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FINANCIAL MANAGEMENT [email protected] HFS1

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EXECUTIVE SUMMARY

The one Thing, which is rising Week after Week, Mouth after Mouth and

which has given the Sleepless Nights to 100 days of Congress Government,

which affects from Prime Minister to Common Man. YES, IT IS INFLATION.

Inflation is commonly understood as a situation of substantial and rapid

general increase in the level of prices and consequent deterioration in the

value of money over a period of time. In other words inflation usually refers to

a persistent and rapid rise in the general price level, which reduces the value of

money or its purchasing power over a period of time.


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Definition

According to Crowther, Inflation is a state in which the value of money

is falling i.e. prices are rising.

How to Measure Inflation

If the price level in the current year is P1 & in the previous year is Po,

then inflation for the current year is

100po

Po-P1Inflation


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FEATURES OF INFLATION

1. Inflation leads to persistent remarkable and continuous rise in generalprice level.

2. Inflation is a scarcity oriented.

3. Inflation is a dynamic phenomenon. It is not a state of high prices, but a

process of rising prices.

4. Inflation is a state of disequilibria. It involves an imbalance between

aggregate demand and aggregate supply.

5. Inflation is a pure monetary phenomenon.

6. Real inflation takes place only after full employment.

7. Inflation is a longer period phenomenon.


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TYPES OF INFLATION

Inflation is often classified on three different criteria. Firstly, one mightdistinguish between various types of inflation on the basis of speed at which

the general price level rises. Secondly, one way distinguishes between open

and suppressed inflation. Finally, as we find in the modern macroeconomic

theory, inflation is classified on the basis of the factors, which induce it.

On the criterion of the rate at which the general price level rises, we

have the following types of inflation

1. Creeping Inflation

2. Walking Inflation

3. Running Inflation

4. Galloping or Hyper-Inflation

5. Cost-Push Inflation

6. Demand-Pull Inflation

7. Built-in Inflation

8. Chronic Inflation

9. Core Inflation

10. Headline inflation

11. Stealth Inflation

12. Assets inflation


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1. Creeping InflationAn extremely mild form of inflation is often characterized as creeping

inflation. In this case prices rise at a rate of around 2 percent per annum. In

case the rate of inflation does not register further increase, those a mild

does of inflation may not have any adverse effects on the economy.

Creeping inflation sometimes provides necessary inducement to investors.

The debatable question about the creeping inflation however, is whether it

would not eventually gather momentum and thereby creates distortions in

the economy. The world has witnessed both types of situations. Certain

countries have lived with mild inflations over long periods and their

economies in these periods have registered rapid economic growth. Inother countries, creeping inflation eventually accelerated and caused the

collapse of the economy.

2. Walking InflationThe walking inflation in terms of degree of prices rise is an

intermediate situation between the creeping and running inflations. Therate of inflation in this case is distinctly higher than that in the case of the

creeping inflation. Since the walking inflation does not invite widespread

protests, the monetary authorities do often not take it seriously and they

dont undertake timely corrective measures. It also sometimes leads to

balance of payments problems because on the one hand it induces imports

and, on the other discourages exports.

3. Running InflationThe running inflation is considered to be a stage between walking

inflation and hyper-inflation. Since the hyper-inflation is often defined as a

situation in which prices rise at a rate of at least 40 percent per month.

When prices rise at a rate exceeding 4-5 percent per month the situation

becomes alarming. This inflation redistributes income to the disadvantages

of the fixed income groups such as workers, pensioners and salary earners,


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it is considered to be highly unjust. Further a running inflation also creates

conditions of uncertainty. If prices rises from 10-12 percent than the

economy will be collapsed and there will be no monetary measures to

prove effective.

4. Hyper Inflation

The hyper-inflation refers to a situation in which prices rise at an

alarming rate of 40 percent per month or even more. The most notable

examples of hyper-inflation are to be found in the economic histories of

Germany, Austria, Russia, Poland, Greece, Hungary and China. In hyper-inflation money loses its importance as a store of value as no one holds it for

precautionary and speculative purposes. In fact, a hyper-inflation invariably

leads to a monetary collapse and national catastrophe. However, it is

important to recognise the fact that hyper-inflation does not arise abruptly. It

is always a result of wrong policies of the government. Whenever in some

country the government indulges recklessly in unproductive expenditures,

which are largely financed by borrowing from the Central Bank of the Country,

a process of inflation begins which often culminates in hyper-inflation.

5. Cost-Push Inflation

Aggregate supply is the total volume of goods and services produced by

an economy at a given price level. When there is a decrease in the aggregate

supply of goods and services stemming from an increase in the cost of

production, we have cost-push inflation. Cost-push inflation basically meansthat prices have been pushed up by increases in costs of any of the four

factors of production (labour, capital, land or entrepreneurship) when

companies are already running at full production capacity. With higher

production costs and productivity maximized, companies cannot maintain

profit margins by producing the same amounts of goods and services. As a

result, the increased costs are passed on to consumers, causing a rise in the

general price level (inflation).


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Management Practice under Cost-Push Inflation

To understand better their effect on inflation, lets take a look into how and

why production costs can change. A company may need to increases wages if

labourers demand higher salaries (due to increasing prices and thus cost ofliving) or if labour becomes more specialized. If the cost of labour, a factor of

production, increases, the company has to allocate more resources to pay for

the creation of its goods or services. To continue to maintain (or increase)

profit margins, the company passes the increased costs of production on to the

consumer, making retail prices higher. Along with increasing sales, increasing

prices is a way for companies to constantly increase their bottom lines and

essentially grow. Another factor that can cause increases in production costs is

a rise in the price of raw materials. This could occur because of scarcity of raw

materials, an increase in the cost of labour and/or an increase in the cost of

importing raw materials and labour (if the they are overseas), which is caused

by a depreciation in their home currency. The government may also increase

taxes to cover higher fuel and energy costs, forcing companies to allocate more

resources to paying taxes.

To visualize how cost-push inflation works, we can use a simple price-quantity

graph showing what happens to shifts in aggregate supply. The graph below

shows the level of output that can be achieved at each price level. Asproduction costs increase, aggregate supply decreases from AS1 to AS2 (given

production is at full capacity), causing an increase in the price level from P1 to

P2. The rationale behind this increase is that, for companies to maintain (or

increase) profit margins, they will need to raise the retail price paid by

consumers, thereby causing inflation.


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6. Demand-Pull Inflation

Demand-pull inflation occurs when there is an increase in aggregate

demand, categorized by the four sections of the macro economy households,

businesses, governments and foreign buyers. When these four sectorsconcurrently want to purchase more output than the economy can produce,

they compete to purchase limited amounts of goods and services. Buyers in

essence bid prices up, again, are causing inflation. This excessive demand,

also referred to as too much money chasing too few goods, usually occurs in

an expanding economy.

The term demand-pull inflation is mostly associated with Keynesian economics.

Management Practice under Demand-Pull Inflation

The increase in aggregate demand that causes demand-pull inflation can be

the result of various economic dynamics. For example, an increase in

government purchases can increase aggregate demand, thus pulling up prices.

Another factor can be the depreciation of local exchange rates, which raises

the price of imports and, for foreigners, reduces the price of exports. As a

result, the purchasing of imports decreases while the buying of exports by

foreigners increases, thereby raising the overall level of aggregate demand (weare assuming aggregate supply cannot keep up with aggregate demand as a

result of full employment in the economy). Rapid overseas growth can also

ignite an increase in demand as more exports are consumed by foreigners.

Finally, if government reduces taxes, households are left with more disposable

income in their pockets. This in turn leads to increased consumer spending,

thus increasing aggregate demand and eventually causing demand-pull

inflation. The results of reduced taxes can lead also to growing consumer

confidence in the local economy, which further increases aggregate demand.

