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Unit V
Economic analysis of Business
UNIT V AGGREGATE SUPPLY AND THE ROLE OF MONEY
Short-run and Long-run supply curve – Unemployment and its impact – Okun’s law – Inflation
and the impact – reasons for inflation – Demand Vs Supply factors –Inflation Vs Unemployement
tradeoff – Phillips curve –short- run and long-run –Supply side Policy and management- Money
market- Demand and supply of money – money-market equilibrium and national income – the role
of monetary policy.
Table of Contents
5.1 Meaning and Definition of Unemployment .............................................................................................................. 1
5.1.1 Types of Unemployment .................................................................................................................................... 2
5.1.2 Causes of Unemployment in India ................................................................................................................ 3
5.2 Okun's Law................................................................................................................................................................ 6
5.3 INFLATION ............................................................................................................................................................. 7
5.3.1 Types of Inflation ............................................................................................................................................... 9
5.3.2 Impact of Inflation........................................................................................................................................ 11
5.4 Inflation Vs Unemployment Trade-off: Phillips Curve .......................................................................................... 18
5.5 Phillips Curve: A Trade-Off .................................................................................................................................... 19
5.6 SUPPLY SIDE POLICY AND MANAGEMENT ................................................................................................. 21
5.7 Supply-Side Effects of Fiscal Policy ....................................................................................................................... 23
5.8 MONEY MARKET ................................................................................................................................................ 25
5.8.1 Nature of Money Market .................................................................................................................................. 26
5.9 Demand of Money................................................................................................................................................... 33
5.10 Supply of Money ................................................................................................................................................... 38
5.11 MONETARY POLICY . ....................................................................................................................................... 45
5.1 Meaning and Definition of Unemployment
Unemployment is a state of inactivity suffered by a worker in spite of his intention to find work
and in spite of his physical fitness to carry-on his trade. Unemployment is also defined as
involuntary idleness of a person willing to work at the prevailing rate of pay but unable to find it.
A person working 8 hours a day for 273 days of the year is regarded as employed on the standard
person year basis.
The total number of able men and women of working age seeking paid work. Unemployment
statistics vary according to how unemployment is defined and who is deemed to be part of the
workforce. Traditional methods for collecting unemployment data are based, typically, on
sampling or the number of unemployment benefit requests. International labor organization (ILO)
computes unemployment on the basis of number of people who have looked for employment in the
last four weeks and are available to start work within two weeks, plus those who are waiting to
start working in a job already obtained.
According to Pigou, "A man is unemployed only when he is both without a job or not employed
and also desires to be employed".
According to International Labor Organization, "Unemployment occurs when people are
without jobs and they actively looked for work within the past four weeks or are waiting to take
up an appointment". In sum, people with jobs are employed, people without jobs but looking for
work are unemployed and people without jobs who are not looking for work are outside the laborforce. The unemployment rate is the number of unemployed divided by the total labour-force.
Unemployment could be defined both in physical (Up) as well as in economic (UE = U) terms.
In the former,
Up = Population - Employed People
And in the latter,
U = Workforce - Employed People Where, Workforce = Population People not in the workforce
5.1.1 Types of Unemployment
1)Frictional Unemployment: This unemployment occurs when a person is out of one job is
searching for another. It generally requires some time before a person can get the next job. During
this time, he is frictionally unemployed. The problem of frictional unemployment is minimized
with the development of efficient labor markets. The time period of shifting from one job to
another is almost nil. However,
imperfect information may aggravate the problem of frictional unemployment. The more
developed an economy is, higher is the probability of getting a job faster and lower is the
probability of frictional unemployment.
2)Structural Unemployment: In this type of unemployment, a person is not sufficient to meet his
job responsibilities. Stated alternatively, structural unemployment arises when the marginal
revenue product of a person falls short of the minimum wage that can be paid for the concerned
job. The minimum wage is set by law or by negotiations with the union. Structural unemployment
can also accompany a situation of zero minimum wages. The extent to which structural
unemployment takes place depends on a number of parameters. Higher the mobility of labor across
different jobs, lower will be the structural unemployment. Along with the mobility of labour,
structural unemployment also depends on the growth rate of an economy as well as the structure of
an industry.
3)Real Wage or Classical Unemployment: This type of unemployment problem arises when the
wages rise above the equilibrium full employment level. In such a situation, the Wages are not
flexible downwards which will imply that unemployment would persist for long. Such wages may
be set by manipulations in the trade union.
4)Cyclical Unemployment: Cyclical or demand deficient unemployment occurs when the economy
is in need of low workforce. This type of unemployment occurs due to economic disequilibrium.
This form of unemployment is most commonly known as cyclical unemployment since,
unemployment moves with the trade cycle. The demand for labour increases with the economy in
the boom phase. Again, when the economy passes through the recession, demand for labor
contracts and the surplus is released as the unemployed labor force.
5)Seasonal Unemployment: There are certain kinds of unemployment that tend to concentrate in a
particular time of the year and are known as seasonal unemployment. Seasonal unemployment is
most common in industries like tourism, hotel, catering and fruit picking.
5.1.2 Causes of Unemployment in India
There are many reasons for unemployment in India out of which few are given below:
1)Jobless Growth: Although India is a developing country, the rate of growth is inadequate to
absorb the entire labor- force in the country. The opportunities of employment are not sufficient to
absorb the addition in the labor-force of the country, which are taking place as a result of the
rapidly increasing unemployment in India.
2)Inefficient Agricultural and Industrial Sectors: industrialization is not rapid in our country and
industrial labor find few job opportunities. As enough other employment opportunities are not
available, agriculture is the principal area of employment in our country. Thus, pressure on land is
high, as about 2/3 of the Labor-force is engaged in agriculture. Land is thus overcrowded and a
large part of the workforce is underemployed and suffer from disguised unemployment.
3)Inappropriate Education System: After remaining at schools and colleges for a number of year
men and women come- out in large numbers, having gained neither occupational nor vocational
training nor functional literacy from which all future skilled, educated professional and managerial
manpower is drawn.
4)Inappropriate Technology: In India, while capital is a scarce factor, labor is available in
abundant quantity. However, not only in industries, but also in agriculture producers are
increasingly substituting capital for labor. On account of abundance of labor, this policy is
resulting in large unemployment.
5)Weaknesses in Planning Techniques: The growth strategy underlying our plans has been found
to be faulty. Lack in infrastructure development and poor labor-intensive techniques planning has
made unemployment a severe issue in our Indian economy.
6)Illiteracy: It is the most important and primary reason for unemployment in our country.
Moreover we do not have adequate educational facilities in rural areas. Poor parents are not willing
to send their children to school as they think that they are a source of income for their family. We
also have a defective education system. A greater stress is laid on general education than
vocational training. This type of education is neither job-oriented nor skill-oriented. Thus, the
country has a large number of educated unemployed.
7)Technology: It is also a major cause of unemployment especially in the agricultural sector.
Machines can perform the job of many persons in a short span of time and in a better way. A large
number of people became unemployed when computers were introduced in our country by Rajiv
Gandhi. It leads to wide-scale protests from all over the country.
8)Population Growth: The employment growth in our country could not keep-up pace with the
population growth. It has also resulted in underutilisation of our resources. Eventually,
investments and savings in our country have reduced considerably. Thus the major sectors have
failed to provide job to all the people.
9)Social and Cultural Factors: It has generally been seen that people do not want to leave their
family and work at distant places. In a joint family, individuals have a tendency to neglect work as
they want to spend their life on the income of other family members.
Measures to Reduce Unemployment
Measures to reduce unemployment are as follows:
Unemployment is a global phenomenon and a growing concern for most governing bodies. As rate
of employment is related to many microeconomic factors of a country's progress, many discussions
have emerged which have led to many theories. Unemployment was an issue even before the
global recession; it is just that recession emphasized and highlighted the issue.
Most of the theories are either impractical or do not suit all the countries and some would manage
to increase the level of unemployment as they suggest remedies with freebies which can reduce
competition. Competition can never be compromised as without it, the overall job satisfaction,
incentive systems, pay scale and many other factors get affected directly or indirectly.
Some steps which can be taken by the government sectors or world bodies in reducing the level of
unemployment are discussed below:1)Population Control: India has to put a check on its rising population if it wants to solve most of
her problems. It is essential so that the additional jobs created do not fall short of new entrants to
the labor market.
2)Reform in the Education System: There should be vocationalisation of education. Efforts should
be made to shape the skills of the individuals so that they can put to practical use.
3)Self-employment Schemes: In India, more than half of the population is self-employed in trade,
transport, cottage industries, etc. Hence, the government should take some measures to develop
self-help centers.
4)Policy towards Seasonal Unemployment: In India, most of the people are engaged in agriculture
which is a highly seasonal work. Hence, they become unemployed during the rest of the year.
Hence, steps should be taken to promote allied activities like animal husbandry, dairy farming,
horticulture, etc. Cottage industries should be developed to help them during non-seasonal periods.
5)Rapid industrialization: More industries should be set-up to generate employment opportunities.
6)Government Policies: Major government policies for removing unemployment are as follows:
i) Swaranjayanti Gram Swarozgar Yojana (SGSY)
ii) Sampoorna Grameen Rozgar Yogana (SGRY)
iii) Swarana Jayanti Shahari Rozgar Yojana (SJSRY)
iv) Prime Minister's Rozgar Yojana (PMRY)
v) National Rural Employment Programme (NREP)
vi) Rural Landless Employment Guarantee Programme (RLEGP)
vii) Integrated Rural Development Programme (lRDP)
viii) Scheme of Training Rural Youth for Self-Employment (TRYSEM)
ix) Jawahar Rozgar Yojana (JRY)
x) Employment Assurance Scheme (EAS)
Government Policies for Removing Unemployment in India
1)Swaranjayanti Gram Swarozgar Yojana (SGSY): It was launched from April 1, 1999 after
restructuring the IRDP and allied schemes. It is the only self-employment programme for the rural
poor. The objective of Swarnjayanti Gram Swarozgar Yojana is to provide sustainable income to
the rural poor by establishing a large number of micro-enterprises in rural areas generating self
employment opportunities. The aim was to bring the assisted families (Swarozgaris) above the
poverty line in three years by ensuring that the individual family had a monthly net income of at
least Rs2000 excluding repayment, be providing income generating assets through a mix of bank
credit and Government subsidy.
2)Sampoorna Grameen Rozgar Yogana (SGRY): It was launched on September 23,2001 and the
scheme of JGSY and Employment Assurance Scheme was fully integrated with SGRY. It aims at
providing additional wage employment in rural areas. The main objectives of this Yojana are:
i) To provide opportunity of employment to surplus labour,
ii) To provide food security,
iii) Development of community. social assets and economic assets, and
iv) Development of the Basic Infrastructure This yojana has set a target of creating 1OO crore
man-days of employment.
3)Swarana Jayanti Shahari Rozgar Yojana (SJSRY): It came into operation from December 1,
1997, subsuming the earlier urban poverty alleviation programs. The major objectives of this
scheme are as follows:
i. Addressing urban poverty alleviation through gainful employment to the urban
unemployed or underemployed poor by encouraging them to set up self-employment
ventures (individual or group), with support for their sustainability; or undertake wage
employment:
ii. Supporting skill development and training programmes to enable the urban poor
have access to employment opportunities opened up by the market or undertake selfemployment; and
iii. Empowering the community to tackle the issues of urban poverty through suitable
self- managed community structures like Neighbourhood Groups (NHGs).
Neighbourhood Conunittees (NHC), Community Development Society (CDS), etc.
4)Prime Minister's Rozgar Yojana (PMRY): It was designed to provide self-employment to more
than a million educated unemployed youth by setting-up seven lac mirco-enterprises under the
Eighth Five Year Plan. The major objectives of this policy are as follows:
i)To generate employment opportunities in rural as well as urban areas of the country through
setting up of new self- employment ventures/ projects/micro enterprises.
ii) To bring together widely dispersed traditional artisans/ rural and urban unemployed youth and
give them self- employment opportunities to the extent possible, at their place.
iii) To provide continuous and sustainable employment to a large segment of traditional and
prospective artisans and rural and urban unemployed youth in the country, so as to help arrest
migration of rural youth to urban areas.
iv) To increase the wage earning capacity of artisans and contribute to increase, in the growth rate
of rural and urban employment.
5)National Rural Employment Programme (NREP): It was started as a part of the Sixth Plan and
was continued under the Seventh Plan. It was meant to help that segment of the rural population
which largely depends on wage employment an has virtually no source of income during the lean
agricultural period: The objective of the Act is to enhance livelihood security in rural areas by
providing at least 100 days of guaranteed wage employment in a financial year to ever household
whose adult members volunteer to do unskilled manual work.
6)Rural Landless Employment Guarantee Programme (RLEGP): It was started on 15th August,
1983, with th objective of expanding employment opportunities for the rural landless, i.e., to
provide guarantee to atleast one member of the landless household for about 100 days in a year.
7)Integrated Rural Development Programme (IRDP): It was launched in 1978-79 and extended all
over the country in 1980-81. It was to provide self-employment in a variety of activities like Seri
culture, animal husbandry, etc., in the primary sector, handicrafts, etc., in the secondary sector, and
service and business activities in the tertiary sector.
8)Scheme of Training Rural Youth for Self-Employment (TRYSEM): It was initiated in 1979. It
aimed at training about 2 lac rural youth every year to enable them to become self-employed.
9)Jawahar Rozgar Yojana (JRY): It was announced in February 1989, it was supposed to provide
intensive employmen creation in the 120 backward districts. It was later renamed Jawahar Gram
Samridhi Yojana (JGSY) whose objective was the creation of infrastructure and durable assets at
the village level so as to increase opportunities for sustained employment to the rural poor.
10)Employment Assurance Scheme (EAS): It aimed at providing 100 days of unskilled manual
work on demand to twc members of a rural family in the age group 18 to 60 years in the
agricultural lean season within the blocks covered under the scheme.
5.1.3 Levels of Unemployment in India
Unemployment rate measures the fraction of work forces that are out of work and are looking for a
job to do. Unemployment rates were found to be stable in the 1990s at 20% and to have sharply
come down by 2000. Employment growth did slow down in the 1990s, but this appears to have
been in response to a sharp slowdown in the growth of the potential labor force i.e. the growth in
the number of people in the labor force age group, 15-59 years. Thus, Stead of a job scarce
economy one strong conclusion of this paper is that India is transitioning from a labour surplus
economy to one with lesser surpluse: and emerging labor scarcities.
The unemployment rate in India was last reported at 3.8 percent in 2010/11 fiscal year.
Historically, from 1983 until 2011 India Unemployment Rate averaged 7.57 Percent reaching an
all time high of 9.40 Percent in December of 2009 and a record low of 3.80 Percent in December
of 2011. The unemployment rate per 1,000 population is at 27, As on January 1,2010, the number
of unemployed was 9.8 million. By January 1,2012, it has increased to 10.8 million.
5.2 Okun's Law

Okun's law refers to the relationship between increases in unemployment and
decreases in a country's Gross Domestic Product (GDP). It states that for every one per cent
increase in unemployment above a "natural" level, that GDP will decrease by anywhere
from two to four per cent of its potential. Okun's law is named after Arthur Okun, the
economist who in 1962 was the first to make detailed observations about this relationship.
So-called "natural unemployment" refers to the fact that there will always be atleast a
certain amount of unemployment in a free market economy, because of voluntary
Changes in employment, and other reasons not related to economic hardship.

Many economists have observed that Okun's law is really not a law at all, but more
of a tendency that can vary based on , number of factors. Although it can be expressed
mathematically, and holds up under real-world scrutiny, Okun's law is an imperfect theory.
This is not as a result of any error on the part of Okun the economist, but rather because
unpredictability. For example, the exact amount of unemployment that constitutes natural
unemployment is not known, nOI can it be.

Another imperfection in Okun's law is that the effect of a given increase in
unemployment could be magnified 01 diminished based on variables like productivity, and
general sentiment regarding the economy. These variables are, ai best, hard to measure.
The definition of unemployment - not having a job but still seeking one - also colours the
data slightly, because unemployment therefore does not take into account those that stop
looking for new work after a certain amount of time.

Despite these imperfections, Okun's law does describe a measurable economic trend
in a way that helps economists and students of economics mentally to crystallize a certain
sequence of causes and effects. The observed relationship between more unemployment
and less GDP becomes intuitive, since people who are out of work not only stop producing,
but also usually cut back significantly on spending. Also, lackluster economic data such as
high unemployment and low consumer spending may discourage investment by businesses.

