Inflation, Monetary and fiscal policy of India

7/27/2019 Inflation, Monetary and fiscal policy of India

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Inflation and Monetary Policy



Inflation

Inflation is defined as a sustained increase in the pricelevel or a sustained fall in the value

of money.

Rate of inflation t = Pt –Pt-1 /pt-1 X100

Where, Pt is the price level in year t, Pt - 1 is the price levelin year t-1, the base year.

If there is a decline in the rate of inflation, such asituation is called DISINFLATION.



Types of Inflation

Open inflation and suppressed Inflation

When the government does not try to prevent a rise in prices, inflation is called asopen inflation. Thus, prices grow without any time-out.

Suppressed inflation occurs in a controlled economy where the upward pressure onprices is not allowed to influence the quoted or managed prices.

Inflation here reveals itself in other forms. For example, government may introducerationing of goods leading to long queues in front of ration shops.

There is very likely to be a black market for such good whose prices are far above the

quoted prices.

In India, suppressed inflation manifests itself in the prices of essential goods soldthrough PDS. The ration prices are deliberately maintained at a certain level whilethe open market prices are above this level.



Creeping Inflation, Galloping Inflation and Hyper Inflation

Recognized on the basis of severity of inflation, as measured in

terms of rate of rise in prices.

Creeping Inflation/ moderate inflation :There is moderate rise in

prices of 2-3 per cent per annum.

It is generally considered good for a growing economy.

Mildly rising prices result in faster growth of output

The profit margins of firms are raised which encourages them to

produce more.

Creeping inflation does not severely distort relative prices nor

does it destabilize price expectations.



Galloping inflation : Prices rise at double or treble digit rates perannum (20-100%).

It tends to distort relative prices .

Results in disquieting changes in distribution of purchasing power of different groups of income earners.

There is often a flight of capital from the country since people tend tosend their investment funds abroad and domestic investmentwithers away.

Hyper inflation or run-away inflation is of a severe type in which pricesrise a thousand

or a million or even a billion per cent per year.

It seriously cripples the economy.

Prices and money supply rise alarmingly.It is generally a result of war, political revolution or some other

catastrophic event.



Demand pull inflation

Such an inflation occurs when aggregatedemand rises more rapidly than the

economy's productive potential, pulling prices

up to equilibrate aggregate supply and

demand. It is characterized by a situation in

which there is "too much money chasing too

few goods".



Factors on demand side

On the demand side, the major inflationary

factors are:

• money supply

• disposable income and consumer

expenditures

•

Increase in business outlays• Increased foreign demand.



Cost push / Supply shock inflation

This inflation occurs due to an increase in the cost orsupply price of goods caused by increases in the

prices of inputs.

Rapidly rising money wages with no corresponding rise

in labour productivity in certain key sectors of the

economy result in higher prices in these same

sectors, particularly as demand rises. This leads to

further erosion of real wages forcing organized

labour, to seek a further rise in money wages. This is

what is commonly referred to as wage price spiral.



Cost push inflation occurs due to non-wage

factors also.

For instance, monopolistic or oligopolistic firms

often attempt to maintain their profit margins

steady by raising the prices of their products

in proportion to the rise in other cost

elements. Such a cost push inflation is

sometimes called "mark-up" inflation.



Causes of cost push inflation

• Wage-push Pressures

• Profit-Push and Mark-up Pricing

•

Import Prices• Exchange rates



Measurement of Inflation

• The GNP deflator

The GNP deflator measures the average level of the prices of all

goods and services that make up the GNP. It is the ratio of

nominal GNP in a given year to real GNP and it is a measure of

inflation from the period for which the base prices for

calculating the real GNP are taken to the current period.



The Consumer Price Index (CPI)

• It measures the cost of buying a fixed basket of

goods and services representative of the purchasesof urban consumers.

• The basket represents the actual consumption

pattern of a typical family from a specific group forwhich the CPI is being constructed.



Whole sale price index

• The items included in WPI include items likefertilizers, minerals, industrial raw materials

and semi-finished goods, machinery and

equipment, etc., apart from items in the foodgroup and in the fuel, light and power group.

• The WPI can be interpreted as an index of

prices paid by producers for their inputs.• Wholesale prices rather than retail prices are

used.



Deflation

• Deflation is a sustained general reduction in

the level of prices, or of the prices of an entire

kind of asset or commodity.

• There is a fall in how much the whole

economy is willing to buy, and the going price

for goods.

• Since this idles capacity, investment also falls,

leading to further reductions in aggregate

demand. This is the deflationary spiral.



• Deflation is generally regarded negatively, as it is a tax on

borrowers and on holders of illiquid assets, which accrues to

the benefit of savers and of holders of liquid assets andcurrency.

