Ratchet Inflation:A ratchet is a toothed wheel provided with a catch that prevents the ratchet wheel from moving backward. The same is the case under ratchet inflation when despite downward pressures in the economy, prices do not fall. In an economy having price, wage and cost inflations, aggregate demand falls below full employment level due to the deficiency of demand in some sectors of the economy.But wage, cost and price structures are inflexible downward because large business firms and labour organisations possess monopoly power. Consequently, the fall in demand may not lower prices significantly. In such a situation, prices will have an upward ratchet effect, and this is known as “ratchet inflation.”12.?Sectoral Inflation:Sectoral inflation arises initially out of excess demand in particular industries. But it leads to a general price rise because prices do not fall in the deficient demand sectors.13.?Reflation:Is a situation when prices are raised deliberately in order to encourage economic activity. When there is depression and prices fall abnormally low, the monetary authority adopts measures to put more money in circulation so that prices rise. This is called reflation.2. Demand-Pull InflationDemand-Pull or excess demand inflation is a situation often described as “too much money chasing too few goods.” According to this theory, an excess of aggregate demand over aggregate supply will generate inflationary rise in prices. Its earliest explanation is to be found in the simple quantity theory of money.The theory states that prices rise in proportion to the increase in the money supply. Given the full employment level of output, doubling the money supply will double the price level. So inflation proceeds at the same rate at which the money supply expands.In this analysis, the aggregate supply is assumed to be fixed and there is always full employment in the economy. Naturally, when the money supply increases it creates more demand for goods but the supply of goods cannot be increased due to the full employment of resources. This leads to rise in prices.Modem quantity theorists led by Friedman hold that “inflation is always and everywhere a monetary phenomenon. The higher the growth rate of the nominal money supply, the higher the rate of inflation. When the money supply increases, people spend more in relation to the available supply of goods and services. This bids prices up. Modem quantity theorists neither assume full employment as a normal situation nor a stable velocity of money. Still they regard inflation as the result of excessive increase in the money supply.The quantity theory version of the demand-pull inflation is illustrated in Figure 3. Suppose the money supply is increased at a given price level OP as determined by the demand and supply curves D and S1?respectively. The initial full employment situation OYF?at this price level is shown by the interaction of these curves at point E. Now with the increase in the quantity of money, the aggregate demand increase which shifts the demand curve D to D1to the right. The aggregate supply being fixed, as shown by the vertical portion of the supply curve SS1?the D1?curve intersects it at point E1. This raises the price level to OP1.The Keynesian theory on demand-pull inflation is based on the argument that so long as there are unemployed resources in the economy; an increase in investment expenditure will lead to increase in employment, income and output. Once full employment is reached and bottlenecks appear, further increase in expenditure will lead to excess demand because output ceases to rise, thereby leading to inflation.The Keynesian theory of demand -pull inflation is explained diagrammatically in Figure 3. Suppose the economy is in equilibrium at E where the SS1and D curves intersect with full employment income level OYF?.The price level is OP. Now the government increases its expenditure. The increase in government expenditure implies an increase in aggregate demand which is shown by the upward shift of the D curve to D1?in the figure. This tends to raise the price level to OP1, as aggregate supply of output cannot be increased after the full employment level.3. Cost-Push InflationCost-push inflation is caused by wage increases enforced by unions and profit increases by employers. This type of inflation has not been a new phenomenon and was found even during the medieval period. But it was revived in the 1950s and again in the 1970s as the principal cause of inflation. It also came to be known as the “New Inflation.”Cost-push inflation is caused by wage-push and profit-push to prices for the following reasons:1.?Rise in Wages:The basis cause of cost-push inflation is the rise in money wages more rapidly than the productivity of labour. In advanced countries, trade unions are very powerful. They press employers to grant wage increases considerably in excess of increases in the productivity of labour, thereby raising the cost of production of commodities. Employers, in turn, raise prices of their products.Higher wages enable workers to buy as much as before, in spite of higher prices. On the other hand, the increase in prices induces unions to demand still higher wages. In this way, the wage-cost spiral continues, thereby leading to cost-push or wage-push inflation. Cost-push inflation may be further aggravated by upward adjustment of wages to compensate for rise in the cost of living index.2.?Sectoral Rise in Prices:Again, a few sectors of the economy may be affected by money wage increases and prices of their products may be rising. In many cases, their production such as steel, raw materials, etc. are used as inputs for the production of commodities in other sectors. As a result, the production cost of other sectors will rise and thereby push up the prices of their products. Thus wage- push inflation in a few sectors of the economy may soon lead to inflationary rise in prices in the entire economy.3.?Rise in Prices of Imported Raw Materials:An increase in the prices of imported raw materials may lead to cost-push inflation. Since raw materials are used as inputs by the manufacturers of the finished goods, they enter into the cost of production of the latter. Thus a continuous rise in the prices of raw materials tends to sets off a cost-price-wage spiral.4.?Profit-Push Inflation:Oligopolist and monopolist firms raise the prices of their products to offset the rise in labour and production costs so as to earn higher profits. There being imperfect competition in the case of such firms, they are able to “administer prices” of their products. “In an economy in which so called administered prices abound there is at least the possibility that these prices may be administered upward faster than cost in an attempt to earn greater profits.To the extent such a process is wide-spread profit-push inflation will result.” Profit-push inflation is, therefore, also called administered-price theory of inflation or price-push inflation or sellers’ inflation or market-power inflation. Cost-push inflation is illustrated in Figure 4. Where S1?S is the supply curve and D is the demand curve. Both intersect at E which is the full employment level OYF, and the price level OP is determined. Given the demand, as shown by the D curve, the supply curve S1?is shown to shift to S2?as a result of cost-push factors. Consequently, it intersects the D curve at E1?showing rise in the price level from OP to OP1?and fall in aggregate output from OYF?to OY1level. Any further shift in the supply curve will shift and tend to raise the price level and decrease aggregate output further.4. The Inflationary GapIn his pamphlet How to pay for the War published in 1940, Keynes explained the concept of the inflationary gap. It differs from his views on inflation given in his General Theory. In the General Theory, he started with underemployment equilibrium. But in How to Pay for the War, he began with a situation of full employment in the economy.He defined an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base prices. According to Lipsey, “The inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at the full employment level of income.” The classical economists explained inflation as mainly due to increase in the quantity of money, given the level of full employment.Keynes, on the other hand, ascribed it to the excess of expenditure over income at the full employment level. The larger the aggregate expenditure, the larger the gap and the more rapid the inflation. Given a constant average propensity to save, rising money incomes at full employment level would lead to an excess of demand over supply and to a consequent inflationary gap. Thus Keynes used the concept of the inflationary gap to show the main determinants that cause an inflationary rise of prices.The inflationary gap is explained with the help of the following example:Suppose the gross national product at pre-inflation prices is Rs. 200 crores. Of this Rs. 80 crores is spent by the government. Thus Rs. 120 (Rs. 200-80) crores worth of output is available to the public for consumption at pre-inflation prices. But the gross national income at current prices at full employment level is Rs. 250 crores. Suppose the government taxes away Rs. 60 crores, leaving Rs. 190 crores as disposable income. Thus Rs. 190 crores is the amount to be spent on the available output worth Rs. 120 crores, thereby creating an inflationary gap of Rs. 70 crores.This inflationary gap model is illustrated as under:1. Gross national income at current prices=Rs. 250 Cr.2. Taxes=Rs. 60 Cr.3. Disposable income=Rs. 190 Cr.4. GNP at pre-inflation prices=Rs. 200 Cr.5. Government expenditure=Rs. 80 Cr.6. Output available for consumption at pre-inflation prices=Rs. 120 Cr.Inflationary gap (Item 3-6)=Rs. 70 Cr.In reality, the entire disposable income of Rs. 190 crores is not spent and a part of it is saved. If, say 20 per cent (Rs, 38 crocs) of it is saved, then Rs. 152 crores (Rs. 190-Rs. 38 crores) would be left to create demand for goods worth Rs. 120 crores. Thus the actual inflationary gap would be Rs. 32 (Rs. 152— 120) crores instead of Rs. 70 crores.The inflationary gap is shown diagrammatically in Figure 5 where OYF?is the full employment level of income, 45° line represents aggregate supply AS and С + 1 + G line the desired level of consumption, investment and government expenditure (or aggregate demand curve).The economy’s aggregate demand curve (C + l +G) = AD intersects the 45° line (AS ) at point E at the income level OY1which is greater than the full employment income level OYF?The amount by which aggregate demand (YFA) exceeds the aggregate supply (YFВ) at the