These two realities, when put together, make it easier to see that unemployment has
a multiplier effect that is not limited to a one-for-one type of trade-off. This is what Okun's
law accomplishes, namely the description of this type of relationship as something to be
expected. It also implies that unemployment is not the only thing that can affect GDP
levels. For example,
if both productivity and the number of people in the labourforce increase, then GDP will
increase even though unemployment statistics may have remained constant.
Okun's law is an empirical relationship between the change in the unemployment rate and
the percentage growth in real output, as measured by GNP. Arthur Okun estimated the
following relationship between the two:
yt = -O.4(Xt -2.5)
This can also be expressed as a more traditional linear regression
as:
Yt = I-O.4Xt
Where, Yt= Change in the unemployment rate in percentage points
Xt = Percentage growth rate in real output, as measured by real
GNP
5.3 INFLATION
Meaning and Definition of Inflation
The overall general upward price movement of goods and services in an
economy(often caused by a increase in the supply of money), usually as
measured by the Consumer Price Index and the Producer Price Index.
Over time, as the cost of goods and services increase, the value of a dollar
is going
to fall because a person won't be able to purchase as much with that dollar as he/she previously
could. While the annual rate of inflation has fluctuated greatly over the last half century, ranging
from nearly zero inflation to 23% inflation, the Fed actively tries to maintain a specific rate of
inflation, which is usually 2-3% but can vary depending on circumstances.
Inflation is normally associated with high prices, which causes decline in the purchasing power or
the value of money. Inflation refers to the substantial and rapid increase in the general price-level.
Inflation is primarily a monetary phenomenon. Prices keep on rising due to excess supply of
money and lower production of exchangeable goods. In the Keynesian sense, true inflation begins
when the elasticity of supply of output in response to increase in money supply has fallen to zero
or when output is unresponsive to changes in money supply.
According to Crowther, "Inflation is a state in which the value of money is falling, i.e., prices are
rising".
According to Pigou, "Inflation takes place when money income is expanding relative to the output
of work done by the productive agents for whom it is the payment".
REASONS FOR INFLATION
– credit policy
Causes of inflation
Inflation is a sustained increase in the general level of prices
There are many possible causes of price inflation in an economy – for example
1. Demand and supply-side causes
2. Inflation from internal and external
sources
3. The inflationary effects of
government / regulatory intervention in
the economy
Average rates of inflation vary widely
across the world across countries at
different stages of development
Features of Inflation
Following are the important features of
inflation:
1)The quantity of money is increasing
but the production is static and not increasing.
2)The quantity of money is stable but the production is declining.
3)If the quantity of money is declining and the production is also declining but decline in
production is higher than the decline in the quantity of money.
4)If the quantity of money is increasing and the volume of production is declining.
5)If the quantity of money is in excess of demand or requirements.
6)If the quantity of money as well as production is increasing but rate of increase in production is
lesser than the rate of increase in the quantity of money.
5.3.1 Types of Inflation
1)According to Rate of Rise in Price
i)Creeping Inflation: When the rise in prices is very slow like that of a snail or creeper, it is called
creeping inflation. In terms of speed, a sustained rise in prices of annual increase of less than 3 per
cent per annum is characterized as creeping inflation.
ii) Walking Inflation: When the rise in prices becomes more pronounced as compared to a creeping
inflation, there exists walking inflation in the economy. Walking inflation presents a warning
signal for the occurrence of running and galloping inflation.
iii)Running Inflation: When the movement of price accelerates rapidly, running inflation emerges.
Running inflation may record more than 100 per cent rise in prices over a decade.
iv) Galloping Inflation/ Hyperinflation: In the case of hyperinflation, prices rise every moment,
and there is no limit to the height to which prices might rise; therefore it is difficult to measure its
magnitude, as prices rise by fits and starts. If, within a year, the prices rise by 100 per cent, it is a
case of hyperinflation or galloping inflation.
2)According to the Factors Influences Money Supply and Demand for Goods and Services
i)Excessive Money Supply Inflation: This is classical types of inflation, where there is an excess of
money supply in relation to the availability of real goods and services.
ii) Cost Inflation: When inflation emerges on account of a rise in factor cost, it is called cost
inflation. It occurs when money incomes expand more than real productivity.
iii) Deficit Inflation: When the government budgets contain heavy deficit financing, through
creating new money, the purchasing power in the community increases and prices rise. This may
be referred to as deficit-induced inflation.
3)According to Coverage or Scope Point of View
i)Comprehensive Inflation: When prices of every commodity throughout the economy rise, it is
called economy- wide or comprehensive inflation.
ii) Sporadic Inflation: This is a kind of sectional inflation. It consists of cases in which the
averages of a group of prices rise because of increases in individual prices due to abnormal
shortage of specific goods.
4)According to Government's Reaction
Inflation is open or repressed according to government's reaction to the prevalence of inflationary
forces in the economy.
i)Open Inflation: When the government does not attempt to prevent a price rise, inflation is said to
be open.
Thus, inflation is open when prices rise without any interruption.
ii) Repressed Inflation: When the government interrupts a price rise, there is repressed or
suppressed inflation. The essential characteristic of repressed inflation, in contract to open
inflation, is that it seeks to prevent distribution system based on controls. -.
5)According to Keynesian View: Keynesian economic theory proposes that changes in money
supply do not directly affect prices, and that visible inflation is the result of pressures in the
economy expressingthemselves in prices. The supply of money is a major, but not the only, cause
of inflation. There are three major types of inflation, as part of what Robert 1. Gordon calls the
"triangle model".
i)Demand-Pull Inflation: It is caused by increases in aggregate demand due to increased private
and government spending, etc. Demand inflation is constructive to a faster rate of economic
growth since the excess demand and favourable market conditions will stimulate investment and
expansion.
ii) Cost-Push Inflation: This is also called "supply shock inflation," is caused by a drop in
aggregate supply (potential output). This may be due to natural disasters, or increased prices of
inputs.
iii) Built-In Inflation: It is induced by adaptive expectations, and is often linked to the "price/wage
spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation),
and firms passing these higher labour costs on to their customers as higher prices, leading to a
'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover
inflation.
iv) Profit Inflation: It was originated by Keynes in his Treatise on Money. According to Keynes,
the price level of consumption goods is a function of the investment exceeding savings. The
considered the investment boom as a reflection of profit boom. Inflation is unjust in its distribution
effect. It redistributes income in favour of profiteers and against the wagering class.
v)Semi-Inflation: It was originated by Keynes. According to Keynes. So long as there are
unemployed resources, the general price level will not rise as output increases. But a large increase
in aggregate expenditure will face shortages of supplies of some factors which may not be
substitutable. This may lead to increase in costs, and prices start rising. This is known as semiinflation or bottleneck inflation because of the bottlenecks in supplies of some factors.
vi) True Inflation: It is the concept of Keynes. According to Keynes, when the economy reaches
the level of full employment, any increase in aggregate expenditure will raise the price level in the
same proportion. This is because it is not possible to increase. The supply of factors of production
and hence of output after the level of full employment. This is called true inflation.
vii) Mark-up Inflation: This is closely related to the price-push problem. Modern Labor
organizations possess substantial monopoly power. They, therefore, set prices and wages on the
basis of markup over costs and relative incomes. Firms possessing monopoly power have control
over the prices charged by them. So they have administered prices which increase their profit
margin. This set-off an inflationary rise in prices. Similarly, when strong trade unions are
successful in raising the wages of workers, this contributes to inflation.
5.3.2 Impact of Inflation
A low inflation rate is beneficial to a country and zero or negative inflation is considered as bad.
Moderate inflation (2-3%) is good, initially - firms take benefit from rising prices. Soon, demand
falls as consumers reduce consumption. Fall different for different commodities depending on the
price elasticity of demand. Production costs go up, especially if wages are linked to inflation index
- costs increase, squeezes profits. A high inflation is also harmful to a business and it affects an
economy in many ways:
1)Distorts Consumer Behaviour: High inflation distorts consumer behaviour. Because of the
fear of price increases, people tend to purchase their requirements in advance as much as
possible. This can
destabilise markets creating unnecessary shortages.
2)Redistributes Income of People: High inflation redistributes the income of people. The fixed
income earners and those lacking bargaining power will become relatively worse off as their
purchasing power falls.
3)High Wages: Trade unions may demand for higher wages at times of high inflation. If the
claims are accepted by the employers, it may give rise to a wage-price spiral which may
aggravate the inflation problem.
4)Difficulty in Predicting Future: During a high inflation period, wide fluctuations in the
inflation rate make it difficult for business organizations predict the future and accurately
calculate prices and returns from investments. Therefore, it can undermine business
confidence.
5)Create Trade Deficit: When inflation in a country is more than that in a competitive country,
the exports from former country will be less attractive compared to the other country. This
means there will be fewer sales for that country's goods both at home and abroad and that will
create a larger trade deficit. At the same time, high inflation in a country weakens its
competitive position in the international market.
Analyzing the Consequences of Inflation
High and volatile inflation has economic and social costs.
Anticipated inflation:

When people are able to make accurate predictions of inflation, they can take steps
to protect themselves from its effects.

Trade unions might use their bargaining power to negotiate for increases in money
wages to protect the real wages of union members.

Households may switch savings into accounts offering a higher rate of interest or
into other financial assets where capital gains might outstrip price inflation.

Businesses can adjust prices and lenders can adjust interest rates. Businesses may
also seek to hedge against future price movements by transacting in “forward markets”. For
example, many airlines buy their fuel months in advance as a protection or ‘hedge’ against
fluctuations in world oil prices.
Unanticipated inflation:

When inflation is volatile, it becomes difficult for individuals and businesses to
correctly predict the rate of inflation in the near future.

Unanticipated inflation occurs when people, businesses and governments make
errors in their inflation forecasts. Actual inflation may end up below or above expectations
causing losses in real incomes and a redistribution of income and wealth from one group to
another
Money Illusion

People often confuse nominal and real values because they are misled by the
effects of inflation.
For example, a worker might experience a 6 per cent rise in his money wages –
giving the impression that he or she is better off in real terms. However if inflation is also
rising at 6 per cent,

in real terms there has been no growth in income.

Money illusion is most likely to occur when inflation is unanticipated, so that
people’s expectations of inflation turn out to be some distance from the correct level.
The Economic Costs of Inflation
We must be careful to distinguish between different degrees of inflation, since low and stable
inflation is less damaging than hyperinflation where prices are out of control.
1.
Impact of Inflation on Savers: When inflation is high, people may lose confidence
in money as the real value of savings is severely reduced. Savers will lose out if interest
rates are lower than inflation – leading to negative real interest rates. This has certainly
happened in the UK during 2009-2011.
2.
Inflation Expectations and Wage Demands: Price increases lead to higher wage
demands as people try to maintain their real living standards. This process is known as a
‘wage-price spiral’.
3.
Arbitrary Re-Distributions of Income: Inflation tends to hurt people in jobs with
poor bargaining positions in the labour market - for example people in low paid jobs with
little or no trade union protection may see the real value of their pay fall. Inflation can also
favour borrowers at the expense of savers as inflation erodes the real value of existing
debts.
4.
Business Planning and Investment: Inflation can disrupt business planning.
Budgeting becomes difficult because of the uncertainty created by rising inflation of both
prices and costs - and this may reduce planned investment spending.
5.
Competitiveness and Unemployment: Inflation is a possible cause of higher
unemployment in the medium term if one country experiences a much higher rate of
inflation than another, leading to a loss of international competitiveness and a subsequent
worsening of their trade performance.
Benefits of inflation
Can inflation have positive consequences? The answer is yes although much depends on what else
is happening in the economy. Some of the potential advantages of benign inflation are as follows:
1.
Higher revenues and profits: A low stable rate of inflation of say between 1% and
3% allows businesses to raise their prices, revenues and profits, whilst at the same time
workers can expect to see an increase in their pay packers. This can give psychological
boost and might lead to rising investment and productivity.
2.
Tax revenues: The government gains from inflation through what is called ‘fiscal
drag effects’. For example many indirect taxes are ad valorem in nature, e.g. VAT at 20%
- so as prices rise, so does the amount of tax revenue flowing into the Treasury.
3.
Cutting the real value of debt: Low stable inflation is also a way of helping to
reduce the real value of outstanding debts – there are many home owners with huge
mortgages who might benefit from a period of inflation to bring down the real burden of
their mortgage loans. The government too might welcome a period of higher inflation
given the huge level of public sector debt!
4.
Avoiding deflation: Perhaps one of the key benefits of positive inflation is that an
economy can manage to avoid some of the dangers of a deflationary recession
Effects of Inflation on Multidimensional Public
Effects of inflation on multidimensional public are explained under following heads:
1.
Debtors and Creditors: Debtors generally gain and creditors lose during inflation.
Gain accrues to debtor because he repays loans at a time when the purchasing power of
money is lower than when it was borrowed. The creditor, on the other hand, is a loser
during inflation, since he receives, in effect, less in goods and services than he would have
received in times of low prices. Thus, borrowers who borrowed funds prior to inflation
stand to gain by inflation, and creditors who lent funds lose.
2.
Business Community: Inflation is welcomed by entrepreneurs and businessmen
because they stand to profit by rising prices. They find that the value of their inventories
and stock of goods is rising in money terms. They also find that prices are rising faster than
the costs of production, so that their profit margin is greatly enhanced. The business
community, therefore, gets supernormal profit during periods of inflation, and those profits
continue to increase as long as prices rise.
3.
Fixed Income Groups: Inflation hits wage earners and salaried people very hard:
Although wage earners, by the grace of trade unions, can chase galloping prices, they
seldom win the race. Since wages do not rise at the same rate, and at the same time, as the
general price level, the cost of living index rises, and the real income of the wage earner
decreases. Moreover in trying to push up wages to sustain their real income wage earners
bring about cost-push inflation, and in the process worsen their position.
4.
Investors: Those who invest in debentures and fixed interest bearing securities,
bonds, etc. lose during inflation. However, investors in equities benefit because more
dividend is yielded on account of high profits made by joint-stock companies during
inflation.
5.
Governinent: Inflation affects the government in various ways. It helps the
government in financing its activities through inflationary finance. As the money income of
the people increases, the government collects that in the form of taxes on incomes and
commodities.
Reasons of Inflation: Demand Vs Supply Factors
The root cause of inflation is the imbalance between the total demand and total supply of goods
and
services in the economy which causes excessive demand. These are following causes of inflation:
1)Increase in Demand for Goods and Services: There are a number of factors that cause increase
in demand for goods and services inflation in the country. Some of the factors can be summed as
under:
i)Increase in Public Expenditure: An increase in public expenditure during the time of war or for
developmental planning increase the demand for goods and services in the economy and finally
result in increase in prices of goods and services causing inflation.
ii) Increase in Private Expenditure: An increase in private expenditure, consumption expenditure as
well as investment expenditure is an important cause of the emergence of excess demand in the
economy. When business conditions are good private entrepreneurs start investing more and more
funds in new business, giving rise to increase in the demand for the service of factor of production.
iii) Increase in Exports: An increase in the foreign demand for the country's products reduces the
stock of commodities available for home consumption. It is evident that when more and more of
commodities are exported to other countries, less and less are available of domestic consumption.
.
iv) Reduction in Taxation: Reduction in taxation is also an important cause of the emergence of
increase in demand. When government reduces tax it results to an increase in purchasing power of
the public and then it is in the position to demand more goods and services for private consumption
and results to an increase in prices causing inflation.
v)Repayment of Past Internal Debts: When the government repays its past debts to the public it
results in an increase of purchasing power of the public which is used by it for buying more goods
and services for consumption purposes.
vi) Rapid Growth of Population: A rapid growth in population results in pushing up the level of
aggregate effective demand for goods and services in a country. This acts as an inflationary force
and tends to raise the prices to higher levels.