• Deflation also occurs when improvements in production

efficiency lowers the overall price of goods. Thoughimprovements in production efficiency are motivated by a

promise of increased profit margins, competition in the

market place often prompts reduction in prices. Consequently

deflation has occurred, since purchasing power has increased.



• Deflation raises real wages, which are both

difficult and costly for management to lower.

This frequently leads to layoffs and makes

employers reluctant to hire new workers,

increasing unemployment.

• In modern economies, deflation is caused by acollapse in demand (usually brought on by

high interest rates), and is associated with

recession and (more rarely) long-termeconomic depressions.



Monetary policy•

The policy concerned with changes in thesupply of money.

• The central bank (RBI in India), administers the

Monetary and Credit policy.• Traditionally announced twice a year, through

which the Reserve Bank of India seeks to

ensure price stability for the economy.

• RBI also announces norms for the banking and

financial sector and the institutions which are

governed by it.



Objectives

•High level of output (or national income)

• High rate of economic growth.

• High employment.

• Price stability (or optimal rate of inflation).

• Low inequality in the distribution of income

and wealth (equity objective).

• External stability or healthy balance of

payment position (stability of external value

of domestic currency).



INSTRUMENTS OF MONETARY POLICY(A) Quantitative Instruments

The Quantitative Instruments are designed to regulate or control

the total volume of bank credit in the economy. These tools

are indirect in nature .

(B) Qualitative Instruments or Selective Tools

These tools are used for discriminating between different uses

of credit. It can be discrimination favoring export over import

or essential over non-essential credit supply. This method can

have influence over the lender and borrower of the credit.



Quantitative Instruments

1. Bank Rate Policy (BRP)Influences the volume or the quantity of the credit in a

country. The bank rate refers to rate at which the

central bank (i.e RBI) rediscounts bills of commercial

banks or provides them advance against approvedsecurities. The Bank Rate affects the actual

availability and the cost of the credit. If the RBI

increases the bank rate, it deters banks from further

credit expansion as it becomes a more costly affair.

On the other hand, if the RBI reduces the bank rate,

borrowing for commercial banks will be easy and

cheaper. This will boost the credit creation.



.

2. Open Market Operation (OMO)

The open market operation refers to the purchase

and/or sale of short term and long term securities bythe RBI in the open market. The OMO is used to wipe

out shortage of money in the money market, to

influence the term and structure of the interest rate

and to stabilize the market for governmentsecurities, etc.

Thus under OMO there is continuous buying and selling

of securities taking place leading to changes in the

availability of credit in an economy.



.

3. Variation in the Reserve Ratios (VRR)

Commercial Banks have to keep a certain proportion of their

total assets in the form of Cash Reserves. These reserve ratiosare named as Cash Reserve Ratio (CRR) and a Statutory

Liquidity Ratio (SLR).

• Any change in the VRR (i.e. CRR + SLR) brings out a change in

commercial banks reserves positions. Thus by varying VRRcommercial banks lending capacity can be affected. RBI

increases VRR during inflation to reduce the purchasing power

and credit creation. But during recession it lowers the VRR

making more cash reserves available for credit expansion.



Cash Reserve Ratio

CRR, or cash reserve ratio, refers to a portion of deposits (as

cash) which banks have to keep/maintain with the RBI. During

Inflation RBI increases the CRR due to which commercial

banks have to keep a greater portion of their deposits with

the RBI .



Statutory Liquidity Ratio

Banks are required to invest a portion of their

deposits in government securities as a part of their

statutory liquidity ratio (SLR) requirements . If SLR

increases the lending capacity of commercial banksdecreases thereby regulating the supply of money in

the economy.

• SLR also refers to some percent of reserves to be

maintained in the form of gold or foreign securities



Qualitative methods

(B) Qualitative Instruments or Selective Tools.

They are used for discriminating between different uses of

credit.

1. Consumer Credit Regulation If there is excess demand for certain consumer durables leading

to their high prices, central bank can reduce consumer credit

by (a) increasing down payment, and (b) reducing the number

of installments of repayment of such credit.



.

2. Fixing Margin Requirements

The margin refers to the "proportion of the loan amount which is

not financed by the bank". A change in a margin implies achange in the loan size. This method is used to encourage

credit supply for the needy sector and discourage it for other

non-necessary sectors. This can be done by increasing margin

for the non-necessary sectors and by reducing it for other

needy sectors. Example:- If the RBI feels that more credit

supply should be allocated to agriculture sector, then it will

reduce the margin and even 85-90 percent loan can be given.

.



.

