Control of Inflation

The measures to control inflation can be divided into: 

I. Monetary Measures: 

These measures are adopted by the central bank of the country and include such steps as an increase in re-discounted rates, sale of government securities in the open market, an increase in reserve ratios and adjustments in selective controls to arrest an inflationary credit boom. Each of these steps has its own limitations though it can be said that monetary measures are more effective in checking inflation than curbing a depression. 

a) Increased Re-discount Rates: 

To curb inflation, the central bank generally increases the re-discount rates. An increase in re-discount rates increases the cost of borrowing funds for business and consumer spending and, thus, discourages excessive activity based on borrowed funds. 

Causes of Inflation

Following are the factors which cause an increase in the size of demand: 

1. Increase in Public Expenditure: 

An increase in public expenditure, consequent upon the outbreak of war or development planning, invariably, causes an increase in the demand for goods and services in the economy. Infact, this is an important cause giving rise to the emergence of excess demand in the country. 

2. Increase in Private Expenditure: 

An increase in private expenditure, both consumption and expenditure as well as investment expenditure is an important cause of the emergence of excess demand in the economy. When business conditions are good, private entrepreneurs start investing more and more funds in new business enterprises, giving rise to an increase in the demand for the services of factors of production. This results in an increase in factor-prices. When factor incomes increases there is more and more expenditure on consumption goods. The ultimate effect of an increase in private expenditure is to push up the demand for commodities as well as factors of production.

Effects of Deflation

Deflation affects the entire economic life of the country. The different sections of society are affected in the following manner. 

(1) Producers and Traders: 

Deflation adversely affects both the producers as well as the traders. The producers are adversely affected on three counts 

1. The production costs at a time of deflation do not fall as rapidly as the prices of the finished product. 
2. Whenever a producer buys raw-materials etc, for the purpose of production, he has to pay a higher price for it when the finished product reaches the market, the prices of raw-materials will have fallen still further and the producer will be compelled to sell his product at a reduced price.
3. The demand for commodities also goes down at a time of deflation. 

Deflation

Deflation is the opposite of inflation. In the words of Prof. Crowther,”deflation is the state of the economy where the value of money is rising or the prices are falling”. 

This definition is not free from defects. From this definition, it appears that every fall in the price-level is deflation but actually this may not be so. Sometimes the price-level starts falling down without any contraction in the supply of money. Now such a fall in the price-level cannot be called deflation. 

According to Prof. Pigou, “Deflation is that state of falling prices which occurs at that time when the output of goods and services increases more rapidly than the volume of money income in the economy”. 

Thus, according to Pigou every fall in the price-level is not deflation. Deflation occurs at that time when the output of goods and services increases at a faster rate than the money income. A fall in prices in the following situations may be termed deflationary according to Pigou.

1. If the money income diminishes but the output remains constant.
2. If the money income and the output both diminish but the money income diminishes much more rapidly than the output.
3. If the volume of output increases but the money income remains constant.
4. If the volume of output increases but the volume of money income diminishes. In each of the cases, the fall in prices will be deflationary. 

Effects of Deflation

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Stock and Flow Concept

Stock refers to a quantity of a commodity accumulated at a point of time. The quantity of the current production of a commodity which moves from a factory to the market is called flow. 

The aggregates of macroeconomics are of two kinds some are stocks, typically the stock of capital ’k’ which is a timeless concept. A stock is always specified to a particular moment. Other aggregates are a flow concept, such as income, output, consumption and investment. A flow variable has the time dimension, it specified per unit of time. 

Stock is the quantity of an economic variable relating to a point of time. For example, store of cloth in a shop at a point of time is a stock concept. Flow is the quantity of an economic variable relating to a period of time. The monthly income and expenditure of an individual, receipt of yearly interest rate on various deposits in a bank, sale of a commodity in a month are some examples of a flow concept.

The concepts of stock and flow are used in the analysis of both micro and macro economics. 

In Micro economics: 

In micro economics, the concept of stock and flow are related to the demand for and supply of goods. The market demand and supply of goods. The market demand and supply of goods at a point of time is expressed as stock. The stock demand curve of good slopes downward from left to right like an ordinary demand curve, which depends upon price. But the stock supply curve of a good is parallel to the y axis because the total quantity of stock of a good is constant at a point of time. 

On the other hand, the flow demand and supply curves are like the ordinary demand and supply curves which are influenced by current prices. 