2)Decrease in Supply for Goods and Services: The factors that result in reduction in the supply
of goods and services may be termed as under:
i)Shortage of Supplies of Factors of Production: Occasionally the economy of a country faces or is
met with shortage of such factors as labour, capital, equipment, raw material, etc. These shortages
are bound to reduce the production of goods and services for consumption purposes. This results to
an increase in prices and inflation as the demand is high and supply is less.
ii) Hoarding by the Traders: At a time of shortages and rising prices, there is a tendency on the part
of traders and merchants to hoard essential commodities for profit purposes. The stocks of
essential goods often go underground during the period of inflation and rising prices, causing
further scarcity of goods in the market.
iii) Hoarding by Consumers: It is not only the traders and the merchants who resort to hoarding at
a time of inflation. The individual consumer also holds essential commodities to avoid payments of
higher prices in future. They also hoard essential commodities to ensure uninterrupted availability
for private consumption.
iv) Natural Calamities: It also creates inflationary conditions by reducing the production in the
economy. Floods and draughts adversely affect the supply of products and raise their prices.
v)Law of Diminishing Returns: The law of diminishing returns operates when production is
increased by employing more and more variable factors with fixed factors and given technology.
vi) War: During the war period, economic resources are diverted to the production of war
materials. This reduces the normal supply of goods and services for civilian consumption and this
leads to the rise in the price level.
vii) International Causes: In modem times a major cause of inflationary rise in prices in most of the
countries is the international rise in the prices of basic materials, (e.g., petrol) used in almost all the
industrial materials.
Remedies to Check Inflation
The various measures which can be taken to establish a better balance between aggregate supply
and demand for money can be studied under the following three main heads:
1)Monetary Measures: Monetary measures aim at reducing money incomes.
i)Credit Control: One of the important monetary measures is monetary policy. The central bank of
the country adopts a number of methods to control the quantity and quality of credit.
ii) Demonetisation of Currency: However, one of the monetary measures is to demonetise currency
of higher denominations. Such a measure is usually adopted when there is abundance of black
money in the country.
iii) Issue of New Currency: The most extreme monetary measure is the issue of new currency in
place of the old currency. Under this system, one new note is exchanged for a number of notes of
the old currency.
2)Fiscal Measures: Monetary policy alone is incapable of controlling inflation. It should, therefore,
be supplemented by fiscal measures. Fiscal measures are highly effective for controlling
government expenditure, personal consumption expenditure, and private and public investment.
The principal fiscal measures are:
i)Reduction in Unnecessary Expenditure: The government should reduce unnecessary expenditure
on non- development activities in order to curb inflation.
ii) Increase in Taxes: To cut personal consumption expenditure, the rates of personal, corporate
and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes
should not be as high as to discourage saving, investment and production.
iii) Increase in Savings: Another measure is to increase savings on the part of the people. This will
tend to reduce disposable income with the people, and hence personal consumption expenditure.
iv) Surplus Budgets: An important measure is to adopt anti-inflationary budgetary policy. For this
purpose, the government should give up deficit financing and instead have surplus budgets.
v)Public Debt: At the same time, it should stop repayment of public debt and postpone it to some
future date till inflationary pressures are controlled within the economy. Instead, the government
should borrow more to reduce money supply with the public.
vi) Control over Investment: Controlling investments is also considered necessary because, due to
the multiplier effect, the initial investment leads to large increase in income and expenditure and
the demand for both the consumer and capital goods goes up speedily.
3)Other Measures: The other types of measures are those which aim at increasing, aggregate
supply and reducing aggregate demand directly.
Increasing Production: The following measures should be adopted to increase production:
a)One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
b)If there is need, raw materials for such products may be imported on preferential basis to
increase the production of essential commodities.
c)Efforts should also be made to increase productivity. For this purpose, industrial peace should be
maintained through agreements with trade unions, binding them not to resort to strikes for some
time
d)The policy of rationalization of industries should be adopted as a long-term measure.
Rationalisation increase productivity and production of industries through the use of brain, brawn
and bullion.
e)All possible help in the form of latest technology, raw materials, financial help, subsidies, etc.
should be provided to different consumer goods sectors to increase production.
ii) Rational Wage Policy: Another important measure is to adopt a rational wage and income
policy. Under hyperinflation, there is a wage-price spiral. To control this, the government should
freeze wages, incomes, profits, dividends, bonus, etc.
iii) Price Control: Price control and rationing is another measure of direct control to check
inflation. Price control means fixing an upper limit for the prices of essential consumer goods.
They are the maximum prices fixed by law and anybody charging more than these prices is
punished by law.
iv) Rationing: Rationing aims at distributing consumption of scarce goods so as to make them
available to a large number of consumers. It is applied to essential consumer goods such as wheat,
rice, sugar, kerosene oil, etc. It is meant to stabilize the prices of necessaries and assure distributive
justice.
Inflation in India Since 1990
Inflation has shown a dogged persistence in the post reform period. Historically, high inflation in
India has been a combination of three factors: poor agricultural productivity and high dependence
on monsoon; commodity price shocks, mainly oil prices; global business cycles and wars.
Year
-1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
A verage Inflation ( %) ( CPI)
2009
2010
2011
2012
10.83
12.11
8,87
9,03
8,92
13,88
11,88
6,31
10.24
10,22
8,98
7.25
13.17
4,84
4.02
3.77
4.31
3.81
3.77
4.25
5.79
6.39
8,32
The declining trend in inflation during 1999 to 2005 was the result of structural changes in the
macroeconomic framework due to liberalization. The improved supply response, improved
financial and real economy, better monetary policy and emphasis on fiscal consolidation all helped
bring down inflation.
Inflation Vs Deflation
Inflation and deflation are two sides of the same coin. Inflation is defined as a phenomenon
wherein the general prices of goods and services rise fast. Inflation is a general increase in the
price level. The price level represents the prices of most products in an economy. Thus, the prices
of most products are increasing during periods of inflation, The forces of supply and demand still
determine prices in individual markets. Yet, inflation creates a tendency for prices to rise
throughout the economy.
Inflation affects the poor more than rich and incomes are redistributed in favor of the rich. Thus it
leads to an increase in inequality in the society which is seen- as rich becoming richer and poor
becoming poorer. It is regressive in nature and hits middle and lower classes. Inflation is
demoralizing and makes people think of earning more by speculation and gambling. Thus
productivity goes down while speculation increases. Savings of people are hit hard as there is
erosion in their net worth.
Whereas, Deflation is a general decrease in the price level. During periods of deflation, the prices
of most products are decreasing. Deflation is undesirable because it usually causes a significant
decrease in overall spending (i.e., aggregate demand) in an economy and is most likely to occur
when the economy is already stagnant.
Deflation on the other hand, by causing falling prices, makes capital less efficient. When
manufacturers do not see prices rising, they tend to shy away from production and investing less,
leading to unemployment. Economic activities slow down and depression sets in the economy.
Output of economy shrinks and even with falling prices, people find it hard to sustain. Profits
tumble, producers suffer losses, and economic activities come to a standstill leading to mass scale
unemployment. Deflation thus seriously affects income levels.
5.4 Inflation Vs Unemployment Trade-off: Phillips Curve
The relationship between the price level and employment was studied by A. W. Phillips, a British
economist, in a slightly different manner in 1958. He collected data relating to unemployment rate
and the rate of change in money wages (may be called inflation rate of wages), in U.K. from 1862
to 1957. He found a certain inverse relationship between these two variables. If the wage rate
increase is substituted by the inflation rate (with some adjustments) then an inverse relationship
emerges between the inflation rate and the unemployment rate. This relationship can be stated as
follows.
This curve shows that the low unemployment rate can be found only at a high inflation rate and if
we want a low inflation rate, then we have to tolerate a high rate of unemployment. Another
important thing in this Phillips Curve is that as the rate of inflation increases the curve becomes
steeper and as the unemployment rate increases the curve becomes flatter. This means that when
unemployment
rate is low, it requires a higher push up of inflation rate to bring down unemployment rate by, say,
1 percentage, but when unemployment rate is high, a small rise in inflation can bring down
unemployment by, say, 1 percentage. A hypothetical table can be made to explain this.
Unemployment
Inflation Rate %
10
9
8
7
Unemployment Rate %
5
6
8
11
6
15
In this hypothetical table we have shown different inflation rates and
corresponding unemployment rates. At 10 per cent inflation rate
unemployment rate is 5 per cent assuming that it is the natural rate of
unemployment. If inflation rate goes down to 9 per cent unemployment rate
becomes 6 per cent. At 8 per cent inflation rate, unemployment rate becomes
8 per cent; at 7 per cent inflation rate, unemployment rate becomes 11 per
cent and so on. We see that initially I per cent decrease in inflation rate raises
unemployment by 1 per cent only but later a I per cent decrease in inflation
rate raises unemployment rates by 2, 3 or 4 percentages.
Unemployment
5.5 Phillips Curve: A Trade-Off
The Phillips curve indicates a trade-off between inflation and unemployment. That is, policy
makers can choose a particular combination of inflation and unemployment from the menu
indicated by Phillips curve. From figure 5.2, the policy-makers can choose 2 per cent
unemployment with 5 per cent inflation or 3 per cent inflation with 6 per cent rate of
unemployment or any other combination on the Phillips curve.
Though such a trade-off seemed to exist in the western countries in 1960s, the '70s portrayed a
different picture of 'Stagflation', where a high level of unemployment was accompanied by high
rates of inflation. This led to the view that the downward sloping Phillips curve is relevant only in
the short-run and in the long-run there is no trade-off in which case the Phillips curve is vertical.
Long-Run Phillips Curve
How is this conclusion of a vertical Phillips curve reached? A first step towards an explanation is
the introduction of the 'natural rate of unemployment'. Natural rate of unemployment is the rate of
unemployment below which the inflation rate tends to increase and above which the inflation rate
tends to decrease. At the natural rate of unemployment, there is tendency for inflation to either
accelerate or decelerate.
UN the natural rate of unemployment which is also the current level of unemployment in the
economy and PCI is the short-run Phillips curve. Given the short-run Phillips curve, Pc1 the rate
of
inflation is I1. The position of the short-run PC depends on the expected rate of inflation. When
expected rate of inflation goes up, PC shifts upwards. In this case, the actual as well as the
expected rate of inflation is I1. If the policy makers try to reduce the rate of unemployment by
resorting to more expansionary macroeconomic policies consistent with an inflation rate 12, the
rate of unemployment can be reduced to U2 in the short-run, if the public expect the inflation to be
at I1. After a while,
the public revise their expected inflation to I2 and the short-run Phillips curve shifts to PC2. Now,
the unemployment increases to the natural rate at UN. This way if the expected rate of inflation is
less than the actual rate of inflation, the unemployment rate will fall below UN for a short period.
When the public revise their expectations, we are back at UN. Suppose the public expect the
inflation rate to be I3 and the actual rate is h now the short-run Phillips curve is PC3. With this
Phillips curve, the rate of unemployment is U3• Therefore, if public over-estimate the actual
increase in the inflation rate; unemployment will rise temporarily above its long-run natural rate.
The above analysis indicates that it will be extremely difficult for policy makers to use demand
stimulus policies to reduce the unemployment rate. Such a strategy is effective, even temporarily,
only when it catches people by surprise. In the long- run, there is no trade-off between rate of
inflation and rate of unemployment and the vertical long-run Phillips curve is positioned at the
natural rate of unemployment.
Post 2004-05, a new phenomenon was observed, i.e., demand conditions (especially nongovernment) influencing inflation along with the supply side. The Indian economy grew between
2004-05 and 2009-10, fuelled by the growth rate in the services sector. This implied a rise in real
per capita income, as inflation was below 6 per cent during those three years (2004-2006). Increase
in income raised aggregate demand, which the supply side found difficult to match, at least in the
short run.
Accompanying this increasing demand were the increases in prices of food and fuel in 2008. India
recovered quickly from the financial crisis. However, the drought of 2009 followed by the uneven
rainfall in 2010 and increase in aggregate demand have kept food prices inflation in double digits.
The recent Middle East political crisis has added to the inflation pressures. These uncertain times
have also increased volatility, in CPI and recently in WPI.
When the current inflation rates to the 1990s are compared to the current rates, they seem high but
compared with four decades of data; the trends are not so worrisome. However, the increased
volatility displayed by both the inflation rates is troubling. India has experienced an unusual
combination of factors in a short span of time after 2004-05 which have affected inflation
volatility, i.e., rise in prices of food and fuel (partly fuelled by increase in global demand),
uncertain monsoon, the financial crisis and then domestic rise in demand.
Not only does volatility deter private investment, it also affects inflation expectations. Considering
that majority of the population in India is relatively poor, double digit food inflation and high
inflation in general hits the poorest and weakest sections the hardest.
Short-Run Phillips Curves
The short-run Phillips curve represents the short-run trade-off. It is, however, a difficult trade-off
to use for
policy purposes, because one never knows when that trade-off will change as the curve shifts to a
new location. To compound the confusion, the natural rate itself changes, causing the long-run
Phillips curve to shift as well. In the late 1990s and into 2001, the short-run Phillips curve had
disappeared. Unemployment went below the commonly-accepted natural rate of 5.2 per cent
(which had been lowered in the late 1990s from 6.1 per cent) while inflation fell. The lack of a
rising inflation along with low unemployment has puzzled economists. Some economists say that
the conditions are the result of structural changes in the economy, such as those that Katz and
Krueger discuss.
This scenario is any more creditable than the conventional one. But it is as creditable. One can,
therefore, conclude that it is as futile to try and reduce the inflation rate by suffering greater
unemployment as it is to attempt to reduce the unemployment rate by enduring an accelerating
inflation. Both are short run efforts to solve what is clearly a long run problem. Pursuing either
strategy in the long run is ineffective. One gives more accelerating inflation rates with no reduction
in unemployment; the other gives more and more unemployment with no permanent decelerating
inflation.
If one thinks about it, the 'Phillips curl' (Samuelson's term) shown in figure 5.4 corroborates this.
Over time until the 1990s the US was gradually suffering accelerating inflation rates and rising
unemployment. Clearly what was called for were policies designed to reduce both at the same
time. One thing was seen correctly. In the long-run there is no trade off. While the 'accelerationists'
assumed the effort to base policy on the short run 'would lead to accelerating inflation rates, the
alternative suggested here would lead to rising unemployment rates, which was in fact what
happened for some years (the rising 'natural rate' which were told was unavoidable). In Samuelson
and Nordhaus's depiction, 'the natural unemployment rate' rose from 1955 to about 1980 and fell
more or less thereafter. It is interesting to note that in his widely admired basic' text Gregory
Mankiw, in contrast to the changing band employed by Samuelson and Nordhaus to represent the
NAIRU, simply employs a straight line at 6 per cent, as though the 'normal rate of unemployment'
(their words) - never varied.
This brings of course, to the 1990s. The presumed secular increase in the 'natural rate of
unemployment' mysteriously began to decline. Inflation increases were for some years pronounced
to be imminent, but ultimately some economists began to declare that the inflationary threat was
not developing as anticipated.
5.6 SUPPLY SIDE POLICY AND MANAGEMENT
Introduction
The supply side refers to factors affecting the quantity or quality of goods and services produced
by an economy such as the level of productivity or investment in research and development.
Supply-side policies are mainly micro-economic policies designed to make markets and industries
operate more efficiently and contribute to a faster underlying-rate of growth of real national output.
Successful policies have the effect of shifting the LRAS curve to the right leading to a rise in
potential output most governments believe that improved supply-side performance is the key to
achieving sustained growth without causing a rise in inflation.
The term 'supply-side economics' was first coined in 1976 to describe economic policies designed
to influence output and employment through their impact on the supply-side, as opposed to the
demand-side, of the economy. Supply-side policies cause a shift to the right of the aggregate
supply curve leading to greater output at lower .,prices, so long as the economy is below the full
employment level.
Although the term 'supply-side economics' is relatively new the basic concept is not. Ever since
1945, governments of both political persuasions have attempted to strengthen the supply-side in
their quest for more rapid economic growth. Until 1979, however, supply-side policy took second
place to demand management policy. While successive governments recognized the potential
benefits of directly promoting the supply-side of the economy, it was generally believed that the
major contribution governments could
make to economic prosperity was to keep - through the active use of demand-management policy the economy as close as possible to 'full-employment'. By ensuring that aggregate demand was
always high enough to allow firms to work at full capacity, it was argued, governments could
create a stable, supportive economic environment in which firms had the confidence and incentive
to invest for growth.
Underpinning both demand-management and supply-side policies during the so-called 'Keynesian
era' was a deep-seated distrust of the free market and a feeling that the 'invisible hand' was unable
to coordinate economic activity and achieve growth. Without the active involvement of
paternalistic government, it was concluded, it would be impossible to achieve economic success.