Demand-pull inflation is a product of an increase in aggregate demand that is

faster than the corresponding increase in aggregate supply. When aggregate

demand increases without a change in aggregate supply, the quantity

supplied will increase (given production is not at full capacity). Looking again

at the price-quantity graph, we can see the relationship between aggregate

supply and demand. If aggregate demand increases from AD1 to AD2, in the

short run, this will not change (shift) aggregate supply, but cause a change in

the quantity supplied as represented by a movement along the AS curve. The


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rationale behind this lack of shift in aggregate supply is that aggregate demand

tends to react faster to changes in economic conditions than aggregate supply.

As companies increase production due to increased demand, the cost to

produce each additional output increases, as represented by the change fromP1 to P2. The rationale behind this change is that companies would need to

pay workers more money (e.g. overtime) and/or invest in additional

equipment to keep up with demand, thereby increasing the cost of production.

Just like cost-push inflation, demand-pull inflation can occur as companies, to

maintain profit levels, pass on the higher cost of production to consumers

prices.

7. Built-in Inflation

Built-in inflation is an economic concept referring to a type of inflationthat resulted from past events and persists in the present. It thus might be

called hangover inflation.

At any one time, built-in inflation represents one of three major determinants

of the current inflation rate. In Robert J. Gordon's triangle model of inflation,

the current inflation rate equals the sum of demand-pull inflation, supply-

shock inflation, and built-in inflation. "Demand-pull inflation" refers to the

effects of falling unemployment rates (rising real gross domestic product) in


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the Phillips curve model, while the other two factors lead to shifts in the

Phillips curve.

The built-in inflation we see now started with either persistent demand-pull or

large cost-push (supply-shock) inflation in the past. It then became a "normal"

aspect of the workings of the economy due to the roles of inflationaryexpectations and the price/wage spiral.

Inflationary expectations play a role because if workers and employers expect

inflation to persist in the future, they will increase their (nominal) wages and

prices now. (see real vs. nominal in economics.) This means that inflation

happens now simply because of subjective views about what may happen in

the future. Of course, following the generally-accepted theory of adaptive

expectations, such inflationary expectations arise because of persistent past

experience with inflation.

The price/wage spiral refers to the conflictual nature of the wage bargain in

modern capitalism. (It is part of the conflict theory of inflation, referring to the

objective side of the inflationary process.) Workers and employers usually do

not get together to agree on the value of real wages. Instead, workers attempt

to protect their real wages (or to attain a target real wage) by pushing for

higher money (or nominal) wages. Thus, if they expect price inflation -- or have

experienced price inflation in the past -- they push for higher money wages. If

they are successful, this raises the costs faced by their employers. To protectthe real value of their profits (or to attain a target profit rate or rate of return

on investment), employers then pass the higher costs onto consumers in the

form of higher prices. This encourages workers to push for higher money

wages.

In the end, built-in inflation involves a vicious circle of both subjective and

objective elements, so that inflation encourages inflation to persist. It means

that the standard methods of fighting inflation using either monetary policy or

fiscal policy to induce a recession are extremely expensive, i.e., meaning largerises in unemployment and large falls in real gross domestic product. This

suggests that alternative methods such as wage and price controls (incomes

policies) may be needed as complementary to recessions in the fight against

inflation.


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8. Chronic Inflation

Chronic inflation is characterized by much higher price increases than

ordinary inflation, at annual rates of 10% to 30% in some industrialized nations

and even 100% or more in a few developing countries. Chronic inflation tendsto become permanent and ratchets upwards to even higher levels as economic

distortions and negative expectations accumulate.

To accommodate chronic inflation, normal economic activities are disrupted

Consumers buy goods and services to avoid even higher prices; property

speculation increases; businesses concentrate on short-term investments;

incentives to acquire savings, insurance policies, pensions, and long-term

bonds are reduced because inflation erodes their future purchasing power;

governments rapidly expand spending in anticipation of inflated revenues;

exporting nations suffer competitive trade disadvantages forcing them to turn

to protectionism and arbitrary currency controls.

9. Core Inflation

Core inflation is a measure of inflation which excludes certain items that

face volatile price movements e.g. food.

The preferred measure by the Federal Reserve of core inflation in the United

States is the core Personal consumption expenditures price index. This is based

on chained dollars.

Since February 2000, the Federal Reserve Boards semi-annual monetary policy

reports to Congress have described the Boards outlook for inflation in terms of

the PCE. Prior to that, the inflation outlook was presented in terms of the CPI.

In explaining its preference for the PCE, the Board stated the chain-type priceindex for PCE draws extensively on data from the consumer price index but,

while not entirely free of measurement problems, has several advantages

relative to the CPI. The PCE chain-type index is constructed from a formula that

reflects the changing composition of spending and thereby avoids some of the

upward bias associated with the fixed-weight nature of the CPI. In addition, the

weights are based on a more comprehensive measure of expenditures. Finally,

historical data used in the PCE price index can be revised to account for newly

available information and for improvements in measurement techniques,

including those that affect source data from the CPI; the result is a more


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consistent series over time. Monetary Policy Report to the Congress, Federal

Reserve Board of Governors, Feb. 17, 2000

The older preferred measure of inflation in the United States was the

Consumer Price Index. This is still used as the indicator for most othercountries, and is presented monthly in the US by the Bureau of Labor Statistics.

This index tends to change more on a month to month basis than does "core

inflation". This is because core inflation eliminates products that can have

temporary price shocks (i.e. energy, food products). Core inflation is thus

intended to be an indicator and predictor of underlying long-term inflation.

The concept of core inflation as aggregate price growth excluding food and

energy was introduced in a 1975 paper by Robert J. Gordon.[1] This is the

definition of "core inflation" most used for political purposes. Analysis by the

Federal Reserve Bank of New York indicates that this measure is no better than

a moving average of the Consumer Price Index as a predictor of inflation. [2]

There are also other types of measuring inflation rates. In the United States the

Dallas Federal Reserve computes a trimmed mean PCE price index, which

separates "noise" and "signal". This is trimmed at 19.4% at the lower tail end

and 25.4% at the upper tail. The Cleveland Federal Reserve computes a Median

CPI and a 16% trimmed mean CPI. Trimmed means that the highest rises anddeclines in prices are trimmed by a certain percentage, attributing to a more

accurate measurement on core inflation. In relation to this, the Median CPI is

usually higher than the trimmed figures for both PCE and CPI. There also is a

median PCE, but is not used for any purpose in determining inflation.

10. Headline Inflation

Headline inflation is a measure of the total inflation within an economy

and is affected by areas of the market which may experience suddeninflationary spikes such as food or energy. As a result, headline inflation may

not present an accurate picture of the current state of the economy. This

differs from core inflation which excludes factors, such as food and energy

costs.


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11. Stealth Inflation

Stealth Inflation is the term used to describe charges and fees created by

business to gain extra profit and revenue from its customers. The stealth part

of the term is that business will often use miscellaneous fees to chargecustomers without the customers consciously knowing the fees existed, even

though they may have agreed then signed a contract for the goods and

services the fee is hidden in a mirage of words and policies. The inflation part

of the term relates to the up charging of the service without actually providing

anything additional. Since most companies charge a fee to accept payment a

portion gets built into profit and revenue. A big example of stealth inflation can

be overdraft fees from banks surcharges from Telco providers, processing fees

and installation fees.

12. Assets Inflation

Assets inflation is an economic phenomenon denoting a rise in price of

assets, as opposed to ordinary goods and services. Typical assets are financial

instruments such as bonds, shares, and their derivatives, as well as real estate

and other capital goods.