full employment income level is the inflationary gap.This is AB in the figure. The excess volume of total spending when resources are fully employed creates inflationary pressures. Thus the inflationary gap leads to inflationary pressures in the economy which are the result of excess aggregate demand.How can the inflationary gap be wiped?out?The inflationary gap can be wiped out by increase in savings so that the aggregate demand is reduced. But this may lead to deflationary tendencies.Another solution is to raise the value of available output to match the disposable income. As aggregate demand increases, businessmen hire more labour to expand output. But there being full employment at the current money age, they offer higher money wages to induce more workers to work for them.As there is already full employment, the increase in money wages leads to proportionate rise in prices. Moreover, output cannot be increased during the short run because factors are already fully employed. So the inflationary gap can be closed by increasing taxes and reducing expenditure. Monetary policy can also be used to decrease the money stock. But Keynes was not in favour of monetary measures to control inflationary pressures within the economy.It’s Importance:Despite these criticisms the concept of inflationary gap has proved to be of much importance in explaining rising prices at full employment level and policy measures in controlling inflation. It tells that the rise in prices, once the level of full employment is attained, is due to excess demand generated by increased expenditures. But the output cannot be increased because all resources are fully employed in the economy. This leads to inflation. The larger the expenditure, the larger the gap and more rapid the inflation.As a policy measure, it suggests reduction in aggregate demand to control inflation. For this, the best course is to have a surplus budget by raising taxes. It also favours saving incentives to reduce consumption expenditure.“The analysis of the inflationary gap in terms of such aggregates as national income, investment outlays and consumption expenditures clearly reveals what determines public policy with respect to taxes, public expenditures, savings campaigns, credit control, wage adjustment—in short, all the conceivable anti-inflationary measures affecting the propensities to consume, to save’ and to invest which together determine the general price level.”5. Phillip Curve in Economics: The Relation between Unemployment and InflationThe Phillips curve examines the relationship between the rate of unemployment and the rate of money wage changes. Known after the British economist A. W. Phillips who first identified it, it expresses an inverse relationship between the rate of unemployment and the rate of increase in money wages. Basing his analysis on data for the United Kingdom, Phillips derived the empirical relationship that when unemployment is high, the rate of increase in money wage rates is low.This is because “workers are reluctant to offer their services at less than the prevailing rates when the demand for labour is low and unemployment is high so that wage rates fall very slowly.” On the other hand, when unemployment is low, the rate of increase in money wage rates is high. This is because, “when the demand for labour is high and there are very few unemployed we should expect employer to bid wage rates up quite rapidly.”The second factor which influences this inverse relationship between money wage rate and unemployment is the nature of business activity. In a period of rising business activity when unemployment falls with increasing demand for labour, the employers will bid up wages. Conversely, in a period of falling business activity when demand for labour is decreasing and unemployment is rising, employers will be reluctant to grant wage increases.Rather, they will reduce wages. But workers and unions will be reluctant to accept wage cuts during such periods. Consequently, employers are forced to dismiss workers, thereby leading to high rates of unemployment. Thus when the labour market is depressed, a small reduction in wages would lead to large increase in unemployment. Phillips concluded on the basis of the above arguments that the relation between rates of unemployment and a change of money wages would be highly non-linear when shown on a diagram. Such a curve is called the Phillips curve.The PC curve in Figure 6 is the Phillips curve which relates percentage change in money wage rate (W) on the vertical axis with the rate of unemployment (U).on the horizontal axis. The curve is convex to the origin which shows that the percentage change in money wages rises with decrease in the employment rate.In the figure, when the money wage rate is 2 per cent, the unemployment rate is 3 per cent. But when the wage rate is high at 4 per cent, the unemployment rate is low at 2 per cent. Thus there is a trade-off between the rate of change in money wage and the rate of unemployment. This means that when the wage rate is high the unemployment rate is low and vice versa.The original Phillips curve was an observed statistical relation which was explained theoretically by Lipsey as resulting from the behaviour of labour market in disequilibrium through excess demand. Several economists have extended the Phillips analysis to the trade-off between the rate of unemployment and the rate of change in the level of prices or inflation rate by assuming that prices would change whenever wages rose more rapidly than labour productivity.If the rate of increase in money wage rates is higher than the growth rate of labour productivity, prices will rise and vice versa. But prices do not rise if labour productivity increases at the same rate as money wage rates rise.This trade-off between the inflation rate and unemployment rate is explained in Figure 6 where the inflation rate (p) is taken along with the rate of change in money wages (W). Suppose labour productivity rises by 2 per cent per year and if money wages also increase by 2 per cent, the price level would remain constant.Thus point В on the PC curve corresponding to percentage change in money wages (M) and unemployment rate of 3 per cent (N) equals zero (O) per cent inflation rate (p) on the vertical axis. Now assume that the economy is operating at point B. If now, aggregate demand is increased, this lowers the unemployment rate to OT (2%) and raises the wage rate to OS (4%) per year.If labour productivity continues to grow at 2 per cent per annum, the price level will also rise at the rate of 2 per cent per annum at OS in the figure. The economy operates at point C. With the movement of the economy from В to C, unemployment falls to T (2%). If points В and С are connected, they trace out a Phillips curve PC.Thus money wages rate increase which is in excess of labour productivity leads to inflation. To keep wage increase to the level of labour productivity (OM) in order to avoid inflation, ON rate of unemployment will have to be tolerated.The shape of the PC curve further suggests that when the unemployment rate is less than 5 ? per cent (that is, to the left of point A), the demand for labour is more than the supply and this tends to increase money wage rates. On the other hand, when the unemployment rate is more than 5 ? per cent (to the right of point A), the supply of labour is more than the demand which tends to lower wage rates. The implication is that the wage rates will be stable at the unemployment rate ОA which is equal to 5 ? per cent per annum.It is to be noted that PC is the “conventional” or original downward sloping Phillips curve which shows a stable and inverse relation between the rate of unemployment and the rate of change in wages.Friedman’s View: The Long-Run Phillips Curve:Economists have criticised and in certain cases modified the Phillips curve. They argue that the Phillips curve relates to the short run and it does not remain stable. It shifts with changes in expectations of inflation. In the long run, there is no trade-off between inflation and employment. These views have been expounded by Friedman and Phelps’ in what has come to be known as the “accelerationist” or the “adaptive expectations” hypothesis.According to Friedman, there is no need to assume a stable downward sloping Phillips curve to explain the trade-off between inflation and unemployment. In fact, this relation is a short-run phenomenon. But there are certain variables which cause the Phillips curve to shift over time and the most important of them is the expected rate of inflation. So long as there is discrepancy between the expected rate and the actual rate of inflation, the downward sloping Phillips curve will be found. But when this discrepancy is removed over the long run, the Phillips curve becomes vertical.In order to explain this, Friedman introduces the concept of the natural rate of unemployment. In represents the rate of unemployment at which the economy normally settles because of its structural imperfections. It is the unemployment rate below which the inflation rate increases, and above which the inflation rate decreases. At this rate, there is neither a tendency for the inflation rate to increase or decrease.Thus the natural rate of unemployment is defined as the rate of unemployment at which the actual rate of inflation equals the expected rate of inflation. It is thus an equilibrium rate of unemployment towards which the economy moves in the long run. In the long run, the Phillips curve is a vertical line at the natural rate of unemployment.This natural or equilibrium unemployment rate is not fixed for all times. Rather, it is determined by a number of structural characteristics of the labour and commodity markets within the economy. These may be minimum wage laws, inadequate employment information, deficiencies in manpower training, costs of labour mobility, and other market imperfections.But what causes the Phillips curve to shift over time is the expected rate of inflation. This refers to the extent the labour correctly forecasts inflation and can adjust wages to the forecast. Suppose the economy is experiencing a mild rate of inflation of 2 per cent and a natural rate of unemployment (N) of 2 per cent. At point A on the short-run Phillips curve SPC1?in Figure 7, people expect this rate of inflation to continue in the future.Now assume that the government adopts a monetary-fiscal programme to raise aggregate demand in order to lower unemployment from 3 to 2 per cent. The increase in aggregate demand will raise the rate of inflation to 4 per cent consistent with the unemployment rate of 2 per cent. When the actual inflation