Economics-1

BALLB-207

Unit 4:
Money and Inflation

Ms. Lavi Vats

 What is Money?
• Money is anything that acts as a means of payment, a store of value, and a unit of account.
• Before the advent of money, the barter system was practiced in which there was direct
exchange of goods and services in exchange for other goods and services.
• Barter system requires the double coincidence of wants i.e. you have to find someone who
has the good you want and wants the good you possess. In a society with few goods, it may
be feasible. But in contemporary societies, there is a wide range of goods and barter becomes
very difficult.
• Limitations of barter system:
– Lack of double coincidence of wants

– Lack of a common measure of value

– Indivisibility of commodities

– Difficulty of storage and transfer of wealth

– Difficulty of deferred payments

– Lack of specialization
Functions of money
 Commodity and fiat money
• Commodity money: When goods that have an intrinsic value themselves are used as money, it is called

commodity money. E.g. cigarettes, gold.

• Fiat or token money: Money that is intrinsically worthless. E.g. Coins and notes.

• In earlier times fiat money was backed by gold or silver (convertible paper money), but these days it is

backed by government approval (inconvertible paper money).

• Credit/bank money: Most popular money that came into existence after the introduction of banking

system.

• When the government is unable to raise money elsewhere for public expenditure, it may do so by printing

more money such that money loses its value. This is called currency debasement/deficit financing. Most

governments have to assure people that it will not print so much money
 Qualities of good money
• General acceptability

• Portability

• Cognisability (Distinguished material e.g. milled edges of coins and

watermarks on notes)

• Durability

• Divisibility and homogeneity

• Stability of value
 Defects of money

• Makes people materialistic and vicious towards each other.

• Excess supply of money may cause volatility in business cycles, acting as hindrance

to development (Schumpeter).

• Money is responsible for creating and accumulating inequalities in the distribution

of income and wealth.

• In reality, however, money by itself has been a boon to society, rather it is the way

humans are attached to it that has created a problem.

 Impact of money
• In Developing or a Mixed capitalist economy:
– Money facilitates all economic activities of consumption, production, exchange,
distribution and public finance.
– It enables capital accumulation through savings made available for borrowing
– It helps people make consumption and production choices, and allows them to pay taxes
to government.
– Removes trade barriers at national and international level.
– It helps government to manage its revenue and expenditure
– Important tool for income and wealth distribution

– Determination of prices of goods and services through price mechanism.

• In a Socialist economy: Even in a socialist economy money is important for industrial
development, growth, and equitable allocation of resources. Money is also required for
payments to the factors of production. However, the role of money is less since all economic
activities are controlled by the State.
 What is inflation?
• Inflation is defined as a state in which the quantity of money in circulation expands faster than the
consequent growth in output causing a continuous price rise.
• According to classical economists, inflation is mainly due to increase in the quantity of money, given the
full employment level.
• However, the great depression of 1930s proved otherwise, and inflation was defined as a situation where
the money income expands more than in proportion to income earning activity (Pigou).
• Keynes related inflation to full employment, and said that inflation refers to a rise in the price level after
full employment level has been reached. At this stage, even though the price is increasing, the output will
not increase in the economy.
• However, Keynes distinguished this to the rise in price that occurs when the output is below full
employment. Below full employment, there are underutilized resources and unemployment, and an
increase in output in such a situation increases prices due to higher income and purchasing power. This rise
in the price level is referred to as reflation or semi inflation or partial inflation.
• However, it is possible that in certain industries, shortage of capital, land, machinery, infrastructure or
technical know how cause the prices to rise even as the output is below the full employment level. Such a
situation is known as stagflation or slumpflation or inflationary recession.
• Although the term inflation may be interpreted differently by different economists, it is basically a general
rise in price level.
 Types of inflation

• On the basis of rate of inflation:

– Creeping inflation: A mild rise in prices (about 2-3% p.a.)

– Running inflation: If mild inflation is kept unchecked for long, the prices may start rising

faster (at 8 to 10% p.a.).

– Hyper inflation: This is the final state of inflation when prices start rising at an

extremely rapid rate, also refereed to as jumping or galloping inflation. It totally distorts

all economic activities and becomes hard to control. E.g. Zimbabwe, Venezuela
 Types of inflation

• On the basis of degree of control:

– Open inflation: It is an inflationary process in which prices are permitted to rise

without being suppressed by government, that eventually leads to hyperinflation.