13. Agflation

Agflation, a term coined in the late 2000s, describes generalised inflation

led by rises in Agricultural commodity prices. In the United States, agricultural

prices are not generally factored into core inflation figures. The term describes

a situation in which "external" (ie Agricultural) price rises drive up core

inflation rates.

It has been claimed that the term was invented by analysts at Merrill Lynch in

early 2007.

14. StagflationStagflation is a macroeconomics term used to describe a period of

inflation combined with stagnation (that is, slow economic growth and rising

unemployment), generally including recession


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OTHER TERMS RELATED TO INFLATION

Deflation

Deflation is the opposite of inflation. Therefore, under the usual

contemporary definition of inflation, 'deflation' means a decrease in the

general price level.[1] Alternatively, the term was used by the classical

economists to refer to a decrease in the money supply; some economists,

including many Austrian school economists, still use the word in this sense. The

two meanings are closely related, since a decrease in the money supply is likely

to cause a decrease in the price level.

Deflation is considered a problem in a modern economy because of thepotential of a deflationary spiral and its association with the Great Depression,

although not all episodes of deflation correspond to periods of poor economic

growth historically.

Disinflation

Disinflation is a decrease in the rate of inflation.[1] Being how much

prices are increasing per unit of time, it can be expressed using the word

disinflation The slowing of the rate of inflation per unit of time.

For example one month the rate of inflation was 4.4% and the next month the

rate of inflation was 4.0%. In this instance the price of goods and services is still

increasing; however, it is increasing at a slower rate, 0.4% less, than a month

before. It should not be confused with deflation, which is an overall decrease

in prices.

Inflationary spikes

Inflationary spikes occur when a particular section of the economy

experiences a sudden price rise possibly due to external factors. For example if

a large amount of crop is destroyed, the value of the remaining crop will rise

sharply. This will distort the overall measure of inflation within the economy

(Headline inflation). Core inflation seeks to avoid the influence of these spikes

by excluding areas of the economy such as food and energy which may be

susceptible to such shocks.


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Reflation

Reflation is the act of stimulating the economy by increasing the money

supply or by reducing taxes. It is the opposite of disinflation. It can refer to an

economic policy whereby a government uses fiscal or monetary stimulus inorder to expand a country's output. This can possibly be achieved by methods

that include reducing tax, changing the money supply, or even adjusting

interest rates. Just as disinflation is an acceptable antidote to high inflation,

reflation is considered to be an antidote to deflation (which, unlike inflation, is

considered bad regardless how high it is).

Originally it was used to describe a recovery of price to a previous desirable

level after a fall caused by a recession. Today it also (in addition to the above)

describes the first phase in the recovery of an economy with increasing

demand from a slump.


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CAUSES OF INFLATION

For controlling the rates of commodity, we must know why these rates

are rising i.e. inflating which means what are the reasons or causes behind

inflation.

There are various factors which causes inflation in the economy which is as

follows-

A) Monetary Factors

B) Non-monetary Factors

C) Structural Factors.


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A)MONETARY FACTORS

1. Expansion of Money Supply

This is the basic factor, which causes inflation. Due to increase in

expansion of money supply, there is increase in demand of

luxurious commodities. Credit facilities allotted by bank are also

the result of inflation. Deficit financing also contribute to the

growth of inflation.

2. Increase in Disposable Income

When the disposable income of people increases, demand for real

goods and services increases, causing a rise in price leading

inflation.

3. Increase in Consumer Spending

As the income of the consumers rises, they spend more due to

expenditure consumption or demonstration effect, which raises

the aggregate demand causing inflation.

4. Development and Non-Development Expenditure

The expenditure for the development of huge plants and projectswill increase the demand for factors of production resulting in

inflation. On the other way, the expenditure for the non-

development like defence expenditure will create shortages of

consumption goods resulting inflation.


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5. Indirect Taxes

Due to high indirect taxes, sellers increase the price of their

products to recover the tax from the consumers, which indirectly

leads to inflation.

6. Demand for Foreign Commodities

When the demand for the foreign commodities increases, the

supply for the home commodities decreases which leads to

increasing the price.


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B)NON-MONETARY FACTORS

1. Rising Population

As population of the economy increases, demand for better

goods increases,which causes inflation. So, rising population

is the foremost non-monetary factor resulting inflation.

2. Natural Calamities

Due to the occurrence of natural calamities like floods,

famines, bad weather, etc results in crop failure, which

leads to rising price.

3. Speculation and Black Money

Speculation, hoarding and black money also causes

inflation, as such unearned money is spend lavishly by

people, creating unnecessary demand for goods and

services.

4. Unfair Practices by Monopoly Houses

The monopoly houses prefer to restrict outputs of their

products and raise their prices to enjoy excess profitsleading to inflation.

5. Bottlenecks and Shortages

Bottlenecks i.e. blockages and shortages of various kinds

destruct the process of the economic development. As a

result of shortages, price rise.


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C) STRUCTURAL FACTORS

1. Capital Shortage

This is due to a very low rate of capital formation in a poor

country where vicious circle of poverty exists.

2. Infrastructural Bottlenecks

Power shortages, inefficient transport, underutilization of

capacities and resources, etc are obstruction to the

economic growth of the country, which leads to the price

rise and finally inflation.

3. Limited Efficient Entrepreneurs

Entrepreneurs do not possess spirit to undertake risky

projects. Investments are generally made in trade and

unproductive assets like land, gold etc. Hence when supply

of money is increased, output of real goods and services

does not increase which leads to inflation.

4. Lack of Foreign Capital

The unfavourable terms of trade and deficit in balance ofpayments have further increased the problem of rising

prices.

5. Imperfections of the Market

Immobility of factors, rigid prices, ignorance of market

conditions etc all these does not allow the resources to

utilize properly so rising prices due to increase in supply and

without increase in real output.


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TRACE THE EFFECTS OF INFLATION

Economic Effects of Inflation

Inflation is a very unpopular happening in an economy. Inflation is the

most important concern of the people as it badly affects their standard of

living. Some America presidential candidates called Inflation As Enemy

Number One

High rate inflation makes the file of the poor very miserable. It is

therefore described as anti-poor. Inflation not only disrupts the economy but

also prepares ground for social and political upheavals.

The effects/consequences of inflation are as followers -

1. EFFECTS ON PRODUCTION

The condition or fact of being operative or in force on production

can be divided into two categories the stimulating or effect and the

disastrous effect.

(A) Stimulating or Favourable Effect

Because of the effects on production it has been observed thatmild inflation or gently rising prices have a stimulating or a tonic

effect on the economy. When price rise profits increases,

investment increases that generates income and creates

employment as a results output expands. This process continues

up to the point of full employment


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(B) Disastrous or Unfavourable Effects

If money supply increases beyond the point of full employment, it

would lead to a galloping or hyperinflation and results in

disastrous effects on the economy.

a] Uncontrolled inflation leads to discouragement in savings

due to falling value of money.

b] Energies of business community are diverted to speculation

and making quick profits rather than genuine production i.e.

encourages speculation.

c] Inflation encourages the hoarding and black marketing

d] Inflation also affects Misallocation of Resources

e] Flight of capital is encouraged due to fall in money the

investors prefer to invest abroad.

f] Consumers suffers as sellers market will be developed if

price of all type of goods rise of any quality.

g] Distortions and Maladjustments in the production dispute

the working of the price systems in the system in the

economy.