rate (4 per cent) is greater than the expected inflation rate (2 per cent), the economy moves from point A to В along the SPC1curve, and the unemployment rate temporarily falls to 2 per cent.This is achieved because the labour has been deceived. It expected the inflation rate of 2 per cent and based their wage demands on this rate. But the workers eventually begin to realise that the actual rate of inflation is 4 per cent which now becomes their expected rate of inflation. Once this happens the short-run Phillips curve SPC1?shifts to the right to SPC2Now workers demand increase in money wages to meet the higher expected rate of inflation of 4 per cent.They demand higher wages because they consider the present money wages to be inadequate in real terms. In other words, they want to keep up with higher prices and to eliminate fall in real wages. As a result, real labour costs will rise, firms will discharge workers and unemployment will rise from В (2%) to С (3%) with the shifting of the SPC1curve to SPC2?At point C, the natural rate of unemployment is re-established at a higher rate of both the actual and expected inflation (4%).If the government is determined to maintain the level of unemployment at 2 per cent, it can do so only at the cost of higher rates of inflation. From point C, unemployment once again can be reduced to 2 per cent via increase in aggregate demand along the SCP2?curve until we arrive at point D. With 2 per cent unemployment and 6 per cent inflation at point D, the expected rate of inflation for workers is 4 per cent.As soon as they adjust their expectations to the new situation of 6 per cent inflation, the short-run Phillips curve shifts up again to SPC’3?and the unemployment will rise back to its natural level of 3 percent at point E. If points A, С and E are connected, they trace out a vertical long-run Phillips curve LPC at the natural rate of unemployment.On this curve, there is no trade-off between unemployment and inflation. Rather, any one of several rates of inflation at points A, С and E is compatible with the natural unemployment rate of 3 per cent. Any reduction in unemployment rate below its natural rate will be associated with an accelerating and ultimately explosive inflation. But this is only possible temporarily so long as workers overestimate or underestimate the inflation rate. In the long-run, the economy is bound to establish at the natural unemployment rate.There is, therefore, no trade-off between unemployment and inflation except in the short run. This is because inflationary expectations are revised according to what has happened to inflation in the past. So when the actual rate of inflation, say, rises to 4 per cent in Figure 7, workers continue to expect 2 per cent inflation for a while and only in the long run they revise their expectations upwards towards 4 per cent.Since they adapt themselves to the expectations, it is called the adaptive expectations hypothesis. According to this hypothesis, the expected rate of inflation always lags behind the actual rate. But if the actual rate remains constant the expected rate would ultimately become equal to it. This leads to the conclusion that a short run trade-off exists between unemployment and inflation, but there is no long run trade-off between the two unless a continuously rising inflation rate is tolerated.It’s Criticisms:The accelerationist hypothesis of Friedman has been criticised on the following grounds:1. The vertical long-run Phillips curve relates to the steady rate of inflation. But this is not a correct view because the economy is always passing through a series of disequilibrium positions with little tendency to approach a steady state. In such a situation, expectations may be disappointed year after year.2. Friedman does not give a new theory of how expectations are formed that would be free from theoretical and statistical bias. This makes his position unclear.3. The vertical long-run Phillips curve implies that all expectations are satisfied and that people correctly anticipate the future inflation rates. Critics point out that people do not anticipate inflation rates correctly, particularly when some prices are almost certain to rise faster than others. There are bound to be disequilibria between supply and demand caused by uncertainty about the future and that is bound to increase the rate of unemployment. Far from curing unemployment, a dose of inflation is likely to make it worse.4. In one of his writings Friedman himself accepts the possibility that the long-run Phillips curve might not just be vertical, but could be positively sloped with increasing doses of inflation leading to increasing unemployment.5. Some economists have argued that wage rates have not increased at a high rate of unemployment.6. It is believed that workers have a money illusion. They are more concerned with the increase in their money wage rates than real wage rates.7. Some economists regard the natural rate of unemployment as a mere abstraction because Friedman has not tried to define it in concrete terms.8. Saul Hyman has estimated that the long-run Phillips curve is not vertical but is negatively sloped. According to Hyman, the unemployment rate can be permanently reduced if we are prepared to accept an increase in inflation rate.Tobin’s View:James Tobin in his presidential address before the American Economic Association in 1971 proposed a compromise between the negatively sloping and the vertical Phillips curve. Tobin believes that there is a Phillips curve within limits. But as the economy expands and employment grows, the curve becomes even more fragile and vanishes until it becomes vertical at some critically low rate of unemployment.Thus Tobin s Phillips curve is kinked-shaped, a part like a normal Phillips curve and the rest vertical, as shown in Figure 8. In the figure, Uc is the critical rate of unemployment at which the Phillips curve becomes vertical where there is no trade-off between unemployment and inflation. According to Tobin, the vertical portion of the curve is not due to increase in the demand for more wages but emerges from imperfections of the labour market.At the Uc level, it is not possible to provide more employment because the job seekers have wrong skills or wrong age or sex or are in the wrong place. Regarding the normal portion of the Phillips curve which is negatively sloping, wages are sticky downward because labourers resist a decline in their relative wages.For Tobin, there is a wage-change floor in excess supply situations. In the range of relatively high unemployment to the right of Uc in the figure, as aggregate demand and inflation increase and involuntary unemployment is reduced, wage-floor markets gradually diminish. When all sectors of the labour market are above the wage floor, the level of critically low rate of unemployment Uc is reached.Solow’s View:Like Tobin, Robert Solow does not believe that the Phillips curve is vertical at all rates of inflation. According to him, the curve is vertical at positive rates of inflation and is horizontal at negative rates of inflation, as shown in Figure 9. The basis of the Phillips curve LPC of the figure is that wages are sticky downward even in the face of heavy unemployment or deflation. But at a particular level of unemployment when the demand for labour increases, wages rise in the face of expected inflation. But since the Phillips curve LPC becomes vertical at that minimum level of unemployment, there is no trade-off between unemployment and inflation.Conclusion:The vertical Phillips curve has been accepted by the majority of economists. They agree that at unemployment rate of about 4 per cent, the Phillips curve becomes vertical and the trade-off between unemployment and inflation disappears. It is impossible to reduce unemployment below this level because of market imperfections.Policy Implications of the Phillips Curve:The Phillips curve has important policy implications. It suggests the extent to which monetary and fiscal policies can be used to control inflation without high levels of unemployment. In other words, it provides a guideline to the authorities about the rate of inflation which can be tolerated with a given level of unemployment. For this purpose, it is important to know the exact position of the Phillips curve.While explaining the natural rate of unemployment, Friedman pointed out that the only scope of public policy in influencing the level of unemployment lies in the short run in keeping with the position of the Phillips curve. He ruled out the possibility of influencing the long-run rate of unemployment because of the vertical Phillips curve.According to him, the trade-off between unemployment and inflation does not exist and has never existed. However rapid the inflation might be, unemployment always tends to fall back to its natural rate which is not some irreducible minimum of unemployment. It can be lowered by removing obstacles in the labour market by reducing frictions.Therefore, public policy should improve the institutional structure to make the labour market responsive to changing patterns of demand. Moreover, some level of unemployment must be accepted as natural because of the existence of large number of part-time workers, unemployment compensation and other institutional factors.Another implication is that unemployment is not a fitting aim for monetary expansion, according to Friedman. Therefore, employment above the natural rate can be reached at the cost of accelerating inflation, if monetary policy is adopted.In his words, “A little inflation will provide a boost at first—like a small dose of a drug for a new addict—but then it takes more and more inflation to provide the boost, just it takes a bigger and bigger dose of a drug to give a hardened addict a high.” Thus if the government wants to have a genuine full employment level at the natural rate, it must not use monetary policy to remove institutional restraints, restrictive practices, barriers to mobility, trade union coercion and similar obstacles to both the workers and the employers.But economists do not agree with Friedman. They suggest that it is possible to reduce the natural rate of unemployment through labour market policies, whereby labour market can be made more efficient. So the natural rate of unemployment can be reduced by shifting the long-run vertical Phillips curve to the left.Johnson doubts about the applicability of the Phillips curve to the formulation of economic policy on two grounds. “On the one hand, the curve represents only a statistical description of the mechanics of adjustment in the labour market, resting on a simple model of economic