3. Publicity

This is yet another method of selective credit control. Through it

Central Bank (RBI) publishes various reports stating what isgood and what is bad in the system. This published

information can help commercial banks to direct credit supply

in the desired sectors

4. Credit Rationing Central Bank fixes credit amount to be granted. Credit is rationed

by limiting the amount available for each commercial bank.

This method controls even bill rediscounting. For certain

purpose, upper limit of credit can be fixed and banks are toldto stick to this limit. This can help in lowering banks credit

exposure to unwanted sectors.



.

5. Moral Suasion

It implies to pressure exerted by the RBI on the indian

banking system without any strict action for

compliance of the rules. It is a suggestion to banks. It

helps in restraining credit during inflationary periods.

Commercial banks are informed about theexpectations of the central bank through a monetary

policy. Under moral suasion central banks can issue

directives, guidelines and suggestions for commercial

banks regarding reducing credit supply forspeculative purposes.



.

6. Control Through Directives

Under this method the central bank issue frequentdirectives to commercial banks. These directives

guide commercial banks in framing their lending

policy. Through a directive the central bank can

influence credit structures, supply of credit to certainlimit for a specific purpose.

.



7. Direct Action

Under this method the RBI can impose an actionagainst a bank. If certain banks are not adhering to

the RBI's directives, the RBI may refuse to rediscount

their bills and securities. Secondly, RBI may refuse

credit supply to those banks whose borrowings are in

excess to their capital. Central bank can penalize a

bank by changing some rates. At last it can even put

a ban on a particular bank if it dose not follow its

directives and work against the objectives of the

monetary policy.



Fiscal Policy• Acts of a government to influence the direction of

nation’s economy by using its financial and

regulatory powers.

• The two main important instruments are

government spending and taxation. These are alsoknown as financial powers.

• By regulatory powers we mean the ability of

government to influence or require its people to

change their behavior. E.g. Indian government mightask all the industries to conform to universal

environmental standards to reduce global warming.



Stances of Fiscal Policy

A neutral stance of fiscal policy implies a

balanced budget where Government spending

(G) is equal to Tax revenue (T) i.e. G=T.

Government spending is fully funded by tax

revenue and overall the budget outcome has aneutral effect on the level of economic

activity.



.

• An expansionary stance of fiscal policy

involves a net increase in government

spending (G > T) through rises in governmentspending or a fall in taxation revenue or a

combination of the two. This will lead to a

larger budget deficit or a smaller budgetsurplus. Expansionary fiscal policy is usually

associated with a budget deficit. Hence, when

government decides to adopt expansionary

fiscal policy, it actually decides to spend more

than what it did earlier.

.



• A contractionary fiscal policy occurs when net

government spending is reduced either

through higher taxation revenue or reduced

government spending or a combination of the

two i.e. G < T. This would lead to a lower

budget deficit or a larger surplus.Contractionary fiscal policy is usually

associated with a surplus.



Objectives of fiscal policy1. Development by effective mobilisation of resources

Ensure rapid economic growth and development by mobilisation

of Financial Resources.

The financial resources can be mobilised by :-

• Taxation : direct taxes as well as indirect taxes.

• Public Savings : reducing government expenditure and

increasing surpluses of public sector enterprises.

• Private Savings : effective fiscal measures such as tax benefits,

can help the government raise resources from private sector

and households. Resources can be mobilised through

government borrowings by ways of treasury bills, issue of

government bonds, etc., loans from domestic and foreign

parties and by deficit financing.

.



2. Efficient allocation of Financial Resources

Financial resources allocated for development activities which

includes expenditure on railways, infrastructure, etc. While

non-development activities includes expenditure on defence,

interest payments, subsidies, etc.

Resource allocation for generation of goods and services which

are socially desirable.

3. Reduction in inequalities of income and wealth

Achieving equity or social justice by reducing income inequalities

among different sections of the society. The direct and

indirect taxes are more on rich people and luxury/ semi

luxury items. The government invests a significant proportion

of its tax revenue in the implementation of poverty alleviation

programmes to improve the conditions of poor in society.



.

4. Price Stability and Control of Inflation

The government always aims to control inflation by reducing

fiscal deficits, introducing tax savings schemes, productive useof financial resources, etc.

5. Employment Generation

Investment in infrastructure has resulted in direct and indirect

employment. Lower taxes and duties on small-scale industrial(SSI) units encourage more investment and consequently

generates more employment. Various rural employment

programmes undertaken by the Government to solve

problems in rural areas. Similarly, self employment scheme is

taken to provide employment to technically qualified persons

.



.

6. Balanced Regional Development

There are various incentives from the government for setting up

projects in backward areas such as Cash subsidy, Concessionin taxes and duties in the form of tax holidays, Finance at

concessional interest rates, etc.

