GSU 07208

PRINCIPLES OF ECONOMICS
Money, Financial Institutions, and Inflation

Course Instructor
Liberati John Msoma
liberati.msoma@tia.ac.tz
 Money, Financial Institutions, and Inflation
What is money?
Money is anything generally acceptable by society as a
medium of exchange and means of settling debts.
Evolution of Money
Money started a long time ago from time immemorial. Before
the discovery of money people were used to exchanging
commodities for commodities in a trade known as Barter trade.
However barter trade had the following problems

Lack of Double Coincidence of Wants

• The double coincidence of wants must be fulfilled in order
for the exchange to take place. For example, if there is a
farmer who has wheat but wants salt he/she must find a
person who has salt but want wheat if he fails to find such a
person who wants wheat but has salt then barter trade could
not take place.
However barter trade had the following problems

Lack of Measure of Value

• It was very difficult to decide how much quantity of one
commodity should be exchanged for another commodity. For
example, it was very difficult to decide how much quantity of
maize must be exchanged with a cow.
Lack of Store of Value
• Under the barter system it was difficult to store perishable
goods like vegetables for exchange with other commodities
in the future.
However barter trade had the following problems

Indivisibility of Some Items

• It was not possible to divide some commodities into smaller
units to exchange with units of other commodities. For
example, if a person has certain units of cloth and wanted to
exchange with some units of beef, the exchange was very
difficult because a cow could not be divided into smaller
units in case the value of the units of cloth was not equal to
the value of the whole cow.
However barter trade had the following problems

Difficult Transporting Some Commodities

• Due to the lack of modern means of transportation and the
immobility of some items, it was difficult to transport some
items from one place to another for exchange.
The development or evolution of money can be summarized as follows:

(i) From barter trade to commodity money

(ii) From commodity money to metallic money
(iii) From metallic money to coinage money
(iv) From coinage money to paper money
(v) From paper money to credit money
How Has Money Solved the Problem of Barter Exchange?

(i) By using money, there is no need for a double coincidence

of wants. For example, if a person has wheat and wants cloth
he/she does not need to find a person who has cloth but wants
wheat instead he can sell wheat and use the money generated
to buy the cloth.
(ii) Also, people can store their assets in the form of money. In
this case, even perishable goods can be stored for a long time
in the form of money.
How Has Money Solved the Problem of Barter Exchange?

(iii) The fact that money can be broken into smaller units has
also solved the problem of the indivisibility of commodities
(iv) Money is easy to carry; hence it can be used to transfer
immovable commodities and do transactions.
Qualities of Good Money

(i) Acceptability; For money to be used, as a medium of

exchange, it must be acceptable in the society in which it is
used as a medium of exchange.
(ii) Portability; Good money must have a reasonable size and
weight so that one can move with it from one place to another
to do various transactions.
Qualities of Good Money

(iii) Divisibility; Good money must be divisible into smaller

units or values to facilitate buying and selling of goods of all
types and with different values.
(iv) Durability; The material used to make money must last
long to avoid easy wear and tear of the money.
Qualities of Good Money

(v) Scarcity; Money must be relatively scarce so that it can

command value and act as a store of value, the volume of
money must be in proportion to the volume of goods and
services that are produced in a country. For that matter, the
supply of money must be equal to the demand for money, but
it must not be too scarce because if it is too scarce people may
resort to other means of payment.
Qualities of Good Money

(vi) Difficult to Counterfeit; Good money must be difficult to

make a fake copy by fraudulent people so as to prevent an
illegal increase in the money supply, which causes harmful
effects on the economy.
(vii) Stability in Value; The value of money must not fluctuate
so often to prevent people from losing confidence in the
currency. If the value of money declines so often, people will
lose confidence in the currency. In this case, money will lose
its credibility as a medium of exchange.
Qualities of Good Money

(viii) Homogeneity; Different coins and notes must have the

same content of materials used to produce them; there should
not be differences in the nature of the materials of one coin or
note to the materials of other coins or notes. This is important
in controlling the problem of counterfeiting.
Functions of Money