dynamics with little general and well-tested monetary theory behind it.On the other hand, it describes the behaviour of the labour market in a combination of periods of economic fluctuation and varying rates of inflation, conditions which presumably influenced the behaviour of the labour market itself, so that it may reasonably be doubted whether the curve would continue to hold its shape if an attempt were made by economic policy to pin the economy down to a point on it.”6. Causes of InflationInflation is caused when the aggregate demand exceeds the aggregate supply of goods and services. We analyse the factors which lead to increase in demand and the shortage of supply.Factors Affecting Demand:Both Keynesians and monetarists believe that inflation is caused by increase in the aggregate demand.They point towards the following factors which raise it.1.?Increase in Money Supply:Inflation is caused by an increase in the supply of money which leads to increase in aggregate demand. The higher the growth rate of the nominal money supply, the higher is the rate of inflation. Modem quantity theorists do not believe that true inflation starts after the full employment level. This view is realistic because all advanced countries are faced with high levels of unemployment and high rates of inflation.2.?Increase in Disposable Income:When the disposable income of the people increases, it raises their demand for goods and services. Disposable income may increase with the rise in national income or reduction in taxes or reduction in the saving of the people.3.?Increase in Public Expenditure:Government activities have been expanding much with the result that government expenditure has also been increasing at a phenomenal rate, thereby raising aggregate demand for goods and services. Governments of both developed and developing countries are providing more facilities under public utilities and social services, and also nationalising industries and starting public enterprises with the result that they help in increasing aggregate demand.4.?Increase in Consumer Spending:The demand for goods and services increases when consumer expenditure increases. Consumers may spend more due to conspicuous consumption or demonstration effect. They may also spend more whey they are given credit facilities to buy goods on hire-purchase and instalment basis.5.?Cheap Monetary Policy:Cheap monetary policy or the policy of credit expansion also leads to increase in the money supply which raises the demand for goods and services in the economy. When credit expands, it raises the money income of the borrowers which, in turn, raises aggregate demand relative to supply, thereby leading to inflation. This is also known as credit-induced inflation.6.?Deficit Financing:In order to meet its mounting expenses, the government resorts to deficit financing by borrowing from the public and even by printing more notes. This raises aggregate demand in relation to aggregate supply, thereby leading to inflationary rise in prices. This is also known as deficit-induced inflation.7.?Expansion of the Private Sector:The expansion of the private sector also tends to raise the aggregate demand. For huge investments increase employment and income, thereby creating more demand for goods and services. But it takes time for the output to enter the market.8.?Black Money:The existence of black money in all countries due to corruption, tax evasion etc. increases the aggregate demand. People spend such unearned money extravagantly, thereby creating unnecessary demand for commodities. This tends to raise the price level further.9.?Repayment of Public Debt:Whenever the government repays its past internal debt to the public, it leads to increase in the money supply with the public. This tends to raise the aggregate demand for goods and services.10.?Increase in Exports:When the demand for domestically produced goods increases in foreign countries, this raises the earnings of industries producing export commodities. These, in turn, create more demand for goods and services within the economy.Factors Affecting Supply:There are also certain factors which operate on the opposite side and tend to reduce the aggregate supply.Some of the factors are as follows:1.?Shortage of Factors of Production:One of the important causes affecting the supplies of goods is the shortage of such factors as labour, raw materials, power supply, capital, etc. They lead to excess capacity and reduction in industrial production.2.?Industrial Disputes:In countries where trade unions are powerful, they also help in curtailing production. Trade unions resort to strikes and if they happen to be unreasonable from the employers’ viewpoint’ and are prolonged, they force the employers to declare lock-outs. In both cases, industrial production falls, thereby reducing supplies of goods. If the unions succeed in raising money wages of their members to a very high level than the productivity of labour, this also tends to reduce production and supplies of goods.3.?Natural Calamities:Drought or floods is a factor which adversely affects the supplies of agricultural products. The latter, in turn, create shortages of food products and raw materials, thereby helping inflationary pressures.4.?Artificial Scarcities:Artificial scarcities are created by hoarders and speculators who indulge in black marketing. Thus they are instrumental in reducing supplies of goods and raising their prices.5.?Increase in Exports:When the country produces more goods for export than for domestic consumption, this creates shortages of goods in the domestic market. This leads to inflation in the economy.6.?Lop-sided Production:If the stress is on the production of comforts, luxuries, or basic products to the neglect of essential consumer goods in the country, this creates shortages of consumer goods. This again causes inflation.7.?Law of Diminishing Returns:If industries in the country are using old machines and outmoded methods of production, the law of diminishing returns operates. This raises cost per unit of production, thereby raising the prices of products.8.?International Factors:In modern times, inflation is a worldwide phenomenon. When prices rise in major industrial countries, their effects spread to almost all countries with which they have trade relations. Often the rise in the price of a basic raw material like petrol in the international market leads to rise in the price of all related commodities in a country.7. Measures to Control InflationWe have studied above that inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand. Inflation can, therefore, be controlled by increasing the supplies and reducing money incomes in order to control aggregate demand.The various methods are usually grouped under three heads:Monetary measures, fiscal measures and other measures.1. Monetary Measures:Monetary measures aim at reducing money incomes.(a)?Credit Control:One of the important monetary measures is monetary policy. The central bank of the country adopts a number of methods to control the quantity and quality of credit. For this purpose, it raises the bank rates, sells securities in the open market, raises the reserved ratio, and adopts a number of selective credit control measures, such as raising margin requirements and regulating consumer credit.Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors. Monetary policy can only be helpful in controlling inflation due to demand-pull factors.(b)?Demonetisation of Currency:However, one of the monetary measures is to demonetise currency of higher denominations. Such a measure is usually adopted when there is abundance of black money in the country.(c)?Issue of New Currency:The most extreme monetary measure is the issue of new currency in place of the old currency. Under this system, one new note is exchanged for a number of notes of the old currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes and there is hyperinflation in the country. It is a very effective measure. But is inequitable for it hurts the small depositors the most.2. Fiscal Measures:Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by fiscal measures. Fiscal measures are highly effective for controlling government expenditure, personal consumption expenditure, and private and public investment.The principal fiscal measures are the following:(a)?Reduction in Unnecessary Expenditure:The government should reduce unnecessary expenditure on non-development activities in order to curb inflation. This will also put a check on private expenditure which is dependent upon government demand for goods and services. But it is not easy to cut government expenditure. Though economy measures are always welcome but it becomes difficult to distinguish between essential and non-essential expenditure. Therefore, this measure should be supplemented by taxation.(b)?Increase in Taxes:To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes should not be so high as to discourage saving, investment and production. Rather, the tax system should provide larger incentives to those who save, invest and produce more.Further, to bring more revenue into the tax-net, the government should penalise the tax evaders by imposing heavy fines. Such measures are bound to be effective in controlling inflation. To increase the supply of goods within the country, the government should reduce import duties and increase export duties.(c)?Increase in Savings:Another measure is to increase savings on the part of the people. This will tend to reduce disposable income with the people, and hence personal consumption expenditure. But due to the rising cost of living, people are not in a position to save much voluntarily. Keynes, therefore, advocated compulsory savings or what he called ‘deferred payment’ where the saver gets his money back after some years.For this purpose, the government should float public loans carrying high rates of interest, start saving schemes with prize money, or lottery for long periods, etc. It should also introduce compulsory provident fund, provident fund-cum-pension schemes, etc. compulsorily. All such measures to increase savings are likely to be effective in controlling inflation.(d)?Surplus Budgets:An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government should give up deficit financing and instead have surplus budgets. It means collecting more in revenues and spending less.