But the price is neither a stock nor a flow variable because it does not need a time dimension. Nor is it a stock quantity. In fact, it is a ratio between the flow of cash and flow of goods. 

In Macro Economics: 

The concepts of stock and flow are used in more in macro economics or in the theory of income, output and employment. Money is a stock variable, whereas the spending the money is a flow variable. Wealth is stock, income is flow, saving by a person within a month is flow, while the total saving on a day is stock. The government debt is stock while the government deficit is a flow and its outstanding loan is a stock. 

Some macro variables like imports, exports, wages, income, tax payments, social security benefits and dividends are always flow concept. Such flows do not have direct stocks but they can affect other stocks indirectly, just as imports can affect the stock of capital goods. 

A Stock can change due to flow, but the size of flows can be determined itself by changes in stock. This can be explained by the relation between stock of capital and flow of investment. The stock of capital can only increase with the increase in the flow of investment, or by the difference between the flow of production of new capital goods and consumption of capital goods. On the other hand, the flow of investment itself depends upon the size of capital stock. But the stocks can affect flows only if the time period is so long that the desired change in stock can be brought about. Thus, flows cannot be influenced by changes in stock in the short run 

Lastly, both the concepts of stock and flow variables are very important in modern theories of income, output, employment, interest-rate, business cycles etc.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Monetary Policy

Monetary policy refers to the credit control measures adopted by the central bank of a country. Johnson defines monetary policy ,” as a policy employing central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy”. G.K Shaw defines it as, “ any conscious action undertaken by the monetary authority to change the quantity , availability or cost of money”. 

Objectives: 

The broad objectives of monetary policy are to establish at full employment level of output, to ensure price stability and to promote economic development of the economy. Monetary policy is concerned with changing the supply of money stock and the rate of interest for the purpose of stabilizing the economy at full employment or potential output level by influencing the level of aggregate demand. More specifically at times of recession monetary policy involves the adoption of some monetary tools which tend to increase the supply of money and lower interest rate so as to stimulate aggregate demand in the economy. On the other hand at times of inflation, monetary policy seeks to contract the aggregate spending by tightening the money supply or rising the rate of interest. It may however be noted that in a developing country like India, in addition to achieving equilibrium at full employment or potential output level, monetary supply also promotes and encourages economic growth both in the industrial and agricultural sectors of the economy. Thus in the context of the developing countries the following three goals are or objectives that are important. They are:

1.  To ensure economic stability at full employment level or potential level of output. 
2. To achieve price stability by controlling inflation and deflation. 
3. To promote and encourage economic growth. 

The role of monetary policy is to achieve economic stability at higher level of output and employment. 

Instruments of the Monetary Policy: 

The instruments of monetary policy are of two types: 

1. Quantitative, general or in-direct methods: 
2. Qualitative, selective or direct methods 

1. Quantitative, general or in-direct methods: 

The following are the three quantitative methods of credit control 

• Bank rate policy 

• Open market operations 

• Change in the reserve ratios 

a) Bank Rate Policy: 

The bank rate is the minimum lending rate of the central bank at which it re-discounts first class bills of exchange and government securities held by commercial banks. When the central bank finds that inflationary pressure have started emerging within the economy it rises the bank rate. Borrowing from the central bank becomes costly and commercial banks borrow less from the central bank. The commercial banks, in turn rise their lending rates to the business community and borrowers borrow less from the commercial bank. There is contraction of credit and prices are checked from rising further. On the contrary, when prices are depressed the central bank lowers the bank rate. It is cheap to borrow from the central bank on the part of commercial banks. The later will also lower their lending rates. Business men are encouraged to borrow more. Investment is encouraged. Output , employment, income and demand start rising and the downward movement of the prices is checked. 

b) Open Market Operations: 

Open market operations refer to the sale and purchase of securities in the money market by the central bank. When prices are rising and there is need to control them, the central bank will sell securities. The reserves of the commercial banks are reduced and they are not in a position to lend more to the business community. Further investment is discouraged and the rise in prices is checked. On the other hand, when recessionary forces start in the economy, the central bank buys securities. The reserves of the commercial banks are raised. They lend more , investment, output, employment, income and demand rise, and fall in price is checked. 

c) Change in the reserve ratios: 

This method of credit control was suggested by Keynes in his “treatise of money” and USA was the first to adopt it as a monetary devise. Every bank is required by law to keep a certain percentage of its total deposits in the form of a reserve fund and also a certain percentage with the central bank. When the prices are rising, the central bank rises the reserve ratio. Banks are required to keep more with the central bank. There reserves are reduced and they lend less. The volume of investment, output and employment are adversely affected. In the opposite case, when the reserve ratio is lowered, the reserves of the commercial banks are raised. They lend more and the economic activity is favorably affected. 

