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Control of inflation

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Policies to control inflation, Phillip's curve

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Control of inflation

  1. 1. CONTROL OF INFLATION Prof. Prabha Panth, Osmania University, Hyderabad 20-Dec-18
  2. 2. Control of Inflation • Inflation occurs due to mismatch between D and S. • Disequilibrium situation. • Measures to control inflation address: o Reduction in D o Increase in S to correct the disequilibrium • Macro Policy measures include: o Monetary Policy, o Fiscal Policy 2
  3. 3. 1. Monetary Policy • Monetary Policy: policy of the Central Bank, (RBI) • Acts on Government’s orders. • Controls Supply of money with the public, to reduce D. • Based on Quantity theory of Money. o Supply of money with public falls o Demand for goods fall, o Prices fall, inflation is controlled. 3
  4. 4. Instruments of Central Bank • Money supply = cash + credit (bank deposits in commercial and central banks) • To reduce money supply with the public, with the commercial banks, and with government. • Two main instruments of credit control 1. Quantitative Measures, 2. Qualitative Measures 4
  5. 5. 1. Quantitative Measures 1. Bank Rate: • Bank Rate: rate at which CB gives long term credit to commercial banks. No securities needed. o Repo Rate = 8 %. Short term loans by commercial banks from RBI (keeping securities for buy back). o Reverse repo rate= 7%. RBI buys securities from Commercial banks. • During inflation, Bank Rate increases. o Discourages Commercial banks borrowing from CB, o Commercial banks increase own interest rates. o Discourages borrowing by the public, o Encourages savings. 5
  6. 6. 2. Open Market Operations (OMO): • CB buys and sells shares and securities in the Open Market (Stock Exchange). • During inflation, it sells its own shares and securities in the Open Market. • Commercial banks, other financial companies, and public buy them. • This reduces their cash in hand, and credit, • Fall in money supply  D   P  6
  7. 7. 3. Cash Reserve Ratio (CRR): • CB is the Banker’s Bank. • Commercial banks must keep a minimum, at least 3% of their cash deposits with CB. • During inflation, CB increases CRR. (In India CRR = 4.75%) • Cash and credit with Commercial Banks fall. • They reduce their own lending to public. • Fall in money supply  D   P  7
  8. 8. Qualitative or Selective Credit Controls 1. Margin Requirements: Entire loan amount is not given to the borrower. • some % of it is retained by the commercial bank. • During inflation, this ratio is increased by CB. • So loan amount actually given is reduced. • Statutory Liquidity Ratio (SLR): minimum % of deposits that commercial banks have to maintain in form of gold, cash or other approved securities. (23% of deposits). 8
  9. 9. 2. Consumer Credit: loans for buying houses, cars, TV sets, etc is reduced during inflation. Decreases down payments, reduces time for repayment of instalments. 3. Direct Action: against erring banks, who do not follow the CB’s directives. • Will not grant them loans, or help them during exigencies. • Take over or closure of such institutions. • Lesson to others who disobey injunctions. 9
  10. 10. o Monetised economy and money market, o Higher interest rates  luxury goods not affected, pass on higher costs of borrowing to the public. Prices rise. o Investment in Capital formation , growth rate falls. o Small farmers, traders, small and medium scale industries cannot afford higher interest. o Output of essential goods  o Supply , prices  Impact of Monetary Policy: 10
  11. 11. Fiscal Policy 1. Reduce Expenditure: Government cuts down unnecessary expenditure. • Reduces pumping more money into the economy. 2. Increase in Direct Taxes: Income, Profit tax, Property tax, to reduce supply of money. 3. Public Borrowing: Removes cash with the public. High interest rates, gilt edged. 11
  12. 12. Fiscal Policy 4. Increase supply of goods: Government investment, or imports. o In less developed countries, increase in supply more important than controlling demand. o Government investment and encouragement in essential goods production should increase. 5. Control over increase in wages and salaries. 6. Price Controls and rationing. 7. Subsidise essential goods and services. 12
  13. 13. Growth and Inflation • Developing economies: Economic growth is necessary. • Large scale investments in Heavy, Basic, and Infrastructure. • Long gestation lags (time between Investment and production of output). • Ys and D for necessaries increase, not output. • Prices rise. Such investments called Inflation Creating Activities. 13
  14. 14. • To reduce rising prices, investment in quick yielding consumer necessaries required. • E.g. in agriculture, small scale production of consumer goods, housing, etc. • Called Inflation Dampening Activities. • Increase in Supply = increase in D for essentials. • When both are in correct proportions (Balanced Allocation Ratio), then inflation can be controlled. 14
  15. 15. Phillips’s curve • The Phillip’s Curve shows an inverse relationship (trade off) between unemployment and wage inflation. • At full employment, there is competition for labour . • Drives up wage rate. • “Cost Push Inflation”, Ps  to maintain profits. • Workers’ real wages will not increase, as P is . • Again demand a rise in nominal wage rates. • More inflation. 15
  16. 16. The Phillip’s Curve Phillip’s curve Rateofwageinflation% Unemployment rate %0 A 2% B 4% 8% 5% • Unemployment, wage inflation • Or unemployment , inflation  16
  17. 17. • The Phillip’s curve causes a dilemma to governments. o If it reduces unemployment, leads to inflation. o If it tries to control inflation, unemployment increases. • So some acceptable level of both unemployment and inflation should be found. • Phillip’s curve hypothesis broke down, due to stagflation during the 1970’s. • Stagflation: Stagnation (unemployment) + inflation. o Due to increase in international oil prices, o And Ratchet effect of higher wages. 17

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