(e)?Public Debt:At the same time, it should stop repayment of public debt and postpone it to some future date till inflationary pressures are controlled within the economy. Instead, the government should borrow more to reduce money supply with the public.Like the monetary measures, fiscal measures alone cannot help in controlling inflation. They should be supplemented by monetary, non-monetary and non-fiscal measures.3. Other Measures:The other types of measures are those which aim at increasing aggregate supply and reducing aggregate demand directly:(a)?To Increase Production:The following measures should be adopted to increase production:(i) One of the foremost measures to control inflation is to increase the production of essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.(ii) If there is need, raw materials for such products may be imported on preferential basis to increase the production of essential commodities.(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be maintained through agreements with trade unions, binding them not to resort to strikes for some time.(iv)?The policy of rationalisation of industries should be adopted as a long-term measure. Rationalisation increases productivity and production of industries through the use of brain, brawn and bullion.(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc. should be provided to different consumer goods sectors to increase production.(b)?Rational Wage Policy:Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there is a wage-price spiral. To control this, the government should freeze wages, incomes, profits, dividends, bonus, etc. But such a drastic measure can only be adopted for a short period and by antagonising both workers and industrialists. Therefore, the best course is to link increase in wages to increase in productivity. This will have a dual effect. It will control wages and at the same time increase productivity, and hence increase production of goods in the economy.(c)?Price Control:Price control and rationing is another measure of direct control to check inflation. Price control means fixing an upper limit for the prices of essential consumer goods. They are the maximum prices fixed by law and anybody charging more than these prices is punished by law. But it is difficult to administer price control.(d)?Rationing:Rationing aims at distributing consumption of scarce goods so as to make them available to a large number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise the prices of necessaries and assure distributive justice. But it is very inconvenient for consumers because it leads to queues, artificial shortages, corruption and black marketing. Keynes did not favour rationing for it “involves a great deal of waste, both of resources and of employment.”Conclusion:From the various monetary, fiscal and other measures discussed above, it becomes clear that to control inflation, the government should adopt all measures simultaneously. Inflation is like a hydra-headed monster which should be fought by using all the weapons at the command of the government.8. Effects of InflationInflation affects different people differently. This is because of the fall in the value of money. When prices rise or the value of money falls, some groups of the society gain, some lose and some stand in between. Broadly speaking, there are two economic groups in every society, the fixed income group and the flexible income group.People belonging to the first group lose and those belonging to the second group gain. The reason is that price movements in the case of different goods, services, assets, etc. are not uniform. When there is inflation, most prices are rising, but the rates of increase of individual prices differ much. Prices of some goods and services rise faster, of others slowly, and of still others remain unchanged. We discuss below the effects of inflation on redistribution of income and wealth, production, and on the society as a whole.1. Effects on Redistribution of Income and Wealth:There are two ways to measure the effects of inflation on the redistribution of income and wealth in a society. First, on the basis of the change in the real value of such factor incomes as wages, salaries, rents, interest, dividends and profits.Second, on the basis of the size distribution of income over time as a result of inflation, i.e. whether the incomes of the rich have increased and that of the middle and poor classes have declined with inflation. Inflation brings about shifts in the distribution of real income from those whose money incomes are relatively inflexible to those whose money incomes are relatively flexible.The poor and middle classes suffer because their wages and salaries are more or less fixed but the prices of commodities continue to rise. They become more impoverished. On the other hand, businessmen, industrialists, traders, reals estate holders, speculators, and others with variable incomes gain during rising prices.The latter category of persons becomes rich at the cost of the former group. There is unjustified transfer of income and wealth from the poor to the rich. As a result, the rich roll in wealth and indulge in conspicuous consumption, while the poor and middle classes live in abject misery and poverty.But which income group of society gains or losses from inflation depends on who anticipates inflation and who does not. Those who correctly anticipate inflation, they can adjust their present earnings, buying, borrowing, and lending activities against the loss of income and wealth due to inflation.They, therefore, do not get hurt by the inflation. Failure to anticipate inflation correctly leads to redistribution of income and wealth. In practice, all persons are unable to anticipate and predict the rate of inflation correctly so that they cannot adjust their economic behaviour accordingly. As a result, some persons gain while others lose. The net result is redistribution of income and wealth.The effects of inflation on different groups of society are discussed below:(1)?Debtors and Creditors:During periods of rising prices, debtors gain and creditors lose. When prices rise, the value of money falls. Though debtors return the same amount of money, but they pay less in terms of goods and services. This is because the value of money is less than when they borrowed the money.Thus the burden of the debt is reduced and debtors gain. On the other hand, creditors lose. Although they get back the same amount of money which they lent, they receive less in real terms because the value of money falls. Thus inflation brings about a redistribution of real wealth in favour of debtors at the cost of creditors.(2)?Salaried Persons:Salaried workers such as clerks, teachers, and other white collar persons lose when there is inflation. The reason is that their salaries are slow to adjust when prices are rising.(3)?Wage Earners:Wage earners may gain or lose depending upon the speed with which their wages adjust to rising prices. If their unions are strong, they may get their wages linked to the cost of living index. In this way, they may be able to protect themselves from the bad effects of inflation. But the problem is that there is often a time lag between the raising of wages by employees and the rise in prices.So workers lose because by the time wages are raised, the cost of living index may have increased further. But where the unions have entered into contractual wages for a fixed period, the workers lose when prices continue to rise during the period of contract. On the whole, the wage earners are in the same position as the white collar persons.(4)?Fixed Income Group:The recipients of transfer payments such as pensions, unemployment insurance, social security, etc. and recipients of interest and rent live on fixed incomes. Pensioners get fixed pensions. Similarly the rentier class consisting of interest and rent receivers get fixed payments. The same is the case with the holders of fixed interest bearing securities, debentures and deposits.All such persons lose because they receive fixed payments, while the value of money continues to fall with rising prices. Among these groups, the recipients of transfer payments belong to the lower income group and the rentier class to the upper income group. Inflation redistributes income from these two groups towards the middle income group comprising traders and businessmen.(5)?Equity Holders or Investors:Persons who hold shares or stocks of companies gain during inflation. For when prices are rising, business activities expand which increase profits of companies. As profits increase, dividends on equities also increase at a faster rate than prices. But those who invest in debentures, securities, bonds, etc. which carry a fixed interest rate lose during inflation because they receive a fixed sum while the purchasing power is falling.(6)?Businessmen:Businessmen of all types, such as producers, traders and real estate holders gain during periods of rising prices. Take producers first. When prices are rising, the value of their inventories rise in the same proportion. So they profit more when they sell their stored commodities. The same is the case with traders in the short ran. But producers profit more in another way.Their costs do not rise to the extent of the rise in the prices of their goods. This is because prices of raw materials and other inputs and wages do not rise immediately to the level of the price rise. The holders of real estate’s also profit during inflation because the prices of landed property increase much faster than the general price level.(7)?Agriculturists:Agriculturists are of three types: landlords, peasant proprietors, and landless agricultural workers. Landlords lose during rising prices because they get fixed rents. But peasant proprietors who own and cultivate their farms gain. Prices of farm products increase more than the cost of production.For prices of inputs and land revenue do not rise to the same extent as the rise in the prices of farm products. On the other hand, the landless agricultural workers are hit hard by rising prices. Their wages are not raised by the farm owners because trade unionism is absent among them. But the prices of consumer goods rise rapidly. So landless agricultural workers are losers.