Implication of Supply Side Policy and Management
Supply-side economists emphasize the importance of effects of tax incentives on labour supply,
saving and investment for promoting growth of output. They further lay stress on the favourable
effects of tax cuts on Government revenue and thereby to achieve reduction in budget deficit. The
following are the basic implication of supply-side economics:
1)Factor Supply Determines Output Growth: The logical basis of proposition can be explained
through Aggregate Supply (AS) and Aggregate Demand (AD) curves, as shown in figure 5.5:
Supply-side economists argue that output is determined by factor supply (labour and capital) and
technology. Both long- term and medium-term growth rates in output are determined by the
growth in factor supply and change in technology. According to supply-side economists, given the
factor supply and state of technology, the medium-term-aggregate- supply curve (AS) can be
represented by a vertical line, as shown by ASo curve in figure 5.5. As a corollary of this, increase
in factor supply and change in technology cause a rightward shift in the aggregate supply curve,
say, from ASo to ASI. To carryon the analysis further, suppose that the initial AS and AD curves
are given as ASo and ADo, respectively, intersecting at point A. Thus, the medium-term level of
output is determined at Yo with general price level at Pz. Let factor supply now increase and
technology improve so that ASo shifts to AS I, AD curve remaining the same. As a result,
equilibrium point shifts to point B. With this shift in the AS curve, real output increases to Y I and
prices fall to PI. This presents the supply-siders' argument that, in medium-term, growth in real
output is supply-determined.
2)Tax Cuts Increase Aggregate Supply: Supply-side economists hypothesise that a tax reduction
enhances post- tax return on labour and capital and, thereby, increases factor demand, both labour
and capital. The increase in factor demand, given the factor supply, causes rise in factor prices.
This causes increase in factor supply. The increase in factor supply shifts the aggregate supply
curve rightward which means increase in output. The effect of tax reduction on output is illustrated
in figure 5.6: The aggregate demand curve is given by AD and vertical line ASc represents the
classical aggregate supply curve
and also the potential output. The curves AD and ASc intersect at point A determining the
equilibrium level of output at Yo. Suppose now that the government reduces income tax rate. As a
result, incentive for work effort, saving and investment increases. Consequently, factor supply
increases and ASc shifts to AS' c. With this shift in AS curve, equilibrium shifts to point C and
output increases from Yo to Yz. This, according to supply-siders, shows the effect of tax cut on the
output.
3)Tax Rate Determines the Tax Revenue -The Laffer Curve: During the Keynesian era, most
countries had adopted a taxation policy aimed mainly at raising revenue for public investment but,
neither the policy-makers nor the economists were sure about the relationship between tax rates
and tax revenue. A supply-side economist, Arthur B. Laffer, brought out this relationship in the
form of a curve, called Laffer curve. The Laffer curve suggests that raising tax rate upto a limit
increases revenue, but beyond a
limit it decreases tax revenue. Laffer curve shows that after a certain point increase in tax rates can
reduce tax revenue as incentives to work, save and investment are adversely affected. Total Tax
Revenue (TR) collected is equal to the tax rate, which we denote by t multiplied by the total
income which we denote by
Y. Thus, total tax revenue TR = tY. According to Laffer, when tax rate t is raised beyond a certain
point the national output and income Y which constitutes the base of taxation declines so much
that total tax revenue ty falls. Laffer curve has been drawn in figure 5.7. The Laffer curve starts
from the origin which means when the tax rate is zero, total tax revenue will also obviously be
zero. Upto point C, Laffer curve is rising which shows that as tax rate rises to t3, tax revenue
collected increases. But if the tax rate is raised beyond t3, Laffer curve slopes downward showing
that tax revenue decreases as tax rate is increased above t3 for the reasons explained above. At tax
rate t3, the tax revenue collected R3 is the maximum. For example, if tax rate is raised from t3 to t4,
the tax revenue falls from R3 to R2. As explained above, when tax rate is raised beyond some point,
tax revenue decreases. This is because higher tax rates serve as disincentives to work, save and
invest, innovate and take business risks and therefore the tax base, (i.e., the level of national
output, income and employment) decreases.
The Laffer curve is regarded as a very important contribution of the supply-side economics as it
has a very important policy implication. It suggests that taxation should be only moderately high so high that its revenue elasticity is approximately equal to 1. Raising tax rate beyond this point
not only begins to yield revenue at a lower rate but also works as a disincentive for saving,
investment and work effort and proves disastrous for the economy. The Laffer curve was initially
drawn in reference to the U.S. economy during the 1970s.
5.7 Supply-Side Effects of Fiscal Policy
When fiscal changes alter tax rates, they influence people's incentives to work, invest, and use
resources efficiently. Thus, tax changes also influence aggregate supply. Prior to 1980,
macroeconomists generally ignored the supply-side effects of changes in tax rates, thinking they
were of little importance. Supply-side economists challenged this view. The supply-side argument
was central to the tax rate reductions of the 1980s, and it also affected tax legislation passed in
both 2001 and 2002. From a supplyside viewpoint, the marginal tax rate is crucially important. The marginal tax rate determines the
breakdown of a person's additional income between tax payments on the one hand and personal
income on the other. Lower marginal tax rates mean that individuals get to keep a larger share of
their additional earnings. For example, reducing the marginal tax rate from 40 per cent to 30 per
cent allows individuals to keep 70 cents of each additional dollar they earn, instead of only 60
cents. In turn, the lower tax rates and accompanying increase in take-home pay provide them with
a greater incentive to earn. Supply-side economists believe that these incentive effects are
important. Most significantly, they argue that high marginal rates - e.g., rates of 50 per cent or
more - seriously discourage people from
working harder and engaging in productive activities. Tax policy changes affect the supply side of
the economy differently than the demand side of the economy, though. On the demand side, lower
taxes stimulate spending by consumers and increase aggregate demand. On the supply side, lower
taxes encourage people to work more, increasing aggregate supply. Figure 5.8 graphically depicts
the impact of a supply-side tax cut, one that reduces marginal tax rates:
The lower marginal tax rates increase aggregate supply because the new incentive structure
encourages tax-payers to earn more and use resources more efficiently. If tax-payers think the cut
will be permanent, both Long- and Short-Run Aggregate Supply (LRAS and SRAS) will increase.
Real output and income will expand. As real income expands, aggregate demand will also
increase (shift to AD2). If the lower marginal rates are financed by a budget deficit, though,
aggregate demand may increase by a larger amount than aggregate supply, putting upward
pressure on the price level.
Supply-side economics should not be viewed as a short-run countercyclical tool. It will take time
for people to react to the tax cuts and move their resources out of investments designed to lower
their taxes and into higher-yielding, production- oriented activities .. The full positive effects of
lower marginal tax rates will not be observed until both labor and capital markets have time to
adjust fully to the new incentive structure. Clearly, supply-side economics is a long-run, growthoriented strategy, not a short-run stabilization tool.
Here, the supply-side effect of lower marginal tax rates is illustrated. The lower marginal tax rates
increase the incentive to earn and use resources efficiently. Because these are long-run as well as
short-run effects, both LRAS and SRAS increase (shift to the right). Real output expands. In turn,
the higher income levels accompanying the expansion in real output will stimulate aggregate
demand (shift it to AD2).
Criticism of Supply-Side Policy and Management
The following are the major criticisms against the supply-side policy measures:
1)Moderate Supply-Side Effect: If one goes by the U.S. experience, tax cut brings about a
moderate effect on output and employment, not as much as suggested by the supply siders. Tax
cuts do not necessarily guarantee that people will work for more hours. Instead, they find it easier
to maintain their consumption expenditure with less hours of work. "Most of the statistical
evidence suggests that it is unrealistic to expect tax reduction to lead to substantial increase in
either labour supply or household saving." Therefore, the effect of tax cut on supply is only
moderate.
2)Effect of Tax Cut on Aggregate Demand Ignored: The supply-siders either ignored or underestimated the effect of tax cut on the aggregate demand whereas it does affect aggregate demand in
a substantial way. A cut in personal income tax induces households to spend more on consumer
goods and services and a cut in business tax encourages investment spending. In both the cases, the
aggregate demand increases shifting AD curve rightward. Although supporters of supply-side
economics argue that a cut in tax reduces the government expenditure and thereby the aggregate
demand. In reality, however, especially in the U.S., the reduction in government spending was
much smaller than the tax cut. This is what generally happens in most other countries because it is
neither practically feasible nor economically desirable to cut government spending as much as the
tax cut.
3)Limited Effect on Inflation: Supply-siders had suggested also the policies which were aimed at
controlling inflation. But their policy measures have been found to have had a small effect on
inflation. Instead, a policy measure like tax cut may even create inflationary conditions, as was
experienced by Britain during the mid-1970s.
4)Adverse Effect on Income Distribution: The supply-side policy measures have been found to
have enhanced income inequality. The reason is that most supply-side measures like tax cut benefit
the rich sections of the society more than the poor sections. This widens the gap between the
incomes of the low-income and high-income households. As a result, supply-side policies tend to
increase income inequalities
5)Fall in Tax Revenue: Most supply-side policy measures relate to tax cut of one kind or another.
This leads to loss of revenue and finally to budgetary deficits. Although Arthur Laffer, a staunch
supply-sider, defended the tax cut by arguing that cutting tax rate increases tax revenue, a vast
majority of economists have found this claim to be 'implausible'.
Importance of Supply-Side Policy , i'
1)Product Market Reforms: Product markets refer to markets in which allbnds of goods and
services are made and traded, for example the market for airline travel; smart-phones, new cars;
pharmaceutical products and the markets for financial services such as banking, mortgages and
pensions. Supply-side policies in product markets are designed to increase competition and
efficiency
2)Reduce Inflationary Pressure: Supply-side policies can help reduce inflationary pressure in the
long term because of efficiency and productivity gains in the product and labour markets. Shifting
AS to the right will cause a lower price level. By making the economy more efficient supply side
policies will help reduce cost push inflation.
3)Sustainable Growth: Supply side policies will increase the sustainable rate of economic growth
by increasing AS. Supply- side policy is less likely to create conflicts between the main objectives
of stable prices, sustainable growth, full employment and a balance of payments. They can also
help create real jobs
and sustainable growth through their positive effect on labour productivity and competitiveness.
Increases in competitiveness will also help improve the balance of payments.
4)Lower .Unemployment: Supply side policies can help reduce structural, frictional and real wage
unemployment and therefore help reduce the natural rate of unemployment.
5)Improved trade and Balance of Payments: By making firms more productive and competitive
they will be able to export more.
5.8 MONEY MARKET
Introduction
As per RBI definitions ― A market for short terms financial assets that are close substitute for
money, facilitates the exchange of money in primary and secondary market.The money market is a
mechanism that deals with the lending and borrowing of short term funds (less than one year). A
segment of the financial market in which financial instruments with high liquidity and very short
maturities are traded.
The term money market is used in a composite sense to mean financial institutions, which deal
with short-term funds in the economy. It refers to the institutional arrangements facilitating
borrowing and lending of short-term funds.
It doesn‘t actually deal in cash or money but deals with substitute of cash like trade bills,
promissory notes & government papers which can converted into cash without any loss at low
transaction cost. It includes all individual, institution and intermediaries.
The money market brings together the lenders who have surplus short-term investible funds and
the borrowers who are in need of short-term funds. In a money market, funds can be borrowed for
a short period varying from a day, a week, a month, or 3 to 6 months and against different types of
instruments, such as bill of exchange, bankers' acceptances, bonds, etc., called 'near money'.
According to Crowther as, "The money market is the collective name given to the various firms
and institutions that deal in the various grades of near money".
Reserve Bank of India describes the Money Market as, "The centre for dealings, mainly of a short
term character, in monetary assets; it meets the short-term requirements of borrowers and provides
liquidity or cash to the lenders".
According to the McGraw Hill Dictionary of Modern Economics, "Money market is the term
designed to include the financial institutions which handle the purchase, sale, and transfer of shortterm credit instruments. The money market includes the entire machinery for the channelising of
short-term funds. Concerned primarily with small business needs for working capital, individuals'
borrowing, and government short-term obligations, it differs from the long-term or capital market
which devotes its attention to dealings in bonds, corporate stocks and mortgage credit".
5.8.1 Nature of Money Market
These are following nature of money market:
1)Highly Organised Commercial Banking System: Commercial banks are the most important
constituent of money markets. A fully developed money market is characterised by the presence of
a highly organised commercial banking system, while in an underdeveloped money market the
banking system is not fully developed. In a developed money market, the other constituents of the
money market are well-linked with the commercial banks and through them to the central bank.
2)An Apex Central Bank: The second essential characteristic of a developed money market is the
presence of an apex central bank at the top. The main function of the central bank is to help,
control and stabilise the monetary and banking system of the country. It is generally a very
powerful bank exercising control over the other constituents of the money market.
3)Adequate Availability of Credit Instruments: In a developed money market, there is an adequate
availability of credit instruments like promissory notes, bill of exchange, treasury bills, shortperiod government bonds, etc.
4)Number of Dealers: There should be a number of dealers and brokers in developed money
market that should buy and sell the credit instruments. An underdeveloped money market, on the
other hand, is characterised by the absence of adequate credit instruments and dealers to deal in
them.
5)Existence of a Large Number of Sub-Markets: Another essential characteristic of a developed
money market is the existence of a large number of specialised sub-markets, such as, call market,
bill market, collateral market and acceptance market. The larger the number of specialised submarkets, the more highly developed is the money market.
6)Proper Co-ordination among Sub-Markets: The whole organisation of the money market should
work in properly coordinated and integrated manner. Various sub-markets of a developed money
market should be complementary to each other and not be independent or isolated.
7)Integrated Interest Structure: The money market to be a developed one should have well
coordinated and integrated interest structure. Any change in the bank rate in the country should
bring proportional changes in the interest rates in the market.
8)Responsive: A developed money market is highly responsive to domestic and international
events. Any event that takes place in the economic or political field anywhere in the world affects
the money market.
9) Remittance Facilities: In a developed money market, cheap facilities for the remittance of funds
from one place to another are readily available. Money market cannot work smoothly in the
absence of cheap remittance facilities.
10)Other Factors: In addition to the above-mentioned important characteristics of a developed
money market, there are other contributory factors such as large volume of trade, stable political
conditions, etc.
Functions of Money Market
The following are the important functions performed by money market in an economy:
1)Match Needs of Borrower: Money market helps in mobilising savings, capital formation and
supply of funds to trade and industry by offering different types of suitable and attractive schemes
to match the needs of various sections of society.
2)Balance supply of Funds: A proper, balanced and efficient working of money market helps in
balancing excessive or limited supply of funds to match seasonal variations in demand.
3)Minimise Fluctuations: A well-functioning money market helps to minimise seasonal
fluctuations in interest rates.
4)Facilitate Borrowers: A money market enables borrowers to get funds at cheaper interest rates by
facilitating increased supply of funds and making them available to legitimate borrowers.
5)Mobilise Funds: An orderly and efficient functioning money market helps different regions
through quick transfer of funds from one place to another.
6)Increase Liquidity: A money market augments the liquidity available to the entire economy.
7)Provide Platform for Earning Profit: A money market, by offering a platform for profitable
investment opportunities for short-term surplus funds, helps to increase the profit of individuals
and financial institutions.
Players of Money Market
1)Government: The government is active and the biggest borrower in the money market. It needs
funds to meet the fiscal requirements.
2)Central Bank: The central bank. of the country, i.e., the Reserve Bank of India (RBI) operates on
behalf of the
government. It issues government securities to finance the deficit and sometimes also underwrites
the issues of government.
3)Commercial Banks: Commercial bank act as borrowers/ lenders in the money market. Banks are
required to maintain statutory liquid reserves and cash reserves with RBI
4)Financial Institution: Financial Institution like Life Insurance Corporation of India (LIC),
General Insurance
Corporation of India (GIC); Industrial Development Bank of India (IDBI) also act as borrowers or
lenders in the
money market depending upon the requirements. In addition to these institutions, mutual funds and
Foreign Institutional Investors (FIls) also participate in the money market as investors or lenders.
The level of participation of these players is mainly dependent on the limits prescribed by the RBI.
For example, FIls can participate in the Indian money market by way of investment in government
securities only.
5)Corporate: Corporate participate in the money market as borrowers of fund for working capital
requirements. There are some specialised institutions like the Discount and Finance House of India
(DFHI) and some primary dealers which also participate in the money market. DFHI provides the
much needed liquidity by acting as a financier whereas primary dealers act as market-makers by
providing two-way quotes for the instruments traded in the money market thus enhancing the
liquidity in the market.
RECENT DEVELOPMENT IN MONEY MARKET
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Integration of unorganized sector with the organized sector
Widening of call Money market
Introduction of innovative instrument
Offering of Market rates of interest
Promotion of bill culture
Entry of Money market mutual funds
Setting up of credit rating agencies
Adoption of suitable monetary policy
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Establishment of DFHI
Setting up of security trading corporation of India ltd. (STCI)
Importance of Money Market
1)Source of Capital: Money market is an important source of financing for trade and industry. The
short-term finances are
made available through bills, commercial papers, etc.