2. Selective Credit Control: 

Selective credit controls are used to influence specific types of credit for particular purposes 

a) Changing Margin Requirements: 

They usually take the form of changing margin requirements to control speculative activities within the economy. When there is brisk speculative activity in the economy or in particular sector in certain commodities and prices start rising, the central bank rises the margin requirements on them. The result is that the borrowers are given less money in loans against specified securities. For instance, rising this margin requirements to 60% means that the pledger of securities of the value of Rs. 10000 will be give 40% of their value, that is, rupees 4000 as loan. In case of recession in a particular sector the central bank encourages borrowing by lowering margin requirements. 

b) Regulation of Consumer Credit: 

Originally used in USA since the beginning of world war II regulation of consumer credit is now being used extensively in many countries. During world war II, an acute scarcity of goods were felt and position was worsened in USA by the system of bank credit to consumers to enable them to buy durable and semi-durable consumer goods through installment buying. This was responsible not only for intensifying inflationary pressure in the country but also in disturbing the production of goods for defence purposes. The federal reserve banks of USA were authorized to regulate the terms and conditions under which consumer credit was extended by the commercial banks. The restraints under these regulations were two fold: 

1. They limited the amount of credit for the purpose of any consumer goods listed in the regulation.
2. They limited the time for repaying the debt. 

c) Control Through Directives: 

In the post war period, most central banks have been vested with the direct power of controlling bank advances. This power has been granted to the central banks either by statute or by mutual consent between the central bank and the commercial bank. For instance, the banking regulation act of India, 1949, specifically empowers the reserve bank of India to give directions commercial banks in respect of their lending policies, the purpose for which advances may or may not be made and the margins to be maintained in respect of secured loans. The RBI can also prohibit any particular bank or banking system as whole against entering into any particular transactions or class of transactions. 

d) Moral Suasion: 

Moral suasion implies persuasion and request made by the central bank to the commercial bank to follow the general monetary policy of the former. In a period of depression the commercial banks may be persuaded to expand their loans and advances to accept inferior types of securities which they may not normally accept fix lower margin and in general, provide favourable conditions to stimulate bank credit and investment. In a period of inflationary pressure the central bank may persuade the commercial banks not to apply for further accommodation already obtained for financing speculative or non-essential activities lest inflationary pressure should further worsened. 

e) Rationing of Credit: 

This is another method in the armoury of the central bank. Rationing of credit as an instrument of credit control was first used by bank of England. The term rationing of credit implies two things. 

1. It means that the central bank fixes a limit upon its rediscounting facilities for any particular bank, 
2. It means the central bank fixes the quota of every affiliated bank for financial accommodation from the central bank. 

f) Publicity: 

Several central banks have adopted publicity as an instrument of credit control. They use this instrument not only for influencing the credit policies of commercial banks but also to educate and influence public opinion in the country.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Fiscal Policy

Meaning of Fiscal Policy: 

Fiscal Policy may be defined as that part of governmental economic policy which deals with taxation, expenditure, borrowing and the management of public debt in an economy. It is an indispensable instrument of modern public finance. The importance of fiscal policy has greatly increased in modern times, both in the developed as well as the underdeveloped countries of the world. In developed countries, fiscal policy is being increasing used as an instrument to achieve full employment and economic stability. In underdeveloped countries, on the contrary, fiscal policy is more and more being used as a means to step up the rate of economic growth. Fiscal policy primarily concerns itself with the flow of funds in the economy. Taxation diverts the funds from the private sector to the governmental sector. Public expenditure on the contrary, diverts funds from the governmental sector back to the economy. Public borrowing, like taxation also diverts funds from the private sector to the governmental sector, but the two diversions influence the private sector in different ways. Management of public debt includes functions, such as, floating of governmental loans, payment of interest thereon and retirement of matured debts. Fiscal policy, thus, exerts a very powerful influence on the working of the national economy. It directly affects the volume of output, income and employment in the economy. The greater the percentage of national income and expenditure represented by the governmental budget, the greater would be the influence of fiscal policy on aggregate economic activity. 