(i) Medium of Exchange; Money facilitates the exchange of

goods and services. People use money to exchange goods and
services since money has eliminated the problem of barter
trade. For money to be used as a medium of exchange, it must
be acceptable in the society in which it is used as a medium of
exchange.
(ii) Money is a measure of value; Money is used to measure
the value of goods and services. Prices of goods which are the
indicators of the values of goods are expressed in terms of
money. For example, if the price of a car is TSh. 40 million
then this amount represents the value of the car.
Functions of Money

(iii) Money is a Store of Value; Money is used to store the

values of goods and services for future use especially when
people can convert goods and services into money with the
aim of using the money for future transactions.
(iv) Money is used as a Standard of Differed Payments; Money
is used to make future transactions in this case money
facilitates credit transactions whereby people can borrow and
pay in the future in installments.
Functions of Money

(v) Money is used to Transfer Items; Money is used to transfer

assets from one area to another area especially immovable like
buildings and land whereby a person owning such asset in one
area can dispose of the asset and use the money to buy the
same kind of asset in another area.
Demand for Money

Demand for money is the desire and ability to hold money in

cash balances rather than in financial assets like bonds.
According to Keynes, there are three motives for the demand
for money:
(i) Transactional motive; In this motive, people hold money in
order to use it to buy their day-to-day requirements of goods
and services.
Demand for Money

(ii) Precautionary Motive

Under these motives, people demand money to meet unforeseen events
such as illness.
The demand for Transactional motive and precautionary motive is a
function of income and price Md = f (income, price). This means that
demand for money depends on the level of income and price when the
income of the people increases their demand for goods and services also
increases leading to an increase in the demand for money. Also when the
price of goods increases people demand more money to be able to buy
the goods. But when income and price decrease demand for money also
decrease.
Demand for Money

(iii) Speculative Motive

This is the demand to hold money for further increase in
income; this is a demand to hold money in terms of bonds and
other assets which bear interest. The demand for money for
speculative motives is inversely related to the rate of interest.
When the rate of interest is high demand for money for
speculative motives will be low and if the rate of interest is
low demand for money will be high.
Relationship between interest rate and money
demand
Money Supply

This is the amount of money (currency) in circulation and

banks. It includes the total number of coins and notes which
are in the economy. Money supply has three definitions.
1. The narrow definition of money Supply (M1)
M0 = Currency in circulation + Demand deposit
2. Broad definition of money supply (M1)
M1 = Currency in circulation + Demand deposit +Time
Deposit
M2 = M1 +Time deposit
Money Supply

3. The extension (Broader) definition

M3 = M2 + foreign exchange.
Classification of money
• MO= Currency held by the public (excludes that held by
Banks for reserves) ===(Money in circulations)
• M1= M0+(Checkable/demand Deposits also travelers checks)
• M2=M1+Near monies (savings, money market deposits,
small time deposits, money market mutual funds)
Increase in Money Supply

• According to Keynes, if the economy is below full

employment i.e there are idle resources, when the money
supply is increased then aggregate demand will also increase.
This will affect the economy as follows:
• Production will be stimulated, leading to a rise in
employment and income.
• However, if the economy is at full employment, which means
there are no idle resources,
Decrease in Money Supply

• If the money supply decreases assuming the economy is

below full employment, it will cause a decrease in aggregate
demand, which will result in a fall in production, price,
employment, and income. On the other hand, if there is
inflation the decrease in money supply will cause a decrease
in purchasing power hence helping to control inflation.
Inflation

Is a persistent increase in the general price level.

Inflation rate
Is a rate at which price increase is expressed in terms of
percentage.