2)Ideal Investment: Money market offers an ideal source of investment for the commercial banks.
The market helps them
invest their short-term surplus funds so as to meet statutory reserve requirements.
Effective Monetary Management: An efficient money market being sensitive in .nature allows for
the effective
implementation of monetary policy of the central bank and thus paves way for the efficient
monetary management of the
country.
3)Economic Development: Money market being an integral part of a country's economy,
contributes substantially to the economic development of a country. A developed money market is
indispensable for the rapid development of the economy.
4)Efficient Banking System: The existence of a developed money market greatly facilitates the
smooth and efficient functioning of the banking and financial system.
5)Facilitating Trade: Money market is of immense help to the business community in the
following ways:
i) Providing an ideal payment mechanism making it possible for expeditious transfer of large sums
of money.
ii) Meeting the working capital requirements for carrying out the production and marketing
activities.
iii) Making efficient investment of surplus funds into near-money assets which can be quickly
converted into money as and when needed.
7)Helpful to Government: The government uses the money market as an arena in which short-term
funds are raised by floating treasury bills.
Money Market Instruments
Money market instruments provide the tools by which one can operate in the money market.
Considering the need for making available an adequate number and different variety of financial
instruments as a precursor for a developed money market, a number of instruments were
introduced in the Indian money market. The various types of money market instruments are as
follows:
1)Call/Notice/Term Money: Call money is the money which is loaned, in the call market, which
can be demanded-for repayment on call, i.e., immediately. Also known as money at short notice, it
is also traded in the money market and is repayable in twenty four hours. Call money market is the
market in which brokers and dealers borrow money to satisfy their credit needs, either to finance
their own inventory of securities or to cover their customers' margin accounts. The call money
market is an integral part of the Indian money market, where the day-to-day surplus funds (mostly
of banks) are traded. The loans are of short-term duration varying from one to fourteen days. The
money that is lent for one day in this market is known as "Call Money", and if it exceeds one day
(but less than fifteen days) it is referred to as "Notice Money". "Term Money" refers to money lent
for fifteen days or more in the inter-bank market.
2)Commercial Bill: A commercial bill is also referred as bill of exchange or bill discounting. It is a
short-term, negotiable and self-liquidating money-market instrument. Bill discounting is a major
activity with some of the smaller banks. Under this type of lending, bank takes the bill drawn by
borrower on his (borrower's) customer and pays him immediately deducting some amount as
discount/commission. The bank then presents the bill to the borrower's customer on the due date of
the bill and collects the total amount. If the bill is delayed, the borrower or his customer pays the
bank a pre- determined interest depending upon the terms of transaction.
3)Treasury-Bills: A kind of finance bills, which are in the nature of promissory notes, issued by the
government under discount for a fixed period, not exceeding one year, containing a promise to pay
the amount stated therein to the bearer of the instrument, are known as "treasury bills". A market
for the purchase and sale of treasury bills is known as a "treasury bills market". Treasury bills (Tbills) are the most marketable money market security. Their popularity is mainly due to their
simplicity. The biggest reason that T -bills are so popular is that they are one of the few money
market instruments that are affordable to the individual investors. T-bills are short-term securities
that mature in one year or less from their issue date.
4)Commercial Papers: Commercial papers are those unsecured promissory notes which are issued
by well-reputed companies. Their buyers are banks, insurance companies, unit trust and firms.
They can be sold in two ways - directly and indirectly. In other words, the company can directly
sell the commercial paper to the buyer or can take the help of some agency. The minimum face
value of a commercial paper is ~5 lac. It is used to meet the demand of a short-term seasonal need
and the requirement of working capital.
5)Certificates of Deposits: A market for the purchase and sale of certificates of deposit is called
'Certificate of Deposit (CD) market'. It is an important constituent of the money market.
Certificates of deposit are unsecured, negotiable, short-term instruments in bearer form, issued by
commercial banks and development financial institutions. Certificates of deposits (CDs)are shortterm borrowings by banks. Certificates of deposits differ from term deposit because they involve
the creation of paper and hence have the facility for transfer and multiple ownerships before
maturity. Certificate of deposits rates are usually higher than the term deposit rates, due to the low
transactions costs. Banks use the certificates of deposits for borrowing during a credit pick-up, to
the extent of shortage in incremental deposits. Most certificates of deposits are held until maturity,
and there is limited secondary market activity. Guidelines for issue of certificate of deposits are
presently governed by various directives issued by the Reserve Bank of India.
6)Repo Reverse Repo: It is a transaction in which two parties agree to sell and repurchase the same
security. Under such an agreement, the seller sells specified securities with an agreement to
repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases
the securities with an agreement to resell the same to the seller on an agreed date in future at a
predetermined price. Such a transaction is called a repo when viewed from the prospective of
the seller of securities (the party acquiring fund) and reverse repo when described from the point of
view of the supplier of funds. Thus, whether a given agreement is termed as repo or a reverse repo
depends on which party initiated the transaction.
Role of Central Banking in Money Market.
Reserve Bank of India is the regulator over the money market in India. As the central bank, it
injects liquidity in the banking
system, when it is deficient and contracts the same in opposite situation. The Reserve Bank of
India (RBI) is the Central Bank of the country. It has been established as a body corporate under
the Reserve Bank of India Act, which came into effect from 1 st April, 1935. The Reserve Bank
was started as shareholders bank with a paid-up. capital of Rs 5 crore. On establishment it took
over the function of management of currency from the Government of India and power of credit
control from the Imperial Bank of India.
1)Note Issue: It is considered one of the primary functions of a central bank. The entire financial
system of a country, with ever-increasing volume and variety of the financial instruments,
institutions and markets, needs a stable supply of legal tender money. This legal tender should tend
to vary, both in volume and composition to the changing requirements of the economy.
Accordingly, the central bank of the country is granted the sole right to issue currency(including
that of the government of the country) and (ii) a monopoly of issuing bank notes (which are its
promises to pay).
2)Banker's Bank: The second main function of a central bank is that of being a bank of the banks.
This function includes the following interrelated sub-functions.
i)The first sub-function is its being a custodian of the cash reserves of the commercial banks. The
exact form of this function has varied from country to country and in terms of legal provisions.
Historically, commercial banks discovered that it was convenient and economical to hold deposit
balances with the central bank for making payments to each other. In some countries, however, the
banks are compelled by law to hold deposit balances with central bank and this gives it an
additional tool to regulate credit creation by them. The legal provision to this effect was first
introduced in US. Later, it was adopted in India also. RBI has found it a very effective regulatory
tool and has used it very extensively.
ii) The reduction in interest rates required to restore equilibrium to the market for money after an
increase in the money supply is achieved in the bond market. The increase in bond prices lowers
interest rates, which will increase the quantity of mopey people demand. Lower interest rates will
stimulate investment and net exports, via changes in the foreign exchange market, and cause the
aggregate demand curve to shift to the right, as shown in Panel (c), from
AD, to AD2. Given the short-run aggregate supply curve SRAS, the economy moves to a higber
real GDP and a higher price level
iii) The second sub-function is that of clearance. When individual banks maintain deposit balances
with the central bank and use them to make payments to each other, the system of interbank
clearance emerges. The interbank clearance and remittances result in appropriate adjustments in
the deposit balances of the banks with the central bank. Actually, the basic motive, which induces
the commercial banks in maintaining deposit balances with the
central bank, is the convenience and economy of making payments to each other. This function
was first developed by the Bank of England in mid 19"century. Currently, it is one of the primary
functions of every central bank of the world.
3)Lender of Last Resort: The central bank is the final source of the supply of legal tender. It is the
lender of the last resort. For this reason, it should be able to adjust the availability of currency with
the market in line with the changing needs of the latter. When the economy expands and it needs
additional money and credit, the central bank can adopt a policy of pumping in additional currency
in the market. Similarly, it can try to curtail the supply of available currency when the economy in
a phase of contraction. The central bank adjusts the volume of currency in two ways.
i)The banks can approach it for cash loans. It can tighten the terms of issue of such loans
(including the rate of interest to be charged) if it wants to restrict the money supply. Alternatively,
it can make it easier and cheaper for the banks to borrow if it wants to increase the supply of
money and credit.
ii) The amount of money needed by the market is also reflected in the bills drawn by the seller
upon the buyers and the central bank can take steps to alter the money supply in the market by
adjusting the volume of bills discounted re- discounted by it. For example, when the volume of
bills drawn is increasing during an expansionary phase of the economy, the central bank can adopt
the policy of discounting more of them and pumping additional currency in the
market. Similarly, when the economy is passing through a phase of contraction, the volume of bills
had drawn decreases.' In this case, the central bank can drain the market of excess money supply
by collecting the earlier discounted bills and discounting less of fresh bills. In addition, it can also
adopt the policy of adjusting its discount rate to encourage or discourage the discounting of bills,
as the need be.
4)Banker to the Government: The central bank of the country happens to be a banker to the
government. This function normally involves two things: providing ordinary banking services to
the government, and being a public debt agent and underwriter to the government.
5)Custodian of Foreign Exchange Reserves: Central bank of a country is also a custodian of its
official foreign exchange reserves. This arrangement helps the authorities in managing and coordinating the monetary matters of the country more effectively. This is because there is a direct
association between foreign exchange reserves and quantity of money in the market. The foreign
exchange reserves are influenced by international capital movements, international trade credits
and so on. Because of the interaction between the domestic money supply, price level and
exchange reserves, the central bank frequently faces several contradictory tendencies which have
to be reconciled.
6)Regulation of Exchange Rate: A related function, which is assigned to the central bank, is the
regulation and stabilisation of the exchange rate. This task is facilitated when the central bank is
also the custodian of official foreign exchange reserves. The need for a stable exchange rate is
more in the case of a paper standard than under a metallic standard. In this context, we should
specifically note two things: the justification for having a stable exchange rate and
avoiding violent and wide fluctuations in it; and the need to assign this task to an expert and
competent agency. As regards expertise and competence central bank of the country is the best
agency to which the task of regulating and stabilising exchange rate should be assigned. The
central bank happens to be the apex institution of the entire financial system of the country. It is in
possession of maximum data and has the expertise 'of estimating the financial trends and the type
of corrective measures needed. Moreover, it possesses several regulatory powers over the financial
system. It can contemplate and take the complementary measures needed for ensuring the success
off the steps taken in the area of exchange rate.
A stable exchange rate is of great help in promoting external trade and orderly capital flows. The
volatility of exchange rate tends to increase if there is complete capital convertibility (that is,
capital can flow in and out of the country without specific permission of the authorities). If the
central bank is given the authority to regulate the use of foreign exchange (that is, if it has the
authority to apply exchange control to the extent it decides), the task of stabilising exchange rate
becomes easier for it.
7)Credit Control: Over the years, credit control has become a leading function of a modern central
bank. In earlier days, the term credit control referred to the regulation of only the"volume" of
money and credit. Currently, the term is used in a wider meaning and covers not only the "volume"
of money and credit, but also its components,its flows, its allocation
between alternative uses and borrowers, terms and conditions attached to credit and so on. ,
The need for credit control arises because it is observed that "money cannot manage itself. Left to
unregulated market forces, flows of money and credit have the tendency to accentuate cyclical
fluctuations. Moreover, in underdeveloped countries, unregulated credit flows strengthen intersectoral imbalances, speculative forces and other distortions.
5.9 Demand of Money
In deciding how much money to hold, people make a choice about how to hold their wealth. How
much wealth shall be held as money and how much as other assets? For a given amount of wealth,
the answer to this question will depend on the relative costs and benefits of holding money versus
other assets. The demand for money is the relationship between the
quantity of money people want to hold and the factors that determine that quantity.
To simplify analysis, it will assumed that there are only two ways to hold wealth - as money in a
checking account, or as funds in a bond market mutual fund that purchases long-term bonds on
behalf of its subscribers. A bond fund is not money. Some money deposits earn interest, but the
return on these accounts is generally lower than what could be obtained in a bond fund. The
advantage of checking accounts is that they are highly liquid and can thus be spent easily. We will
think of the demand for money as a curve that represents the outcomes of choices between the
greater liquidity of money deposits and the higher interest rates that can be earned by holding a
bond fund. The difference between the interest rates paid on money deposits and the interest return
available from bonds is the cost of holding money.
Motives for Demand of Money
The demand for money is affected by several factors, including the level of income, interest rates,
and inflation as well as uncertainty about the future. The way in which these factors affect money
demand is usually explained in terms of the three motives for demanding money:
1)Transactions Motive: The transactions motive for demanding money arises from the fact that
most transactions involve an exchange of money. Because it is necessary to have money
available for transactions, money will be demanded. The total number of transactions made in
an economy tends to increase over time as income rises. Hence, as income or GDP
rises, the transactions demand for money also rises. Precautionary Motive: People often
demand money as a precaution against an uncertain future. Unexpected expenses,
such as medical or car repair bills, often require immediate payment.. The need to have money
available in such situations is referred to as the precautionary motive for demanding money.
2)Speculative Motive: Money, like other stores of value, is an asset. The demand for an asset
depends on both its rate of return and its opportunity cost. Typically, money holdings provide no
rate of return and often depreciate in value due to inflation. The opportunity cost of holding money
is the interest rate that can be earned by the lending or investing one's
money holdings. The speculative motive for demanding money arises in situations where holding
money is perceived to be less risky than the alternative of lending the money or investing it in
some other asset.
3)For example, if a stock market crash seemed imminent, the speculative motive for demanding
money would come into play; those expecting the market to crash would sell their stocks and hold
the proceeds as money. The presence of a speculative motive for demanding money is also
affected by expectations of future interest rates and inflation. If interest rates are expected to rise,
the opportunity cost of holding money will become greater, which in turn diminishes the
speculative motive for demanding money. Similarly, expectations of higher inflation presage a
greater depreciation in the purchasing power of money and therefore lessen the speculative motive
for demanding money.
Interest Rates and the Demand for Money
The quantity of money people hold to pay for transactions and to satisfy precautionary and
speculative demand is likely to vary with the interest rates they can earn from alternative assets
such as bonds. When interest rates rise relative to the rates that can be earned on money deposits,
people hold less money. When interest rates fall, people hold more money. The logic
of these conclusions about the money people hold and interest rates depends on the people's
motives for holding money.
For example, the quantity of money households want to hold varies according to their income and
the interest rate; different average quantities of money held can satisfy their transactions and
precautionary demands for money. To see why, suppose a household earns and spends $3,000 per
month. It spends an equal amount of money each day. For a month with 30 days, i.e.,
$100 per day. One way the household could manage this spending would be to leave the money in
a checking account, which will be assumed pays zero interest. The household would thus have
$3,000 in the checking account when the month begins, $2,900 at the end of the first day, $1,500
halfway through the month, and zero at the end of the last day of the month. Averaging the daily
balances, we find that the quantity of money the household demands equals $1,500. This approach
to money management, which we will call the "cash approach", has the virtue of simplicity, but the
household will earn no interest on its funds.
Demand Curve for Money
The transactions, precautionary, and speculative demands for money vary negatively with the
interest rate. Putting those three sources of demand together, demand curve for money can be
drawn a to show how the interest rate affects the total quantity of money people hold. The demand
curve for money shows the quantity of money demanded at each interest rate, all other
things unchanged. Such a curve is shown in figure 5.9, "The Demand Curve for Money":
An increase in the interest rate reduces the quantity of money demanded. A reduction in the
interest rate increases the quantity of money demanded. The demand curve for money shows the
quantity of money demanded at each interest rate. Its downward slope expresses the negative
relationship between the quantity of money demanded and the interest rate.
The relationship between interest rates and the quantity of money demanded is an application of
the law of demand. If we think of the alternative to holding money as holding bonds, then the
interest rate - or the differential between the interest rate in the bond market and the interest paid
on money deposits - represents the price of holding money. As is the case with all
goods and services, an increase in price reduces the quantity demanded.
Factor Affecting of the Demand for Money
We draw the demand curve for money to show the quantity of money people will hold at each
interest rate, all other determinants of money demand unchanged. A change in those "other
determinants" will shift the demand for money. Among the most important variables that can shift
the demand for money are the level of income and real GDP, the price level, expectations, transfer
costs, and preferences. These are as follows:
1)Real GDP: A household with an income of $10,000 per month is likely to demand a larger
quantity of money than a household with an income of $1,000 per month. That relationship
suggests that money is a normal goods - as income increases, people demand more money at each
interest rate, and as income falls, they demand less. An increase in real GDP increases incomes
throughout the economy. The demand for money in the economy is therefore likely to be greater
when real GDP is greater.