(8)?Government:The government as a debtor gains at the expense of households who are its principal creditors. This is because interest rates on government bonds are fixed and are not raised to offset expected rise in prices. The government, in turn, levies less taxes to service and retire its debt. With inflation, even the real value of taxes in reduced. Thus redistribution of wealth in favour of the government accrues as a benefit to the tax-payers.Since the tax-payers of the government are high- income groups, they are also the creditors of the government because it is they who hold government bonds. As creditors, the real value of their assets declines and as tax-payers, the real value of their liabilities also declines during inflation. The extent to which they will be gainers or losers on the whole is a very complicated calculation.Conclusion:Thus inflation redistributes income from wage earners and fixed income groups to profit recipients, and from creditors to debtors. In so far as wealth redistributions are concerned, the very poor and the very rich are more likely to lose than middle income groups.This is because the poor hold what little wealth they have in monetary form and has few debts, whereas the very rich hold a substantial part of their wealth in bonds and have relatively few debts. On the other hand, the middle income groups are likely to be heavily in debt and hold some wealth in common stock as well as in real assets.2. Effects on Production:When prices start rising, production is encouraged. Producers earn wind-fall profits in the future. They invest more in anticipation of higher profits in the future. This tends to increase employment, production and income. But this is only possible up to the full employment level.Further increase in investment beyond this level will lead to severe inflationary pressures within the economy because prices rise more than production as the resources are fully employed. So inflation adversely affects production after the level of full employment.The adverse effects of inflation on production are discussed below:(1)?Misallocation of Resources:Inflation causes misallocation of resources when producers divert resources from the production of essential to non-essential goods from which they expect higher profits.(2)?Changes in the System of Transactions:Inflation leads to changes in transactions pattern of producers. They hold a smaller stock of real money holdings against unexpected contingencies than before. They devote more time and attention to converting money into inventories or other financial or real assets. It means that time and energy are diverted from the production of goods and services and some resources are used wastefully.(3)?Reduction in Production:Inflation adversely affects the volume of production because the expectation of rising prices along with rising costs of inputs brings uncertainty. This reduces production.(4)?Fall in Quality:Continuous rise in prices creates a seller’s market. In such a situation, producers produce and sell sub-standard commodities in order to earn higher profits. They also indulge in adulteration of commodities.(5)?Hoarding and Black-marketing:To profit more from rising prices, producers hoard stocks of their commodities. Consequently, an artificial scarcity of commodities is created in the market. Then the producers sell their products in the black market which increase inflationary pressures.(6)?Reduction in Saving:When prices rise rapidly, the propensity to save declines because more money is needed to buy goods and services than before. Reduced saving adversely affects investment and capital formation. As a result, production is hindered.(7)?Hinders Foreign Capital:Inflation hinders the inflow of foreign capital because the rising costs of materials and other inputs make foreign investment less profitable.(8)?Encourages Speculation:Rapidly rising prices create uncertainty among producers who indulge in speculative activities in order to make quick profits. Instead of engaging themselves in productive activities, they speculate in various types of raw materials required in production.3. Other Effects:Inflation leads to a number of other effects which are discussed as under:(1)?Government:Inflation affects the government in various ways. It helps the government in financing its activities through inflationary finance. As the money income of the people increases, the government collects that in the form of taxes on incomes and commodities. So the revenues of the government increase during rising prices.Moreover, the real burden of the public debt decreases when prices are rising. But the government expenses also increase with rising production costs of public projects and enterprises and increase in administrative expenses as prices and wages rise. On the whole, the government gains under inflation because rising wages and profits spread an illusion of prosperity within the country.(2)?Balance of Payments:Inflation involves the sacrificing of the advantages of international specialisation and division of labour. It adversely affects the balance of payments of a country. When prices rise more rapidly in the home country than in foreign countries, domestic products become costlier compared to foreign products. This tends to increase imports and reduce exports, thereby making the balance of payments unfavourable for the country. This happens only when the country follows a fixed exchange rate policy. But there is no adverse impact on the balance of payments if the country is on the flexible exchange rate system.(3)?Exchange Rate:When prices rise more rapidly in the home country than in foreign countries, it lowers the exchange rate in relation to foreign currencies.(4)?Collapse of the Monetary System:If hyperinflation persists and the value of money continues to fall many times in a day, it ultimately leads to the collapse of the monetary system, as happened in Germany after World War I.(5)?Social. Inflation is socially harmful:By widening the gulf between the rich and the poor, rising prices create discontentment among the masses. Pressed by the rising cost of living, workers resort to strikes which lead to loss in production. Lured by profit, people resort to hoarding, black-marketing, adulteration, manufacture of substandard commodities, speculation, etc. Corruption spreads in every walk of life. All this reduces the efficiency of the economy.(6)?Political:Rising prices also encourage agitations and protests by political parties opposed to the government. And if they gather momentum and become unhandy they may bring the downfall of the government. Many governments have been sacrificed at the alter of inflation.?InflationBefore publishing your articles on this site, please read the following pages:1.?Content Guidelines?2.?Prohibited Content?3.?Plagiarism Prevention?4.?Image Guidelines?5.?Content Filtrations?6.?TOS?7.?Privacy Policy?8.?Disclaimer?9.?Copyright?10.?Report a ViolationCopyright ? 2016 , All rights reserved.Skip to main contentTop of FormSearch formSearch?Bottom of FormContact?Site map?RSSHomeManagement SciencesSocial SciencesExams / TestsTechnologyWhat is Deflation, Remedies and Causes of DeflationWed, 03/27/2013 - 09:02?--?Umar Farooq?What is DeflationThe concept of deflation is opposite to inflation. It is defined as?a situation when the general income level and price level are falling.?It is also known as negative inflation. During deflation the income level falls against the available supply of goods and services. The stage of deflation arises when.Prices are falling continuouslyPeople prefer to hold money with them and do not keep goods.The available supply of goods does not dispose off on the prevailing prices.People expect more reduction in prices thus reduce their consumption to bring prices down.Causes of?DeflationThe main causes of deflation as under.Fall in demand for goods and services are the primary causes.People due?to one reason or the other reduce their consumption on the purchase of goods & services due to which?prices?start falling.Sometime people start saving more than before which causes reduction in the aggregate demand and?the?available supply is sold at falling prices.If due to some reason the level of investment in all economy is falling. It will negatively affect the economy. The demand for capital goods will fall and prices will tend to come down.Decline in incomes of the people can also cause deflation in the economy. Due to reduction in the income level of the people the aggregate demand for goods services falls short of the aggregate supply, thus prices start falling.Excess of supply due to some reasons can also cause deflation because in this case the aggregate supply will exceed the aggregate demand?hence?the price level will fall.Remedies for DeflationFollowing are the remedies suggested to control deflation.If the central bank reduces the interest rate then the commercial banks will also advance loans at a lower interest rate which will boost up the investment, resulting increase in demand for capital goods and employment. Thus incomes will increase price level will start rising.In order to increase the aggregate demand the government has to increase its expenditures. By increasing expenditures incomes of the people will rise and price level will tend to move upward.By Printing extra money through the central bank and injecting in the economy the government can increase the aggregate demand which will further enhance the price level.By encouraging the private sector for investment through various immunities like subsides or tax reduction the aggregate demand can be usedPeople should start using their savings on consumer goods or investment.To increase exports and reduce the imports, the income level of the people and prices level can be raised?THE RELATIONSHIP BETWEEN MONEY AND PRICESThe quantity theory of money and its accompanying equation of exchange are generally accepted as defining the relationship between money and prices. The equation has been expressed a number of ways, always including “velocity of circulation”, which is a variable essential to balance the equation.Few disagree with the simple premise that an increase in the quantity of money tends to increase prices; the mistake is to try to tie the relationship mathematically, because it rides roughshod over what actually happens. Not all prices rise at the same time, nor do they rise evenly. Furthermore, the equation of exchange cannot differentiate between price changes that emanate from demand for goods and those that emanate from changes in preference for money – two effects that can produce very different results. These unknowns are effectively wrapped up in that catch-all, velocity of circulation.Aprioristic theory tells us where the error lies. People make a choice to allocate their income between current consumption and savings for the future. The most they can do without incurring debt is spend their earnings once. In practice most income is spent on consumption, but some is put aside for savings, and those savings are lent on through financial intermediaries to businesses for investment. Savings end up being spent on capital goods and working capital, instead of immediate consumption, but they are still spent.If there is an increase in the quantity of money it