Objectives of Fiscal Policy in a Developed Capitalist Economy: 

There are two broad objectives of fiscal policy in a developed capitalist economy, namely, 1. To achieve and maintain full employment in the economy, and 2. To achieve economic stability in the economy through avoidance both of inflation as well as deflation. In short, the basic goal of fiscal policy in a developed economy is one of full employment and economic stability. 

Objectives of Fiscal Policy in Underdeveloped Economy: 

The nature of fiscal policy in an underdeveloped economy is bound to be different from that of a developed economy. In a developed economy, the problem is not so much that of development as that of achieving economic stability on account of business fluctuations caused by the operation of the trade cycles. But the problem of an underdeveloped economy is not so much that of economic stability as that of promoting rapid economic growth in the country. 

The major objectives of fiscal policy in an underdeveloped country are: 

• The first objective of fiscal policy in an underdeveloped country should be to maximize the level of aggregate saving by applying a cut to the actual and potential consumption of the public at large. The fiscal policy should especially curb conspicuous consumption of the rich and force them to save more for capital formation. 

• The second objective should be to maximize the rate of capital formation to break economic stagnation and to lead the country on to the path of rapid economic progress and growth. 

• The third objective of fiscal policy in an underdeveloped economy should be to divert capital resources from less productive to more productive and from socially less desirable to socially more desirable uses.
• The fourth objective of fiscal policy should be to protect the economy of an underdeveloped country from inflation. Inflation can ruin an underdeveloped country. As such, the fiscal policy of an underdeveloped country should be designed in such a manner so as to curb inflationary forces arising during the process of growth. 

• The fifth objective of fiscal policy should be to eliminate as far as possible, sectoral imbalances arising in the economy from time to time. 

• The sixth objective of fiscal policy should be to provide incentives for encouraging those industries which have a high employment potential in the economy. 

• The seventh objective of fiscal policy in an underdeveloped country should be eliminate as far as possible, the glaring economic inequalities in the economy and bring about an equitable redistribution of income and wealth in society. 

Fiscal Policy and Economic Growth: 

Fiscal policy is also a potent weapon for the achievement of accelerated economic growth in a backward, underdeveloped economy. Without an appropriate fiscal policy, the process of economic growth in a country is bound to suffer. In achieving a fast economic growth, the government may have to deploy all the instruments of fiscal policy at its disposal, namely, taxation, public expenditure, public debt and deficit financing. The problem in a backward underdeveloped economy is not one of lack of real resources, but that of shortage of financial resources. So the instruments of fiscal policy may have to be used to raise adequate finance for economic growth. 

1. Taxation: 

It is an indispensable instrument for raising finance for economic development. For this purpose, the government may resort to direct as well indirect taxation. Direct taxes, such as, income tax, wealth tax, gift tax, capital gains tax etc may have to be levied to net adequate revenues for development purposes. The incidence of these taxes mostly falls on the richer classes. As such, they are quite justified from the point of equity. The government may impose steep excise duties and import taxes on luxury goods which are consumed exclusively by the rich. To raise enough revenue for developmental purposes, it may also be necessary to levy excise taxes on articles of mass consumption, though the burden of such taxes is mostly borne by the poor and middle-class. 

2. Public Debt: 

Taxation taken alone may not yield adequate revenue for mobilizing the real resources of the country. The government may therefore resort to public borrowings, short-term as well as long-term, to add to its fund of investible resources. There may be opposition to heavy taxation, but no one opposes public borrowings because the government pays interest on public loans. While borrowing from the public, the government should ensure that the burden of interest charges does not turn to be unbearable for it. For this purpose, the government may adopt a cheap money policy to keep interest-rates at a comparatively low level. Since the amount raised through internal borrowings may not be adequate there is no harm if the government if the government resorts to the international money market for raising the necessary funds for developmental purposes. The government may even take loans from foreign countries or international lending agencies on suitable conditions and terms of repayment. While raising external loans, the government has to be alert enough to see that such loans do not compromise its economic and political sovereignty in any way. 