2)Price Level: The higher the price level, the more money is required to purchase a given quantity
of goods and services. All other things unchanged, the higher the price level, the greater the
demand for money.
3)Expectations: The speculative demand for money is based on expectations about bond' prices.
All other things unchanged, if people expect bond prices to fall, they will increase their demand for
money. If they expect bond prices to rise, they will reduce their demand for money.
The expectation that bond prices are about to change actually causes bond prices to change. If'
people expect bond prices to fall, e.g., they will sell their bonds, exchanging them for money. That
will shift the supply curve for bonds to the right, thus lowering their price. The importance of
expectations in moving markets can lead to a self-fulfilling prophecy.
Expectations about future price levels also affect the demand for money. The expectation of a
higher price level means that people expect the money they are holding to fall in value. Given that
expectation, they are likely to hold less of it in anticipation of a jump in prices.
4)Transfer Costs: For a given level of expenditures, reducing the quantity of money demanded
requiresmore frequent transfers between non-money and money deposits. As the cost of such
transfers rises, some consumers will choose to make fewer of them. They will therefore increase
the quantity of money they demand. In general, the demand for money will increase as it becomes
more expensive to transfer between money and non-money accounts. The demand for money will
fall if transfer costs decline. In recent years, transfer costs have fallen, leading to a decrease in
money demand.
S)Preferences: Preferences also play a role in determining the demand for money. Some people
place a high value on having a considerable amount of money on hand. For others, this may not be
important. "' Household attitudes toward risk are another aspect of preferences that affect money
demand. As we have seen, bonds pay higher interest rates than money deposits, but holding bonds
entails a risk that bond prices.might fall. There is also a chance that the issuer of a bond will
default, i.e., will not pay the amount specified on the bond to bond-holders; indeed, bond issuers
may end-up paying nothing at all. A money deposit, such as a savings deposit, might earn a lower
yield, but it is a safe yield. People's attitudes about the trade-off between risk and yields affect the
degree to which they hold their wealth as money. Heightened concernsabout risk in the last half of
2008 led many households to increase their demand for money.
Figure, "An Increase in Money Demand" shows an increase in the demand for money. Such an
increase could result from a higher real GDP, a higher price . level, a change in expectations, an
increase in transfer costs, or a change in preferences.
An increase in real GDP, the price level, or transfer costs, e.g., will increase the quantity of money
demanded at any interest rate r, increasing the demand for money from DJ to D2. The quantity of
money demanded at interest rate r rises from M to M'. The reverse of any such events would
reduce the quantity
of money demanded at every interest rate, shifting the demand curve to the left.
Changes in Money Demand
Suppose that, the money market is initially in equilibrium at r, with supply curve S, and a demand
curve DI as shown in Panel (a) of figure 5.11, "a decrease in the Demand for Money". Now,
suppose that there is a decrease in money demand, all other things unchanged. A decrease in
money demand could result from a decrease in the cost of transferring between money and nonmoney
deposits, from a change in expectations, or from a change in preferences. Panel (a) shows that the
money demand curve shifts to the left to D2. We can see that the interest rate will fall to r2. To see
why the interest rate falls, we recall that if people want to hold less money, then they will want to
hold more bonds. Thus, Panel (b) shows that the demand for bonds increases. The higher price of
bonds means lower interest rates; lower interest rates restore equilibrium in the money market.
Panel – a
Panel - C
Panel – b
Quantity of money per period
GDP per year
Quantity of bonds per period
Real
A decrease in the demand for money due to a change in transactions costs, preferences, or
expectations, as shown in Panel (a), will be accompanied by an increase in the demand for bonds
as shown in Panel (b), and a fall in the interest rate. The fall in the interest rate will cause a
rightward shift in the aggregate demand curve from AD! to AD2, as shown in Panel (c). As a
result, real GDP and the price level rise.
Lower interest rates in turn increase the quantity of investment. They also stimulate net exports, as
lower interest rates lead to a lower exchange rate. The aggregate demand curve shifts to the right
as shown in Panel (c) from AD! to AD2. Given the short-run aggregate supply curve SRAS, the
economy moves to a higher real GDP and a higher price level.
An increase in money demand due to a change in expectations, preferences, or transactions costs
that make people want to hold more money at each interest rate will have the opposite effect. The
money demand curve will shift to the right and the demand for bonds will shift to the left. The
resulting higher interest rate will lead to a lower quantity of investment. Also, higher interest rates
will lead to a higher exchange rate and depress net exports. Thus, the aggregate demand curve will
shift to the left. All other things unchanged, real GDP and the price level will fall.
5.10 Supply of Money
The supply curve of money shows the relationship between the quantity of money supplied and the
market interest rate, all other determinants of supply unchanged. We have learned that the fed,
through its open-market operations, determines the total quantity of reserves in the banking
system. We shall
assume that banks increase the money supply in fixed proportion to their reserves. Because the
quantity of reserves is determined by Federal Reserve policy, we draw the supply curve of money
in figure, "The Supply
Curve of Money" as a vertical line, determined by the Fed's monetary policies. In drawing the
supply curve of money as a vertical line, we are assuming the money supply does not depend on
the interest rate. Changing
the quantity of reserves and hence the money supply is an example of monetary policy.
Supply curve of money
Interest rate
Money supply
M
Quantity of money per period
We assume that the quantity of money supplied in the economy is determined as a fixed multiple
of the quantity of bank reserves, which is determined by the fed. The supply curve of money is a
vertical line at that quantity
Factors Affecting Money Supply
There are five sources which contribute to the aggregate monetary resources in the country (M3):
1)Net Bank Credit to the Government: There are two types of bank credit to the government; RBI
credit to the Central and State Government and others banks' credit to the Central and State
Government. The government provides its securities and IOUs to the RBI against which it receives
loans from the RBI. The RBI prints and issues currency notes against government securities. This
increases money supply in the country and when the government buys back its securities, it
reduces the supply. Similarly, when the government borrows from commercial banks, it also
increases the supply of money with the public.
2)Bank Credit to the Commercial Sector: When banks lend to customers it increases the supply of
money in the hands of the public. Lending by the commercial sector has a multiplier effect. When
banks lend to the customer, they do not hand over currency to him, but instead allow him the
facility of withdrawal by cheque. These cheques come back to the banking system as fresh
deposits. By giving more such loans, banks multiply their deposits. More bank loans mean more
supply of money and more investment.
3)Foreign Exchange Assets: Foreign exchange assets acquired by the banking system are also a
source of money supply. When an exporter receives a payment in foreign exchange (forex) he
surrenders it to the bank, which in turn gives him local currency. This increases supply of money
in the country. On the other hand, when an importer asks for foreign exchange to import, he gives
local currency to the bank and supply of money in the country is reduced.
4)Government Currency Liabilities to the Public: The Government of India prints/mints one rupee
notes, rupee coins and small coins (50 paisa, 25 paisa, etc.) which constitute the government's
currency liabilities to the public. This leads to increase in the volume of money supply and the
government's currency liabilities to the public. . Non-Monetary Liabilities of the Banking Sector:
Non-monetary liabilities of the RBI and other banks are deducted before we calculate the stock of
money. These liabilities of bank include their paid up capital and reserves, pension fund, provident
fund and other liabilities like bills payable over other assets of banks, errors and omission, etc.
Since they are liabilities of the banking system, they have to be deducted to arrive at the money
stock (M3).
Measures of Money Supply in India (Monetary Aggregates)
There are two basic measures of money globally; narrow and broad. The former usually consists of
the currency with the public and demand deposits with banks. The latter includes the time deposits
with banks. Till 1998, the RBI calculated four components of money supply in India, now termed
as old money measures. These are known as money stock measures of monetary aggregates.
1)Money Stock Measures
i)Old Money Aggregates
a) Ml = Currency with the public, i.e., coins and currency notes + demand deposits with banks +
other deposits with RBI.
b)M2 = Ml + Post Office savings.
c)M3 = Ml + time deposits of the public with banks; this is also known as broad money.
d)M4 = M3 + saving and time deposits with the post office.
Out of the four concepts of money supply, RBI emphasizes only two concepts, viz., ordinary
money or narrow money (Ml) and money supply in the broad sense (M3), which consists of Ml
plus time deposit of people with the bank. M3 is also referred to as broad money or aggregate
monetary resource of the people.
ii) New Monetary Aggregates
a)MO = Currency in Circulation + Bankers Deposits with the RBI + 'Other' Deposits with the RBI.
b)Ml (NMl) = Currency with the Public + Demand Deposits with the Banking System + 'Other'
Deposits with the RBI.
c)M2 (NM2) = MJ + Time Liabilities Portion of Savings Deposits with the Banking System +
Certificates of
Deposit issued by Banks + Term Deposits of residents with a contractual maturity of up to and
including one
year with the Banking System (excluding CDs).
M3(NM3) = Mi + Term Deposits of residents with a contractual maturity of over one year with the
Banking
System + Call1Tenn borrowings from 'Non-depository' Financial Corporations by the Banking
System.
There are three major changes in the new and old monetary aggregates:
i)New intermediate monetary aggregate, which is to be referred to as NM2, comprises of currency
and resident's
short-term bank deposits that would stand between narrow money (MI, which includes only the
non-interest bearing
monetary liabilities of the banking sector) and broad money (M3).
ii) The new broad money aggregate (referred to as NM3 for purpose of clarity) in the Monetary
Survey would comprise of NM2, long-term deposits of residents, and call/term borrowings from
non-bank sources which have emerged as an
important source of resource mobilization for banks. The critical difference between M3 and NM3,
essentially, lies in the treatment of non-resident repatriable fixed foreign currency liabilities of the
banking system in the money supply compilation.
iii) Post office deposits have been dropped from the new money and thus the old concept of M2
and M4 concepts have been dropped.
Need to Regulate the Money Supply
The supply of money has a direct impact on inflation, level of investment, employment generation,
interest rate, etc. It is clear that supply of money has an effect on every aspect of the economy and
has a close relationship with development. Supply of money is a sensitive issue as even a slight
imbalance can create havoc in the form of deflation or hyperinflation in the country.
Thus need to regulate the supply of money is based on the following:
1)Money Supply and Inflation: There is a direct relationship between the supply of money and
inflation. It is based on the simple fundamental of demand and supply. The value of a currency is
defined by its purchasing power. As the supply of money increases its value decreases. Decrease in
purchasing power means an increase in inflation.
When the supply of money increases with the people it gives them more purchasing power, which
results in an increase in demand. Prices rise if demand increases without a correspondent
increment in supply. This doesn't mean that money supply is directly proportional to inflation.
Because increment in supply of money
not only increases the demand, it also increases investment, i.e., supply. Part of the increased
money also goes into savings. This is the reason that with an increase in money supply, the
government promotes investment and savings so that it does not have an inflationary impact. There
is thus a close relationship between inflation and supply of money, but not a proportional relation.
2)Supply of Money, Interest Rate and Investment: The supply of money also has an impact on
interest rates and level of investment. In fact, economists have propounded the theory that to boost
development and to create employment, the government should expand money.
Here too, the fundamentals are the same. As supply of money increases its value goes down. The
price of money is its interest rate.
So when banks get more money,
Supply of Money
Low Interest Rate Higher Investment they provide loans at low rates.
This increases the level of
investment in the country because
more people go for investments
Employment
with low interest rates. This
Inflation
Increase Demand
results in creation of employment,
which results in an increase in purchasing power. This in turn, increases demand and results in
inflation, which again works as a catalyst for investment.
So it is clear that there is cyclical relation between money supply, inflation, interest and
investment. We can put the four things in the following manner:
Relation between supply of money and inflation
Changes in the Money Supply
Now, suppose the market for money is in equilibrium and the Fed changes the money supply. All
other things unchanged, how will this change in the money supply affect the equilibrium interest
rate and aggregate demand, real GDP,and the price level?
Suppose, the Fed conducts open-market operations in which it buys bonds. This is an example of
"Expansionary Monetary Policy". The impact of Fed bond purchases is illustrated in Panel (a) of
figure 5.14, "An Increase in the Money Supply". The Fed's purchase of bonds shifts the demand
curve for bonds to the right, raising bond prices to pb2. As we learned, when the Fed buys bonds,
the supply of money increases. Panel (b) of figure 5.14, "An Increase in the Money Supply" shows
an economy with a money supply of M, which is in equilibrium at an interest rate of r.. Now,
suppose the bond purchases by the Fed as shown in Panel (a) result in an increase in the money
supply to M'; that policy change shifts the supply curve for money to the right to S2. At the
original interest rate r., people do not wish to hold the newly supplied money; they would prefer to
hold non-money assets. To re-establish equilibrium in the money market, the interest rate must fall
to increase the
quantity of money demanded. In the economy shown, the interest rate must fall to r2 to increase
the quantity of money demanded to M'.
Panel – a
Quantity of bonds per period
GDP per year
Panel – b
Quantity of money per period
Panel - C
Real
The Fed increases the money supply by buying bonds, increasing the demand for bonds in
Panel (a) from 0, to O2, and the price of bonds to pb2. This corresponds to an increase in the money
supply to M' in Panel (b). The interest rate must fall to r2 to achieve equilibrium. The lower
interest rate leads to an increase in investment and net exports, which shifts the aggregate demand
curve from AD, to AD2 in Panel, (c). Real GOP and the price level rise.
Money Market Equilibrium and National Income: IS-LM Model
The IS-LM model is an algebraic and graphical representation of relationships set out more or less
explicitly by Keynes in the General Theory, incorporating an interaction between the money
market and the market for goods and services to determine simultaneously national income and the
rate of interest. The model was later extended to take account of the labour market, the price level,
and financial assets otter than money or real capital. The IS and LM curves relate the two variables
such as, income, the rate of interest. National Income and the rate of interest are dete;mined
together at the point of intersection is called market equilibrium.
The IS-LM model depicts the simultaneous attainment of equilibrium in the markets for money
and for goods and services. It starts with a closed, single-goods economy with a single asset,
claims on which are a perfect substitute for real capital Stocks, wealth, and productive capital are
taken as given as, to begin with, is the general price level.
1)Market for Goods and Services: In a closed economy, the whole value of output is equal in value
to income and thus also consumption and savings, whilst the value of demand is split between
consumption and investment. It follows that equality of savings and investment coincides with
equilibrium in the goods market. The relationships which hold in equilibrium may be specified as
follows, variables being expressed in real terms, given the assumption of constant prices.
I = I (i)
S = S(Y)
1= S
Investment is a decreasing function of the rate of
interest.
Savings are an increasing function of income.
In equilibrium, the two are equal.
Solving this model in three equations and four unknowns produces a relationship Y(i), the IS curve
in figure
The IS curve represents the pairs of values of national income Y and the rate of interest i
compatible with the attainment of equilibrium in the goods market
2)Money Market: The exogenous money supply M, has to satisfy a dual demand - a transactions
and precautionary demand MJ (Y) and a speculative demand M2(i), a function of the rate of
interest. The total demand for money is thus:
while the equilibrium condition may be written M = Mo.
Since the value of M, is given, the system has three unknowns M, I, and Y, and two equations.
Again there is one degree of freedom in the solution and the set of solutions is defined by a
function Y(i) called the LM curve and drawn as in figure
Example 1: Consider a simple macro-economic model which takes into account conditions in the
money market. Assume
the following relationship:
Y =C+I+G
C = 100 + O.6Y
I = 0.2Y - 50i
MD = 0.25Y - 30i
Ms =65
G = 100
where, Y= gross national product
C= consumption
G = government expenditures
I = investment
MD = money demanded
Ms = money supplied
i = interest rate
Find (a) the equilibrium level of income, (b) the interest rate at that level.
Solution: To find the equilibrium level we must look for the intersection of the IS and LM curves.
The IS curve
demonstrates the relationship between the rate of interest and the equilibrium level of national
income. The national income equilibrium occurs when savings is equal to investment. By plotting
national income on the "X" axis and the interest rate on the "Y" axis, we see, the lower the rate of
interest, the greater the level of investment, and hence, the higher is the level of national income
equilibrium consistent with that interest rate. See diagram "A" below:
A
Interest rate
IS
National Income
The LM curve, on the other hand, shows the relationship between the level of income
and the rate of interest required to clear the money market given a fixed money supply. Since the
rate of interest is determined by the equilibrium between money supply, assuming a fixed-money
supply, the LM curve will be positively sloped.