is spent by those that first obtain it, but the same rule applies: they can only spend their money once. How that increase is spent determines which prices will tend to rise. Furthermore demand for goods can change as the quantity of currency and bank credit changes and consumers can also change their preference for money by hoarding or dishoarding only marginal amounts of cash. It is these factors that govern the relationship between money and prices. Therefore, the number of times a unit of account circulates over a given time is a red herring.The fallacies behind the equation of exchange are more fully exposed in the case of a fiat currency, which unlike gold has no intrinsic value at all. What it will buy is set by its domestic acceptability as a money substitute amongst those that use it for transactions, and by its external value in the foreign exchanges set by those that don’t. Its purchasing power boils down to a matter of confidence and nothing else; therefore velocity is meaningless.Consider the Icelandic krona’s dramatic fall in purchasing power in October 2008. According to the equation of exchange, the sharp increase in domestic prices that followed must be the result of an expansion in the quantity of money and/or an acceleration of velocity of circulation. What actually happened was simply a collapse in the purchasing power of the krona that originated in the markets, which had nothing to do with any monetary equation.Velocity is an invention by economists to balance an equation conjured out of their own imagination, instead of understanding that the purchasing power of today’s fiat currencies is governed solely by the confidence placed in them. And because they have no intrinsic value, the quantity theory itself is a wholly inadequate explanation of the relationship between fiat money and prices.This article was previously published at?.??What Is the Connection between Money Supply and Price Level?The relationship between?money supply?and price level lies in the fact that the amount of money in circulation in an economy has a direct impact on the aggregate price level. This is mainly because an abundance of money leads to an increase in demand for goods and services, while a scarcity of money has the opposite effect. In economic terms, this effect is explained by the?quantity theory of money, which states that the amount of money in supply in an economy has a direct bearing on the price level.A simple way of looking at the relationship between money supply and price level is to consider the fact that consumers will only spend when they have something to spend. That is to say that when there is a lot of money in the economy, people will have more to spend. This increase in demand also causes a corresponding increase in the price level. Excess liquidity leads to a situation in which a lot of cash will be vying for an often limited supply of goods. This causes the money to gradually lose its value, which consequently leads to price increases.AdEconomists rely on the relationship between money supply and price level as one of the indicators of the state of the economy. When there is a rise in the aggregate price, one of the chief factors responsible is too much demand caused by consumers having easy access to money. The response of the government to this is often to introduce monetary or fiscal policies meant to restrict the ease with which consumers can obtain money, including bank loans and various types of credit. One method by which the government can restrict access to money is through increases in general interest rates.The effect of this restriction further illustrates the relationship between money supply and price level, because this maneuver usually forces the price level to drop. When the?central bank?of a country increases the interest rate, consumers may find the conditions attached to obtaining money to be either too prohibitively expensive or too rigorous, as other banks tighten their lending policies in response to the interest rates increase. As a consequence of the lack of easy access to funds, consumers tend to become more conservative in their spending habits, leading to a drop in the demand for goods and services. The consequence of a reduction in demand is an accompanying drop in the prices of goods and services.Difference between FDI and FIITweetKey difference:?FDI stands for Foreign Direct Investment, which means the investment made by a company or individual entity into an entity or a company based in another country. FII is the abbreviation for Foreign Institutional Investor, which means the investment made by an investor or an investment fund of one country, into the financial markets of another country.FDI is a very important concept, in regard to governments and world economy. The term FDI, short for Foreign Direct Investment, stands for an investment made by an individual entity or a company in a country that is not its own. FDI’s can be facilitated by setting up a subsidiary or an associate company in a foreign country, by acquiring shares of an overseas company, or through entering into a merger or a joint venture. Entities performing FDI have a considerable amount of control and influence over the management of the company that is being invested in. The accepted international threshold for making a Foreign Direct Investment is to own at least 10% or more of the voting stock, or the ordinary shares of the company invested in. An example of foreign direct investment would be a Canadian company setting up a joint venture to develop a mineral deposit in Chile.FII is an abbreviated term for Foreign Institutional Investor. It means the investment made by an individual investor or an investment fund, into the financial markets of another nation. Organizations like hedge funds, insurance companies, pension funds and mutual funds can be called as institutional investors. The term FII is mainly used in India to denote the foreign companies investing in its financial markets. For such an investment to take place in India, the investor must first be registered with SEBI (Securities and Exchange Board of India). The Indian government regularly practices the policy of limiting FII ownership in Indian companies. India has also announced in its annual fiscal budget of the year 2013-14 that it shall act inline with the international practice of classifying FDI and FII according to their respective stakes in a particular stock. That is, foreign investors with less than 10% stake in a particular stock will be considered as FII, and more than 10% stake will be treated as parison between FDI and FII:?FDIFIIMeaningThe investment made by a company or individual entity into an entity or a company based in another country.The investment made by an investor or an investment fund into the financial markets of another nation.Abbreviation forForeign Direct InvestmentForeign International InvestorInvestment made bySetting up a subsidiary company in the foreign country, acquiring shares of an overseas company, performing a merger, entering into a joint venture.The hedge funds, insurance companies, pension funds and mutual funds of one country into another.International threshold of owning stockMore than 10%, or at least?10%.Less than 10%Foreign-exchange reservesForeign-exchange reserves?(also called?forex reserves?or?FX reserves) is money or other assets held by a?central bank?or other?monetary authority?so that it can pay if need be its?liabilities, such as the?currency?issued by the central bank, as well as the various?bank reserves?deposited with the central bank by the?government?and other?financial institutions.[1]?Reserves are held in one or more?reserve currency, mostly the?United States dollar?and to a lesser extent the?Japanese yen.[1]Definition[ HYPERLINK "" \o "Edit section: Definition" edit]In a strict sense, foreign-exchange reserves should only include foreign?banknotes, foreign bank deposits, foreign?treasury bills, and short and long-term foreign government securities.[2]?However, the term in popular usage commonly also adds?gold reserves,?special drawing rights?(SDRs), and?International Monetary Fund(IMF) reserve positions. This broader figure is more readily available, but it is more accurately termed?official international reserves?or?international reserves.Foreign-exchange reserves are called?reserve assets?in the?balance of payments?and are located in the?capital account. Hence, they are usually an important part of the?international investment position?of a country. The reserves are labeled as reserve assets under assets by functional category. In terms of financial assets classifications, the reserve assets can be classified as Gold bullion, Unallocated gold accounts, Special drawing rights, currency, Reserve position in the IMF, interbank position, other transferable deposits, other deposits, debt?securities,?loans,?equity?(listed and unlisted), investment fund shares and financial?derivatives, such as?forward contracts?and?options. There is no counterpart for reserve assets in liabilities of the International Investment Position. Usually, when the monetary authority of a country has some kind of liability, this will be included in other categories, such as Other Investments.[3]?In the Central Bank’s Balance Sheet, foreign exchange reserves are assets, along with domestic credit.Purpose[ HYPERLINK "" \o "Edit section: Purpose" edit]Official international reserves assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank (since it prints the money or?fiat currency?as?IOUs). Thus, the quantity of foreign exchange reserves can change as a central bank implements?monetary policy, HYPERLINK "" \l "cite_note-4" [4]?but this dynamic should be analyzed generally in the context of the level of capital mobility, the?exchange rate?regime and other factors. This is known as? HYPERLINK "" \o "Trilemma" Trilemma?or?Impossible trinity. Hence, in a world of perfect capital mobility, a country with?fixed exchange rate?would not be able to execute an independent monetary policy.A central bank that implements a fixed exchange rate policy may face a situation where?supply?and?demand?would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower) and thus the central bank would have to use reserves to maintain its fixed exchange rate. Under perfect capital mobility, the change in reserves is a temporary measure, since the fixed exchange rate attaches the domestic monetary policy to that of the country of the?base currency. Hence, in the long term, the monetary policy has to be adjusted in order to be compatible with that of the country of the base currency. Without that, the country will experience outflows or inflows of capital. Fixed pegs were usually used as a form of monetary policy, since attaching the domestic currency to a currency of a country with lower levels of inflation should usually assure convergence of prices.In a pure flexible exchange rate regime or?floating exchange rate?regime, the central bank does not intervene in the exchange rate dynamics; hence the exchange rate is determined by the market. Theoretically, in this case reserves are not necessary. Other instruments of monetary policy are generally used, such as interest rates in the context of an?inflation targeting?regime.?Milton Friedman?was a strong advocate of flexible exchange rates, since he considered that independent monetary (and in some cases fiscal) policy and openness of the capital account are more valuable than a fixed exchange rate. Also, he valued the role of exchange rate as a price. As a matter of fact, he believed that sometimes it could be less painful and thus desirable to adjust only one price (the exchange rate) than the whole set of prices of?goods?and?wages?of the economy, that are less flexible.