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2. EFFECTS OF INFLATION ON INCOME DISTRIBUTION

Inflation is socially undesirable. It redistributes wealth in favour of

the rich at the cost of poor it makes the rich richer and poor poorer. The

people whose real incomes erode during inflation are the victims ofinflation.

a] As the value of money falls the burdens of debt is reduced

and debtors gain creditor suffer because in real sense they receive

less during inflation.

b] Fixed income groups like salaried class and pensioners are

hit hard during inflation.

c] Business community welcomes inflation as they earn super

normal profits.

d] Investors in shares benefit during inflation small savers,

small investors and class lose during inflation.

e] Farmers gain in inflation by prices of agriculture prices

commodities rise and costs paid them lag behind prices.

3. EFFECT OF INFLATION ON CONSUMPTION AND WELFARE

Inflation reduces the economic welfare of the fixed income groups

as the price raises the purchasing power of money falls hence the people

get a smaller amount of goods services or low quality for the same

amount of money. As a result their consumption would fall and the

standard of living. Hence galloping inflation is the Cruelest tax of all.


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4. EFFECTS OF INFLATION ON FOREIGN TRADE

Inflation affects adversely the Countrys balance of payments

situation when prices are raising foreign demand for our goods will fall

and exports declined due to high prices domestic consumers buy foreign

goods and imports rise hence unfavourable balance of payments.

5. SOCIAL AND POLITICAL EFFECTS

a] The antisocial elements get rewarded and the masses suffer

during inflation.

b] Inflation disrupts social life by favouring rich and black market.

c] The standard of business morality go down during inflation.

d] People lose faith in democratic government due to inflation.

6. EFFECTS ON MANUFACTURERS

Inflation is harmful to trade. Manufacturers generally sell goods

on credit. When they seek repayment they find that the money theyreceive is less than they expected. They therefore become reluctant to

trade.


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MEASURES TO CONTROL INFLATION

These are the following actions taken to control inflation

1) Monetary Measures

2) Fiscal Measures

3) Other Non-monetary Measures


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(1) MONETARY MEASURES

(A) Quantitative Methods

1. Raising the Bank Rate

To control inflation the central bank increases the bank

rate. With this the cost of borrowing of commercial banks

from central bank will increase so the commercial banks will

charge higher rate of interest on loans. This discourages

borrowings and thereby helps to reduce the money in

circulation.

2. Open Market Operations

During inflation, the central bank sells the bills and

securities. These cash reserves of commercial banks will

decrease as they pay central bank for purchasing these

securities. Thus the loan able funds with commercial banks

decrease which leads to credit contraction.

3. Variable Reserve Ratio

The commercial banks have to keep certain percentage of

their deposits with the central bank in the form of cash

reserve. During inflation, the central bank increases this

cash reserve ratio this will reduce the lending capacity of

the banks.


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(B) The Qualitative Methods

1. Fixation of Margin Requirements

Commercial banks have to maintain certain fixed margins

while granting loans. In inflation central bank raises the

margin to contract credit and reduce the price level.

2. Regulation of Consumer Credit

For purchase of durable consumer goods on instalment

basis rules regarding payments are fixed. During inflation

and initial payment is increased and the number of

instalments are reduced. These results in credit contraction

and fall in prices.

3. Control through Directives

Certain directives are issued by central bank to commercial

banks and they are asked to follow them while lending. This

keeps in check the volume of money.

4. Rationing of Credit

The central bank regulates the amount and purpose forwhich credit is granted by commercial banks.

5. Moral Suasion

This refers to request made by central bank to commercial

banks to follow its general monetary policy.


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6. Direct Action

Direct action is taken by central bank against commercial

banks if they do not follow the monetary policy laid by it.

7. Publicity

The central bank undertakes publicity to educate

commercial bank and public about the trends in money

market. By undertaking these measures the central bank

can control the money supply and help to curb inflation.


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(2) FISCAL MEASURES

1. Taxation

The rates of direct and indirect taxes may be raised and new taxesmay be imposed. This policy will reduce the disposable income in

the hands of the people and their expenditure.

2. Public Expenditure

During inflation, the government should reduce its expenditure.

This would reduce the income in the hands of some people. Hence

the effective demand would decrease.

3. Public Borrowing

The government may resort to voluntary and compulsory

borrowing. This policy reduces the income in the hands of some

people. Hence the effective demand would decrease.

4. Over Valuation of Domestic Currency

Over valuation of domestic currency makes exports costlier andthere is a fall in the volume of exports. Imports also become

cheaper and there is an increase in money supply causing a fall in

prices.

5. Inducement to Save

The government should induce savings through incentives. This

will reduce the supply of money and purchasing power of the

people causing a fall in prices.

6. Public debt management

The public debt should be handled in such a way that there is no

increase in the supply of money. Hence the surplus in the budget

should be used to repay the public debts.


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(3) NONMONETARY MEASURES/OTHER MEASURES

1. Increase in output

Every country suffering from inflation should take steps to

increase the output of scarce goods and services. The production

of essential goods at the cost of luxury goods can also serve as an

anti-inflationary measure.

2. Price control and rationing

Price control must be introduced in respect of essentialcommodities. Also rationing should be introduced for equitable

distribution of essential commodities. The supply of essential

goods can be undertaken through public distribution system to

keep the prices in check.

3. Imports

Imports of food grains and other essential goods which are in

short supply should be allowed.

4. Legal action

Legal action should be taken against hoarders and black

marketers.

5. Wage-rate

During inflation, the rise in wage rate should be linked to rise inlabour productivity. This will help to control inflation.

6. Check on population growth

It is essential to check the growth of population by adopting

effective family planning devices.


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Above all, an efficient and honest administration and good

discipline among people are essential. The various measures

stated above have to be combined in a proper manner depending

on the situation of the country.


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PRICE RISE STILL PINCHING COMMON MANS POCKET

The 15 per cent rise in national and per capita income and a buoyant 9.4per cent GDP growth notwithstanding, the common man is still reeling under

the massive burden of rising prices.

In fact, excepting for just sugar, the rates of as many as 7-8 essential

commodities have shot up by over 25 per cent between January and May as

against the same period last year.

While the prices of wheat, pulses, spices and condiments, edible oil,

meat & meat products, milk products and fruits & vegetables on an average

increased by over 25 per cent in this period, forcing the aam aadmi to question

the authenticity of the much promised inclusive growth.

The price rises come at a time when India has witnessed a growth of

15.8 per cent in 2006-07 in its national income from Rs 28,46,762 crore in

2005-06 to Rs 32,96,639 crore in 2006-07.

The primary reason for their vegetables price rise is the entry of retailers

in organised market which has been sourcing supplies directly from the

farmers to retail warehouses.


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TACKLING INFLATION

Many people think it is ok to tolerate some inflation if, in return, it is

possible to sustain higher growth rates. Nothing matters as much for peace,

prosperity and poverty alleviation as high GDP growth.

However, the link between inflation and growth is complex. High

inflation does not give high growth. The growth miracles of Asia, where above

7% growth was sustained over a 25-year period, were not associated with high

inflation. In fact, countries with high inflation have tended to have low growth.

In the business cycle, an acceleration of inflation can support a

temporary acceleration of growth. In India, expected inflation has gone upfrom roughly 3% in 2004 to roughly 7% today--a rise of 4 percentage points.

Interest rates have risen by less than 4 percentage points. As a consequence,

real interest rates have actually gone down. Borrowing has become cheaper;

we have a credit boom; and this is giving heightened GDP growth.

If inflation now stands still at 7%, this boost to GDP growth will fade

away. Episodes where inflation went up are associated with a brief

acceleration of GDP growth. A government can jolt an economy by raising theinflation rate. This heightened growth is not sustained. Conversely, achieving

high sustained GDP growth is about fundamental issues of economic reform,

and does not concomitantly require high inflation.

One of the great strengths of India is that the political system just does

not accept high inflation. This is one area where politicians have been ahead of

the intellectuals. Inflation of 3% is politically acceptable, and inflation above

5% sets off alarm bells.