– Suppressed inflation: In this type of inflation, the government may control the rise

in prices through rationing, price ceilings, monetary or fiscal policies. These types

of controls may cause problems of inefficiency and diversion of economic

resources.
 Types of inflation

• On the basis of causes:

– Credit inflation: Banks may extend loans or advances leading to increase in

money supply over and above the output, causing inflation.

– Currency inflation: It occurs when government issues too much money,

leading to excessive money supply

– Deficit induced inflation: Government finances its budget deficit by printing

too much money

 Types of inflation
• On the basis of causes:

– Demand pull inflation: It is the type of inflation that occurs due to an increase in demand for

goods and services even when the supply has reached its full employment level. Here, the

prices keep rising even though there is no increase in output. It may occur due to:

• An increase in illegal incomes

• An increase in money supply in the economy

• Excessive government expenditure on war or military

• Increasing foreign expenditure on domestic goods

 Types of inflation
• On the basis of causes:

– Cost Push Inflation: It occurs when the costs of production of the industry rise either due to an

increase in the price of raw materials, intermediate goods or increase in wages. The reasons

for this are:

• Higher wage rate

• Higher profit margins

• Higher taxes

• Availability and prices of basic inputs

• Other factors: Natural calamities, strikes or power break down

 Causes of inflation in India
• Demand side:
– Rise in money supply

– Rise in public expenditure

– Deficit financing

– Rise in population
• Supply side:
– Inadequate agricultural growth

– Slow industrial growth

– Rise in administered prices

– Taxation

– Rising import prices

 Impact of Inflation
• Effects on production and economic activities:

– Mild inflation raises profits of firms, encouraging them to

invest in production activities. This may lead to capital

formation, increased incomes, higher demand, and economic

growth.

–However, very high inflation will result in practices of hoarding

by producers and fall in real incomes of workers. These factors

will result in inefficiency and lower productivity.

 Impact of Inflation
• Effects on the distribution of income:

–Businessmen: As the prices rise due to inflation, the wages do not increase to the same extent, leading to

high profit margins for the producers. Large farmers also make profits. Businessmen may also gain a lot

through speculative activities.

–Debtors and Creditors: Debtors gain during inflation, while creditors lose due to decreasing real value of

the money borrowed/lent.

–Most investors and speculators benefit during inflation, as shareholders earn dividends and secure capital

gains. However, investors in fixed interest ventures suffer as the real income from them declines during

inflation.

–Fixed income earners suffer the most due to inflation, as their real earnings decline, and the wages do not

move as fast as the prices.

 Impact of Inflation
• Other effects:

–Creates uncertainty, discourages business risks

–Diversion of resources from essential to luxury goods

–Makes domestic goods less competitive in the international market

–Investment and FDI may increase

–Tax revenue of the government increases

 Effects of inflation in India
• Rise in Economic Inequalities: Inflation leads to concentration of wealth in the hands of few big businesses,

through malpractices of hoarding, speculation, and black marketing.

• Obstacle to development: Inflation diverts investment from long term projects to short term ones, and from

essential goods to non-essential goods.

• Changes in inter-Sectoral terms of trade: In the initial phase of planning, prices of agricultural goods increased

more than the price of non agricultural goods. So, terms of trade became favourable to agriculture against

industries. This benefitted the big farmers at the cost of the marginalised workers, and the farmers were exempted

from taxes as well. However, in the seventies, the terms of trade went against agriculture.

• Balance of payments position: As prices in India rose more compared to other countries, the value of our currency

depreciated, affecting the confidence of traders. Demand for our products declined in the foreign market, while

the demand for imports increased. This led to a fall in the balance of payments. It also led to a foreign exchange

shortage.
 Remedies for inflation
• Inflationary gap arises on account of extra expenditure by the

government. Since it is not advisable to stop government

expenditure, inflationary gap can be bridged by:

– Rise in the voluntary saving, to reduce demand

– To increase taxes

– Increasing imports to fulfill the excess demand

 Remedies for inflation
Monetary measures

• Bank credit forms a large part of the money supply, so controlling bank credit is

the main objective. The various methods used are:

– Bank rate: By raising bank rates, banks can make savings more attractive compared to

borrowing. This will reduce money supply and increase inflation.