Inflation rate = 100

For example if the current year price for commodity X is TSh
200 and the Base year price is TSh 100. required inflation rate.
FINANCIAL INSTITUTIONS
• Financial institutions are the institutions that involve
themselves with financial transactions such as mobilizing
savings, provision of credits, accepting deposits, and
providing advice to traders and the government.
• Types of Financial Institutions
• There are two types of financial institutions, namely;
• (i) Banks
• (ii) Non-banks
(i) Banks
• These are financial institutions that perform the following
functions:
• Mobilizing funds from the public and opening different types
of accounts like savings accounts, fixed deposits, and current
accounts
• Other functions include, advancing loans; providing various
commercial services to the public, e.g. settling debts through
cheques, keeping valuable items, transferring funds from one
area to another, or from one person to another, through
travelers’ cheques and telegraph transfers.
(ii) Non-Banks
• These are institutions that do not perform banking functions such as
opening accounts to customers or provision of commercial services,
but they provide specific services to the customers or members, such
as insurance and pensions. Non-banks do not mobilize savings like
banks. They obtain funds from the members through contractual
savings, and these savings are normally voluntary, they are
compulsory. For example, all employees in Tanzania have a legal
obligation to submit a certain amount of money each month from their
salaries as a contribution to their pensions to either the National Social
Security Fund (NSSF) or the Parastatal Pension Fund (PPF)
Differences between Banks and Non-Banks
• Non-banks do not operate accounts for their customers'
savings, while banks open different types of accounts such as
savings, current and fixed deposits for their customers.
• Banks make profits through the loans advanced to their
customers, while non-banks depend on revenues that they
obtain through investments such as buildings, dividends on
shares bought, etc.
• Banks, especially commercial banks are established mainly
to make a profit, while non-banks are established mainly to
provide social security to their clients.
Differences between Banks and Non-Banks
• Mobilization of savings by non-banks is made contractual
and compulsory, while banks use persuasion/influence to
induce the public to save money.
• Commercial banks operate bank accounts with the central
bank, which is the banker's bank, whereas non-banks
intermediaries do not have such a facility.
• Some deposits of customers in commercial banks, such as in
current accounts, do not get interest, whereas all deposits in the
non-banks bear interest.
Types of banks
(a) Central Bank; This is the government’s bank which is
established to assist the state to control its money. It also gives
financial advice to the government and acts as a banker for the
commercial banks.
(b) Commercial Banks; These offer a wide variety of banking
services and are usually owned by shareholders.
(c) Savings Bank; This is mainly intended to provide a safe
place for keeping small deposits and paying interest on them,
e.g. Post Office Savings Bank.
Types of banks
(d) Specialized Banks; These are banks that serve a special
type of customer or aim at providing special types of services
or functions to the general public e.g. Development Banks.
(e) Co-operative Banks; These are Banks that are established
to mobilize funds within a cooperative movement. The banks
help co-operatives to finance their activities.
(f) Merchant Banks; These are banks that specialize in
accepting and discounting bills of exchange, and assisting
traders in international trade.
Central bank
• The Central Bank is the government’s institution established
to control, guide and assist other banks in the country, and
also to provide banking services and financial advice to the
government.
(a) Banking Functions

• Under banking functions, the B.O.T has the following functions:

• Fiduciary issue/currency issue; The Central Bank has the role of
printing notes and minting coins and issuing them into the
economy.
• It is the Bankers Bank; The Central Bank is the custodian reserve
of other Banks. All banks and non-banks are supposed to keep a
certain specific amount of their capital as reserves in the Central
Bank, and it is the responsibility of the Central Bank to keep, the
reserves safely.
(a) Banking Functions
• It is the Banker of the government; The Central Bank keeps
the government’s money. It is also the major advisor to the
formulation and implementation of monetary and fiscal
policies of the country, the Central Bank can sometimes
advance loans to the government in case it faces a budget
deficit.
• It is a lender of last resort; If commercial banks are short of
money and cannot get them from any source, then it is the
responsibility of the Central Bank to advance loans to the
commercial banks
(a) Banking Functions
• It is the central clearing house for commercial banks; If any dispute
concerning the settlement of debts arises between two banks, then it is
the responsibility of the Central Bank to settle this dispute.
(b) Domestic Monetary Management
Functions
• Under this function, the Central Bank has the following functions:
• Financing the government budget deficit; In case the government faces
a budget Deficit, the Central Bank finances the deficit by providing
loans to the government.
• Management of the government debts; The Central Bank manages the
government debts both local and foreign debts, by keeping the amount
and paying on behalf of the government.
• It is a financial adviser; The Central Bank gives advice to the
government on all monetary issues, such as money supply, inflation,
public debts, taxation, expenditure, etc.
(c) External Monetary Management
Functions
• Under this function, the Central Bank has the following functions:
• Management of the country's foreign exchange reserves; Under
this function, the Central Bank controls all the foreign currencies
which are received through exports and which are paid through
imports and other payments.
• Control exchange rate and importation of goods; The Central
Bank is responsible for determining the value of the domestic
currency in relation to foreign currencies. It also controls the
importation of goods and services from abroad.
(c) External Monetary Management
Functions
• Export promotion; The Central Bank helps in promoting the
export sector so as to increase the government’s foreign
exchange.
• Participation in discussions with international financial
institutions; The Central Bank on behalf of the government,
participates in discussions with International Financial Institutions
and the World Bank on the stability of its currency, payments of
debts, and other financial assistance.
(d) Development Functions
• Under this function, the Central Bank has the following
functions:
• It provides medium and long-term loans to commercial
banks.
• It supervises commercial banks and non-banks.
• It is involved with the formulation and implementation of
monetary and fiscal policies of the country.
How does the Central Bank control Money
Supply in the country?
• Open market operation; This is buying and selling of
government securities. During inflation, the Central Bank
sells securities to the public. By doing so, money is
reduced/withdrawn from the public. When this happens, the
prices of goods and services will fall because the public has
less money to buy goods and services. During deflation, the
Central Bank buys securities in order to increase the money
supply. An increase in the money supply stimulates
investment, employment, and income.
How does the Central Bank control Money Supply
in the country?
• Bank rate; This is the rate at which the Central Bank charges
commercial banks when they borrow money from the Central
Bank. During inflation, the Central Bank increases the bank rates
in order to discourage commercial banks from borrowing money.
In response, commercial banks increase interest rates (the rate
which is charged to borrowers of money from commercial banks)
in order to discourage borrowing. When this happens, the money
in circulation decreases. In this case, inflation may be controlled.
During deflation, the Central Banks reduce the bank rates and
instruct commercial banks to reduce their interest rates.
How does the Central Bank control Money
Supply in the country?
• Control of credits; In order to control the money in
circulation, the Central Bank instructs commercial banks to
reduce the amount of credits (loans). So, in this case, the
amount of money in circulation declines, consequently a fall
in price and control of inflation. During deflation,
commercial banks are encouraged to give more credit.
How does the Central Bank control Money
Supply in the country?
• Reserves requirements; The reserve requirement is the minimum
balance that commercial banks are required to maintain as
reserves, it means they are not allowed to give more than the
reserve requirements. During inflation, the Central Bank instructs
commercial banks to increase the reserve requirement. By doing
so, the ability of commercial banks to provide credit is lowered;
therefore the amount of money in circulation is reduced, leading
to a fall in price and inflation. During deflation commercial banks
are required to reduce reserve requirements in order to give more
credit.
How does the Central Bank control Money
Supply in the country?
• Special deposits; These are special accounts that are opened
by commercial banks at the Central Bank. During inflation,
the Central Bank instructs commercial banks to make special
deposits at the Central Bank apart from the usual deposits
that they make. The aim is to reduce the ability of
commercial banks to provide credit. In this way, the Central
Bank is able to control the amount of money that commercial
banks can provide as credit.
How does the Central Bank control Money
Supply in the country?
• Special credits; In this method, the Central Bank instructs
commercial banks to provide credits to special projects such as
Agricultural projects and industrial projects only. The aim is to
boost and control the number of credits. During inflation, the
Central Bank instructs commercial banks to provide credits to
productive sectors of the economy in order to increase
production.
• Moral suasion; In this instrument, the Central Bank persuades
or advises the commercial banks to reduce the number of
credits during inflation
Contribution of the Bank of Tanzania to
economic development
• It provides financial facilities to commercial banks in terms
of loans, which are used by commercial banks to provide
loans to investors. In this case, the Central Bank is involved
with the promotion of investment in the country.
• It is involved with controlling imports and therefore it helps
to create a favorable balance of payment.
• It provides financial assistance to the government during
budget deficits and, thus enables the government to meet its
expected expenditures.
Contribution of the Bank of Tanzania to
economic development
• The Central Bank is helpful in the stabilization of the
economy. In this process, the Central Bank is engaged in the
stabilization of the economy by controlling the money supply
by using monetary policy instruments. For example, open
market operation, bank rates, control of credits, etc.
• The Central Bank provides employment to Tanzanians. A
good number of Tanzanians are employed either directly or
indirectly by the Central Bank.
COMMERCIAL BANKS
• These are profit-making financial institutions that lend
money at higher interest rates than it pays on deposits. They
are formed as joint stock companies for the purpose of
operating businesses with the aim of making a profit from the
services that they render to the public. Examples of
commercial banks in Tanzania are; the National Bank of
Commerce (NBC), CRDB, Barclays Bank, Standard
Chartered Bank, and Stanbic Bank.
Functions of Commercial Banks
• They accept money and deposits from customers
• They safeguard money, deposits, and valuable documents
kept with them.
• They advance loans and overdrafts for their customers.
• They provide cheque facilities that make payments easy, i.e.
travelers’ cheques.
• Commercial banks also create credits through the excess
funds kept with them.
Functions of Commercial Banks
• Provide night-strong room safes in which money can be
deposited after working hours.
• Provide employment opportunities to the general public.
• Offer trustee services to their customers.
• They pay customers money on demand through different
accounts offered, i.e. savings, Current, and Fixed deposit
accounts.
• They give financial advice to their customers.
Functions of Commercial Banks