7. Reducing the Deficit in the Balance of Payment

Fiscal policy attempts to encourage more exports by way of fiscalmeasures like exemption of income tax on export earnings,

Exemption of central excise duties and customs, Exemption of

sales tax and octroi, etc.

The foreign exchange is also conserved by Providing fiscalbenefits to import substitute industries, Imposing customs

duties on imports, etc.

.



.

8. Capital Formation

Aims at increasing the rate of capital formation so as to

accelerate the rate of economic growth. To increase the rate

of capital formation, the fiscal policy must be efficiently

designed to encourage savings and discourage and reduce

spending.

9. Increasing National Income

This is because fiscal policy facilitates the capital formation. This

results in economic growth, which in turn increases the GDP,

per capita income and national income of the country.

.



.

10. Development of Infrastructure

A part of the government's revenue is investedin the infrastructure development. Due to this,

all sectors of the economy get a boost.

11. Foreign Exchange Earnings Fiscal policy attempts to encourage more

exports and reduce dependence on imports.



Instruments of Fiscal Policy:

1. Public expenditure

2. Taxes

3. Public debts

The above mentioned instruments are used by

the public authorities to achieve desirable

level of production , consumption and

National Income.

.



• During inflationary trend more and more taxes are levied on

the community. In this way, purchasing power of the people

can be decreased and desirable price level is achieved.

• During inflation public expenditure is decreased so that

aggregate demand decreases decreasing high prices and

increase the value of money .

• During deflationary period taxes are reduced and public

expenditure is increased. In this way incentives to invest are

increased and national income begins to rise.

• For economic development public debts are necessary. In

under developed countries, due to insufficient resources

economic development is not possible. Public loans are drawn

internally and externally.



Fiscal deficit

Fiscal deficit is defined as the difference

between government expenditure and its

revenue i.e.

Fiscal deficit = Government spending –

Government revenue

It is expressed in terms of percentage of GDP



Effects of fiscal policy

Changes in the level and composition of taxation and

government spending can impact on the following variables in

the economy:

• Aggregate demand and the level of economic activity

• The pattern of resource allocation • The distribution of income

Fiscal policy is used by governments to influence the level of

aggregate demand in the economy, in an effort to achieve

economic objectives of price stability, full employment andeconomic growth. This is generally done during recession to

boost spending and demand.



Deficit financing

Deficit financing is an approach to money

management that involves spending more

money than is collected during the same

period.

When used properly, this financing method

helps to launch a chain of events that

ultimately enhances the financial conditionrather than simply creating debt that may or

may not be repaid.



By establishing a specific plan of action that involves using

borrowed resources to make purchases, the government can

increase the demand for output from various sectors of thebusiness community.

This in turn motivates businesses to hire additional employees

and helps to fight unemployment.

The renewed vigor in the marketplace helps to restore consumerconfidence, making it more likely for consumers to buy more

goods and services.

A carefully crafted and closely monitored plan will restore a

measure of stability to the national economy over a period of months or years.



Government spendingGovernment expenditure or spending can be categorized in

three ways:

1. Spending on goods and service

2. Transfer payments- It involves payments to individuals by the

government under several welfare schemes such as

unemployment benefits, elderly pensions, healthcare benefits

or food coupons.

3. Net interest payments- Governments pay interest rates to

people who hold government bonds or debt. Hence, any

increase or decrease in the interest rate will directly affect theincome from these bonds.

By changing its spending, government can influence aggregate

demand in the economy.



Government Revenue

Government generates revenue by collecting taxes from its

people and businesses. Across the globe, maximum tax is

collected as payroll taxes i.e. income taxes, followed by

corporate taxes. The next largest category is sales taxes and

import duties.By changes in tax rates government can influence demand.

For example – lowering of income tax rate will increase the

disposable income of people. With more money in hand

people will spend those money on goods and service; hence,creating a demand for the same.



Fiscal policy in the short-run

The idea of fiscal policy in the short-run is very

simple- if aggregate demand is too low, the

government would:

• Buy more goods and service • Increase transfer payments

• Reduce tax rates on income

• Reduce imports and excise duties

.



Buying more

goods and

services would:

Increase

transfer

payments

would:

Reducing tax

rates on

household

income would:

Reducing taxes

or changing

regulations that

influence

corporate

income would:

Directly increasespending and

AD

Increasedisposable

income and

generally

increased

spending byhouseholds

Increasedisposable

income due to

lower taxes

would increase

spending power of individuals

and hence

increase in AD

Increasebusiness

spending

depending on

the overall

sentiments ineconomy

Inflation, Monetary and fiscal policy of India

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