5.11 MONETARY POLICY .
5.6.1. Meaning & Definition of Monetary Policy
Monetary policy refers to use of instruments within the control of the Central Bank to influence the
level of aggregate demand for goods and services or to influence the trends in certain sectors of the
economy. Monetary policy operates through varying the cost and availability of credit these
programme producing
desired changes in the assets pattern of credit institutions, principally commercial banks. These
variations affect the demand for, and the supply of, credit in the economy, and the level and nature
of economic activities.
Monetary policy is usually defined as the central bank's policy pertaining to the control of the
availability. cost and use of money and credit with the help of monetary measures in order to
achieve specific goals.
Monetary policy deals with the monetary system of a country. It is concerned with monetary
decisions and measures. Non- monetary decisions and measures having monetary effects are also
dealt with under the monetary policy. All those measures which affect the volume of money are
included under monetary policy. It controls, directs, and guides the methods of cost and used of
money and credit.
According to Paul Einzig, "Monetary policy is the attitude of the political authority towards the
monetary system of the community under its control".
According to G.K. Shaw, "Monetary policy IS any conscious action undertaken by the monetary
authorities to change the quantity, availability or cost of money".
According to Prof. Harry Johnson, "A policy employing the central banks control of the supply of
money as an instrument for achieving the objectives of general economic policy is a monetary
policy".
According to A.G. Hart, "A policy which influences the public stock of money substitute of public
demand for such assets of both that is policy which influences public liquidity position is known as
a monetary policy".
It is an important tool of economic policy. Its role on the general level of economic activity has
been recognised since long. It is also defined as a means to control the supply and cost of money to
achieve certain objectives. Currency, depo its, credit, and foreign exchanges are controlled under
monetary policy. The importance of monetary policy has been realised from time to time.
In the economically advanced countries, the monetary authority concentrates on the regulatory
aspect of monetary measures in order to achieve the goal of economic stabilisation, while in a
developing economy like India, monetary policy tends to be typical in nature aiming at controlled
expansion. The policy of controlled expansion contains the attempt at reconciliation of two
contradictory motives:
1)To facilitate economic growth, and
2)To restrain inflationary pressures.
In fact, there are two facets of monetary policy in a developing economy:
1)Positive Aspects: It sets-out the promotional role of central banking in improving the savings
ratio and expanding credit for facilitating capital formation.
2)Negative Aspects: It implies a regulatory phase of restricting credit expansion, and its allocation
according to the absorbing capacity of the economy.
Features of Monetary Policy
Following are the main features of the monetary policy of the Reserve Bank of India:
1)Active Policy: Before the advent of planning in India in 1951, the monetary policy of the
Reserve Bank was a passive policy. It means that Reserve Bank did not use the measures of
monetary policy to regulate the availability of credit. But since 1951, the Reserve Bank has been
following an active monetary policy. It has been using all the measures of credit control.
2)ControUed Money Supply: Monetary supply of RBI has been achieving contradictory objective
of economic growth and controlling inflation. For promoting economic growth, more money
supply is needed, while to control inflation money supply has to be curbed. If RBI feels that more
credit is required for economic growth, then it expands credit. But if RBI feels that inflation is
rising then it restricts credit. Thus, RBI controls money supply to achieve these contradictory
objectives.
2)Seasonal Variations: The monetary policy is characterised by the changing behaviour of busy
and slack seasons. These seasons are tied to the agricultural seasons. In the busy season, there is an
expansion of funds on account of the seasonal needs of financing production, and inventory
building of agricultural commodities. On the other hand, during slack season there is less demand
for funds. Thus during busy season the Reserve Bank expands credit, and during the slack season,
RBI contracts credit.
3)Flexible: Monetary policy has changed according to change in market conditions and
requirements. If there are more requirements of funds in the market, then RBI follows liberal
monetary policy by lowering bank rate, CRR, repo rates, interest rates, etc. For example, at
present, economy needs more funds for economic growth, so RBI has given liberal monetary
policy. On the other hand, when inflation is very high, then RBI decreases supply of money (to
check inflation) by adopting tight monetary policy. ,_.
5)Investment and Saving Oriented: The monetary policy adopted by the Reserve Bank is both
investment and saving oriented. To encourage investment, adequate funds are made available for
productive purposes at reasonably low rates of interest. The Reserve Bank has also kept the
interest on deposits at a reasonably high rate to attract savings.
6)Wide Range of Methods of Credit Control: The Reserve Bank has used a wide range of
instruments of credit control. It has adopted all the measures of quantitative and qualitative credit
controls, to regulate credit as per the needs and requirement of the economy.
Types of Monetary Policy
Monetary policy design changes as per the goals set for the monetary policy and the emerging
economic scenario. The monetary policy is characterised as expansionary policy, contractionary
policy, counter cyclical policy, rule-based policy or discretionary policy.
1)Expansionary (Easy) Monetary Policy: This type of monetary policy aims at encouraging
spending on goods and services by expanding the supply of credit and money by lowering the
policy rates (bank rate or repo rate), lowering the reserve requirements and purchasing the
government securities from the market.
2)Contractionary (Tight) Monetary Policy: This type of monetary policy aims at preventing
inflation by contracting the money supply. Contraction in money supply is achieved by increasing
the policy rates, increasing the reserve requirements and selling the governD?ent securities in the
market.
3)Countercyclical Monetary Policy: This type of monetary policy aims at moderating the cyclical
.• fluctuations in the economy and stabilising the economy around its trend path by following
countercyclical measures. For example, in an overheated booming economy where inflation rate is
very high the contractionary monetary policy is pursued, whereas in a slowdown or recession an
expansionary policy may be pursued to boost up the level of economic activities.
4)Rule-Based Monetary Policy: Under this policy, money supply and related variables are
controlled by predetermined rules, norms and standards. The Central Bank authorities cannot use
their disC'retion to change the values of these variables. For example, given that the inflation rate
is around 8 to 10 per cent and GDP growth is 3 to 5 percent, the money supply growth may be
restricted to 4 to 5 per cent. Under rule-based set-up monetary policy plays a passive role.
5)Discretionary Monetary Policy: This type of monetary policy allows the Central Bank greater
autonomy in the conduct of monetary policy. Under such a policy rather than getting constrained
by the pre-set rule, the central banks, after assessing the emerging economic scenario and using its
own judgement, can change the values of money supply and the related variables.
Objectives of Monetary Policy
Broadly speaking, there can be five major causes which are based on the objectives of monetary
policy:
1)Neutrality of Money: Monetary authority in a country should aim at complete neutrality of
money vis a vis the economy. The exponents of neutral money hold the view that monetary
changes are the root cause of all economic fluctuations. In fact, it is the monetary changes which
cause the operation of the trade cycle. Besides, these monetary changes also cause distortions and
disturbances in the operation of the economic system of the country. They cause changes in such
economic entities like prices, output and employment. The changes in money supply also cause
imbalances between demand and supply, production and consumption, in the economy. According
to neutralists, the monetary changes are the real villains of the piece. In other words, money has
only a strictly neutral role to play in the functioning of the national economy.
2)Price Stabilisation: A policy of price stabilisation carefully implemented by the monetary
authority will render the trade cycle inoperative. It will render the economy free of all cyclical
fluctuations, which causes so much harm to the economy. This objective will also help to promote
business activity in the economy. As is well-known, economic uncertainty is the greatest economy
of sound business. With frequent price fluctuations, the progress of business activity is bound to
suffer a serious setback. Atleast, there shall be little possibility of businessmen entering into
forward contracts with each other with frequent changes in the price structure.
3)Exchange Rate Stability: Maintenance of stable exchange rates is an essential condition for the
creation of international confidence and promotion of smooth international trade on the largest
scale possible. Instability in exchange rates might lead to undesirable effects such as weakening of
the value of currency in the world market, speculation and even flight of capital abroad. The
objectives of exchange stability of a monetary policy could easily achieve equilibrium in the
balance of payments of a country under the gold standard. Traditionally, countries faced with
balance of payments problems have used monetary policy as a means of eliminating their deficits.
4)Full Employment: This is considered as the foremost and ideal objective of monetary policy.
Full employment is achieved where saving is equal to the investment. There are as many jobs as
there are persons seeking them. Full employment is not an end in itself. It is a pre-condition of
social welfare. It relates employment of not only human resources, but full utilisation of all the
resources with maximum efficiency and productivity. Thus, it is an ideal objective of monetary
policy for maximising economic welfare. Employment will be provided to all the members of the
society and economic resources will be utilised most efficiently. Under the condition of full
employment, under-employed and half-employed are also getting alternative employments and
they are utilising their time fully well. It does not mean that certain persons are over-employed.
Similarly, it does not indicate that unemployable boys, girls, aged and incapable persons are also
employed. It means that the willing members and able persons of the society are getting jobs.
5)Economic Growth: Economic growth relates to physical or real output. It means that growth
involves quantitative and qualitative production of goods, so as to satisfy the consumers. In brief,
economic growth implies substantial increase in per capita output or real national income. It does
not mean more money in economic growth. It is not, but the real production that makes a nation
economically advanced. Economic growth ultimately aims at total welfare of masses. It can be
achieved through equitable distribution of income between different social classes and individuals.
Role of Monetary Policy
The monetary policy plays a vital role in developing the economy from a stage of primary
backwardness to a stage of self- sustained growth. Under the growth-oriented monetary policy,
monetary management by the central bank becomes a strategic factor of development in a country,
on the following counts:
1)Rapid Economic Development: When the country aspires for rapid economic development, it
adopts economic planning. In the process, financial planning needs the support of credit planning
and appropriate monetary management.
2)Stability: Countries are most susceptible to inflation. However, the maintenance of stability in
the domestic price level and a fixed, realistic exchange rate are very essential preconditions for
achieving a maximum rate of sustained economic growth. This needs equilibrium of savings and
investment. In an underdeveloped country, however, since the rate of savings is very low,
government is usually tempted to raise the level of investment by means of credit expansion and
deficit financing. Development efforts of this nature are generally confronted by inflationary price
increases. To some economists, this (inflation) is an inevitable price to be paid for economic
growth.
3)Promotional Role of Monetary Authorities: The growth objective of monetary policy implies the
promotional role of monetary authorities. Briefly, the promotional role of the monetary authority in
an underdeveloped country may be to improve the efficiency of the banking system as a whole or
extend sound credit where needed and to respond promptly to changing conditions.
4)Improve Money and Capital Markets: It is an important task of the monetary authority to
improve the conditions of unorganised money and capital markets in poor countries in the interest
of rapid economic development and the successful working of monetary management.
5)Suitable Interest Rate Structure: An important function of monetary policy in an underdeveloped
economy is to have and also to make use of a most suitable interest rate structure.
6)Public Debt Management: Public debt management responsibility also lies with the monetary
authority of the country. In a growing economy, thus, it is very important and difficult task.
7)Extend the Process of Monetization: It is the prime duty of the monetary authority to extend the
process of
monetization in these barter sections of the economy. This will tend to improve the working and
effectiveness of the monetary policy.
Instruments of Monetary Policy
The instruments of monetary policy are also known as control measures of monetary policy by
RBI. The instruments of monetary policy may be broadly divided into:
1)General (Quantitative) Methods, and
2)Selective (Qualitative) Methods.
General (Quantitative) Methods
There are following three general quantitative instruments of credit control:
1)Bank Rate: The bank rate, also known the Discount Rate, is the oldest instrument of monetary
policy. Bank rate is the rate at which the RBI discounts - or, more accurately, rediscounts - eligible
bills. In a broader sense, it refers to the minimum rate at which the central bank provides financial
accommodation to commercial banks in the discharge of its function as the lender of the last resort.
The bank rate policy seeks to affect both the cost and availability of credit.
Benefits of Bank Rate
i) Delivers effective control over bank credit if reserve money creation is otherwise controlled.
ii) Minimises loss of monetary control during translation to indirect instruments when transmission
mechanism is uncertain.
Limitations of Bank Rate Policy
The efficacy of the bank rate policy as an instrument of controlling credit is limited by the
following factors:
i)Market Rates do not Change with Bank Rate: The success of the bank rate policy depends upon
the extent to
which other market rates of interest change along with the bank rate. The theory of bank rate
policy presupposes
that other rates of interest prevailing in the money market change in the direction of the change in
the bank rate. If this condition is not satisfied, the bank rate policy will be totally ineffective as an
instrument of credit control.
ii) Wages, Costs, and Prices not Elastic: The success of the bank rate policy requires elasticity not
only in interest rates but also in wages, costs, and prices. It implies that when suppose the bank rate
is raised; wages, costs and prices should automatically adjust themselves to a lower level. But this
was possible only under gold standard. Nowadays the emergence of strong trade unions has made
wages rigid during deflationary trends. And they also lag behind when there are inflationary
tendencies because it takes time for unions to get a wage rise from employers. So the bank rate
policy cannot be a success in a rigid society.
iii) Banks do not Approach Central Bank: The effectiveness of the bank rate policy as a tool of
credit control is also limited by the behaviour of the commercial banks. It is only if the commercial
banks approach the central bank for rediscounting facilities that this policy can be a success. But
the banks keep with them large amounts of liquid assets and do not find it necessary to approach
the central bank for financial help.
iv) Bills of Exchange not used: As a corollary (outcome) to the above, the effectiveness of the
bank rate policy depends on the existence of eligible bills of exchange. In recent years, the bill of
exchange as an instrument of financing commerce and trade has fallen into disuse. Businessmen
and banks prefer cash credit and overdrafts. This makes the bank rate policy less effective for
controlling credit in the country.
v)Pessimism or Optimism: The efficacy of the bank rate policy also depends on waves of
pessimism or optimism among businessmen. If the bank rate is raised, they will continue to borrow
even at a higher rate of interest if there is boom condition in the economy, and prices are expected
to rise further. On the other hand, a reduction in the bank rate will not induce them to borrow
during periods of falling prices. Thus businessmen are not very sensitive to changes in interest
rates and they are influenced more by business expectations.
vi) Power to Control Deflation Limited: Another limitation of the bank rate policy is that the
power of a central bank to force a reduction in the market rates of interest is limited. For example,
a lowering of bank rate below 3 per cent will not lead to a decline in the market rates of interest
below 3 per cent. So the bank rate policy is ineffective in controlling deflation. It may, however,
control inflationary tendencies by forcing an increase in the market rates of interest.
vii) Level of Bank Rate in Relation to Market Rate: The efficacy of the discount rate policy as an
instrument of credit control depends upon its level in relation to the market rate. If in a boom the
bank rate is not raised to such an extent as to make borrowing costly from the central bank, and it
is not lowered
during a recession so as to make borrowing cheaper from it, it would have a destabilising effect on
economic activity.
viii) Non-Discriminatory: The bank rate policy is non-discriminatory because it does not
distinguish between
productive and unproductive activities in the country.
ix) Not Successful in Controlling BOP Disequilibrium: The bank rate policy is not effective in
controlling balance of payments disequilibrium in a country because it requires the removal of all
restrictions on foreign exchange and movements of international capital.
2. Open Market Operations: It refers broadly to the purchase and sale by the RBI of a variety of
assets, such as foreign exchange, gold, government securities and even company shares. Under the
Open Market Operations, the Central bank seeks to influence the economy either by increasing the
money supply or by decreasing the money supply.
Benefits of Open Market Operation
Benefits of open market operation are as follows:
i)Act as Support to Bank Rate: Open market operations can be used to support the bank rate policy
to make the latter more effective. For example, during the period of depression a lower bank rate
may be accompanied by purchase of securities.
ii) Support to Government Credit: These operations can be used to support government credit. By
buying at the time when the prices of securities are low and selling when they are high, the central
bank can bring about stability in the price of government securities. It can also prepare suitable
conditions for the issue or conversion of -government loans, for example, purchase of securities
will help floating of new loans.
iii) Influence Internal Prices and Wages: These operations influence internal prices and wages and
thus help in influencing, the balance of payments through an inflow or outflow of gold. The selling
of securities, if it succeeds in bringing about a deflationary effect will create conditions for a
favourable balance of trade and payments and for inflow of gold or foreign exchange.
iv) Fulfilling Seasonal Needs: A very important function of the operation is to offset the seasonal
needs of credit expansion and contraction. During the busy season securities may be purchased and
during the slack season, they may be sold out.