• They assist the Central Bank to implement monetary policies

and also in replacing old currency.
• They act as clearing houses when they accept cheques from
their customers which are not drawn on them but from other
banks.
• They facilitate international trade by discounting bills of
exchange and money transfer services on behalf of their
customers. They also issue bank drafts, traveling cheques,
and letters of credit.
Problems facing commercial banks in East
Africa
• The existence of large subsistence sectors in which most
people are illiterate and production is basically for
subsistence.
• There is low savings from the people, which is a result of
low-income levels due to poverty.
• Some customers of commercial banks are untrustworthy and
lack collateral security to secure loans.
Problems facing commercial banks in East
Africa
• Most banks are concentrated in urban areas, and they are not
widely spread in rural areas; hence it is a problem to mobilize
savings.
• The banks have been mismanaged, through corruption and
embezzlements.
• Commercial banks charge high-interest rates on loans, hence
discouraging many prospective borrowers.
• They lack enough skilled manpower since there is inadequate
staff training.
Problems facing commercial banks in East
Africa
• They are faced with stiff competition from other commercial
banks, which has led to some commercial banks being
closed.
• There is government interference in the running of
commercial banks.
• There are faced with problems of poor transport and
communication in rural areas.
Types of Inflation

• Inflation can be categorized into two

1. According to the rate of inflation
2. According to the causes
According to the Rate of Inflation

• In this category there are four types of inflation

(i) Creeping inflation; This is the type of inflation that occurs
when the price rises by 2% to 3%. This type of inflation is not
harmful to the economy since it can stimulate investments.

(ii) Moderate inflation; This type of inflation occurs when the

price changes by 4% to 5%. This type is also not harmful to
the economy.
According to the Rate of Inflation

(iii) Rapid inflation; This happens when the price rises at a rate
of 6% per annum. This type is harmful to the economy.

(iv) Hyperinflation; This is a type of inflation that occurs when

the price rises daily such that people lose confidence in their
currency. In this case, a new currency must be introduced. This
kind of inflation occurred in countries such as German,
Austria, and Hungary, during world war two.
According to the causes
1.Cost Push Inflation
This type of inflation is caused by the increase in the cost of
production which is resulting from workers demanding more
wages. When workers demand more wages, it results in an
increase in the cost of production. In order to cover the costs of
production, firms may raise the prices of goods.
Cost Push Inflation

• When prices increase, workers will demand more wages, this

will again increase the cost of production and force firms to
raise prices of the goods and workers to demand for more
wages. At last cost-push inflation will occur. Cost-push
inflation is also known as wage spiral inflation.
Cost-push inflation
(ii) Demand Pull Inflation:
This is a type of inflation, that is caused by excessive
aggregate demand. That is, when aggregate demand is greater
than aggregate supply, it leads to a rise in price which results
in inflation.
DEMAND PULL INFLATION
OTHER TYPES OF INFLATION
(iii) Structural or Demand Shift Inflation; This is a type of
inflation that combines some elements of cost-push inflation
and demand-push inflation it occurs when there are changes in
the structure of demand and structural rigidities in the
economy.
OTHER TYPES OF INFLATION
(iv) Imported Inflation; This is a type of inflation, that occurs
due to the importation of commodities from a country that is
affected by inflation. Increases in the prices of imported fuels,
materials, and components increase domestic costs of
production and lead to increases in the prices of domestically
produced goods. Imported inflation may be set off by foreign
price increases, or by depreciation of a country's exchange
rate.
OTHER TYPES OF INFLATION
(v) Expectation Inflation; This is a type of inflation that
transpires when buyers expect the price to rise further and
make panic purchases by buying more at a high price. This
action of the buyers makes the sellers further increase the
price, consequently, inflation takes place.
OTHER TYPES OF INFLATION
(vi) Monetary Inflation; This is a type of inflation, that results
due to monetary reasons either due to an excessive increase in
money supply or money demand for transactionary motive.
That is:-
- When the money supply increases it results in an increase in
the purchasing power of the people but if the supply is less,
elastic prices of goods will rise.
- When the demand for money for transactionary motive
increases it pulls up prices of goods and services.
Causes of Inflation