The government that can jolt an economy by raising the inflation rate

then has to go through the costly process of wringing out the inflation, to get

back to 3%. Since there is no trade-off between inflation and GDP growth,

Parliament is right in demanding low inflation and high GDP growth.

Currently, in India, we go through boom-and-bust cycles; sometimes

GDP growth rates are very high and sometimes GDP growth rates drop sharply.

This boom-and-bust cycle is unpleasant for every household. There is a


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powerful international consensus that stabilizing inflation reduces this boom-

and-bust cycle of GDP growth.

The ideal combination, which has been achieved in all mature market

economies, is one involving low inflation, which is also predictable and non-volatile. Low inflation volatility induces low volatility of GDP growth.

Low and predictable inflation also reduces the number of mistakes made

by entrepreneurs in formulating investment plans. What India does not have is

an institutional capacity for delivering predictable, non-volatile inflation of 3%.

In socialist India, the way to deal with an outbreak of inflation was to do

government interference in commodity markets. A few commodities that

"cause" inflation are identified, and the government swings into action

banning exports, giving out import licences, banning futures trading, sending

the police to unearth "hoarding", etc.

This is deeply distortionary. Milk exports were banned, and milk prices

fell. But why should milk farmers pay for a macroeconomic problem of

inflation? The cost of bringing down inflation needs to be dispersed all across

the economy.

If milk prices had been allowed to rise, then more labour and capital

would shift from unproductive cereals to high-value milk production. India has

the potential to be the world's biggest exporter of milk. But this requires a

sophisticated web of producers, supply chain, exporters, factories, etc.

This sophisticated ecosystem will not flourish when the government

meddles in the milk industry. A meddlesome government will go through the

whiplash of doing an MSP one day because milk prices are low and banningexports another day because milk prices are high.

There is something profoundly wrong about a government that

interferes in what can be imported and what can be exported. If the export of

ball bearings were sometimes banned by the government, you can be sure

there would be fewer factories to build ball bearings.

India is evolving from a socialist past into a mature market economy.

How can predictable, non-volatile inflation of 3% be achieved? The recipe that


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has been developed worldwide is to devote the entire power of monetary

policy to this one task. In India, the RBI has a complex mandate spanning over

many contradictory roles. This has led to failures on inflation control.

In a mature market economy, a modern central bank watches expectedinflation with great interest. Active trading takes place on the spot and

derivatives markets, for both ordinary bonds and inflation-indexed bonds.

Using these prices, a modern central bank is able to infer expected inflation.

When the short-term interest rate is raised or lowered, in order to

respond to changes in expected inflation, there is a slow impact on the

economy, possibly spread over two to three years. A modern central bank has

the economic knowledge required to watch out for expected inflation deep inthe future, and respond to it ahead of time, so as to deliver inflation that is on

target.

In India's case, the RBI Act of 1934 predates modern monetary

economics. In other countries, fundamental reforms have been undertaken in

order to refashion monetary institutions in the light of modern knowledge. As

an example, in the late 1990s, when Tony Blair and Gordon Brown won the

election, they refashioned the Bank of England as a focused central bank whichhas three core values

The bad drafting of the RBI Act of 1934 is the ultimate cause of the

distress of milk producers today. These linkages are not immediately visible,

but they are very real. It is because India does not have a proper institutional

foundation for monetary policy that we are reduced to distortionary

mechanisms for inflation control.


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MEASURES OF INFLATION

Inflation is measured by calculating the percentage rate of change of a

price index, which is called the inflation rate. This rate can be calculated for

many different price indices, including

Consumer price indices (CPIs) which measure the price of a selection of goods

purchased by a "typical consumer." In the UK, an alternative index called the

Retail Price Index (RPI) uses a slightly different market basket.

Cost-of-living indices (COLI) are indices similar to the CPI which are often used

to adjust fixed incomes and contractual incomes to maintain the real value of

those incomes.

Wholesale price index The Wholesale Price Index (WPI) is the most widely

used price index in India. It is the only general index capturing price

movements in a comprehensive way. WPI was first published in 1902, and was

one of the more economic indicators available to policy makers until it was

replaced by most developed countries by the Consumer Price Index in the

1970s.It is an indicator of movement in prices of commodities in all trade and

transactions.

Producer price indices (PPIs) which measure the prices received by producers.

This differs from the CPI in that price subsidization, profits, and taxes may

cause the amount received by the producer to differ from what the consumer

paid. There is also typically a delay between an increase in the PPI and any

resulting increase in the CPI. Producer price inflation measures the pressure

being put on producers by the costs of their raw materials. This could be

"passed on" as consumer inflation, or it could be absorbed by profits, or offsetby increasing productivity. In India and the United States, an earlier version of

the PPI was called the Wholesale Price Index.

Commodity price indices, which measure the price of a selection of

commodities. In the present commodity price indices are weighted by the

relative importance of the components to the "all in" cost of an employee.


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The GDP Deflator is a measure of the price of all the goods and services

included in Gross Domestic Product (GDP). The US Commerce Department

publishes a deflator series for US GDP, defined as its nominal GDP measure

divided by its real GDP measure.

Capital goods price Index, although so far no attempt at building such an index

has been made, several economists have recently pointed out the necessity of

measuring capital goods inflation (inflation in the price of stocks, real estate,

and other assets) separately.[citation needed] Indeed a given increase in the

supply of money can lead to a rise in inflation (consumption goods inflation)

and or to a rise in capital goods price inflation. The growth in money supply has

remained fairly constant through since the 1970's however consumption goods

price inflation has been reduced because most of the inflation has happened in

the capital goods prices.

Regional Inflation The Bureau of Labor Statistics breaks down CPI-U

calculations down to different regions of the US.

Historical Inflation Before collecting consistent econometric data became

standard for governments, and for the purpose of comparing absolute, rather

than relative standards of living, various economists have calculated imputedinflation figures. Most inflation data before the early 20th century is imputed

based on the known costs of goods, rather than compiled at the time. It is also

used to adjust for the differences in real standard of living for the presence of

technology. This is equivalent to not adjusting the composition of baskets over

time.


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INFLATION & INDIA (WPI)

The Wholesale Price Index (WPI) is the most widely used price index in

India. It is the only general index capturing price movements in a

comprehensive way. WPI was first published in 1902, and was one of the more

economic indicators available to policy makers until it was replaced by most

developed countries by the Consumer Price Index in the 1970s.It is an indicator

of movement in prices of commodities in all trade and transactions. It is also

the price index in India which is available on a weekly basis with the shortest

possible time lag of two weeks. It is due to these attributes that it is widely

used in business and industry circles and in Government and is generally taken

as an indicator of the rate of inflation in the economy.

The current series of Index Number of Wholesale Prices in India with 1981-

82 as base year came into existence from July 1989. With a view to reflecting

adequately the changes that have taken place in the economy since 1981-82,

the Government appointed a Working Group to revise the existing WPI series

and to examine the commodity coverage, selection of the base year, weighting

diagram and other related issues. WPI is the index that is used to measure the

change in the average price level of goods traded in wholesale market. The

new series with 1993-94 as the base has as many as 435 items in theCommodity basket. To reflect the structural changes in the economy that have

taken place over a decade, a large number of commodities have been added

and a few with diminished importance have been dropped. In the revised

series, Primary Articles contribute 98 items, Fuel, Power, Light and

Lubricants 19 items, and Manufactured Products provide 318 items. The

number of price quotations in the revised series is spread out to as many as

1918 quotations. In all, there are 136 new items in the revised series. Out of

that, Primary Articles account for 13, Fuel Group contributes 1 and

Manufactured Products have 122 new commodities. The revised weights of thethree major groups are given below. Figures in the parentheses are the

weights of the respective groups in the 1981-82 series.