Limitations of Open Market Operation
The effectiveness of open market operations as a method of credit control is dependent upon the
existence of a number of conditions, the absence of which limits the full working of this policy:
i)Lack of Securities Market: The first condition is the existence of a large and well-organised
security market. This condition is very essential for open market operations because without a
well-developed security market the central bank will not be able to buy and sell securities on a
large scale, and thereby influence the reserves of the commercial banks. Further, the central bank
must have enough saleable securities with it.
ii) Cash Reserve Ratio not Stable: The success of open market operations also requires the
maintenance of a stable cash reserve ratio by the commercial bank. It implies that when the central
bank sells or buys securities, the reserves of the commercial banks decrease or increase
accordingly to maintain the fixed ratio. But usually the banks do not stick to the legal minimum
reserve ratio and keep a higher ratro than this. This makes open market operations less effective in
controlling the volume of credit.
iii) Penal Bank Rate: According to Prof. Aschheim, one of the necessary conditions for the success
of open market operations is a penal bank rate. If there is no penal discount rate fixed by the
central bank, the commercial banks can increase their borrowings from it when the demand for
credit is strong on the part of the latter. In this situation, the scale of securities by the central bank
to restrict monetary expansion will be unsuccessful. But if there is a penal rate of discount, which
is a rate higher than the market rates of interest, the banks will be reluctant to approach the central
bank for additional financial help easily.
iv) Banks Act Differently: Open market operations are successful only if the people also act the
way the central bank expects them. When the central hank sells securities, it expects the business
community and financial institutions to restrict the use of credit. If they simultaneously start
dishoarding money, the act of selling securities by the central banks will not be a success in
restricting credit. SImilarly, the purchase of securities by the central bank will not be effective if
people start hoarding money.
v)Pessimistic or Optimistic Attitude: Pessimistic or optimistic attitude of the business community
also limits the operation of open market policy. When the central bank purchases securities and
increases the supply of bank money, businessmen may be unwilling to take loans during a
depression because of the prevailing pessimism among them. As aptly put by Crowther, banks may
place plenty of water before the public horse, but the horse cannot be forced to drink, if it is afraid
of loss through drinking water. On the other hand, if businessmen are optimistic during a boom,
the sale of securities by the central bank to contract the supply of bank money and even the rise in
market rates cannot discourage them from getting loans from the banks. On the whole, this policy
is more successful in controlling booms than depressions.
vi) Velocity of Credit Money not Constant: The success of open market operations depends upon a
constant velocity of circulation of bank money. But the velocity of credit money is not constant. It
increases during periods of brisk business activity and decreases in periods of falling prices. Thus a
policy of contracting credit by the sale of securities by the central bank maynot be successful by
increased velocity of circulation of bank credit. Despite these limitations, open market operations
are more effective than the other instruments of credit control available with the central bank. This
method is being successfully used for controlling credit in developed countries Variations in the
Reserve Requirement: The Reserve Bank also uses the method of variable reserve requirements to
control credit in India. By changing the ratio, the Reserve Bank seeks to influence the credit
creation power of the commercial banks. These requirements are of two types:
',
.
i)Cash Reserve Ratio :Refers to that portion of total deposits of a commercial bank which it has to
keep
with the Reserve Bank in the form Of cash reserves. The Reserve Bank is empowered to vary this
ratio between 3 percent and 15 per cent of the total demand and time liabilities. "
~
ii) Statutory Liquidity Ratio (SLR): It refers to that portion of total deposits of a commercial bank,
which it has to keep with itself in the form of liquid assets. The SLR is fixed percentage for entire
net demand and time liabilities of the scheduled commercial banks.
Limitations of Variable Reserve Ratio
The variable reserve ratio as a method of credit control has a number of limitations:
i)Excess Reserves: The commercial banks usually possess large excessive reserves which make the
policy of variable reserve ratio ineffective. When the banks keep excessive reserves, an increase in
the reserve ratio will not affect their lending operations. They will stick tq the legal minimum
requirements of cash to deposits and at the same time continue to create credit on the strength of
the excessive reserves.
ii) -Clumsy Method: It is a clumsy method of credit control as compared with open market
operations. This is because it lacks definiteness in the sense that it is inexact and uncertain as
regards changes not only in the amounts of reserves but also the place where these changes can be
made effective. It is not possible to tell "how much of active or potential reserve base" has been
affected by changes in the reserve ratio. Moreover, the changes in reserves involve far larger sums
than in the case of open market operations.' ;
iii) Discriminatory: It is discriminatory that affects different banks differently. A rise in the
required reserve ratio will not affect those banks which have large excess reserves, On the other
hand, it will hit hard the banks with little or no excess reserves. This policy is also discriminatory
in the sense that non-banking financial intermediaries like cooperative societies, insurance
companies, building societies, development banks, etc., are not affected by variations in reserve
requirements, though they compete with the commercial banks for lending purposes.
iv) Inflexible: This policy is inflexible because the minimum reserve ratio fixed by the central
banks is applicable to banks located in all regions of the country. More credit may be needed in
one region were there is monetary stringency, and it may be superfluous in the other region.
Raising the reserve ratio for all banks is not justified in the former region though it is appropriate
for the latter region.
v)Business Climate: The success of the method of credit control also depends on the business
climate in the economy. If the businessmen are pessimistic about the future, as under a depression,
even a sizable lowering of the reserve ratio will not encourage them to ask for loan. Similarly, if
they are optimistic about profit expectations, a considerable rise in the variable ratio will not
prevent them from asking for more loans from the banks
vi) Stability of Reserve Ratio: The effectiveness of this technique depends upon the degree of
stability of the reserve ratio. If the commercial banks are authorised to keep widely fluctuating
ratio, say 10 per cent to 17 per cent, and change in the upper or lower limit will have no effect on
the credit creation power of the banks.
vii) Depressive Effect: The variable reserve ratio has been criticized for exercising a depressive
effect on the securities market. When the central bank suddenly directs the commercial banks to
increase their reserve ratios, they may be forced to sell securities to maintain that ratio. This
widespread selling of securities will bring down the prices of securities and may even lead to an
utter collapse of the bond market.
viii) Rigid: It is rigid in its operations because it does not distinguish between desired and
undesired credit flows and can affect them equally.
ix) Not for Small Changes: This method is more like an axe than a scalpel. It cannot be used for
day to day and week to week adjustments but can be used to bring about large changes in the
reserve positions of the commercial banks. Thus it cannot help in 'fine tuning' of the money and
credit systems by making small changes.
x)Other Factors: The reserve ratio held by the commercial banks is determined not only by legal
requirements but also by how much they want to hold in relation to their deposits in addition to
such requirements. This, in turn, will depend upon their expectations about future developments,
their competition with other banks, and so on.
4)Repo Rate and Reverse Repo Rate: Whenever the banks have any shortage of funds they can
borrow it from RBI. Repo rate is the rate at which banks borrow rupees from RBI. A reduction in
the repo rate will help banks to get money at a cheaper rate. When the repo rate increases
borrowing from E. BI becomes more expensive. Reverse repo rate is the rate at which Reserve
Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RllI
since their money are in safe hands with a good interest, An increase in reverse repo rate can cause
the banks to transfer more funds to RBI due to these attractive interest rates. It can cause the
money to be drawn out of the banking system.
5)Liquidity Adjustment Facility: It is a tool used in monetary policy that allows banks to borrow
money through
repurchase agreements. This arrangement allows banks to respond to liquidity pressures and is
used by governments to assure basic stability in the financial markets.
II Selective (Qualitative) Methods
The quantitative controls explained above affect indiscriminately all sectors of the economy, which
depend upon bank credit, they control volume of credit but leave the directionary credit completely
free. Selective controls are designed to regulate the direction of credit. These controls, by
distinguished between essential and non-essential uses of bank credit, divert resources to essential
and priority sectors, These are explained below:
1)Rationing of Credit; Credit rationing implies controlling and regulating the purpose for which
bank credit can be used. It generally provides for three things:
i) An overall ceiling on loans & advances for every commercial bank,
ii) ii) Fixing the ratio which the capital of a commercial bank should have, and
iii) Fixing ceilings for specific categories of loans and advances.
Credit rationing is also exercised by placing restrictions on demand of accommodation and
rediscounting facilities for each bank. The central may charge a 'penal rate of interest from banks,
which cross the prescribed limits in relation to their overall liquidity position. This method curtails
the freedom and initiative of the commercial bank.
2)Margin Requirement: The difference between the value of security and the amount borrowed
against this security is known as margin. The RBI is generally empowered to fix margin limits for
various uses of credit which the commercial banks must observe. Margin requirements, while
directly affecting the lender also put a restraint upon the borrower and thus keep-down the volume
of credit. By prescribing different margin requirements for different uses, the central bank can
divert credit to more urgent uses.
Benefits of Margin Requirements
This method of selective credit control has certain merits which make it unique.
i)It is non-discriminatory because it applies equally to borrowers and tenders. Thus it limits both
the supply and
demand for credit simultaneously.
ii) It is equally applicable to commercial banks and non-banking financial intermediaries.
iii) It increases the supply of credit for more productive uses.
iv) It is a very effective anti-inflationary device because it controls the expansion of credit in those
sectors of the economy which breed inflation.
v)It is simple and easy to administer since this device is meant to regulate the use of credit for
specific purposes. But the success of this technique requires that there are no leakages of bank
credit for non-purpose loans to speculators.
Limitations of Margin Requirements
However, a number of leakages have appeared in this method over the years.
i)A borrower may not show any intention of purchasing stocks with his borrowed funds and pledge
other assets as security for the loan. But it may purchase stocks through some other source.
ii) The borrower may purchase stocks with cash which he would normally use to purchase
materials and supplies and then borrow money to finance the materials and supplies already
purchased, pledging the stocks he already has as security for the loan.
iii) Lenders, other than commercial banks and brokers, who are not subject to margin
requirements, may increase their security loans when commercial banks and brokers are being
controlled by high margin requirements. Further, some of these non-regulated lenders may be
getting the funds they lent to finance the purchase of securities from commercial banks themselves.
3)Variable Interest Rates: Variable interest rates charged selectively for different uses, places or
borrowers can
be considered as selective as against a general dear or cheap money policy pursued through
changes in the bank
rate. Ceilings are also provided for rates which commercial banks can charge from the borrowers
for specific
uses.
4)Regulation of Consumer Credit: This is often practiced when there is either abundance or
shortage of certain consumer articles. The regulation includes permitting or banning credit for the
purchase of certain consumer articles, extending or limiting the time for repayment or by lowering
or raising the limit of down payment to meet the situation of depression on recession on the one
hand and inflation on the other.
5)Licensing: The RBI ensures proper regional coverage through licensing. Through this
incidentally is served the cause of selectivity in regional development.
Limitations of Selective Credit Control
Though regarded superior to quantitative credit controls, yet selective credit controls are not free
from certain limitations:
1)Limited Coverage: Like general credit controls, selective credit controls have a limited,
coverage. They are only applicable to the commercial banks but not to non-banking financial
institutions. But in the case of the regulation of consumer credit which is applicable both to
banking and non-banking institutions, it becomes cumbersome to administer this technique.
2)No Specificity: Selective credit controls fail to fulfil the specificity function. There is no
guarantee that the bank loans would be used for the specific purpose for which they are sanctioned.
3)Difficult to Distinguish Between Essential and Non-Essential Factors: It may be difficult for the
central bank to distinguish precisely between essential and non-essential sectors and between
speculative and productive investment for the purpose of enforcing selective credit controls. The
same reasoning applies to the commercial banks for the purpose of advancing loans unless they are
specifically laid down by the central bank.
4)Require Large Staff: The commercial banks, for the purpose of earning large profits, may
advance loans for purposes other than laid down by the central bank. This is particularly so if the
central bank does not have a large staff to check minutely the accounts of the commercial banks.
As a matter of fact, no central bank can afford to check their accounts. Hence selective credit
controls are liable to be ineffective in the case of unscrupulous banks.
5)Discriminatory: Selective controls unnecessarily restrict the freedom of borrowers and lenders.
They also discriminate between different types of borrowers and banks. Often small borrowers and
small banks are hit harder by selective control than big borrowers and large banks.
6)Mal-Allocation of Resources: Selective credit controls also lead to mal-allocation of resources
when they are applied to selected sectors, areas and industries while leaving others to operate
freely. They place undue restrictions on the freedom of the former and affect their production.
Limitations of Monetary Policy
The following are the main limitations of the monetary policy adopted by the Reserve Bank:
1)Limited Scope of Monetary Policy in Economic Development: In reality, the monetary policy
has been assigned only a minor role in the process of economic development. The Reserve Bank is
not given any predominant role in the process of economic development. The Reserve Bank is just
expected to see that the process of economic development should not be hindered for want of
availability of adequate funds. The decision regarding currency to the printed is dictated by finance
ministry to RBI. So RBI has little control overthe supply of money.
2)Limited Role in Controlling Prices: The monetary policy of Reserve Bank has played only a
limited role in controlling the inflationary pressure. Prices are affected by many factors. Money
supply is only one of them. Other factors are beyond the control of monetary policy.
3)Poor Banking Habits: An important limitation of the monetary policy is poor banking habits of
Indian masses. People in India prefer to make use of cash rather than cheques. This means that a
major portion of the cash generally continues to circulate in the economy without coming to the
banks in the form of deposits. This reduces the credit creation capacity of the banks. Due to high
proportion of currency in.
4)Underdeveloped Money Market: Another limitation of monetary policy in India is
underdeveloped money market. Money market is the market where government securities, treasury
bills, RBI's securities, etc., are purchased and sold. The weak money market limits the efficient
working of the monetary policy. The money market comprises of two parts, the organised money
market and unorganised money market. The monetary policy works only in organised money
market. It fails to achieve the desired results in unorganised money market.
5)Existence of Black Money: The existence of black money in the economy limits the working of
the monetary policy. The black money is not recorded since the borrowers and lenders keep their
transactions secret. Government cannot regulate the black money in accordance with the objectives
of monetary policy. So, effectiveness of monetary policy is reduced.
6)Conflicting Objectives: An important limitation of monetary policy arises from its conflicting
objectives. To achieve the objective of economic development the monetary policy is to be
expansionary but contrary to it to achieve the objective of price stability or to curb inflation money
supply has to be contracted. The monetary policy generally fails to achieve a proper balance
between these two conflicting objectives.
7)Lack of Coordination with Fiscal Policy: If monetary policy and fiscal policy are not coordinated
with each other, then they may go against the objectives of each other. If fiscal policy involves
huge deficit financing, then efforts of monetary policy to control money supply will fail. Deficit
financing here means printing of more notes by RBI to give loans to government. Printing of more
notes leads to increase in money supply. RBI cannot regulate the deficit financing, which affects
money supply considerably.
8)Limitations of Monetary Instruments: An important limitation of monetary policy is related to
the inherent limitations of various instruments of credit control. The margin requirements of loans
are already so high, that the scope for further
increase in them is limited. If CRR and SLR are fixed high, then it will badly affect the
profitability of banks. Similarly if CRR and SLR are kept low then it will increase the risk of
banks. These limitations of monetary instruments hamper the smooth working of monetary policy.
.
9)Non-Monetised Sector: In non-monetised sector transactions are conducted through barter
exchange. Money plays no role here. Money supply of the country or interest rate determined by
monetary policy has no effect on the level of economic activity in this non-monetised sector.
10)Lack of Banking Facilities: Banking facilities are not available in some remote areas of the
county. So monetary policy cannot regulate credit in such areas. In such areas, indigenous banks
operate which are not regulated by monetary policy.
11) Persuasive Policy: Some qualitative instruments of credit control like moral persuasion, loans
for priority sector, and loans for weaker sections, etc., are only persuasive and not compulsive in
nature. The banks do not consider these measures seriously.
12)Imbalance in Credit Allocation: The monetary policy ignores the interest of agriculture sector
and small-scale industries. Agriculture does not get the required institutional finance because of
lack of sufficient security. Consequently, it has to depend upon indigenous money lenders to a
considerable extent for its credit needs. Farmers have to pay high rate of interest to the indigenous
bankers. Even in case of industrial sector, large part of funds flow to large industries. Even smallscale industries cannot get much from banks, because of lack of security. Thus monetary policy
has resulted in imbalance in credit allocation.
13)Poor Implementation: Banks do not cooperate with RBI in implementing the monetary policy,
so it hinders the success of monetary policy.
In short, the monetary policy of the Reserve Bank suffers from many limitations. It requires
improvement in many directions. Successful application of monetary policy is not merely a
question of availability of instruments of credit control. It is also a question of judgment with
regard to timing and the degree of restraint required or relaxation needed. However, past
experience shows that Reserve Bank's credit restrictions have always fallen short of the required
extent of restraint. Reserve Bank has adopted a hesitant attitude in the field of monetary control.