(i) Excessive Demand for Goods and Services; When demand

for goods increases while supply remains constant it
underscores (causes) a rise in price and if the rise is persistent
it results in inflation.
(ii) Shortage of Goods and Services; If the supply of goods
decreases while demand is constant it results in demand-pull
inflation.
Causes of Inflation

(iii) Increase in the Cost of Production; If the cost of

production increases producers are forced to raise prices to be
able to cover the increased cost of production hence cost-push
inflation.
(iv) Increase in Government Spending; If the government
deficit is financed by printing money it causes excessive
money supply and leads to monetary inflation.
Causes of Inflation

(v) Increase in Indirect Tax; Indirect taxes such as value-added

tax have a direct impact on the prices of goods, when the
government increases indirect tax the prices of goods also
increase by the amount of tax which may also lead to inflation.
(vi) Illegal Activities; Illegal activities such as smuggling
cause an artificial shortage of goods and therefore rise in the
prices of goods consequently inflation occurs.
Causes of Inflation

(vii) Calamities e.g. Earthquakes, War, Drought; Flood, etc.

When these calamities occur production is discouraged
resulting in a shortage of goods and services hence a rise in the
prices of goods and services.
Effects of Inflation (Costs and Benefits)
A. Benefits (Positive Effects of Inflation)
1. If inflation is moderate, it can stimulate production because producers
are encouraged to produce more because of the high prices of goods.
2. Moderate inflation stimulates the employment of resources because
when inflation is moderate producers increase production. In this case,
they employ more resources.
3. Due to an increase in employment income also increases. Examples
of such incomes which increase when production is increased are
salaries, wages, rent, interest, profit, etc.
Effects of Inflation (Costs and Benefits)
B. Cost of Inflation/ Negative Effects
When the inflation rate is greater than 6%, it can cause the following
negative effects:
1. It discourages savings because people use a lot of money to buy
goods and services that are sold at high prices and little amount remains
as saving, Due to the decrease in savings, investments also decrease
because savings influence investment.
2. It can lead to balance of payment problems. Imports may be
expensive during inflation while exports decline because during
inflation exports become more expensive. Also, the cost of producing
export commodities increase while the price of export which are
sometimes fixed in the world market remains constant
Effects of Inflation (Costs and Benefits)

3. Peasants lose because prices of agricultural commodities tend to

lag behind inflation, and their savings, welfare, and productivity
fall.
4. Inflation results in rural-urban migration since it becomes less
profitable to grow cash crops in rural areas. People migrate to
towns to start businesses; this discourages agriculture in rural areas
and also leads to urban unemployment.
5. People with low income and those with fixed incomes like
pensioners suffer during inflation because they can not afford to
buy goods and services at an inflationary price.
Effects of Inflation (Costs and Benefits)

6. During inflation, the cost of production increases, and

therefore production is discouraged.
7. If it is hyperinflation people lose confidence in their
currency. If this happens money can not be accepted as a
medium of exchange.
8. Money seizes to be a store of value. During inflation, the
value of money declines, and money can not perform its
function as a store of value.
Measures of Controlling Inflation

Depending on the cause of inflation, inflation can be

controlled by the following measures:
(a) Monetary Measures
(b) Fiscal Measures
(c) Non-Monetary Measures
A. Monetary Measures