[5]Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may require the use of foreign exchange operations to maintain the targeted exchange rate within the prescribed limits, such as fixed exchange rate regimes. As seen above, there is an intimate relation between exchange rate policy (and hence reserves accumulation) and monetary policy. Foreign exchange operations can be?sterilized?(have their effect on the money supply negated via other financial transactions) or unsterilized.Non-sterilization will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect?inflation?and monetary policy. For example, to maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase foreign currency, which will increase the sum of foreign reserves. Since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation. Also, some central banks may let the exchange rate appreciate to control inflation, usually by the channel of cheapening?tradable?goods.Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a?currency crisis?or?devaluation?could be the end result. For a currency in very high and rising demand, foreign exchange reserves can theoretically be continuously accumulated, if the intervention is sterilized through?open market operations?to prevent inflation from rising. On the other hand, this is costly, since the sterilization is usually done by?public debt?instruments (in some countries Central Banks are not allowed to emit debt by themselves). In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and?productivity, imports and exports, relative prices of goods and services, etc.) will affect the eventual outcome. Besides that, the hypothesis that the world economy operates under perfect capital mobility is clearly flawed.As a consequence, even those central banks that strictly limit foreign exchange interventions often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements (that may include?speculative attacks). Thus, intervention does not mean that they are defending a specific exchange rate level. Hence, the higher the reserves, the higher is the capacity of the central bank to smooth the?volatility?of the Balance of Payments and assure?consumption smoothing?in the long term.Foreign Exchange Reserves HYPERLINK "" ?SHAREDEFINITION of 'Foreign Exchange Reserves'Foreign exchange reserves are reserve assets held by a central bank in foreign currencies, used to back liabilities on their own issued currency as well as to influence monetary policy.BREAKING DOWN 'Foreign Exchange Reserves'Generally speaking, foreign exchange reserves consist of any foreign currency held by a centralized monetary authority, like the U.S.?Federal Reserve. Foreign exchange reserves include foreign banknotes, bank deposits, bonds, treasury bills and other government securities. Colloquially, the term can also encompass gold reserves or?IMF?funds. Foreign reserve assets serve a variety of purposes, but are primarily used to give the central government flexibility and resilience; should one or more currencies crash or become rapidly devalued, the central banking apparatus has holdings in other currencies to help them withstand such markets shocks.Almost all countries in the world, regardless of the size of their economy, hold significant foreign exchange reserves. More than half of all foreign exchange reserves in the world are held in U.S. dollars, the most traded global currency. The British pound sterling (GBP), the Eurozone's?euro (EUR), the Chinese yuan (CNY) and the Japanese yen (JPY) are also common foreign exchange currencies. Many theorists believe that it's best to hold foreign exchange reserves in currencies not immediately connected to one's own, to further distance it from potential shocks; this has, however, become more difficult as currencies have become more interconnected. Currently, China holds the world's largest foreign exchange reserves, with more than 3.5 trillion of assets held in foreign currencies (mostly the dollar).Foreign exchange reserves are traditionally used to back a nation's domestic currency. Currency – in the form of a coin or a?banknote?– is itself worthless, merely an IOU from the issuing state with the assurance that the value of the currency will be upheld. Foreign exchange reserves are alternate forms of money to back that assurance. In this respect, security and?liquidity?are paramount for a useful reserve investment.?However, foreign reserves are now more commonly used as a tool of?monetary policy, especially for those countries who wish to pursue a fixed exchange rate. Retaining the option to push reserves from another currency into the market can give a central lending institution the ability to exert some control over exchange rates. It is theoretically possible for a currency to be completely "floating," that is, completely open and subject to exchange rates. In this situation, it would be possible for a nation to hold no foreign exchange reserves. However, this is very rare in practice. Since the breakdown of the Bretton Woods system in 1971, countries have accumulated greater stores of foreign reserves, in part to control exchange rates. (See also:?How Foreign Exchange Affects Mergers and Acquisitions Deals).Theorists differ as to how much of a nation's assets should be held in foreign reserves, and different nations hold reserves for different reasons. For example, China's vast foreign exchange stores are used to maintain considerable control over?exchange rates?for the yuan, and thus to promote favorable international trade deals for the Chinese government. But they also hold reserves (mostly in dollars) because it makes international trade, which is done almost exclusively in U.S. dollars, considerably simpler. Other countries, like Saudi Arabia, may hold vast foreign reserves if their economy is largely dependent on a single resource (in their case, oil). Should the price of oil drop rapidly, liquid foreign exchange reserves afford their economy much more flexibility, at least temporarily.Reserves are considered assets in a?capital account, but it is important to remember the liabilities associated with foreign reserves. They are either borrowed, swapped with domestic currency on the international exchange market, or purchased outright with domestic currency - all of which incurs a debt. Exchange reserves are also as risky as any other investment; should a currency collapse, all foreign exchange reserves held in that currency around the world will become worthless.For many years, gold served as the primary currency reserve for most countries. Gold was long considered the ideal reserve asset, often appreciating in value even during times of financial crisis, and believed to retain an almost-permanent value. However, all assets are only worth as much as buyers are willing to pay for them, and since the breakdown of the?Bretton?Woods system in 1971, gold has steadily declined in value. (See also:?The Bretton Woods System: How it Changed the World).The Bretton Woods system, devised in 1944 at a?conference in Bretton?Woods, New Hampshire, called on all accordant countries to agree to a system of international monetary policy that would promote free trade. At the time, the United States was emerging as the world's superior military power and furthermore, held more than half of international gold reserves. The system thus pegged international currency to both the U.S. dollar and to gold reserves. However, in 1971, President Richard Nixon ceased the direct conversion of the U.S. dollar to gold, which all but ended the usefulness of gold as an international reserve currency. From this point on, U.S. dollars became by far the most-held foreign reserve currency in international markets.?Trading CenterNEXT?UPForeign Exchange Reserves?Monetary Reserve?Reserve Assets?China's State Administration Of ...?Currency Substitution?Key Currency?Reserve Ratio?Free Reserves?Working Reserves?Translation RiskMonetary Reserve HYPERLINK "" ?SHAREA nation's assets held in a foreign currency and/or commodities like gold and silver. Monetary reserves are used to back up the national currency and to provide a cushion for executing central banking functions like adding to the money supply and settling foreign exchange contracts in local currencies.BREAKING DOWN 'Monetary Reserve'When the United States was using the Bretton Woods inspired monetary system, only gold was used as a monetary reserve, a structural problem that most saw as a roadblock to future economic growth. The U.S. dollar is now a fiat currency (not pegged to gold reserves), and even though the Federal Reserve Banks keep a large amount of reserves, most of what is held today is used for settling short-term currency contracts and for liquidity activities for the domestic economy.Reserve Assets HYPERLINK "" ?SHARECurrency, commodities or other financial capital held by monetary authorities, such as central banks, to finance trade imbalances, check the impact of?foreign exchange?fluctuations and address other issues under the purview of the central bank. Reserve?assets?should be liquid and under the monetary authority's control.BREAKING DOWN 'Reserve Assets'Before the Bretton?Woods agreement ended in 1971, most central banks used gold as their reserve assets. Today, central banks may still hold gold in reserve, but this has been supplanted by reserves of foreign currencies. Currencies held by central banks have to be readily convertible, meaning that the?currency?should have high enough stable demand (and low controls) to allow the bank to use them. ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download