Primary Articles Fuel, Power, Light & Lubricants Manufactured Products


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India uses the Wholesale Price Index (WPI) to calculate and then decide the

inflation rate in the economy. Most developed countries use the Consumer

Price Index (CPI) to calculate inflation.

Annual rates of change in the WPI calculated using both the existing and thenew series are given below. It is seen that the new series starts at a higher

level than the old series accounting for a relatively higher annual rate of

change, but thereafter the two series virtually move in cycle.

Main constituents of WPI

1.

Primary articles2. Fuel, power3. Manufactured products4. Food articles5. Vegetables6. Food products7. Edible oils8. Cement

Criteria for Selection of Wholesale Price Outlets

The following criteria were used to determine the wholesale price outlets

1. Popularity of an establishment along the line of goods to be priced2. Consistency of the stock3. Permanency of the outlet4. Cooperativeness of the price informant5. Location

Measures of inflation in India

Three different price indices are available in India

1. Wholesale price index2. Consumer price index [calculated for 3 different types of workers]3. GDP deflator


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Availability

1. The WPI is available weekly [for a lag of 2 weeks]2. The CPI is available monthly [for a log of 1 month]3. The GDP deflator is available annuallyIn many countries, the main focus is placed on CPI for assessing inflationary

trends, because

1. It is the index most statistical resources are placed2. It is most closely related to the cost of livingIn India however the main focus is placed on WPI because it has a broader

coverage and is published on a more frequent and timely basis than the CPI.

However, the CPI remains important because it is used for indexation purposes

for many wage and salary earners.


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INDIAN SCENARIO

Inflation is no stranger to the Indian economy. In fact, till the early

nineties Indians were used to double-digit inflation and its attendant

consequences. But, since the mid-nineties controlling inflation has become a

priority for policy framers.

The natural fallout of this has been that we, as a nation, have become

virtually intolerant to inflation. While inflation till the early nineties was

primarily caused by domestic factors (supply usually was unable to meet

demand, resulting in the classical definition of inflation of too much money

chasing too few goods), today the situation has changed significantly.

Inflation today is caused more by global rather than by domestic factors.

Naturally, as the Indian economy undergoes structural changes, the causes of

domestic inflation too have undergone tectonic changes.

Needless to emphasise, causes of today's inflation are complicated.

However, it is indeed intriguing that the policy response even to this day

unfortunately has been fixated on the traditional anti-inflation instruments of

the pre-liberalisation era.

Reasons for inflation in India

1) Increase in Demand and fall in supply causes rise in prices.2) A Growing Economy has to pass through Inflation.3)

Lack of Competition and Advanced Technology (increases cost ofproduction and rise in price)

4) Defective Monetary and Fiscal Policy (In India its fine)5) Hoarding (when traders hoard goods with intention to sell later at high

prices)

6) Weak Public Distribution System


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INFLATION PRESSURE OVER THE LAST FEW MONTHS

Date Inflation Rate4-April-2008 7.14

11-April-2008 7.33

18-April-2008 7.41

25-April-2008 7.33

2-May-2008 7.57

9-MAY-2008 7.82

16-MAY-2008 8.1

24-MAY-2008 8.24


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INFLATION IN INDIA AND OTHER DEVELOPED COUNTRIES


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INFLATION DURING 1980s AND1990s

WPI inflation was relatively stable between 1983 and 1990, averaging 6

percent, recording a low of 3 percent in early 1986, and a high of a little over

10 percent in 1988. In the 1990s, inflation has, on average, been higher at 8

percent, and considerably more variable. Inflation rose sharply in the early

1990s, reaching a peak of a little over 16 percent in late 1991, as primary

product prices rose sharply and the balance of payment crisis resulted in a

sharp depreciation of the rupee and upward pressure on the price of industrial

inputs. However, as the agricultural sector rebounded, industrial activity

slowed, and financial stability was restored, inflation declined to 7 percent by

mid 1993 but then again accelerated to over 10 percent during 1994 and 1995

as economic activity recovered strongly. In response, the RBI moved to tightenmonetary policy, and inflation was brought down gradually, reaching a low of

3 percent in mid 1997.However, more recently, inflation again accelerated in

the second half of 1998as adverse supply conditions in key commodity markets

put upward pressure on food price. As these conditions have eased, inflation

has again fallen sharply.

Within the three sub-component of WPI, prices in the manufacturing

sector have been lowered and more stable, ranging from 2-13 percent.

Inflation in both primary products and fuel and energy categories has been

considerably high in1990s than in the 1980s. Both indices have also volatile.

Within the fuel and energy category, the sharp rise in prices in the recent year

is partly due to government moving more towards market based prices,


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although given the administered nature of these prices such adjustment have

tended to occur at irregular intervals leading to sharp movements in the index.


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GLOBAL INFLATION A COMPARISON WITH INDIA

Inflation rates in some developed and developing economies based on

the Consumer Price Indices. Up to the mid 1990s, while inflation rate in the

developed economies ranged between 1-2 percent, it was in a much higher

range for the developing economies including India - with some years even

recording double digit inflation. For exchange rate stability and smoother

trade, it is imperative that inflation rate in India be close to our major trading

partners. Over the last three to four years, we have moved closer to this

objective with inflation rate being in the range 3-5 percent as against 2-3

percent in the developed economies. The declining trend in inflation is also

visible in many of the developing economies in Asia.


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ISSUES IN MEASURING INFLATION

Measuring inflation requires finding objective ways of separating outchanges in nominal prices from other influences related to real activity. In the

simplest possible case, if the price of a 10 kgs of corn changes from 90 to 100

over the course of a year, with no change in quality, then this price change

represents inflation. But we are usually more interested in knowing how the

overall cost of living changes, and therefore instead of looking at the change in

price of one good, we want to know how the price of a large 'basket' of goods

and services changes. This is the purpose of looking at a price index, which is a

weighted average of many prices. The weights in the Consumer Price Index, for

example, represent the fraction of spending that typical consumers spend on

each type of goods (using data collected by surveying households).

Inflation measures are often modified over time, either for the relative

weight of goods in the basket, or in the way in which goods from the present

are compared with goods from the past. This includes hedonic adjustments

and reweighing as well as using chained measures of inflation. As with many

economic numbers, inflation numbers are often seasonally adjusted in order to

differentiate expected cyclical cost increases, versus changes in the economy.

Inflation numbers are averaged or otherwise subjected to statistical techniques

in order to remove statistical noise and volatility of individual prices. Finally,

when looking at inflation, economic institutions sometimes only look at

subsets or special indices. One common set is inflation excluding food and

energy, which is often called core inflation.


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AN EXAMPLE OF HOW INFLATION CAN BE DANGEROUS

Hazards of inflation [How Zimbabwe was affected by inflation]

Have you heard of a country which is dotted with malls filled with goods, butno customers? It is Zimbabwe, the land of Mugabe.

Zimbabwe is a classic case of how inflation can make life hell for people.

Experts say it all started with Mugabes regime. Whatever may be the reason,

the basic flaw in Zimbabwes economy is that Zimbabwe lost its ability to feed

itself.

So, if you dont have enough agriculture commodities the prices are

bound to go up. This is one lesson India can learn from Zimbabwe.

Indias wheat, rice, pulses and edible oil production is not enough to

keep pace with the growth the country is witnessing. That is why Indian

government is worrying about the rising inflation rates.

However, it is not anywhere near Zimbabwe. Zimbabwes skyrocketing

inflationnow the worlds highest, running at more than 100,000 per cent a

year keeps the cost of living rising.