3. Public Expenditure: 

The government of an underdeveloped country should devote quite a substantial portion of its expenditure to the building up of the necessary infrastructural facilities for economic growth, such as, roads. Railways, communications, irrigation works, power stations, coal-mining, general and technical education. These facilities will induce the rapid growth of the economy. Along with that, a part of the purpose expenditure may also be allocated for the growth and development of basic industries which will provide the foundation of industrial growth in future. Agriculture which is generally the most important segment of an underdeveloped economy should receive special attention of the government. Expenditure incurred by the government on the promotion of labour and social welfare also aids the rapid growth of the economy by improving the productivity of the labour force. 

4. Deficit Financing: 

It is still another important instrument of fiscal policy. It has proved to be a dispensable means of financing the economic growth of underdeveloped economy. Several developing countries have in recent years, employed the technique of deficit financing as a means of financing economic development. 

Limitations of Fiscal Policy: 

Fiscal policy as an instrument of economy stability and economic growth suffers from certain limitations which may be as follows; 

1. Firstly, the difficulty of accurately forecasting the onset of depression robs fiscal policy of much of its utility and effectiveness as an anti-cyclical device. More often than not, a country finds itself already knee-deep in depression before it moves about to take corrective action. 
2. Secondly, the corrective action taken by the government does not produce immediate results, because, there is often a prolonged time interval between the enforcement of fiscal measures and their final impact on the functioning of the economy. 
3. Thirdly, fiscal steps taken by the government to curb unemployment may fail to yield results if the unemployment is due to causes other than the deficiency of aggregate demand. Fiscal measures for example will fail to create any dent on unemployment, if it is due to seasonal, frictional, structural or technological causes. 
4. Fourthly, fiscal measures may prove inadequate or ineffective in dealing even with cyclical unemployment caused by the deficiency of aggregate demand for several reasons. For example: increased public expenditure intended to create more employment opportunities may be accompanied by a decline in private expenditure due to an increase in factoral prices. Increased public expenditure may also have adverse effect on employment-generation in the private sector through a general increase in wage-levels. 
5. Fifthly a strong and powerful fiscal policy adopted to deal with more mass unemployment may unduly inflate the size of the public debt which will impose an unbearable burden on the future generations. 
6. Sixthly, while dealing with hyper-inflation and boom, the government may carry its fiscal measures to the other extreme, namely, far too high taxation and cut-back in public investment, which will pave the way for the forth coming depression. 
7. Lastly, fiscal measures taken to finance economic growth in an underdeveloped economy may not suffice unless and until recourse is taken to monetary devices such as deficit financing etc.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Module 01: Question Bank

Two Marks Questions:

1. Define macroeconomics. 
2. Give any four concepts of macroeconomics. 
3. State any two importance of Macroeconomics. 
4. What is unemployment? 
5. What is an economic policy? 
6. Name any four economic problems in an economy. 
7. Define National Income. 
8. Define economic growth. 
9. Define economic planning. 
10. What is business cycle? 
11. Define stagflation. 
12. Mention the two functions of investment. 
13. Mention any four central issues of Macro economics. 
14. What is Fallacy of composition? 
15. State any four limitations of macro economics. 
16. What is an exchange rate? 
17. What is surplus balance of payments? 
18. What is deficit balance of payments? 
19. State the types of Macro economics. 
20. What is macro statics? 
21. What is Macro dynamics? 
22. What is comparative macro statics? 
23. Mention any two concepts of National Income. 
24. What is NNP? 
25. What is depreciation? 
26. What is Personal Income? 
27. What is disposable personal income? 
28. What is Per capita income? 
29. State the methods of measuring National Income. 
30. State any two difficulties in the estimation of National Income. 
31. State any two importance of National Income analysis. 

Five Marks Questions:

1. Define Macroeconomics and discuss its nature. 
2. Describe the importance of Macro economics. 
3. Discuss any four central issues of macro economics. 
4. Describe the subject matter of macro economics. 
5. Describe any four limitations of macro economics. 
6. Describe macro statics. 
7. Describe macro dynamics. 
8. Describe comparative macro statics. 
9. Discuss Macro statics v/s Macro dynamics. 
10. Describe any four concepts of National Income. 
11. Describe any two methods of calculating the National Income. 
12. Describe the difficulties in measuring the national income. 
13. Describe the importance of national income analysis. 

Ten Marks Questions:

1. Describe the central issues of macro economics. 
2. Describe the limitations of macro economics. 
3. Describe the types of macro economics. 
4. Describe the concepts of National Income. 
5. Describe the methods of measurement of the National Income.