– Open market operations: Central bank may increase or decrease money supply by

buying or selling government securities.

– Variable reserve requirements: By raising the cash reserve ratio, the central bank can

reduce the money supply by reducing the credit creation by banks.

– Selective control measures: Regulation of consumer credit by raising down payments,

reducing the payment period, and higher margin requirements.

 Remedies for inflation
Fiscal measures

• Public expenditure: Government can reduce the money supply in the economy by reducing

its expenditure, preferably non essential expenditure.

• Taxation: Raising the tax rates will reduce the purchasing power, and at the same time

provide resources to the government to control inflation. The government should focus on

increasing excise duties, and taxing luxury items.

• Public borrowing and debt: By increasing the borrowing from public, either voluntary or

forced, the government can reduce the aggregate demand, thereby controlling inflation. It

can do so by compulsory investment in schemes like provident funds, pension schemes etc.
 Remedies for inflation
• Other measures

– Price control and rationing: Setting an upper limit to prices and restricting the

amount of goods sold. However, this practice may be inefficient and reduce

overall welfare.

– Wage policy: Wages, salaries as well as profit margins etc. may be controlled

through the system of income freeze. Wage freeze policy is opposed by

workers and trade unions.

– Output Adjustment: Shifting factors of production from less inflation sensitive

goods to more inflation sensitive goods like food, clothing, and other essential

goods.
 Suggestive Control Measures in India
•Restrictive monetary policy should not deny legitimate credit requirement for productive

purposes.

•Higher taxes to be imposed on luxury consumption and production.

•Reducing fertility rates.

•Improvement in PDS

•Rise in income of any factor should be consistent with the rise in productivity.

•Raising the supplies of essential goods through imports.

•Export promotion should not be at the cost of domestic scarcity of goods.

•Licensing of wholesale dealers, and transfer from surplus to deficit areas.

 Deflation
• Deflation is reverse inflation, and may be defined as persistent and

substantial fall in the general price level below full employment level.

• Disinflation, on the other hand, is the process designed to reverse the

inflationary trend in prices without creating unemployment.

• Disinflation relieves the economy from the harmful effects of inflation,

while Deflation negatively affects incomes as well as employment.

• During deflation, money value is rising, but price level is falling.

 Causes of deflation
• Demand side: Money shortage, fall in disposable income, and

fall in business outlays leading to lower credit, consumption,

and investment expenditure.

• Supply side: Over investment may cause rapid increase in

production surpassing demand.

• Contraction in money supply due to anti inflationary

measures.
 Effects of deflation
• Effects on production and employment: Continuous fall in prices causes losses to

firms, and forces them to go out of business. This makes them leave capital idle, an

lay off workers. This creates a pessimistic business environment leading to high

unemployment and low growth.

• Effects on distribution: Producers, traders, real estate owners, merchants, equity

holders, and farmers lose due to lower prices. Accumulation of excess inventories

of goods also increases costs. Consumers, fixed income earners, and creditors get

immediate gains due to deflation.

 Control of deflation
• Deflationary gap refers to the amount by which aggregate expenditure falls short of

aggregate demand at full employment level. Following measures may be taken to control

inflation:

– Monetary measures: Money supply in the economy can be increased through a fall in

bank rate, purchase of government securities, and lowering cash reserve requirements.

– Fiscal measures: The government can cut taxes to increase purchasing power, and invest

in public works. Expenditure on public works also provides employment opportunities

and increases income through multiplier effects.

– Other measures: Price support programs (Minimum support price) may be supported by

the purchase of excess stocks by the government.

 Inflation versus deflation
• While inflation is the rise in prices without increase in employment, deflation is fall in prices with rising

unemployment.

• Inflation reduces the value of money and purchasing power.

– It distorts the distribution of income in favour of the rich, while impoverishing the rich.

– It also encourages business malpractices, corruption, and shortages.

• Deflation may benefit the consumers for a while, but leads to a contraction of output and employment.

• Hyperinflation can have very damaging effects on the economy, but deflation can completely stop

economic activities all together.

• While the government can use monetary and fiscal tools to combat high inflation, it is difficult to manage

deflation as the government will also run out of resources to pump liquidity into the economy.