• These are measures of controlling inflation where by inflation

is controlled by controlling the money supply. These
measures are initiated by the Central Bank and implemented
by commercial Banks.
• Monetary measures involve the use of the following
tools/instruments.
A. Monetary Measures
(i)Open Market Operation; This is the market that involves
buying and selling securities, during inflation the central bank
sells securities to the public. By doing so money is reduced in
circulation which reduces the purchasing power of the people
and thus helps to control inflation.
A. Monetary Measures
(ii) Bank Rate; This is the rate that the central bank charges
commercial banks whenever commercial banks borrow money
from the central bank, during inflation the central bank
discourages commercial banks from borrowing money by
increasing the bank rate in response commercial banks also
increase the interest rate in order to discourage the public from
borrowing money, this results to a decrease in money supply
hence control of inflation.
A. Monetary Measures
(iii) Control of Credit; To control inflation the central bank
gives orders to the commercial banks to reduce the money
supply by reducing the volume of lending. When banks reduce
lending to the public, money in circulation is reduced and thus
the purchasing power of the people is checked hence inflation
is put under control.
A. Monetary Measures
(iv) Reserve Requirement; A reserve requirement is a
minimum balance that every commercial bank is required to
have to meet the daily demand for customers; commercial
banks are not required to give loans beyond the reserve
requirement. During inflation, the central bank instructs
commercial banks to increase reserve requirements to reduce
the lending power of commercial banks.
A. Monetary Measures

(v) Special Deposits; These are special accounts that are

opened by commercial banks at the central bank; during
inflation, the central bank instructs commercial banks to
increase special deposits to reduce the lending powers of
commercial banks.
(vi) Special Credits; This is a type of instrument where the
central bank instructs commercial banks to provide credits to
only special sectors or projects which may increase production
and therefore control inflation.
A. Monetary Measures

(vii) Moral Suasion; In this instrument, the central bank

persuades or advises commercial banks to reduce the number
of credits to control inflation.
B. Fiscal Measures

These are measures whereby the government controls inflation

by controlling revenue (taxation) and expenditure. The
following are the fiscal measures:-
(a) Reduction of indirect tax; During inflation, the government
reduces indirect tax ie tax on goods and services. By doing so
prices of these goods and services may decline, leading to a
fall in the inflation rate.
(b) Increasing direct tax; During inflation, the government
increases direct tax i.e. income tax. By doing so income of the
people declines as well as their purchasing power, when the
purchasing power is reduced inflation rate declines.
B. Fiscal Measures

(c) Reducing Government Expenditure (development and

recurrent expenditure)
During inflation, the government reduces its expenditure on
things such as wages, education, health, defense, and security,
leading to a fall in the purchasing power and therefore
decreases in the price of goods.
Non- Monetary Measures

(a) Wage Control;

During inflation, the government controls excessive rises in
wages so as to reduce the purchasing power of people, when
the purchasing power decline price falls.
Non- Monetary Measures

(b) Promotion of Production;

During inflation, the government takes various measures in
order to increase production in various sectors. Such a measure
is the provision of credits and subsidies to the productive
sectors of the economy like agriculture and industry. Also, the
government can improve infrastructures such as electricity,
road, and water supply in order to promote production. When
production is increased, prices fall and then inflation is put
under control.
Non- Monetary Measures

(c) Price Control

During inflation, the government can control the rise of prices
by fixing the maximum price for various essential
commodities.
Deflation

This is the continuous (persistent) decrease in the price level

Causes of Deflation
(i) Excessive Supply; When the supply of goods exceeds the
demand for the goods it causes a decrease in prices.
(ii) Decrease in Effective Demand; When the effective demand
of the people declines it results in a fall in the price level.
(iii) Decrease in the Money Supply; A decrease in the money
supply affects the purchasing power of the people and leads to
a fall in the price level.
Deflation

(iv) Fall in Incomes; When incomes of the people such as

wages and profit decline it restrains the purchasing power of
the people leading to a fall in prices.
(v) Decrease in Government Expenditure; If the government’s
spending on expenditures such as wages, security, and
education is reduced it affects the incomes of the people and
their purchasing power consequently a fall in the prices of
goods and services.
Deflation

(vi) Increase in Tax; If the government increases tax on the

income it reduces the disposable incomes i.e. income that
remains after the deductions have been made from the income
of the income earners. This affects people the purchasing
power and results in a fall in the prices of goods.