In 1979, when Mugabes nationalist rebels overthrew the white-

dominated government of Rhodesia, and changed the name of the country to

Zimbabwe, thousands of commercial farms managed to grow enough food to

export throughout the region.

At present, more than a decade of mismanagement and neglect has

dropped agricultural production to pre-colonial levels.

This year, Zimbabwes shortfall in maize is 360,000 tonnes, and its

shortfall in wheat is 255,000 tonnes.

Streets of Zimbabwe are dotted with shopping mall. That shows that

there is food on the shelves, but all of it highly priced.

Massive department stores, built for a time when farmers from miles

around would come to do their weekend shopping, are full of clothes, but

without customers.


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With cash almost a worthless possession, people have started investing

in something different. They stack bags of maize meal in their homes.

The situation in Zimbabwe has hit several Indians badly. Many of the

Indian businessmen in Zimbabwe, especially Gujaratis, are finding it tough todo trade there.

Because, a sausage sandwich sells for 30 million Zimbabwe dollars, or

about US $1.25. A 30-pound bag of potatoes cost 90 million in the first week of

March. Now that same bag costs 160 million.

So, Zimbabwe is an example for the world how inflation can ruin a

country, which does not produce enough food for itself.


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RESERVE BANK OF INDIA

The central bank of the country is the Reserve Bank of India (RBI). It wasestablished in April 1935 with a share capital of Rs. 5 crores on the basis of the

recommendations of the Hilton Young Commission. The share capital was

divided into shares of Rs. 100 each fully paid which was entirely owned by

private shareholders in the beginning. The Government held shares of nominal

value of Rs. 2, 20,000.

Reserve Bank of India was nationalised in the year 1949. The general

superintendence and direction of the Bank is entrusted to Central Board of

Directors of 20 members, the Governor and four Deputy Governors, one

Government official from the Ministry of Finance, ten nominated Directors by

the Government to give representation to important elements in the economic

life of the country, and four nominated Directors by the Central Government to

represent the four local Boards with the headquarters at Mumbai, Kolkata,

Chennai and New Delhi. Local Boards consist of five members each CentralGovernment appointed for a term of four years to represent territorial and

economic interests and the interests of co-operative and indigenous banks.

The Reserve Bank of India Act, 1934 was commenced on April 1, 1935.

The Act, 1934 (II of 1934) provides the statutory basis of the functioning of the

Bank.

The Bank was constituted for the need of following

To regulate the issue of bank notes

To maintain reserves with a view to securing monetary stability and

To operate the credit and currency system of the country to its

advantage.


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Functions of Reserve Bank of India

To maintain monetary stability so that the business and economic lifecan deliver welfare gains of a properly functioning mixed economy.

To maintain financial stability and ensure sound financial institution sothat monetary stability can be safely pursued and economic units can

conduct their business with confidence.

To maintain stable payments system so that financial transactions can besafely and efficiently executed.

To promote the development of financial infrastructure of markets andsystems, and to enable it to operate efficiently i.e., to play a leading role

in developing a sound financial system so that it can discharge itsregulatory function efficiently.

To ensure that credit allocation by the financial system broadly reflectsthe national economic priorities and societal concerns.


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ROLE OF RBI

The Reserve Bank of India Act of 1934 entrust all the important functions of acentral bank the Reserve Bank of India.

1] Bank of Issue

Under Section 22 of the Reserve Bank of India Act, the Bank has the sole

right to issue bank notes of all denominations. The distribution of one rupee

notes and coins and small coins all over the country is undertaken by the

Reserve Bank as agent of the Government. The Reserve Bank has a separate

Issue Department which is entrusted with the issue of currency notes. The

assets and liabilities of the Issue Department are kept separate from those of

the Banking Department. Originally, the assets of the Issue Department were

to consist of not less than two-fifths of gold coin, gold bullion or sterling

securities provided the amount of gold was not less than Rs. 40 crores in value.

The remaining three-fifths of the assets might be held in rupee coins,

Government of India rupee securities, eligible bills of exchange and promissory

notes payable in India. Due to the exigencies of the Second World War and thepost-war period, these provisions were considerably modified. Since 1957, the

Reserve Bank of India is required to maintain gold and foreign exchange

reserves of Ra. 200 crores, of which at least Rs. 115 crores should be in gold.

The system as it exists today is known as the minimum reserve system.

2] Banker to Government

The second important function of the Reserve Bank of India is to act as

Government banker, agent and adviser. The Reserve Bank is agent of Central

Government and of all State Governments in India excepting that of Jammu

and Kashmir. The Reserve Bank has the obligation to transact Government

business, via. to keep the cash balances as deposits free of interest, to receive

and to make payments on behalf of the Government and to carry out their

exchange remittances and other banking operations. The Reserve Bank of India

helps the Government - both the Union and the States to float new loans and


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to manage public debt. The Bank makes ways and means advances to the

Governments for 90 days. It makes loans and advances to the States and local

authorities. It acts as adviser to the Government on all monetary and banking

matters.

3] Bankers' Bank and Lender of the Last Resort

The Reserve Bank of India acts as the bankers' bank. According to the

provisions of the Banking Companies Act of 1949, every scheduled bank was

required to maintain with the Reserve Bank a cash balance equivalent to 5% of

its demand liabilities and 2 per cent of its time liabilities in India. By anamendment of 1962, the distinction between demand and time liabilities was

abolished and banks have been asked to keep cash reserves equal to 3 per cent

of their aggregate deposit liabilities. The minimum cash requirements can be

changed by the Reserve Bank of India.

The scheduled banks can borrow from the Reserve Bank of India on the

basis of eligible securities or get financial accommodation in times of need orstringency by rediscounting bills of exchange. Since commercial banks can

always expect the Reserve Bank of India to come to their help in times of

banking crisis the Reserve Bank becomes not only the banker's bank but also

the lender of the last resort.

4] Controller of CreditThe Reserve Bank of India is the controller of credit i.e. it has the power

to influence the volume of credit created by banks in India. It can do so

through changing the Bank rate or through open market operations. According

to the Banking Regulation Act of 1949, the Reserve Bank of India can ask any

particular bank or the whole banking system not to lend to particular groups or

persons on the basis of certain types of securities. Since 1956, selective

controls of credit are increasingly being used by the Reserve Bank.


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The Reserve Bank of India is armed with many more powers to control

the Indian money market. Every bank has to get a licence from the Reserve

Bank of India to do banking business within India, the licence can be cancelledby the Reserve Bank of certain stipulated conditions are not fulfilled. Every

bank will have to get the permission of the Reserve Bank before it can open a

new branch. Each scheduled bank must send a weekly return to the Reserve

Bank showing, in detail, its assets and liabilities. This power of the Bank to call

for information is also intended to give it effective control of the credit system.

The Reserve Bank has also the power to inspect the accounts of any

commercial bank.

As supreme banking authority in the country, the Reserve Bank of India,

therefore, has the following powers

(a) It holds the cash reserves of all the scheduled banks.

(b) It controls the credit operations of banks through quantitative and

qualitative controls.

(c) It controls the banking system through the system of licensing, inspection

and calling for information.

(d) It acts as the lender of the last resort by providing rediscount facilities to

scheduled banks.

5] Custodian of Foreign Reserves

The Reserve Bank of India has the responsibility to maintain the official

rate of exchange. According to the Reserve Bank of India Act of 1934, the Bank

was required to buy and sell at fixed rates any amount of sterling in lots of not

less than Rs. 10,000. The rate of exchange fixed was Re. 1 = sh. 6d. Since 1935

the Bank was able to maintain the exchange rate fixed at lsh.6d. though there

were periods of extreme pressure in favour of or against the rupee. After India

became a member of the International Monetary Fund in 1946, the Reserve


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Bank has the responsibility of maintaining fixed exchange rates with all other

member countries of the I.M.F.

