inflation, monetary and fiscal policy of india
TRANSCRIPT
7/27/2019 Inflation, Monetary and fiscal policy of India
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Inflation and Monetary Policy
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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.
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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.
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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.
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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.
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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".
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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.
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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.
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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.
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Causes of cost push inflation
• Wage-push Pressures
• Profit-Push and Mark-up Pricing
•
Import Prices• Exchange rates
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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.
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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.
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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.
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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.
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• 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.
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• 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.
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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.
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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).
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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.
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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.
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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.
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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.
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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 .
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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
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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.
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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.
.
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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.
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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.
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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.
.
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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.
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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.
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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.
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• 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.
.
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• 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.
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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.
.
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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.
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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
.
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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.
.
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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.
.
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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.
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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.
.
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• 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.
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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
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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.
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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.
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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.
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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.
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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.
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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
.
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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