Besides maintaining the rate of exchange of the rupee, the Reserve Bank

has to act as the custodian of India's reserve of international currencies. Thevast sterling balances were acquired and managed by the Bank. Further, the

RBI has the responsibility of administering the exchange controls of the

country.

6] Supervisory functions

In addition to its traditional central banking functions, the Reserve bank

has certain non-monetary functions of the nature of supervision of banks and

promotion of sound banking in India. The Reserve Bank Act, 1934, and the

Banking Regulation Act, 1949 have given the RBI wide powers of supervision

and control over commercial and co-operative banks, relating to licensing and

establishments, branch expansion, liquidity of their assets, management and

methods of working, amalgamation, reconstruction, and liquidation. The RBI is

authorised to carry out periodical inspections of the banks and to call for

returns and necessary information from them. The nationalisation of 14 major

Indian scheduled banks in July 1969 has imposed new responsibilities on the

RBI for directing the growth of banking and credit policies towards more rapid

development of the economy and realisation of certain desired social

objectives. The supervisory functions of the RBI have helped a great deal in

improving the standard of banking in India to develop on sound lines and to

improve the methods of their operation.

7] Promotional functions

With economic growth assuming a new urgency since Independence, the

range of the Reserve Bank's functions has steadily widened. The Bank now

performs a variety of developmental and promotional functions, which, at one

time, were regarded as outside the normal scope of central banking. The

Reserve Bank was asked to promote banking habit, extend banking facilities to


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rural and semi-urban areas, and establish and promote new specialised

financing agencies. Accordingly, the Reserve Bank has helped in the setting up

of the IFCI and the SFC; it set up the Deposit Insurance Corporation in 1962,

the Unit Trust of India in 1964, the Industrial Development Bank of India also in

1964, the Agricultural Refinance Corporation of India in 1963 and the Industrial

Reconstruction Corporation of India in 1972. These institutions were set up

directly or indirectly by the Reserve Bank to promote saving habit and to

mobilise savings, and to provide industrial finance as well as agricultural

finance. As far back as 1935, the Reserve Bank of India set up the Agricultural

Credit Department to provide agricultural credit. But only since 1951 the

Bank's role in this field has become extremely important. The Bank has

developed the co-operative credit movement to encourage saving, toeliminate moneylenders from the villages and to route its short term credit to

agriculture. The RBI has set up the Agricultural Refinance and Development

Corporation to provide long-term finance to farmers.


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CONTROL MEASURES OF RBI

RBI actually has four chief weapons in its arsenal to control the inflation. They

are

1. Open Market Operations (OMO)2. Reserve Requirements (CRR and SLR)3. Bank Rate or Discount rate4. Repo rate

1.Open Market Operations (OMO)In this case RBI sells or buys government securities in open market

transaction depending upon whether it wants to increase the liquidity or

reduce it. So when RBI sells government securities in secondary market it sucks

out the liquidity (stock of money) in the economy. So overall it reduces the

money supply available with banks in effect the capital available with banks for

lending purpose becomes scarce hence interest rates move in upward

direction. Exactly opposite happens when RBI buys securities from open

market. The transaction increases the money supply available with banks so

the cost of money (interest rate) moves in downward direction and business

activities like new investments, capacity expansion gets boost.

In a nutshell RBI buys securities when the economy is sluggish and

demand is not picking up and sells securities when the economy is overheated

and needs to cool down.

OMO is also used in curbing the artificial liquidity created to avoidstrengthening of rupee against dollar in order to remain competitive in

exports.


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2.Reserve RequirementsThis mainly constitute of Cash to Reserve Ratio (CRR) and Statutory

Liquidity ratio (SLR). CRR is the portion of deposits (as cash) which banks have

to keep/maintain with the RBI. This serves two purposes firstly, it ensures that

a portion of bank deposits is totally risk-free and secondly it enables that RBI

control liquidity in the system, and thereby, inflation. Whereas SLR is the

portion of their deposits banks are required to invest in government securities.

So due to CRR and SLR obligation towards RBI financial institutions will be

able to lend only the part of money available with them although this effect is

small when transaction is between just two entities and constitute one layer.

But when money flows through series of players and layers very less money

will be left with the institutions present at the bottom of pyramid. So higher is

the CRR less is the money available in the economy. So interest rates will move

in upward direction and opposite happens when CRR is reduced.

Recently RBI raised CRR from 4.5% to 5% in two stages which enabled to

transfer about 8000 Crore rupees from money in supply to RBIs coffers. CRR

has actually been reduced to this level of 5% from 15% in 1981.

3.Bank Rate or Discount rateThis is the rate at which the RBI makes very short term loans to banks.

Banks borrow from the RBI to meet any shortfall in their reserves. An increase

in the discount rate means the RBI wants to slow the pace of growth to reduce

inflation. A cut means that the RBI wants the economy to grow and take up

new ventures. Indian bank rate is at 6 per cent down from 10 per cent in 1981

and 12 per cent in 1991

4.Repo rateIt is the rate at which the RBI borrows short term money from the

market. After economic reforms RBI started borrowing at market prevailing

rates. So it makes more sense to banks to lend money to RBI at competitive


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rate with no risk at all. Although the repo rate transactions are for very short

duration the everyday quantum of operations is approximately Rs 40,000 crore

everyday. Thus, large amount of capital is not available for circulation. With

increase in repo rate banks tend to invest more in repo transactions.

Open market operations have limitations due to amount of government

securities with RBI is limited and close to Rs 60,000 Crore and out of that only

Rs 45,000 Crore is in form of marketable securities. Considering Bank Rate

which is untouched in current scenario RBI is left with only 2 major measures

viz. CRR and Repo Rate in its armory to guard against the onslaught of

inflation.

Since large part of inflation is attributed to large increase in international oiland metal prices, the cooling price trend in them comes as a great relief to RBI

and Indian economy as a whole and along with RBI measures has helped

stabilize inflation


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MONETARY POLICY

The Reserve bank of India, being primarily concerned with money

matters, so organize currency and credit that it subs serves the broad

economic objectives of the country. In the performance of this task, it

formulates and executes a monetary policy with clear cut goals and tools to be

used for this.

Meaning and objectives

Monetary policy, also described as money and credit policy, itself

with the supply of money as also credit to the economy. This is a statement,

announced twice in a year. With decline in the share of agricultural credit, anda rise in that of a industrial credit, the RBI has started making an annual policy

statement in April with a review of the same in October Beginning with 1999-

2000 The RBI has decided that the policy announcement will be an annual

affair.

The policy statement gives an overview of the working of the economy.

In the light it specifies the measures that the RBI intends to take a influence

such key factors of money supply , interest rate and inflation so as to ensureprice stability. It also lays down norms for financial institutions (like bank s,

finance companies etc.) governed by the RBI. There pertain to such matters as

cash reserves ratio, capital adequacy etc. in short, it is a sort of blue-print

containing a description of aims and means.

Two set of objective have been pursued for long. One is controlled

expansion of money. It sought to achieve the twin objectives of meeting in the

full needs of production and trade, and at the same time moderating thegrowth of money supply to contain the inflationary pressure in the economy.

Second is sect oral deployment of the funds depending upon the priorities lay

down in the plant, the RBI as determined the allocation of funds also the

interest rate among the different sector. The sector which have received

special attention are; core industries (coal, iron, steel and engineering etc);

food grains (rice, wheat); priority sector (agriculture, small scale industries etc);

and weaker section of population.


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During the 1990s, and since then, while the growt

vikii final management paradise

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